ch15, Accounting Principles

Prepared by
Coby Harmon
University of California, Santa Barbara
Westmont College
15-1
15 Long-Term Liabilities
Learning Objectives
After studying this chapter, you should be able to:
[1] Explain why bonds are issued.
[2] Prepare the entries for the issuance of bonds and interest expense.
[3] Describe the entries when bonds are redeemed or converted.
[4] Describe the accounting for long-term notes payable.
[5] Contrast the accounting for operating and capital leases.
[6] Identify the methods for the presentation and analysis of long-term
liabilities.
15-2
Preview of Chapter 15
Accounting Principles
Eleventh Edition
Weygandt Kimmel Kieso
15-3
Bond Basics
Bonds are a form of interest-bearing notes payable.
Three advantages over common stock:
1. Stockholder control is not affected.

2. Tax savings result.
3. Return on common stockholders equity may be higher.
Helpful
Helpful Hint
Hint Besides
Besides
corporations,
corporations, governmental
governmental
agencies
agencies and
and universities
universities
also
also issue
issue bonds
bonds to
to raise
raise
capital.
capital.
15-4 LO 1 Explain why bonds are issued.

Bond Basics
Effects on earnings per sharestocks vs. bonds.

Illustration 15-2

Bond Basics
Question
Major disadvantages resulting from the use of bonds are:
a. that interest is not tax deductible and the principal

must be repaid.
b. that the principal is tax deductible and interest must be

paid.
c. that neither interest nor principal is tax deductible.
d. that interest must be paid and principal repaid.

Bond Basics
Types of Bonds
Secured and Unsecured (debenture) bonds.
Term and Serial bonds.
Registered and Bearer (or coupon) bonds.
Convertible and Callable bonds.

Bond Basics
Issuing Procedures
State laws grant corporations the power to issue bonds.
Board of directors and stockholders must approve bond

issues.
Board of directors must stipulate number of bonds to be

authorized, total face value, and contractual interest rate.
Bond contract known as a bond indenture.
Paper certificate, typically a $1,000 face value.

Bond Basics
Issuing Procedures
Represents a promise to pay:
sum of money at designated maturity date, plus
periodic interest at a contractual (stated) rate on the

maturity amount (face value).
Interest payments usually made semiannually.
Generally issued when the amount of capital needed is

too large for one lender to supply.

Bond Basics
Issuer Illustration 15-3
Issuer of
of Bond certificate
Bonds
Bonds
Maturity
Maturity
Date
Date
Contractual
Contractual
Interest
Interest
Rate
Rate
Face
Face or
or
15-10 Par
Par Value
Value LO 1 Explain why bonds are issued.
Bond Basics
Determining the Market Value of a Bond

Market value is a function of the three factors that determine
present value:
1. dollar amounts to be received,
2. length of time until the amounts are received, and
3. market rate of interest.
The features of a bond (callable, convertible, and so on) affect the

market rate of the bond.

15-12
Accounting for Bond Issues
Corporation records bond transactions when it

issues (sells),
retires (buys back) bonds and
when bondholders convert bonds into common stock.
NOTE: If bondholders sell their bond investments to other investors,

the issuing firm receives no further money on the transaction, nor
does the issuing corporation journalize the transaction.
15-13 LO 2 Prepare the entries for the issuance of bonds and interest expense.
Issue at Par, Discount, or Premium?

Illustration 15-4
Bond
Contractual
Interest Rate
of 10%
Question
The rate of interest investors demand for loaning funds to a
corporation is the:
a. contractual interest rate.
b. face value rate.
c. market interest rate.
d. stated interest rate.
Question
Karson Inc. issues 10-year bonds with a maturity value of $200,000.
If the bonds are issued at a premium, this indicates that:
a. the contractual interest rate exceeds the market interest rate.
b. the market interest rate exceeds the contractual interest rate.
c. the contractual interest rate and the market interest rate are
the same.
d. no relationship exists between the two rates.
Issuing Bonds at Face Value

Illustration: On January 1, 2014, Candlestick, Inc. issues
$100,000, five-year, 10% bonds at 100 (100% of face value). The
entry to record the sale is:
Jan. 1 Cash 100,000
Bonds Payable 100,000

$100,000, five-year, 10% bonds at 100 (100% of face value).
Assume that interest is payable semiannually on January 1 and
July 1. Prepare the entry to record the payment of interest on July
1, 2014, assume no previous accrual.
July 1 Interest Expense 5,000
Cash 5,000

$100,000, five-year, 10% bonds at 100 (100% of face value).
Assume that interest is payable semiannually on January 1 and
July 1. Prepare the entry to record the accrual of interest on
December 31, 2014, assume no previous accrual.
Dec. 31 Interest Expense 5,000
Interest Payable 5,000
Issuing Bonds at a Discount

Illustration: On January 1, 2014, Candlestick,
Inc. sells $100,000, five-year, 10% bonds for
$92,639 (92.639% of face value). Interest is
payable on July 1 and January 1. The entry to
record the issuance is:
Jan. 1 Cash 92,639
Discount on Bonds Payable 7,361
Statement Presentation
Illustration 15-5
Carrying value or
book value
Sale of bonds below face value causes the total cost of borrowing to be
more than the bond interest paid.
The reason: Borrower is required to pay the bond discount at the maturity
date. Thus, the bond discount is considered to be a increase in the
cost of borrowing.
Total Cost of Borrowing

Illustration 15-6
Illustration 15-7
Question
Discount on Bonds Payable:
a. has a credit balance.
b. is a contra account.
c. is added to bonds payable on the balance sheet.
d. increases over the term of the bonds.
Issuing Bonds at a Premium

Illustration: On January 1, 2014, Candlestick,
Inc. sells $100,000, five-year, 10% bonds for
$108,111 (108.111% of face value). Interest is
payable on July 1 and January 1. The entry to
record the issuance is:
Jan. 1 Cash 108,111
Premium on Bonds Payable 8,111
Statement Presentation
Illustration 15-8
Sale of bonds above face value causes the total cost of borrowing to be
less than the bond interest paid.
The reason: The borrower is not required to pay the bond premium at the
maturity date of the bonds. Thus, the bond premium is considered to
be a reduction in the cost of borrowing.
Total Cost of Borrowing

Illustration 15-9
Illustration 15-10
Accounting for Bond Redemptions
Redeeming Bonds at Maturity

Assuming that the company pays and records separately the
interest for the last interest period, Candlestick records the
redemption of its bonds at maturity as follows:
Jan. 1 Bonds Payable 100,000

Cash 100,000
15-27 LO 3 Describe the entries when bonds are redeemed or converted.

Redeeming Bonds before Maturity

When bonds are retired before maturity, it is necessary to:
1. eliminate carrying value of bonds at redemption date;
2. record cash paid; and
3. recognize gain or loss on redemption.
The carrying value of the bonds is the face value of the bonds less
unamortized bond discount or plus unamortized bond premium at the
redemption date.

Question
When bonds are redeemed before maturity, the gain or loss on
redemption is the difference between the cash paid and the:
a. carrying value of the bonds.
b. face value of the bonds.
c. original selling price of the bonds.
d. maturity value of the bonds.

Illustration: Assume Candlestick, Inc. has sold its bonds at a

premium. At the end of the eighth period, Candlestick retires these
bonds at 103 after paying the semiannual interest. The carrying
value of the bonds at the redemption date is $101,623.
Candlestick makes the following entry to record the redemption at
the end of the eighth interest period (January 1, 2018):
Jan. 1 Bonds Payable 100,000

Premium on Bonds Payable 1,623
Loss On Bond Redemption 1,377
Cash 103,000

Converting Bonds into Common Stock

Until conversion, the bondholder receives interest on the bond.
For the issuer, the bonds sell at a higher price and pay a lower
rate of interest than comparable debt securities without the
conversion option.
Upon conversion, the company transfers the carrying value of

the bonds to paid-in capital accounts. No gain or loss is
recognized.

Illustration: On July 1, Saunders Associates converts

$100,000 bonds sold at face value into 2,000 shares of $10 par
value common stock. Both the bonds and the common stock
have a market value of $130,000. Saunders makes the
following entry to record the conversion:
July 1 Bonds Payable 100,000

Common Stock (2,000 x $10) 20,000
Paid-in Capital in Excess of Par 80,000

Question
When bonds are converted into common stock:
a. a gain or loss is recognized.
b. the carrying value of the bonds is transferred to paid-in
capital accounts.
c. the market price of the stock is considered in the entry.
d. the market price of the bonds is transferred to paid-in

capital.

Accounting for Other Long-Term Liabilities
Long-Term Notes Payable

May be secured by a mortgage that pledges title to specific assets
as security for a loan.
Typically, terms require borrower to make installment payments

over the term of the loan. Each payment consists of
interest on the unpaid balance of the loan and
a reduction of loan principal.
Companies initially record mortgage notes payable at face value.
15-34 LO 4 Describe the accounting for long-term notes payable.

Illustration: Porter Technology Inc. issues a $500,000, 12%, 20-

year mortgage note on December 31, 2014. The terms provide for
semiannual installment payments of $33,231 (not including real
estate taxes and insurance). The installment payment schedule for
the first two years is as follows.
Illustration 15-11

Illustration: Porter Technology Inc. issues a $500,000, 12%, 20-

year mortgage note on December 31, 2014. The terms provide for
semiannual installment payments of $33,231 (not including real
estate taxes and insurance). Prepare the entries to record the
mortgage and first payment.
Dec. 31 Cash 500,000

Mortgage Payable 500,000
Jun. 30 Interest Expense 30,000

Mortgage Payable 3,231
Cash 33,231

Question
Each payment on a mortgage note payable consists of:
a. interest on the original balance of the loan.
b. reduction of loan principal only.
c. interest on the original balance of the loan and reduction

of loan principal.
d. interest on the unpaid balance of the loan and reduction

of loan principal.

15-38
Lease Liabilities
A lease is a contractual arrangement between a lessor (owner
of the property) and a lessee (renter of the property).
Illustration 15-12
15-39 LO 5 Contrast the accounting for operating and capital leases.

The issue of how to report leases is the case of substance versus

form. Although technically legal title may not pass, the benefits
from the use of the property do.
Operating Lease Capital Lease

Journal Entry: Journal Entry:
Rent Expense xxx Leased Equipment xxx
Cash xxx Lease Liability xxx
A lease that transfers substantially all of the benefits and risks

of property ownership should be capitalized (only
noncancellable leases may be capitalized).

To capitalize a lease, one or more of four criteria must be

met:
Transfers ownership to the lessee.
Contains a bargain purchase option.
Lease term is equal to or greater than 75 percent of the
estimated economic life of the leased property.
The present value of the minimum lease payments
(excluding executory costs) equals or exceeds 90 percent of
the fair value of the leased property.

Illustration: Gonzalez Company decides to lease new equipment.

The lease period is four years; the economic life of the leased
equipment is estimated to be five years. The present value of the
lease payments is $190,000, which is equal to the fair market value
of the equipment. There is no transfer of ownership during the
lease term, nor is there any bargain purchase option.
Instructions:
a. What type of lease is this? Explain.
b. Prepare the journal entry to record the lease.

Illustration: (a) What type of lease is this? Explain.
Capitalization Criteria: Capital Lease?

1. Transfer of ownership NO
2. Bargain purchase option NO
3. Lease term => 75% of Lease term
economic life of leased
property 4 yrs.
Economic life
4. Present value of minimum
YES - PV and FMV
lease payments => 90% of 5 yrs.are the same.
FMV of property YES
15-43 LO 5 Contrast the accounting for
80% operating and capital leases.
Illustration: (b) Prepare the journal entry to record the lease.
Leased Asset - Equipment 190,000
Lease Liability 190,000
The portion of the lease liability expected to be paid in the next

year is a current liability.
The remainder is classified

as a long-term liability.

Question
The lessee must record a lease as an asset if the lease:
a. transfers ownership of the property to the lessor.
b. contains any purchase option.
c. term is 75% or more of the useful life of the leased

property.
d. payments equal or exceed 90% of the fair market

value of the leased property.

Statement Presentation and Analysis
Presentation
Illustration 15-13
15-46
LO 6 Identify the methods for the presentation
and analysis of long-term liabilities.
Analysis
Two ratios that provide information about debt-paying ability
and long-run solvency are:
Debt to Total Assets Ratio
Times Interest Earned
15-47
LO 6 Identify the methods for the presentation
and analysis of long-term liabilities.
Analysis
Illustration: Kellogg had total liabilities of $8,925 million, total assets
of $11,200 million, interest expense of $295 million, income taxes of
$476 million, and net income of $1,208 million.
The higher the percentage of debt to total assets, the greater the
risk that the company may be unable to meet its maturing obligations.
15-48
LO 6
Analysis
Illustration: Kellogg had total liabilities of $8,925 million, total assets
of $11,200 million, interest expense of $295 million, income taxes of
$476 million, and net income of $1,208 million.
Times interest earned indicates the companys ability to meet

interest payments as they come due.
15-49
LO 6
15-50
Present Value Concepts Related to
APPENDIX 15A Bond Pricing
Present Value of a Single Amount

Illustration: Assume that you are willing to invest a sum of money
that will yield $1,000 at the end of one year, and you can earn 10%
on your money. What is the $1,000 worth today?
To compute the answer,

1. divide the future amount by 1 plus the interest rate ($1,000
1.10 = $909.09 OR
2. use a Present Value of 1 table. ($1,000 X .90909) = $909.09

(10% per period, one period from now).
15-51 LO 7 Compute the market price of a bond.

APPENDIX 15A Present Value of a Single Amount
1. divide the future amount by 1 plus the interest rate

($1,000 1.10 = $909.09.
Illustration 15A-1

2. use a Present Value of 1 table. ($1,000 X .90909) =

$909.09 (10% per period, one period from now).

The future amount ($1,000), the interest rate (10%), and the
number of periods (1) are known
Illustration 15A-2

If you are to receive the single future amount of $1,000 in

two years, discounted at 10%, its present value is $826.45
[($1,000 1.10) 1.10].
Illustration 15A-3

To compute the answer using a Present Value of 1 table.

($1,000 X .82645) = $826.45 (10% per period, two periods
from now).

APPENDIX 15A Present Value of Interest Payments (Annuities)
In addition to receiving the face value of a bond at maturity,

an investor also receives periodic interest payments
(annuities) over the life of the bonds.
To compute the present value of an annuity, we need to

know:
1) interest rate,
2) number of interest periods, and
3) amount of the periodic receipts or payments.

Assume that you will receive $1,000 cash annually for three
years and the interest rate is 10%.
Illustration 15A-5

Illustration 15A-6

$1,000 annual payment x 2.48685 = $2,486.85

APPENDIX 15A Computing the Present Value of a Bond
Selling price of a bond is equal to the sum of:

Present value of the face value of the bond discounted at
the investors required rate of return
PLUS
Present value of the periodic interest payments discounted

at the investors required rate of return

Assume a bond issue of 10%, five-year bonds with a face value

of $100,000 with interest payable semiannually on January 1
and July 1.
Illustration 15A-8


and July 1.
Illustration 15A-9


and July 1.
Illustration 15A-10


and July 1.
Illustration 15A-11

Effective-Interest Method of Bond
APPENDIX 15B Amortization
Effective-Interest Method of Bond Amortization

Under the effective-interest method, the amortization of bond
discount or bond premium results in periodic interest expense
equal to a constant percentage of the carrying value of the
bonds.
Required steps:
1. Compute the bond interest expense.
2. Compute the bond interest paid or accrued.
3. Compute the amortization amount.
LO 8 Apply the effective-interest method of amortizing

15-66
bond discount and bond premium.
Effective-Interest Method of Bond
APPENDIX 15B Amortization
Amortizing Bond Discount

Illustration: Candlestick, Inc. issues $100,000 of 10%, five-year
bonds on January 1, 2014, for $92,639, with interest payable each
July 1 and January 1. This results in a discount of $7,361.
Illustration 15B-2

15-67
APPENDIX 15B Amortizing Bond Discount

July 1 and January 1. This results in a discount of $7,361.
Journal entry on July 1, 2014, to record the interest payment and

amortization of discount is as follows:

Cash 5,000
Discount on Bonds Payable 558

15-68
APPENDIX 15B Amortizing Bond Premium

July 1 and January 1. This results in a premium of $8,111.
Illustration 15B-4

15-69
APPENDIX 15B Amortizing Bond Premium

July 1 and January 1. This results in a premium of $8,111.

amortization of premium is as follows:

Premium on Bonds Payable 676
Cash 5,000

15-70
APPENDIX 15C Straight-Line Amortization
Amortizing Bond Discount

Illustration: Candlestick, Inc., sold $100,000, five-year, 10%
bonds on January 1, 2014, for $92,639 (discount of $7,361).
Interest is payable on July 1 and January 1.
Illustration 15C-2
15-71 LO 9 Apply the straight-line method of bond discount and bond premium.

bonds on January 1, 2014, for $92,639 (discount of $7,361).
Interest is payable on July 1 and January 1. The bond discount
amortization for each interest period is $736 ($7,361/10).


Discount on Bonds Payable 736
Cash 5,000
Amortizing Bond Premium

bonds on January 1, 2014, for $108,111 (premium of $8,111).
Illustration 15C-4

bonds on January 1, 2014, for $108,111 (premium of $8,111).


Premium on Bonds Payable 811
Cash 5,000
A Look at IFRS
Key Points
As indicated in Chapter 11, in general GAAP and IFRS define liabilities
similarly.
IFRS requires that companies classify liabilities as current or non-current
on the face of the statement of financial position (balance sheet), except
in industries where a presentation based on liquidity would be
considered to provide more useful information (such as financial
institutions). When current liabilities (also called short-term liabilities) are
presented, they are generally presented in order of liquidity.
Under IFRS, liabilities are classified as current if they are expected to be
paid within 12 months.
15-75 LO 10 Compare the accounting for long-term liabilities under GAAP and IFRS.
A Look at IFRS
Key Points
Similar to GAAP, items are normally reported in order of liquidity.
Companies sometimes show liabilities before assets. Also, they will
sometimes show non-current (long-term) liabilities before current
liabilities.
Under both GAAP and IFRS, preferred stock that is required to be
redeemed at a specific point in time in the future must be reported as
debt, rather than being presented as either equity or in a mezzanine
area between debt and equity.
The basic calculation for bond valuation is the same under GAAP and
IFRS. In addition, the accounting for bond liability transactions is
essentially the same between GAAP and IFRS.
A Look at IFRS
Key Points
IFRS requires use of the effective-interest method for amortization of
bond discounts and premiums. GAAP allows use of the straight-line
method where the difference is not material. Under IFRS, companies
do not use a premium or discount account but instead show the bond
at its net amount. For example, if a $100,000 bond was issued at 97,
under IFRS a company would record:
Cash 97,000
A Look at IFRS
Key Points
The accounting for convertible bonds differs across IFRS and GAAP,
Unlike GAAP, IFRS splits the proceeds from the convertible bond
between an equity component and a debt component. The equity
conversion rights are reported in equity.
Both Boards share the same objective of recording leases by lessess
and lessors according to their economic substancethat is,
according to the definitions of assets and liabilities. However, GAAP
for leases is much more rules-based with specific bright-line criteria
(such as the 90% of fair value test) to determine if a lease
arrangement transfers the risks and rewards of ownership; IFRS is
more conceptual in its provisions. Rather than a 90% cut-off, it asks
whether the agreement transfers substantially all of the risks and
rewards associated with ownership.
A Look at IFRS
Looking to the Future

The FASB and IASB are currently involved in two projects, each of which
has implications for the accounting for liabilities. One project is investigating
approaches to differentiate between debt and equity instruments. The other
project, the elements phase of the conceptual framework project, will
evaluate the definitions of the fundamental building blocks of accounting.
The results of these projects could change the classification of many debt
and equity securities.
In addition to these projects, the FASB and IASB have also identified leasing
as one of the most problematic areas of accounting. A joint project will
initially focus primarily on lessee accounting.
A Look at IFRS
IFRS Self-Test Questions

The accounting for bonds payable is:
a) essentially the same under IFRS and GAAP.
b) differs in that GAAP requires use of the straight-line method for

amortization of bond premium and discount.
c) the same except that market prices may be different because the
present value calculations are different between IFRS and GAAP.
d) not covered by IFRS.
A Look at IFRS

Under IFRS, if preference shares (preferred stock) have a requirement
to be redeemed at a specific point in time in the future, they are treated:
a) as a type of asset account.
b) as ordinary shares (common stock).
c) in the same fashion as other types of preference shares.
d) as a liability
A Look at IFRS

The leasing standards employed by IFRS:
a) rely more heavily on interpretation of the conceptual meaning of

assets and liabilities than GAAP.
b) are more rules based than those of GAAP.
c) employ the same bright-line test as GAAP.
d) are identical to those of GAAP.
Copyright
Copyright 2013 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
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express written permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser
may make back-up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no responsibility for
errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.
15-83

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[1] Explain why bonds are issued.

[3] Describe the entries when bonds are redeemed or converted.

[4] Describe the accounting for long-term notes payable.

[5] Contrast the accounting for operating and capital leases.

Bonds are a form of interest-bearing notes payable.

Three advantages over common stock:

1. Stockholder control is not affected.

15-4 LO 1 Explain why bonds are issued.

Effects on earnings per sharestocks vs. bonds.

15-5 LO 1 Explain why bonds are issued.

a. that interest is not tax deductible and the principal

b. that the principal is tax deductible and interest must be

c. that neither interest nor principal is tax deductible.

d. that interest must be paid and principal repaid.

15-6 LO 1 Explain why bonds are issued.

Term and Serial bonds.

Registered and Bearer (or coupon) bonds.

Convertible and Callable bonds.

15-7 LO 1 Explain why bonds are issued.

Board of directors and stockholders must approve bond

Board of directors must stipulate number of bonds to be

Bond contract known as a bond indenture.

Paper certificate, typically a $1,000 face value.

15-8 LO 1 Explain why bonds are issued.

sum of money at designated maturity date, plus

periodic interest at a contractual (stated) rate on the

Interest payments usually made semiannually.

Generally issued when the amount of capital needed is

15-9 LO 1 Explain why bonds are issued.

Determining the Market Value of a Bond

2. length of time until the amounts are received, and

3. market rate of interest.

The features of a bond (callable, convertible, and so on) affect the

15-11 LO 1 Explain why bonds are issued.

Corporation records bond transactions when it

NOTE: If bondholders sell their bond investments to other investors,

Issue at Par, Discount, or Premium?

b. face value rate.

c. market interest rate.

d. stated interest rate.

a. the contractual interest rate exceeds the market interest rate.

b. the market interest rate exceeds the contractual interest rate.

d. no relationship exists between the two rates.

Issuing Bonds at Face Value

Jan. 1 Cash 100,000

Bonds Payable 100,000

Illustration: On January 1, 2014, Candlestick, Inc. issues

July 1 Interest Expense 5,000

Illustration: On January 1, 2014, Candlestick, Inc. issues

Dec. 31 Interest Expense 5,000

Interest Payable 5,000

Issuing Bonds at a Discount

Jan. 1 Cash 92,639

Discount on Bonds Payable 7,361

Bonds Payable 100,000

Total Cost of Borrowing

a. has a credit balance.

c. is added to bonds payable on the balance sheet.

d. increases over the term of the bonds.

Issuing Bonds at a Premium

Jan. 1 Cash 108,111

Bonds Payable 100,000

Premium on Bonds Payable 8,111