Chapter 13 - Longterm Liabilites

Bonds Payable

A bond is a type of note payable in which the amount is divided into smaller pieces, usually $1,000 each. With more units, the company can issue bonds to more investors and raise more money, as compared to a single note payable to a single lender or investor.

Times Interest Earned

(Net Income + Interest Expense + Income Tax Expense) / Interest Expense Indicates the company's ability to meet interest payments as they come due.

On January 1, 2025, Peloton Company solid 12% bonds having a maturity value of $500,000 for $537,907.37. The market rate of interest at the time of issuance is 10%. The bonds are dated January 1, 2025, and mature January 1, 2030, with interest payable December 31 of each year. Peloton Company allocates interest and unamortized discount or premium on the effective-interest basis. INSTRUCTIONS (Round answers to the nearest cent.) a.Verify the price for the bonds and prepare the Journal entry at the date of the bond Issuance. b.Prepare a schedule of interest expense and bond amortization for 2025-2027. c.Prepare the journal entry to record the interest payment and the amortization for 2025. d.Prepare the Journal entry to record the interest payment and the amortization for 2027.

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Scenic Development Company sells land having a cash sale price of $200,000 to Health Spa, Inc. In exchange for the land, Health Spa gives a 5-year, $293,866, zero-interest-bearing note. The $200,000 cash sale price represents the present value of the $293,866 note discounted at 8% for 5 years. QUESTIONS (a) Should both parties record the transaction on the sale date at the face amount of the note, which is $293,866? Explain. (b) What entries do Health Spa and Scenic Development make at the exchange date

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Unsecured Bond

A bond backed only by the reputation of the issuer; also called a debenture bond.

Mortgage Notes Payable

A promissory note secured by a document called a mortgage that pledges title to property as security for the loan. •Most common form of long-term notes payable. •Payable in full at maturity or in installments. •Fixed-rate mortgage. •Variable-rate mortgages.

Long Term Notes Payable

Accounting for notes and bonds is quite similar. •A note is valued at the present value of its future interest and principal cash flows. •Company amortizes any discount or premium over the life of the note. •Companies compute the present value of an interest-bearing note, record its issuance, and amortize any discount or premium and accrual of interest in the same way that they do for bonds.

Bond Discount and Premium Amortization Computation

BOND INTEREST EXPENSE - BOND INTEREST PAID

If GreenTea Company issues the $800,000 of bonds on January 1, 2025, at 97 (meaning 97% of par), it records the following issuance.

Cash ($800,000 x .97) 776,000 Discount on Bonds Payable 24,000 Bonds Payable 800,000 Notice that bonds payable is always recorded at face value, even if the bonds are issued at a discount or premium. Recall from our earlier discussion that because of its relation to interest, companies amortize the discount and charge it to interest expense over the period of time that the bonds are outstanding. The straight-line method amortizes a constant amount each interest period, in this case 20 interest periods.2

Scandinavian Imports issues a $10,000, three-year note, at face value to Fjords Unlimited. The stated rate and the effective rate were both 10 percent. Scandinavian would record the issuance of the note as follows.

Cash 10,000 Notes Payable 10,000 Recognize Interest Incurred Each Year as follows: Interest Expense 1,000 Cash 1,000 *10,000 x 10% = 1,000

Turtle Cove Company issued the 3 -year, $10,000, zero-interest-bearing note to Jeremiah Company illustrated in Chapter 6 (notes receivable). The implicit rate that equated the total cash to be paid ($10,000 at maturity) to the present value of the future cash flows ($7,721.80 cash proceeds at date of issuance) was 9%. (The present value of $1 for 3 periods at 9% is $0.77218.)

Cash 7,721.80 Discount on Notes Payable 2,278.20 Notes Payable 10,000.00

FACTS Edmonds Company has issued $500,000 of 6% bonds at face value on May 1, 2025. Edmonds chooses the fair value option for these bonds. At December 31, 2025, the value of the bonds is now $480,000 because interest rates in the market have increased to 8%. QUESTION What entry does Edmonds make to record the change in fair value?

December 31, 2025 BP 20,000 Unrealized Holding Gain or Loss - Income (500,000-480,000) 20,000

FACTS Refer to the Edmonds Company bonds in Example 13.18. Assume that the Edmonds Company fair value change on its bonds is due to its credit rating dropping from AA to BB. QUESTIONS What entry does Edmonds make to record the change in fair value, under these conditions?

December 31, 2025 Bonds Payable 20,000 Unrealized Holding Gain or Loss - Equity 20,000

c.Prepare the journal entry to record the interest payment and the amortization for 2025.

December 31, 2025 Interest Expense 53,790.74 Premium on Bonds Payable: 6,209.26 Cash: 60,000

Evermaster Corporation issued $100,000 of 8% term bonds on January 1, 2025, due on January 1, 2030, with interest payable each July 1 and January 1. Investors require an effective-interest rate of 10%. QUESTION What amount will investors pay for the Evermaster bonds, and what amount of discount will Evermaster record when the bonds are issued? SOLUTION

Evermaster computes the price of the bonds at $92,278 and the discount of $7,722 as shown in the following calculation. Maturity value of bonds payable $100,000 Present valueof $100,000 due in 5 years at 10%, interest payable semiannually (Table 5.2, t = 5%, n = 10; $100,000 × .61391) $61,391 Present value of $4,000 interest payable semiannually for 5 years at 10% annually (Table 5.4 t = 5%, n = 10; $4,000 × 7.72173) 30,887 Proceeds from sale of bonds 92,278 Discount on bonds payable $ 7,722

Reporting and Analyzing Liabilities

Fair Value Option Companies have the option to record fair value in their accounts for most financial assets and liabilities, including bonds and notes payable. The FASB believes that fair value measurement for financial instruments, including financial liabilities, provides more relevant and understandable information than amortized cost. The FASB considers fair value to be more relevant because it reflects the current cash equivalent value of financial instruments.

special notes payable situations

If a company cannot determine the fair value of the property, goods, services, or other rights, and if the note has no ready market, company must approximate an applicable interest rate. Choice of rate is affected by: •Prevailing rates for similar instruments. •Factors such as restrictive covenants, collateral, payment schedule, the existing prime interest rate.

Exstinguishment of Debt Before Maturity

If a company extinguishes debt before maturity: •Amount paid before maturity, including any call premium and expense, is called reacquisition price. •On any specified date, the net carrying amount of the bonds is the amount payable at maturity, adjusted for unamortized premium or discount. •Any excess of net carrying amount over reacquisition price is a gain from extinguishment. •Any excess of reacquisition price over net carrying amount is a loss from extinguishment. •At the time of reacquisition, the unamortized premium or discount, and any costs of issue applicable to the bonds, must be amortized up to the reacquisition date.

Exsitnguishment of Debt At maturity

If a company holds the bonds to maturity: •Premium or discount will be fully amortized at date bonds mature. •Carrying amount will equal the maturity (face) value of bond at date bonds mature. •No gain or loss.

Fair Value Measurement

If companies choose the fair value option, noncurrent liabilities, such as bonds and notes payable, are reported at fair value. In addition, companies report unrealized holding gains or losses as •part of net income or •in other comprehensive income, depending on the circumstances.

(a) What is the 3-year amortization schedule, using effective-interest amortization? (b) What is the entry to record interest expense for the first year of the note? SOLUTION a.The 3-year discount amortization and interest expense schedule is as follows (This schedule is similar to the note receivable schedule of Jeremiah Company in Illustration 6.10)

Interest Expense ($7,721.80 x .09) 694.96 Discount on Notes Payable 694.96

d.Prepare the Journal entry to record the interest payment and the amortization for 2027.

Interest Expense: 52,486.79 Premium on Bonds Payable: 7,513.21 Cash: 60,000

In the previous example, the interest payment dates and the date the financials were issued were the same. If Evermaster wishes to report financials at the end of February 2025, it would prorate the premium by the appropriate number of months, to arrive at the proper interest expense.

Interest accrual ($4,000 × 2/6) $1,333.33 Premium amortized ($744 × 2/6) (248.00) Interest Expense (Jan.-Feb.) $1,085.33

Zero Interest bearing Notes

Issuing company records the difference between the face amount and the present value (cash received) as •a discount and •amortizes that amount to interest expense over the life of the note.

FACTS Consider the bond discount of $24,000 on the GreenTea bonds. QUESTION What entries does GreenTea make in 2025 to record interest expense and amortize discount on the bonds?

JULY 1 Interest Expense: 41,200 Discount on BP: (24,0000/2) 1,200 Cash: 40,000 (800,000 x .10 x 6/12) DECEMBER 31 Interest Expense: 41,200 Discount on BP: 1,200 Interest Payable: 40,000

FACTS Refer to the bonds issued in Example 13.5, except now assume that the 6% bonds were issued at 102. QUESTION What entries does GreenTea make in March and July 2025 to record issuance and interest expense for the bonds?

MARCH 1 ISSUANCE Cash (800,000 x 1.02) + (800,000 x .06 x 2/12): 824,000 Bonds Payable: 800,000 Premium on Bonds Payable (800,000 x .02) 16,000 Interest Expense (Payable) 8,000 INTEREST EXPENSE Interest Expense: 23,547.63 Premium on Bonds Payable: 542.37 (16,000/118) x 4) Cash (800,000 x .06 x 6/12) 24,000

Now assume that the previous bond issue by Evermaster Corporation, investors are willing to accept an effective-interest rate of 6%:

Maturity value of bonds payable $100,000 Present value of $100,000 due in 5 years at 6%, interest payable semiannually (Table 5.2, I = 3%, n =10); ($100,000 ×.74409) $74,409 Present value of $4,000 interest payable semiannually for 5 years at 6% annually (Table 5.4, I = 3%, n =10); ($4,000 × 8.53020) 34,121 Less: Proceeds from sale of bonds 108,530 Premium on bonds payable $ 8,530

Presentation of Long Term Debt

Note disclosures generally indicate the nature of the liabilities, maturity dates, interest rates, call provisions, conversion privileges, restrictions imposed by the creditors, and assets designated or pledged as security. Fair value of the debt should be disclosed. Must disclose future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next five years.

Off-balance-sheet financing

Off-balance-sheet financing is an attempt to borrow monies in such a way to prevent recording the obligations. Different Forms 1.Non-Consolidated Subsidiary 2.Special-Purpose Entity (SPE)

If the company prepare financials six months later, it follows the same procedure.

Premium amortized (March-June) ($744 × 4/6) $496.00 Premium amortized (July-August) ($766 × 2/6) 255.33 Premium amortized (March-August) $751.33

Co. issued for cash a $10,000, three year note bearing interest at 10% to Morgan Corp. (This is the same note example presented in Chapter 6.) The market rate of interest for a note of similar risk is 12%. QUESTION What is the time diagram and entry to record issuance of the note? SOLUTION The time diagram for this note is as follows.

Present value of the principal [$10,000 × .71178 (Table 5.2, t = 12%, n=3)] $7,118 Present value of the interest [$1,000 x 2.40183 (Table 5.4, t = 12%, n=3)] 2,402 Present value of the note S9,520 In this case, because the effective rate of interest (12%) is greater than the stated rate (10%), the present value of the note ($9,520) is less than the face value ($10,000). That is, the note is exchanged at a discount. Marie Co. records the issuance of the note as follows Cash 9,520 Discount on Notes Payable 480 Notes Payable 10,000

FACTS Real-Tech, a developer of augmented reality software, issues $100,000 in bonds, due in 5 years with 9% interest payable annually at year-end. At the time of issue, the market rate for such bonds is 11%. QUESTION What is the price of the bond? That is, what is the present value of the bond issue?

Present value of the principal: $100,000 × .59345(Table 5.2, t = 11%, n = 5) $59,345.00 Present value of the interest payments: $9,000 × 3.69590 (Table 5.4, t=11%, n = 5) 33,263.10 Present value (selling price) of the bonds $92,608.10 By paying $92,608.10 for the bonds at the date of issue, investors actually earn an effective rate or yield of 11% over the 5-year term of the bonds because they paid less than face value. The discount on these bonds of $7,391.90 ($100,000 - $92,608.10) represents additional earnings to the investor. At the maturity date, investors are repaid the full face value of $100,000.

FACTS On January 1, 2018, General Bell Corp. issued at 95, bonds with a par value of $800,000, due in 20 years. Eight years after the issue date, General Bell calls the entire issue at 101 and extinguishes it.5 At that time, the unamortized discount balance (based on straight-line amortization) is $24,000. QUESTION What entry does General Bell make to record the extinguishment (redemption) of the bonds?

The loss on redemption is computed as follows. Reacquisition price ($800,000 × 1.01) $808,000 Net carrying amount of bonds redeemed: Face value $800,000 Less: Unamortized discount ($40,000* × 12/20) 24,000 776,000 Loss on redemption $ 32,000 *[$800,000 ×(1 — .95)] General Bell records the extinguishment of the bonds as follows. Bonds Payable 800,000 Loss on Redemption of Bonds 32,000 Discount on Bonds Payable 24,000 Cash 808,000

Effective Interest Method

The preferred procedure for computing the amortization of a discount or premium. Under this method, companies compute bond interest expense (revenue) at the beginning of the period by the effective-interest rate and then subtract bond interest paid (calculated as the face amount of the bonds times the stated interest rate); the result is the amortization amount.

FACTS On December 31, 2025, Wunderlich Company issued a promissory note to Brown Interiors Company for architectural services related to its building. The note has a face value of $550,000, a due date of December 31, 2030, and bears a stated interest rate of 2%, payable at the end of each year. Interest paid each period is therefore $11,000 ($550,000 × .02). Wunderlich cannot readily determine the fair value of the architectural services, nor is the note readily marketable. On the basis of Wunderlich's credit rating, the absence of collateral, the prime interest rate at that date, and the prevailing interest on Wunderlich's other outstanding debt, the company imputes an 8% interest rate in this situation. QUESTION What is the present value of the note and the imputed fair values of the services received by Wunderlich?

The present value of the note and the imputed fair value of the architectural services are determined as follows. Face value of the note $550,000 Present value of $550,000 due in 5 years at 8% interest payable annually (Table 5.2 t = 8%, n = 5); ($550,000 × .68058) $374,319 Present value of $11,000 interest payable annually for 5 years at 8%; (Table 5.4t = 8%, n = 5); ($11,000 × 3.99271) 43,920 Present value of the note (418,239) Discount on notes payable $131,761

Pricing of a Bond

The selling price of a bond is determined by calculating the present value of its expected future cash flows. The cash flows consist of: 1.Interest payments over the bond term calculated at the stated rate. 2.The principal, or face value, that will be paid at the maturity date.

Selling Price of a Bond (Stated Coupon or Nominal Rate)

The selling price of a bond is impacted by several factors, such as supply and demand of buyers and sellers, relative risk, market conditions, and the state of the economy. It is important that you understand these two interest rates:

Notes Payable

When a single lender or investor loans money to a company, a note payable is created. The note is a legal document that specifies the important features of the note, such as the amount, maturity date, and the rate of interest to be paid.

Notes Issued for Property, Goods, or Services

When exchanging the debt instrument for property, goods, or services in a bargained transaction, the stated interest rate is presumed to be fair unless: 1.No interest rate is stated, or 2.The stated interest rate is unreasonable, or 3.The face amount is materially different from the current cash price for the same or similar items or from the current fair value of the debt instrument.

Bonds Issued At Par

When the stated rate and market rate are equal at the time bonds are issued, no premium or discount exists. When this happens, the bonds are "issued at par". Also, if bonds are issued on an interest payment date, no interest is accrued. The company simply records the cash proceeds and the face value of the bonds.

Secured Bond

a bond issued with some form of collateral

Convertible Bond

a bond that can be exchanged, at the owner's option, for a specified number of shares of the corporation's common stock

Revenue Bond

a bond that is repaid from the income generated by the project it is designed to finance

Income Bond

a bond that pays interest only if the issuing company is profitable

Callable Bond

a bond that the issuer has the right to pay off before its maturity date

Deep Discount Bond

a bond with a price significantly less than its face value

a. Verify the price for the bonds and prepare the Journal entry at the date of the bond Issuance.

a. a. $500,000 × .62092 (Table 5.2 t = 10%, n = 5) $310,460.00 ($500,000 × 12%) × 3.79079 (Table 5.4 t = 10%, n = 5) 227,447.40 Price of bonds $537,907.40 JE: January 1, 2025 Cash 537,907.40 Premium on Bonds Payable 37,907.40 Bonds Payable 500,000.00

(a) Should both parties record the transaction on the sale date at the face amount of the note, which is $293,866? Explain.

a.No. If they did, Health Spa's Land account and Scenic's sales would be overstated by $93,866 (the interest for 5 years at an effective rate of 8%). Similarly, interest revenue to Scenic and interest expense to Health Spa for the 5-year period would be understated by $93,866.

b.Prepare a schedule of interest expense and bond amortization for 2025-2027.

b.Schedule of Interest Expense and Bond Premium Amortization Effective-Interest Method 12% Bonds Sold to Yield 10% Date Cash Paid (12%) Interest Expense (10%) Premium Amortized Carrying Value of Bonds (1) (2) (1) - (2) 1/1/25 - - $537,907.40 12/31/25 $60,000.00* $53,790.74 $6,209.26 531,698.14 12/31/26 60,000.00 53,169.81 6,830.19 524,867.95 12/31/27 60,000.00 52,486.79 7,513.21 517,354.74 *$500,000 × .12

Serial Bond

bond issue matures in installments

Bond Interest Expense

carrying value of bonds at beginning of period x effective interest rate

Bond Interest Paid

face amount of bond x contractual interest rate

Bond Issued at Discount

market rate > stated rate <1000

Term Bond

matures on a single date

FACTS In order to fund improvements to their brewing process, GreenTea Company issues at par 10-year term bonds with a par value of $800,000, dated January 1, 2025, and bearing interest at an annual rate of 10% payable semiannually on January 1 and July 1. QUESTION What entries does GreenTea make in 2025 related to this bond issue if the market rate of interest is 10%?

o recordTo record issuance: Cash: 800000 Bonds Payable: 800000 Record First Semiannual Payment: Interest Expense: 40000 (800,000 x .10 x 6/12) Cash 40000 To record accrued interest expense: Interest Expense: 40,000 Interest Payable: 40,000

Bonds issued at Premium

the stated interest rate is more than the market interest rate >1000

Debt to Assets Ratio

total liabilities/total assets The higher the percentage of liabilities to total assets, the greater the risk that the company may be unable to meet its maturing obligations.

Issuing Bonds

•Bond contract known as a bond indenture. •Represents a promise to pay a sum of money at designated maturity date, plus periodic interest at a specified rate on the maturity amount (face value). •Paper certificate, typically a $1,000 face value. •Interest payments usually made semiannually. •Used when amount of capital needed is too large for one lender to supply.

market (effective) interest rate

•Market (or effective ) rate (effective yield). This is the prevailing interest rate in the investing markets for bonds with similar characteristics. It is driven by many factors, including the risk of the company, government policy, central bank interest rates, and the state of the economy. This interest fluctuates up or down over time.

Rationale of Off Balance Sheet Financing

•Removing debt enhances the quality of the balance sheet and permits credit to be obtained more readily and at less cost. •Loan covenants often limit the amount of debt a company may have. These types of commitments might not be considered in computing the debt limitation. •Some argue that the asset side of the balance sheet is severely understated.

Stated Rate

•Stated (coupon or nominal) rate. This is the interest rate written in the terms of the bond indenture. The bond issuer sets this rate, which represents the amount of interest that will be paid.