Chapter 09 – Long-Term Liabilities
9-1
Chapter 9
Long-Term Liabilities
INSTRUCTOR’S MANUAL
Learning Objectives
LO9-1 Explain financing alternatives.
LO9-2 Account for installment notes payable.
LO9-3 Understand the balance sheet effects of operating and capital leases.
LO9-4 Identify the characteristics of bonds.
LO9-5 Determine the price of a bond issue.
LO9-6 Account for the issuance of bonds.
LO9-7 Record the retirement of bonds.
Analysis
LO9-8 Make financial decisions using long-term liability ratios.
Chapter 09 – Long-Term Liabilities
9-2
Teaching Suggestions
Historically, long-term liabilities, especially bonds, are one of the toughest topics in a financial
accounting course. Some financial accounting textbooks combine current and long-term
liabilities into one chapter, opting to skim over the topics related to long-term liabilities. We
redesigned the chapter to provide instructors flexibility in the coverage of long-term liabilities.
Instructors who prefer an overview of long-term liabilities including installment notes, leases,
and bonds can just cover Part A. Instructors who prefer more detailed coverage of bonds can also
cover Part B (Pricing a Bond) and/or Part C (Recording Bonds Payable).
Chapters 4–12 focus on a separate underlying industry theme. Chapter 9 focuses on
amusement parks as these companies tend to carry a very high level of debt. References to Six
Flags and Cedar Fair are made in the feature story and continue periodically throughout the
chapter. The end-of-chapter material and supplements continue the amusement park theme.
Chapter 9 starts with the basic accounting equation to contrast debt financing with equity
financing. Students need to understand the advantages and disadvantages of borrowing money
(debt financing) in comparison to obtaining additional investment from stockholders (equity
financing). Part A provides an overview of long-term debt including coverage of installment
notes (car loans and home loans), leases, and bonds.
Part B is a stand-alone section explaining how bond prices are determined. As a separate
section, Part B allows instructors flexibility to choose whether to include the topic of bond
pricing in reading and homework assignments. Some instructors feel strongly that students need
to understand how to price a bond and that pricing a bond provides a key example of present
value concepts. Other instructors feel equally strong that bond pricing is better left for finance
and intermediate accounting courses. The chapter is designed to leave the choice up to you. Bond
pricing is shown using a financial calculator, Excel spreadsheets, and present value tables, as
instructors use all three methods.
Part C illustrates the recording of bonds issued at face value, at a discount, and at a premium.
Interest expense is calculated based on the effective interest method, as this is GAAP. We do not
cover the straight-line interest method, as this method is not true GAAP, and introducing
multiple methods adds confusion for students. Part C concludes with recording the retirement of
bonds, including a decision maker’s perspective explaining why a company may choose to buy
back debt early.
The chapter concludes with a debt analysis using the actual financial statements of Coca-
Cola and PepsiCo. PepsiCo’s higher leverage increases risk. In good times, PepsiCo’s higher
leverage results in a higher return to investors. However, in down times, their higher leverage
results in a lower overall return to investors.
Chapter 09 – Long-Term Liabilities
9-3
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Questions
Learning
Objective(s)
Topic
Time
(Min.)
1
LO9-1
Define capital structure
5
2
LO9-1
Compare borrowing with issuing stock
5
3
LO9-2
Relate interest expense to the carrying value of an
installment note with fixed monthly payments
5
4
LO9-3
Explain the difference between an operating lease
and a capital lease
5
5
LO9-4
Describe bond issue costs
5
6
LO9-4
Compare borrowing from a bank to issuing bonds
5
7
LO9-4
Contrast bond characteristics
5
8
LO9-4
Define convertible bonds and explain how they
might benefit the investor and the issuer
5
9
LO9-5
Explain how to calculate the issue price of bonds
5
10
LO9-5
Describe the difference in bond terms
5
11
LO9-5
Explain the relationship between the stated interest
rate and the market interest rate for bonds issued at
a discount
5
12
LO9-5
Explain the relationship between the stated interest
rate and the market interest rate for bonds issued at
a premium
5
13
LO9-5
Calculate the interest payment for a bond issue
5
14
LO9-5
Calculate the issue price of bonds
5
15
LO9-6
Explain the relationship between the carrying value
of bonds payable and the amount recorded for
interest expense for bonds issued at a discount
5
16
LO9-6
Explain the relationship between the carrying value
of bonds payable and the amount recorded for
interest expense for bonds issued at a premium
5
17
LO9-6
Describe how the columns in an amortization
schedule are calculated
5
18
LO9-7
Explain why a company would choose to buy back
bonds before their maturity date
5
19
LO9-7
Describe the entry to record the early retirement of
bonds
5
20
LO9-8
Describe the potential risks and rewards of carrying
additional debt
5
Chapter 09 – Long-Term Liabilities
9-4
Brief
Exercises
Learning
Objective(s)
Topic
Time
(Min.)
BE9-1
LO9-2
Record installment notes
10
BE9-2
LO9-4
Explain the conversion feature of bonds
5
BE9-3
LO9-5
Calculate the issue price of bonds
5
BE9-4
LO9-5
Calculate the issue price of bonds
5
BE9-5
LO9-5
Calculate the issue price of bonds
5
BE9-6
LO9-6
Record bond issue and related semiannual interest
10
BE9-7
LO9-6
Record bond issue and related semiannual interest
10
BE9-8
LO9-6
Record bond issue and related semiannual interest
10
BE9-9
LO9-6
Record bond issue and related annual interest
10
BE9-10
LO9-6
Record bond issue and related annual interest
10
BE9-11
LO9-6
Record bond issue and related annual interest
10
BE9-12
LO9-6
Calculate interest expense
5
BE9-13
LO9-6
Calculate interest expense
5
BE9-14
LO9-6
Interpret a bond amortization schedule
5
BE9-15
LO9-6
Interpret a bond amortization schedule
5
BE9-16
LO9-7
Record early retirement of bonds issued at a
discount
5
BE9-17
LO9-7
Record early retirement of bonds issued at a
premium
5
BE9-18
LO9-8
Calculate ratios
15
Exercises
Learning
Objective(s)
Topic
Time
(Min.)
E9-1
LO9-1
Compare financing alternatives
10
E9-2
LO9-2
Record installment notes
15
E9-3
LO9-3
Compare operating and capital leases
20
E9-4
LO9-4
Match bond terms with their definitions
10
E9-5
LO9-5
Calculate the issue price of bonds
15
E9-6
LO9-5
Calculate the issue price of bonds
15
E9-7
LO9-6
Record bonds issued at face amount
10
E9-8
LO9-6
Record bonds issued at a discount
20
E9-9
LO9-6
Record bonds issued at a premium
20
E9-10
LO9-6
Record bonds issued at face amount
10
E9-11
LO9-6
Record bonds issued at a discount
20
E9-12
LO9-6
Record bonds issued at a premium
20
E9-13
LO9-6
Record bonds issued at face amount with interest
payable annually
20
E9-14
LO9-6
Record bonds issued at a discount with interest
payable annually
20
E9-15
LO9-6
Record bonds issued at a premium with interest
payable annually
20
E9-16
LO9-7
Record the retirement of bonds
20
E9-17
LO9-7
Record the retirement of bonds
20
9-5
E9-18
LO9-8
Calculate and analyze ratios
20
E9-19
LO9-2, 9-8
Complete the accounting cycle using long-term
liability transactions
60
Problems
Learning
Objective(s)
Topic
Time
(Min.)
P9-1A
LO9-2
Record and analyze installment notes
25
P9-2A
LO9-3, 9-8
Explore the impact of leases on the debt to equity
ratio
25
P9-3A
LO9-5, 9-6
Calculate the issue price of a bond and prepare
amortization schedules
30
P9-4A
LO9-6
Record bond issue and related interest
30
P9-5A
LO9-6
Understand a bond amortization schedule
15
P9-6A
LO9-6
Prepare a bond amortization schedule and record
transactions for the bond issuer
20
P9-7A
LO9-8
Calculate and analyze ratios
30
P9-1B
LO9-2
Record and analyze installment notes
25
P9-2B
LO9-3, 9-8
Explore the impact of leases on the debt to equity
ratio
25
P9-3B
LO9-5, 9-6
Calculate the issue price of a bond and prepare
amortization schedules
30
P9-4B
LO9-6
Record bond issue and related interest
30
P9-5B
LO9-6
Understand a bond amortization schedule
15
P9-6B
LO9-6
Prepare a bond amortization schedule and record
transactions for the bond issuer
20
P9-7B
LO9-8
Calculate and analyze ratios
30
Additional
Perspectives
Topic
Time
(Min.)
AP9-1
Continuing Problem: Great Adventures
20
AP9-2
Financial Analysis: American Eagle Outfitters, Inc.
25
AP9-3
Financial Analysis: The Buckle, Inc.
25
AP9-4
Comparative Analysis: American Eagle Outfitters, Inc. vs. The
Buckle, Inc.
25
AP9-5
Ethics
25
AP9-6
Internet Research
20
AP9-7
Written Communication
15
AP9-8
Earnings Management
30
Chapter 09 – Long-Term Liabilities
9-6
Chapter Quiz Questions
The following multiple-choice questions are 10 unique quiz questions that correspond to the 10
questions at the end of each chapter. Each question covers the same learning objective but with a
little different twist. The correct answer is highlighted in bold for each item.
LO9-1
1. Which of the following is not a common long-term debt?
LO9-3
2. Which of the following leases is simply a rental?
LO9-4
3. Bonds can be secured or unsecured. Likewise, bonds can be term or serial bonds. Which is
more common?
LO9-4
4. Convertible bonds:
a. Provide potential benefits only to the lender.
LO9-5
5. Bonds issued at a discount are:
a. Issued above face value.
9-7
LO9-6
6. Which of the following is true for bonds issued at a premium?
LO9-6
7. The cash paid for interest on bonds payable is calculated as:
a. Face amount times the stated interest rate.
LO9-6
8. When bonds are issued at a premium, what happens to the carrying value and interest
expense over the life of the bonds?
LO9-7
9. Douglas County Fairgrounds retires a $50 million bond issue when the carrying value of the
bonds is $52 million, but the market value of the bonds is only $47 million. The entry to
LO9-8
10. Financial leverage is best measured by which of the following ratios?
Chapter 09 – Long-Term Liabilities
9-8
Alternate Let’s Review
Problem #1
Assume that on January 1, 2018, Adventure Island issues $500,000 of 8% bonds, due in 10
years, with interest payable semi-annually on June 30 and December 31 each year.
Required:
1. If the market rate is 8%, will the bonds issue at face amount, a discount, or a premium?
Calculate the issue price.
2. If the market rate is 9%, will the bonds issue at face amount, a discount, or a premium?
Calculate the issue price.
3. If the market rate is 7%, will the bonds issue at face amount, a discount, or a premium?
Calculate the issue price.
Solution:
1. If the market rate is 8%, the bonds will issue at face amount.
Calculator Input
Bond
Characteristics
Key
Amount
Calculator Output
$228,195
Chapter 09 – Long-Term Liabilities
9-9
Calculator Input
Bond
characteristics
Key
Amount
1. Face amount
FV
$500,000
2. Interest payment each period
3. Market interest rate each period
4. Periods to maturity
N
Calculator Output
Issue price
PV
$467,480
Present value of principal = $500,000 x 0.41464*
$207,321
Present value of interest payments = $20,0001 x 13.00794**
$467,480
3. If the market rate is 7%, the bonds will issue at a premium. The only change we make is that
now I = 3.5%.
Calculator Input
Bond
characteristics
Key
Amount
1. Face amount
FV
$500,000
2. Interest payment each period
3. Market interest rate each period
4. Periods to maturity
N
Calculator Output
Issue price
PV
$535,531
Present value of principal = $500,000 x 0.50257*
$251,285
Present value of interest payments = $20,0001 x 14.21240**
9-10
Problem #2
Assume that on January 1, 2018, Adventure Island issues $500,000 of 8% bonds, due in 10
years, with interest payable semi-annually on June 30 and December 31 each year.
Required:
1. If the market rate is 8%, the bonds will issue at $500,000. Record the bond issue on January
1, 2018, and the first two semi-annual interest payments on June 30, 2018, and December 31,
2018.
2. If the market rate is 9%, the bonds will issue at $467,480. Record the bond issue on January
1, 2018, and the first two semi-annual interest payments on June 30, 2018, and December 31,
2018.
3. If the market rate is 7%, the bonds will issue at $535,531. Record the bond issue on January
1, 2018, and the first two semi-annual interest payments on June 30, 2018, and December 31,
2018.
Solution:
1.
January 1, 2018
Debit
Credit
Cash
June 30, 2018
Interest Expense
20,000
20,000
December 31, 2018
Interest Expense
20,000
20,000
2.
January 1, 2018
Debit
Credit
Cash
Discount on Bonds Payable
32,520
June 30, 2018
Interest Expense ($467,480 x 9% x ½)
21,037
December 31, 2018
Chapter 09 – Long-Term Liabilities
9-11
Interest Expense ([$467,480 + 1,037] x 9% x ½)
21,083
Discount on Bonds Payable (difference)
3.
January 1, 2018
Debit
Credit
Cash
535,531
Bonds Payable
500,000
Premium on Bonds Payable
Interest Expense ($535,531 x 7% x ½)
Premium on Bonds Payable (difference)
December 31, 2018
Interest Expense ([$535,531 – 1,256] x 7% x ½)
Premium on Bonds Payable (difference)
Chapter 09 – Long-Term Liabilities
9-12
Key Points by Learning Objective
LO9-1 Explain financing alternatives.
LO9-2 Account for installment notes payable.
LO9-3 Understand the balance sheet effects of operating and capital leases.
LO9-4 Identify the characteristics of bonds.
The distinguishing characteristics of bonds include whether they are backed by collateral
LO9-5 Determine the price of a bond issue.
LO9-6 Account for the issuance of bonds.
When bonds issue at face amount, the carrying value and the corresponding interest expense
LO9-7 Record the retirement of bonds.
Chapter 09 – Long-Term Liabilities
9-13
Analysis
LO9-8 Make financial decisions using long-term liability ratios.
The debt to equity ratio is a measure of financial leverage. Assuming more debt (higher leverage)
Chapter 09 – Long-Term Liabilities
9-14
Common Mistakes
Common Mistake
The interest rate we use to calculate the bond issue price is always the market rate, never the
stated rate. Some students get confused and incorrectly use the stated rate to calculate present
Common Mistake
Students sometimes incorrectly record interest expense using the stated rate rather than the
Chapter 09 – Long-Term Liabilities
9-15
Decision Points
Question
Accounting Information
Analysis
How do you
determine a
company’s capital
Balance sheet
A debt capital structure would have a
higher portion of liabilities relative to
stockholders’ equity. An equity
Question
Accounting Information
Analysis
obligations related to
the financial statements
sheet but are disclosed in the notes to
Does the company
have significant
Disclosure of lease
commitments in the notes to
Operating lease commitments are not
reported as liabilities on the balance
Question
Accounting Information
Analysis
Which company has
higher leverage?
Debt to equity ratio
Question
Accounting Information
Analysis
Debt to equity is a measure of
financial leverage. Companies with
Chapter 09 – Long-Term Liabilities
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Career Corner
Career Corner
Financing alternatives, capital structure, notes, leases, and bonds are topics covered in both
accounting and finance. How do you decide whether to major in accounting or finance? Some
Chapter 09 – Long-Term Liabilities
9-17
Ethical Dilemma
Ethical Dilemma
On January 1, 2017, West-Tex Oil issued $50 million of 8% bonds maturing in 10 years. The
market interest rate on the issue date was 9%, which resulted in the bonds being issued at a
discount. In December 2018, Tex Winters, the company CFO, notes that in the two years since
the bonds were issued, interest rates have fallen almost 3%. Tex suggests that West-Tex might
consider repurchasing the 8% bonds and reissuing new bonds at the lower current interest rates.
Another executive, Will Bright, asks, “Won’t the repurchase result in a large loss to our
financial statements?” Tex agrees, indicating that West-Tex is likely to just meet earnings targets
for 2018. The company would probably not meet its targets with a multimillion-dollar loss on a
bond repurchase. However, 2019 looks to be a record-breaking year. They decide that maybe
they should wait until 2019 to repurchase the bonds.
How could the repurchase of debt cause a loss to be reported in net income? Explain how the
repurchase of debt might be timed to manage reported earnings. Is it ethical to time the
repurchase of bonds to help meet earnings targets?
Bond prices move in the opposite direction of interest rates. When interest rates decrease, bond
prices increase. This makes the debt more expensive, resulting in a loss on repurchase equal to
the difference between the higher repurchase price and the current carrying value of the bonds.
Key Issues
• Is it ethical to time the repurchase of bonds to help meet earnings targets?
• More broadly, when is it acceptable and when is it not acceptable to time accounting
practices to meet earnings targets?