CHAPTER 10

Long-Term
Debt Financing
 Learning Objective 1

Use present
value concepts
to measure
long-term
liabilities.
 Define Long-Term Liabilities

Debts and other obligations that will not

be paid in cash or satisfied with other
assets or services within one year.
 Notes payable
 Bonds payable
 Mortgages payable
 Lease payments
 Pension obligations
 Accounting for
Long-Term Liabilities
Measurement and recording of long-term liabilities
are based on the time value of money concept.

Present value of $1 is
the value today of $1 to
be received or paid in
the future, given a
specific interest rate.

If money can earn 10% per year, $100 to be received 1

year from now is approximately equal to $90.91 received
today.
 Present and Future
Value Tables
Present Value Table
 Locate the number of
periods in the left column
and the interest rate in the
row at the top of the table.
 This intersection is the
factor representing the
present value of $1.
 Discounting—present
value amount is the
amount that could be paid
today to satisfy the
obligation.
Future Value Table
 Locate the number of
periods in the left
column and the interest
rate in the row at the top
of the table.
 This intersection is the
factor representing the
future value of $1.
 Compounding—the
frequency with which
interest is added to the
principal.
 Present Value
Present value of $100 paid in 5 years
discounted at 10 percent.

Today 1 2 3 4 Future

Discount at 10%

PV = $62.09 $100
 Future Value
Future value of $100 today
compounded for 5 years at 10 percent.

Today 1 2 3 4 Future

Compound at 10%

$100 FV = $161.05
 Value Table — Future Value
Joan invested $2,000 for 3 years at 12 percent,
compounded annually. Using the table below,
what is the future value of the $2,000?

Periods 6% 8% 10% 12%

3 1.1910 1.2597 1.3310 1.4049
4 1.2625 1.3605 1.4641 1.5735
5 1.3382 1.4693 1.6105 1.7623
6 1.4185 1.5869 1.7716 1.9738

Future value = Amount x FV Factor

Future value = $2,000 x 1.4049
Future value = $2,809.80
 Value Table — Future Value
Joan invested $2,000 for 3 years at 12 percent,
compounded semiannually. Using the table
below, what is the future value of the $2,000?

Periods 6% 8% 10% 12%

3 1.1910 1.2597 1.3310 1.4049
4 1.2625 1.3605 1.4641 1.5735
5 1.3382 1.4693 1.6105 1.7623
6 1.4185 1.5869 1.7716 1.9738
Future value = Amount x FV Factor
Future value = $2,000 x 1.4185
Future value = $2,837
 Computing the Interest Rate
Provide the Appropriate Formula.
Interest rate per compounding period =

Yearly interest rate

Compounding periods per year

Number of interest periods =

Compounding x Number
periods per year of
years
 Define Annuities

Annuity
A series of equal amounts to be
received or paid at the end of equal
time intervals.
Present Value of an Annuity
The value today of a series of
equally spaced, equal-amount
payments to be made or received
in the future given a specified
interest rate.
 Value Tables — Annuity
Joan is paid $8,000 a year for 8 years at 10
percent interest per year. Using the table below,
what is the present value of the annuity?

Periods 6% 8% 10% 12%

7 5.5824 5.2064 4.8684 4.5683
8 6.2098 5.7466 5.3349 4.9676
9 6.8017 6.2469 5.7590 5.3282
10 7.3601 6.7101 6.1446 5.6502

Present value = Amount x PV Factor

Present value = $8,000 x 5.3349
Present value = $42,679.20
 Learning Objective 2

Account for long-term

liabilities, including
notes payable and
mortgages payable.
 Time Line of
Business Issues

+
Bond Bond
Note
Payable

–
Mortgage
Payable
Bond

Choose Issue Pay Amortize Retire

 Example: Interest-Bearing
Notes
On January 1, 2003, Silver Eagle Co. borrowed
$20,000 for 3 years at 12 percent interest. The
interest is payable on December 31 of each
year. What entries are necessary for 2003?

Jan. 1 Cash. . . . . . . . . . . . . . . . . 20,000

Note Payable . . . . . . . 20,000
Borrowed $20,000 for 3 years at 12%.

Dec. 31Interest Expense . . . . 2,400

Cash. . . . . . . . . . . . . . 2,400
Made interest payment ($20,000 x 0.12).
 Example: Interest-Bearing
Notes

What entry is needed when Silver Eagle Co.

repays the loan on December 31, 2002?

Dec. 31Interest Expense . . . . . . . 2,400

Note Payable. . . . . . . . . . 20,000
Cash. . . . . . . . . . . . . . 22,400
Interest payment and repayment of loan.
 What is a Mortgage Payable?
 A written promise to pay a stated amount of
money at one or more specified future dates.
 Secured by the pledging of certain assets,
usually real estate, as collateral.
 Generally requires periodic (usually
monthly) payments of principal plus interest.
 Example: Mortgages Payable
On January 1, 2003, Blue Bird Corp. borrowed
$500,000 to acquire a new building. The building
was signed as collateral for the 30-year, 7 percent
loan. Payments of $3,326.51 are to be made
monthly. What are the January 2003 entries?

Jan. 1 Cash. . . . . . . . . . . . . . . 500,000

Mortgage Payable. . 500,000
Borrowed $500,000 to purchase building.
Jan. 31 Mortgage Payable . . . . 409.84

Interest Expense . . . . . 2,916.67

Cash. . . . . . . . . . . . 3,326.51
Made first month’s mortgage payment.
 Mortgages Payable
A mortgage amortization schedule shows
the breakdown between interest and
principal for each payment over the life of
a mortgage.

Monthly Principal Interest Mortgage

Month Payment Paid Paid Balance
1 3,326.51 409.84 2,916.67 499,590.16
2 3,326.51 412.23 2,914.28 499,177.93
3 3,326.51 414.64 2,911.87 498,763.29
4 3,326.51 417.06 2,909.45 498,346.23
5 3,326.51 419.49 2,907.02 497,926.74
6 3,326.51 421.94 2,904.57 497,504.80
 Learning Objective 3

Account for capital

lease obligations and
understand the
significance of
operating leases
being excluded from
the balance sheet.
 Lease Obligations
Match the Following Terms.

Lessor 1. The party that is granted the right to

use property under the terms of a lease.
Operating 2. The owner of property that is rented
Lease (leased) to another party.
3. A simple short-term rental agreement.
Lease
4. A leasing transaction that is recorded
as a purchase by the lessee.
Lessee
5. A contract that specifies the terms
Capital under which the owner of an asset
Lease agrees to transfer the right to use the
asset to another party.
 Classifying Leases
YE If the lease is cancelable or does not meet any of
S the four requirements, is it an operating lease?

Yes No
Transfer of Ownership?

Yes No
Bargain Purchase
Option?

Yes No
Term  75% of
Useful Life?
Yes No
Capital PV Payment 90% Operating
Lease of FMV? Lease
 Example: Lease Obligations
On January 1, 2003, The Cockatoo Company leased a
computer. The lease requires annual payments of
$5,000 for 8 years. The applicable interest rate is 12
percent. How is the lease recorded? What is the
December 31, 2003 entry for interest expense?

Jan. 1 Leased Computer . . . . . . .24,838

Lease Liability . . . . . . . 24,838
Leased a computer for company use.
Dec. 31 Lease Liability . . . . . . . . . . 2,019
Interest Expense . . . . . . . . 2,981
Cash. . . . . . . . . . . . . . . 5,000
Paid annual lease payment for computer.
 Learning Objective 4

Account for bonds,

including the original
issuance, the payment
of interest, and the
retirement of bonds.
 Define These Types of Bonds
Bond
A contract between a borrower (issuer) and a lender
(investor). The borrower promises to pay a specified
amount of interest for each period the bond is
outstanding and to repay the principal at the maturity
date.
Unsecured Bonds (Debentures)
Bonds for which no collateral has been pledged.
Secured Bonds
Bonds for which assets have been pledged in order to
guarantee repayment.
Coupon (Bearer) Bonds
Unregistered bonds for which owners receive periodic
interest payments by clipping a coupon from the bond
and sending it to the issuer as evidence of ownership.
Types of
Bonds 1. Bonds that mature in one lump
sum on a specified future date.
Matching
2. Bonds that mature in a series of
Serial Bonds 2. installments at specified future
dates.
Convertible
Bonds 4. 3. Bonds for which the issuer
reserves the right to pay the
obligation before its maturity
Term Bonds 1. date.
Callable Bonds 4. Bonds that can be traded for, or
3. converted to, other securities
Registered after a specified period of time.
Bonds 5. The names and addresses of the
5. bondholders are kept on file by
the issuing company.
 Types of Bonds

Zero-Coupon Bonds
Bonds issued with no promise of interest
payments; only a lump sum payment will be
made.
Junk Bonds
Bonds issued by companies in weak financial
condition with large amounts of debt already
outstanding; these bonds yield high rates of
return because of high risk.
 Characteristics of Bonds
Match Correctly.

Principal (face AA contract

contract between
between aa bond
bond issuer
issuer
value or market and
anda abond
bondpurchaser
purchaserthatthat
value) specifies
specifiesthe
theterms
termsofofa abond.
bond.

The amount
The amount thatthat will
will be
be paid
paid on
on aa
Bond Maturity bond
Date bondatatthe
thematurity
maturitydate.
date.

The date
The date at
at which
which aa bond
bond principal
Bond Indenture principal
or face or face amount
amount becomes
becomes
payable.payable.
 Determining Issuance Price
Price should equal:
present value of the interest payments +
present value of the bond’s lump-sum face value at
maturity
Market rate (effective rate or yield rate) of
interest
The interest rate investors expect to earn on their
investment.
Stated rate of interest
The rate of interest printed on the bond.
 Determining Issuance Price
Correctly Define Each Term.
Face Value
The amount that will be paid on a bond at the maturity
date.
Bond Discount
The difference between the face value and the sales
price when bonds are sold below their face value.
Bond Premium
The difference between the face value and the sales
price when bonds are sold above their face value.
 Characteristics of Bonds
Market Rate Bond Sold at

8% Premium
Bond
Stated
Interest 10% Face Value
Rate
10%
12% Discount
 Example: Bond Issued at Face
Value
Falcon Company agreed to issue 5-year,
$500,000 bonds and pay 10 percent
interest, compounded semiannually.
Assume the effective and stated rates are
equal. Calculate the issue price.

1. Semiannual interest payments $ 25,000

Present value of interest annuity $193,043

2. Maturity value of bonds $500,000

Present value of bonds 306,957

3. Issuance price of bonds $500,000

 Example: Bond Issued
at a Discount
Falcon Company agreed to issue 5-year,
$500,000 bonds and pay 10 percent
interest, compounded semiannually.
Assume the effective rate is 12 percent.
Calculate the issue price of the bonds.

1. Semiannual interest payments $ 25,000

Present value of interest annuity $184,002

2. Maturity value of bonds $500,000

Present value of bonds 279,197

3. Issuance price of bonds $463,199

 Example: Bond Issued
at a Premium
Falcon Company agreed to issue 5-year,
$500,000 bonds and pay 10 percent
interest, compounded semiannually.
Assume the effective rate is 8 percent.
Calculate the issue price of the bonds.

1. Semiannual interest payments $ 25,000

Present value of interest annuity $202,772

2. Maturity value of bonds $500,000

Present value of bonds 337,782

3. Issuance price of bonds $540,554

 Example: Accounting for
Bonds Payable
On January 1, 2003, Falcon Company
agreed to issue 5-year, $500,000 bonds
and pay 10 percent interest, compounded
semiannually. Assume the effective rate is
10 percent. What entry is needed to
record the liability?

Jan. 1 Cash . . . . . . . . . . . . . . . . 500,000

Bonds Payable. . . . . . . 500,000
Issued $500,000, 10%, 5-year bonds.
 Example: Accounting for
Bonds Payable
On January 1, 2003, Falcon Company
agreed to issue 5-year, $500,000 bonds and
pay 10 percent interest, compounded
semiannually. Assume the effective rate is
10 percent. What entry is needed to record
the first interest payment?

Jun. 30 Bond Interest Expense . . 25,000

Cash. . . . . . . . . . . . . . 25,000
Paid interest ($500,000 x 0.10 x 0.5).
 Example: Bond Retirements
at Maturity
On January 1, 2003, Falcon Company agreed
to issue 5-year, $500,000 bonds and pay 10
percent interest, compounded semiannually.
Assume the effective rate is 10 percent.
What entry is needed to record the
retirement of the bond on January 1, 2008?

Jan. 1 Bond Interest Expense. . . . . 25,000

Bonds Payable. . . . . . . . . . . . 500,000
Cash. . . . . . . . . . . . . . 525,000
Retired 5-year, $500,000, 10% bonds; paid
interest ($500,000 x 0.10 x 0.5).
Example: Bond Retirements
Before Maturity
The Great Owl Company issued $200,000, 14
percent bonds, which are now selling for 107
and are callable at 110. The bonds were
issued at face value. If the company decides
to call the bonds, what entry is needed?

Jan. 1 Bonds Payable. . . . . . . . .200,000

Loss on Bond Retirement.20,000
Cash (200,000 x 1.10) . 220,000
Retired a callable bond at 110.
 Learning Objective 5

Use debt-related ratios to

determine the degree of a
company’s financial leverage
and its ability to repay loans
 Debt Ratio

Measures the amount of

assets supplied by lenders.

Total Liabilities
Total Assets
 Debt-to-Equity Ratio

Measures the balance of funds

being provided by creditors and
stockholders

Total Liabilities
Total stockholders’ equity
 Times Interest Earned Ratio
The ratio of
income that is Income before interest
available for and taxes (operating profit)
interest payments Annual interest expense
to the annual
interest expense.
 Expanded Material
Learning Objective 6

Amortize bond
discounts and bond
premiums using either
the straight-line
method or the
effective-interest
method.
 Define the Two Bond
Premium/Discount Amortization
Methods
Straight-line Method
A method of systematically writing Which
off a bond premium or discount, method is
resulting in equal amounts being preferred by
amortized each period. GAAP?
Effective-interest Method
A method of systematically writing
off a bond premium or discount,
GAAP prefers
taking into consideration the time
value of money. the effective-
interest method.
 Example: Bond Issued
at a Discount
On January 1, 2003, The Ostrich Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. The company received
$196,000 for the bonds. Make the entry to
record the issuance of the bonds.

Jan. 1 Cash. . . . . . . . . . . . . . . . . 196,000

Discount on Bonds. . . . . . 4,000
Bonds Payable . . . . . . . 200,000
Issued $200,000 at a discount.
 Example: Bond Issued
at a Discount
On January 1, 2003, The Ostrich Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. Using straight-line
amortization, what entry is made for the
interest payment on June 30, 2003?

Jun. 30 Bond Interest Expense . . .10,200

Discount on Bonds. . . . 200
Cash. . . . . . . . . . . . . . . 10,000
Paid interest ($200,000 x 0.10 x 0.5).
 Example: Bond Issued
at a Discount
On January 1, 2003, The Ostrich Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. Using straight-line
amortization, what adjusting entry is
needed on December 31, 2003?

Dec. 31Bond Interest Expense . . .10,200

Discount on Bonds. . . . 200
Bond Interest Payable . 10,000
To recognize interest expense for 6
months.
 Example: Bond Issued
at a Discount
On January 1, 2003, The Ostrich Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. What entry is necessary to
retire the debt after 10 years?

Jan. 1 Bonds Payable. . . . . . . . . . 200,000

Cash . . . . . . . . . . . . . . . 200,000
Retired a $200,000, 10-year, 10% bond.
 Example: Bond Issued
at a Premium
On January 1, 2003, The Parrot Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. The company received
$210,000 for the bonds. Make the entry to
record the issuance of the bonds.

Jan. 1 Cash. . . . . . . . . . . . . . . . . 210,000

Premium on Bonds. . . 10,000
Bonds Payable . . . . . . . 200,000
Issued $200,000 at a premium.
 Example: Bond Issued
at a Premium
On January 1, 2003, The Parrot Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. The company received
$210,000 for the bonds. Using straight-
line amortization, what entry is made for
the interest payment on June 30, 2003?

Jun. 30 Bond Interest Expense. . . 9,500

Premium on Bonds. . . . . . 500
Cash . . . . . . . . . . . . . . 10,000
Paid interest ($200,000 x 0.10 x 0.5).
 Example: Bond Issued
at a Premium
On January 1, 2000, The Parrot Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. The company received
$210,000 for the bonds. Using straight-line
amortization, what entry is needed on
December 31, 2000?

Dec. 31 Bond Interest Expense. . . .9,500

Premium on Bonds. . . . . . .500
Bond Interest Expense . 10,000
To recognize interest expense for 6 months.
 Example: Bond Issued
at a Premium
On January 1, 2003, The Parrot Company
agreed to issue 10-year, $200,000 bonds
and pay 10 percent interest, compounded
semiannually. The company received
$210,000 for the bonds. What entry is
necessary to retire the debt after 10 years?

Jan. 1 Bonds Payable. . . . . . . . . .200,000

Cash . . . . . . . . . . . . . . 200,000
Retired a $200,000, 10-year, 10% bond.
Example: Effective-Interest Method
The Woodpecker Company issued a $1,000, 8
percent bond. The market rate was 7 percent at
the time of issuance. Create an effective-
interest table.
A B C D E
(1,000 x 0.04) (E x 0.035) (A-B) (D-C) (1,000+D)

Interest Premium Unamortized Bond

# Payment Expense Amortization Premium Book
$71.00 $1,071.00
1 $40.00 $37.49 $2.51 68.49 1,068.49
2 40.00 37.40 2.60 65.89 1,065.89
3 40.00 37.31 2.69 63.20 1,063.20