Chapter 12 Long-Term Liabilities: Bonds and Notes 243
Group Learning Activity—Installment Notes
Ask your students to work in groups to determine the annual payment given the following conditions:
OBJECTIVE 5
Describe and illustrate the reporting of long-term liabilities, including bonds and notes
payable.
SYNOPSIS
Bonds payable and notes payable are reported as liabilities on the balance sheet. Any portion of these
debts that is due within one year is reported as a current liability and the remaining portion is reported as a
long-term liability. The bonds are reported at their carrying or book value. A description of the debt
should be reported in the accompanying notes.
SUGGESTED APPROACH
Use the following notes to review the presentation of bonds payable and notes payable. Refer your
students to Mornin’ Joe’s balance sheet presentation for liabilities in the text for an example of a
consolidated balance sheet that illustrates many of the accounting practices covered in Chapters 6–12.
LECTURE AID—Balance Sheet Presentation of Bonds Payable and Notes
Payable
Ask your students where bonds payable and notes payable are reported on a balance sheet. Unless bonds
and/or notes are due to mature within the next year, they are listed in the Long-Term Liabilities section of
the balance sheet.
244 Chapter 12 Long-Term Liabilities: Bonds and Notes
OBJECTIVE 6
Describe and illustrate how the number of times interest charges are earned is used to
evaluate a company’s financial condition.
SYNOPSIS
As creditors, bondholders are concerned with the company’s ability to pay its interest payments and repay
the maturity value of the bonds. Analysts assess this risk by calculating the number of times interest
charges are earned ratio. It is computed as: number of times interest charges are earned = (income before
income tax + interest expense)/interest expense. This ratio tells the number of times interest payments
could be paid out of current period earnings. This measures the company’s ability to pay its interest
payments.
Key Terms and Definitions
• Number of Times Interest Charges Are Earned – A ratio that measures creditor margin of
safety for interest payments, calculated as income before interest and taxes divided by interest
expense.
Relevant Example Exercises and Exhibits
• Example Exercise 12-9 Number of Times Interest Charges Are Earned
SUGGESTED APPROACH
The number of times interest charges are earned compares the “pool” of money available for interest
payments to a company’s interest expense. The larger the “pool,” the easier it is for a company to meet its
interest payments. The group learning activity below will help your students master this concept.
Chapter 12 Long-Term Liabilities: Bonds and Notes 245
Next, present the formula for number of times interest charges earned:
Income Before Income Tax + Interest Expense
Interest expense
Ask your students to calculate Bates’s number of times interest charges earned. The answer is:
APPENDIX 1—PRESENT VALUE CONCEPTS
AND PRICING BONDS PAYABLE
SYNOPSIS
Investors consider many factors when deciding what they are willing to pay for a bond. Face value,
interest, and market rate of interest are all considered. The investor may also consider the present value of
the bonds’ future cash receipts. This concept is based on the time value of money. To illustrate the present
Key Terms and Definitions
• Annuity – A series of equal cash flows at fixed intervals.
• Future Value – The value of an asset or cash at a specified date in the future that is equivalent in
value to a specified sum today.
• Present Value – Cash to be received (or paid) in the future is not the equivalent of the same
246 Chapter 12 Long-Term Liabilities: Bonds and Notes
Relevant Example Exercises and Exhibits
• Exhibit 5 – Present Value and Future Value
• Exhibit 6 – Present Value of an Amount to Be Received in One Year
SUGGESTED APPROACH—Computation of Present Value of Bonds
Payable
This introduces students to present value concepts used to price bonds. This concept is new to most
accounting principles students, and many find it very difficult. Therefore, you may want to spend time
discussing present value in general before applying this concept to bonds.
2. Calculate the interest payment. Use the bond interest rate for this calculation
4. Add the PV of the lump sum (step 1) to the PV of the annuity (step 3). The results will be the present
value of the bond.
LECTURE AID—Introduction to Present Value
Present the following scenario to your class:
If I told you that I would give you $100 today or $100 one year from now, how many of
you would want the money today? What if I told you that I would give you $100 today or
$105 one year from now? How many of you would wait one year to get an extra $5? If I
offered to pay $110 one year from now, how many would wait one year for an extra $10?
What about $125 in one year? What about $150 in one year?
Chapter 12 Long-Term Liabilities: Bonds and Notes 247
Your students’ comments should provide a good lead-in to a discussion of time value of money.
DEMONSTRATION PROBLEM—Present Value of a Single Sum
One hundred dollars today is more valuable than $100 in the future. You can invest the $100 you have
today and end up with more than $100 in the future.
Ask your students to calculate how much money they would have in one year if they invested $100 and
earned 7 percent interest on their money. (Answer: $107)
Let X = $ to be invested today
X + 0.07X = $100
1.07X = $100
$93.46 is the present value of receiving $100 in one year if interest rates are 7 percent.
Next, ask your students to write down the equation to determine how much they would need to invest to
have $100 in two years, assuming a 7 percent interest rate. After a minute, show them the correct formula.
Therefore,
1.145X = $100
X = $87.34
This calculation gets fairly complex after just two years because of the compounding of interest. Present
value tables, such as the one in Exhibit 4 in the text, were developed as a shortcut. To calculate the
amount needed today to accumulate $100 in two years at 7 percent, the present value factor from the table
for two periods at 7 percent is multiplied by $100.
$100 0.87344 = $87.34
Ask your students to use the table to find the present value of receiving $100,000 ten years from now at 7
percent.
$100,000 0.50835 = $50,835
248 Chapter 12 Long-Term Liabilities: Bonds and Notes
In simple terms, this means that $50,835 invested at 7 percent will grow to $100,000 in ten years.
Finally, ask your students to answer the following question (TM 12-8):
DEMONSTRATION PROBLEM—Present Value of an Annuity
Begin by defining an annuity. An annuity is a series of equal payments at equal intervals (for example,
$100 per year for five years). Ask students for examples of annuities. Examples include insurance and
pension annuities.
Demonstrate the need to calculate the present value of an annuity through the following scenario:
Assume that you have won a sweepstakes with a $5 million grand prize. Now you have to choose how to
take your winnings: $500,000 per year for ten years or $3 million now. If interest rates are 11 percent,
which would you choose?
GROUP LEARNING ACTIVITY—Present Value of an Annuity
TM 12-9 contains additional annuity problems to be solved with present value concepts. One of these
problems requires students to use present value interest factors for a 20-year period. These factors can be
found in the expanded present value tables included in Appendix A of the text.
Chapter 12 Long-Term Liabilities: Bonds and Notes 249
Ask your students to solve the present value problems in small groups. TM 12-10 presents the solutions.
LECTURE AID—Pricing Bonds
The selling price of a bond is determined by the relationship between the bond’s contract interest rate and
the market interest rate when the bond is sold.
If contract rate = market rate, bond sells at face value.
APPENDIX 2—EFFECTIVE INTEREST RATE
METHOD OF AMORTIZATION
SYNOPSIS
The effective interest rate method provides a constant rate of interest over the life of the bond as opposed
to the straight-line method that provides a constant amount of interest expense each period. You may use
the chart in Exhibit 11 to figure the interest expense for each period for bonds sold at a discount. Exhibit
12 shows the varying interest expense for a bond issued at a premium.
Relevant Example Exercises and Exhibits
• Exhibit 11 – Amortization of Discount on Bonds Payable
• Exhibit 12 – Amortization of Premium on Bonds Payable
250 Chapter 12 Long-Term Liabilities: Bonds and Notes
The following comparison of the straight-line and effective interest amortization methods will help your
students distinguish between the two methods:
Straight-Line Method Constant Amount of Interest
DEMONSTRATION PROBLEM—Amortizing a Bond Discount Using the
Effective Interest Method
The easiest way to amortize a bond discount correctly is to set up an amortization table with the following
headings:
Interest Interest
Paid Expense Bond
Interest (based on the (based on the Discount Unamortized Carrying
Payment contract rate) market rate) Amortization Discount Amount
For example, assume a $100,000, two-year, 11 percent bond that makes semiannual interest payments is
sold for $96,574 when the market interest rate is 13 percent. Prepare an amortization table for your
students illustrating all four interest payments. Show each calculation as you step through this table. In
5.5% 6.5% Bond
Interest Interest Interest Discount Unamortized Carrying
Payment Paid Expense Amortization Discount Amount
3,426 96,574
2. When amortizing a discount, make sure that the carrying value of the bond increases after each
interest payment. The carrying value must be raised up to the face value by the last interest payment.
3. When recording the last interest payment, any remaining discount must be amortized.
Point out that interest expense reported on the income statement increases each year as you amortize the
bond discount. This occurs because the bond’s carrying value is increasing. You may also want to
illustrate the journal entry to repay the bond at maturity:
DEMONSTRATION PROBLEM—Amortizing a Bond Premium
The easiest way to amortize a bond premium correctly is to set up an amortization table with the
following headings:
Interest Interest
Paid Expense Bond
Interest (based on the (based on the Premium Unamortized Carrying
Payment contract rate) market rate) Amortization Premium Amount
For example, assume a $250,000, three-year, 13 percent bond that makes semiannual interest payments is
sold for $269,035 when the market interest rate is 10 percent. Start the following amortization table by
computing the premium amortized with the first two interest payments. Also, make the journal entries to
record the first two interest payments. Ask your students to complete the amortization table on their own.
6.5% 5% Bond
Interest Interest Interest Premium Unamortized Carrying
Payment Paid Expense Amortization Premium Amount
19,035 269,035
1 16,250 13,452 2,798 16,237 266,237
2 16,250 13,312 2,938 13,299 263,299
Cash……………………….. 16,250
252 Chapter 12 Long-Term Liabilities: Bonds and Notes
2nd payment: Interest Expense…………………… 13,312
Premium on Bonds Payable……….. 2,938
Cash……………………….. 16,250
Handout 12-1
PRESENT-VALUE PROBLEMS
2. You’ve just accepted a contract to provide services for a client for seven years at a fee of
3. Ellen Saber is contemplating paying several years’ rent on her business office in advance.
4. Craig Jones owns a computer sales and repair business. He has decided to sell maintenance
contracts with new computers that cover all repairs needed within three years of purchase.
On average, each new computer needs $100 in repairs and maintenance per year during the
first three years it is operated. (The $100 is the customer’s cost for maintenance, including
parts, labor, and Craig’s profit.) How much should Craig charge for a maintenance contract
if interest rates are 13 percent?
Type Item Description LO(s) Difficulty Time Est BUSPROG AICPA ACBSP – APC Bloom’s EE Excel GL SMH FAI Service Real W orld Writing Ethics Internet Group
DQ 1 2 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Knowledge
DQ 2 2 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Knowledge
DQ 3 2 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Knowledge
DQ 4 2 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Knowledge
DQ 5 2 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Knowledge
DQ 6 2 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Knowledge
DQ 7 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Knowledge
DQ 8 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Knowledge
DQ 9 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Knowledge
DQ 10 4 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Knowledge
PE 1A Alternative financing plans 1 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 1B Alternative financing plans 1 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 2A Issuing bonds at face amount 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 2B Issuing bonds at face amount 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 3A Issuing bonds at a discount 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 3B Issuing bonds at a discount 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 4A Discount amortization 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 4B Discount amortization 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 5A Issuing bonds at a premium 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 5B Issuing bonds at a premium 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 6A Premium amortization 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 6B Premium amortization 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 7A Redemption of bonds payable 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 7B Redemption of bonds payable 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 8A Journalizing installment notes 4 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 8B Journalizing installment notes 4 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
PE 9A Number of times interest charges are earned 6 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x x
PE 9B Number of times interest charges are earned 6 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x x
EX 1 Effect of financing on earnings per share 1 Easy 10 min. Analytic Measurement Long-term Liabilities Reporting Application x x
EX 2 Evaluate alternative financing plans 1 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
EX 3 Corporate financing 1 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
EX 4 Bond price 3 Easy 10 min. Analytic Measurement Long-term Liabilities Reporting Application x x
EX 5 Entries for issuing bonds 3 Easy 10 min. Analytic Measurement Long-term Liabilities Reporting Application x
EX 6 Entries for issuing bonds and amortizing discount by straight-line method 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
EX 7 Entries for issuing bonds and amortizing premium by straight-line method 2,3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
EX 8 Entries for issuing and calling bonds; loss 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
EX 9 Entries for issuing and calling bonds; gain 3 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
EX 10 Entries for installment note transactions 4 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Application x
EX 11 Entries for installment note transactions 4 Easy 10 min. Analytic Measurement Long-term Liabilities Reporting Application x
EX 12 Entries for installment note transactions 4 Easy 15 min. Analytic Measurement Long-term Liabilities Reporting Application x x
EX 13 Reporting bonds 5 Easy 10 min. Analytic Measurement Long-term Liabilities Reporting Application x
EX 14 Number of times interest charges are earned 6 Easy 10 min. Analytic Measurement Long-term Liabilities Reporting Application x x x
EX 15 Number of times interest charges are earned 6 Easy 10 min. Analytic Measurement Long-term Liabilities Reporting Application x x
EX 16 Number of times interest charges are earned 6 Easy 10 min. Analytic Measurement Long-term Liabilities Reporting Application x x
EX 17 Present value of amounts due Appendix 1 Easy 15 min. Analytic Measurement Long-term Liabilities Reporting Application
EX 18 Present value of an annuity Appendix 1 Moderate 15 min. Analytic Measurement Long-term Liabilities Reporting Application
EX 19 Present value of an annuity Appendix 1 Moderate 15 min. Analytic Measurement Long-term Liabilities Reporting Application
EX 20 Present value of an annuity Appendix 1 Moderate 15 min. Analytic Measurement Long-term Liabilities Reporting Application x
EX 21 Present value of bonds payable; discount Appendix 1 Moderate 15 min. Analytic Measurement Long-term Liabilities Reporting Application
EX 22 Present value of bonds payable; premium Appendix 1 Moderate 15 min. Analytic Measurement Long-term Liabilities Reporting Application
EX 23 Amortize discount by interest method Appendix 2 Moderate 15 min. Analytic Measurement Long-term Liabilities Reporting Application
EX 24 Amortize premium by interest method Appendix 2 Moderate 15 min. Analytic Measurement Long-term Liabilities Reporting Application
EX 25 Compute bond proceeds, amortizing premium by interest method, and interest expense Appendix 1; Appendix 2 Moderate 15 min. Analytic Measurement Long-term Liabilities Reporting Application
EX 26 Compute bond proceeds, amortizing premium by interest method, and interest expense Appendix 1; Appendix 2 Moderate 15 min. Analytic Measurement Long-term Liabilities Reporting Application
PR 1A Effect of financing on earnings per share 1 Moderate 1.5 hours Analytic Measurement Long-term Liabilities Reporting Application x x
PR 2A Bond discount, entries for bonds payable transactions 2,3 Moderate 1 hour Analytic Measurement Long-term Liabilities Reporting Application x x
PR 3A Bond premium, entries for bonds payable transactions 2,3 Moderate 1 hour Analytic Measurement Long-term Liabilities Reporting Application x
PR 4A Entries for bonds payable and installment note transactions 3.4 Moderate 1 hour Analytic Measurement Long-term Liabilities Reporting Application x x x
PR 5A Bond discount, entries for bonds payable transactions, interest method of amortizing bond discount Appendix 1; Appendix 2 Moderate 45 min. Analytic Measurement Long-term Liabilities Reporting Application
PR 1B Effect of financing on earnings per share 1 Moderate 1.5 hours Analytic Measurement Long-term Liabilities Reporting Application x x
PR 4B Entries for bonds payable and installment note transactions 3.4 Moderate 1 hour Analytic Measurement Long-term Liabilities Reporting Application x x x
PR 6B Bond premium, entries for bonds payable transactions, interest method of amortizing bond premium Appendix 1; Appendix 2 Moderate 45 min. Analytic Measurement Long-term Liabilities Reporting Application
CP 1 General Electric bond issuance 2 Easy 5 min. Ethics Industry Long-term Liabilities Reporting Analysis x x x
CP 2 Ethics and professional conduct in business 2 Easy 5 min. Ethics Industry Long-term Liabilities Reporting Analysis x x
CP 3 Present values 2 Easy 10 min. Analytic Measurement Long-term Liabilities Reporting Application x
CP 4 Preferred stock vs. bonds 1 Easy 5 min. Analytic Measurement Long-term Liabilities Reporting Comprehension x
CP 5 Financing business expansion 2 Moderate 30 min. Analytic Measurement Long-term Liabilities Reporting Application x
CP 6 Number of times interest charges are earned 6 Moderate 10 min. Analytic Measurement Long-term Liabilities Reporting Application x x
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