CHAPTER 15
LONG-TERM LIABILITIES
Learning Objectives
1. DESCRIBE THE MAJOR CHARACTERISTICS OF
BONDS.
2. EXPLAIN HOW TO ACCOUNT FOR BOND
TRANSACTIONS.
3. EXPLAIN HOW TO ACCOUNT FOR LONG–TERM NOTES
PAYABLE.
CHAPTER REVIEW
Bonds
1. (L.O. 1) Long-term liabilities are obligations that are expected to be paid after one year. Long-term
liabilities include bonds, long-term notes, and lease obligations.
2. Bonds offer the following advantages over common stock:
a. Stockholder control is not affected.
Types of Bonds
4. Secured bonds have specific assets of the issuer pledged as collateral for the bonds. A mortgage
bond is secured by real estate. Unsecured bonds are issued against the general credit of the
borrower; they are also called debenture bonds.
5. Bonds that mature at a single specified future date are called term bonds. In contrast, bonds that
mature in installments are called serial bonds.
Market Price of Bonds
9. The market price (present value) of a bond is a function of three factors: (a) the dollar amounts to
be received, (b) the length of time until the amounts are received, and (c) the market rate of interest.
The process of finding the present value is referred to as discounting the future amounts.
Bond Issues
10. (L.O. 2) The issuance of bonds at face value results in a debit to Cash and a credit to Bonds
Payable.
a. Over the term of the bonds, entries are required for bond interest.
b. At the maturity date, it is necessary to record the final payment of interest and payment of the
face value of the bonds.
a. If the market (effective) rate of interest is higher than the contractual (stated) rate, the bonds
will sell at less than face value, or at a discount.
b. If the market rate of interest is less than the contractual rate on the bonds, the bonds will sell
above face value, or at a premium.
Bond Issues at a Discount
12. When bonds are issued at a discount,
Bond Issues at a Premium
13. When bonds are issued at a premium,
a. The premium is credited to the account, Premium on Bonds Payable, and it is added to
Bond Redemptions
14. When bonds are redeemed before maturity it is necessary to (a) eliminate the carrying value of
the bonds at the redemption date, (b) record the cash paid, and (c) recognize the gain or loss on
redemption.
Long-term Notes Payable
16. (L.O. 3) A long-term note payable may be secured by a document called a mortgage that pledges
Leases
17. A lease is a contractual agreement between a lessor (owner) and a lessee (renter) that grants the
right to use specific property for a period of time in return for cash payments.
Operating Leases
Capital Leases
19. A capital lease transfers substantially all the benefits and risks of ownership from the lessor to
the lessee.
a. The lessee is required to record an asset and the related liability at the present value of the
future lease payments.
b. The leased asset is reported on the balance sheet under plant assets.
c. The portion of the lease liability to be paid in the next year is a current liability, and the
remainder is classified as a long-term liability.
Presentation and Analysis
21. (L.O. 4) Long-term liabilities are reported in a separate section of the balance sheet immediately
following current liabilities.
22. The debt to assets ratio measures the percentage of the total assets provided by creditors. It is
computed by dividing debt (both current and long-term liabilities) by assets.
Present Value Concepts
*24. The present value is based on three variables: (1) the dollar amount to be received (future
amount), (2) the length of time until the amount is received (number of periods), and (3) the
interest rate (the discount rate).
PV = FV (1 + i)
Present Value of an Annuity
*26. In computing the present value of an annuity, it is necessary to know (1) the discount rate, (2) the
number of interest periods, and (3) the amount of the periodic receipts or payments. When the
Time Periods and Discounting
*27. Present value computations may also be done over shorter periods of time such as monthly,
quarterly, or semiannually. When the time frame is less than one year, it is necessary, to convert
the annual interest rate to the applicable time frame.
Computing the Present Value of a Bond
Straight-Line Method
*29. (L.O. 5) The straight-line method of amortization allocates the same amount of bond discount
each interest period. The formula is:
Bond Discount ÷ Number of Interest Periods = Bond Discount Amortization
30. The straight-line method of amortization allocates the same amount of bond premium each
interest period. The formula is:
Effective-Interest Method
*31. (L.O. 6) The effective-interest method of amortization is an alternative to the straight-line
method. Under this method,
a. Interest Expense is computed first by multiplying the carrying value of the bonds at the
beginning of the period by the effective interest rate.
32. The effective-interest method produces a periodic interest expense equal to a constant percentage
LECTURE OUTLINE
A. Why Issue Bonds?
1. Bonds are sold in relatively small denominations (usually $1,000), and
as a result, they attract many investors.
2. From the standpoint of the corporation seeking long-term financing, bonds
offer the following advantages over common stock:
3. One disadvantage in using bonds is that the company must pay interest
B. Types of Bonds.
1. Bonds may be classified by certain features. Some types of bonds com–
monly issued include:
a. Secured bonds have specific assets of the issuer pledged as collateral
for the bonds. Unsecured bonds are issued against the general credit
of the borrower.
d. Bonds that can be converted into common stock at the bondholder’s
option are convertible bonds. Bonds that the issuing company can
redeem (buy back) at a stated dollar amount prior to maturity are
callable bonds.
2. Issuing procedures.
a. In authorizing the bond issue, the board of directors must stipulate
the number of bonds to be authorized, total face value, and con-
tractual interest rate.
3. Determining the market price of a bond.
a. Present value is the amount that must be invested today at a given
interest rate to have a specified sum of money at a specified date.
b. The current market price (present value) of a bond is the value at
which it should sell in the marketplace. Market price is a function of
the three factors that determine present value:
C. Issuing Bonds at Face Value.
1. When bonds are issued, Cash is debited for the cash proceeds and Bonds
Payable is credited for the face value of the bonds.
3. The entry to accrue bond interest includes a debit to Interest Expense and a
credit to Interest Payable.
D. Issuing Bonds at a Discount or Premium.
1. If the market interest rate is higher than the contractual (stated) rate, the
bonds will sell at a discount (less than face value).
2. If the market interest rate is lower than the contractual (stated) rate on the
bonds, the bonds will sell at a premium (more than face value).
3. The entry to record bonds issued at a discount includes a debit to Cash
for the cash proceeds, a credit to Bonds Payable for the face value of the
bonds, and a debit to Discount on Bonds Payable for the difference.
4. The entry to record bonds issued at a premium includes a debit to Cash
for the cash proceeds, a credit to Bonds Payable for the face value of
the bonds, and a credit to Premium on Bonds Payable for the difference.
a. Companies add the premium on bonds payable to the bonds payable
amount on the balance sheet.
E. Redeeming Bonds Before Maturity.
1. Bonds may be redeemed before maturity because a company may decide
to reduce interest cost and to remove debt from its balance sheet.
2. When a company redeems bonds before maturity, it is necessary to:
a. Eliminate the carrying value of the bonds at the redemption date.
F. Converting Bonds into Common Stock.
1. Convertible bonds give bondholders an opportunity to benefit if the market
price of the common stock increases substantially. For the issuer of
convertible bonds, the bonds sell at a higher price and pay a lower rate
of interest than nonconvertible bonds.
G. Long-Term Notes Payable.
1. Long-term notes payable are similar to short-term interest-bearing notes
payable except that the term of the notes exceeds one year.
H. Lease Liabilities.
1. In an operating lease, the intent is temporary use of the property by the
lessee while the lessor continues to own the property.
3. In a capital lease the company capitalizes the present value of the cash
payments for the lease and records that amount as an asset. A capital
lease is in substance an installment purchase by the lessee.
4. If any one of the following conditions exists, the lessee must record a
lease as an asset (a capital lease):
a. The lease transfers ownership of the property to the lessee.
I. Statement Presentation and Analysis.
1. Companies should report the nature and amount of each long-term debt in
the balance sheet or in the notes accompanying the financial statements.
2. Companies may present summary data in the balance sheet, with detailed
data (interest rates, maturity dates, conversion privileges, and assets pledged
as collateral) shown in a supporting schedule.
3. Companies report the current maturities of long-term debt under current
liabilities if they are to be paid within one year or the operating cycle,
whichever is longer.
INVESTOR INSIGHT
In many corporate loans the lending agreement specifies debt convenants—
specific financial measures that a company must maintain during the life of the
loan. Covenants protect lenders because they enable lenders to step in and try to
get their money back before the borrower gets too deep into trouble.
How can financial ratios such as those covered in this chapter provide protection
for creditors?
Answer: Financial ratios such as the current ratio, debt to total assets ratio, and
the times interest earned ratio provide indications of a company’s
*J. Present Value a Single Amount.
1. The present value of the future amount is the value today of a future amount
to be received (or paid), assuming compound interest.
2. The present value of the future amount can be computed using the following
formula:
3. Another way to compute the present value of a single future amount is to
use Table 1, which shows the present value of 1 for n periods.
*K. Present Value of Interest Payments (Annuities).
1. The present value of an annuity is the value today of a series of future
amounts to be received (or paid), assuming compound interest.
2. In order to compute the present value of an annuity, one needs to know the:
a. interest rate.
b. number of interest periods.
*L. Computing the Present Value of a Bond.
1. The present value (or market price) of a bond is a function of the:
a. payment amounts.
b. length of time until the amounts are paid.
c. interest (discount) rate.
2. The payment amounts (dollars to be paid) are made up of two elements:
3. To compute the present value of the bond, one must discount both the
interest payments and the principal amount.
a. Multiply the principal amount by the appropriate present value
factor from Table 1.
*M. Straight-Line Amortization.
1. The straight-line method of amortization results in a constant amount of
amortization and interest expense per period.
2. Bond interest expense is computed by adding (subtracting) the bond
discount (premium) amortization per period to (from) the interest to be
paid.
*N. Effective-Interest Method of Bond Amortization.
1. Under the effective-interest method of amortization, the amortization of bond
discount or bond premium results in periodic interest expense equal to a
constant percentage of the bonds’ carrying value.
2. The effective-interest method results in varying amounts of amortization
and interest expense per period. Companies compute:
3. When the difference between the straight-line method and the effective-
interest method of amortization is material, GAAP requires the use of the
effective-interest method.
IFRS
A Look at IFRS
IFRS and GAAP have similar definitions of liabilities. IFRSs related to reporting
and recognition of liabilities are found in IAS I (revised) (“Presentation of
Financial Statements”) and IAS 37 (“Provisions, Contingent Liabilities, and
Contingent Assets”).
KEY POINTS
• As indicated in Chapter 11, in general GAAP and IFRS define liabilities
similarly.
• IFRS requires that companies classify liabilities as current or noncurrent on
the face of the statement of financial position (balance sheet), except in
industries where a presentation based on liquidity would be considered to
provide more useful information (such as financial institutions). When
current liabilities (also called short-term liabilities) are presented, they are
generally presented in order of liquidity.
• The basic calculation for bond valuation is the same under GAAP and
IFRS. In addition, the accounting for bond liability transactions is essentially
the same between GAAP and IFRS.
• IFRS requires use of the effective-interest method for amortization of bond
discounts and premiums. GAAP also requires the effective-interest method,
except that it allows use of the straight-line method where the difference is
not material. Under IFRS, companies do not use a premium or discount
account but instead show the bond at its net amount.
• The accounting for convertible bonds differs between IFRS and GAAP. Unlike
GAAP, IFRS splits the proceeds from the convertible bond between an equity
component and a debt component. The equity conversion rights are reported in
equity.
LOOKING TO THE FUTURE
The FASB and IASB are currently involved in two projects, each of which has
implications for the accounting for liabilities. One project is investigating
approaches to differentiate between debt and equity instruments. The other
project, the elements phase of the conceptual framework project, will evaluate
the definitions of the fundamental building blocks of accounting. The results of
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. A bond that matures at a single specified future date is called a secured bond.
True False
2. Transactions between a bondholder and other investors are journalized by the issuing
corporation.
True False
3. Bondholders have voting rights and retain full control of the company.
True False
4. The amount that must be invested today at current interest rates in order to receive a
specified sum of money at a specified date is the present value.
True False
5. When bonds are issued at face value, the debit to Cash is equal to the credit to Bonds
Payable.
True False
6. Bonds with a higher contractual interest rate than the market rate for similar bonds will
sell at a discount.
True False
7. The sale of bonds above face value causes the total cost of borrowing to be more than
the bond interest paid.
True False
8. Under a capital lease, Rent Expense should be recorded each period.
True False
*9. Under the straight-line method of amortization, the amortization of a bond premium will
increase each year over the life of the bond.
True False
*10. Under the effective-interest method, the amortization of a bond discount will result in an
increasing interest expense each year over the life of the bond.
True False
Multiple Choice
1. The total cost of borrowing on a 10-year, 9%, $1,000 bond that is sold for $960 is
a. $960.
b. $940.
c. $860.
d. $870.
2. A $2,000,000 bond issue with a carrying value of $2,080,000 is called at 103 and retired.
Which of the following is true?
a. A gain of $80,000 is recorded.
b. A loss of $20,000 is recorded.
c. A gain of $20,000 is recorded.
d. No gain or loss is recorded.
3. If bonds payable are issued at a discount, the contractual interest rate is
a. higher than the market rate of interest.
b. lower than the market rate of interest.
c. equal to the market rate of interest.
d. changed to reflect the market rate of interest.
*4. Caldwell Company issued 8%, 10-year bonds that pay interest semiannually. The market
rate of interest for such bonds is 10%. In computing the market price of these bonds, the
appropriate interest rate is
a. 10%.
b. 8%.
c. 5%.
d. 4%.
*5. When the effective-interest method is used, the interest expense for the period is calculated by
multiplying the
a. face value of the bonds at the beginning of the period by the contractual interest rate.
b. carrying value of the bonds at the beginning of the period by the contractual interest
rate.
c. face value of the bonds at the beginning of the period by the effective rate.
d. carrying value of the bonds at the beginning of the period by the effective rate.
ANSWERS TO QUIZ
True/False
1. False 6. False
2. False 7. False
Multiple Choice
1. b.