14-1

Long-Term
Chapter
Liabilities

14
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 14-2

Advantages
Advantages of
of Bonds
Bonds
Bonds
Bonds do
do not
not affect
affect
stockholder
stockholder control.
control.

Interest
Interest on
on bonds
bonds is
is
tax
tax deductible.
deductible.

Bonds
Bonds can
can increase
increase
return
return on
on equity.
equity.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-3

Disadvantages
Disadvantages of
of Bonds
Bonds

Bonds
Bonds require
require payment
payment ofof both
both
periodic
periodic interest
interest and
and par
par value
value at
at
maturity.
maturity.

Bonds
Bonds can
can decrease
decrease return
return on
on
equity
equity when
when the
the company
company pays pays
more
more in
in interest
interest than
than itit earns
earns on
on
the
the borrowed
borrowed funds.
funds.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-4

Types
Types of
of Bonds
Bonds

Secured
Secured and
and Convertible
Convertible
Unsecured
Unsecured and
and Callable
Callable

Term
Term and
and Registered
Registered
Serial
Serial and
and Bearer
Bearer

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-5

Bond
Bond Trading
Trading
Bond market values
are expressed as a
percent of their par
value.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-6

Basics
Basics of
of Bonds
Bonds
Bond Par Value
at Maturity Date

Corporation Investors

Bond Issue Bond

Date Maturity
Date
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 14-7

Basics
Basics of
of Bonds
Bonds
Bond Selling Price

Bond Certificate
Corporation at Par Value Investors

Bond Issue
Date
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 14-8

Basics
Basics of
of Bonds
Bonds
Bond Interest Payments

Corporation Investors
Bond Interest Payments

Interest Payment =
Bond Issue
Bond Par Value  Stated Interest Rate
Date
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 14-9

Bond
Bond Issuing
Issuing Procedures
Procedures

. . .an investment firm

A company sells the called an underwriter.
bonds to. . . The underwriter sells
the bonds to. . .

. . . investors.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 14-10

Bond
Bond Issuing
Issuing Procedures
Procedures

. . .an investment firm

A company sells the called an underwriter.
bonds to. . . The underwriter sells
the bonds to. . .

A trustee
monitors
the bond
. . . investors issue.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 14-11

Issuing
Issuing Bonds
Bonds at
at Par
Par
King
King Co.
Co. issues
issues the
the following
following bonds
bonds onon January
January 1,
1, 2005
2005
Par
Par Value
Value == $1,000,000
$1,000,000
Stated
Stated Interest
Interest Rate
Rate == 10%
10%
Interest
Interest Dates
Dates == 6/30
6/30 and
and 12/31
12/31
Bond
Bond Date
Date == Jan.
Jan. 1,
1, 2005
2005
Maturity
Maturity Date
Date == Dec.
Dec. 31,
31, 2024
2024 (20
(20 years)
years)

Jan. 1 Cash 1,000,000

Bonds payable 1,000,000
Issues bonds at par

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-12

Issuing
Issuing Bonds
Bonds at
at Par
Par

The
The entry
entry on
on June
June 30,
30, 2005
2005 to
to record
record thethe
first
first semiannual
semiannual interest
interest payment
payment isis .. .. ..
June 30 Bond interest expense 50,000
Cash 50,000
Paid semi-annual interest

$1,000,000
$1,000,000 ×× 10%10% ×× ½
½ year
year == $50,000
$50,000
This
This entry
entry is
is made
made every
every six
six months
months until
until
the
the bonds
bonds mature.
mature.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-13

Issuing
Issuing Bonds
Bonds at
at Par
Par
On
On Dec.
Dec. 31,
31, 2024,
2024, the
the bonds
bonds mature,
mature, King King
Co.
Co. makes
makes the
the following
following entry
entry .. .. ..

Dec. 31 Bonds payable 1,000,000

Cash 1,000,000
Paid bond principal at maturity

The debt has now been

extinguished.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 14-14

Bond
Bond Discount
Discount or
or Premium
Premium
Prepare
Prepare the
the entry
entry for
for Jan.
Jan. 1,
1, 2005
2005 to
to record
record the
the following
following
bond
bond issue
issue by
by Rose
Rose Co.Co.
Par
Par Value
Value == $1,000,000
$1,000,000
Issue
Issue Price
Price == 92.6405%
92.6405% of of par
par value
value
Stated
Stated Interest
Interest Rate
Rate == 10%
10%
Market
Market Interest
Interest Rate
Rate == 12%
12%
Interest
Interest Dates
Dates == 6/30
6/30 and
and 12/31
12/31
Bond
Bond Date
Date == Jan.
Jan. 1,
1, 2005
2005
Maturity
Maturity Date
Date == Dec.
Dec. 31,
31, 2009
2009 (5(5 years)
years)
Contract rate is: Bond sells:
Above market rate At a premium
Equal to market rate At par value
McGraw-Hill/Irwin Below market rate At a discount
© The McGraw-Hill Companies, Inc., 2005
 14-15

Issuing
Issuing Bonds
Bonds at
at aa Discount
Discount
Cash
Cash
Par
Par Value
Value Proceeds
Proceeds Discount
Discount
1,000,000 -- $$926,405
$$1,000,000 926,405 == $$ 73,595
73,595

$1,000,000 
$1,000,000 92.6405%
92.6405%
Amortizing
Amortizing the
the discount
discount increases
increases
Interest
Interest Expense
Expense over over the
the outstanding
outstanding
life
life of
of the
the bond.
bond.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 14-16

Issuing
Issuing Bonds
Bonds at
at aa Discount
Discount
On
On Jan.
Jan. 1,
1, 2005
2005 Rose
Rose Co.
Co. would
would record
record the
the
bond
bond issue
issue as
as follows.
follows.

Jan. 1 Cash 926,405

Discount on bonds payable 73,595
Bonds payable 1,000,000
Sold bonds at a discount on issue date

Contra-Liability
Account

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-17

Issuing
Issuing Bonds
Bonds at
at aa Discount
Discount
Partial
Partial Balance
Balance Sheet
Sheet as
as of
of Jan.
Jan. 1,
1, 2005
2005

Long-term
Long-term Liabilities:
Liabilities:
Bonds
Bonds Payable
Payable $$1,000,000
1,000,000
Less:
Less: Discount
Discount on on Bonds
Bonds Payable
Payable 73,595
73,595 $$926,405
926,405

Maturity Value

Using
Using the
the straight-line
straight-line method,
method, the
the Carrying Value
discount
discount amortization
amortization will
will be
be $7,360
$7,360
every
every six
six months.
months.
$73,595
$73,595 ÷÷ 10
10 periods
periods == $7,360*
$7,360*
*(rounded)
*(rounded)
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 14-18

Issuing
Issuing Bonds
Bonds at
at aa Discount
Discount
Make
Make the
the following
following entry
entry every
every six
six months
months toto
record
record the
the cash
cash interest
interest payment
payment and
and the
the
amortization
amortization of of the
the discount.
discount.
June 30 Bond interest expense 57,360
Discount on bonds payable 7,360
Cash 50,000
Paid semi-annual interest and amortized discount

$73,595 ÷ 10 periods = $7,360 (rounded)

$1,000,000 × 10% × ½ = $50,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-19

Straight-Line Amortization Table

Interest Interest Discount Unamortized Carrying
Date Payment Expense Amortization* Discount Value
1/1/2005 $ 73,595 $ 926,405
6/30/2005 $ 50,000 $ 57,360 $ 7,360 66,235 933,765
12/31/2005 50,000 57,360 7,360 58,875 941,125
6/30/2006 50,000 57,360 7,360 51,515 948,485
12/31/2006 50,000 57,360 7,360 44,155 955,845
6/30/2007 50,000 57,360 7,360 36,795 963,205
12/31/2007 50,000 57,360 7,360 29,435 970,565
6/30/2008 50,000 57,360 7,360 22,075 977,925
12/31/2008 50,000 57,360 7,360 14,715 985,285
6/30/2009 50,000 57,360 7,360 7,355 992,645
12/31/2009 50,000 57,355 7,355 0 1,000,000
$ 500,000 $ 573,595 $ 73,595
* Rounded.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-20

Straight-Line
Straight-Line and
and Effective
Effective Interest
Interest
Methods
Methods
Both methods report the same amount of interest
expense over the life of the bond.
Interest Expense

60,000
59,000
58,000
SL
57,000
Eff. Int.
56,000
55,000
54,000
2002 2003 2004 2005 2006
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 14-21

Issuing
Issuing Bonds
Bonds at
at aa Premium
Premium
Prepare
Prepare the
the entry
entry for
for Jan.
Jan. 1,
1, 2005
2005 to
to record
record the
the
following
following bond
bond issue
issue by
by Rose
Rose Co.Co.
Par
Par Value
Value == $1,000,000
$1,000,000
Issue
Issue Price
Price == 108.1145%
108.1145% of of par
par value
value
Stated
Stated Interest
Interest Rate
Rate == 10%
10%
Market
Market Interest
Interest Rate
Rate == 8%
8%
Interest
Interest Dates
Dates == 6/30
6/30 and
and 12/31
12/31
Bond
Bond Date
Date == Jan.
Jan. 1,
1, 2005
2005
Maturity
Maturity Date
Date == Dec.
Dec. 31,
31, 2009
2009 (5(5 years)
years)

Contract rate is: Bond sells:

Above market rate At a premium
Equal to market rate At par value
McGraw-Hill/Irwin Below market rate At a discount
© The McGraw-Hill Companies, Inc., 2005
 14-22

Issuing
Issuing Bonds
Bonds at
at aa Premium
Premium
Cash
Cash
Proceeds
Proceeds Par
Par Value
Value Premium
Premium
$$1,081,145
1,081,145 -- $$1,000,000
1,000,000 == $$ 81,145
81,145

$1,000,000 
$1,000,000 108.1145%
108.1145%

Amortizing
Amortizing the
the premium
premium decreases
decreases Interest
Interest
Expense
Expense over
over the
the life
life of
of the
the bond.
bond.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-23

Issuing
Issuing Bonds
Bonds at
at aa Premium
Premium
On
On Jan.
Jan. 1,
1, 2005
2005 Rose
Rose Co.
Co. would
would record
record the
the
bond
bond issue
issue as
as follows.
follows.

Jan. 1 Cash 1,081,145

Premium on bonds payable 81,145
Bonds payable 1,000,000
Issued bonds at a premium on issue date

Adjunct-Liability
Adjunct-Liability
Account
Account

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-24

Issuing
Issuing Bonds
Bonds at
at aa Premium
Premium
Partial
Partial Balance
Balance Sheet
Sheet as
as of
of Jan.
Jan. 1,
1, 2005
2005

Long-term
Long-term Liabilities:
Liabilities:
Bonds
Bonds Payable
Payable $$1,000,000
1,000,000
Add:
Add: Premium
Premium on on Bonds
Bonds Payable
Payable 81,145
81,145 $$ 1,081,145
1,081,145

Using
Using the
the straight-line
straight-line method,
method, the
the premium
premium
amortization
amortization will
will be
be $8,115
$8,115 every
every six
six months.
months.
$81,145
$81,145 ÷÷ 10
10 periods
periods == $8,115
$8,115 (rounded)
(rounded)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-25

Issuing
Issuing Bonds
Bonds at
at aa Premium
Premium
This
This entry
entry is
is made
made every
every six
six months
months to
to
record
record the
the cash
cash interest
interest payment
payment and
and the
the
amortization
amortization of
of the
the premium.
premium.
June 30 Bond interest expense 41,885
Premium on bonds payable 8,115
Cash 50,000
Paid semi-annual interest and amortized premium

$81,145
$81,145 ÷÷ 10
10 periods
periods == $8,115
$8,115 (rounded)
(rounded)

$1,000,000
$1,000,000 ×× 10%
10% ×× ½
½ == $50,000
$50,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-26

Straight-Line Amortization Table

Interest Interest Premium Unamortized Carrying
Date Payment Expense Amortization* Premium Value
1/1/2005 $ 81,145 $ 1,081,145
6/30/2005 $ 50,000 $ 41,885 $ 8,115 73,030 1,073,030
12/31/2005 50,000 41,885 8,115 64,915 1,064,915
6/30/2006 50,000 41,885 8,115 56,800 1,056,800
12/31/2006 50,000 41,885 8,115 48,685 1,048,685
6/30/2007 50,000 41,885 8,115 40,570 1,040,570
12/31/2007 50,000 41,885 8,115 32,455 1,032,455
6/30/2008 50,000 41,885 8,115 24,340 1,024,340
12/31/2008 50,000 41,885 8,115 16,225 1,016,225
6/30/2009 50,000 41,885 8,115 8,110 1,008,110
12/31/2009 50,000 41,890 8,110 0 1,000,000
$ 500,000 $ 418,855 $ 81,145
* Rounded.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-27

Issuing
Issuing Bonds
Bonds Between
Between Interest
Interest Dates
Dates
Apr. 1, 2005 June 30, 2005
Jan. 1, 2005 Bond Issue First Interest
Bond Date Date Payment

Accrued interest

Investor pays bond purchase

price + accrued interest.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-28

Issuing
Issuing Bonds
Bonds Between
Between Interest
Interest Dates
Dates
Apr. 1, 2005 June 30, 2005
Jan. 1, 2005 Bond Issue First Interest
Bond Date Date Payment

Accrued interest Earned interest

Investor
receives 6
months’
interest.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-29

Issuing
Issuing Bonds
Bonds Between
Between Interest
Interest Dates
Dates
Prepare
Prepare the
the entry
entry to
to record
record the
the following
following bond
bond issue
issue
by
by King
King Co.
Co. on
on Apr.
Apr. 1,
1, 2005.
2005.
Par
Par Value
Value == $1,000,000
$1,000,000
Stated
Stated Interest
Interest Rate
Rate == 10%
10%
Market
Market Interest
Interest Rate
Rate == 10%
10%
Interest
Interest Dates
Dates == 6/30
6/30 and
and 12/31
12/31
Bond
Bond Date
Date == Jan.
Jan. 1,
1, 2005
2005
Maturity
Maturity Date
Date == Dec.
Dec. 31,
31, 2009
2009 (5(5 years)
years)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-30

Issuing
Issuing Bonds
Bonds Between
Between Interest
Interest Dates
Dates
At the date of issue the following entry is made:
Apr. 1 Cash 1,025,000
Interest payable 25,000
Bonds payable 1,000,000
Issued bonds at par plus accrued interest

The first interest payment on June 30, 2005 is:

June 30 Interest payable 25,000
Bond interest expense 25,000
Cash 50,000
Paid semi-annula interest

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-31

Accruing
Accruing Bond
Bond Interest
Interest Expense
Expense
End of
accounting
Interest Payment Dates period
Jan. 1 Apr. 1 Oct. 1 Dec. 31
3 months’
accrued interest

At
At year-end,
year-end, an
an adjusting
adjusting entry
entry isis necessary
necessary to
to
recognize
recognize bond
bond interest
interest expense
expense accrued
accrued since
since
the
the most
most recent
recent interest
interest payment.
payment.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-32

Present
Present Value
Value of
of aa Discount
Discount Bond
Bond
Calculate
Calculate the
the issue
issue price
price of
of Rose
Rose Inc.’s
Inc.’s bonds.
bonds.
Par
Par Value
Value == $1,000,000
$1,000,000
Issue
Issue Price
Price == ??
Stated
Stated Interest
Interest Rate
Rate == 10%
10%
Market
Market Interest
Interest Rate
Rate == 12%
12%
Interest
Interest Dates
Dates == 6/30
6/30 and
and 12/31
12/31
Bond
Bond Date
Date == Jan.
Jan. 1,
1, 2005
2005
Maturity
Maturity Date
Date == Dec.
Dec. 31,
31, 2009
2009 (5
(5 years)
years)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-33

Present
Present Value
Value of
of aa Discount
Discount Bond
Bond
Table Present
Cash Flow Table Value Amount Value
Par value of the bond PV of $1 0.5584 $ 1,000,000 $ 558,400

Interest (annuity) PV of an
Annuity of $1 7.3601 50,000 368,005
Price of bond $ 926,405

1.
1. Semiannual
Semiannual rate
rate == 6%
6% (Market
(Market rate
rate 12%
12% ÷÷ 2)
2)
2.
2. Semiannual
Semiannual periods
periods == 10
10 (Bond
(Bond life
life 55 years
years ×× 2)
2)

$1,000,000 × 10% × ½ = $50,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-34

Bond
Bond Retirement
Retirement
 At Maturity
Dec. 31 Bonds payable 1,000,000
Cash 1,000,000
Retirement of bonds at maturity
 Before Maturity
Carrying Value > Retirement Price = Gain
Carrying Value < Retirement Price = Loss

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-35

Are you
ready to
discuss long-
term notes
payable?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-36

Long-Term
Long-Term Notes
Notes Payable
Payable
Cash

Company Note
Note Payable
Payable Lender

When is the repayment of the principal

and interest going to be made?

Note Date Note Maturity

Date
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 14-37

Long-Term
Long-Term Notes
Notes Payable
Payable

Single Payment of
Principal plus Interest

Company Lender
Single Payment of
Principal plus
Interest

Note Date Note Maturity

Date
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 14-38

Long-Term
Long-Term Notes
Notes Payable
Payable

Regular Payments of
Principal plus Interest

Company Lender
Regular Payments of Principal plus Interest

Note Date Payments can either be Note Maturity

equal principal payments Date
McGraw-Hill/Irwin
or equal payments. © The McGraw-Hill Companies, Inc., 2005
 14-39

Installment
Installment Notes
Notes with
with Equal
Equal Principal
Principal
Payments
Payments

$16,000 Annual
$14,000 payments
$12,000 decrease.
$10,000
Interest
$8,000
Principal
$6,000
$4,000
$2,000
$-
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

The
The principal
principal payments
payments are
are $10,000
$10,000 each
each year.
year.
Interest
Interest expense
expense decreases
decreases each
each year.
year.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 14-40

Installment
Installment Notes
Notes with
with Equal
Equal Payments
Payments
$14,000 Annual
$12,000 payments are
$10,000
constant.
$8,000 Interest
$6,000 Principal
$4,000
$2,000
$-
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

The
The principal
principal payments
payments increase
increase each
each year.
year.
Interest
Interest expense
expense decreases
decreases each
each year.
year.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005
 14-41

Mortgage
Mortgage Notes
Notes and
and Bonds
Bonds
 AA legal
legal agreement
agreement that
that helps
helps protect
protect the
the
lender
lender ifif the
the borrower
borrower fails
fails to
to make
make the
the
required
required payments.
payments.
 Gives
Gives the
the lender
lender the
the right
right to
to be
be paid
paid out
out of
of
the
the cash
cash proceeds
proceeds from
from the
the sale
sale of
of the
the
borrower’s
borrower’s assets
assets specifically
specifically identified
identified in
in
the
the mortgage
mortgage contract.
contract.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-42

Pledged
Pledged Assets
Assets to
to Secured
Secured Liabilities
Liabilities

Pledged
Assets to Book Value of Pledged Assets
Secured = Book Value of Secured Liabilities
Liabilities

This ratio helps creditors determine whether the

pledged assets of a debtor provide adequate
security for secured debt obligations.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

 14-43

End of Chapter 14

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005