Chapter 11: Longterm Liabilities

1
Chapter 11 Long-term Liabilities

• By. J. Paquette
• Bellevue Community College

2
Chapter 11 Long-term
Liabilities - OBJECTIVES

• Management issues
• Why bonds are issued
• Types of bonds.
• Journal Entries
• Issuance of bonds
• Interest expense.
• Redemption

3
Chapter 11 Long-term
Liabilities - OBJECTIVES

• Account for
• Mortgages payable
• Installment notes payable
• Long-term leases
• Pensions/postretirement benefits

4
Liabilities are..

• Creditors claims on total assets
• Existing debts and obligations

Liabilities must be settled in the future by
transfer of assets or services.
5
Management Issues. . . .

• To have or not to have?
• How much to have?
• What types (what mix)?

6
Long-Term Liabilities...

• Are obligations that are expected to be paid
  after 1 year.

7
An Investor Question

• Can the company meet its Interest Payments as
  they become due?

8
Interest Coverage Ratio...

• Higher is Better

Income Interest Expense Income
Tax Interest Expense
9
Bonds...

• Are a form of interest-bearing notes payable
• Sold in small denominations

10
No, not this Bond. . . .
11
Advantages of Bond Financing over Common Stock

• Stockholder control
• Tax expense
• Earnings per share

12
Secured Bonds...

• Have specific assets of the issuer pledged as
  collateral for bonds, e.g., real estate, or
  sinking fund

13
Unsecured or Debenture Bonds...

• Are issued against the general credit of the
  borrower.
  

14
Term Bonds...

• Are due for payment (mature) at a single
  specified future date.
  
  

15
Serial Bonds...

• Mature in installments.

16
Issuing Bonds...

• Requires formal approval by board of directors
  and stockholders.
• Board of Directors must stipulate
• Total number of bonds to be authorized
• Total face value
• Contractual
  Interest Rate

17
Bond Indenture...

• The terms of a bond issue set forth in a legal
  document.
• Summarizes the rights and privileges of
  bondholders and trustees.
• Summarizes obligations and commitments of issuing
  company.

18
How do you keep them straight?

• Indenture?
• Debenture?

19
Indenture
Think pilgrims, think servants, think indentured
servants. . ..
An indentured servant worked 7 years to pay for
his trip to America. He/she signed a CONTRACT.
20
DEBENTURE DIE HARD

• Open the Safe!

21
The amount of principal due at maturity date.
Face Value...
Contractual Interest Rate... (Face Interest
Rate)
Is the rate used to determine the amount of cash
interest the borrower pays and investor receives.
22
Market Interest Rate...
The rate that investors demand for loaning
funds.
Not the same as contractual rate.
23
Accounting for Bond Issues

• Bonds may be issued at
• Face value 10
• Below face value-discount or (e.g, market is 12)
• Above face value-premium (e.g., market is 8)

24
Issuing Bonds at Face Value

• Assume that Devour Corporation issued 1,000,
  5-year 10, 1,000 bonds dated January 1, 2001 at
  100 (100 of face value) with interest payable on
  July 1 and January 1.
• 1/1 Cash 1,000,000 Bonds Payable
  1,000,00
• (To record sale of bonds at face value)

25
Issuing Bonds at Face Value

• The bonds are reported in the long-term
  liability section of the balance sheet because
  the maturity date is more than 1 year away.
• The entry to record the semiannual interest on
  July 1 is
• 7/1 Bond Interest Expense 50,000 Cash
  50,000
• (To record the payment of bond interest)

26
Issuing Bonds at Face Value

• On December 31 the following adjusting entry is
  required to record the 50,000 of interest
  accrued since July 1
• 12/31 Bond Interest Expense 50,000
  Bond Interest Payable 50,000 (To
  accrue bond interest)

27
Discount or Premiums on Bonds

• Often the contractual (stated) interest rate and
  the market (effective) interest rate differ
  therefore bonds sell above or below face value.

28
Bond Discount...

• When the investor pays less than the face value
  of the bond.
• WHY?
• To adjust the contractual interest to the
  market interest rate.

29
Bond Premium...

• When the investor pays more than the face value
  of the bond.
• WHY?
• To adjust the contractual interest to the
  market interest rate.

30
Bond Prices Vary Inversely With Changes in
Market Interest Rates
31
Selling Bonds at Discount

• Assume that on January 1, 1998, Candlestick,
  Inc., sells 1 million, 5-year, 10 bonds at 98
  with interest payable on July 1 and January 1.
• 1/1 Cash 980,000 Unamtzd Disct on
  Bonds Pay 20,000
• Bonds Payable 1,000,000
• (To record sale of bonds at a discount)

32
Carrying (Book) Value of Bonds

• Long-term liabilities
• Bonds payable 1,000,000
• Less Unamtzd Discount on bonds
  20,000
  payable
  980,000

33
Selling Bonds at Premium

• Assume that on January 1, 2001, Candlestick,
  Inc., sells 1 million, 5-year, 10 bonds at 102
  with interest payable on July 1 and January 1.
• 1/1 Cash 1,020,000
  
• Bonds Payable 1,000,000
• Unamtzd Premium Bonds Pay 20,000
• (To record sale of bonds at a premium)

34
How do you present a premium?
35
Carrying (Book) Value of Bonds

• Long-term liabilities
• Bonds payable
  1,000,000
• Add Unamtzd Premium on bonds 20,000
  
  payable 1,020,000

36
Straight-line Method of Allocation Is
Used to Comply with Matching Principle
Page 471 in Book
Amortizing Bond Discount
Page 469 in Book
Amortizing Bond Premium
37
Amortizing Bond
Discount/Premium

• Candlestick would amortize the 20,000
  discount/premium as follows
• 20,000 10 Interest Periods
• 2,000 Semiannually

38
Bonds Amortization at Discount

• On July 1, an interest payment is made on a
  bond which sold at 98.
• 7/1 Bond Interest Expense 52,000
• Unamtzd Bonds Discount 2,000
• Cash
  50,000
• (To record payment of interest and amort. Of
  bond)

39
Bonds Amortization at Premium

• On July 1, an interest payment is made on a
  bond which sold at 102.
• 7/1 Bond Interest Expense 48,000
• Unamtzd Bonds Premium 2,000
• Cash
  50,000
• (To record payment of interest and amort. Of
  bond)

40
Bond Retirement

• Bonds may be redeemed at maturity or before
  maturity.

41
Redeeming Bonds Before Maturity

• A company may decide to retire bonds before
  maturity to
• reduce interest cost
• remove debt from its balance sheet.
• A company should retire debt early only if it has
  sufficient cash resources.

42
Convertible Bonds...

• Changed into common stock at the bondholders
  option.

Callable BondsChanged into common stock at the
issuers option.
43
Redeeming Bonds Before Maturity

• When bonds are retired before maturity, it is
  necessary to
• Eliminate the carrying value of the bonds at the
  redemption date
• Record the cash paid
• Recognize the gain or loss on redemption.

44
Retiring a Bond - Callable

• Assume that, Candlestick, Inc., calls 1
  million, 5-year, 10 bonds at 105 on interest
  payment date of July 1, 2002. Bond was sold at
  premium at 102 on January 1, 2001. Assume
  interest payment and amortization has already
  been made. (Retirement takes place on 3rd
  interest payment date)
• 7/1 Bonds Payable 1,000,000
• Unamtzd Bond Premium 14,000
• Cash 1,050,000 (To record
  retirement of bonds at 105)

Loss on Retirement of B. 36,000
45
Retiring a Bond - Callable

• Assume that, Candlestick, Inc., calls 1
  million, 5-year, 10 bonds at 101 on interest
  payment date of July 1, 2002. Bond was sold at
  premium at 102 on January 1, 2001. Assume
  interest payment and amortization has already
  been made. (Retirement takes place on 3rd
  interest payment date)
• 7/1 Bonds Payable 1,000,000
• Unamtzd Bond Premium 14,000
• Cash
  1,010,000 (To record retirement of bonds at 101)

Gain on Retirement of B. 4,000
46
Partial Balance Sheet

• Long-term liabilities
• Bonds payable 10 due in 2009 1,000,000
• Less Discount on bonds payable 80,000
  
• 
  920,000
• Notes payable, 11, due in 2015
• and secured by plant assets
  500,000
• Lease liability
  540,000
• Total long-term liabilities
  1,960,000

47
Present Value...
The value today of an amount to be received at
some date in the future after taking into account
current interest rates.
48
Cash Flow of Bonds

• Im LOCKED IN WITH
• I (interest), FV (future value), N (periods)
• 10, 1,000,000, 5 years gt 10 periods
• ?---------------------------------------------?
• 50,000 50,000 50,000 50,000 50,000
  50,000 50,000 50,000 50,000 50,000
• 1,000,000

49
Present Value of Bonds

• If contract rate is 10 and market is 10. . . .
  You can sell the Bond at face value
• 10, 100,000, 5 years gt 10 periods
• ?---------------------------------------------?
• 5,000 5,000 5,000 5,000 5,000
• 5,000 5,000 5,000 5,000 5,000
• ?---------------------------------------------?
• 100,000

I 5, table 4, factor 7.722 x 5,000 38,609
I 5, table 3, factor .613 x 100,000 61,300
38,609 61,391 100,000 would be Issue Price
or 100
50
Present Value of Bonds

• If contract rate is 10 and market is 8. . . .
  You can sell the Bond at premium
• 10, 100,000, 5 years gt 10 periods
• ?---------------------------------------------?
• 5,000 5,000 5,000 5,000 5,000 5,000
  
• 5,000 5,000 5,000 5,000 5,000 5,000
  
• ?---------------------------------------------?
• 100,000

I 4, table 4, factor 8.111 x 5,000 40,555
I 4, table 3, factor .676 x 100,000 67,600
40,555 67,600 108,155 would be Issue Price
or 108.155
51
Mortgages Payable. . .

• Long term debt
• Secured by Real Property
• Usually equal monthly payments
• Interest is calculated on unpaid balance

Interest Expense is variable 500, 497, 494. . .
Although payment is 800
52
Installment Notes Payable

• Obligations which call for a series of payments
• Principal Interest

53
Installment Note Payable
2001
Assume 100,000 is borrowed at 15, to be paid
annually over 5 years.
54
Journal
Dec 31, 2001 Cash 100,000
Notes Payable 100,000 (To record issuance
of 15, 5-year note to bank)
Dec 31, 2002 Notes Payable 20,000
Interest Expense
15,000 Cash
35,000 (To make
installment on note) 100,000 x .15
55
Journal
Dec 31, 2003 Notes Payable 20,000
Interest Expense
12,000 Cash
32,000 (To make
installment on note) 80,000 x .15
Dec 31, 2004 Notes Payable 20,000
Interest Expense
9,000 Cash
29,000 (To make
installment on note) 60,000 x .15
56
Lease Liabilities

• Should we Buy or Lease???
• Operating Lease treat as Expense ?payment
  charged to Rent Expense
• Capital Lease treat as Asset , its effectively
  an Installment Purchase

57
Capital Lease

• Will lessee end up with the asset?
• Will the lessee use the asset for most of its
  useful life?
• Do lease payments same installment payments?

58
Capital Lease requirement

• Record the asset and a related liability (and
  depreciate it). Value the asset Present Value
  of total lease payments.

• Journal Entry
• To record the least contract (asset liability)
• Equipment Under Capital Lease XX
• Obligations Under Cap. Lease XX

59
Leases Lots of Accounts

• To book Depreciation
• Depreciation Exp, EUCL XX
• Accum. Deprec, EUCL XX
• To record Payments recog. interest
• Interest Expense XX
• Obligations Under Cap. Lease XX
• Cash
  XX

60
Pensions. . . .

• A contract between a company employees
• Creating a Pension Fund
• For future payments of benefits
• Since 1989, any pension shortfalls must be
  recorded on Financial Statements

61
Pensions. . . .

• Defined contribution plan current contribution
  is specified by company/employees (or board of
  directors)
• Defined benefit plan- amount of future benefit
  is specified/fixed, but current contribution vary
  (depending upon assumption about how much the
  pension fund will earn) Very complicated. . . . .

62
Current Maturities of Long-Term Debt

• The portion of the long-term debt that is due
  within the current year or operating cycle should
  be classified as a current liability.

63
(No Transcript)
64
Selling Bonds BETWEEN Interest dates

• Collect the Bond selling price (e.g., at 100)
• Collect interest accrued on the bond
• Why???????????????

65
Selling Bonds BETWEEN Interest dates

• Assume Vason Corp sold 100,000 of 9, 5 year
  bonds for FACE VALUE on May 1, 2001, rather than
  Jan. 1, 2001, the issue date.
• How much interest is Accrued?
• Jan, Feb, Mar, Apr (4 months)
• Collect an ADDITIONAL 3,000