Understanding Long-Term Liabilities & Bond Pricing: Notes, Mortgages, Bonds, Study Guides, Projects, Research of Accounting

Download Understanding Long-Term Liabilities & Bond Pricing: Notes, Mortgages, Bonds and more Study Guides, Projects, Research Accounting in PDF only on Docsity! Accounting Principles II: Long-Term Liabilities Complete Study Guide Long‐Term Liabilities Defined Long‐term liabilities are existing obligations or debts due after one year or operating cycle, whichever is longer. They appear on the balance sheet after total current liabilities and before owners' equity. Examples of long‐term liabilities are notes payable, mortgage payable, obligations under long‐term capital leases, bonds payable, pension and other post‐employment benefit obligations, and deferred income taxes. The values of many long‐term liabilities represent the present value of the anticipated future cash outflows. Present value represents the amount that should be invested now, given a specific interest rate, to accumulate to a future amount.  Notes Payable Notes payable represent obligations to banks or other creditors based on formal written agreements. A specific interest rate is usually identified in the agreement. Following the matching principle, if interest is owed but has not been paid, it is accrued prior to the preparation of the financial statements. Assume The Flower Lady signed a $10,000 three‐year note with interest of 10% on July 1 in exchange for a piece of equipment. The interest is due and payable quarterly on Oct. 1, Jan. 1, April 1, and July 1. The Flower Lady operates on a calendar‐year basis and issues financial statements at the end of each quarter. A long‐term note payable must be recorded as of July 1 with interest accrued at the end of each quarter. The entries related to the note for the current year are:  In the final year, the June 30 quarterly interest accrual and July 1 payoff would be as shown.  Lease Obligations In a lease, the property owner (lessor) gives the right to use property to a third party (lessee) in exchange for a series of rental payments. The accounting for lease obligations is determined based on the substance of the transaction. Leases are categorized as operating or capital leases using the following four questions which are simplified from the criteria established in Statement of Financial Accounting Standards No. 13, Accounting for Leases, issued in 1976 by the Financial Accounting Standards Board (FASB):   Does the title pass to the lessee at any time during or at the end of the lease?  Is there an opportunity to purchase the leased item at the end of the lease term at a price so below market rate (a bargain purchase option) that the lessee is likely to take advantage of the opportunity?  Is the term of the lease greater than or equal to 75% of the service life of the leased item?  At the time of the agreement, is the present value of the minimum lease payments greater than or equal to 90% of the fair value of the leased item to the lessor? If the answer to any one of these is yes, the lease is considered a capital lease because the lessee has in essence accepted the risks and benefits of ownership. A capital lease requires an asset, which must be subsequently depreciated, and a liability to be recorded based on the value of the asset on the date of the lease. The liability is usually paid off with a series of equal payments. A portion of each payment is interest, similar to the mortgage payments previously discussed.  If the questions are all answered no, the lease is considered an operating lease and recorded as lease or rent expense, an income statement account, every time a payment is made. Bonds Payable One source of financing available to corporations is long‐term bonds. Bonds represent an obligation to repay a principal amount at a future date and pay interest, usually on a semi‐annual basis. Unlike notes payable, which normally represent an amount owed to one lender, a large number of bonds are normally issued at the same time to different lenders. These lenders, also known as investors, may sell their bonds to another investor prior to their maturity.  Types of bonds  There are many different types of bonds available to interested investors. Some of the more common forms are:   Serial bonds. Bonds issued in groups that mature at different dates. For example, $5,000,000 of serial bonds, $500,000 of which mature each year from 5–14 years after they are issued.   Sinking fund bonds. Bonds that require the issuer to set aside a pool of assets used only to repay the bonds at maturity. These bonds reduce the risk that the company will not have enough cash to repay the bonds at maturity.  Convertible bonds. Bonds that can be exchanged for a fixed number of shares of the company's common stock. In most cases, it is the investor's decision to convert the bonds to stock, although certain types of convertible bonds allow the issuing company to determine if and when bonds are converted.    Registered bonds. Bonds issued in the name of a specific owner. This is how most bonds are issued today. Having a registered bond allows the owner to automatically receive the interest payments when they are made.  Bearer bonds. Bonds that require the bondholder, also called the bearer, to go to a bank or broker with the bond or coupons attached to the bond to receive the interest and principal payments. They are called bearer or coupon bonds because the person presenting the bond or coupon receives the interest and principal payments.   Secured bonds. Bonds are secured when specific company assets are pledged to serve as collateral for the bondholders. If the company fails to make payments according to the bond terms, the owners of secured bonds may require the assets to be sold to generate cash for the payments.   Debenture bonds. These unsecured bonds require the bondholders to rely on the good name and financial stability of the issuing company for repayment of principal and interest amounts. These bonds are usually riskier than secured bonds. A subordinated debenture bond means the bond is repaid after other unsecured debt, as noted in the bond agreement.  Bond prices  The price of a bond is based on the market's assessment of any risk associated with the company that issues (sells) the bonds. The higher the risk associated with the company, the higher the interest rate. Bonds issued with a coupon interest rate (also called contract rate or stated rate) higher than the market interest rate are said to be offered at a premium. The premium is necessary to compensate the bond purchaser for the above average risk being assumed. Bonds are issued at a discount when the coupon interest rate is below the market interest rate. Bonds sold at a discount result in a company receiving less cash than the face value of the bonds. Bonds are denominated in $1,000s. A market price of 100 means the bond sold for 100% of face value. If its face value is $1,000, the sales price was $1,000. A bond sold at 102, a premium, would generate $1,020 cash for the issuing company (102% × $1,000) while one sold at 97, a discount, would provide $970 cash for the issuing company (97% × $1,000). To illustrate how bond pricing works, assume Lighting Process, Inc. issued $10,000 of ten‐year bonds with a coupon interest rate of 10% and semi‐annual interest payments when the market interest rate is 10%. This means Lighting Process, Inc. will repay the principal amount of $10,000 at maturity in ten years and will pay $500 interest ($10,000 The bonds are classified as long‐term liabilities when they are issued. When the bond matures, the principal repayment is recorded as follows: Bonds issued at a discount  Lighting Process, Inc. issues $10,000 ten‐year bonds, with a coupon interest rate of 9% and semiannual interest payments payable on June 30 and Dec. 31, issued on July 1 when the market interest rate is 10%. The entry to record the issuance of the bonds increases (debits) cash for the $9,377 received, increases (debits) discount on bonds payable for $623, and increases (credits) bonds payable for the $10,000 maturity amount. Discount on bonds payable is a contra account to bonds payable that decreases the value of the bonds and is subtracted from the bonds payable in the long‐ term liability section of the balance sheet. Initially it is the difference between the cash received and the maturity value of the bond.   After this entry, the bond would be included in the long‐term liability section of the balance sheet as follows:   The $9,377 is called the carrying amount of the bond. The discount on bonds payable is the difference between the cash received and the maturity value of the bonds and represents additional interest expense to Lighting Process, Inc. (the company that issued the bond). The total interest expense can be calculated using the bond‐related payments and receipts as shown:   The interest expense is amortized over the twenty periods during which interest is paid. Amortization of the discount may be done using the straight‐line or the effective interest method. Currently, generally accepted accounting principles require use of the effective interest method of amortization unless the results under the two methods are not significantly different. If the amounts of interest expense are similar under the two methods, the straight‐line method may be used.   The straight‐line method of allocating the discount to interest expense (also called amortization of the discount) spreads the $623 of discount evenly over the 20 semiannual interest payments made for the bonds. To calculate the additional interest expense to be recognized when recording the semiannual interest payments, divide the total discount by the number of interest payments. In this example, an additional $31.15 ($623 ÷ 20) of interest expense would be recognized every six months. This has been rounded to $31 for illustration purposes. The amount of discount amortized ($31) is added to the interest paid ($450) to determine the total interest expense recorded. The entry to pay interest on December 31, 20X1 would be:   The effective interest method of amortizing the discount to interest expense calculates the interest expense using the carrying value of the bonds and the market rate of interest at the time the bonds were issued. For the first interest payment, the interest expense is $469 ($9,377 carrying value × 10% market interest rate × 6/ 12 semiannual interest). The semiannual interest paid to bondholders on Dec. 31 is $450 ($10,000 maturity amount of bond × 9% coupon interest rate × 6/ 12 for semiannual payment). The $19 difference between the $469 interest expense and the $450 cash payment is the amount of the discount amortized. The entry on December 31 to record the interest payment using the effective interest method of amortizing interest is shown on the following page.   As the discount is amortized, the discount on bonds payable account's balance decreases and the carrying value of the bond increases. The amount of discount amortized for the last payment is equal to the balance in the discount on bonds payable account. As with the straight‐line method of amortization, at the maturity of the bonds, the discount account's balance will be zero and the bond's carrying value will be the same as its principal amount. See Table 2 for interest expense and carrying values over the life of the bond calculated using the effective interest method of amortization .  TABLE 2 Interest Method of Amortization of Discount Ending Discount Ending | Carrying Beginning | Interest | Interest | Amoritzed | Beginning | Discount} Value Carrying |Expense|Payment| (4)=(2)- | Discount (6)= (7)= Date Value (1) (2) (3) (3) (5) (5)-(4) | (1)4+(4) 7/1/XO 9,377 12/31/X0| 9,377 469 450 abe 623 604 9,396 6/30/X1 |9,396 470 450 20 601 584 9,416 12/31/X1| 9,416 471 450 21 584 563 9,437 6/30/X2 |9,437 472 450 22 563 541 9,459 12/31/X2|9,459 473 450 23 541 518 9,482 6/30/X3 |9,482 474 450 24 518 494 9,506 12/31/X3| 9,506 475 450 25 494 469 9,531 6/30/x4 |9,531 477 450 27 469 442 9,558 12/31/X4|9,558 478 450 28 442 414 9,586 6/30/xX5 |9,586 479 450 29 414 385 9,615 12/31/X5|9,615 461 450 31 385 354 9,646 6/30/x6 |9,646 482 450 a2 354 322 9,678 12/31/X6| 9,678 484 450 34 322 288 ‘Qe7d2  The carrying value will continue to decrease as the premium account's balance decreases. When the bond matures, the premium account's balance will be zero and the bond's carrying value will be the same as the bond's principal amount. The premium amortized for the last payment should be the balance in the premium on bonds payable account. At maturity, the entry to record the principal repayment is:   See Table 3 for interest expense and carrying value calculations over the life of the bond using the straight‐line method of amortization .  TABLE 3 Straight-Line Amortization of Premium Total Ending Interest Ending | Carrying Beginning| Interest | Premium | Expense] Beginning|Premium| Value Carrying |Payment|Amoritzed| (4)= Premium (6)= (7)= Date value (1) Q) (3) ()-(3) (5) (5)-(3) | (1)-(3) F/1/XO 11,246 (A) 12/31/XO| 11,246 600 62 538 1,246 1,184 11,184 6/30/X1 |11,184 600 62 538 1,184 1,122 11,122 12/31/X1| 11,122 600 62 538 1,122 1,060 11,060 6/30/X2 |11,060 600 62 538 1,060 998 10,998 12/31/X2| 10,998 600 62 538 998 936 10,936 6/30/X3 | 10,936 600 62 538 936 874 10,874 12/31/X3 | 10,874 600 62 538 874 812 10,812 6/30/x4 |10,812 600 62 538 812 750 10,750 12/31/X4| 10,750 600 62 538 750 683 10,688 6/30/xX5 |10,688 600 62 538 688 626 10,626 12/31/X5| 10,626 600 62 538 626 564 10,564 6/30/xX6 | 10,564 600 62 538 564 502 10,502 12/31/X6 | 10,502 600 62 538 502 440 10,440  The effective interest method of amortizing the premium calculates interest expense using the carrying value of the bonds and the market interest rate when the bonds were issued. For the first payment, the interest expense is $562. It is calculated by multiplying the $11,246 (carrying value of the bonds) times 10% (market interest rate) × / (semiannual payment). The amount of interest paid is $600 ($10,000 face value of bonds × 12% coupon interest rate × / semiannual payments). The $38 of premium amortization is the difference between the interest expense and the interest paid. The entry to record the first interest payment on December 31 using the effective interest method of amortizing the premium would be:  As the premium is amortized, the balance in the premium account and the carrying value of the bond decreases. The amount of premium amortized for the last payment is equal to the balance in the premium on bonds payable account. As with the straight-line method of amortizing the premium, the effective interest method of amortizing the premium results in the premium account's balance being zero at the maturity of the bonds such that the carrying value of the bonds will be the same as the their principal amount. See Table 4 for interest expense and carrying value calculations over the life of the bonds using the effective interest method of amortizing the premium. At maturity, the General Journal entry to record the principal repayment is shown in the entry that follows Table 4 . Deferred Income Taxes Many companies report different amounts of income on their income statement and on their income tax return. This difference occurs because the definition of income is not the same under GAAP (generally accepted accounting principles) and federal income tax regulations. GAAP requires income tax expense to be calculated on income before taxes on the income statement while the tax return calculates taxes due based on taxable income per the income tax return.  If the differences are considered temporary, in other words, if certain revenues and/or expenses are reported in different years in income statements and on income tax returns, an asset or liability called deferred income tax exists. If deferred income tax represents the portion of the income tax expense that will be paid in future years, a long‐term liability called deferred taxes is recorded on the balance sheet.