Chapter 14
Long-Term Liabilities
QUESTIONS
1. A bond is a liability of the issuing company. A share of stock represents an ownership interest in the company.
2. Notes payable generally involve borrowing from a single creditor, whereas bonds payable are usually sold to many different lenders (bondholders).
3. Bonds can allow a company’s owners to increase their return on equity without investing additional amounts. This result occurs as long as the rate of return on the assets acquired from the borrowed cash is greater than the interest rate paid on the bonds. Bonds also help the current owners remain in control of the company. There is also a tax advantage with bonds when issued by corporations.
4. A trustee for bondholders has the responsibility of monitoring the issuer’s actions, financial performance, and financial condition to ensure that the obligations in the bond indenture are met.
5. A bond indenture is a legal contract between the issuing company and the bondholders that identifies the obligations and rights of both parties. It specifies such items as the par value of the bonds, the contract interest rate, the due dates for interest payments, and the maturity date(s) of the bonds. It also may name a trustee, describe the bond issue in detail, and provide for a sinking fund.
6. The contract rate (also known as the coupon rate, stated rate, or nominal rate) is the rate that is identified in the bond indenture. It is applied to the par value to determine the size of the cash interest payments. The market rate is the consensus rate that a company is willing to pay and that investors are willing to accept for a specific bond.
7. In general, the supply of and demand for bonds affect market rates. The market rate for a particular bond issue is also affected by risks unique to the issuer (e.g., financial performance and condition) and the length of time until the bonds mature.
8.B The effective interest method creates a constant rate of interest over a bond’s life because the market rate at the time of issuance is multiplied by the beginning balance for each period. The straight-line method produces either an increasing or decreasing rate because it allocates the same amount of expense to each period, even if the liability balance is growing (a discount) or decreasing (a premium).
9.C When issuing bonds between interest dates, a company collects accrued interest from the purchasers to avoid keeping detailed records of bond purchasers and the dates when bonds are purchased. If the company did not collect accrued interest, individual checks would be needed to pay the correct amount of interest to each purchaser. By collecting in advance, the issuer merely distributes the same amount per check to all bondholders, regardless of when they purchased the bonds.
10. The price of bonds can be computed by finding the present value of both the par value at maturity and the periodic cash interest payments discounted at the market rate of interest.
11. The issue price of a $2,000 bond sold at 98 ¼ is 98.25% of $2,000, or $1,965. The issue price of a $6,000 bond priced at 101 ½ is 101.5% of $6,000, or $6,090.
12. The debt-to-equity ratio is calculated by dividing total liabilities by total equity. The higher a company’s debt-to-equity ratio, the higher proportion of a company’s assets that are provided by creditors. If a company has a high debt-to-equity ratio, the company may be at risk during poor economic times, because it must still pay off creditors even though it may not be earning as much as it did in the past.
13. An entrepreneur (owner) must repay the bondholders the principal (par value) according to the term of the bonds. He or she must also pay interest on the bonds per the amount and frequency cited in the bond indenture, and must adhere to any stipulations (covenants) specified in the bond contract.
14. Best Buy shows long-term both “Long-term Liabilities” and “Long-Term Debt” on its balance sheet. To determine whether the long-term debt is comprised of bonds or other obligations we must read footnote 5 disclosing details of the Long-Term Debt of the company. The footnote reports that its long-term debt is comprised of Convertible debentures (bonds), Lease Obligations, and other debt.
15. Per Circuit City’s February 28, 2007, statement of cash flows (financing section), the company repaid $6,724,000 for the fiscal year ended February 28, 2007.
16. RadioShack’s long-term debt decreased by $149,100,000 ($494,900,000 - $345,800,000) during the year ended December 31, 2006.
17. The financing section of the statement of cash flows of Apple indicates that for the year ended September 30, 2006, the company issued common stock totaling $318,000,000. For that same period, the company issued no additional debt.
18.D If a lease qualifies to be recorded as a capital lease, an asset account for the leased asset will be debited with an amount equal to the present value of the future lease payments. The corresponding credit will be to a lease liability account.
19.D An operating lease is a short-term or cancelable lease in which the lessor retains the risks and rewards of ownership. The lessee expenses operating lease payments when incurred and the lessee does not report the leased item(s) as an asset nor as a liability. A capital lease is a long-term or noncancelable lease in which the lessor transfers substantially all the risks and rewards of ownership to the lessee. The lessee records the leased item as its own asset along with a lease liability at the start of the lease term—the amount recorded equals the present value of all lease payments.
20.D Pension plans can be designed as defined benefit plans or defined contribution plans. In a defined benefit plan the employer estimates the contribution necessary to pay a pre-defined benefit amount to its retirees. For example, an employee’s monthly pension benefit may be set at $1,000 per month. The employer must contribute the amount necessary to the pension plan to fund the $1,000 a month to the employee when the employee retires. Alternatively, with a defined contribution plan, the pension contribution is defined and the employer or employee contributes the amount specified in the pension agreement. For example, a defined contribution plan might specify that the employer will contribute 2% of an employee’s annual salary to the pension plan every year.
QUICK STUDIES
Quick Study 14-1 (10 minutes)
1. Bond’s cash proceeds: $150,000 x 0.9325 = $139,875
2. / Twenty semiannual interest payments of $5,250* / $105,000Plus bond discount ($150,000 - $139,875) / 10,125
Total bond interest expense / $115,125
*$150,000 x 0.07 x ½ = $5,250
3. Bond interest expense on first payment date:
$115,125 / 20 semiannual periods = $5,756.25 (or $5,756 rounded)
Quick Study 14-2B (10 minutes)
1. Bond’s cash proceeds: $350,000 x 1.0975 = $384,125
2. / Thirty semiannual interest payments of $12,250* / $367,500Less premium ($384,125 - $350,000) / (34,125)
Total bond interest expense / $333,375
*$350,000 x 0.07 x ½ = $12,250
3. Bond interest expense on first payment date:
$384,125 x 3% = $11,523.75 (or $11,524 rounded)
Quick Study 14-3 (10 minutes)
2009
Jan. 1 / Cash / 139,875Discount on Bonds Payable / 10,125
Bonds Payable / 150,000
To record issuing bonds at a discount.
Jan. 1 / Cash / 384,125
Bonds Payable / 350,000
Premium on Bonds Payable / 34,125
To record issuing bonds at a premium.
Quick Study 14-4 (10 minutes)
a. Using facts in QS 14-1, the bond’s cash proceeds for the bond selling at a discount are computed as follows
Cash Flow / Table Value / Present Value$150,000 par (maturity) value / 0.4564 / $ 68,460
$ 5,250 interest payment / 13.5903 / 71,349
Price of Bond / $139,809*
*Agrees with $139,875 as given in QS 14-1, except for rounding difference.
(Instructor note: The price in QS 14-1 is adjusted to 93 ¼ from 93.21, yielding the $66 difference.)
b. Using facts in QS 14-2, the bond’s cash proceeds for the bond selling at a premium are computed as
Cash Flow / Table Value / Present Value$350,000 par (maturity) value / 0.4120 / $144,200
$ 12,250 interest payment / 19.6004 / 240,105
Price of Bond / $384,305*
*Agrees with $384,125 as given in QS 14-2, except for rounding difference.
(Instructor note: The price in QS 14-2 is adjusted to 109 ¾ from 109.8 yielding the $180 difference.)
Quick Study 14-5 (15 minutes)
2008
(a)Dec. 31 / Cash / 92,277
Discount on Bonds Payable / 7,723
Bonds Payable / 100,000
Sold bonds at discount.
2009
(b)
June 30 / Bond Interest Expense / 4,772
Discount on Bonds Payable* / 772
Cash** / 4,000
Paid semiannual interest and record amor-tization. *$7,723 - $6,951 **$100,000 x 8%/2
(c)
Dec. 31 / Bond Interest Expense / 4,772
Discount on Bonds Payable* / 772
Cash** / 4,000
Paid semiannual interest and record amor-tization. *$6,951 - $6,179 **$100,000 x 8%/2
Quick Study 14-6 (10 minutes)
2009
July 1 / Bonds Payable / 200,000Premium on Bonds Payable / 8,000
Gain on Retirement of Bonds* / 4,000
Cash / 204,000
To record retirement of bonds before maturity. *$4,000 = $208,000 - $204,000
Quick Study 14-7 (10 minutes)
2009
Jan. 1 / Bonds Payable / 1,000,000Common Stock*
/ 500,000Paid-In Capital in Excess of Par Value
/ 500,000To record retirement of bonds by stock
conversion. *500,000 shares x $1.00Quick Study 14-8 (10 minutes)
Amount of annual payment =
a. 4%: Payment = $600,000 / 4.4518 = $134,777
b. 6%: Payment = $600,000 / 4.2124 = $142,437
c. 8%: Payment = $600,000 / 3.9927 = $150,274
Quick Study 14-9 (10 minutes)
1. / E / Convertible bond / 5. / A / Registered bond2. / D / Bond Indenture / 6. / C / Serial bond
3. / G / Sinking fund bond / 7. / H / Secured bond
4. / B / Debenture / 8. / F / Bearer bond
Quick Study 14-10 (10 minutes)
Ratio of debt to equity
NLF Company / ABL CompanyTotal liabilities / $615,000 / $ 480,000
Total equity / $820,000 / $1,500,000
Debt-to-equity ratio / 0.75 / 0.32
Analysis and interpretation: NLF Company’s debt-to-equity ratio of 0.75 implies a riskier financing structure than ABL Company’s 0.32 debt-to-equity ratio.
Quick Study 14-11C (10 minutes)
2009
Mar. 1 / Cash / 202,000Interest payable* / 2,000
Bonds payable / 200,000
Sold $200,000 of bonds with two months’
accrued interest. *($200,000 x .06 x 2/12)
Quick Study 14-12D (10 minutes)
Rental Expense / 400Cash (or Payable) / 400
To record rental expense for car lease.
Quick Study 14-13D (10 minutes)
Leased Asset—Office Equipment / 13,500Lease Liability / 13,500
To record capital lease of office equipment.
EXERCISES
Exercise 14-1 (15 minutes)
1. Semiannual cash interest payment = $3,650,000 x 10% x 1/2 = $182,500
2. Journal entries
2009
(a)Jan. 1 / Cash / 3,650,000
Bonds Payable / 3,650,000
Sold bonds at par.
(b)
June 30 / Bond Interest Expense / 182,500
Cash / 182,500
Paid semiannual interest on bonds.
(c)
Dec. 31 / Bond Interest Expense / 182,500
Cash / 182,500
Paid semiannual interest on bonds.
3.
2009
(a)Jan. 1 /
Cash*
/ 3,577,000Discount on Bonds Payable / 73,000
Bonds Payable / 3,650,000
Sold bonds at 98. *($3,650,000 x 0.98)
(b)
Jan. 1 /
Cash*
/ 3,832,500Premium on Bonds Payable / 182,500
Bonds Payable / 3,650,000
Sold bonds at 105. *($3,650,000 x 1.05)
Exercise 14-2 (30 minutes)
1. Discount = Par value - Issue price = $175,000 - $165,523 = $9,477
2. Total bond interest expense over the life of the bonds
Amount repaidSix payments of $3,500* / $ 21,000
Par value at maturity / 175,000
Total repaid / 196,000
Less amount borrowed / (165,523)
Total bond interest expense / $ 30,477
*175,000 x 0.04 x ½ = $3,500
or:
Six payments of $3,500 / $ 21,000Plus discount / 9,477
Total bond interest expense / $ 30,477
3. Straight-line amortization table ($9,477/6 = $1,580 [rounded])
SemiannualPeriod-End / Unamortized Discount / Carrying
Value
(0) / 1/01/2009 / $9,477 / $165,523
(1) / 6/30/2009 / 7,897 / 167,103
(2) / 12/31/2009 / 6,317 / 168,683
(3) / 6/30/2010 / 4,737 / 170,263
(4) / 12/31/2010 / 3,157 / 171,843
(5) / 6/30/2011 / 1,577 / 173,423
(6) / 12/31/2011 / 0 / 175,000
Exercise 14-3B (30 minutes)
1. Discount = Par value - Issue price = $300,000 - $277,872 = $22,128
2. Total bond interest expense over the life of the bonds
Amount repaidSix payments of $13,500* / $ 81,000
Par value at maturity / 300,000
Total repaid / 381,000
Less amount borrowed / (277,872)
Total bond interest expense / $103,128
*$300,000 x 0.09 x ½ = $13,500
or
Six payments of $13,500 / $ 81,000Plus discount / 22,128
Total bond interest expense / $103,128
3. Effective interest amortization table
SemiannualInterest Period-End / (A)
Cash Interest Paid
[4.5% x $300,000] / (B)
Bond Interest Expense
[6% x Prior (E)] / (C)
Discount Amortization
[(B) - (A)] / (D)
Unamortized
Discount
[Prior (D) - (C)] / (E)
Carrying
Value
[$300,000 - (D)]
1/01/2009 / $22,128 / $277,872
6/30/2009 / $ 13,500 / $ 16,672 / $ 3,172 / 18,956 / 281,044
12/31/2009 / 13,500 / 16,863 / 3,363 / 15,593 / 284,407
6/30/2010 / 13,500 / 17,064 / 3,564 / 12,029 / 287,971
12/31/2010 / 13,500 / 17,278 / 3,778 / 8,251 / 291,749
6/30/2011 / 13,500 / 17,505 / 4,005 / 4,246 / 295,754
12/31/2011 / 13,500 / 17,746 * / 4,246 / 0 / 300,000
$ 81,000 / $103,128 / $22,128
*Adjusted for rounding.
Exercise 14-4 (30 minutes)
1. Premium = Issue price - Par value = $461,795 - $450,000 = $11,795
2. Total bond interest expense over the life of the bonds
Amount repaidSix payments of $20,250* / $121,500
Par value at maturity / 450,000
Total repaid / 571,500
Less amount borrowed / (461,795)
Total bond interest expense / $109,705
*$450,000 x 0.09 x ½ = $20,250
or