Objective 1: Identify the Management Issues Related to Long-Term Debt

CHAPTER 10

Long-Term Liabilities

reviewing the chapter

Objective 1: Identify the management issues related to long-term debt.

1.To foster growth, companies often invest in long-term assets and in research and development and other activities that will benefit the business in the long run. To finance these investments, they must obtain long-term funding. They commonly do so by issuing stock and long-term debt in the form of bonds, notes, mortgages, and leases. Long-term debt consists of liabilities to be settled beyond one year or the normal operating cycle, whichever is longer. The management issues related to issuing long-term debt are whether to issue it, how much of it to carry, and what types of it to incur.

2.In considering whether to issue long-term debt, management must weigh the advantages of this method of obtaining funds against the advantages of relying solely on stockholders’ equity.

a.One advantage of issuing long-term debt is that bondholders and other creditors do not have voting rights, and common stockholders therefore retain their level of control. Another advantage is that interest on debt is tax-deductible, which lowers the company’s tax burden. A third advantage of issuing long-term debt is that it may give the company financial leverage—that is, if earnings on the funds obtained exceed the interest incurred, then stockholders’ earnings will increase (this is also called trading on equity).

b.One disadvantage of issuing long-term debt is that the more of it a company issues, the more periodic interest it must pay. Failure to pay either periodic interest or the principal at maturity can force a company into bankruptcy. Another disadvantage is that financial leverage can work against a company if the earnings from its investments do not exceed its interest payments. Thus, when a business issues long-term debt, it assumes financial risk, as well as the possibility of negative financial leverage.

3.Managers can determine how much debt to carry by computing the debt to equity ratio. It is expressed in “times” and is calculated as follows:

Total Liabilities
Total Stockholders’ Equity

4.When a business structures its long-term debts in such a way that they do not appear as liabilities on the balance sheet (as for certain leases), that business is engaging in off-balance-sheet financing. However, because the business is committed to cash payments in the long-run, off-balance-sheet financing has the same effect as long-term liabilities. The practice is perfectly legal.

5.Financial leverage is advantageous as long as a business is able to make timely interest payments and to settle the debt at maturity. A common measure of how much risk a company undertakes in issuing debt is the interest coverage ratio. It is expressed in “times” and is calculated as follows:

Income Before Income Taxes + Interest Expense
Interest Expense

The higher the interest coverage ratio, the lower the company’s risk will be of defaulting on interest payments.

6.The most common types of long-term debt are bonds payable, notes payable, mortgages payable, long-term leases, pension liabilities, other postretirement benefits, and deferred income taxes.

a.Long-term bonds are the most common type of long-term debt. They can have many different characteristics, and will be covered in much detail below.

b.A long-term note is a written promise to pay, resulting from a loan from a bank or other creditor. A bond, however, is a more complex financial instrument that usually involves debt to many creditors. Notes and bonds produce similar effects on the financial statements.

c.A mortgage is a long-term debt secured by real property. It is usually paid in equal monthly installments. When a payment is made, both Mortgage Payable and Mortgage Interest Expense are debited, and Cash is credited. Each month, the interest portion of the payment decreases, while the principal portion of the payment increases.

d.A lease is a contract that allows a business or individual to use an asset for a specific length of time in return for periodic payments. The parties involved in a lease are the lessor, who owns the lease asset, and the lessee, who pays rent to the lessor for use of the leased asset. A capital lease is a long-term lease in which the risks of ownership lie with the lessee and whose terms resemble those of a purchase on installment. It is, in fact, so much like a purchase that the lessee should record it as an asset (to be depreciated) and a related liability. An operating lease is a short-term lease in which the risks of ownership remain with the lessor; each monthly lease payment should be charged to Rent Expense.

e.A pension plan is a contract under which a company agrees to pay benefits to its employees after they retire. Benefits to retirees are usually paid out of a pension fund. Pension plans are classified as defined contribution plans or defined benefit plans. Other postretirement benefits, such as health care, should be estimated and accrued while the employee is still working (in accordance with the matching rule).

f.A liability for deferred income taxes arises from the use of different accounting methods for financial reporting purposes than for tax-return purposes. It represents an amount that is currently expensed on the income statement (based on GAAP), but which need not be paid to the government until a later time (as allowed by income tax laws).

Objective 2: Describe the features of a bond issue and the major characteristics of bonds.

7.A bond is a security representing money borrowed from the investing public. The holders of bonds are creditors of the issuing organizations. They are entitled to periodic interest and to the principal of the debt on some specified date. Their claims to a corporation’s assets, like the claims of all creditors, have priority over stockholders’ claims.

8.When a corporation issues bonds, it enters into a contract, called a bond indenture, with the bondholders. It may also give each bondholder a bond certificate as evidence of the corporation’s debt. A bond issue is the total value of bonds issued at one time. Bonds are usually issued with a face value that is some multiple of $1,000. Bond prices are expressed as a percentage of face value; for example, when bonds with a face value of $100,000 are issued at 97, the corporation receives $97,000.

9.The face interest rate is the rate paid to bondholders based on the face value, or principal, of the bonds. The market interest rate (also called the effective interest rate) is the rate paid in the market on bonds of similar risk.

a.When the face interest rate is less than the market interest rate for similar bonds on the issue date, the bonds will probably sell at a discount (less than face value).

b.When the face interest rate is greater than the market interest rate for similar bonds on the issue date, the bonds usually sell at a premium (greater than face value).

10.A corporation can issue several types of bonds, each having different features.

a.Unsecured bonds (also called debenture bonds) are issued on the general credit of the corporation. Secured bonds give the bondholders a pledge of certain of the corporation’s assets as a guarantee of repayment.

b.When all the bonds in an issue mature on the same date, they are called term bonds. When the bonds in an issue mature on different dates, they are called serial bonds.

c.Callable bonds give the issuer the right to buy back and retire the bonds at a specified call price before the maturity date. The retirement of a bond issue before its maturity date is called early extinguishment of debt. A company may decide to retire its callable bonds for a number of reasons—for example, because it wants to restructure its debt to equity ratio or, if the market interest rate drops, because it wants to issue new debt at a lower interest rate.

d.Convertible bonds give the bondholder the option of converting them to the common stock of the issuing corporation. Because of this feature, the interest rate the corporation pays is usually lower than the rate it pays on other types of bonds.

e.Registered bonds are those for which the corporation maintains a record of bondholders and pays them interest by check on the interest payment date. Coupon bonds have detachable coupons stating the amount of interest due and the payment date, which the bondholders remove and present at a bank for collection of the interest due.

Objective 3: Record bonds issued at face value and at a discount or premium.

11.It is not necessary to make a journal entry to record the authorization of a bond issue. However, most companies disclose the authorization in the notes to their financial statements. The bonds will eventually be sold at face value, at a discount, or at a premium.

a.When the face interest rate equals the market interest rate on the issue date, the corporation will probably receive face value for the bonds. The journal entry consists of a debit to Cash and a credit to Bonds Payable for the face amount of the bond. When periodic interest is paid or accrued, the journal entry consists of a debit to Bond Interest Expense and a credit to Cash or Interest Payable. The formula for calculating interest for a period is as follows:

Interest = Principal × Rate × Time

b.When bonds are issued at a discount, the journal entry consists of a debit to Cash, a debit to Unamortized Bond Discount, and a credit to Bonds Payable. Unamortized Bond Discount appears on the balance sheet as a contra-liability to Bonds Payable. The difference between the two amounts is the carrying value, or present value, of the bonds. The carrying value increases as the discount is amortized and equals the face value of the bonds at maturity.

c.When bonds are issued at a premium, the journal entry consists of a debit to Cash, a credit to Unamortized Bond Premium, and a credit to Bonds Payable. Unamortized Bond Premium is added to Bonds Payable on the balance sheet to produce the carrying value. The carrying value decreases as the premium is amortized and equals the face value of the bonds at maturity.

12.The costs involved in issuing bonds (such as underwriters’ fees) benefit the entire life of a bond issue. The usual way of treating these costs is to establish a separate account for them and to spread them out over the life of the bonds, often through the amortization of a discount or premium.

Objective 4: Use present values to determine the value of bonds.

13.Theoretically, the value of a bond is equal to the sum of the present values of (a) the periodic interest payments and (b) the single payment of the principal at maturity. The present value of an ordinary annuity table is used for the interest payment component, and the present value of a single sum table is used for the principal payment component. The discount rate used is based on the current market rate of interest.

14.When semiannual interest is assumed, cut the discount rate in half and double the number of periods when referring to the tables. If the present value of the bond is less than its face value, then a discount applies. However, if the present value of the bond is greater than its face value, a premium applies.

Objective 5: Amortize bond discounts and bond premiums using the straight-line and effective interest methods.

15.When a company issues bonds at a discount or premium, the interest payments it makes do not equal the actual total interest cost. Instead, total interest cost equals the interest payments over the life of the bond plus the original discount amount or minus the original premium amount.

16.A discount on bonds payable is considered an interest charge that must be amortized (spread out) over the life of the bond. Amortization is usually recorded on the interest payment dates, using either the straight-line method or the effective interest method.

a.The straight-line method allocates a bond discount equally over each interest period in the life of the bond. The amount to be amortized each period is calculated by dividing the bond discount by the total number of interest payments.

b.The effective interest method is more difficult to apply than the straight-line method, but it must be used when the results of the two methods differ significantly. To apply the effective interest method to the amortization of a discount, it is first necessary to determine the market interest rate for similar securities on the issue date. This rate (halved for semiannual interest) is multiplied by the carrying value of the bonds for each interest period to obtain the bond interest expense to be recorded. The actual interest paid is then subtracted from the recorded bond interest expense to obtain the discount amortization for the period. Because the unamortized discount is now less, the carrying value is greater. The new carrying value is applied to the next period, and the same procedure is repeated.

c.A zero coupon bond is a promise to pay a fixed amount at maturity, with no periodic interest payments. Investors’ earnings consist of the large discount given when the bond is issued, which the issuing organization then amortizes over the life of the bond.

17.Amortization of a premium acts as an offset against interest paid in determining the interest expense to be recorded.

a.Under the straight-line method, the premium to be amortized in each period equals the bond premium divided by the number of interest payments during the life of the bond.

b.The effective interest method is applied to the amortization of bond premiums in almost exactly the same way as it is applied to the amortization of bond discounts. The only difference is that the amortization for the period is computed by subtracting the bond interest expense recorded from the actual interest paid (rather than by subtracting actual interest paid from the bond interest expense recorded).

Objective 6: Account for the retirement of bonds and the conversion of bonds into stock.

18.Whenever bonds are called, an entry is needed to eliminate Bonds Payable and any unamortized premium or discount and to record the payment of cash at the call price. In addition, a gain or loss on the retirement of the bonds must be recorded.

19.When a bondholder converts his or her bonds into common stock, the company records the common stock at the carrying value of the bonds. The entry eliminates Bonds Payable and any unamortized discount or premium and records common stock and additional paid-in capital. No gain or loss is recorded.

Supplemental Objective 7: Record bonds issued between interest dates and year-end adjustments.

20.When an organization issues bonds between interest payment dates, it collects from investors the interest that has accrued since the last interest payment date. The journal entry consists of a debit to Cash, a credit to Bond Interest Expense, and a credit to Bonds Payable. At the end of the first interest period, the investors are reimbursed for the payment described above, and are paid for the rest of the interest earned during the period.

21.When an accounting period ends between interest payment dates, the accrued interest and the proportionate discount or premium amortization must be recorded. On the subsequent interest payment date, the journal entry must eliminate the liability for interest that was previously established.

Summary of Journal Entries Introduced in Chapter 13

A. / (LO1) / Mortgage Payable / XX (principal)
Mortgage Interest Expense / XX (interest)
Cash / XX (monthly payment)
Made monthly mortgage payment
B. / (LO1) / Capital Lease Equipment / XX (present value)
Capital Lease Obligations / XX (present value)
To record capital lease
C. / (LO1) / Depreciation Expense, Capital Lease Equipment / XX (amount allocated)
Accumulated Depreciation, Capital Lease Equipment / XX (amount allocated)
To record depreciation expense on capital lease
D. / (LO1) / Interest Expense / XX (amount incurred)
Capital Lease Obligations / XX (amount reduced)
Cash / XX (amount paid)
Made payment on capital lease
E. / (LO3) / Cash / XX (amount received)
Bonds Payable / XX (face value)
Sold bonds at face value
F. / (LO3) / Bond Interest Expense / XX (amount incurred)
Cash (or Interest Payable) / XX (amount paid or due)
Paid (or accrued) interest to bondholders
G. / (LO3) / Cash / XX (amount received)
Unamortized Bond Discount / XX (amount of discount)
Bonds Payable / XX (face value)
Sold bonds at a discount
H. / (LO3) / Cash / XX (amount received)
Unamortized Bond Premium / XX (amount of premium)
Bonds Payable / XX (face value)
Sold bonds at a premium
I. / (LO5) / Bond Interest Expense / XX (amount incurred)
Unamortized Bond Discount / XX (amount amortized)
Cash (or Interest Payable) / XX (amount paid or due)
Paid (or accrued) interest to bondholders and
amortized the discount
J. / (LO5) / Bond Interest Expense / XX (amount incurred)