Financial accounting 9th jamie pratt chapter 11

Chapter 11
Long-Term Liabilities
Notes, Bonds, and Leases


Long-Term Liabilities
 Many companies finance their operations and growth

opportunities through the use of long term debt
instruments:

 Notes Payable – Formal borrowing agreement

 Bonds Payable – Issued to bondholders, smaller

dollar amounts and larger amount of notes

 Leasehold Obligations – future cash payments for

use of an asset


The Relative Size of Long-Term Liabilities
Figure 11-1 Long-term liabilities as a
percentage of total assets, total
liabilities, and shareholders’ equity


Economic Consequences of Reporting
Long-Term Liabilities

 Improved credit ratings can lead to

lower borrowing costs

 Management has strong incentive to

manage the balance sheet by using
“off-balance-sheet financing”


Basic Definitions and Different Contractual
Forms
•

Some contracts, called interest-bearing obligations, require periodic
(annual or semiannual) cash payments (called interest) that are
determined as a percentage of the face, principal, or maturity value,
which must be paid at the end of the contract period.

•

Non-interest-bearing obligations, on the other hand, require no
periodic payments, but only a single cash payment at the end of the
contract period.

•

These contractual forms may contain additional terms that specify
assets pledged as security or collateral in case the required cash
payments are not met (default), as well as additional provisions

(restrictive covenants).


Basic Definitions and Different Contractual
Forms

Figure 11-2 Six possible kinds of notes


Long-Term Liabilities Notes, Bonds, and
Leases
 Long-term liabilities are recorded at the present value of the future cash

flows.

 Two components determine the “time value” of money:
 interest (discount) rate
 number of periods of discounting

 Types of activities that require PV calculations:
 notes payable
 bonds payable and bond investments
 capital leases


Accounting for Long-Term Notes Payable

Figure 11-3 Accounting for non-interest-bearing note in exchange for equipment

Present Value of a Single Sum
All present value calculations presume a discount rate (i) and a
number of periods of discounting (n). There are 3 different
ways you can calculate the PV1:
1. Formula: PV1 = FV1 [1/(1+i)n]
2. Tables – near the back of your book
3. Financial Calculator (time value of money).


Long-term Notes Payable
Example Problem 1: On January 2, 2014, Pearson Company
purchases a section of land for its new plant site. Pearson issues a
5 year non-interest bearing note, and promises to pay $50,000 at the
end of the 5 year period. What is the cash equivalent price of the
land, if a 6 percent discount rate is assumed?
PV1 = 50,000 x ( 0.74726) = $37,363
(0.74726 from PV Table)

Journal entry Jan. 2, 2008:
Dr. Land 37,363
Dr. Discount on N/P

12,637

Cr. Notes Payable 50,000

[ i=6%, n=5]


Long-term Notes Payable – Ex. Prob 1 cont’d

The Effective Interest Method:
Interest Expense =
Carrying value x Interest rate x Time period
(CV)

(Per year)

(Portion of year)

Where carrying value = face - discount.
For Example 1, CV= 50,000 - 12,637 = 37,363
Interest expense = 37,363 x 6% per year x 1year
= $2,242


Long-term Notes Payable – Ex. Prob 1 cont’d
Journal entry, December 31, 2014:
Interest expense
Discount on N/P

2,242
2,242

Carrying value on B/S at 12/31/2014:
Notes Payable
Discount on N/P

$50,000
(10,395)

$39,605

(Discount = $12,637 - 2,242 = $10,395)


Long-term Notes Payable – Ex. Prob 1 cont’d
Interest expense at Dec. 31, 2015:
39,605 x 6% x 1 = $2,376
Journal entry, December 31, 2015:
Interest expense
2,376
Discount on N/P
2,376
Carrying value on B/S at 12/31/2015:
Notes Payable
$50,000
Discount on N/P
(8,019) $41,981
(Discount = 10,395 - 2,376)
Carrying value on 12/31/2018 (before retirement)?
$50,000


Bonds Payable
Figure 11-4 (partial) Bond Terminology


Bonds Payable Example

Figure 11-5 Example of bond issuance: Northern States Power Company (dollars in thousands)

The Price of a Bond

Figure 11-6 Bond prices and the relationship between the effective rate and
the stated rate (bond terms: $1,000 face value, a 6 percent stated rate, and
a five-year life)


Case 1: Bonds at Par
Case 2: Bonds at a Discount
Cash Flows for Bonds Payable

Figure 11-7 Cash flows for bonds payable: Two cases compared


Case 1: Bonds Issued at Par

Figure 11-8
Bonds issued
at face value:
Case 1


Bonds Payable at a Discount
 If bonds are issued at a discount, the carrying value will be

below face value at the date of issue.

 The Discount on B/P account has a normal debit balance

and is a contra to B/P (similar to the Discount on N/P).

 The Discount account is amortized with a credit. Note that

the difference between Cash Paid and Interest Expense is
still the amount of amortization.
 Interest expense for bonds issued at a discount will be
greater than cash paid.

 The amortization table will show the bonds amortized up to

face value.


Case 2: Bonds Issued at a Discount

Figure
11-9
Bonds
issued
at a
discount:
Case 2


Issuing Bonds at Par and at a Discount: A Comparison
Amortization Tables

Figure

11-10
Bonds
amortization
tables


Present Value of an Ordinary Annuity
(PVOA)

PVOA calculations presume a discount rate (i),
where (A) = the amount of each annuity, and (n) =
the number of annuities (or rents), which is the same
as the number of periods of discounting. There are
3 different ways you can calculate PVOA:
1. Formula: PVOA = A [1-(1/(1+i)n)] / i
2. Tables: near the back of you book
3. Financial Calculator (time value of money).


Accounting for Bonds Payable
Example Problem 2: On July 1, 2014, Mustang Corporation issues
$100,000 of its 5-year bonds which have an annual stated rate of
7%, and pay interest semiannually each June 30 and December 31,
starting December 31, 2014. The bonds were issued to yield 6%
annually.

 Calculate the issue price of the bond:

(1) What are the cash flows and factors?
Face value at maturity = $100,000

Stated Interest =
Face value x stated rate x time period
100,000 x 7% x (1/2) = $3,500
Number of periods = n = 5 years x 2 = 10
Discount rate = 6% / 2 = 3% per period


Accounting for Bonds Payable – Ex. Prob 2 cont’d
PV of interest annuity:
PVOA Table

PVOA = 3,500 (8.53020) = $29,856
i = 3%, n = 10
PV of face value:
PV1 Table

PV = 100,000 (0.74409)=$74,409
i=3%, n=10
Total issue price =
$104,265
Issued at a premium of $4,265 because the company
was offering an interest rate greater than the market
rate, and investors were willing to pay more for the
higher interest rate.