Chapter 10: Accounting for Long-Term Liabilities

A. Interest Expense, $2,5000

A company issues $100,000 of 5%, 10-year bonds dated January 1 that pay interest semiannually on June 30 and December 31 each year. If bonds are sold at par value, the issuer records the first semi-annual interest payment with a debit to which of the following accounts and in what amount?A. Interest Expense, $2,5000B. Cash, $2,500C. Interest Payable, $2,500D. Interest Payable, $5,000E. Cash, $5,000F. Interest Expense, $5,000

Cash and $2,000

A company issues $50,000 of 8%, 10-year bonds dated January 1 that pay interest semiannually on June 30 and December 31 each year. If bonds are sold at par value, the issuer records the semi-annual interest payment with a credit to __________ in the amount of __________.

Cash and $75,000

A company issues $75,000 of 6%, 10-year bonds dated January 1 that pay interest semiannually on June 30 and December 31 each year. If bonds are sold at par value, the issuer records the payment of principal at maturity with a credit to __________ in the amount of __________.

tax deductible

A second advantage of bond financing is that interest on bonds is __________. This applies for the issuer who makes bond interest payments, not to the owners who receive equity payments (distributions).

contra account

An account with a balance that is opposite, or "contra," to that of its related accounts.

A company issues $500,000 of 9%, 10-year bonds dated January 1 and pay interest semiannually on June 30 and December 31 each year. The bonds are sold for $480,000, yielding a discount of $20,000. Using the straight-line amortization method, the company will amortize the discount by __________ on each semiannual interest payment.A. $23,500B. $1,000C. $2,000D. $48,000

B, 1,000

Issuing Bonds at Par: Interest Payments: On June 30, 2022, the issuer of the bond pays the first semiannual interest payment of $4,000.

Bond interest expense 4,000 cash 4,000 1,000x 8% x 1/2 year = 4,000 The issuer records the first semiannual interest payment as shown. The issuer pays and records its semiannual interest obligation every six months until the bonds mature.

Bond Interest Payment=

Bond par value x contra interest rate x rate

Issuing Bonds at Par: Maturity: On December 31, 2023, the bonds mature and the issuer of the bond pays face value of $100,000 to the bondholders.

Bonds payable 100,000 cash 100,000 When the bonds mature, the issuer records its payment of principal

A company issues $400,000 of 8%, 10-year bonds dated January 1. The bonds pay interest semiannually on June 30 and December 31 each year. If bonds are sold at par value, the issuer records the sale with a __________ (debit/credit) to Bond Payable in the amount of __________.

Credit and $800,000

A company issues $80,000 of 6%, 5-year bonds dated January 1 that pay interest semiannually on June 30 and December 31. If the issuer accepts $84,000 for the bonds, the issuer will record the sale with a __________ (debit/credit) to __________ (Discount/Premium) on Bonds Payable in the amount of $4,000.

Credit and Premium

Annuity

Sometimes payments follow an __________, which is a series of equal payments at equal time intervals.

Issuing Bonds at Par: Issue Date

Suppose a company receives authorization to issue $100,000 of 8%, 2-year bonds dated December 31, 2021, that mature on December 31, 2023, and pay interest semiannually on each June 30 and December 31. After accepting the bond indenture on behalf of the bondholders, the trustee can sell all or a portion of the bonds to an underwriter. If all bonds are sold at par value, the issuer records the sale as shown. This entry reflects increases in the issuer's cash and long-term liabilities.

contract rate

The __________ is the interest rate specified in the indenture—sometimes referred to as the coupon rate, stated rate, of nominal rate. the bond issuer pays the bond interest rate

Straight-Line Bond Amortization

The __________ method allocates an equal portion of the total bond interest expense to each interest period.

Bond issuances state the number of bonds authorized, their par value, and the contract interest rate. The legal contract between the bondholders and the issuer is called the

bond indenture

If contract rate is below market rate...

bond sold at a discount.

If contract rate is above market rate...

bond sold at a premium.

A premium on bonds payable occurs when a company issues bonds with a

contract rate higher than the market rate. This means that the issue price is more than par value.

When the market rate is 10%, a company issues $50,000 of 12%, 10-year bonds dated January 1, 2009, that mature on December 31, 2018, and pay interest semiannually. When the bonds mature, the issuer records its payment of principal with a __________ (debit/credit) to Cash in the amount of __________.

debit and 50,000

A company issues $60,000 of 6%, 5-year bonds dated January 1 that pay interest semiannually on June 30 and December 31 each year. If the issuer accepts $62,000 for the bonds, the premium on the bonds payable will __________ (increase/decrease) total interest expense recognized over the life of the bond by __________.

decrease and 2,000

A(n) __________ is an obligation requiring a series of payments to the lenders.

installment note

Installment Notes

is an obligation requiring a series of payments to the ledger

The par value of a bond, also called face value, is

is paid at a specified future date called the maturity date

A bondholder may also receive a bond certificate as evidence of the company's debt. A bond certificate, includes specifics such as the

issuer's name, the par value, the contract interest rate, and the maturity date.

Discount on Bonds Payable is a contra

liability account

The note's carrying (book) value at any time equals its face value minus any unamortized discount or plus any unamortized premium; carrying value is also computed as the present value of all remaining payments, discounted using the

market rate at issuance

The annual interest rate is computed by

multiplying the bond par value by the contract rate which is usually stated on an annual basis, even though interest is paid semiannually.

Premium on Bonds Payable is an adjunct liability account with a

normal credit balance

The bond's market rate

of interest is the rate that borrowers are willing to pay and lenders are willing to accept for a bond and its risk level.

Bearer bonds

or unregistered bonds are bonds payable to whoever holds them

A bond is it's issuer's written promise to pay an amount identified as the __________ value of the bond with interest.

par

When the contract rate and market rate are equal, a bond sells at par value. If they are not equal, it is sold at a

premium above par value or at a discount below par value. Exhibit 10.3 shows the relation between the contract rate, the market rate, and a bond's issue price.

maturity value

the amount that is due on the maturity date of a note

carrying value

the balance in the bonds payable account, which equals the face value of bonds payable minus the discount or the face value plus the premium

Debt-to-Equity Ratio

total liabilities/ total equity This ratio helps investors assess the risk of a company's financing structure.

A company borrows $80,000 by signing an $80,000, 6%, 5-year note that requires equal payments of $18,992 at the end of each year. The first payment will record interest expense of __________.

4,800

A company borrows $60,000, by signing a 8%, 6-year note that requires equal payments of $12,979 at the end of each year. The first payment will record interest expense of $4,800 and will reduce interest principal by __________.

8,179

Bond

A __________ is its issuer's written promise to pay an amount identified as the par value of the bond with interest.

note payable

A __________ is similar to a bond payable but is normally transacted with a single lender such as a bank.

Market Rate

A bond's __________ of interest is the rate that borrower's are willing to pay and lenders are willing to accept for a particular bond and it's risk level.

Periodic Interest and Par Value at Maturity

A second disadvantage of bond financing is that bonds require payment of both __________ and __________. Bond payments can be especially burdensome when income and cash are really low. Equity financing, in contrast, does not require any payments because cash withdrawals (dividends) are paid at the discretion of the owner (or board).

Increase Return on Equity

A third advantage of bond financing is that bonds can __________. A company that earns a higher return with borrowed funds than it pays in interest on those funds increases its return on equity. This process is called financial leverage or trading on the equity.

When the market rate is 12%, a company issues $50,000 of 9%, 10-year bonds dated January 1, 2017, that mature on December 31, 2026, and pay interest semiannually. When the bonds mature, the issuer records its payment of principal with a debit to __________ in the amount of __________.A. Bonds Payable; $50,000B. Bonds Payable; $95,000C. Cash; $50,000D. Cash; $95,000

A. Bonds Payable; $50,000

A company borrows $70,000 by signing a $70,000 8%, 6-year note that requires equal payments of $15,142 at the end of each year. The first payment will record interest expense of $5,600 and will reduce principal by $9,642. The journal entry to record this transaction will include a debit to which of the following accounts and for how much? (Check all that apply.)A. Cash; $15,142B. Notes Payable; $9,542C. Interest Expense; $5,600D. Interest Payable; $5,600

B and C

Par Value of a Bond

The __________, also called the face amount or face value, is paid at a specified future date known as the bond's maturity date.

Interest Expense

The straight-line bond amortization method allocates an equal portion of the total bond __________ to each interest period.

discount on bonds payable occurs when

a company issues bonds with a contract rate less than the market rate. This means that the issue price is less than par value.

A mortgage

a legal agreement that helps protect a lender if a borrower fails to make required payments on notes or bonds. A mortgage gives the lender a right to be paid from the cash proceeds of the sale of a borrower's assets identified in the mortgage. Mortgages are popular in the purchase of homes and plant assets. Accounting for mortgages is similar to that for unsecured notes and bonds, except that the mortgage agreement must be disclosed.

Straight-line bond amortization

allocates an equal portion of the total bond interest expense to each interest period

Term bonds (and notes)

are scheduled for maturity on one specified date

If contract rate is equal to market rate...

bond sold at par.

Bond Discount or Premium

bonds are sold for an amount different than the face amount

Unsecured bonds (and notes)

bonds backed only by the issuer's credit standing; almost always riskier than secured bonds; also called debentures

Serial bonds (and notes)

bonds consisting of separate amounts that mature at different dates

Registered bonds

bonds issued in the names and addresses of their holders

Secure bonds (and notes)

bonds that have specific assets of the issuer pledged as collateral

Sinking fund bonds

bonds that require the issuer to make deposits to a separate account; set aside at specified amounts and dates to repay the bonds

Convertible bonds (and notes)

can be exchanged for a fixed number of shares of the issuing corporation's common stock

A premium is added to par value to yield

carrying (book) value of bonds

A discount is deducted from the par value of bonds to yield the

carrying (book) value of bonds.

Bonds are securities that can be purchased or sold in the securities markets. They have a market value which is expressed as a percent of their par value. The closing price indicates that the IBM bond is being sold at 103.08% of

face value

Callable bonds (and notes)

have an option exercisable by the issuer to retire them at the stated dollar amount before maturity

times interest earned ratio

income before interest expense and income taxes/interest expense

Times interest earned

is often viewed as a fixed expense because it usually does not vary as a result of short-term changes in sales or other operating activities. While fixed expenses can be good when a company is growing, they create risk. The risk is that a company might be unable to pay fixed expenses if sales decline. Companies that loan money to a business want to be assured that the principal and interest will be paid when due. One measure that helps creditors assess the risk of a loan is the Times Interest Earned ratio. We calculate the ratio by dividing income before interest and income taxes by interest expense. Income before interest and income taxes is sometimes referred to as operating income.

Market rate

is the rate that borrowers are willing the pay and the lenders are willing to accept for a particular bond and its risk level

two main disadvantages of bond financing are

1. Bonds can decrease return on equity. 2. Bonds require payment of both periodic interest and the par value at maturity.

3 advantages of bond financing

1. Bonds do not affect owner control. 2. Interest on bonds is tax-deductible. 3. Bonds can increase return on equity.

A company issues $50,000 of 5%, 10-year bonds dated January 1 and pay interest semiannually on June 30 and December 31 each year. The bonds are sold for $48,000. Using the straight-line amortization method, the company will amortize the discount by __________ on each semiannual interest payment.(Hint: Semiannual Interest Payment Amount = Discount / Total Number of Payments)

100

Features of Bonds and Notes

-Secured and Unsecured -Term and Serial -Registered and Bearer -Convertible and Callable Secured or Unsecured Secured bonds (and notes) have specific assets of the issuer pledged (or mortgaged) as collateral. If the issuer fails to pay interest or par value, the secured holders can demand that the collateral be sold and the proceeds used to pay the obligation. Unsecured bonds (and notes), also called debentures, are backed by the issuer's general credit standing. Unsecured debt is riskier than secured debt. Term or Serial Term bonds (and notes) mature on one specified date. Serial bonds (and notes) mature at more than one date (often in series) and thus are usually repaid over a number of periods. For instance, $100,000 of serial bonds might mature at the rate of $10,000 each year from six to 15 years after they are issued. Sinking fund bonds, which to reduce the holder's risk require the issuer to create a sinking fund of assets set aside at specified amounts and dates to repay the bonds. Registered or Bearer: Bonds issued in the names and addresses of their holders are registered bonds. The issuer makes bond payments by sending checks (or cash transfers) to registered holders. Bonds payable to whoever holds them (the bearer) are called bearer bonds or unregistered bonds. Sales or exchanges might not be recorded, so the holder of a bearer bond is presumed to be its rightful owner. As a result, lost bearer bonds are difficult to replace. Many bearer bonds are also coupon bonds. This term reflects interest coupons that are attached to the bonds. When each coupon matures, the holder presents it to a bank or broker for collection. At maturity, the holder follows the same process and presents the bond certificate for collection. Issuers of coupon bonds cannot deduct the related interest expense for taxable income. This is to prevent abuse by taxpayers who own coupon bonds but fail to report interest income on their tax returns. Convertible and/or Callable Convertible bonds (and notes) can be exchanged for a fixed number of shares of the issuing corporation's common stock. Convertible debt offers holders the potential to participate in future increases in stock price. Holders still receive periodic interest while the debt is held and the par value if they hold the debt to maturity. In most cases, the holders decide whether and when to convert debt to stock. Callable bonds (and notes) have an option exercisable by the issuer to retire them at a stated dollar amount before maturity.

Par Value and Interest

Most bonds require __________ (interest/par value) to be repaid at maturity and __________ (interest/par value) to be paid semiannually.

Owner Control

One advantage of bond financing is that bonds do not affect __________. Equity financing reflects ownership in a company, whereas bond financing does not.

Decrease Return on Equity

One disadvantage of bond financing is that bonds can __________. This occurs when a company earns a lower return with the borrowed funds than it pays in interest. This downside risk of financial leverage is more likely to arise when a company has periods of low income or net losses.

The bond carrying value can be determined by which of the following formulas?

Par value - discount on bonds payable