Chapter 11 notes
Current liabilities
Current liabilities are those liabilities due within one year or less such as notes payable, sales taxes payable, payroll and payroll taxes payable, unearned revenues and current maturities of long-term debt.
Long-term liabilities:
Bonds are used by companies to borrow money from third parties. Each bond will have a face value (the borrowed amount), contract (stated) interest rate, and the term (end on maturity date).
From P483 to P486, the text talks about different bond features, issuing and trading procedures. Bonds can be issued at face value(selling price = face value), at a premium (selling price > face value) or at a discount (selling price < face value).
When the market rate(return from other investments with comparable risk) at the time of transaction is same as the bond contract rate, then bonds should be traded at face value. However, if the market rate (return from other investments with comparable risk) is higher than the bond contract rate, then in order to attract buyers to buy these bonds, the bonds need to be sold at a discount (below face value). There will be an account called ‘Discount on Bonds payable’ with a debit balance created for these bonds. On the balance sheet, the bonds payable account balance will be reduced by the balance on the ‘Discount on Bonds Payable’ account to come up with the carrying value of the bonds.
On the other hand, if the market rate is smaller than the bond contract rate, the bonds can be sold at a premium (above face value). There will be an account called ‘premium on Bonds payable’ with a credit balance created for these bonds. On the balance sheet, the bonds payable account balance will be increased by the balance on the ‘premium on Bonds Payable’ account to come up with the carrying value of the bonds.
The first question is how to figure out the fair market value of a bond with given bond face value, market interest rate and bond contract rate. Please refer to appendix A for further explanation. The second question is what do we do with the balances on the premium/discount on bonds payable. There two available methods to amortize the balance on these accounts through the term of the bond.
- Effective interest method (appendix B)
- Straight-line method (appendix C)
Under either method, when we amortize premium every period, we treat that as a reduction of interest expense. When we amortize discount every period, we treat that as an increase in interest expense. When bonds are redeemed either at or before maturity, bonds payable account, premium/discount on bonds payable accounts must be zeroed out. There will be gain/loss resulted from bonds disposal. On P497, there is a demonstration problem that is worth investigating.