Chapter 10
Long-Term Liabilities
After studying this chapter, students should be able to:
◼ Identify the components of the Long-Term Liability category of the balance sheet
(Module 1–LO1).
◼ Define the important characteristics of bonds payable (Module 1–LO2).
◼ Determine the issue price of a bond using compound interest techniques (Module 1–LO3).
INSTRUCTOR’S MANUAL
10-2
Chapter Outline
MODULE 1 LONG-TERM LIABILITIES INCLUDING BONDS
PAYABLE
Module 1
LO 1
Long-Term Liabilities Including Bonds Payable
Long-term liabilities are obligations that will not be satisfied within one year or the current operating cycle.
◼ All liabilities that are not classified as current liabilities are long-term.
Module 1
LO 2
Bonds Payable: Characteristics
A bond is a security or financial instrument that allows firms to borrow large sums of money and repay the
loan over a long period of time.
◼ Bonds are sold, or issued to investors who want a return on their investment.
◼ Borrower (issuing firm) promises to pay interest on specific dates, usually semiannually or
annually.
CHAPTER 10 LONG-TERM LIABILITIES
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• Collateral represents the assets that back secured bonds in the event the issuer defaults on
principal and interest payments.
• Due date is the due (maturity) date in which the bond principal must be paid.
Term bond has the entire principal due on a specific date.
• Other features of bonds.
Convertible bonds can be converted into common stock at a future time.
• Investor buys a security that pays a fixed interest rate but can be converted into stock
(equity) if the issuing firm is growing and profitable.
Module 1
LO 3
Issuance of Bonds
Factors Affecting Bond Price
Two rates of interest apply to bonds :
◼ Face rate of interest (also called stated rate, nominal rate, contract rate, or coupon rate) is the rate
specified on the bond certificate; determines the cash to be paid each interest period.
• Cash interest payment = face rate of interest × face value of bond.
◼ Market rate of interest (also called the effective rate or bond yield) is the rate bondholders could
obtain from investing in other bonds that are similar to the issuing firm’s bonds.
INSTRUCTOR’S MANUAL
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◼ Bond issue price is determined by the relationship between face rate and market rate of interest,
and the market’s perception of risk.
• See Example 10-1 for calculating bond issuance at a discount.
NOTE: 1. The issue price of a bond is always calculated using the market rate of interest.
2. The face rate of interest determines the amount of interest payments.
◼ Exhibit 10-3 shows how bonds are listed on the bond market.
Module 1
LO 4
Premium or Discount on Bonds
Premium or discount represents the difference between the face value and the issuance price of the bond.
◼ Premium = Issue Price minus the Face Value.
◼ Discount = Face Value minus the Issue Price.
• Occurs when the market rate of interest exceeds the face rate.
• Discount on Bonds Payable is a deduction to the bonds payable liability and thus is a contra
liability account.
◼ Bonds issued at a premium. (Example 10-2)
• Occurs when the face rate of interest exceeds the market rate.
• Premium is the excess of the issue price over the face value of the bonds.
CHAPTER 10 LONG-TERM LIABILITIES
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◼ It can be determined if the bond will sell at a premium or a discount by the relationship that exists
between the face rate and the market rate of interest.
SUMMARY:
1. If market rate = face rate, bonds are issued at face value amount.
2. If market rate > face rate, bonds are issued at a discount.
3. If market rate < face rate, bonds are issued at a premium.
MODULE 2 BOND AMORTIZATION AND BOND RETIREMENT
Module 2
LO 5
Bond Amortization and Retirement
Amortization of premium or discount on bonds payable allocates the difference in interest rates (face and
market rates) over the life of the bond, so that interest expense each period reflects the effective rate, or the
market rate, of the borrowing.
◼ The amount of interest expense that should be reflected on the income statement for bonds payable
is the true, or effective, interest.
Effective Interest Method: Impact on Expense
The effective interest method amortizes the discount or premium in a manner that produces a constant
effective interest rate from period to period.
INSTRUCTOR’S MANUAL
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◼ This method results in a different dollar amount of interest every period, but the same rate of
interest every period.
• This is referred to as the effective interest rate and is equal to the market rate of interest at the
◼ Carrying value (book value) of a bond is the face value of a bond plus the amount of unamortized
premium or minus the amount of unamortized discount.
• Carrying Value = Face Value minus Unamortized Discount.
• Carrying Value = Face Value plus Unamortized Premium.
◼ Amortization tables are used for the effective interest method. Exhibit 10-4 illustrates an
amortization table for a bond issued at a discount:
• Column 1 Cash Interest = Bond Face Value × Face Rate.
◼ In analyzing the bond amortization table:
• Amount of interest expense changes each year because the carrying value changes as the
discount is amortized.
◼ Recording the amortization of discount (Example 10-3):
• Debit Interest Expense, credit Cash and credit Discount on Bonds Payable.
Assets decrease, liabilities increase, and expenses increase. This causes net income and
stockholders’ equity to decrease.
◼ Understanding the amortization tables for bond premiums (Exhibit 10-5).
• Amortization of a premium has an impact opposite that of the amortization of a discount.
CHAPTER 10 LONG-TERM LIABILITIES
Column 4 Carrying value = Previous year’s carrying value less premium amortized in
column 3.
• The cash interest in Column 1 exceeds the interest expense in Column 2.
Therefore the Premium amortized (Column 3) equals the cash interest less the interest
expense.
NOTE: Reference can be made to the concept of the time value of money learned in
Chapter 9.
Module 2
LO 6
Redemption of Bonds
◼ Redemption refers to retirement of bonds by repayment of the principal.
◼ If bonds are retired on their due date:
Retired Early at a Gain or Loss
◼ A firm may want to retire bonds before their due date if:
• Excess cash is available, and the company thinks it is best used to repay outstanding bond
obligations.
INSTRUCTOR’S MANUAL
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• Amount of any unamortized premium or discount on the bonds must be considered when
bonds retired early.
• Calculating a loss on bond redemption ( Example 10-6):
Gain or loss can be calculated in two steps:
• Calculate the carrying value of the bonds as of the date they are retired.
• Calculate the loss. The loss equals the redemption price less the carrying value.
Financial Statement Presentation of Gain or Loss
MODULE 3 LIABILITY FOR LEASES
Module 3
LO 7
Liability for Leases
Leases
A lease, a contractual arrangement between two parties, allows one party, the lessee, the right to use an
asset in exchange for making payments to its owner, the lessor.
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◼ Accounting questions that arise from leasing:
• Should the right to use property be reported as an asset by the lessee?
Two types of lease agreements from the viewpoint of the lessee: operating and capital.
◼ Operating leases give the lessee the right to use an asset for a limited period of time.
• Lessee is not required to record the right to use the property as an asset or to record the
obligation for payments as a liability.
An operating lease does not meet any of the four criteria required for a capital lease.
◼ Capital leases give the lessee sufficient rights of ownership and control of the property to be
considered the owner.
• Called a capital lease because it is capitalized (recorded) on the balance sheet by the lessee.
Recorded as an asset by the lessee.
• Lease is considered a capital lease by the lessee when one or more of the following criteria are
met:
Lease transfers ownership of the property to the lessee at the end of the lease term.
◼ Accounting for operating leases (Example 10-7):
• Recorded by debiting rent expense (or prepaid rent).
• Not recorded on the balance sheet.
• Although the lease is not on the balance sheet, FASB requires note disclose of the amount of
future lease obligations for leases that are considered operating leases. (Exhibit 10-6).
INSTRUCTOR’S MANUAL
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◼ Capital leases are presented as assets and liabilities by the lessee because they meet one or more of
the lease criteria. (Example 10-8)
• Actually represents a purchase of the asset by the lessee with payments made over time.
• A portion of each periodic payment represents interest on the obligation and the remainder
represents a reduction of the principal amount.
Effective interest method is used.
Effective interest table can be prepared using the same concepts used to amortize a
premium or discount on bonds payable (Exhibit 10-7).
• Table begins with an obligation amount equal to the present value of the payments.
• Depreciated asset does not equal the present value of the lease obligation.
IFRS and Leasing
◼ U.S. criteria for capital leases are applied in a rigid, “rule–based” way.
CHAPTER 10 LONG-TERM LIABILITIES
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MODULE 4 ANALYSIS OF LONG-TERM LIABILITIES AND CASH
FLOW ISSUES
Module 4
LO 8
Analysis of Long-Term Liabilities and Cash Flow Issues
◼ Long-term liabilities are a component of the “capital structure” of the company and are included in
the calculation of the debt-to-equity ratio.
get a return on their money.
◼ Times interest earned measures a company’s ability to meet interest obligations as they come due.
• Times Interest Earned Ratio = Income Before Interest and Tax
Interest Expense
◼ Use Ratio Analysis Model to analyze the amount of a company’s debt:
1. Formulate the Question. What is the amount of debt in relation to the total equity of the
company? Will the company be able to meet its obligations related to the debt?
4. Compare the Ratio With Other Ratios. Compare PepsiCo’s ratio to Coca-Cola.
5. Interpret the Ratios. Both companies have strong ratios that increased from 2013 to 2014.
Both companies have a small amount of interest expense compared to their income available
to meet these obligations. Ratios indicate that creditors for both companies are confident that
each company will be able to meet its interest obligations on its long-term debt.
INSTRUCTOR’S MANUAL
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2. Gather Information from the Financial Statements and Other Sources. The information will
come from a variety of sources, not limited to, but including:
3. Analyze the Information Gathered.
4. Make the Decision. Taking into account all of the various sources of information, decide to
loan the money to PepsiCo or find an alternative use for the money.
5. Monitor Your Decision. Monitor the investment periodically during the time it is
outstanding. Assess the company’s debt levels as well as other factors considered before
making the investment.
Module 4
LO 9
How Long-Term Liabilities Affect the Statement of Cash Flows
Long-term liabilities are generally financing activities.
◼ Decreases in a long-term liability indicate that cash has been used to pay the liability.
• Therefore, in the statement of cash flows, a decrease in a long–term liability account should
appear as a subtraction, or reduction.