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divided by the number of periods per year. The same type of computations
used to compute the present value of an annuity can also be used to compute
the proper amount of a periodic payment, such as the monthly payment on a
car loan.




2 ACCOUNTING FOR LONG-TERM LIABILITIES
Account for long-term
Now that we have explained how present value concepts are applied in measuring long-term li-
liabilities, including notes
payable and mortgages abilities, we are ready to discuss the accounting for those liabilities. The time line in Exhibit
payable.
10-2 illustrates the business events associated with long-term liabilities.
A company s first decision is to determine the type of long-term financing to use. In this
chapter we will discuss four different types of financing: notes payable, mortgages payable, leas-
ing, and bonds. There are advantages and disadvantages to each type of financing. For example,
bonds (which are sold in $1,000 increments) allow a company to borrow a little bit of money
from a lot of different people, whereas notes involve borrowing a lot of money from one lender
(or perhaps a consortium of lenders). The benefit of a mortgage is typically a lower interest rate
because the property being purchased is used as collateral on the loan, thereby providing the
lender with less risk. Leases have the advantage of typically requiring a lower down payment as
there are no risks associated with product obsolescence. (At the end of many leases, the asset be-
ing leased is returned to the owner.) Once the pros and cons of the various types of financing
are analyzed, and the company selects an option, the accounting differs, depending upon the
type of financing chosen. In this section, we will discuss the recording of long-term debt, in-
cluding notes payable and mortgages payable.

Interest-Bearing Notes
To illustrate the accounting for a long-term interest-bearing note payable, assume that on Jan-
uary 1, 2003, Giraffe Company borrowed $10,000 from City Bank for three years at 10% in-
terest. Assume also that interest is payable annually on December 31. The entries to account for
the note are:



Time Line of Business Issues Involved with Long-Term Liabilities
exhibit 10-2
d
d
B on




Bond
Bon




Note
Bond
Payable
Mortgage
Payable
Bond




PAY RETIRE
ISSUE AMORTIZE
CHOOSE
interest the debt
the debt (in the case of
the method
a bond) a premium
of financing
or discount
462 f463
Long-Term Debt Financing Chapter 10
Long-Term Debt Financing



2003
Jan. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Note Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Borrowed $10,000 from City Bank for three years.

Dec. 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Made first annual interest payment
on City Bank note ($10,000 0.10).

2004
Dec. 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Made second annual interest payment
on City Bank note ($10,000 0.10).

2005
Dec. 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Note Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000
Made final interest payment ($10,000 0.10)
and repaid principal on City Bank note.


A long-term note such as this three-year note should be recorded in the books at the pre-
sent value of the future cash payments to be made in connection with the note. If the market
interest rate is 10%, then the present value of the cash payments on the note is computed as
follows:
fyi Present value of interest payments:
Amount of each interest payment . . . . . . . . . . . . . . . . . . . . . $ 1,000
As illustrated later in the chap-
Table II factor for 3 payments at 10% . . . . . . . . . . . . . . . . . . 2.4869
ter in the discussion of ac-
Present value of annuity . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,487
counting for bonds, if the mar-
Present value of principal payment:
ket rate of interest differs from
Amount of principal payment . . . . . . . . . . . . . . . . . . . . . . . . $ 10,000
the annual interest rate to be
Table I factor for 3 periods at 10% . . . . . . . . . . . . . . . . . . . . 0.7513
paid on a loan, then the present
Present value of single payment . . . . . . . . . . . . . . . . . . . . . . 7,513
value of the cash payments will Present value of interest and principal . . . . . . . . . . . . . . . . . . . $10,000
not be the same as the face
amount of the loan. For exam- The total present value is the sum of the present values of the interest payments (an
ple, if no interest payments annuity) and the single principal payment due in three years. In this case, the present value
were to be made on the note in of the cash payments on the note is exactly equal to the note s face amount of $10,000.
This is because the annual interest payments of 10% are equal to the market rate of in-
the example given here, then
terest, or the rate of interest that lenders would insist on earning for lending money in ex-
the present value of the cash
change for the note.
flows associated with the note
In the notes to its 1999 financial statements, THE WALT DISNEY COMPANY re-
would be just $7,513, which is
ported the existence of a variety of notes payable, including notes for which the amounts
the present value of the $10,000
to be repaid were stated in Japanese yen and Italian lira. In addition, Disney reported the
payment to be made at the end
existence of $1.247 billion in participating notes; the rate of interest to be paid on these
of three years.
notes depends on the financial performance of the films whose production was financed
through the issuance of the notes.
mortgage payable A written
promise to pay a stated
Mortgages Payable
amount of money at one or
more specified future dates;
A mortgage payable is similar to a note payable in that it is a written promise to pay a stated
a mortgage is secured by
sum of money at one or more specified future dates. It differs from a note in the way it is ap-
the pledging of certain as-
plied. Whereas money borrowed with a note can often be used for any business purpose, mort-
sets, usually real estate, as
gage money is usually related to a specific asset, typically real estate. Assets purchased with a
collateral.
463
f464 Part 3 Long-Term Debt Financing
Investing and Financing Activities



business environment essay


How Interest Rates Affect Mortgage GAGE CORPORATION and most lending institutions
Payments The interest rate on a mort- recommend that the monthly payment not exceed
gage is as important as the amount of 28% of a person s monthly gross income. If, for ex-
the loan in determining whether a per- ample, you earn $30,000 a year, you should pay no
son can afford a mortgage. This is be- more than $700 a month on a mortgage, which would
cause the amount of interest paid over be a $100,000 mortgage at 7% or a $58,000 mortgage
an extended period of time will be at at 14%. For this reason, most people shop around
least equal to, or even two or three times, for the lowest mortgage rates and even then, many
the amount of the loan. The table on the will not qualify for a loan.
next page shows the monthly payments To calculate the monthly payments on a smaller or
on a $100,000, 25-year mortgage at interest rates from larger mortgage, divide the amount by $100,000, then
7 to 14%, as well as the qualifying annual income. multiply that percentage by the figure in the table. For
The qualifying annual income is the minimum example, the monthly payment on a $60,000 mort-
amount a person must earn to afford the payments at gage at 9% is $503.40 [($60,000/$100,000) $839].
each interest rate. The FEDERAL HOME LOAN MORT-




mortgage are usually pledged as security or collateral on the loan. Individuals commonly obtain
home mortgages, and companies frequently use plant mortgages. In either case, a mortgage gen-
erally requires periodic (usually monthly) payments of principal plus interest.
To illustrate the accounting for a mortgage, we will assume that McGiven Automobile Com-
pany borrows $100,000 on January 1 to purchase a new showroom and signs a mortgage agree-
ment pledging the showroom as collateral on the loan. If the mortgage is at 8% for 30 years,
and the monthly payment is $733.76, payable on January 31 with subsequent payments due at
the end of each month thereafter, the entries to record the acquisition of the mortgage and the
first monthly payment are:


Jan. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Mortgage Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Borrowed $100,000 to purchase the automobile
showroom.

Jan. 31 Mortgage Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67.09
Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 666.67
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 733.76
Made first month s mortgage payment.



As this entry shows, only $67.09 of the $733.76 payment is applied to reduce the mort-
gage; the remainder is interest ($100,000 0.08 1/12). In each successive month, the amount
applied to reduce the mortgage will increase slightly until, toward the end of the 30-year mort-
gage, almost all of the payment will be for principal. A mortgage amortization schedule iden-
mortgage amortization
schedule A schedule that tifies how much of each mortgage payment is interest and how much is principal reduction, as
shows the breakdown be-
shown in Exhibit 10-3. Note that during the first 20 years of McGiven s $100,000, 8%, 30-
tween interest and principal
year mortgage, more of each mortgage payment is for interest than for principal.
for each payment over the
At the end of each year, a mortgage is reported on the balance sheet in two places: (1) the
life of a mortgage.
principal to be paid during the next year is shown as a current liability, and (2) the balance of
the mortgage payable is shown as a long-term liability. Further, any accrued interest on the mort-
464 f465
Long-Term Debt Financing Chapter 10
Long-Term Debt Financing




$100,000, 25-Year Mortgage

Interest Rate Monthly Payment Total Amount Paid Qualifying Annual Income

7% $ 707 $212,100 $30,300
8% 772 231,600 33,086
9% 839 251,700 35,957
10% 909 272,700 38,957
11% 980 294,000 42,000
12% 1,053 315,900 45,129
13% 1,128 338,400 48,343
14% 1,204 361,200 51,600




Mortgage Amortization Schedule ($100,000, 30-Year Mortgage at 8%)
exhibit 10-3


End-of-Year Totals

Monthly Principal Paid Interest Paid Outstanding
Year Payment during Year during Year Mortgage Balance

1 $733.76 $ 835 $7,970 $99,165
2 733.76 905 7,900 98,260
3 733.76 980 7,825 97,280
4 733.76 1,061 7,744 96,219
5 733.76 1,149 7,656 95,070
10 733.76 1,712 7,093 87,725
15 733.76 2,551 6,254 76,783
20 733.76 3,800 5,005 60,080
25 733.76 5,661 3,144 36,793
30 733.76 8,434 371 0
Total payments over life of mortgage: $264,154*
*$733.76 360 payments $264,154.




gage is reported as a current liability, and the interest expense for the year is included with other
expenses on the income statement.



to summarize
Long-term interest-bearing notes are obligations that will be repaid over sev-
eral years. Interest on the note is computed by multiplying the outstanding
465
f466 Part 3 Long-Term Debt Financing
Investing and Financing Activities



balance of the note times the rate of interest. Mortgages payable are long-term
liabilities that arise when companies borrow money to buy land, construct
buildings, or purchase additional operating assets. Mortgages are tied to spe-
cific assets. They are amortized over a period of time and involve periodic, usu-
ally monthly, payments that include both principal and interest.




ACCOUNTING FOR LEASE OBLIGATIONS
3
Account for capital lease
As discussed in Chapter 9, a company may choose to lease rather than purchase an asset. If a
obligations and understand
the significance of lease is a simple, short-term rental agreement, called an operating lease, lease payments are
operating leases being
recorded as Rent Expense by the lessee and as Rent Revenue by the lessor. However, if the
excluded from the balance
terms of a lease agreement meet specific criteria (see Chapter 9, page 401), the transaction is
sheet.
classified as a capital lease and is accounted for as if the asset had been purchased with long-
term debt. The lessee records the leased property as an asset and recognizes a liability to the
lessor.
In Chapter 9, we focused on the recording of assets acquired under capital leases, using as-
sumed amounts for the present value. Here we will explain how the present value of a capital
lease is determined. To illustrate the measurement and recording of a capital lease, we will as-
sume that Malone Corporation leases a mainframe computer from Macro Data, Inc., on De-
cember 31, 2002. The lease requires annual payments of $10,000 for 10 years, with the first
payment due on December 31, 2003.2 The rate of interest applicable to the lease is 14% com-
pounded annually.
Assuming the lease meets the criteria for a capital lease, Malone Corporation will record the
computer and the related liability at the present value of the future lease payments. From Table
II, on page 484, the factor for the present value of an annuity for 10 payments at 14% is 5.2161.

A construction company
may choose to lease large
equipment rather than
purchase such an asset.




2 Readers should be aware that the illustration of a capital lease presented here assumes that lease payments
are made at the end of each year, with the present values based on an ordinary annuity. Usually, lease pay-
ments are made at the beginning of each lease period, which requires present value calculations using the con-
cept of an annuity in advance or annuity due. These calculations are explained in intermediate accounting
texts.
466 f467
Long-Term Debt Financing Chapter 10
Long-Term Debt Financing


This factor is multiplied by the annual lease payment to determine the present value. The
fyi
entry to record the lease on Malone s books is:
Many companies structure
their lease agreements so as
2002
not to meet the lease capital-
Dec. 31 Leased Computer. . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,161
ization criteria. In these cases,
Lease Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,161
the companies must still dis-
Leased a computer from Macro Data, Inc., for
close their expected future $10,000 a year for 10 years discounted at
14% ($10,000 5.2161 $52,161).
lease payments in the notes to
the financial statements.
If Malone Corporation uses a calendar year for financial reporting, the December 31,
2003 balance sheet will report the leased asset in the property, plant, and equipment section and
the lease liability in the liabilities section.
A schedule of the computer lease payments is presented in Exhibit 10-4. Each year the lease
liability account balance is multiplied by 14% to determine the amount of interest included in
each of the annual $10,000 lease payments.


Schedule of Computer Lease Payments
exhibit 10-4


Annual Interest Expense Lease
Year Payment (0.14 Lease Liability) Principal Liability

$52,161
1 $10,000 (0.14 $52,161) $7,303 $2,697 49,464
2 10,000 (0.14 49,464) 6,925 3,075 46,389
3 10,000 (0.14 46,389) 6,494 3,506 42,883
4 10,000 (0.14 42,883) 6,004 3,996 38,887
5 10,000 (0.14 38,887) 5,444 4,556 34,331
6 10,000 (0.14 34,331) 4,806 5,194 29,137
7 10,000 (0.14 29,137) 4,079 5,921 23,216
8 10,000 (0.14 23,216) 3,250 6,750 16,466
9 10,000 (0.14 16,466) 2,305 7,695 8,771
10 10,000 (0.14 8,771) 1,229* 8,771 0

*Rounded.




Note that this is the same procedure used with a mortgage when determining the amount of each
payment that is applied to reduce the principal and the amount that is considered interest expense.
The remainder of the payment is a reduction in the liability. For example, the first lease
payment is recorded as follows:

2003
Dec. 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,303
Lease Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,697
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Paid annual lease payment for computer
($52,161 0.14 $7,303; $10,000 $7,303 $2,697).


Similar entries would be made in each of the remaining nine years of the lease, except that
the principal payment (reduction in Lease Liability) would increase while the interest expense
would decrease. Interest expense decreases over the lease term because a constant rate (14%) is
applied to a decreasing principal balance.
467
f468 Part 3 Long-Term Debt Financing
Investing and Financing Activities


Although the asset and liability accounts have the same balance at the beginning of the lease
term, they seldom remain the same during the lease period. The asset and the liability are ac-
counted for separately, with the asset being depreciated using one of the methods discussed in
Chapter 9.

Operating Leases
When a lease is accounted for as a capital lease, the lease obligation (and an associated leased as-
set) will appear on the balance sheet of the company using the leased asset. If, on the other hand,
a company is able to classify a lease as an operating lease according to the criteria outlined in
Chapter 9, nothing will appear on the balance sheet. Neither the leased asset nor the lease liabil-
ity will be recognized. For this reason, an operating lease is often referred to as a form of off-
balance-sheet financing the economic obligation associated with the financing arrangement
entered into to secure the use of an asset is not reported on the balance sheet.
Because operating leases are not reported on the balance sheet, accounting rules require
companies to disclose operating lease details in the financial statement notes so that financial
statement users will be aware of these off-balance-sheet obligations. The information from the
operating lease note from DISNEY s 1999 financial statements is reproduced below:


The company has various real estate operating leases, including retail outlets for the
distribution of consumer products and office space for general and administrative
purposes. Future minimum lease payments under these non-cancelable operating leases
totaled $2.2 billion at September 30, 1999, payable as follows [in millions]:

2000 $ 297
2001 262
2002 239
2003 216
2004 185
Thereafter 1,019



Recall that the obligation to make this $2.2 billion in operating lease payments is not reported
as a liability on Disney s balance sheet.




to summarize
A lease is a contract whereby the lessee makes periodic payments to the lessor
for the use of an asset. A simple short-term rental agreement, or operating
lease, involves only the recording of rent expense by the lessee and rent rev-
enue by the lessor. A capital lease is accounted for as a debt-financed purchase
of the leased asset. Both the asset and the liability are initially recorded by the
lessee at the present value of the future lease payments discounted at the ap-
plicable interest rate. Subsequently, the asset is depreciated and the lease lia-
bility is written off as periodic payments are made. Part of each lease payment
is interest expense, computed at a constant interest rate, and the remainder is
a reduction of the principal amount of the liability. Operating leases are a form
of off-balance-sheet financing because the obligation to make future operating
lease payments is not recognized as a liability on the balance sheet. Compa-
nies are required to disclose the amount of their future operating lease pay-
ments in the notes to the financial statements.
468 f469
Long-Term Debt Financing Chapter 10
Long-Term Debt Financing



4 THE NATURE OF BONDS
Account for bonds,
A bond is a contract between the borrowing company (issuer) and the lender (investor) in which
including the original
issuance, the payment of the borrower promises to pay a specified amount of interest at the end of each period the bond is
interest, and the retirement
outstanding and to repay the principal at the maturity date of the bond contract. Bonds generally
of bonds.
have maturity dates exceeding 10 years and, as a result, are another example of a long-term liability.

bond A contract between a
Types of Bonds
borrower and a lender in
which the borrower Bonds can be categorized on the basis of various characteristics. The following classification sys-
promises to pay a specified
tem considers three characteristics:
rate of interest for each pe-
riod the bond is outstand- 1. The extent to which bondholders are protected.
ing and repay the principal
a. Debentures (or unsecured bonds). Bonds that have no underlying assets pledged as
at the maturity date.
security, or collateral, to guarantee their repayment.
b. Secured bonds. Bonds that have a pledge of company assets, such as land or build-
debentures (unsecured
bonds) Bonds for which no ings, as a protection for lenders. If the company fails to meet its bond obligations, the
collateral has been pledged.
pledged assets can be sold and used to pay the bondholders. Bonds that are secured
with the issuer s assets are often referred to as mortgage bonds.
secured bonds Bonds for
2. How the bond interest is paid.
which assets have been
pledged in order to guaran- a. Registered bonds. Bonds for which the issuing company keeps a record of the names
tee repayment.
and addresses of all bondholders and pays interest only to those whose names are on file.
b. Coupon bonds. Unregistered bonds for which the issuer has no record of current bond-
registered bonds Bonds for
holders but instead pays interest to anyone who can show evidence of ownership. Usu-
which the names and ad-
dresses of the bondholders ally, these bonds have a printed coupon for each interest payment. When a payment is
are kept on file by the issu-
due, the bondholder clips the coupon from the certificate and sends it to the issuer as ev-
ing company.
idence of bond ownership. The issuer then sends an interest payment to the bondholder.
3. How the bonds mature.
coupon bonds Unregistered
bonds for which owners re- a. Term bonds. Bonds that mature in one single sum on a specified future date.
ceive periodic interest pay-
b. Serial bonds. Bonds that mature in a series of installments.
ments by clipping a coupon
c. Callable bonds. Term or serial bonds that the issuer can redeem at any time at a spec-
from the bond and sending
ified price.
it to the issuer as evidence
d. Convertible bonds. Term or serial bonds that can be converted to other securities,
of ownership.
such as stocks, after a specified period, at the option of the bondholder. (The accounting
term bonds Bonds that ma-
for this type of bond is discussed in advanced accounting texts.)
ture in one single sum at a
specified future date.
Two other types of bonds that are often encountered are zero-coupon bonds and junk bonds.
Zero-coupon bonds are issued with no promise of interest payments. The company issuing the
serial bonds Bonds that
mature in a series of install- bonds promises only to repay a fixed amount at the maturity date. While the idea of having to
ments at specified future
make no interest payments might be initially appealing to the issuer, remember that the present
dates.
value of the bond is affected by both the single payment at the end of the bond s life and the
annuity payment. If this annuity (interest) payment will not be part of the bond, potential buy-
callable bonds Bonds for
which the issuer reserves ers will pay much less for the bond. For this reason, zero-coupon bonds are often referred to as
the right to pay the obliga-
deep-discount bonds.
tion before its maturity
Junk bonds are high-risk bonds issued by companies in weak financial condition or with
date.
large amounts of debt already outstanding. These bonds typically yield returns of at least 12%,
convertible bonds Bonds but some may return in excess of 20%. Of course, with these high returns comes greater risk.
that can be traded for, or
converted to, other securi-
Characteristics of Bonds
ties after a specified period
of time.
When an organization issues bonds, it usually sells them to underwriters (brokers and invest-
zero-coupon bonds Bonds
ment bankers), who in turn sell them to various institutions and to the public. At the time of
issued with no promise of
the original sale, the company issuing the bonds chooses a trustee to represent the bondhold-
interest payments; only a
ers. In most cases, the trustee is a large bank or trust company to which the company issuing
single payment will be
the bonds delivers a contract called a bond indenture, deed of trust, or trust indenture. The
made.
469
f470 Part 3 Long-Term Debt Financing
Investing and Financing Activities


bond indenture specifies that in return for an investment of cash by investors, the company
junk bonds Bonds issued
by companies in weak fi- promises to pay a specific amount of interest (based on a specified, or stated, rate of interest)
nancial condition with large
each period the bonds are outstanding and to repay the principal (also called face value or ma-
amounts of debt already
turity value) of the bonds at a specified future date (the bond maturity date). It is the duty of
outstanding; these bonds
the trustee to protect investors and to make sure that the bond issuer fulfills its responsibilities.
yield high rates of return
The total value of a single bond issue often exceeds several million dollars. A bond issue
because of high risk.
is generally divided into a number of individual bonds, which may be of varying denominations.
bond indenture A contract
The principal, or face value, of each bond is usually $1,000 or a multiple thereof. Note that the
between a bond issuer and
price of bonds is quoted as a percentage of $1,000 face value. Thus, a bond quoted at 98 is sell-
a bond purchaser that spec-
ing for $980 (98% $1,000), and a bond quoted at 103 is selling for $1,030 (103% $1,000).
ifies the terms of a bond.
By issuing bonds in small denominations, a company increases the chances that a broad range
principal (face value or ma-
of investors will be able to compete for the purchase of the bonds. This increased demand usu-
turity value) The amount
ally results in the bonds selling for a higher price.
that will be paid on a bond
In most cases, the market price of bonds is influenced by (1) the riskiness of the bonds and
at the maturity date.
(2) the interest rate at which the bonds are issued. The first factor, riskiness of the bonds, is de-
bond maturity date The
termined by general economic conditions and the financial status of the company selling the
date at which a bond prin-
bonds, as measured by organizations (MOODY S or STANDARD AND POOR S, for instance)
cipal or face amount be-
that regularly assign a rating, or a grade, to all corporate bonds.
comes payable.
Companies strive to earn as high a bond rating as possible because the higher the rat-
fyi ing, the lower the interest rate they will have to pay to attract buyers. For example, using
the widely cited Moody s bond rating, an Aaa bond is a bond of the highest quality with
Another type of bond that has
the least risk of nonpayment. As of October 2000, bonds with this rating were paying in-
arisen in recent years is the
terest of approximately 6.6%. A high-risk bond, on the other hand, will have a low rat-
Yankee bond. A Yankee bond
ing, which means the company will have to offer a higher rate of interest to attract buy-
is a bond issued by a non-U.S.
ers. For example, as of October 2000, the bonds of financially troubled CHIQUITA
company with all bond-related
BRANDS (the banana company) were rated B1 by Moody s, a rating indicating that the
payments made in U.S. dollars.
bonds were highly speculative. Lenders were requiring an interest rate of more than 30%
Non-U.S. companies sometimes to induce them to purchase these bonds.
choose to pay principal and in-
terest on bonds in U.S. dollars
because U.S. dollar amounts are
associated with less risk of cur-
to summarize
rency exchange fluctuations
than are payments in less stable Bonds are certificates of debt issued by companies or government agen-
cies, guaranteeing a stated interest rate and repayment of the principal at
currencies such as Indonesian
a specified maturity date. Corporations issue bonds as a form of long-
rupiah. Lower risk means that
term borrowing to finance the acquisition of operating assets, such as
the company can pay a lower in-
land, buildings, and equipment. Bonds can be classified by their level of
terest rate to lenders.
security (debentures versus secured bonds), by the way interest is paid
(registered versus coupon bonds), and by the way they mature (term
fyi bonds, serial bonds, callable bonds, and convertible bonds).
Bonds are bought and sold on
trading markets just like stocks.
The New York Bond Exchange
Determining a Bond s Issuance Price
is the largest exchange of this
type. When a company issues bonds, it is generally promising to make two types of payments:
(1) a payment of interest of a fixed amount at equal intervals (usually semiannually but
sometimes quarterly or annually) over the life of the bond and (2) a single payment the prin-
cipal, or face value, of the bond at the maturity date. For example, assume that Denver Com-
pany issues 10%, five-year bonds with a total face value of $800,000. Interest is to be paid semi-
annually. This information tells us that Denver Company agrees to pay $40,000 ($800,000
0.10 ° year) in interest every six months and also agrees to pay to the investors the princi-
pal amount of $800,000 at the end of five years. The following diagram reflects this agreement
between Denver Company and the bond investors:
470 f471
Long-Term Debt Financing Chapter 10
Long-Term Debt Financing


$800,000
Issued bonds
principal
face value
repayment
$800,000
Interest payments
$40,000 $40,000 $40,000 $40,000 $40,000 $40,000 $40,000 $40,000 $40,000 $40,000




2
0 1/2 1 11/2 21/2 3 31/2 4 41/2 5
Years




In this example, we assumed that the bonds were issued at their face value of $800,000.
However, bonds are frequently issued at a price that is more or less than their face value. The
actual price at which bonds are issued is affected by the interest rate investors are seeking at
the time the bonds are sold in relation to the interest rate specified by the
borrower in the bond indenture. How, then, is the issuance price of bonds
If the market rate of in-
determined?
terest is higher than the rate of interest
Essentially, present value concepts are used to measure the effect of time
stated on the bonds, will the bonds sell at
on the value of money. The price should equal the present value of the inter-
a price higher or lower than the face value? est payments (an annuity) plus the present value of the bond s face value at
Think about the question this way: Is the maturity. These present values are computed using the market rate of inter-
est (also called the effective rate or yield rate), which is the rate investors ex-
higher rate more attractive to investors,
pect to earn on their investment. It is contrasted with the stated rate of in-
and if it is, what would investors do as a
terest, which is the rate printed on the bond (10% in the Denver Company
result?
example).
If the effective rate is equal to the stated rate, the bonds will sell at face value (that is, at
market rate (effective rate
or yield rate) of interest $800,000). If the effective rate is higher than the stated rate, the bonds will sell at a bond dis-
The actual interest rate
count (at less than the face value) because the investors desire a higher rate than the company
earned or paid on a bond
is promising to pay. Likewise, if the effective rate is lower than the stated rate, the bonds will
investment.
sell at a bond premium (at more than face value) because the company is promising to pay a
stated rate of interest The higher rate than the market is paying at that time.
rate of interest printed on
Consider the following scenario: If Company A is issuing bonds with a stated rate of 12%
the bond.
and the market rate for similar bonds is 10%, what will happen to the price of Company A s
bonds? Investors, eager to receive a 12% return, will bid the price of the bonds up until the
bond discount The differ-
ence between the face price at which the bonds sell yields a 10% return. The amount paid for the bonds over and
value and the sales price
above the maturity value is the bond premium. If Company A were issuing bonds with a stated
when bonds are sold below
rate of 8%, no one would buy the bonds until the price was lowered sufficiently to allow in-
their face value.
vestors to earn a return of 10%. The difference between the selling price and the maturity value
bond premium The differ- would be the amount of the bond discount.
ence between the face
We will use the Denver Company bonds example (from page 470) to explain how the price
value and the sales price
is computed in each situation.
when bonds are sold above
their face value.
Denver Company has agreed to issue $800,000 bonds
BONDS ISSUED AT FACE VALUE
and pay 10% interest, compounded semiannually. Assume that the effective interest rate de-
manded by investors for bonds of this level of risk is also 10%. Using the effective interest
rate, which happens to be the same as the stated rate, the calculation to determine the price
at which the bonds will be issued is shown at the top of the next page. (Note that because
the interest is compounded semiannually, the interest rate is halved and the five-year bond
life is treated as 10 six-month periods.)
The calculation shows why the bonds sell at face value. At the effective rate, the sum of the
present value of the interest payments and the payment at maturity is $800,000, which is the
issuance price at the stated rate. This equality of present values will occur only when the effec-
tive rate and the stated rate are the same.
471
f472 Part 3 Long-Term Debt Financing
Investing and Financing Activities


1. Semiannual interest payments . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000
Present value of an annuity of
10 payments of $1 at 5% (Table II) . . . . . . . . . . . . . . . . . . . . . . 7.7217
Present value of interest payments . . . . . . . . . . . . . . . . . . . . . . . $308,868
2. Maturity value of bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000
Present value of $1 received 10 periods
in the future discounted at 5% (Table I) . . . . . . . . . . . . . . . . . . 0.6139
Present value of principal amount . . . . . . . . . . . . . . . . . . . . . . . . 491,132*

3. Issuance price of bonds (total present value). . . . . . . . . . . . . . . . $800,000
*Difference is due to the rounding of the present value factor.

The value of the bonds can also be computed using a business calculator as follows:

Hewlett-Packard Keystrokes:

a. CLEAR ALL.
b. Set P/YR to 1.
1. 800,000 Press FV.
2. 40,000 Press PMT.
3. 10 Press N.
4. 5 Press I/YR.
5. Press PV for the answer of $800,000.


Denver Company will sell its bonds at less than the
BONDS ISSUED AT A DISCOUNT
face value of $800,000 (at a discount) if the stated rate of interest is less than the effective rate
that investors are seeking. To illustrate the issuance of bonds at a discount, assume that the ef-
fective rate is 12% compounded semiannually; the stated rate remains 10% compounded semi-
annually. In this case, the bonds will be issued at a price of $741,124, as shown here:
1. Semiannual interest payments . . . . . . . . . . . . . . . . . . . . . . . . . . $40,000
Present value of an annuity of
10 payments of $1 at 6% (Table II) . . . . . . . . . . . . . . . . . . . . . . 7.3601
Present value of interest payments . . . . . . . . . . . . . . . . . . . . . . . $294,404

2. Maturity value of bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000
Present value of $1 received 10 periods
in the future discounted at 6% (Table I) . . . . . . . . . . . . . . . . . . 0.5584
Present value of principal amount . . . . . . . . . . . . . . . . . . . . . . . . 446,720
3. Issuance price of bonds (total present value). . . . . . . . . . . . . . . . $741,124

Denver Company will receive less than the $800,000 face value because the stated rate of interest is
lower than the effective rate. In this case, there is a discount of $58,876 ($800,000 $741,124).
caution The following keystrokes are used to compute the value of the bonds using a busi-
ness calculator:
The most common mistake
made in computing bond values
Hewlett-Packard Keystrokes:
is to use the stated rate of in-
terest in calculating the present a. CLEAR ALL.
value of the cash flows. The b. Set P/YR to 1.
stated rate of interest is used
1. 800,000 Press FV.
only to compute the amount of
2. 40,000 Press PMT.
the semiannual interest pay-
3. 10 Press N.
ments. The present value com- 4. 6 Press I/YR.
putations are done using the 5. Press PV for the answer of $741,119.30. This answer differs slightly from the
value computed using the tables because of rounding.
current market rate of interest.
472 f473
Long-Term Debt Financing Chapter 10
Long-Term Debt Financing


The Denver Company bonds will be issued for more
BONDS ISSUED AT A PREMIUM
than $800,000 (at a premium) when the stated interest rate is higher than the effective rate. Let
us now assume that the effective rate is 8% compounded semiannually and that the stated rate
is still 10% compounded semiannually. In this case, the bonds will be issued at $864,916, as
shown here:
1. Interest payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000
Present value of an annuity of
10 payments of $1 at 4% (Table II) . . . . . . . . . . . . . . . . . . . . . . 8.1109
Present value of interest payments . . . . . . . . . . . . . . . . . . . . . . . $324,436

2. Maturity value of bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000
Present value of $1 received 10 periods
in the future discounted at 4% (Table I) . . . . . . . . . . . . . . . . . . 0.6756
Present value of principal amount . . . . . . . . . . . . . . . . . . . . . . . . 540,480
3. Issuance price of bonds (total present value). . . . . . . . . . . . . . . . $864,916

Denver Company will receive more than the $800,000 face value when the bonds are issued be-
cause the company has agreed to pay the investors a higher rate of interest than the market rate.
The same calculation can be done using a business calculator as follows:

Hewlett-Packard Keystrokes:

a. CLEAR ALL.
b. Set P/YR to 1.
1. 800,000 Press FV.
2. 40,000 Press PMT.
3. 10 Press N.
4. 4 Press I/YR.
5. Press PV for the answer of $864,887.17. This answer differs slightly from the value
computed using the tables because of rounding.


In all three situations, the 10% stated rate determined the amount of each interest pay-
ment. The price of the bonds was determined by discounting the $40,000 of interest payments
and the $800,000 face amount at maturity by the effective rate of interest, which may vary from
day to day, depending on market conditions. In essence, the issuance price depends on four fac-
tors: (1) face value of the bonds, (2) periodic interest payments (face value stated interest
rate), (3) time period, and (4) effective interest rate. Although the bond price is the exact amount
that allows investors to earn the interest rate they are seeking, it also reflects the real cost of
money to the borrowing company.
Now that you know how to calculate bond values, you may feel ready to move to New
York City and become a Wall Street bond trader. Not so fast. There are four steps to comput-
ing bond values, as outlined below:
1. Determine the market interest rate.
2. Compute the present value of the maturity amount (using the market interest rate as the
discount rate).
3. Compute the present value of the annuity of annual interest payments (using the market
interest rate as the discount rate).
4. Add the quantities computed in (2) and (3).
Three of these steps 2, 3, and 4 are very straightforward. These are the steps that you have
learned in this chapter. The initial step of determining the market interest rate is where the art
and analysis of bond trading are brought to bear. For example, how can you tell whether a com-
pany s riskiness requires that the market interest rate on its bonds should be 7.2% or 7.3%? This
is an extremely difficult determination to make, and yet it is exactly the type of decision that
bond traders must make many times each day.
473
f474 Part 3 Long-Term Debt Financing
Investing and Financing Activities




to summarize
The price at which bonds are issued is a function of the interest rate investors
are seeking when the bonds are issued in relation to the interest rate the bor-
rowing company is promising to pay. The bond s face value, or principal, and
future interest payments (face value stated interest rate) are discounted by
the interest rate desired by investors (the effective, yield, or market rate) to ar-
rive at the issuance price of the bonds. Bonds will sell at their face value if the
stated interest rate is equal to the effective rate. If the effective rate is higher
than the stated rate, the bonds will sell at a discount. If the effective rate is
lower than the stated rate, the bonds will sell at a premium. The effective rate
used to discount the payments promised by the borrower reflects the real cost
of the money borrowed.



Accounting for Bonds Payable Issued at Face Value
When a company issues bonds, it must account for the issuance (sale) of the bonds, for the in-
terest payments, and for the amortization of any bond premium or discount. Then, at or before
maturity, the company must account for the bond s retirement.
The accounting for these four elements depends on the issuance price of the bonds and on
the date of issuance in relation to the date on which interest is paid. In the following sections,
we explain the accounting for bonds when the issue price is equal to face value. The account-
ing for bonds issued at a premium or at a discount is discussed in the expanded material sec-
tion of the chapter. For most of this discussion, we will use the following data:

Issuing company Central Trucking Company
Accounting year Calendar year ending December 31
Face value of bonds issued $100,000
Stated interest rate 12%
Effective interest rate when issued 12%
Initial date of issuance January 1, 2003
Date of maturity January 1, 2013
Interest payment dates January 1 and July 1


Central Trucking Company issued $100,000 bonds with a stated interest rate of 12% on
January 1, 2003. The bonds were issued at face value because 12% is the effective, or market,
rate of interest for similar bonds. The journal entry to record their issuance on January 1, 2003,
is as follows:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Issued $100,000, 12%, 10-year bonds at face value.


The entry to record the first payment of interest on July 1, 2003, is:

Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Paid semiannual interest on the $100,000, 12%,
10-year bonds ($100,000 0.12 1/2 year).


Because Central Trucking operates on a calendar-year basis, it will need to make the fol-
lowing adjusting entry on December 31, 2003, to account for the interest expense between July
1 and December 31, 2003:
474 f475
Long-Term Debt Financing Chapter 10
Long-Term Debt Financing



Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Bond Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
To recognize expense for the six months July 1 to
December 31, 2003 ($100,000 0.12 1/2 year).


At the end of the accounting period (December 31, 2003), the financial statements will re-
port the following:


Income Statement

Bond interest expense ($6,000 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,000

Balance Sheet

Current liabilities:
Bond interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000
Long-term liabilities:
Bonds payable (12%, due January 1, 2013) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000


On January 1, 2004, when the semiannual interest is paid, the bond interest payable ac-
count is eliminated. The January 1 entry is:

Bond Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Paid semiannual bond interest.


The entries to record the interest expense payments during the remaining nine years will
be the same as those made during 2003 and on January 1, 2004. The only other entry required
in accounting for these bonds is the recording of their retirement on January 1, 2013. That en-
try, assuming that all interest has been accounted for, will be:

Bonds Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Retired the $100,000, 10-year, 12% bonds.


As the preceding entries illustrate, accounting for the issuance of bonds, the payment of the
interest, and the retirement of the bonds is relatively simple when the bonds are issued at face
value.

Bond Retirements before Maturity
Bond issues are, by definition, an inflexible form of long-term debt. The issuing company has
a set schedule of interest payments and a specified maturity date, usually at least 5 or 10 years
from the issuance date. In many cases, however, a company may want to pay off (redeem) and
retire its bonds before maturity. This situation might occur when interest rates fall a company
uses the money obtained by issuing new bonds at a lower interest rate to retire the older, higher-
interest bonds. As a result, the company retains the money it needs for expansion or other long-
range projects but pays less interest for using that money.
As noted earlier, callable bonds are issued with an early redemption provision. Although the
company usually has to pay a premium (penalty) for the privilege of redeeming (calling) the
bonds, the amount of the penalty will probably be less than the amount gained by paying a
lower interest rate. With bonds that are not callable, the company simply purchases the bonds
in the open market, as available, at the going price.
475
f476 Part 3 Long-Term Debt Financing
Investing and Financing Activities


To illustrate the retirement of bonds before maturity, assume that the Central Trucking Com-
pany bonds are now selling in the bond market at 109 and are callable at 110. The company de-
cides to take advantage of the lower interest rate (8%) by issuing new bonds and using the pro-
ceeds to pay off the outstanding bonds. Given that the bonds were issued at their face value, the
penalty (the call premium) is $10,000. The entry to record the retirement of the bonds at 110 is:

Bonds Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Loss on Bond Retirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Cash ($100,000 1.10). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000
To retire $100,000 of bonds at a call price of 110.


In this case, the bonds were retired at a loss of $10,000. The loss is probably tolerable be-
cause the company expects to pay significantly less interest over the life of the new bond issue
than it would have had to continue to pay on the old bonds. Gains and losses on the early re-
tirement of bonds are reported on the income statement as extraordinary gains and losses.



to summarize
Accounting for bonds involves three steps: (1) accounting for their issuance,
(2) accounting for the periodic interest payments, and (3) accounting for their
retirement. When bonds are retired at maturity, there is no gain or loss be-
cause the amount paid is equal to the face value of the bonds. When bonds
are retired before maturity, a gain or loss often results because the price paid
to retire the bonds can be different from the carrying value of the bonds. The
gain or loss on retirement of bonds is reported on the income statement as an
extraordinary item.




5 USING DEBT-RELATED FINANCIAL RATIOS
Use debt-related financial
As illustrated earlier in the chapter in Exhibit 10-2, an important business issue associated with
ratios to determine the
degree of a company s long-term debt is the determination of how a company wishes to obtain the money it needs to
financial leverage and its
buy necessary assets. A company s leverage is the degree to which the company has borrowed
ability to repay loans.
the funds needed for asset acquisitions. This section describes the financial ratios that are com-
monly used to evaluate the level of a company s financial leverage.

Debt Ratio and Debt-to-Equity Ratio
The debt ratio measures the amount of assets supplied by lenders. It is calculated as follows:
debt ratio A measure of
leverage, computed by di-
viding total liabilities by to- Total liabilities
Debt ratio
tal assets.
Total assets


The computed value of the debt ratio indicates the percentage of a company s funding that has
come through borrowing.
The debt ratio for DISNEY for 1999 is calculated as follows (the numbers are in millions):

$22,704
debt-to-equity ratio The
Debt ratio 52%
number of dollars of bor- $43,679
rowed funds for every dol-
lar invested by owners;
Thus, 52% of Disney s assets are provided by lenders and 48% by stockholders.
computed as total liabilities
The debt-to-equity ratio also measures the balance of funds being provided by creditors
divided by total stockhold-
and stockholders. This ratio is calculated by dividing total liabilities by total stockholders eq-
ers equity.
476 f477
Long-Term Debt Financing EM Chapter 10
Long-Term Debt Financing


uity. The higher the debt-to-equity ratio, the more debt the company has. The debt-to-equity
ratio for Disney is calculated as follows:

Total liabilities
Debt-to-equity ratio
Total stockholders equity

$22,704
Debt-to-equity ratio 1.08
$20,975

In this case, the debt-to-equity ratio indicates that Disney s debt is about 8% higher than its eq-
uity. Note that the debt ratio and the debt-to-equity ratio both indicate the same thing that
Disney has acquired just a little bit more of its total financing from borrowing than from stock-
holders. It doesn t matter which of these two ratios you use to measure a company s leverage;
the important thing is that you are consistent and that any ratios you use for comparison have
been computed using the same formula.

Times Interest Earned Ratio
Lenders like to have an indication of the borrowing company s ability to meet the required in-
terest payments. Times interest earned is the ratio of the income that is available for interest
times interest earned A
measure of a borrower s payments to the annual interest expense. Times interest earned is computed as follows:
ability to make required in-
terest payments; computed Income before interest and taxes (operating profit)
Times interest earned
as income before interest
Annual interest expense
and taxes divided by an-
nual interest expense.
To illustrate the computation of this ratio, we will return to Disney. For year-end 1999,
Disney s interest expense was $612 million, and its operating profit was $4,056 million. This
results in times interest earned of 6.6 times, computed as follows:

$4,056
Times interest earned 6.6 times
$612

Disney s times interest earned value of 6.6 times means that its operations in 1999 generated
enough profit to be able to pay Disney s interest expense for the year 6.6 times. This suggests
that Disney s creditors have a substantial cushion before they need to be concerned about Dis-
ney s ability to meet its required periodic interest payments.




The present value techniques discussed in this chapter are useful in determin-

ing the value of obligations due at some future time. The computations and ac-
counting are similar for interest-bearing notes, mortgages, capital leases, and
bonds. However, there are certain complexities associated with these liabilities

that deserve additional attention. In this section of the chapter, we discuss the

procedures associated with the amortization of a bond discount or premium.


6 BONDS ISSUED AT A DISCOUNT
OR AT A PREMIUM
Amortize bond discounts
and bond premiums using
either the straight-line
As we have explained, bonds may be issued at a discount or a premium because their stated in-
method or the effective-
terest rate may be (and often is) lower or higher than the effective rate. The two rates often dif-
interest method.
477
f478 Long-Term Debt Financing
Part 3 EM Investing and Financing Activities


fer because economic conditions in the marketplace change between the date the stated interest
is set and the date the bonds are actually sold. Various factors determine this second date for
example, the time it takes to print the bonds and the investment banker s decision regarding the
best time to offer the bonds. Because the cost to the company for the use of the bond money
is really the effective interest rate rather than the stated rate, the discount or premium must be
written off (amortized) over the period the bonds are outstanding, and the amortization is treated
as an adjustment to bond interest expense.
There are two methods of amortizing bond discounts and bond premiums: straight-line
amortization and effective-interest amortization. With straight-line amortization, a company
straight-line amortization A
method of systematically writes off the same amount of discount or premium each period the bonds are held. For exam-
writing off a bond discount
ple, with a $4,000 discount on a 10-year bond, $400 is amortized each year. Effective-interest
or premium in equal
amortization takes the time value of money into consideration. The amount of discount or pre-
amounts each period until
mium amortized is the difference between the interest actually incurred (based on the effective
maturity.
rate) and the interest actually paid (based on the stated rate). The straight-line amortization
effective-interest amortiza-
method will be used to explain the accounting for the amortization of discounts and premiums;
tion A method of systemati-
then the effective-interest method will be explained and illustrated.
cally writing off a bond pre-
mium or discount that takes
into consideration the time
Accounting for Bonds Issued at a Discount
value of money and results
in an equal interest rate be-
When bonds are issued at a discount, a contra-liability account is used to keep a separate record
ing used for amortization
of the discounted amount. To illustrate, we will assume that the $100,000, 10-year, 12% bonds
for each period.
issued by Central Trucking on January 1, 2003, sold for $98,000. The entry to record the is-
suance of the bonds is:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98,000
Discount on Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Issued $100,000, 12%, 10-year bonds at 98.


The discount on bonds account represents the difference between the face value of the bonds
and the issuance price. This discount is accounted for as additional bond interest expense over
the life of the bonds. In other words, if the company receives only $98,000 when the bonds are
issued and is required to pay $100,000 at maturity, the $2,000 difference is additional interest.
The following analysis shows that total interest on the bonds is $122,000, comprised of the pe-
riodic interest payments ($120,000) plus the $2,000 discount.

Amount to be paid to bondholders:
Interest paid each year for 10 years ($100,000 0.12 10) . . . . . . . . . . . . . . . . . . . $120,000
Face value to be paid at maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Total amount to be paid to bondholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $220,000
Proceeds received from sale of bonds ($100,000 0.98) . . . . . . . . . . . . . . . . . . . . . . . 98,000
Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $122,000
Average annual interest expense ($122,000/10 years) . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,200


Although the $2,000 of additional interest arising from the discount will not be paid un-
til the bonds mature, interest accrues, or accumulates, over time. Thus, each year that the
bonds are outstanding, Central Trucking will record bond interest expense for the amount
paid at the stated rate ($100,000 0.12 $12,000) and will also recognize a portion of the
discount as bond interest expense. In recording the additional bond interest expense, the con-
tra account Discount on Bonds is amortized or written off over the life of the bonds. Using
straight-line amortization, an even amount is amortized each period. In the Central Trucking
Company example, the semiannual amortization would be $100 ($2,000 discount/10 years
°). Bond amortization is recorded when interest payments are made, and the entry on July
1, 2003, is:
478 f479
Long-Term Debt Financing EM Chapter 10
Long-Term Debt Financing



Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,100
Discount on Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Paid semiannual interest on the $100,000, 12%, 10-year bonds
($100,000 0.12 ° year) and amortized the bond discount
($2,000/10 years ° year).


As illustrated, amortization of a discount increases bond interest expense. In this case, the
bond interest expense is $6,100, or the sum of the semiannual interest payment and the semi-
annual amortization of the bond discount. Over the 10-year life of the bonds, the bond inter-
est expense will be increased by $2,000 (20 periods $100), the amount of the discount. Thus,
these bonds pay an effective interest rate of approximately 12.45%3 per year ($12,200 inter-
est/$98,000 received on the bonds).
The adjusting entry to record the bond interest expense on December 31, 2003, is:


Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,100
Discount on Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Bond Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
To recognize bond interest expense for the six months July 1 to
December 31, 2003.


The financial statements prepared at December 31, 2003, would report the following:


Income Statement

Bond interest expense ($6,100 2). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,200

Balance Sheet

Current liabilities:
Bond interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000
Long-term liabilities:
Bonds payable (12%, due January 1, 2013) . . . . . . . . . . . . . . . . . . . . . . $100,000
Less unamortized discount ($2,000 $200) . . . . . . . . . . . . . . . . . . . . . . 1,800 $98,200



The entries to account for the bond interest expense and bond discount amortization dur-
ing the remaining nine years will be the same as those illustrated. And because the bond dis-
count will be completely amortized at the end of the 10 years, the entry to record the retire-
ment of the bonds will be the same as that for bonds issued at face value. That entry is:


Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Retired the $100,000, 12%, 10-year bonds.



Accounting for Bonds Issued at a Premium
Like discounts, premiums must be amortized over the life of the bonds. To illustrate the ac-
counting for bonds sold at a premium, we will assume that Central Trucking was able to sell its


3 Because straight-line amortization was used, this effective rate of 12.45% is only an approximation that will
change slightly each period. An accurate effective rate can be calculated only if the effective-interest method of
amortization is used.
479
f480 Long-Term Debt Financing
Part 3 EM Investing and Financing Activities


$100,000, 12%, 10-year bonds at 103 (that is, at 103% of face value). The entry to record the
issuance of these bonds on January 1, 2003, is:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103,000
Premium on Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Sold $100,000, 12%, 10-year bonds at 103.


Premium on Bonds is added to Bonds Payable on the balance sheet and, like Discount on
Bonds, is amortized using either the straight-line method or the effective-interest method. Thus,
if Central Trucking uses the straight-line method, the annual amortization of the premium will
be $300 ($3,000/10 years), or $150 every six months. The entry to record the first semiannual
interest payment and the premium amortization of July 1, 2003, is:

Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,850
Premium on Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Paid semiannual interest on the $100,000, 12%, 10-year bonds
($100,000 0.12 ° year) and amortized the bond premium
($3,000/10 years °).


The amortization of a premium on bonds reduces the actual bond interest expense. The fol-
lowing analysis shows why bond interest expense is reduced when bonds are sold at a premium:

Amount to be paid to bondholders:
[($12,000 interest 10 years) $100,000 face value] . . . . . . . . . . . . . . . . . . . . . . . . $220,000
Proceeds received from sale of bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103,000
Total interest to be paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $117,000
Average annual interest expense ($117,000/10 years) . . . . . . . . . . . . . . . . . . . . . . . . . . $ 11,700

In this case, the annual payments of $12,000 include interest of $11,700 and $300, which
represents a partial repayment (one-tenth) of the bond premium. Thus, the effective interest rate
is approximately 11.36% ($11,700/$103,000), which is less than the stated rate of 12%.
The adjusting entry to record the accrual of the interest expense on December 31,
caution
2003, is:
If bonds issued at a premium or
discount are retired before ma-
Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,850
turity, remember that the bond
Premium on Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
payable and any associated
Bond Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
premium or discount would be
To recognize bond interest expense for the six months
taken off the books. July 1 to December 31, 2003.


The financial statements prepared at December 31, 2003, would report the following:


Income Statement

Bond interest expense ($5,850 2). . . . . . . . . . . . . . . . . . . . . . . . . . . $ 11,700

Balance Sheet

Current liabilities:
Bond interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000
Long-term liabilities:
Bonds payable (12%, due January 1, 2013) . . . . . . . . . . . . . . . . . . . $100,000
Plus unamortized premium ($3,000 $300). . . . . . . . . . . . . . . . . . . 2,700 $102,700
480 f481
Long-Term Debt Financing EM Chapter 10
Long-Term Debt Financing



Effective-Interest Amortization
Companies can often justify use of the straight-line method of amortizing bond premiums and
discounts on the grounds that its results are not significantly different from those of the theo-
bond carrying value The
retically more accurate effective-interest method. Nevertheless, because the effective-interest
face value of bonds minus
method considers the time value of money, it is required by generally accepted accounting prin-
the unamortized discount
ciples if it leads to results that differ significantly from those obtained by the straight-line
or plus the unamortized
method.
premium.
The effective-interest method amortizes a varying amount each period, which is the
difference between the interest actually incurred and the cash actually paid. The amount
fyi
actually incurred is the changing bond carrying value (the face value of the bond mi-
Note that the table below looks
nus the unamortized discount or plus the unamortized premium) multiplied by a con-
a lot like the mortgage amorti-
stant rate, the effective interest rate.
zation schedule on page 465 To illustrate the effective-interest method, let s continue with the Central Trucking
and the schedule of computer Company example we have used previously. We will assume that the Central Trucking
lease payments on page 467. Company $100,000, 12%, 10-year bonds were issued on January 1, 2003, for $112,463.
The bonds pay interest semiannually on January 1 and July 1, so their effective interest
The reason is that these other
rate is approximately 10%4 a year, or 5% every six months. Because the actual bond in-
schedules also use the effective-
terest expense for each interest period is equal to the effective rate of 5% multiplied by
interest amortization method.
the bond carrying value, the amortization (rounded to the nearest $1) for the 10 years
is calculated as shown in the following table.


1 2 3 4
Premium
Cash Paid Semiannual Interest Expense Amortization Carrying
Period for Interest (0.05 Bond Carrying Value) (1) (2) Value

Issuance date $112,463
Year 1, first six months $6,000 $5,623 $377 112,086
Year 1, second six months 6,000 5,604 396 111,690
Year 2, first six months 6,000 5,585 415 111,275
Year 2, second six months 6,000 5,564 436 110,839
Year 3, first six months 6,000 5,542 458 110,381
Year 3, second six months 6,000 5,519 481 109,900
Year 4, first six months 6,000 5,495 505 109,395
Year 4, second six months 6,000 5,470 530 108,865
Year 5, first six months 6,000 5,443 557 108,308
Year 5, second six months 6,000 5,415 585 107,723
Year 6, first six months 6,000 5,386 614 107,109
Year 6, second six months 6,000 5,355 645 106,464
Year 7, first six months 6,000 5,323 677 105,787
Year 7, second six months 6,000 5,289 711 105,076
Year 8, first six months 6,000 5,254 746 104,330
Year 8, second six months 6,000 5,217 783 103,547
Year 9, first six months 6,000 5,177 823 102,724
Year 9, second six months 6,000 5,136 864 101,860
Year 10, first six months 6,000 5,093 907 100,953
Year 10, second six months 6,000 5,047 953 100,000



4 The 10% rate is the rate that will discount the face value of the bonds and the semiannual interest payments
to a present value that equals the issuance price of the bonds, computed as follows:

Present value of $100,000 at 5% for 20 payments $100,000 0.3769 $ 37,690
Present value of $6,000 at 5% for 20 payments $ 6,000 12.4622 74,773
Total present value issuance price of the bonds $112,463
481
f482 Long-Term Debt Financing
Part 3 EM Investing and Financing Activities


In this computation, the $6,000 in column (1) is the actual cash paid each six months. Col-
umn (2) shows the interest expense for each six months, which is the amount that will be re-
ported on the income statement. Column (3), which is the difference between columns (1) and
(2), represents the amortization of the premium. Column (4) shows the carrying, or book, value
of the bonds (that is, the total of the bonds payable and the unamortized bond premium), which
is the amount that will be reported on the balance sheet each period. Using the effective-
interest method, the bond carrying value is always equal to the present value of the bond oblig-
ation. As the carrying value decreases, while the effective rate of interest remains constant, the
interest expense also decreases from one period to the next, as illustrated in column (2) of the
amortization schedule.
To help you translate this table into the entries for the interest payments and premium
amortization at the end of each six-month period, we have provided the semiannual journal en-
tries for year 3.


Year 3, End of First Six Months
Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,542
Bond Premium. . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 458
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 6,000
To record effective-interest expense on Central Trucking Company
bonds for the first six months of year 3.

Year 3, End of Second Six Months
Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,519
Bond Premium. . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 481
Bond Interest Payable . . . . . . . . . . . . . . . . . . . . . ................ 6,000
To record effective-interest expense on Central Trucking Company
bonds for the second six months of year 3.


Because the straight-line method would show a constant amortization ($12,463/20
$623.15 per six-month period) on a decreasing bond balance, the straight-line interest rate can-
not be constant. When the straight-line results differ significantly from the effective-interest re-
sults, generally accepted accounting principles require use of the effective-interest method.
The effective-interest method of amortizing a bond discount is essentially the same as amor-
tizing a bond premium. The main difference is that the bond carrying value is increasing in-
stead of decreasing.



to summarize
When bonds are issued at a premium or a discount, the premium or discount
must be amortized over the life of the bond. A discount or premium results when
the market rate and the stated rate are different. Because of this difference, bond
interest expense recognized on the income statement is not equal to the amount
of cash paid for interest. The objective of amortization is to reflect the actual
bond interest expense incurred over the life of the bond. Two methods of amor-
tization are available the straight-line method and the effective-interest method.
The straight-line method amortizes an equal amount of premium or discount
every period. When the effective-interest method is used, the amount of discount
or premium amortized each period is equal to the market rate of interest multi-
plied by the bond s carrying value.
482



table I The Present Value of $1 Due in n Periods*



Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 14% 15% 16% 18% 20%

.9901 .9804 .9709 .9615 .9524 .9434 .9346 .9259 .9174 .9091 .8929 .8772 .8696 .8621 .8475 .8333
01
.9803 .9612 .9426 .9246 .9070 .8900 .8734 .8573 .8417 .8264 .7972 .7695 .7561 .7432 .7182 .6944
02
.9706 .9423 .9151 .8890 .8638 .8396 .8163 .7938 .7722 .7513 .7118 .6750 .6575 .6407 .6086 .5787
03
.9610 .9238 .8885 .8548 .8227 .7921 .7629 .7350 .7084 .6830 .6355 .5921 .5718 .5523 .5158 .4823
04
.9515 .9057 .8626 .8219 .7835 .7473 .7130 .6806 .6499 .6209 .5674 .5194 .4972 .4761 .4371 .4019
05
Long-Term Debt Financing




.9420 .8880 .8375 .7903 .7462 .7050 .6663 .6302 .5963 .5645 .5066 .4556 .4323 .4104 .3704 .3349
06
.9327 .8706 .8131 .7599 .7107 .6651 .6227 .5835 .5470 .5132 .4523 .3996 .3759 .3538 .3139 .2791
07
.9235 .8535 .7894 .7307 .6768 .6274 .5820 .5403 .5019 .4665 .4039 .3506 .3269 .3050 .2660 .2326

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