Chapter 14: Long-term Liabilities 

We would all agree that the thought of being in debt for a number of years is not appealing, but usually from a business standpoint, these sacrifices bring economic benefit in return. For example, if Annie's fashion corporation needs to raise funds to run a business, it could issue bonds - After that it would need to find investors to buy the bonds. Annie's Fashion Corp. would have to pay the investors interest more than likely semiannually. At maturity, it would pay the investors face value of the bond. From an investor's side of this situation, by loaning Annie's fashion corporation money, he/she would earn interest on the principal amount semi annually, this is the return on the investment. From the Fashion corporations' side, it could afford to run the business and begin earning revenue - so paying back the principal to the bondholder (investor) at the day of maturity would be no problem for the corporation. (hopefully)

I know you're so excited to learn about long-term debt!  So let's get started!

I did a little research and found that ULTA has $164,598 in long-term liabilities! Not too bad considering their net income is $71 million. This year they plan to open approximately 61 new stores, remodel 17 stores and relocate 1 store.

 
Let's get started on learning the core of this chapter! You might be thinking, what exactly is a long-term liability?
Well, it is long-term debt, and this essentially is:
  1. Probable future sacrifices of economic benefits arising from present obligations,
  2. Payable in the future, normally beyond one year or operating cycle, whichever is longer.
  • Examples: bonds payable, long-term notes payable, mortgage notes payable, pension liabilities and lease obligations.

 Bonds

A bond contract is known as a bond indenture:

  • Represents a promise to pay:
           1) Sum of money at designated maturity date, plus
       2) periodic interest at a specific rate on the maturity amount (face value).
  • Paper certificate, typically a $1,000 face value.
  • Interest payments usually made semiannually.
  • Purpose is to borrow when the amount of capital needed is too large for one lender to supply.
 
It is a lot like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure.

Common types found in practice:

  • Secured and Unsecured (debenture) bonds: Secured bonds are backed by a pledge of some sort of collateral. For example: Mortgage bonds are secured by a claim on real estate. Collateral trust bonds are secured by stocks and bonds of other corporations. Bonds not backed by collateral are unsecured. A debenture bonds is unsecured. A "junk bond" is unsecured and also very risky, and therefore pays a higher interest rate. Companies often use these bonds to finance leverage buyouts.
  • Term, Serial, and Callable bonds: Bond issues that mature on a single date are called term bonds; issues that mature in installments are called Serial bonds. Serially maturing bonds are frequently used by school or sanitary districts, municipalities, or other local taxing bodies that receive money through a special levy. Callable bonds give the issuer the right to call and retire the bonds prior to maturity.
      • Term bonds: Bond sinking funds.
      • Serial bonds: series of maturities
      • Callable bonds: can be called back early by the issuer at request.
  • Convertible bonds, Commodity-backed bonds, Deep-discount bonds (Zero-Interest debenture bonds):If bonds are convertible into other securities of the corporation for a specified time after issuance, they are Convertible bonds. Two types of bonds have been developed in an attempt to attract capital in a tight money market: commodity-backed bonds and deep-discount bonds. Commodity backed bonds (also called asset-linked bonds) are redeemablein measures of a commodity, such as barrells of oil, tons of coal,or ounces of rare metal. JCPenney sold the first publicly marketed long-term debt securities in the United States that do not bear interest. These deep-discount bonds, also referred to as zero-interest debenture bonds, are sold at a discount that provides the buyer's total interest payoff at maturity.
  • Registered Bonds and bearer of coupon bonds: Bonds issued in the name of the owner are registered bonds  and require surrender of the certificate and issuance of a new certificate to complete a sale. A bearer or coupon bond, however, is not recorded in the name of the owner and may be transferred from one owner to another by mere delivery.
  • Income and Revenue bonds: Income bonds pay no interest unless the issuing company is profitable. Revenue bonds, so called because the interest on them is paid from specified revenue sources, are most frequently issued by airports, school districts, counties, toll-road authorities, and governmental bodies.
Between the time the company sets the terms and the time it issues the bonds, the market conditions and the financial position of the issuing corporation may change significantly. Such changes affect the marketability of the bonds and thus their selling price.

The investment community values a bond at the present value of its expected future cash flows, which consists of:
  1. Interest and
  2. Principal.
Interest Rates
  • Stated, Coupon, or Nominal rate = The interest rate written in the terms of the bond indenture.
    • This rate is used to calculate the interest payment.
  • Market rate or effective yield = rate that provides an acceptable return on an investment commensurate with the issuer's risk characteristics. 
    • This is the rate of interest actually earned by the bondholders. (investors)
    • The market determines this rate, also. 
So you might be asking yourself, How do I calculate the amount of interest that is actually paid to the bondholder each period?
  • Stated rate x Face value of the bond ***The only time we use the stated rate is to calculate the interest payment.
Next, you need to calculate the amount of interest that is actually recorded as interest expense by the issuer of the bond! 
  • Market rate x Carrying Value of the bond
So now you are ready to calculate the Selling price of a Bond! 

First, you know this depends on the Market rate of interest - 
So now that you know the market rate, you compute the selling price this way:
  • PV of maturity value, plus (This is a single amount - So you would use Table 2, Present value of 1)
  • PV of interest payments, at what rate? 
    • Market rate of interest.
For semiannual interest paying bonds:
  • Requires doubling the periods
  • Halving the interest rate
Now let's try an exercise! 

Three year bonds are issued at Face value of $100,000 on Jan 1, 2011, with a stated interest rate of 8%. Interest paid annually on Dec. 31. Calculate the issue price of the bonds, market rate of 8%.

(Notice the stated rate = market rate - So that is a hint that the bond is being sold at par)
n=3 i=8%

Principal: 100,000 x .79383 = 79,383 (Since we are computing the PV of a SINGLE sum - we use Table 2)

Interest: 8,000* x 2.57710 = 20,617 (Since we are computing the PV of an annuity (series of payments) that is due on Dec 31, it would be classified as an ordinary annuity and we would use Table 4)

Next we add the Principal + Interest to get the Present value of the bond.

So 79,383 + 20,617 = 100,000. Since this amount = the Face value, then the bond is being sold at par, thus no discount or premium will be recorded.

* 100,000 (face value)  x 8% (stated rate, only time we use this rate)  = 8,000 

I will use my professor's amortization table to show the effective interest method

                                   A                               B                               C                                        D                                            E  
                              PV at beg. of period        Interest Expense         Interest Payment    Amortization of (premium)/discount    PV @ End period (CV)
1/1/11 issuance                                        (A x Effective rate)  (MV x stated rate)                     (B-C)                                    (A+D)
Periods                                                      (100,000 x 8%)
1                                   100,000                         8,000                         8,000                                      0                                      100,000
2                                   100,000                         8,000                         8,000                                      0                                      100,000
3                                   100,000                         8,000                         8,000                                      0                                      100,000

Issuance of the bond (@ beginning):

1/1        Cash                       100,000
                Bonds Payable                      100,000   (always put the maturity value in bonds payable account)

12/31     Interest Expense       8,000
                 Cash                                   8,000

This video below really helps explain bonds sold at par!

Issuance:

Bonds are sold at a premium when the contract (stated) rate exceeds the market (effective) rate. The difference between the sales price and the face value is credited to premium on Bonds payable. (An adjunct account to Bonds payable):
  Cash                                                      xx
      Premium on Bonds payable                           xx
      Bonds payable                                                xx 
Bonds are sold at a discount when the contract (stated) rate is less than the market (effective) rate. The difference between the sales price and the face value is debited to Discount on Bonds payable. (Contra-account to Bonds Payable):
  Cash                                                      xx
  Discount on Bonds payable                   xx
         Bonds payable                                           xx


Stated rate = the market rate, the bond sells at par.
Stated rate < the market rate, the bond sells at a discount.
State rate > the market rate, the bond sells at a premium.

 

Amortization of bond discounts and premiums:

A Bond discount or premium must be amortized using the effective interest method. Under the interest method, interest expense changes every period, but the interest rate is constant.
Carrying value of Bonds = Face value Plus Premium (or Less Discount).
Interest Payable = Stated interest rate x Face value of Bonds x Time.
Interest Expense = Effective Interest Rate x Carrying Value of Bonds x Time.
If a premium exists:
 Interest Expense                                    xx
 Premium on Bonds Payable               xx
                Interest Payable                                                 xx
If a discount exists:
 Interest Expense                                    xx
               Discount on Bonds payable                            xx
               Interest Payable                                                  xx
Discount on bonds payable: is a liability valuation account, that reduces the face amount of the related liability (contra-account).
Premium on bonds payable: is a liability valuation account, that adds to the face amount of the related liability. (adjunct-account)
Unamortized bond issue costs are treated as a deferred charge and amortized over the life of the debt.
Straight-line method amortization may be used if interest expense is not materially different from the effective interest method.
Issuance expenses are debited to a deferred charge account (Bond issue costs) and amortized over the life of the bond, usually using a straight-line method.

 

Now let's try an exercise!

Annie's Fashion Co. issued 100, $1,000 bonds, with a stated interest rate of 6%, on January 1, 2011, to yield an effective interest rate (market rate) of 5%. The bonds pay interest annually on December 31, and are due on December 31, 2016. (a 5-year term for this example only).
First we need to compute the selling price of the bonds and any related premium or discount:
Present Value of an ordinary annuity of $6,000*** per period for 5 yrs. @ 5% (always use market rate) Using the tables, please refer to Table 4 (The PV of an Ord. annuity of 1) Look under i=5%, n=5 and you will find 4.32948. So now we multiply $6,000 x 4.32948 = $25,976.88 (This amount is the present value of the total interest payments)
Next we compute the Present value of the 100 bonds Annie's Fashion Co. issued.  100 x $1,000 = $100,000, this is the total principal Annie's Fashion Co. will pay at maturity. So $100,000 due in 5 periods (5 years) at 5% - going back to the tables, we use table Table 2 (Present Value of 1 - We use this table because we are computing the present value of a lump sum) again, letting i=5%, n=5 - you will find 0.78353. So now we multiply $100,000 x 0.78353 = $78,353.00.
Now we add $25,976.88 + $78,353.00 = $104,329.88 (total PV selling price) Notice, since the selling price ($104,329.88) of the bond is more than the actual price Annie's Fashion Co. issued it for ($100,000) the Fashion Co. earned a premium of $4,330 (the difference). This is always great because Annie's Fashion Co. received more money than it must repay at maturity. This premium is later recognized as Bond Income. Next let's record Annie's Fashion Company's journal entry for the issuance:
  Cash                                            104,330                                   (the cash received)
        Bonds Payable                                                 100,000     (the amount to be paid at maturity)
        Premium on Bonds Payable                          4,330         (the extra cash earned)
Balance Sheet Presentation: 
Long-term Liabilities: 
   Bonds Payable                                  $100,000
   Premium on Bonds Payable              4,330           104,330
*** Total amount issued 100 x price of bonds $1,000 = $100,000, Now multiply 100,000 by the stated interest rate of 6% to get $6,000. Also notice that this is an ordinary annuity because it is a series of payments that are due to the investor on December 31 - The end of the period.

 

Let's try another one!!

Three year bonds are issued at face value of $100,000 on Jan. 1, 2011, and a stated interest rate if 8%. Calculate the issue price of the bonds assuming a market interest rate of 10%.

*Hint- notice the stated rate is smaller than the market rate - so basically we're selling/issuing the bond at a discount because we are receiving a smaller amount than we must repay at maturity. This looks attractive to bondholders/investors. 

Let's calculate the bond selling price:

i=10% n=3

Principal: 100,000 x  .75131 = $75,131       (remember this is a lump sum amount, Table 2-PV of 1)

Interest: So now take 8,000** x  2.48685* = $19,895 

Notice you're using Table 5- PV of ord. annuity because the bonds were issued on Jan 1*

Now we add Principal + Interest = Present value of the bonds - 75,131 + 19,895 =  $95,026 Now we compare this number to the Face value of $100,000. Notice the difference to be the Discount of $4,974.

Only use stated rate to calc. the interest expense - 100,000 x .08 = 8,000**

Now let's look at my professor's amortization table:

                                  A                                                                                                    D                                          E  
                           PV @ beg. of period           Interest Expense           Interest Payment  Amortization of (premium)/discount    PV @ End period (CV)
1/1/11 issuance                                  (A x Effective or Market rate) (MV x stated rate)             (B-C)                                   (A+D)
Periods                                                       (95,026 x 10%)
1                                   95,026                           9,503                            8,000                              1,503                                    96,529
2                                   96,529                           9,653                            8,000                              1,653                                    98,182
3                                   98,182                           9,818                            8,000                              1,818                                    100,000**
 
**Notice @ the end of the 3 years, we have reached the maturity value of the bond!! Using this information we can easily make our entries!
Issuance:
1/1/11     Cash                                             95,026
                Discount on bonds payable        4,973
                      Bonds payable                                      100,000* 
*We pay back more than we receieved - thus the bondholder is getting a discount.
Amortization:
 
12/31/12  Interest Expense                         9,503
                      Discount on bonds payable                   1,503*
                      Cash                                                          8,000  
*Remember we are driving this account to zero - So we credit it to reduce it. I got this amount from Part D of the Amortization Table. 

I am thinking we need more practice - Let's try another one!

 

Three year bonds are issued at face value of $100,000 on Jan. 1, 2011, and a stated interest rate of 8%. Calculate the issue price of the bonds assuming a market rate of 6%.

If you remember the rules - when stated rate > market rate = bonds sells at premium. This is great for us! We are receiving more money for the bond we are selling/issuing than we must repay at maturity.  

i=6% n=3

Calculate the price:

Principal: 100,000 x .83962 =$83,962  [Table 2 - PV of 1]

Interest:  8,000 x 2.67301 = $21,384 [PV of ordinary annuity]

83,962 + 21,384 = 105,346 =selling price.

Now we compare 105,346 to the face value of 100,000 - the difference of 5,346 is the premium we have received.

 Now let's compute the Amortization Table:

                                                                      B                                                                    D                                       E                    

                         PV @ beg. of period           Interest Expense           Interest Payment  Amortization of (premium)/discount    PV @ End period (CV)

1/1/11 issuance                                  (A x Effective or Market rate) (MV x stated rate)             (B-C)                                   (A+D)
Periods                                                       (105,346 x 6%)
1                            105,346                                6,321                              8,000                           (1,679)                                 103,667
2                            103,667                                6,220                              8,000                           (1,780)                                  101,887
3                            101,887                                6,113                              8,000                           (1,887)                                  100,000
 
Now we make the journal entries!
 
Issuance:
1/1/11     Cash                                              105,346
                      Premium on bonds payable                     5,346
                      Bonds payable                                        100,000* 
*We pay back less than we receieved - So this is a good deal for us.
 
Amortization:
 
12/31/12  Interest Expense                           6,321
                  Premium on bonds payable        1,679
                       Cash                                                          8,000  
 

I found these videos below to be very helpful in explaining the issuance of a bond at a premium & discount. They are very basic - they do not explain how to compute the selling price as I did, but he explains the concepts very good.

When Bonds are issued (sold) between interest payment dates:
  • include the interest accrued since the last interest payment in the purchase price.
  • Interest expense for a period is equal to the carrying amount of the bonds at the beginning of the period (face amount - unamortized premium) times the yield (market) interest rate.
  • The cash paid for periodic interest is equal to the face amount of the bonds times the stated rate. It remains constant over the life of the bonds.
  • Accrued interest is credited to Bond Interest Expense.
               Cash                                       xx
                      Interest expense                           xx
                      Bonds payable                              xx
                 (Assuming the bond is issued at par)
  •  A full interest payment is made to each investor on the next interest payment date.
  • Accrued interest is recorded in:
          1) Interest payable or
          2) Interest expense 

Let's look at an illustration of a bond issued between interest dates!

 

VF corporation (owner of the brand Seven for all mankind) has issued 100, $1,000 bonds, with a stated interest rate of 6%. On April 1, 2010, to yield an effective interest rate (market rate) of 5%. The bonds pay interest annually on December 31, and are due on December 31, 2015. (a 5-year term).

Accrued interest 1/1/10-4/1/10 = $100,000 x .06 x 3/12 = $1,500

 (issuance)

April 1                    Cash                                                       105,830*

                                       Bonds payable                                                             100,000

                                       Premium on bonds payable                                           4,330

                                       Interest Expense                                                             1,500

 (Amortization)  

December 31     Interest Expense                                           5,216

                             Premium on Bonds payable                          784

                                       Cash                                                                                  6,000**

*This is the amount Seven for all mankind co. received for the bond it issued. So it is the selling price. I computed this number by calculating the PV of interest payments and PV of the bonds issued like this:

So, for the PV of interest payments: this is computed the same way the exercise above was:

$6,000 x  4.32948 = $25,976.88

Pv of the bonds:

$100,000 x 0.78353 = $78,353.00.

Now we add $25,976.88 + $78,353.00 = $104,329.88 (selling price) + $1,500 (accrued interest) = $105,829.88

**1,500 x 4 (# of years remaining) = 6,000.

Let's try another one!

 

On March 1, 2010, Dolce & Gabbana Fashion Corporation issues 10-year bonds, dated January 1, 2010 with a par value of $800,000 . These bonds have an annual interest rate of 6%, payable semiannually on January 1 and July 1. Prepare the journal entry to record the bond issuance at par plus accrued interest: ($800,000 x .06 x 2/12)= $8,000

       Cash                             808,000

          Bonds payable                       800,000

          Bond Interest Expense            8,000

On July 1, 2010, four months after the date of purchase, Dolce & Gabbana Corp. pays the purchaser six months' interest. Dolce & Gabbana make the following entry on July 1, 2010.

(800,000 x .06 x 6/12) = $24,000

    Bond Interest Expense            24,000

            Cash                                             24,000

 

Notice Bond interest expense has a $16,000 debit balance now.

24,000 debit (minus) 8,000 credit = 16,000 debit balance. 

Extinguishment of Debt

  • Reacquisition price > Net carrying amount = Loss  
      • Costing us more to get rid of the debt than what it's on the books for.
  • Net Carrying amount > Reacquisition price = Gain
  • At time of reacquistion, unamortized premium or discount, and any costs of issue applicable to the bonds, must be amortized up to the reacquistion date.

 

Make a Free Website with Yola.