Long-Term Liabilities

CHAPTER 14

LONG-TERM LIABILITIES

SECTION 1: Bonds Payable

For January 27: Read pages 711-725. Answer questions 1-25.

For January 29: Answer questions 26-51.

For February 3: Read pages 725-736. Answer questions 52-67.

1.  What is the definition of long-term debt? Give several examples.

2.  Give some examples of items included in a bond indenture or note agreement.

3.  When/why do companies choose bonds over notes to raise large sums of capital?

4.  What is the most common denomination for bonds ($100, $1,000 or $10,000)?

5.  How often do most bonds pay interest?

6.  Review the terms in the blue boxes on pages 713-714. Be sure you understand these.

7.  What does the quality ratings given by Moody’s or Standard and Poor’s tell about a company’s bonds? Does an AAA (Aaa) rating mean that the bonds are a good investment? Why or why not?

8.  If two companies issue identical bonds and Company A receives an AAA rating from S&P while Company B receives a BBB rating, which bond will sell for a higher price?

BOND

Ameen Company, for value received, hereby promises to pay to the bearer on the thirty-first day of December 31, 2005, the sum of ONE THOUSAND DOLLARS ($1,000), and to pay interest on such principal sum from the date issued at the rate of FIVE AND 85/100 PERCENT (5.85%) per year, payable June 30, 2003, and semi-annually thereafter on the thirty-first day of December and the thirtieth day of June in each year until maturity of the bond.

9.  What is the $1,000 called?

10.  What is the 5.85% called?

11.  What is the term of the bond?

EXAMPLE 1

12.  If the Ameen Company wants to borrow $4,000,000, how many bonds will be issued?

13.  What amounts must the Ameen Company pay to the purchasers of the bonds? Give dates and total amounts.

14.  How did the Ameen Company choose the 5.85% rate? See footnote 3 on pg 715.

15.  Assume that the Ameen Company sold (issued) the bonds on December 31, 2002, at 100 (face value, par). How much cash did Ameen Co. receive?

16.  What does this suggest about the market rate of interest on December 31, 2002, for companies similar to Ameen Co.?

17.  Prepare the journal entry to record the issuance of the bonds.

18.  Prepare the journal entry to record the first interest payment on June 30, 2003.

19.  For this example only, assume the company uses October 31 as its fiscal year-end. Prepare the adjusting entry related to the bond interest on October 31, 2003.

20.  Prepare the entry to record the second interest payment on December 31, 2003.

EXAMPLE 2

Assume that Ameen Company was not able to sell the bonds on December 31, 2002, and the bonds were not issued until February 28, 2003. The bonds were issued at 100 plus accrued interest.

21.  Why must investors pay accrued interest on the bonds?

22.  How much cash did Ameen Co. receive for the bonds, excluding the accrued interest?

23.  How much cash did Ameen Co. receive for the accrued interest?

24.  Prepare the journal entry for the issuance of the bonds on February 28, 2003.

25.  Record the first interest payment on June 30, 2003.

EXAMPLE 3

Assume that before the bonds are issued on December 31, the market rate of interest for these bonds increases to 6%. This could be due to changes in the economy (interest rates in general are rising); changes in the industry (outlook is not as good as before); or changes in the Ameen Co. (losing market share, involved in litigation, etc.).

26.  Can Ameen Co. still sell these 5.85% bonds? If so, how?

27.  The bonds will sell for $3,983,731. Prove this by calculating the present value of the interest payments and the present value of the maturity value.

28.  What is the total amount of interest to be paid by Ameen Co.? (Hint: Calculate the total payments to be made to the bondholders and subtract the amount received from the bondholders.)

29.  Record the issuance of the bonds on December 31, 2002.

30.  How would these bonds appear on a balance sheet prepared on December 31, 2002?

31.  What kind of account is DISCOUNT ON BONDS PAYABLE? What does the amount in this account represent?

32.  When do we recognize this discount as interest expense?

33.  One method for amortizing the bond discount is the straight-line method. This method is only acceptable if the results are not materially different from the required method (effective interest method). Under the SL method, the amount of discount amortization each period is calculated as:

Discount amortized = total discount / # of interest periods

Interest expense = cash paid + discount amortized

34.  Record the first interest payment and discount amortization on June 30, 2003. Round to the nearest dollar.

35.  Record the adjusting entry related to the bonds on December 31, 2003.

36.  GAAP requires companies to use the effective interest method to amortize bond discounts. The effective interest method calculates interest expense using the effective interest rate (market rate), in this case, 6%. This rate is applied to the carrying value (book value) of the bonds (face value – unamortized discount). Calculate the interest expense and discount to be amortized on June 30, 2003.

INTEREST = CARRYING EFFECTIVE

EXPENSE VALUE * RATE * TIME

DISCOUNT AMORTIZED = INTEREST EXPENSE - CASH PAID

37.  Record the first interest payment and discount amortization on June 30, 2003, using the effective interest method and the amounts computed in #36.

38.  Calculate the interest expense and discount to be amortized for the second 6-months.

CARRYING VALUE = FACE VALUE – UNAMORTIZED DISCOUNT

(or NEW CARRYING VALUE = PREVIOUS CARRYING VALUE + DISCOUNT AMORTIZED)

INTEREST = CARRYING EFFECTIVE

EXPENSE VALUE * RATE * TIME

DISCOUNT AMORTIZED = INTEREST EXPENSE - CASH PAID

39.  Use the above calculations to prepare the adjusting entry on December 31, 2003.

40.  It is useful to prepare a schedule of discount amortization when the bonds are issued. This makes recording the journal entries much easier. Prepare a schedule of bond discount amortization using the effective interest method for the Ameen Co. bonds.

AMEEN COMPANY

SCHEDULE OF DISCOUNT AMORTIZATION

EFFECTIVE INTEREST METHOD – SEMIANNUAL INTEREST

3-YEAR, 5.85% BONDS SOLD TO YIELD 6%

EXAMPLE 4

Assume instead that the Ameen Co. bonds were sold on December 31, 2002, when the market rate of interest for similar bonds was 5%.

41.  The bonds sold for $4,093,651. Prove this by calculating the present value of the interest payments and the present value of the maturity value.

42.  The bonds sold at a premium. What happens to this premium? Does the Ameen Co. get to keep this money?

43.  Calculate the total amount of interest expense over the life of the bonds.

44. Record the issuance of the bonds on December 31, 2002.

45.  How is the Premium on Bonds Payable account classified?

46.  Prepare a schedule of premium amortization for the bonds.

AMEEN COMPANY

SCHEDULE OF PREMIUM AMORTIZATION

EFFECTIVE INTEREST METHOD – SEMIANNUAL INTEREST

3-YEAR, 5.85% BONDS SOLD TO YIELD 5%

47.  Record the first interest payment on June 30, 2003, using the effective interest method.

EXAMPLE 5

When bonds are issued, the corporation incurs costs for engraving and printing the certificates, legal and accounting fees, commissions, promotion fees, etc. These are called bond issue costs and must be recorded and amortized over the life of the bonds. The bond issue costs account is considered a deferred charge (asset) and is typically shown under the other assets category on the balance sheet.

48.  Assume that Ameen Co. issues the bonds at 99.6 on December 31, 2002. Bond issue costs were $24,000. Record the issuance.

49.  The Ameen Co. uses the straight-line method of amortizing bond issue costs (as do most other companies). The results are not materially different from the effective interest method. Record the amortization of the bond issue costs on December 31, 2003. Ameen Co. prepares this entry only once per year.

EXAMPLE 6

50.  Record the retirement of the Ameen Co. bonds on December 31, 2005, the maturity date.

51.  Assume instead that the bonds were retired (extinguished) before maturity. The bonds were purchased in the open market at 101. The bonds were carried on the books as follows on the date of retirement:

Bonds Payable $4,000,000

Premium on Bonds Payable 32, 780

Bond Issue Costs 10,000

a. Calculate the cash paid for the bonds.

b. Calculate the net carrying value of the bonds including bond issue costs.

c. Calculate the gain or loss on extinguishments (cash paid – net carrying value).

d. Record the retirement of the bonds.

NOTE: The gain or loss on extinguishment of debt is no longer classified as an extraordinary item.

CHAPTER 14: SECTION 2

SECTION 2: LONG-TERM NOTES PAYABLE

EXAMPLE 1: Notes issued at face value

On December 31, 2001, the Wilkins Company borrowed $50,000 cash by signing a $50,000, 12%, 3-year note at First National Bank. Interest is to be paid annually on December 31 and the principal is to be paid at maturity. The effective rate of the note is 12%.

52. Record the issuance of the note on December 31, 2001:

53. Record the first interest payment on December 31, 2002:

EXAMPLE 2: Zero-interest-bearing note

On January 1, 2002, the Catrett Company signed a 5-year, $200,000 note payable and received cash of $124,184. The note has no stated interest rate.

54. Record the issuance of the note:

55. Determine the effective interest rate of the note:

56. Record the adjusting entry related to interest on the note on December 31, 2002, using the effective interest rate method.

57. Record the adjusting entry related to interest on the note on December 31, 2003, using the effective interest method.

EXAMPLE 3: Notes issued with stated rate not equal to effective rate:

On December 31, 2001 the Akin Company issued a $60,000, 5-year note bearing interest at 8% (interest is to be paid annually on December 31) to Dyer Company for cash. The market rate of interest on similar notes is 12%.

58. Compute the cash proceeds received by Akin. (Hint: treat this like a bond)

59. Record the issuance of the note:

60. Record the interest payment on December 31, 2002 using the effective interest method.

EXAMPLE 4: Notes issued for Property, Goods or Services when

1.  there is no stated interest rate (i.e., non-interest-bearing note)

2.  the stated rate is unreasonable (i.e., 2% stated rate when 8% is reasonable)

3.  the stated face amount of the debt instrument is materially different from the cash sales price of the item or the current market value of the debt.

In the above situations, we must impute an effective interest rate by using as the present value of the note one of the following:

1.  the current cash sales price of the item

2.  the current market value of the note

When neither of these is known, we must determine the effective interest rate by looking at the credit rating of the issuer. (i.e., What rate of interest would they be expected to pay?)

EXAMPLE 4-a:

The Mercer Company issued a $146,933, 5-year, non-interest-bearing note in exchange for a machine with a cash price of $100,000.

61. Determine the implied interest rate for the note.

62. Record the purchase of the machine.

EXAMPLE 4-b:

The Conley Company purchased a used machine (with no established second-hand market) from Reed Company. Conley Company signed a $100,000, 2-year note with no stated interest rate. Neither the value of the machine nor the note is determinable. Conley’s incremental borrowing rate is 12% while Reed’s incremental borrowing rate is 10%.

63. Compute the purchase price of the machine (i.e., the present value of the note).

64. Record the purchase of the machine.

SECTION 3:

REPORTING AND ANALYSIS OF LONG-TERM DEBT

65.  What are three ways in which companies may keep debt off the balance sheet?

66.  Why do companies attempt to keep debt off the balance sheet?

67.  What ratios are used to analyze long-term debt? Give the formulas.

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