Accounting For Long-Term Liabilities - Financial Accounting | ACC 101, Study notes of Financial Accounting

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ACC101 – CHAPTER 10

Accounting for Long-Term Liabilities

Key Terms and Concepts to Know

Present Value: There is an old saying that time is money. Applied to accounting, it means that a dollar today is worth more to an investor or company than a dollar to be received in the future. The sooner the dollar is received, the longer it can be invested and used to generate more dollars. Therefore in order to properly compare a series of cash inflows and outflows occurring in various years, present value must be used to restate all of the cash inflows and outflows in current period dollars.

• Present value is based on compound interest, that is, current period interest is based on the principal amount plus the interest for all prior periods.
• Future cash flows are discounted back to the year when the bond was issued. The term discounting is appropriate because the future cash flows are worth less than their full amount today because we had to wait to receive them.
• Certain future cash flows may be annuities if they consist of equal amounts received of paid with equal frequency. Annuities are discounted using the Present value of an Annuity of $1 table.
• All other future cash flows are considered single payment cash flows. Single payments are discounted using the Present Value of $1 table.

Bonds:

• Bonds are a medium to long-term financing alternative to issuing stock.
• Bonds are issued or sold face amount or par, at a discount if they pay less than the current market rate of interest, or a premium if they pay more that the current market interest rate.
• Bonds typically pay interest twice a year, i.e., semi-annually.
• The price of a bond is stated as a percent of face value, although the percent sign is not used. Therefore a $1,000 bond selling at 101 is selling at 101% of face value or $1,010. The “extra” $10 received when the bond is issued or sold represents the premium.
• Required journal entries include a. issuing the bond at par, discount or premium b. calculating and recording the bond interest payments c. calculating and recording amortization of the discount or premium d. retiring the bonds at maturity e. retiring the bonds prior to maturity and calculating the gain or loss on retirement
• Be able to calculate the interest expense for the year including the amortization of the premium or discount

Notes:

• Installment notes are loans that are repaid in a series of equal payments over a number of years.

The Concept of Present Value

1. Present Value of a Lump Sum - a lump sum is an amount expected to be received or paid in the future - the unknown is what the amount is worth in today’s dollars - to solve, the following information must be known: the number of interest compounding periods the interest rate per compounding period - Use the Present Value of $1 Table by selecting the row equal to the number of periods and the column equal to the interest rate

Example # If the current rate of interest is 10% and interest is compounded semiannually, what is the present value of receiving $10,000 at the end of 7 years?

There are 14 interest compounding periods (7 years x 2) The interest rate per compounding period is 5% (10%/2) Rate from the PV of $1 Table =. Present Value = 10,000 * .50507 = $5,050.

2. Present Value of an Annuity - An annuity is a series of equal payments expected to be received or paid at regular future intervals - the unknown is what the series of payments or receipts is worth in today’s dollars? - to solve, the following information must be known: the number of interest compounding periods the interest rate per compounding period - Use the Present Value of an Annuity of $1 Table by selecting the row equal to the number of periods and the column equal to the interest rate

Example # If the current interest rate is 12% and interest is compounded semiannually, what is the present value of receiving $5,000 each year for 10 years?

There are 20 compounding periods (10 years x 2) The interest rate per compounding period is 6% (12%/2) Rate from the PV of Annuity Table = 11. Present Value = 5,000 * 11.46992 = $57,349.

Practice Problem # a. Alpha Company is considering prepaying their rent for the next 4 years to avoid a price increase. Currently they pay $8,000 per year. Calculate the present value of the rent payments to determine what amount Alpha should pay today if current interest rates are 12% and interest is compounded annually.

b. Omega, Inc. won a lawsuit and will be receiving $400,000 at the end of 5 years. Calculate the present value of this award if interest is compounded semiannually and the current interest rate is 1) 18% and 2) 10%.

c. Bonnie has just received news of her inheritance. She will be receiving $10,000 per year for the next 20 years and a lump sum payout after 20 years of $200,000. Calculate the present value of her inheritance if the current interest rate is 9% and it is compounded annually.

Accounting for Bonds Payable

Calculating the Selling Price of a Bond

• Companies usually pay interest to the bondholder semiannually and repay the face value of the bond at maturity.
• The series of interest payments represents an annuity.
• The repayment of face value at maturity represents a lump sum or single payment
• The selling price of a bond is calculated as: The present value of the face value (lump sum) + The present value of the interest payments (annuity)
• Interest payments are calculated using the contract interest rate
• The present value of the future cash outflows is calculated using the current market interest rate

Example # Beta Company issued $4,000,000 of 10-year, 11% bonds on January 4. The Bonds pay interest semiannually on June 30 and December 31. If the current market rate of interest is 10%, at what price will the bonds sell for?

Interest Payment = 4,000,000 * .11 * ½ year = $220, Number of compounding periods = 10 years * 2 = 20 Interest rate per compounding period = 10%/2 = 5%

PV of Face Value: 4,000,000 * .37689 (20 periods, 5%) = $1,507, PV of Interest: 220,000 * 12.46221 (20 periods, 5%) = 2,741, Selling Price of Bond: $4,249,

10 = $24,924.60/year

Journal Entry for Amortization of Premium

Premium on Bonds Payable 24,924. Interest Expense 24,924.

The debit to Premium on Bonds Payable reduces that account. The credit to Interest Expense reduces interest expense.

**If the amortization had been combined with the payment of interest, then the entries would be as follows:

6/30 Premium on Bonds Payable 12,462. Interest Expense 207,537. Cash 220,000.

12/31 Premium on Bonds Payable 12,462. Interest Expense 207,537. Cash 220,000.

Total Amortization for the year: 12,462.30 + 12,462.30 = 24,924. Total Interest Expense for the year: 207,537.70 + 207,537.70 = 415,075.

OR: 440,000 paid – 24,924.60 amortized = 415,075.

Journal Entry for Amortization of Discount

Interest Expense XXX Discount on Bonds Payable XXX

The debit to Interest Expense increases interest expense The credit to Discount on Bonds Payable decreases that account

Bond Redemptions Redeeming the bonds prior to maturity:

1. Amortize the bonds to the date of sale and determine the new balance of the premium or discount account
2. Remove the bonds payable account with a debit
3. Remove the premium or discount account with a debit or credit, respectively
4. Record a gain if the redemption price is less than the carrying value of the bonds
5. Record a loss if the redemption price is greater that the carrying value of the bonds Carrying Value = Bonds Payable + Premium on Bonds Payable

OR Bonds Payable – Discount on Bonds Payable

Example # At the end of the 6 th^ year, the bonds from Example #3 were redeemed at 102.

Premium on Bonds Payable Balance: Amortization = 24,924.60 * 6 years = 149,547. Account Balance = 249,246 – 149,547.60 = 99,698.

Bonds Payable Balance = 4,000, Redemption Price = 4,000,000 * 102% = 4,080,000. Carrying Value = 4,000,000 + 99,698.40 = 4,099,698. Gain (Redemption < CV) = 4,099,698.40 – 4,080,000 = 19,698.

Journal Entry Bonds Payable 4,000,000. Premium on Bonds Payable 99,698. Cash 4,080,000. Gain on Redemption 19,698. Example # Journalize the following entries.

2001 July 1 Issued $20,000,000 of 8-year 12% callable bonds dated July 1, 2001 at an effective interest rate of 14%, receiving cash of $18,110,780. Interest is paid semiannually on December 31 and June 30.

Dec. 31 Paid the semiannual interest on the bonds. Recorded the bond discount amortization for 6 months using the straight-line method. Closed the interest expense account.

Practice Problem # Journalize the following entries. Round all amounts to the nearest dollar.

2003 Sept 2 Issued $5,000,000 of 10-year, 15% callable bonds at an effective interest rate of 14% receiving cash of $5,529,704. Interest is payable semiannually on September 1 and March 1. Dec. 31 Recorded 4 months of accrued interest on the bonds. Dec. 31 Amortized the bond premium for 4 months. Dec. 31 Closed the interest expense account.

2004 Jan. 1 Reversed the accrual entry made on December 31. Mar 1 Paid the semiannual interest on the bonds. Sept 1 Paid the semiannual interest on the bonds. Dec. 31 Recorded 3 months of accrued interest on the bonds. Dec. 31 Amortized the bond premium for the year. Dec. 31 Closed the interest expense account

2005 Feb. 2 Redeemed the bonds at 108. The balance in the Premium on Bonds account after amortizing to the date of sale is $454,663.

SAMPLE MULTIPLE CHOICE QUESTIONS

1. Number of times interest charges earned is computed a. Income before income taxes less Interest Expense divided by Interest Expense. b. Income before income taxes divided by Interest Expense. c. Income before income taxes plus Interest Expense divided by Interest Revenue. d. Income before income taxes plus Interest Expense divided by Interest Expense.
2. The account, Investment in bonds, is reported a. At cost as a long-term liability along with the current portion reported as a current liability. b. At cost as a long-term asset less any amortized premium, or plus any amortized discount. c. At fair market value because that is all that is required. d. At cost as a long-term assets less Discount on Bonds Investments or plus Premium on Bond Investments.

3. One potential advantage of financing corporations through the use of bonds rather than common stock is: a. The interest on bonds must be paid when due b. The interest expense is deductible for tax purposes by the corporation. c. The corporation must pay the bonds at maturity. d. A higher earnings per share is guaranteed for existing common shareholders.
4. When the contract rate of interest on bonds is higher than the market rate of interest, the bonds sell at: a. their face value b. their maturity value c. a discount d. a premium
5. Sinking Fund Cash would be classified on the balance sheet as: a. a current asset b. a plant asset c. an investment d. an intangible asset
6. Bonds Payable has a balance of $2,000,000 and Discount on Bonds Payable has a balance of $15,000. If the issuing corporation redeems the bonds at 99, what is the amount of gain or loss on redemption? a. $20,000 loss b. $20,000 gain c. $5,000 gain d. $5,000 loss
7. On June 1, $1,000,000 of bonds were purchased as a long-term investment at 99 plus accrued interest and $1,000 was paid as the brokerage commission. If the bonds bear interest at 12%, which is paid semiannually on January 1 and July 1, what is the total cost to be debited to the investment account? a. $1,100, b. $1,000, c. $991, d. $990,

14. On January 1, 2001, $5,000,000, 10-year, 8% bonds were issued at $5,150,000. Interest is paid each January 1 and July 1. If the straight-line method of amortization is used to amortize the premium, the amortization for the first year is: a. $7, b. $15, c. $150, d. $250,
15. A 10%, 5-year, $100,000 bond that sells when the market rate of interest is 12% will sell at a. face value b. a premium c. a discount d. par
16. Bonds with a face value of $2,000,000 are sold at 97. The entry to record the issuance is a. Debit Cash $2,000,000; Credit Discount on Bonds Payable $60,000 and Bonds Payable $1,940, b. Debit Cash $1,940,000; Credit Bonds Payable $1,940, c. Debit Cash $2,060,000; Credit Discount on Bonds Payable $60,000 and Bonds Payable $2,000, d. Debit Cash $1,940,000 and Discount on Bonds Payable $60,000; Credit Bonds Payable $2,000,
17. A $500,000 bond liability is retired at 97 when the carrying value of the bond is $483,000. The entry to record the retirement would include a a. $2,000 loss b. $15,000 gain c. $15,000 loss d. $2,000 gain
18. Bonds with a face value of $800,000 and interest rate of 8% are issued at 105 on January 2, 2002. The bonds pay interest semiannually on January 1 and July 1 and mature in 5 years. What is the total interest expense in 2002? a. $32, b. $56, c. $64, d. $72,

19. The journal entry to amortize a discount on an investment in bonds includes a debit to: a. Interest Expense b. Interest Income c. Investment in Bonds d. Discount on Bonds Payable
20. An investment in bonds with a face value of $300,000 is sold at 110 less brokerage commission of $1,500. The current balance of the Investment in Bonds account is $325,800. The gain or loss from this sale is: a. $4,200 gain b. $4,200 loss c. $2,700 gain d. $2,700 loss

• Practice Problem #
• 9/2 Cash 5,529, - Premium on Bonds Payable 529, - Bonds Payable 5,000,
• 12/31 Interest Expense 250, - Interest Payable 250, - Accrued interest for 4 months: 5,000,000 * .15 * 4/
• 12/31 Premium on Bonds Payable 17, - Interest Expense 17, - 52,970 * 4/12 = 17, Premium of 529,704/10 years = 52,970 per year
• 12/31 Income Summary 232, - Interest Expense 232,
• 1/1 Interest Payable 250, - Interest Expense 250,
• 3/1 Interest Expense 375, - Cash 375,
• 9/1 Interest Expense 375, - Cash 375,
• 12/31 Interest Expense 250, - Interest Payable 250,
• 12/31 Premium on Bonds Payable 52, - Interest Expense 52,
• 12/31 Income Summary 697, - Interest Expense 697,
• 2/2 Bonds Payable 5,000,
  • Premium on Bonds Payable 454,
    • Cash 5,400,
    • Gain on Redemption 54,
• Practice Problem #
• 11/1 Investment in Bonds 461,
  • Interest Income 20,
    • Cash 481,
• 12/31 Cash 30, - Interest Income 30,
• 12/31 Interest Income - Investment in Bonds
• 6/30 Cash 30, - Interest Income 30,
• 8/31 Interest Income 1, - Investment in Bonds 1,
  • Loss on Sale of Investment 4, 8/31 Cash 216,600*
    • Interest Income 5,
    • Investment in Bonds 215, (200,000 * .15 * 2/12)
• 12/31 Cash 15, *200,000 * 106% = 212,000 + 5,000 interest – 400 commission - Interest Income 15,
• 12/31 Interest Income 2, - Investment in Bonds 2,