And Then There Were Two
Debt can help a company acquire the things it needs to grow, but it is often the very thing that kills a company. A brief history of Maxwell Car Company illustrates the role of debt in the U.S. auto industry. In 1920, Maxwell Car Company was on the brink of financial ruin. Because it was unable to pay its bills, its creditors stepped in and took over. They hired a former General Motors (GM) executive named Walter Chrysler to reorganize the company. By 1925, he had taken over the company and renamed it Chrysler. By 1933, Chrysler was booming, with sales surpassing even those of Ford.
But the next few decades saw Chrysler make a series of blunders. By 1980, with its creditors pounding at the gates, Chrysler was again on the brink of financial ruin.
At that point, Chrysler brought in a former Ford executive named Lee Iacocca to save the company. Iacocca argued that the United States could not afford to let Chrysler fail because of the loss of jobs. He convinced the federal government to grant loan guarantees—promises that if Chrysler failed to pay its creditors, the government would pay them. Iacocca then streamlined operations and brought out some profitable products. Chrysler repaid all of its government-guaranteed loans by 1983, seven years ahead of the scheduled final payment.
To compete in today's global vehicle market, you must be big—really big. So in 1998, Chrysler merged with German automaker Daimler-Benz to form DaimlerChrysler. For a time, this left just two U.S.-based auto manufacturers—GM and Ford. But in 2007, DaimlerChrysler sold 81% of Chrysler to Cerberus, an investment group, to provide much-needed cash infusions to the automaker. In 2009, Daimler turned over its remaining stake to Cerberus. Three days later, Chrysler filed for bankruptcy. But by 2010, it was beginning to show signs of a turnaround.
The car companies are giants. GM and Ford typically rank among the top five U.S. firms in total assets. But GM and Ford accumulated truckloads of debt on their way to getting big. Although debt made it possible to get so big, the Chrysler story, and GM's recent bankruptcy, make it clear that debt can also threaten a company's survival.
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Read A Look at IFRS p. 735
After studying this chapter, you should be able to:
[1] Explain why bonds are issued.
[2] Prepare the entries for the issuance of bonds and interest expense.
[3] Describe the entries when bonds are redeemed or converted.
[4] Describe the accounting for long-term notes payable.
[5] Contrast the accounting for operating and capital leases.
[6] Identify the methods for the presentation and analysis of long-term liabilities.
Preview of Chapter 15
As you can see from the Feature Story, having liabilities can be dangerous in difficult economic times. In this chapter, we will explain the accounting for the major types of long-term liabilities reported on the balance sheet. Long-term liabilities are obligations that are expected to be paid more than one year in the future. These liabilities may be bonds, long-term notes, or lease obligations.
The content and organization of Chapter 15 are as follows.
Bond Basics
Bonds are a form of interest-bearing notes payable. To obtain large amounts of long-term capital, corporate management usually must decide whether to issue common stock (equity financing) or bonds (debt financing). Bonds offer three advantages over common stock, as shown in Illustration 15-1.
Illustration 15-1
Advantages of bond financing over common stock
As Illustration 15-1 shows, one reason to issue bonds is that they do not affect stockholder control. Because bondholders do not have voting rights, owners can raise capital with bonds and still maintain corporate control. In addition, bonds are attractive to corporations because the cost of bond interest is tax-deductible. As a result of this tax treatment, which stock dividends do not offer, bonds may result in lower cost of capital than equity financing.
To illustrate another advantage of bond financing, assume that Microsystems, Inc. is considering two plans for financing the construction of a new $5 million plant. Plan A involves issuance of 200,000 shares of common stock at the current market price of $25 per share. Plan B involves issuance of $5 million, 8% bonds at face value. Income before interest and taxes on the new plant will be $1.5 million. Income taxes are expected to be 30%. Microsystems currently has 100,000 shares of common stock outstanding. Illustration 15-2 shows the alternative effects on earnings per share.
Illustration 15-2
Effects on earnings per share—stocks vs. bonds
Note that net income is $280,000 less ($1,050,000 − $770,000) with long-term debt financing (bonds). However, earnings per share is higher because there are 200,000 fewer shares of common stock outstanding.
One disadvantage in using bonds is that the company must pay interest on a periodic basis. In addition, the company must also repay the principal at the due date. A company with fluctuating earnings and a relatively weak cash position may have great difficulty making interest payments when earnings are low.
A corporation may also obtain long-term financing from notes payable and leasing. However, notes payable and leasing are seldom sufficient to furnish the amount of funds needed for plant expansion and major projects like new buildings.
Bonds are sold in relatively small denominations (usually $1,000 multiples). As a result of their size and the variety of their features, bonds attract many investors.
Helpful Hint Besides corporations, governmental agencies and universities also issue bonds to raise capital.
Types of Bonds
Bonds may have many different features. In the following sections, we describe the types of bonds commonly issued.
SECURED AND UNSECURED BONDS
Secured bonds have specific assets of the issuer pledged as collateral for the bonds. A bond secured by real estate, for example, is called a mortgage bond. A bond secured by specific assets set aside to redeem (retire) the bonds is called a sinking fund bond.
Unsecured bonds, also called debenture bonds, are issued against the general credit of the borrower. Companies with good credit ratings use these bonds extensively. For example, at one time, DuPont reported over $2 billion of debenture bonds outstanding.
TERM AND SERIAL BONDS
Bonds that mature–are due for payment–at a single specified future date are term bonds. In contrast, bonds that mature in installments are serial bonds.
REGISTERED AND BEARER BONDS
Bonds issued in the name of the owner are registered bonds. Interest payments on registered bonds are made by check to bondholders of record. Bonds not registered are bearer (or coupon) bonds. Holders of bearer bonds must send in coupons to receive interest payments. Most bonds issued today are registered bonds.
CONVERTIBLE AND CALLABLE BONDS
Bonds that can be converted into common stock at the bondholder's option are convertible bonds. The conversion feature generally is attractive to bond buyers. Bonds that the issuing company can redeem (buy back) at a stated dollar amount prior to maturity are callable bonds. A call feature is included in nearly all corporate bond issues.
Issuing Procedures
State laws grant corporations the power to issue bonds. Both the board of directors and stockholders usually must approve bond issues. In authorizing the bond issue, the board of directors must stipulate the number of bonds to be authorized, total face value, and contractual interest rate. The total bond authorization often exceeds the number of bonds the company originally issues. This gives the corporation the flexibility to issue more bonds, if needed, to meet future cash requirements.
The face value is the amount of principal due at the maturity date. The maturity date is the date that the final payment is due to the investor from the issuing company. The contractual interest rate, often referred to as the stated rate, is the rate used to determine the amount of cash interest the borrower pays and the investor receives. Usually the contractual rate is stated as an annual rate. Interest is generally paid semiannually.
The terms of the bond issue are set forth in a legal document called a bond indenture. The indenture shows the terms and summarizes the rights of the bondholders and their trustees, and the obligations of the issuing company. The trustee (usually a financial institution) keeps records of each bondholder, maintains custody of unissued bonds, and holds conditional title to pledged property.
Ethics Note 
Some companies try to minimize the amount of debt reported on their balance sheet by not reporting certain types of commitments as liabilities. This subject is of intense interest in the financial community.
In addition, the issuing company arranges for the printing of bond certificates. The indenture and the certificate are separate documents. As shown in Illustration 15-3, a bond certificate provides the following information: name of the issuer, face value, contractual interest rate, and maturity date. An investment company that specializes in selling securities generally sells the bonds for the issuing company.
Illustration 15-3
Bond certificate
Determining the Market Price of a Bond
If you were an investor wanting to purchase a bond, how would you determine how much to pay? To be more specific, assume that Coronet, Inc. issues a zero-interest bond (pays no interest) with a face value of $1,000,000 due in 20 years. For this bond, the only cash you receive is a million dollars at the end of 20 years. Would you pay a million dollars for this bond? We hope not! A million dollars received 20 years from now is not the same as a million dollars received today.
The term time value of money is used to indicate the relationship between time and money—that a dollar received today is worth more than a dollar promised at some time in the future. If you had $1 million today, you would invest it. From that investment, you would earn interest such that at the end of 20 years, you would have much more than $1 million. Thus, if someone is going to pay you $1 million 20 years from now, you would want to find its equivalent today, or its present value. In other words, you would want to determine the value today of the amount to be received in the future after taking into account current interest rates.
The current market price (present value) of a bond is the value at which it should sell in the marketplace. Market price therefore is a function of the three factors that determine present value: (1) the dollar amounts to be received, (2) the length of time until the amounts are received, and (3) the market rate of interest. The market interest rate is the rate investors demand for loaning funds. Appendix 15A discusses the process of finding the present value for bonds. Appendix G near the end of the textbook also provides additional material for time value of money computations.
ACCOUNTING ACROSS THE ORGANIZATION 
How About Those 30-Year Bonds?
Companies like Philip Morris International, Medtronic Inc., Plains All American Pipeline LP, and Simon Properties Group all sold 30-year bonds in 2012. The chart below indicates that companies are on pace to issue a record number of investment-grade bonds of 30-year maturities in 2012.
These companies are looking to extend their debt to lock in low interest rates and take advantage of investor demand.
The issuers of these bonds are benefitting from “a massive sentiment shift” says one bond expert. The belief that the economy will recover is making investors more comfortable holding longer-term bonds, as they search for investments that offer better returns than U.S. Treasury bonds.
Source: Vipal Monga, “The Big Number,” Wall Street Journal (March 20, 2012), p. B5.
What are the advantages for companies of issuing 30-year bonds instead of 5-year bonds? (See page 735.)
Bond Terminology
State whether each of the following statements is true or false.
________ 1. Mortgage bonds and sinking fund bonds are both examples of secured bonds.
________ 2. Unsecured bonds are also known as debenture bonds.
________ 3. The stated rate is the rate investors demand for loaning funds.
________ 4. The face value is the amount of principal the issuing company must pay at the maturity date.
________ 5. The market price of a bond is equal to its maturity value.
Action Plan
Review the types of bonds and the basic terms associated with bonds.
Solution
1. True.
2. True.
3. False. The stated rate is the contractual interest rate used to determine the amount of cash interest the borrower pays.
4. True.
5. False. The market price of a bond is the value at which it should sell in the marketplace. As a result, the present value of the bond and its maturity value are often different.
Related exercise material: BE15-1, E15-1, E15-2, and DO IT! 15-1.
Accounting for Bond Issues
A corporation records bond transactions when it issues (sells) or redeems (buys back) bonds and when bondholders convert bonds into common stock. If bond-holders sell their bond investments to other investors, the issuing firm receives no further money on the transaction, nor does the issuing corporation journalize the transaction (although it does keep records of the names of bondholders in some cases).
Bonds may be issued at face value, below face value (discount), or above face value (premium). Bond prices for both new issues and existing bonds are quoted as a percentage of the face value of the bond. Face value is usually $1,000. Thus, a $1,000 bond with a quoted price of 97 means that the selling price of the bond is 97% of face value, or $970.
Issuing Bonds at Face Value
To illustrate the accounting for bonds issued at face value, assume that on January 1, 2014, Candlestick, Inc. issues $100,000, five-year, 10% bonds at 100 (100% of face value). The entry to record the sale is:
Candlestick reports bonds payable in the long-term liabilities section of the balance sheet because the maturity date is January 1, 2019 (more than one year away).
Over the term (life) of the bonds, companies make entries to record bond interest. Interest on bonds payable is computed in the same manner as interest on notes payable, as explained in Chapter 11 (page 524). Assume that interest is payable semiannually on January 1 and July 1 on the Candlestick bonds. In that case, Candlestick must pay interest of $5,000 ($100,000 × 10% × 6/12) on July 1, 2014. The entry for the payment, assuming no previous accrual of interest, is:
At December 31, Candlestick recognizes the $5,000 of interest expense incurred since July 1 with the following adjusting entry:
Companies classify interest payable as a current liability because it is scheduled for payment within the next year. When Candlestick pays the interest on January 1, 2015, it debits (decreases) Interest Payable and credits (decreases) Cash for $5,000.
Candlestick records the payment on January 1 as follows.
Discount or Premium on Bonds
The previous illustrations assumed that the contractual (stated) interest rate and the market (effective) interest rate paid on the bonds were the same. Recall that the contractual interest rate is the rate applied to the face (par) value to arrive at the interest paid in a year. The market interest rate is the rate investors demand for loaning funds to the corporation. When the contractual interest rate and the market interest rate are the same, bonds sell at face value (par value).
However, market interest rates change daily. The type of bond issued, the state of the economy, current industry conditions, and the company's performance all affect market interest rates. As a result, contractual and market interest rates often differ. To make bonds salable when the two rates differ, bonds sell below or above face value.
To illustrate, suppose that a company issues 10% bonds at a time when other bonds of similar risk are paying 12%. Investors will not be interested in buying the 10% bonds, so their value will fall below their face value. When a bond is sold for less than its face value, the difference between the face value of a bond and its selling price is called a discount. As a result of the decline in the bonds’ selling price, the actual interest rate incurred by the company increases to the level of the current market interest rate.
Conversely, if the market rate of interest is lower than the contractual interest rate, investors will have to pay more than face value for the bonds. That is, if the market rate of interest is 8% but the contractual interest rate on the bonds is 10%, the price of the bonds will be bid up. When a bond is sold for more than its face value, the difference between the face value and its selling price is called a premium. Illustration 15-4 (page 692) shows these relationships graphically.
Illustration 15-4
Interest rates and bond prices
Issuance of bonds at an amount different from face value is quite common. By the time a company prints the bond certificates and markets the bonds, it will be a coincidence if the market rate and the contractual rate are the same. Thus, the issuance of bonds at a discount does not mean that the issuer's financial strength is suspect. Conversely, the sale of bonds at a premium does not indicate that the financial strength of the issuer is exceptional.
Helpful Hint 
Issuing Bonds at a Discount
To illustrate issuance of bonds at a discount, assume that on January 1, 2014, Candlestick, Inc. sells $100,000, five-year, 10% bonds for $92,639 (92.639% of face value). Interest is payable on July 1 and January 1. The entry to record the issuance is:
Although Discount on Bonds Payable has a debit balance, it is not an asset. Rather, it is a contra account. This account is deducted from bonds payable on the balance sheet, as shown in Illustration 15-5.
Illustration 15-5
Statement presentation of discount on bonds payable
Helpful Hint Carrying value (book value) of bonds issued at a discount is determined by subtracting the balance of the discount account from the balance of the Bonds Payable account.
The $92,639 represents the carrying (or book) value of the bonds. On the date of issue, this amount equals the market price of the bonds.
The issuance of bonds below face value—at a discount—causes the total cost of borrowing to differ from the bond interest paid. That is, the issuing corporation must pay not only the contractual interest rate over the term of the bonds but also the face value (rather than the issuance price) at maturity. Therefore, the difference between the issuance price and face value of the bonds—the discount—is an additional cost of borrowing. The company records this additional cost as interest expense over the life of the bonds. Appendices 15B and 15C show the procedures for recording this additional cost.
The total cost of borrowing $92,639 for Candlestick, Inc. is $57,361, computed as follows.
Illustration 15-6
Total cost of borrowing—bonds issued at a discount
Alternatively, we can compute the total cost of borrowing as follows.
Illustration 15-7
Alternative computation of total cost of borrowing—bonds issued at a discount
Issuing Bonds at a Premium
To illustrate the issuance of bonds at a premium, we now assume the Candlestick, Inc. bonds described above sell for $108,111 (108.111% of face value) rather than for $92,639. The entry to record the sale is:
Candlestick adds the premium on bonds payable to the bonds payable amount on the balance sheet, as shown in Illustration 15-8.
Illustration 15-8
Statement presentation of bond premium
Helpful Hint 
The sale of bonds above face value causes the total cost of borrowing to be less than the bond interest paid. The reason: The borrower is not required to pay the bond premium at the maturity date of the bonds. Thus, the bond premium is considered to be a reduction in the cost of borrowing. The company credits the bond premium to Interest Expense over the life of the bonds. Appendices 15B and 15C show the procedures for recording this reduction in the cost of borrowing. The total cost of borrowing $108,111 for Candlestick, Inc. is computed as follows.
Illustration 15-9
Total cost of borrowing—bonds issued at a premium
Alternatively, we can compute the cost of borrowing as follows.
Illustration 15-10
Alternative computation of total cost of borrowing—bonds issued at a premium
DO IT!
Bond Issuance
Giant Corporation issues $200,000 of bonds for $189,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the balance sheet at the date of issuance.
Action Plan
Record cash received, bonds payable at face value, and the difference as a discount or premium.
Report discount as a deduction from bonds payable and premium as an addition to bonds payable.
Solution
Related exercise material: BE15-2, BE15-3, BE15-4, E15-3, E15-4, E15-7, and DO IT! 15-2.
Accounting for Bond Redemptions
An issuing corporation retires bonds either when it buys back (redeems) the bonds or when bondholders convert them into common stock. We explain the entries for these transactions in the following sections.
Redeeming Bonds at Maturity
Regardless of the issue price of bonds, the book value of the bonds at maturity will equal their face value. Assuming that the company pays and records separately the interest for the last interest period, Candlestick records the redemption of its bonds at maturity as follows.
Redeeming Bonds before Maturity
Bonds also may be redeemed before maturity. A company may decide to redeem bonds before maturity to reduce interest cost and to remove debt from its balance sheet. A company should redeem debt early only if it has sufficient cash resources.
Helpful Hint Question: A bond is redeemed prior to its maturity date. Its carrying value exceeds its redemption price. Will this result in a gain or a loss on redemption? Answer: Gain.
When a company redeems bonds before maturity, it is necessary to (1) eliminate the carrying value of the bonds at the redemption date, (2) record the cash paid, and (3) recognize the gain or loss on redemption. The carrying value of the bonds is the face value of the bonds less any remaining bond discount or plus any remaining bond premium at the redemption date.
To illustrate, assume that Candlestick, Inc. has sold its bonds at a premium. At the end of the eighth period, Candlestick redeems these bonds at 103 after paying the semiannual interest. Assume also that the carrying value of the bonds at the redemption date is $101,623. Candlestick makes the following entry to record the redemption at the end of the eighth interest period (January 1, 2018).
Note that the loss of $1,377 is the difference between the cash paid of $103,000 and the carrying value of the bonds of $101,623.
Converting Bonds into Common Stock
Convertible bonds have features that are attractive both to bondholders and to the issuer. The conversion often gives bondholders an opportunity to benefit if the market price of the common stock increases substantially. Until conversion, though, the bondholder receives interest on the bond. For the issuer of convertible bonds, the bonds sell at a higher price and pay a lower rate of interest than comparable debt securities without the conversion option. Many corporations, such as Intel, Ford, and Wells Fargo, have convertible bonds outstanding.
When the issuing company records a conversion, the company ignores the current market prices of the bonds and stock. Instead, the company transfers the carrying value of the bonds to paid-in capital accounts. No gain or loss is recognized.
To illustrate, assume that on July 1, Saunders Associates converts $100,000 bonds sold at face value into 2,000 shares of $10 par value common stock. Both the bonds and the common stock have a market value of $130,000. Saunders makes the following entry to record the conversion.
Note that the company does not consider the current market value of the bonds and stock ($130,000) in making the entry. This method of recording the bond conversion is often referred to as the carrying (or book) value method.
DO IT!
Bond Redemption
R & B Inc. issued $500,000, 10-year bonds at a premium. Prior to maturity, when the carrying value of the bonds is $508,000, the company redeems the bonds at 102. Prepare the entry to record the redemption of the bonds.
Action Plan
Determine and eliminate the carrying value of the bonds.
Record the cash paid.
Compute and record the gain or loss (the difference between the first two items).
Solution
Related exercise material: BE15-5, E15-5, E15-6, E15-8, E15-9, and DO IT! 15-3.
Accounting for Other Long-Term Liabilities
Other common types of long-term obligations are notes payable and lease liabilities. The accounting for these liabilities is explained in the following sections.
Long-Term Notes Payable
The use of notes payable in long-term debt financing is quite common. Long-term notes payable are similar to short-term interest-bearing notes payable except that the term of the notes exceeds one year. In periods of unstable interest rates, lenders may tie the interest rate on long-term notes to changes in the market rate for comparable loans. Examples are the 8.03% adjustable rate notes issued by General Motors and the floating-rate notes issued by American Express Company.
A long-term note may be secured by a mortgage that pledges title to specific assets as security for a loan. Individuals widely use mortgage notes payable to purchase homes, and many small and some large companies use them to acquire plant assets. At one time, approximately 18% of McDonald's long-term debt related to mortgage notes on land, buildings, and improvements.
Like other long-term notes payable, the mortgage loan terms may stipulate either a fixed or an adjustable interest rate. The interest rate on a fixed-rate mortgage remains the same over the life of the mortgage. The interest rate on an adjustable-rate mortgage is adjusted periodically to reflect changes in the market rate of interest. Typically, the terms require the borrower to make equal installment payments over the term of the loan. Each payment consists of (1) interest on the unpaid balance of the loan and (2) a reduction of loan principal. While the total amount of the payment remains constant, the interest decreases each period, while the portion applied to the loan principal increases.
Companies initially record mortgage notes payable at face value. They subsequently make entries for each installment payment. To illustrate, assume that Porter Technology Inc. issues a $500,000, 12%, 20-year mortgage note on December 31, 2014, to obtain needed financing for a new research laboratory. The terms provide for semiannual installment payments of $33,231 (not including real estate taxes and insurance). The installment payment schedule for the first two years is as follows.
Illustration 15-11
Mortgage installment payment schedule
Porter records the mortgage loan on December 31, 2014, as follows.
On June 30, 2015, Porter records the first installment payment as follows.
In the balance sheet, the company reports the reduction in principal for the next year as a current liability, and it classifies the remaining unpaid principal balance as a long-term liability. At December 31, 2015, the total liability is $493,344. Of that amount, $7,478 ($3,630 + $3,848) is current, and $485,866 ($493,344 − $7,478) is long-term.
ACCOUNTING ACROSS THE ORGANIZATION
Companies have a choice in the form of long-term borrowing they undertake—issue bonds or issue notes. Notes are generally issued to a single lender (usually through a loan from a bank). Bonds, on the other hand, allow the company to divide the borrowing into many small investing units, thereby enabling more than one investor to participate in the borrowing. As indicated in the graph below, companies are recently borrowing more from bond investors than from banks and other loan providers in a bid to lock in cheap, long-term funding.
Why this trend? For one thing, low interest rates and rising inflows into fixed-income funds have triggered record bond issuances as banks cut back lending. In addition, for some high-rated companies, it can be riskier to borrow from a bank than the bond markets. The reason: High-rated companies tended to rely on short-term financing to fund working capital but were left stranded when these markets froze up. Some are now financing themselves with longer-term bonds instead.
Source: A. Sakoui and N. Bullock, “Companies Choose Bonds for Cheap Funds,” Financial Times (October 12, 2009).
Why might companies prefer bond financing instead of short-term financing? (See page 735.)
DO IT!
Long-Term Note
Cole Research issues a $250,000, 8%, 20-year mortgage note to obtain needed financing for a new lab. The terms call for semiannual payments of $12,631 each. Prepare the entries to record the mortgage loan and the first installment payment.
Action Plan
Record the issuance of the note as a cash receipt and a liability.
Each installment payment consists of interest and payment of principal.
Solution
Related exercise material: BE15-6, E15-10, E15-11, and DO IT! 15-4.
Lease Liabilities
A lease is a contractual arrangement between a lessor (owner of the property) and a lessee (renter of the property). It grants the right to use specific property for a period of time in return for cash payments. Leasing is big business. The global leasing market has recently been between $600 to $700 billion for capital equipment. This represents approximately one-third of equipment financed in a year. The two most common types of leases are operating leases and capital leases.
OPERATING LEASES
The renting of an apartment and the rental of a car at an airport are examples of operating leases. In an operating lease, the intent is temporary use of the property by the lessee, while the lessor continues to own the property.
In an operating lease, the lessee records the lease (or rental) payments as an expense. The lessor records the payments as revenue. For example, assume that a sales representative for Western Inc. leases a car from Hertz Car Rental at the Los Angeles airport and that Hertz charges a total of $275. Western, the lessee, records the rental as follows.
The lessee may incur other costs during the lease period. For example, in the case above, Western will generally incur costs for gas. Western would report these costs as an expense.
CAPITAL LEASES
In most lease contracts, the lessee makes a periodic payment and records that payment in the income statement as rent expense. In some cases, however, the lease contract transfers to the lessee substantially all the benefits and risks of ownership. Such a lease is in effect a purchase of the property. This type of lease is a capital lease. Its name comes from the fact that the company capitalizes the present value of the cash payments for the lease and records that amount as an asset. Illustration 15-12 indicates the major difference between operating and capital leases.
Illustration 15-12
Types of leases
Helpful Hint A capital lease situation is one that, although legally a rental case, is in substance an installment purchase by the lessee. Accounting standards require that substance over form be used in such a situation.
If any one of the following conditions exists, the lessee must record a lease as an asset—that is, as a capital lease:
1. The lease transfers ownership of the property to the lessee. Rationale: If during the lease term the lessee receives ownership of the asset, the lessee should report the leased item as an asset on its books.
2. The lease contains a bargain purchase option. Rationale: If during the term of the lease the lessee can purchase the asset at a price substantially below its fair value, the lessee will exercise this option. Thus, the lessee should report the leased item as an asset on its books.
3. The lease term is equal to 75% or more of the economic life of the leased property. Rationale: If the lease term is for much of the asset's useful life, the lessee should report the leased item as an asset on its books.
4. The present value of the lease payments equals or exceeds 90% of the fair value of the leased property. Rationale: If the present value of the lease payments is equal to or almost equal to the fair value of the asset, the lessee has essentially purchased the asset. As a result, the lessee should report the leased item as an asset on its books.
To illustrate, assume that Gonzalez Company decides to lease new equipment. The lease period is four years. The economic life of the leased equipment is estimated to be five years. The present value of the lease payments is $190,000, which is equal to the fair value of the equipment. There is no transfer of ownership during the lease term, nor is there any bargain purchase option.
In this example, Gonzalez has essentially purchased the equipment. Conditions 3 and 4 have been met. First, the lease term is 75% or more of the economic life of the asset. Second, the present value of cash payments is equal to the equipment's fair value. Gonzalez records the transaction as follows.
The lessee reports a leased asset on the balance sheet under plant assets. It reports the lease liability on the balance sheet as a liability. The portion of the lease liability expected to be paid in the next year is a current liability. The remainder is classified as a long-term liability.
Most lessees do not like to report leases on their balance sheets. Why? Because the lease liability increases the company's total liabilities. This, in turn, may make it more difficult for the company to obtain needed funds from lenders. As a result, companies attempt to keep leased assets and lease liabilities off the balance sheet by structuring leases so as not to meet any of the four conditions discussed earlier. The practice of keeping liabilities off the balance sheet is referred to as off–balance-sheet financing.
Ethics Note
Accounting standard-setters are attempting to rewrite rules on lease accounting because of concerns that abuse of the current standards is reducing the usefulness of financial statements.
Statement Presentation and Analysis
Identify the methods for the presentation and analysis of long-term liabilities.
Presentation
Companies report long-term liabilities in a separate section of the balance sheet immediately following current liabilities, as shown in Illustration 15-13. Alternatively, companies may present summary data in the balance sheet, with detailed data (interest rates, maturity dates, conversion privileges, and assets pledged as collateral) shown in a supporting schedule.
Illustration 15-13
Balance sheet presentation of long-term liabilities
Companies report the current maturities of long-term debt under current liabilities if they are to be paid within one year or the operating cycle, whichever is longer.
Analysis
Long-term creditors and stockholders are interested in a company's long-run solvency. Of particular interest is the company's ability to pay interest as it comes due and to repay the face value of the debt at maturity. Here we look at two ratios that provide information about debt-paying ability and long-run solvency.
The debt to assets ratio measures the percentage of the total assets provided by creditors. It is computed by dividing debt (both current and long-term liabilities) by assets. To illustrate, we use data from a recent Kellogg Company annual report. The company reported total liabilities of $8,925 million, total assets of $11,200 million, interest expense of $295 million, income taxes of $476 million, and net income of $1,208 million. As shown in Illustration 15-14, Kellogg's debt to assets ratio is 79.7%. The higher the percentage of debt to assets, the greater the risk that the company may be unable to meet its maturing obligation.
Illustration 15-14
Debt to assets ratio
Times interest earned indicates the company's ability to meet interest payments as they come due. It is computed by dividing income before income taxes and interest expense by interest expense. As shown in Illustration 15-15, Kellogg's times interest earned is 6.71 times. This interest coverage is considered safe.
Illustration 15-15
Times interest earned
“Covenant-Lite” Debt 
In many corporate loans and bond issuances, the lending agreement specifies debt covenants. These covenants typically are specific financial measures, such as minimum levels of retained earnings, cash flows, times interest earned, or other measures that a company must maintain during the life of the loan. If the company violates a covenant, it is considered to have violated the loan agreement. The creditors can then demand immediate repayment, or they can renegotiate the loan's terms. Covenants protect lenders because they enable lenders to step in and try to get their money back before the borrower gets too deep into trouble.
During the 1990s, most traditional loans specified between three to six covenants or “triggers.” In more recent years, when lots of cash was available, lenders began reducing or completely eliminating covenants from loan agreements in order to be more competitive with other lenders. When the economy declined, lenders lost big money when companies defaulted.
Source: Cynthia Koons, “Risky Business: Growth of ‘Covenant-Lite’ Debt,” Wall Street Journal (June 18, 2007), p. C2.
How can financial ratios such as those covered in this chapter provide protection for creditors? (See page 735.)
Lease Liability; Analysis of Long-Term Liabilities
FX Corporation leases new equipment on December 31, 2014. The lease transfers ownership to FX at the end of the lease. The present value of the lease payments is $240,000. After recording this lease, FX has assets of $2,000,000, liabilities of $1,200,000, and stockholders’ equity of $800,000. (a) Prepare the entry to record the lease, and (b) compute and discuss the debt to assets ratio at year-end.
Action Plan
Record the present value of the lease payments as an asset and a liability.
Use the formula for the debt to assets ratio (debt divided by assets).
Solution
Related exercise material: BE15-7, E15-12, E15-14, and DO IT! 15-5.
Comprehensive DO IT!
Snyder Software Inc. has successfully developed a new spreadsheet program. To produce and market the program, the company needed $2 million of additional financing. On January 1, 2014, Snyder borrowed money as follows.
1. Snyder issued $500,000, 11%, 10-year convertible bonds. The bonds sold at face value and pay semiannual interest on January 1 and July 1. Each $1,000 bond is convertible into 30 shares of Snyder's $20 par value common stock.
2. Snyder issued $1 million, 10%, 10-year bonds at face value. Interest is payable semiannually on January 1 and July 1.
3. Snyder also issued a $500,000, 12%, 15-year mortgage payable. The terms provide for semiannual installment payments of $36,324 on June 30 and December 31.
Instructions
1. For the convertible bonds, prepare journal entries for:
(a) The issuance of the bonds on January 1, 2014.
(b) Interest expense on July 1 and December 31, 2014.
(c) The payment of interest on January 1, 2015.
(d) The conversion of all bonds into common stock on January 1, 2015, when the market price of the common stock was $67 per share.
2. For the 10-year, 10% bonds:
(a) Journalize the issuance of the bonds on January 1, 2014.
(b) Prepare the journal entries for interest expense in 2014. Assume no accrual of interest on June 30.
(c) Prepare the entry for the redemption of the bonds at 101 on January 1, 2017, after paying the interest due on this date.
3. For the mortgage payable:
(a) Prepare the entry for the issuance of the note on January 1, 2014.
(b) Prepare a payment schedule for the first four installment payments.
(c) Indicate the current and noncurrent amounts for the mortgage payable at December 31, 2014.
Action Plan
Compute interest semiannually (six months).
Record the accrual and payment of interest on appropriate dates.
Record the conversion of the bonds into common stock by removing the book (carrying) value of the bonds from the liability account.
Solution to Comprehensive DO IT!
Action Plan
Record the issuance of the bonds.
Compute interest expense for each period.
Compute the loss on bond redemption as the excess of the cash paid over the carrying value of the redeemed bonds.
Compute periodic interest expense on a mortgage payable, recognizing that as the principal amount decreases, so does the interest expense.
Record mortgage payments, recognizing that each payment consists of (1) interest on the unpaid loan balance and (2) a reduction of the loan principal.
SUMMARY OF LEARNING OBJECTIVES
1 Explain why bonds are issued. Companies may sell bonds to investors to raise long-term capital. Bonds offer the following advantages over common stock: (a) stockholder control is not affected, (b) tax savings result, and (c) earnings per share of common stock may be higher.
2 Prepare the entries for the issuance of bonds and interest expense. When companies issue bonds, they debit Cash for the cash proceeds and credit Bonds Payable for the face value of the bonds. The account Premium on Bonds Payable shows a bond premium. Discount on Bonds Payable shows a bond discount.
3 Describe the entries when bonds are redeemed or converted. When bondholders redeem bonds at maturity, the issuing company credits Cash and debits Bonds Payable for the face value of the bonds. When bonds are redeemed before maturity, the issuing company (a) eliminates the carrying value of the bonds at the redemption date, (b) records the cash paid, and (c) recognizes the gain or loss on redemption. When bonds are converted to common stock, the issuing company transfers the carrying (or book) value of the bonds to appropriate paid-in capital accounts. No gain or loss is recognized.
4 Describe the accounting for long-term notes payable. Each payment consists of (1) interest on the unpaid balance of the loan and (2) a reduction of loan principal. The interest decreases each period, while the portion applied to the loan principal increases.
5 Contrast the accounting for operating and capital leases. For an operating lease, the lessee (renter) records lease (rental) payments as an expense. For a capital lease, the lessee records the asset and related obligation at the present value of the future lease payments.
6 Identify the methods for the presentation and analysis of long-term liabilities. Companies should report the nature and amount of each long-term debt in the balance sheet or in the notes accompanying the financial statements. Stockholders and long-term creditors are interested in a company's long-run solvency. Debt to assets and times interest earned are two ratios that provide information about debt-paying ability and long-run solvency.
GLOSSARY
Bearer (coupon) bonds Bonds not registered in the name of the owner. (p. 687).
Bond certificate A legal document that indicates the name of the issuer, the face value of the bonds, the contractual interest rate, and maturity date of the bonds. (p. 688).
Bond indenture A legal document that sets forth the terms of the bond issue. (p. 687).
Bonds A form of interest-bearing notes payable issued by corporations, universities, and governmental entities. (p. 686).
Callable bonds Bonds that are subject to redemption (buy back) at a stated dollar amount prior to maturity at the option of the issuer. (p. 687).
Capital lease A contractual arrangement that transfers substantially all the benefits and risks of ownership to the lessee so that the lease is in effect a purchase of the property. (p. 699).
Contractual interest rate Rate used to determine the amount of cash interest the borrower pays and the investor receives. (p. 687).
Convertible bonds Bonds that permit bondholders to convert them into common stock at the bondholders’ option. (p. 687).
Debenture bonds Bonds issued against the general credit of the borrower. Also called unsecured bonds. (p. 687).
Debt to assets ratio A solvency measure that indicates the percentage of total assets provided by creditors; computed as debt divided by assets. (p. 701).
Discount (on a bond) The difference between the face value of a bond and its selling price, when the bond is sold for less than its face value. (p. 691).
Face value Amount of principal due at the maturity date of the bond. (p. 687).
Long-term liabilities Obligations expected to be paid more than one year in the future. (p. 685).
Market interest rate The rate investors demand for loaning funds to the corporation. (p. 689).
Maturity date The date on which the final payment on the bond is due from the bond issuer to the investor. (p. 687).
Mortgage bond A bond secured by real estate. (p. 687).
Mortgage notes payable A long-term note secured by a mortgage that pledges title to specific assets as security for a loan. (p. 696).
Operating lease A contractual arrangement giving the lessee temporary use of the property, with continued ownership of the property by the lessor. (p. 699).
Premium (on a bond) The difference between the selling price and the face value of a bond, when the bond is sold for more than its face value. (p. 691).
Registered bonds Bonds issued in the name of the owner. (p. 687).
Secured bonds Bonds that have specific assets of the issuer pledged as collateral. (p. 687).
Serial bonds Bonds that mature in installments. (p. 687).
Sinking fund bonds Bonds secured by specific assets set aside to redeem them. (p. 687).
Term bonds Bonds that mature at a single specified future date. (p. 687).
Times interest earned A solvency measure that indicates a company's ability to meet interest payments; computed by dividing income before income taxes and interest expense by interest expense. (p. 701).
Time value of money The relationship between time and money. A dollar received today is worth more than a dollar promised at some time in the future. (p. 688).
Unsecured bonds Bonds issued against the general credit of the borrower. Also called debenture bonds. (p. 687).
APPENDIX 15A Present Value Concepts Related to Bond Pricing
Congratulations! You have a winning lottery ticket and the state has provided you with three possible options for payment. They are:
LEARNING OBJECTIVE 7
Compute the market price of a bond.
1. Receive $10,000,000 in three years.
2. Receive $7,000,000 immediately.
3. Receive $3,500,000 at the end of each year for three years.
Which of these options would you select? The answer is not easy to determine at a glance. To make a dollar-maximizing choice, you must perform present value computations. A present value computation is based on the concept of time value of money. Time value of money concepts are useful for the lottery situation and for pricing other amounts to be received in the future. This appendix discusses how to use present value concepts to price bonds. It also will tell you how to determine what option you should take as a lottery winner.
Present Value of a Single Amount
To illustrate present value concepts, assume that you are willing to invest a sum of money that will yield $1,000 at the end of one year. In other words, what amount would you need to invest today to have $1,000 one year from now? If you want to earn 10%, the investment (or present value) is $909.09 ($1,000 ÷ 1.10). Illustration 15A-1 shows the computation.
Illustration 15A-1
Present value computation—$1,000 discounted at 10% for one year
The future amount ($1,000), the interest rate (10%), and the number of periods (1) are known. We can depict the variables in this situation as shown in the time diagram in Illustration 15A-2.
Illustration 15A-2
Finding present value if discounted for one period
If you are to receive the single future amount of $1,000 in two years, discounted at 10%, its present value is $826.45 [($1,000 ÷ 1.10) ÷ 1.10], depicted as follows.
Illustration 15A-3
Finding present value if discounted for two periods
We also can determine the present value of 1 through tables that show the present value of 1 for n periods. In Table 15A-1, n is the number of discounting periods involved. The percentages are the periodic interest rates or discount rates, and the 5-digit decimal numbers in the respective columns are the present value of 1 factors.
When using Table 15A-1, we multiply the future amount by the present value factor specified at the intersection of the number of periods and the interest rate. For example, the present value factor for 1 period at an interest rate of 10% is .90909, which equals the $909.09 ($1,000 × .90909) computed in Illustration 15A-1.
For two periods at an interest rate of 10%, the present value factor is .82645, which equals the $826.45 ($1,000 × .82645) computed previously.
Let's now go back to our lottery example. Given the present value concepts just learned, we can determine whether receiving $10,000,000 in three years is better than receiving $7,000,000 today, assuming the appropriate discount rate is 9%. The computation is as follows.
Illustration 15A-4
Present value of $10,000,000 to be received in three years
What this computation shows you is that you would be $721,800 better off receiving the $10,000,000 at the end of three years rather than taking $7,000,000 immediately.
Present Value of Interest Payments (Annuities)
In addition to receiving the face value of a bond at maturity, an investor also receives periodic interest payments over the life of the bonds. These periodic payments are called annuities.
In order to compute the present value of an annuity, we need to know: (1) the interest rate, (2) the number of interest periods, and (3) the amount of the periodic receipts or payments. To illustrate the computation of the present value of an annuity, assume that you will receive $1,000 cash annually for three years and the interest rate is 10%. The time diagram in Illustration 15A-5 (page 708) depicts this situation.
Illustration 15A-5
Time diagram for a three-year annuity
The present value in this situation may be computed as follows.
Illustration 15A-6
Present value of a series of future amounts computation
We also can use annuity tables to value annuities. As illustrated in Table 15A-2 below, these tables show the present value of 1 to be received periodically for a given number of periods.
From Table 15A-2 you can see that the present value factor of an annuity of 1 for three periods at 10% is 2.48685.1 This present value factor is the total of the three individual present value factors as shown in Illustration 15A-6. Applying this amount to the annual cash flow of $1,000 produces a present value of $2,486.85.
Let's now go back to our lottery example. We determined that you would get more money if you wait and take the $10,000,000 in three years rather than take $7,000,000 immediately. But there is still another option—to receive $3,500,000 at the end of each year for three years (an annuity). The computation to evaluate this option (again assuming a 9% discount rate) is as follows.
Illustration 15A-7 Present value of lottery payments to be received over three years
If you take the annuity of $3,500,000 for each of 3 years, you will be $1,137,750 richer as a result.
Time Periods and Discounting
We have used an annual interest rate to determine present value. Present value computations may also be done over shorter periods of time, such as monthly, quarterly, or semiannually. When the time frame is less than one year, it is necessary to convert the annual interest rate to the shorter time frame.
Assume, for example, that the investor in Illustration 15A-6 received $500 semiannually for three years instead of $1,000 annually. In this case, the number of periods becomes 6 (3 × 2), the interest rate is 5% (10% ÷ 2), the present value factor from Table 15A-2 is 5.07569, and the present value of the future cash flows is $2,537.85 (5.07569 × $500). This amount is slightly higher than the $2,486.86 computed in Illustration 15A-6 because interest is computed twice during the same year. That is, interest is earned on the first half year's interest.
Computing the Present Value of a Bond
The present value (or market price) of a bond is a function of three variables: (1) the payment amounts, (2) the length of time until the amounts are paid, and (3) the interest (discount) rate.
The first variable (dollars to be paid) is made up of two elements: (1) a series of interest payments (an annuity), and (2) the principal amount (a single sum). To compute the present value of the bond, we must discount both the interest payments and the principal amount.
When the investor's interest (discount) rate is equal to the bond's contractual interest rate, the present value of the bonds will equal the face value of the bonds. To illustrate, assume a bond issue of 10%, five-year bonds with a face value of $100,000 with interest payable semiannually on January 1 and July 1. If the discount rate is the same as the contractual rate, the bonds will sell at face value. In this case, the investor will receive: (1) $100,000 at maturity and (2) a series of ten $5,000 interest payments [$100,000 × (10% ÷ 2)] over the term of the bonds. The length of time is expressed in terms of interest periods (in this case, 10) and the discount rate per interest period (5%). The time diagram in Illustration 15A-8 (page 710) depicts the variables involved in this discounting situation.
Illustration 15A-8
Time diagram for the present value of a 10%, five-year bond paying interest semiannually
The computation of the present value of Candlestick's bonds, assuming they were issued at face value (page 690), is shown below.
Illustration 15A-9
Present value of principal and interest (face value)
Now assume that the investor's required rate of return is 12%, not 10%. The future amounts are again $100,000 and $5,000, respectively. But now we must use a discount rate of 6% (12% ÷ 2). The present value of Candlestick's bonds issued at a discount (page 692) is $92,639 as computed below.
Illustration 15A-10
Present value of principal and interest (discount)
If the discount rate is 8% and the contractual rate is 10%, the present value of Candlestick's bonds issued at a premium (page 693) is $108,111, computed as shown in Illustration 15A-11.
Illustration 15A-11
Present value of principal and interest (premium)
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 15A
7 Compute the market price of a bond. Time value of money concepts are useful for pricing bonds. The present value (or market price) of a bond is a function of three variables: (1) the payment amounts, (2) the length of time until the amounts are paid, and (3) the interest rate.
APPENDIX 15B Effective-Interest Method of Bond Amortization
Under the effective-interest method, the amortization of bond discount or bond premium results in periodic interest expense equal to a constant percentage of the carrying value of the bonds. The effective-interest method results in varying amounts of amortization and interest expense per period but a constant percentage rate.
LEARNING OBJECTIVE 8
Apply the effective-interest method of amortizing bond discount and bond premium.
The following steps are required under the effective-interest method.
1. Compute the bond interest expense. To do so, multiply the carrying value of the bonds at the beginning of the interest period by the effective-interest rate.
2. Compute the bond interest paid (or accrued). To do so, multiply the face value of the bonds by the contractual interest rate.
3. Compute the amortization amount. To do so, determine the difference between the amounts computed in steps (1) and (2).
Illustration 15B-1 depicts these steps.
Illustration 15B-1
Computation of amortization—effective-interest method
When the difference between the straight-line method of amortization (Appendix 15C) and the effective-interest method is material, GAAP requires the use of the effective-interest method.
Amortizing Bond Discount
To illustrate the effective-interest method of bond discount amortization, assume that Candlestick, Inc. issues $100,000 of 10%, five-year bonds on January 1, 2014, with interest payable each July 1 and January 1 (pages 692–693). The bonds sell for $92,639 (92.639% of face value). This sales price results in a bond discount of $7,361 ($100,000 − $92,639) and an effective-interest rate of 12%. A bond discount amortization schedule, as shown in Illustration 15B-2 (page 712), facilitates the recording of interest expense and the discount amortization. Note that interest expense as a percentage of carrying value remains constant at 6%.
Illustration 15B-2
Bond discount amortization schedule
We have highlighted columns (A), (B), and (C) in the amortization schedule to emphasize their importance. These three columns provide the numbers for each period's journal entries. They are the primary reason for preparing the schedule.
For the first interest period, the computations of interest expense and the bond discount amortization are:
Illustration 15B-3 Computation of bond discount amortization
Candlestick records the payment of interest and amortization of bond discount on July 1, 2014, as follows.
For the second interest period, bond interest expense will be $5,592 ($93,197 × 6%), and the discount amortization will be $592. At December 31, Candlestick makes the following adjusting entry.
Total interest expense for 2014 is $11,150 ($5,558 + $5,592). On January 1, Candlestick records payment of the interest by a debit to Interest Payable and a credit to Cash.
Helpful Hint When a bond sells for $108,111, it is quoted as 108.111% of face value. Note that $108,111 can be proven as shown in Appendix 15A.
Amortizing Bond Premium
The amortization of bond premium by the effective-interest method is similar to the procedures described for bond discount. For example, assume that Candlestick, Inc. issues $100,000, 10%, five-year bonds on January 1, 2014, with interest payable on July 1 and January 1 (pages 693–694). In this case, the bonds sell for $108,111. This sales price results in bond premium of $8,111 and an effective-interest rate of 8%. Illustration 15B-4 shows the bond premium amortization schedule.
Illustration 15B-4 Bond premium amortization schedule
For the first interest period, the computations of interest expense and the bond premium amortization are:
Illustration 15B-5
Computation of bond premium amortization
Candlestick records payments on the first interest date as follows.
For the second interest period, interest expense will be $4,297, and the premium amortization will be $703. Total bond interest expense for 2014 is $8,621 ($4,324 + $4,297).
DO IT!
Gardner Corporation issues $1,750,000, 10-year, 12% bonds on January 1, 2014, at $1,968,090, to yield 10%. The bonds pay semiannual interest July 1 and January 1. Gardner uses the effective-interest method of amortization.
Instructions
(a) Prepare the journal entry to record the issuance of the bonds.
(b) Prepare the journal entry to record the payment of interest on July 1, 2014.
Action Plan
Compute interest expense by multiplying bond carrying value at the beginning of the period by the effective-interest rate.
Compute credit to cash (or interest payable) by multiplying the face value of the bonds by the contractual interest rate.
Compute bond premium or discount amortization, which is the difference between interest expense and cash paid.
Interest expense decreases when the effective-interest method is used for bonds issued at a premium. The reason is that a constant percentage is applied to a decreasing book value to compute interest expense.
Solution
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 15B
8 Apply the effective-interest method of amortizing bond discount and bond premium. The effective-interest method results in varying amounts of amortization and interest expense per period but a constant percentage rate of interest. When the difference between the straight-line and effective-interest method is material, GAAP requires the use of the effective-interest method.
GLOSSARY FOR APPENDIX 15B
Effective-interest method of amortization A method of amortizing bond discount or bond premium that results in periodic interest expense equal to a constant percentage of the carrying value of the bonds. (p. 711).
APPENDIX 15C Straight-Line Amortization
Amortizing Bond Discount
Under the straight-line method of amortization, the amortization of bond discount or bond premium results in periodic interest expense of the same amount in each interest period. In other words, the straight-line method results in a constant amount of amortization and interest expense per period. The amount is determined using the formula in Illustration 15C-1.
LEARNING OBJECTIVE 9
Apply the straight-line method of amortizing bond discount and bond premium.
Illustration 15C-1
Formula for straight-line method of bond discount amortization
In the Candlestick, Inc. example (pages 692–693), the company sold $100,000, five-year, 10% bonds on January 1, 2014, for $92,639. This price resulted in a $7,361 bond discount ($100,000 – $92,639). Interest is payable on July 1 and January 1. The bond discount amortization for each interest period is $736 ($7,361 ÷ 10). Candlestick records the payment of bond interest and the amortization of bond discount on the first interest date (July 1, 2014) as follows.
At December 31, Candlestick makes the following adjusting entry.
Over the term of the bonds, the balance in Discount on Bonds Payable will decrease annually by the same amount until it has a zero balance at the maturity date of the bonds. Thus, the carrying value of the bonds at maturity will be equal to the face value.
It is useful to prepare a bond discount amortization schedule as shown in Illustration 15C-2. The schedule shows interest expense, discount amortization, and the carrying value of the bond for each interest period. As indicated, the interest expense recorded each period for the Candlestick bond is $5,736. Also note that the carrying value of the bond increases $736 each period until it reaches its face value $100,000 at the end of period 10.
Illustration 15C-2
Bond discount amortization schedule
We have highlighted columns (A), (B), and (C) in the amortization schedule to emphasize their importance. These three columns provide the numbers for each period's journal entries. They are the primary reason for preparing the schedule.
Amortizing Bond Premium
The amortization of bond premium parallels that of bond discount. Illustration 15C-3 presents the formula for determining bond premium amortization under the straight-line method.
Illustration 15C-3
Formula for straight-line method of bond premium amortization
Continuing our example, assume that Candlestick sells the bonds for $108,111, rather than $92,639 (pages 693–694). This sale price results in a bond premium of $8,111 ($108,111 – $100,000). The bond premium amortization for each interest period is $811 ($8,111 ÷ 10). Candlestick records the first payment of interest on July 1 as follows.
At December 31, the company makes the following adjusting entry.
Over the term of the bonds, the balance in Premium on Bonds Payable will decrease annually by the same amount until it has a zero balance at maturity.
It is useful to prepare a bond premium amortization schedule as shown in Illustration 15C-4. It shows interest expense, premium amortization, and the carrying value of the bond. The interest expense recorded each period for the Candlestick bond is $4,189. Also note that the carrying value of the bond decreases $811 each period until it reaches its face value ($100,000) at the end of period 10.
Illustration 15C-4
Bond premium amortization schedule
DO IT!
Glenda Corporation issues $1,750,000, 10-year, 12% bonds on January 1, 2014, for $1,968,090 to yield 10%. The bonds pay semiannual interest July 1 and January 1. Glenda uses the straight-line method of amortization.
Instructions
(a) Prepare the journal entry to record the issuance of the bonds.
(b) Prepare the journal entry to record the payment of interest on July 1, 2014.
Action Plan
Compute credit to cash (or interest payable) by multiplying the face value of the bonds by the contractual interest rate.
Compute bond premium or discount amortization by dividing bond premium or discount by the total number of periods.
Understand that interest expense decreases when bonds are issued at a premium. The reason is that the amortization of premium reduces the total cost of borrowing.
Solution
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 15C
9 Apply the straight-line method of amortizing bond discount and bond premium. The straight-line method of amortization results in a constant amount of amortization and interest expense per period.
GLOSSARY FOR APPENDIX 15C
Straight-line method of amortization. A method of amortizing bond discount or bond premium that results in allocating the same amount to interest expense in each interest period. (p. 715).
Self-Test, Brief Exercises, Exercises, Problem Set A, and many more components are available for practice in WileyPLUS.
*Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.
SELF-TEST QUESTIONS
Answers are on page 735.
1. The term used for bonds that are unsecured is:
(LO 1)
(a) callable bonds.
(b) indenture bonds.
(c) debenture bonds.
(d) bearer bonds.
2. The market interest rate:
(LO 1)
(a) is the contractual interest rate used to determine the amount of cash interest paid by the borrower.
(b) is listed in the bond indenture.
(c) is the rate investors demand for loaning funds.
(d) More than one of the above is true.
3. Karson Inc. issues 10-year bonds with a maturity value of $200,000. If the bonds are issued at a premium, this indicates that:
(LO 2)
(a) the contractual interest rate exceeds the market interest rate.
(b) the market interest rate exceeds the contractual interest rate.
(c) the contractual interest rate and the market interest rate are the same.
(d) no relationship exists between the two rates.
4. Four-Nine Corporation issued bonds that pay interest every July 1 and January 1. The entry to accrue bond interest at December 31 includes a:
(LO 2)
(a) debit to Interest Payable.
(b) credit to Cash.
(c) credit to Interest Expense.
(d) credit to Interest Payable.
5. Gester Corporation redeems its $100,000 face value bonds at 105 on January 1, following the payment of semiannual interest. The carrying value of the bonds at the redemption date is $103,745. The entry to record the redemption will include a:
(LO 3)
(a) credit of $3,745 to Loss on Bond Redemption.
(b) debit of $3,745 to Premium on Bonds Payable.
(c) credit of $1,255 to Gain on Bond Redemption.
(d) debit of $5,000 to Premium on Bonds Payable.
6. Colson Inc. converts $600,000 of bonds sold at face value into 10,000 shares of common stock, par value $1. Both the bonds and the stock have a market value of $760,000. What amount should be credited to Paid-in Capital in Excess of Par—Common Stock as a result of the conversion?
(LO 3)
(a) $10,000.
(b) $160,000.
(c) $600,000.
(d) $590,000.
7. Howard Corporation issued a 20-year mortgage note payable on January 1, 2014. At December 31, 2014, the unpaid principal balance will be reported as:
(LO 4)
(a) a current liability.
(b) a long-term liability.
(c) part current and part long-term liability.
(d) interest payable.
8. Andrews Inc. issues a $497,000, 10% 3-year mortgage note on January 1. The note will be paid in three annual installments of $200,000, each payable at the end of the year. What is the amount of interest expense that should be recognized by Andrews Inc. in the second year?
(LO 4)
(a) $16,567.
(b) $49,700.
(c) $34,670.
(d) $346,700.
9. Lease A does not contain a bargain purchase option, but the lease term is equal to 90% of the estimated economic life of the leased property. Lease B does not transfer ownership of the property to the lessee by the end of the lease term, but the lease term is equal to 75% of the estimated economic life of the leased property. How should the lessee classify these leases?
(LO 5)
| Lease A | Lease B |
| (a) Operating lease | Capital lease |
| (b) Operating lease | Operating lease |
| (c) Capital lease | Operating lease |
| (d) Capital lease | Capital lease |
10. For 2014, Corn Flake Corporation reported net income of $300,000. Interest expense was $40,000 and income taxes were $100,000. The times interest earned was:
(LO 6)
(a) 3 times.
(b) 4.4 times.
(c) 7.5 times.
(d) 11 times.
* 11. The market price of a bond is dependent on:
(LO 7)
(a) the payment amounts.
(b) the length of time until the amounts are paid.
(c) the interest rate.
(d) All of the above.
*12. On January 1, Besalius Inc. issued $1,000,000, 9% bonds for $938,554. The market rate of interest for these bonds is 10%. Interest is payable annually on December 31. Besalius uses the effective-interest method of amortizing bond discount. At the end of the first year, Besalius should report unamortized bond discount of:
(LO 8)
(a) $54,900.
(b) $57,591.
(c) $51,610.
(d) $51,000.
*13. On January 1, Dias Corporation issued $1,000,000, 10%, 5-year bonds with interest payable on July 1 and January 1. The bonds sold for $1,081,105. The market rate of interest for these bonds was 8%. On the first interest date, using the effective-interest method, the debit entry to Interest Expense is for:
(LO 8)
(a) $50,000.
(b) $54,055.
(c) $43,244.
(d) $100,811.
*14. On January 1, Hurley Corporation issues $500,000, 5-year, 12% bonds at 96 with interest payable on July 1 and January 1. The entry on July 1 to record payment of bond interest and the amortization of bond discount using the straight-line method will include a:
(LO 9)
(a) debit to Interest Expense $30,000.
(b) debit to Interest Expense $60,000.
(c) credit to Discount on Bonds Payable $4,000.
(d) credit to Discount on Bonds Payable $2,000.
*15. For the bonds issued in Question 14 above, what is the carrying value of the bonds at the end of the third interest period?
(LO 9)
(a) $486,000.
(b) $488,000.
(c) $472,000.
(d) $464,000.
Go to the book's companion website, www.wiley.com/college/weygandt, for additional Self-Test Questions.
QUESTIONS
1. (a) What are long-term liabilities? Give three examples. (b) What is a bond?
2. (a) As a source of long-term financing, what are the major advantages of bonds over common stock?
(b) What are the major disadvantages in using bonds for long-term financing?
3. Contrast the following types of bonds: (a) secured and unsecured, (b) term and serial, (c) registered and bearer, and (d) convertible and callable.
4. The following terms are important in issuing bonds: (a) face value, (b) contractual interest rate, (c) bond indenture, and (d) bond certificate. Explain each of these terms.
5. Describe the two major obligations incurred by a company when bonds are issued.
6. Assume that Remington Inc. sold bonds with a face value of $100,000 for $104,000. Was the market interest rate equal to, less than, or greater than the bonds’ contractual interest rate? Explain.
7. If a 7%, 10-year, $800,000 bond is issued at face value and interest is paid semiannually, what is the amount of the interest payment at the end of the first semiannual period?
8. If the Bonds Payable account has a balance of $900,000 and the Discount on Bonds Payable account has a balance of $120,000, what is the carrying value of the bonds?
9. Which accounts are debited and which are credited if a bond issue originally sold at a premium is redeemed before maturity at 97 immediately following the payment of interest?
10. Rattigan Corporation is considering issuing a convertible bond. What is a convertible bond? Discuss the advantages of a convertible bond from the standpoint of (a) the bondholders and (b) the issuing corporation.
11. Rob Grier, a friend of yours, has recently purchased a home for $125,000, paying $25,000 down and the remainder financed by a 10.5%, 20-year mortgage, payable at $998.38 per month. At the end of the first month, Rob receives a statement from the bank indicating that only $123.38 of principal was paid during the month. At this rate, he calculates that it will take over 67 years to pay off the mortgage. Is he right? Discuss.
12. (a) What is a lease agreement? (b) What are the two most common types of leases? (c) Distinguish between the two types of leases.
13. Jhutti Company rents a warehouse on a month-to-month basis for the storage of its excess inventory. The company periodically must rent space when its production greatly exceeds actual sales. What is the nature of this type of lease agreement and what accounting treatment should be used?
14. Benedict Company entered into an agreement to lease 12 computers from Haley Electronics, Inc. The present value of the lease payments is $186,300. Assuming that this is a capital lease, what entry would Benedict Company make on the date of the lease agreement?
15. In general, what are the requirements for the financial statement presentation of long-term liabilities?
16. Did Apple redeem any of its debt during the fiscal year ended September 24, 2011? (Hint: Examine Apple's statement of cash flows.)
*17. Kelli Deane is discussing the advantages of the effective-interest method of bond amortization with her accounting staff. What do you think Kelli is saying?
*18. Windsor Corporation issues $500,000 of 9%, 5-year bonds on January 1, 2014, at 104. If Windsor uses the effective-interest method in amortizing the premium, will the annual interest expense increase or decrease over the life of the bonds? Explain.
*19. Jill Grey and Mike Goreman are discussing how the market price of a bond is determined. Jill believes that the market price of a bond is solely a function of the amount of the principal payment at the end of the term of a bond. Is she right? Discuss.
*20. Explain the straight-line method of amortizing discount and premium on bonds payable.
*21. DeWeese Corporation issues $400,000 of 8%, 5-year bonds on January 1, 2014, at 105. Assuming that the straight-line method is used to amortize the premium, what is the total amount of interest expense for 2014?
BRIEF EXERCISES
Compare bond versus stock financing.
(LO 1)
BE15-1 Moby Inc. is considering two alternatives to finance its construction of a new $2 million plant.
(a) Issuance of 200,000 shares of common stock at the market price of $10 per share.
(b) Issuance of $2 million, 8% bonds at face value.
Complete the following table, and indicate which alternative is preferable.
BE15-2 Meera Corporation issued 4,000, 8%, 5-year, $1,000 bonds dated January 1, 2014, at 100.
Prepare entries for bonds issued at face value.
(LO 2)
(a) Prepare the journal entry to record the sale of these bonds on January 1, 2014.
(b) Prepare the journal entry to record the first interest payment on July 1, 2014 (interest payable semiannually), assuming no previous accrual of interest.
(c) Prepare the adjusting journal entry on December 31, 2014, to record interest expense.
BE15-3 Nasreen Company issues $2 million, 10-year, 8% bonds at 97, with interest payable on July 1 and January 1.
Prepare entries for bonds sold at a discount and a premium.
(LO 2)
(a) Prepare the journal entry to record the sale of these bonds on January 1, 2014.
(b) Assuming instead that the above bonds sold for 104, prepare the journal entry to record the sale of these bonds on January 1, 2014.
BE15-4 Frankum Company has issued three different bonds during 2014. Interest is payable semiannually on each of these bonds.
Prepare entries for bonds issued.
(LO 2)
1. On January 1, 2014, 1,000, 8%, 5-year, $1,000 bonds dated January 1, 2014, were issued at face value.
2. On July 1, $900,000, 9%, 5-year bonds dated July 1, 2014, were issued at 102.
3. On September 1, $400,000, 7%, 5-year bonds dated September 1, 2014, were issued at 98.
Prepare the journal entry to record each bond transaction at the date of issuance.
BE15-5 The balance sheet for Miley Consulting reports the following information on July 1, 2014.
Prepare entry for redemption of bonds.
(LO 3)
Miley decides to redeem these bonds at 101 after paying semiannual interest. Prepare the journal entry to record the redemption on July 1, 2014.
BE15-6 Hanschu Inc. issues an $800,000, 10%, 10-year mortgage note on December 31, 2014, to obtain financing for a new building. The terms provide for semiannual installment payments of $64,195. Prepare the entry to record the mortgage loan on December 31, 2014, and the first installment payment.
Prepare entries for long-term notes payable.
(LO 4)
BE15-7 Prepare the journal entries that the lessee should make to record the following transactions.
Contrast accounting for operating and capital leases.
(LO 5)
1. The lessee makes a lease payment of $80,000 to the lessor in an operating lease transaction.
2. Imhoff Company leases a new building from Noble Construction, Inc. The present value of the lease payments is $700,000. The lease qualifies as a capital lease.
BE15-8 Presented below are long-term liability items for Lind Company at December 31, 2014. Prepare the long-term liabilities section of the balance sheet for Lind Company.
Prepare statement presentation of long-term liabilities.
(LO 6)
*BE15-9 (a) What is the present value of $10,000 due 8 periods from now, discounted at 10%?
(b) What is the present value of $20,000 to be received at the end of each of 6 periods, discounted at 8%?
Determine present value.
(LO 7)
*BE15-10 Presented below is the partial bond discount amortization schedule for Ferree Corp. Ferree uses the effective-interest method of amortization.
Use effective-interest method of bond amortization.
(LO 2,8)
(a) Prepare the journal entry to record the payment of interest and the discount amortization at the end of period 1.
(b) 
Explain why interest expense is greater than interest paid.
(c) Explain why interest expense will increase each period.
*BE15-11 Sweetwood Company issues $5 million, 10-year, 9% bonds at 96, with interest payable on July 1 and January 1. The straight-line method is used to amortize bond discount.
Prepare entries for bonds issued at a discount.
(LO 2,9)
(a) Prepare the journal entry to record the sale of these bonds on January 1, 2014.
(b) Prepare the journal entry to record interest expense and bond discount amortization on July 1, 2014, assuming no previous accrual of interest.
*BE15-12 Golden Inc. issues $4 million, 5-year, 10% bonds at 102, with interest payable on July 1 and January 1. The straight-line method is used to amortize bond premium.
Prepare entries for bonds issued at a premium.
(LO 2,9)
(a) Prepare the journal entry to record the sale of these bonds on January 1, 2014.
(b) Prepare the journal entry to record interest expense and bond premium amortization on July 1, 2014, assuming no previous accrual of interest.
DO IT! Review
Evaluate statements about bonds.
(LO 1)
DO IT! 15-1 State whether each of the following statements is true or false.
_______ 1. Mortgage bonds and sinking fund bonds are both examples of debenture bonds.
_______ 2. Convertible bonds are also known as callable bonds.
_______ 3. The market rate is the rate investors demand for loaning funds.
_______ 4. Semiannual interest on bonds is equal to the face value times the stated rate times 6/12.
_______ 5. The present value of a bond is the value at which it should sell in the market.
Prepare journal entry for bond issuance and show balance sheet presentation.
(LO 2)
DO IT! 15-2 Eubank Corporation issues $500,000 of bonds for $520,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the balance sheet at the date of issuance.
DO IT! 15-3 Prater Corporation issued $400,000 of 10-year bonds at a discount. Prior to maturity, when the carrying value of the bonds was $390,000, the company redeemed the bonds at 99. Prepare the entry to record the redemption of the bonds.
Prepare entry for bond redemption.
(LO 3)
DO IT! 15-4 Detwiler Orchard issues a $700,000, 6%, 15-year mortgage note to obtain needed financing for a new lab. The terms call for semiannual payments of $35,714 each. Prepare the entries to record the mortgage loan and the first installment payment.
Prepare entries for mortgage note and installment payment on note.
(LO 4)
DO IT! 15-5 Huebner Corporation leases new equipment on December 31, 2014. The lease transfers ownership of the equipment to Huebner at the end of the lease. The present value of the lease payments is $192,000. After recording this lease, Huebner has assets of $1,800,000, liabilities of $1,100,000, and stockholders’ equity of $700,000. (a) Prepare the entry to record the lease, and (b) compute and discuss the debt to assets ratio at year-end.
Prepare entry for lease, and compute debt to assets ratio.
(LO 5, 6)
EXERCISES
Evaluate statements about bonds.
(LO 1)
E15-1 Nick Bosch has prepared the following list of statements about bonds.
1. Bonds are a form of interest-bearing notes payable.
2. When seeking long-term financing, an advantage of issuing bonds over issuing common stock is that stockholder control is not affected.
3. When seeking long-term financing, an advantage of issuing common stock over issuing bonds is that tax savings result.
4. Secured bonds have specific assets of the issuer pledged as collateral for the bonds.
5. Secured bonds are also known as debenture bonds.
6. Bonds that mature in installments are called term bonds.
7. A conversion feature may be added to bonds to make them more attractive to bond buyers.
8. The rate used to determine the amount of cash interest the borrower pays is called the stated rate.
9. Bond prices are usually quoted as a percentage of the face value of the bond.
10. The present value of a bond is the value at which it should sell in the marketplace.
Instructions
Identify each statement as true or false. If false, indicate how to correct the statement.
E15-2 Gilliland Airlines is considering two alternatives for the financing of a purchase of a fleet of airplanes. These two alternatives are:
Compare two alternatives of financing—issuance of common stock vs. issuance of bonds.
(LO 1)
1. Issue 90,000 shares of common stock at $30 per share. (Cash dividends have not been paid nor is the payment of any contemplated.)
2. Issue 10%, 10-year bonds at face value for $2,700,000.
It is estimated that the company will earn $800,000 before interest and taxes as a result of this purchase. The company has an estimated tax rate of 30% and has 120,000 shares of common stock outstanding prior to the new financing.
Instructions
Determine the effect on net income and earnings per share for these two methods of financing.
Prepare entries for issuance of bonds, and payment and accrual of bond interest.
(LO 2)
E15-3 On January 1, Klosterman Company issued $500,000, 10%, 10-year bonds at face value. Interest is payable semiannually on July 1 and January 1.
Prepare entries for issuance of bonds, and payment and accrual of bond interest.
(LO 2)
Instructions
Prepare journal entries to record the following.
(a) The issuance of the bonds.
(b) The payment of interest on July 1, assuming that interest was not accrued on June 30.
(c) The accrual of interest on December 31.
E15-4 On January 1, Forrester Company issued $400,000, 8%, 5-year bonds at face value. Interest is payable semiannually on July 1 and January 1.
Prepare entries for bonds issued at face value.
(LO 2)
Instructions
Prepare journal entries to record the following events.
(a) The issuance of the bonds.
(b) The payment of interest on July 1, assuming no previous accrual of interest.
(c) The accrual of interest on December 31.
E15-5 Laudie Company issued $400,000 of 9%, 10-year bonds on January 1, 2014, at face value. Interest is payable semiannually on July 1 and January 1.
Prepare entries for bonds issued at face value.
(LO 2, 3)
Instructions
Prepare the journal entries to record the following events.
(a) The issuance of the bonds.
(b) The payment of interest on July 1, assuming no previous accrual of interest.
(c) The accrual of interest on December 31.
(d) The redemption of bonds at maturity, assuming interest for the last interest period has been paid and recorded.
E15-6 Swisher Company issued $2,000,000 of bonds on January 1, 2014.
Prepare entries for issuance, redemption, and conversion of bonds.
(LO 2, 3)
Instructions
(a) Prepare the journal entry to record the issuance of the bonds if they are issued at (1) 100, (2) 98, and (3) 103.
(b) Prepare the journal entry to record the redemption of the bonds at maturity, assuming the bonds were issued at 100.
(c) Prepare the journal entry to record the redemption of the bonds before maturity at 98. Assume the balance in Premium on Bonds Payable is $9,000.
(d) Prepare the journal entry to record the conversion of the bonds into 60,000 shares of $10 par value common stock. Assume the bonds were issued at par.
E15-7 Whitmore Company issued $500,000 of 5-year, 8% bonds at 97 on January 1, 2014. The bonds pay interest twice a year.
Prepare entries to record issuance of bonds at discount and premium.
(LO 2)
Instructions
(a) (1) Prepare the journal entry to record the issuance of the bonds.
(2) Compute the total cost of borrowing for these bonds.
(b) Repeat the requirements from part (a), assuming the bonds were issued at 105.
Prepare entries for bond interest and redemption.
(LO 2, 3)
E15-8 The following section is taken from Ohlman Corp.'s balance sheet at December 31, 2013.
Bond interest is payable semiannually on January 1 and July 1. The bonds are callable on any interest date.
Instructions
(a) Journalize the payment of the bond interest on January 1, 2014.
(b) Assume that on January 1, 2014, after paying interest, Ohlman calls bonds having a face value of $600,000. The call price is 103. Record the redemption of the bonds.
(c) Prepare the entry to record the payment of interest on July 1, 2014, assuming no previous accrual of interest on the remaining bonds.
E15-9 Presented below are three independent situations.
Prepare entries for redemption of bonds and conversion of bonds into common stock.
(LO 3)
1. Longbine Corporation redeemed $130,000 face value, 12% bonds on June 30, 2014, at 102. The carrying value of the bonds at the redemption date was $117,500. The bonds pay semiannual interest, and the interest payment due on June 30, 2014, has been made and recorded.
2. Tastove Inc. redeemed $150,000 face value, 12.5% bonds on June 30, 2014, at 98. The carrying value of the bonds at the redemption date was $151,000. The bonds pay semiannual interest, and the interest payment due on June 30, 2014, has been made and recorded.
3. Precision Company has $80,000, 8%, 12-year convertible bonds outstanding. These bonds were sold at face value and pay semiannual interest on June 30 and December 31 of each year. The bonds are convertible into 30 shares of Precision $5 par value common stock for each $1,000 worth of bonds. On December 31, 2014, after the bond interest has been paid, $20,000 face value bonds were converted. The market price of Precision common stock was $44 per share on December 31, 2014.
Instructions
For each independent situation above, prepare the appropriate journal entry for the redemption or conversion of the bonds.
E15-10 Jernigan Co. receives $300,000 when it issues a $300,000, 10%, mortgage note payable to finance the construction of a building at December 31, 2014. The terms provide for semiannual installment payments of $25,000 on June 30 and December 31.
Prepare entries to record mortgage note and installment payments.
(LO 4)
Instructions
Prepare the journal entries to record the mortgage loan and the first two installment payments.
E15-11 Dreiling Company borrowed $300,000 on January 1, 2014, by issuing a $300,000, 8% mortgage note payable. The terms call for semiannual installment payments of $20,000 on June 30 and December 31.
Prepare entries to record mortgage note and installment payments.
(LO 4)
Instructions
(a) Prepare the journal entries to record the mortgage loan and the first two installment payments.
(b) Indicate the amount of mortgage note payable to be reported as a current liability and as a long-term liability at December 31, 2014.
E15-12 Presented below are two independent situations.
Prepare entries for operating lease and capital lease.
(LO 5)
1. Flinthills Car Rental leased a car to Jayhawk Company for one year. Terms of the operating lease agreement call for monthly payments of $500.
2. On January 1, 2014, Throm Inc. entered into an agreement to lease 20 computers from Drummond Electronics. The terms of the lease agreement require three annual rental payments of $20,000 (including 10% interest) beginning December 31, 2014. The present value of the three rental payments is $49,735. Throm considers this a capital lease.
Instructions
(a) Prepare the appropriate journal entry to be made by Jayhawk Company for the first lease payment.
(b) Prepare the journal entry to record the lease agreement on the books of Throm Inc. on January 1, 2014.
E15-13 The adjusted trial balance for Karr Farm Corporation at the end of the current year contained the following accounts.
Prepare long-term liabilities section.
(LO 6)
Instructions
Prepare the long-term liabilities section of the balance sheet.
E15-14 Hatfield Corporation reports the following amounts in its 2014 financial statements:
Compute debt to assets ratio and times interest earned.
(LO 6)
Instructions
(a) Compute the December 31, 2014, balance in stockholders’ equity.
(b) Compute the debt to assets ratio at December 31, 2014.
(c) Compute times interest earned for 2014.
*E15-15 England Corporation is issuing $200,000 of 8%, 5-year bonds when potential bond investors want a return of 10%. Interest is payable semiannually.
Compute market price of bonds.
(LO 7)
Instructions
Compute the market price (present value) of the bonds.
*E15-16 Lorance Corporation issued $800,000, 9%, 10-year bonds on January 1, 2014, for $750,150. This price resulted in an effective-interest rate of 10% on the bonds. Interest is payable semiannually on July 1 and January 1. Lorance uses the effective-interest method to amortize bond premium or discount.
Prepare entries for issuance of bonds, payment of interest, and amortization of discount using effective-interest method.
(LO 2, 8)
Instructions
Prepare the journal entries to record the following. (Round to the nearest dollar.)
(a) The issuance of the bonds.
(b) The payment of interest and the discount amortization on July 1, 2014, assuming that interest was not accrued on June 30.
(c) The accrual of interest and the discount amortization on December 31, 2014.
*E15-17 LRNA Company issued $300,000, 11%, 10-year bonds on January 1, 2014, for $318,694. This price resulted in an effective-interest rate of 10% on the bonds. Interest is payable semiannually on July 1 and January 1. LRNA uses the effective-interest method to amortize bond premium or discount.
Prepare entries for issuance of bonds, payment of interest, and amortization of premium using effective-interest method.
(LO 2, 8)
Instructions
Prepare the journal entries to record the following. (Round to the nearest dollar.)
(a) The issuance of the bonds.
(b) The payment of interest and the premium amortization on July 1, 2014, assuming that interest was not accrued on June 30.
(c) The accrual of interest and the premium amortization on December 31, 2014.
*E15-18 Adcock Company issued $600,000, 9%, 20-year bonds on January 1, 2014, at 103. Interest is payable semiannually on July 1 and January 1. Adcock uses straight-line amortization for bond premium or discount.
Prepare entries to record issuance of bonds, payment of interest, amortization of premium, and redemption at maturity.
(LO 2, 3, 9)
Instructions
Prepare the journal entries to record the following.
(a) The issuance of the bonds.
(b) The payment of interest and the premium amortization on July 1, 2014, assuming that interest was not accrued on June 30.
(c) The accrual of interest and the premium amortization on December 31, 2014.
(d) The redemption of the bonds at maturity, assuming interest for the last interest period has been paid and recorded.
*E15-19 Gridley Company issued $800,000, 11%, 10-year bonds on December 31, 2013, for $730,000. Interest is payable semiannually on June 30 and December 31. Gridley Company uses the straight-line method to amortize bond premium or discount.
Prepare entries to record issuance of bonds, payment of interest, amortization of discount, and redemption at maturity.
(LO 2, 3, 9)
Instructions
Prepare the journal entries to record the following.
(a) The issuance of the bonds.
(b) The payment of interest and the discount amortization on June 30, 2014.
(c) The payment of interest and the discount amortization on December 31, 2014.
(d) The redemption of the bonds at maturity, assuming interest for the last interest period has been paid and recorded.
EXERCISES: SET B AND CHALLENGE EXERCISES
Visit the book's companion website, at www.wiley.com/college/weygandt, and choose the Student Companion site to access Exercise Set B and Challenge Exercises.
PROBLEMS: SET A
P15-1A On May 1, 2014, Herron Corp. issued $600,000, 9%, 5-year bonds at face value. The bonds were dated May 1, 2014, and pay interest semiannually on May 1 and November 1. Financial statements are prepared annually on December 31.
Prepare entries to record issuance of bonds, interest accrual, and bond redemption.
(LO 2, 3, 6)
Instructions
(a) Prepare the journal entry to record the issuance of the bonds.
(b) Prepare the adjusting entry to record the accrual of interest on December 31, 2014.
(c) Show the balance sheet presentation on December 31, 2014.
(d) Prepare the journal entry to record payment of interest on May 1, 2015, assuming no accrual of interest from January 1, 2015, to May 1, 2015.
(d) Int. exp. $18,000
(e) Prepare the journal entry to record payment of interest on November 1, 2015.
(f) Assume that on November 1, 2015, Herron calls the bonds at 102. Record the redemption of the bonds.
(f) Loss $12,000
P15-2A Asquith Electric sold $750,000, 10%, 10-year bonds on January 1, 2014. The bonds were dated January 1 and paid interest on January 1 and July 1. The bonds were sold at 104.
Prepare entries to record issuance of bonds, interest accrual, and bond redemption.
(LO 2, 3, 6)
Instructions
(a) Prepare the journal entry to record the issuance of the bonds on January 1, 2014.
(b) At December 31, 2014, the balance in the Premium on Bonds Payable account is $27,000. Show the balance sheet presentation of accrued interest and the bond liability at December 31, 2014.
(c) On January 1, 2016, when the carrying value of the bonds was $774,000, the company redeemed the bonds at 105. Record the redemption of the bonds assuming that interest for the period has already been paid.
(c) Loss $13,500
P15-3A Talkington Electronics issues a $400,000, 8%, 10-year mortgage note on December 31, 2013. The proceeds from the note are to be used in financing a new research laboratory. The terms of the note provide for semiannual installment payments, exclusive of real estate taxes and insurance, of $29,433. Payments are due June 30 and December 31.
Prepare installment payments schedule and journal entries for a mortgage note payable.
(LO 4)
Instructions
(a) Prepare an installment payments schedule for the first 2 years.
(b) Prepare the entries for (1) the loan and (2) the first two installment payments.
(b) June 30 debit Mortgage Payable $13,433
(c) Show how the total mortgage liability should be reported on the balance sheet at December 31, 2014.
(c) Current liability—2014 $29,639
P15-4A Presented below are three different lease transactions that occurred for Ruggiero Inc. in 2014. Assume that all lease contracts start on January 1, 2014. In no case does Ruggiero receive title to the properties leased during or at the end of the lease term.
Analyze three different lease situations and prepare journal entries.
(LO 5)
Instructions
(a) Which of the leases are operating leases and which are capital leases? Explain.
(b) How should the lease transaction for Hester Co. be recorded in 2014?
(c) How should the lease transaction for Judson Delivery be recorded on January 1, 2014?
*P15-5A On July 1, 2014, Flanagin Corporation issued $2,000,000, 10%, 10-year bonds at $2,271,813. This price resulted in an effective-interest rate of 8% on the bonds. Flanagin uses the effective-interest method to amortize bond premium or discount. The bonds pay semiannual interest July 1 and January 1.
Prepare entries to record issuance of bonds, payment of interest, and amortization of bond premium using effective-interest method.
(LO 2, 8)
Instructions
(Round all computations to the nearest dollar.)
(a) Prepare the journal entry to record the issuance of the bonds on July 1, 2014.
(b) Prepare an amortization table through December 31, 2015 (3 interest periods), for this bond issue.
(c) Prepare the journal entry to record the accrual of interest and the amortization of the premium on December 31, 2014.
(c) Amortization $9,127
(d) Prepare the journal entry to record the payment of interest and the amortization of the premium on July 1, 2015, assuming no accrual of interest on June 30.
(d) Amortization $9,493
(e) Prepare the journal entry to record the accrual of interest and the amortization of the premium on December 31, 2015.
(e) Amortization $9,872
*P15-6A On July 1, 2014, Kellerman Company issued $5,000,000, 8%, 10-year bonds at $4,376,892. This price resulted in an effective-interest rate of 10% on the bonds. Kellerman uses the effective-interest method to amortize bond premium or discount. The bonds pay semiannual interest July 1 and January 1.
Prepare entries to record issuance of bonds, payment of interest, and amortization of discount using effective-interest method. In addition, answer questions.
(LO 2, 6, 8)
Instructions
(Round all computations to the nearest dollar.)
(a) Prepare the journal entries to record the following transactions.
(1) The issuance of the bonds on July 1, 2014.
(2) The accrual of interest and the amortization of the discount on December 31, 2014.
(3) The payment of interest and the amortization of the discount on July 1, 2015, assuming no accrual of interest on June 30.
(a) (3) Amortization $19,787
(4) The accrual of interest and the amortization of the discount on December 31, 2015.
(a) (4) Amortization $20,776
(b) Bond carrying value $4,436,300
(b) Show the proper balance sheet presentation for the liability for bonds payable on the December 31, 2015, balance sheet.
(c) Provide the answers to the following questions in letter form.
(1) What amount of interest expense is reported for 2015?
(2) Would the bond interest expense reported in 2015 be the same as, greater than, or less than the amount that would be reported if the straight-line method of amortization were used?
(3) Determine the total cost of borrowing over the life of the bond.
(4) Would the total bond interest expense be greater than, the same as, or less than the total interest expense that would be reported if the straight-line method of amortization were used?
*P15-7A Wainwright Electric sold $3,000,000, 10%, 10-year bonds on January 1, 2014. The bonds were dated January 1 and pay interest July 1 and January 1. Wainwright Electric uses the straight-line method to amortize bond premium or discount. The bonds were sold at 104. Assume no interest is accrued on June 30.
Prepare entries to record issuance of bonds, interest accrual, and straight-line amortization for 2 years.
(LO 2, 6, 9)
Instructions
(a) Prepare the journal entry to record the issuance of the bonds on January 1, 2014.
(b) Prepare a bond premium amortization schedule for the first 4 interest periods.
(b) Amortization $6,000
(c) Prepare the journal entries for interest and the amortization of the premium in 2014 and 2015.
(d) Show the balance sheet presentation of the bond liability at December 31, 2015.
(d) Premium on bonds payable $96,000
*P15-8A Saberhagen Company sold $3,500,000, 8%, 10-year bonds on July 1, 2014. The bonds were dated July 1, 2014, and pay interest July 1 and January 1. Saberhagen Company uses the straight-line method to amortize bond premium or discount. Assume no interest is accrued on June 30.
Prepare entries to record issuance of bonds, interest, and straight-line amortization of bond premium and discount.
(LO 2, 6, 9)
Instructions
(a) Prepare all the necessary journal entries to record the issuance of the bonds and bond interest expense for 2014, assuming that the bonds sold at 104.
(a) Amortization $7,000
(b) Amortization $3,500
(b) Prepare journal entries as in part (a) assuming that the bonds sold at 98.
(c) Show balance sheet presentation for the bonds at December 31, 2014.
(c) Premium on bonds payable $133,000 Discount on bonds payable $66,500
*P15-9A The following is taken from the Colaw Company balance sheet.
Prepare entries to record interest payments, straight-line premium amortization, and redemption of bonds.
(LO 2, 3, 9)
Interest is payable semiannually on January 1 and July 1. The bonds are callable on any semiannual interest date. Colaw uses straight-line amortization for any bond premium or discount. From December 31, 2014, the bonds will be outstanding for an additional 10 years (120 months).
Instructions
(a) Journalize the payment of bond interest on January 1, 2015.
(b) Prepare the entry to amortize bond premium and to pay the interest due on July 1, 2015, assuming no accrual of interest on June 30.
(b) Amortization $10,000
(c) Assume that on July 1, 2015, after paying interest, Colaw Company calls bonds having a face value of $1,200,000. The call price is 101. Record the redemption of the bonds.
(c) Gain $64,000
(d) Prepare the adjusting entry at December 31, 2015, to amortize bond premium and to accrue interest on the remaining bonds.
(d) Amortization $6,000
PROBLEMS: SET B
P15-1B On June 1, 2014, Weller Corp. issued $2,000,000, 9%, 5-year bonds at face value. The bonds were dated June 1, 2014, and pay interest semiannually on June 1 and December 1. Financial statements are prepared annually on December 31.
Prepare entries to record issuance of bonds, interest accrual, and bond redemption.
(LO 2, 3, 6)
Instructions
(a) Prepare the journal entry to record the issuance of the bonds.
(b) Prepare the adjusting entry to record the accrual of interest on December 31, 2014.
(c) Show the balance sheet presentation on December 31, 2014.
(d) Prepare the journal entry to record payment of interest on June 1, 2015, assuming no accrual of interest from January 1, 2015, to June 1, 2015.
(d) Int. exp. $75,000
(e) Prepare the journal entry to record payment of interest on December 1, 2015.
(f) Assume that on December 1, 2015, Weller calls the bonds at 102. Record the redemption of the bonds.
(f) Loss $40,000
P15-2B Shonrock Co. sold $800,000, 9%, 10-year bonds on January 1, 2014. The bonds were dated January 1, and interest is paid on January 1 and July 1. The bonds were sold at 105.
Prepare entries to record issuance of bonds, interest accrual, and bond redemption.
(LO 2, 3, 6)
Instructions
(a) Prepare the journal entry to record the issuance of the bonds on January 1, 2014.
(b) At December 31, 2014, the balance in the Premium on Bonds Payable account is $36,000. Show the balance sheet presentation of accrued interest and the bond liability at December 31, 2014.
(c) On January 1, 2016, when the carrying value of the bonds was $832,000, the company redeemed the bonds at 105. Record the redemption of the bonds assuming that interest for the period has already been paid.
(c) Loss $8,000
P15-3B Crosetti's Electronics issues a $600,000, 8%, 10-year mortgage note on December 31, 2014, to help finance a plant expansion program. The terms provide for semiannual installment payments, not including real estate taxes and insurance, of $44,149. Payments are due June 30 and December 31.
Prepare installment payments schedule and journal entries for a mortgage note payable.
(LO 4)
Instructions
(a) Prepare an installment payments schedule for the first 2 years.
(b) Prepare the entries for (1) the mortgage loan and (2) the first two installment payments.
(b) June 30 debit Mortgage Payable $20,149
(c) Show how the total mortgage liability should be reported on the balance sheet at December 31, 2015.
(c) Current liability—2015: $44,458
P15-4B Presented below are three different lease transactions in which Naylor Enterprises engaged in 2014. Assume that all lease transactions start on January 1, 2014. In no case does Naylor receive title to the properties leased during or at the end of the lease term.
Analyze three different lease situations and prepare journal entries.
(LO 5)
Instructions
(a) Identify the leases above as operating or capital leases. Explain.
(b) How should the lease transaction for Mendenhall Co. be recorded on January 1, 2014?
(c) How should the lease transaction for Midas Inc. be recorded in 2014?
*P15-5B On July 1, 2014, Witherspoon Satellites issued $4,500,000, 9%, 10-year bonds at $4,219,600. This price resulted in an effective-interest rate of 10% on the bonds. Witherspoon uses the effective-interest method to amortize bond premium or discount. The bonds pay semiannual interest July 1 and January 1.
Prepare entries to record issuance of bonds, payment of interest, and amortization of bond discount using effective-interest method.
(LO 2, 8)
Instructions
(Round all computations to the nearest dollar.)
(a) Prepare the journal entry to record the issuance of the bonds on July 1, 2014.
(b) Prepare an amortization table through December 31, 2015 (3 interest periods), for this bond issue.
(c) Prepare the journal entry to record the accrual of interest and the amortization of the discount on December 31, 2014.
(c) Amortization $8,480
(d) Prepare the journal entry to record the payment of interest and the amortization of the discount on July 1, 2015, assuming that interest was not accrued on June 30.
(d) Amortization $8,904
(e) Prepare the journal entry to record the accrual of interest and the amortization of the discount on December 31, 2015.
(e) Amortization $9,349
*P15-6B On July 1, 2014, Ashlock Chemical Company issued $4,000,000, 10%, 10 year bonds at $4,543,627. This price resulted in an 8% effective-interest rate on the bonds. Ash-lock uses the effective-interest method to amortize bond premium or discount. The bonds pay semiannual interest on each July 1 and January 1.
Prepare entries to record issuance of bonds, payment of interest, and amortization of premium using effective-interest method. In addition, answer questions.
(LO 2, 6, 8)
Instructions
(Round all computations to the nearest dollar.)
(a) Prepare the journal entries to record the following transactions.
(1) The issuance of the bonds on July 1, 2014.
(a) (2) Amortization $18,255
(2) The accrual of interest and the amortization of the premium on December 31, 2014.
(a) (3) Amortization $18,985
(3) The payment of interest and the amortization of the premium on July 1, 2015, assuming no accrual of interest on June 30.
(4) The accrual of interest and the amortization of the premium on December 31, 2015.
(a) (4) Amortization $19,745
(b) Bond carrying value $4,486,642
(b) Show the proper balance sheet presentation for the liability for bonds payable on the December 31, 2015, balance sheet.
(c) Provide the answers to the following questions in letter form.
(1) What amount of interest expense is reported for 2015?
(2) Would the bond interest expense reported in 2015 be the same as, greater than, or less than the amount that would be reported if the straight-line method of amortization were used?
(3) Determine the total cost of borrowing over the life of the bond.
(4) Would the total bond interest expense be greater than, the same as, or less than the total interest expense if the straight-line method of amortization were used?
*P15-7B Fernetti Company sold $6,000,000, 9%, 20-year bonds on January 1, 2014. The bonds were dated January 1, 2014, and pay interest on January 1 and July 1. Fernetti Company uses the straight-line method to amortize bond premium or discount. The bonds were sold at 96. Assume no interest is accrued on June 30.
Prepare entries to record issuance of bonds, interest accrual, and straight-line amortization for 2 years.
(LO 2, 6, 9)
Instructions
(a) Prepare the journal entry to record the issuance of the bonds on January 1, 2014.
(b) Prepare a bond discount amortization schedule for the first 4 interest periods.
(b) Amortization $6,000
(c) Prepare the journal entries for interest and the amortization of the discount in 2014 and 2015.
(d) Show the balance sheet presentation of the bond liability at December 31, 2015.
(d) Discount on bonds payable $216,000
*P15-8B Roswell Corporation sold $4,000,000, 8%, 10-year bonds on January 1, 2014. The bonds were dated January 1, 2014, and pay interest on July 1 and January 1. Roswell Corporation uses the straight-line method to amortize bond premium or discount. Assume no interest is accrued on June 30.
Prepare entries to record issuance of bonds, interest, and straight-line amortization of bond premium and discount.
(LO 2, 6, 9)
Instructions
(a) Prepare all the necessary journal entries to record the issuance of the bonds and bond interest expense for 2014, assuming that the bonds sold at 103.
(a) Amortization $6,000
(b) Prepare journal entries as in part (a) assuming that the bonds sold at 96.
(b) Amortization $8,000
(c) Show balance sheet presentation for the bonds at December 31, 2014.
(c) Premium on bonds payable $108,000 Discount on bonds payable $144,000
*P15-9B The following is taken from the Sinjh Corporation balance sheet.
Prepare entries to record interest payments, straight-line discount amortization, and redemption of bonds.
(LO 2, 3, 9)
Interest is payable semiannually on January 1 and July 1. The bonds are callable on any semiannual interest date. Sinjh uses straight-line amortization for any bond premium or discount. From December 31, 2014, the bonds will be outstanding for an additional 10 years (120 months).
Instructions
(Round all computations to the nearest dollar).
(a) Journalize the payment of bond interest on January 1, 2015.
(b) Prepare the entry to amortize bond discount and to pay the interest due on July 1, 2015, assuming that interest was not accrued on June 30.
(b) Amortization $4,500
(c) Assume that on July 1, 2015, after paying interest, Sinjh Corp. calls bonds having a face value of $800,000. The call price is 102. Record the redemption of the bonds.
(c) Loss $44,500
(d) Prepare the adjusting entry at December 31, 2015, to amortize bond discount and to accrue interest on the remaining bonds.
(d) Amortization $3,000
PROBLEMS: SET C
Visit the book's companion website, at www.wiley.com/college/weygandt, and choose the Student Companion site to access Problem Set C.
COMPREHENSIVE PROBLEM: CHAPTERS 13 TO 15
CP15 Quigley Corporation's trial balance at December 31, 2014, is presented below. All 2014 transactions have been recorded except for the items described below.
1. On January 1, 2014, Quigley issued 1,000 shares of $20 par, 6% preferred stock for $22,000.
2. On January 1, 2014, Quigley also issued 1,000 shares of common stock for $23,000.
3. Quigley reacquired 300 shares of its common stock on July 1, 2014, for $49 per share.
4. On December 31, 2014, Quigley declared the annual preferred stock dividend and a $1.50 per share dividend on the outstanding common stock, all payable on January 15, 2015.
5. Quigley estimates that uncollectible accounts receivable at year-end is $5,100.
6. The building is being depreciated using the straight-line method over 30 years. The salvage value is $5,000.
7. The equipment is being depreciated using the straight-line method over 10 years. The salvage value is $4,000.
8. The unearned rent was collected on October 1, 2014. It was receipt of 4 months’ rent in advance (October 1, 2014 through January 31, 2015).
9. The 10% bonds payable pay interest every January 1 and July 1. The interest for the 6 months ended December 31, 2014, has not been paid or recorded.
Instructions
(Ignore income taxes.)
(a) Prepare journal entries for the transactions listed above.
(b) Total $868,700
(b) Prepare an updated December 31, 2014, trial balance, reflecting the unrecorded transactions.
(c) Prepare a multiple-step income statement for the year ending December 31, 2014.
(d) Prepare a retained earnings statement for the year ending December 31, 2014.
(e) Prepare a classified balance sheet as of December 31, 2014.
(e) Total assets $270,900
CONTINUING COOKIE CHRONICLE
(Note: This is a continuation of the Cookie Chronicle from Chapters 1 through 14.)
CCC15 Natalie and Curtis have been experiencing great demand for their cookies and muffins. As a result, they are now thinking about buying a commercial oven. They know which oven they want and how much it will cost. They have some cash set aside for the purchase and will need to borrow the rest. They met with a bank manager to discuss their options.
Go to the book's companion website,www.wiley.com/college/weygandt, to see the completion of this problem.
Broadening Your Perspective
Financial Reporting and Analysis
Financial Reporting Problem: Apple Inc.
BYP15-1 Refer to the financial statements of Apple Inc. in Appendix A. Instructions for accessing and using the company's complete annual report, including the notes to the financial statements, are also provided in Appendix A.
Instructions
(a) What were Apple's total long-term liabilities at September 24, 2011? What was the increase/decrease in total long-term liabilities from the prior year?
(b) Determine whether Apple redeemed (bought back) any long-term liabilities during the fiscal year ended September 24, 2011.
Comparative Analysis Problem:
PepsiCo, Inc. vs. The Coca-Cola Company
BYP15-2 PepsiCo's financial statements are presented in Appendix B. Financial statements of The Coca-Cola Company are presented in Appendix C. Instructions for accessing and using the complete annual reports of PepsiCo and Coca-Cola, including the notes to the financial statements, are also provided in Appendices B and C, respectively.
Instructions
(a) Based on the information contained in these financial statements, compute the following 2011 ratios for each company.
(1) Debt to assets.
(2) Times interest earned.
(b) What conclusions concerning the companies’ long-run solvency can be drawn from these ratios?
Comparative Analysis Problem:
Amazon.com, Inc. vs. Wal-Mart Stores, Inc.
BYP15-3 Amazon.com, Inc.'s financial statements are presented in Appendix D. Financial statements of Wal-Mart Stores, Inc. are presented in Appendix E. Instructions for accessing and using the complete annual reports of Amazon and Wal-Mart, including the notes to the financial statements, are also provided in Appendices D and E, respectively.
Instructions
(a) Based on the information contained in these financial statements, compute the following 2011 ratios for each company.
(1) Debt to assets.
(2) Times interest earned.
(b) What conclusions concerning the companies’ long-run solvency can be drawn from these ratios?
REAL-WORLD FOCUS
BYP15-4 Bond or debt securities pay a stated rate of interest. This rate of interest is dependent on the risk associated with the investment. Also, bond prices change when the risks associated with those bonds change. Standard & Poor's provides ratings for companies that issue debt securities.
Address: www.standardandpoors.com/ratings/definitions-and-faqs/en/us, or go to www.wiley.com/college/weygandt
Instructions
Go to the website shown and answer the following questions.
(a) Explain the meaning of an “A” rating. Explain the meaning of a “C” rating.
(b) What types of things can cause a change in a company's credit rating?
(c) Explain the relationship between a company's credit rating and the merit of an investment in that company's bonds.
Critical Thinking
Decision-Making Across the Organization
*BYP15-5 On January 1, 2012, Glover Corporation issued $2,400,000 of 5-year, 8% bonds at 95. The bonds pay interest semiannually on July 1 and January 1. By January 1, 2014, the market rate of interest for bonds of risk similar to those of Glover Corporation had risen. As a result, the market value of these bonds was $2,000,000 on January 1, 2014—below their carrying value. Joanna Glover, president of the company, suggests repurchasing all of these bonds in the open market at the $2,000,000 price. To do so, the company will have to issue $2,000,000 (face value) of new 10-year, 11% bonds at par. The president asks you, as controller, “What is the feasibility of my proposed repurchase plan?”
Instructions
With the class divided into groups, answer the following.
(a) What is the carrying value of the outstanding Glover Corporation 5-year bonds on January 1, 2014? (Assume straight-line amortization.)
(b) Prepare the journal entry to redeem the 5-year bonds on January 1, 2014. Prepare the journal entry to issue the new 10-year bonds.
(c) Prepare a short memo to the president in response to her request for advice. List the economic factors that you believe should be considered for her repurchase proposal.
Communication Activity
BYP15-6 Sam Masasi, president of Masasi Corporation, is considering the issuance of bonds to finance an expansion of his business. He has asked you to (1) discuss the advantages of bonds over common stock financing, (2) indicate the types of bonds he might issue, and (3) explain the issuing procedures used in bond transactions.
Instructions
Write a memo to the president, answering his request.
Ethics Case
BYP15-7 Ken Iwig is the president, founder, and majority owner of Olathe Medical Corporation, an emerging medical technology products company. Olathe is in dire need of additional capital to keep operating and to bring several promising products to final development, testing, and production. Ken, as owner of 51% of the outstanding stock, manages the company's operations. He places heavy emphasis on research and development and on long-term growth. The other principal stockholder is Barb Lowery who, as a nonemployee investor, owns 40% of the stock. Barb would like to deemphasize the R&D functions and emphasize the marketing function, to maximize short-run sales and profits from existing products. She believes this strategy would raise the market price of Olathe's stock.
All of Ken's personal capital and borrowing power is tied up in his 51% stock ownership. He knows that any offering of additional shares of stock will dilute his controlling interest because he won't be able to participate in such an issuance. But, Barb has money and would likely buy enough shares to gain control of Olathe. She then would dictate the company's future direction, even if it meant replacing Ken as president and CEO.
The company already has considerable debt. Raising additional debt will be costly, will adversely affect Olathe's credit rating, and will increase the company's reported losses due to the growth in interest expense. Barb and the other minority stockholders express opposition to the assumption of additional debt, fearing the company will be pushed to the brink of bankruptcy. Wanting to maintain his control and to preserve the direction of “his” company, Ken is doing everything to avoid a stock issuance. He is contemplating a large issuance of bonds, even if it means the bonds are issued with a high effective-interest rate.
Instructions
(a) Who are the stakeholders in this situation?
(b) What are the ethical issues in this case?
(c) What would you do if you were Ken?
All About You
BYP15-8 Numerous articles have been written that identify early warning signs that you might be getting into trouble with your personal debt load. You can find many good articles on this topic on the Internet.
Instructions
Find an article that identifies early warning signs of personal debt trouble. Write a summary of the article and bring your summary and the article to class to share.
FASB Codification Activity
BYP15-9 If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following:
(a) What is the long-term obligation?
(b) What guidance does the Codification provide for the disclosure of long-term obligations?
Answers to Chapter Questions
Answers to Insight and Accounting Across the Organization Questions
p. 689 How About Those 30-Year Bonds? Q: What are the advantages for companies of issuing 30-year bonds instead of 5-year bonds? A: The major advantages for companies are to extend their debt and to pay low interest rates. This locks in these low rates for a considerable period of time.
p. 698 Bonds versus Notes? Q: Why might companies prefer bond financing instead of short-term financing? A: In some cases, it is difficult to get loans from banks. In addition, low interest rates have encouraged companies to go more long-term and fix their rate. Recently, short-term loans suddenly froze, leading to liquidity problems for certain companies.
p. 702 “Covenant-Lite” Debt Q: How can financial ratios such as those covered in this chapter provide protection for creditors? A: Financial ratios such as the current ratio, debt to assets ratio, and times interest earned provide indications of a company's liquidity and solvency. By specifying minimum levels of liquidity and solvency, as measured by these ratios, a creditor creates triggers that enable it to step in before a company's financial situation becomes too dire.
Answers to Self-Test Questions
1. c 2. c 3. a 4. d 5. b 6. d $600,000 − (10,000 × $1) 7. c 8. c $200,000 − (10% × $497,000) = $150,300; ($497,000 − $150,300) × 10% 9. d 10. d ($300,000 + $40,000 + $100,000) ÷ $40,000 *11. d *12. b [($938,554 × 10%) − ($1,000,000 × 9%)] = $3,855; ($1,000,000 − $938,554) − $3,855 *13. c ($1,081,105 × 8%) ÷ 2 *14. d [$500,000 − (96% × $500,000)] = $20,000; ($20,000 ÷ 10) *15. a 500,000 × .96) = 480,000; ($480,000 + $2,000 + $2,000 + $2,000)
A Look at IFRS
IFRS and GAAP have similar definitions of liabilities. IFRSs related to reporting and recognition of liabilities are found in IAS I (revised) (“Presentation of Financial Statements”) and IAS 37 (“Provisions, Contingent Liabilities, and Contingent Assets”).
LEARNING OBJECTIVE 10
Compare the accounting for long-term liabilities under GAAP and IFRS.
Key Points
- As indicated in Chapter 11, in general GAAP and IFRS define liabilities similarly.
- IFRS requires that companies classify liabilities as current or noncurrent on the face of the statement of financial position (balance sheet), except in industries where a presentation based on liquidity would be considered to provide more useful information (such as financial institutions). When current liabilities (also called short-term liabilities) are presented, they are generally presented in order of liquidity.
- Under IFRS, liabilities are classified as current if they are expected to be paid within 12 months.
- Similar to GAAP, items are normally reported in order of liquidity. Companies sometimes show liabilities before assets. Also, they will sometimes show noncurrent (long-term) liabilities before current liabilities.
- Under both GAAP and IFRS, preferred stock that is required to be redeemed at a specific point in time in the future must be reported as debt, rather than being presented as either equity or in a “mezzanine” area between debt and equity.
- The basic calculation for bond valuation is the same under GAAP and IFRS. In addition, the accounting for bond liability transactions is essentially the same between GAAP and IFRS.
- IFRS requires use of the effective-interest method for amortization of bond discounts and premiums. GAAP also requires the effective-interest method, except that it allows use of the straightline method where the difference is not material. Under IFRS, companies do not use a premium or discount account but instead show the bond at its net amount. For example, if a $100,000 bond was issued at 97, under IFRS a company would record:
- The accounting for convertible bonds differs between IFRS and GAAP. Unlike GAAP, IFRS splits the proceeds from the convertible bond between an equity component and a debt component. The equity conversion rights are reported in equity.
To illustrate, assume that Harris Corp. issues convertible 7% bonds with a face value of $1,000,000 and receives $1,000,000. Comparable bonds without a conversion feature would have required a 9% rate of interest. To determine how much of the proceeds would be allocated to debt and how much to equity, the promised payments of the bond obligation would be discounted at the market rate of 9%. Suppose that this results in a present value of $850,000. The entry to record the issuance would be:
- The IFRS leasing standard is IAS 17. Both Boards share the same objective of recording leases by lessees and lessors according to their economic substance—that is, according to the definitions of assets and liabilities. However, GAAP for leases is much more “rules-based” with specific bright-line criteria (such as the “90% of fair value” test) to determine if a lease arrangement transfers the risks and rewards of ownership; IFRS is more conceptual in its provisions. Rather than a 90% cut-off, it asks whether the agreement transfers substantially all of the risks and rewards associated with ownership.
Looking to the Future
The FASB and IASB are currently involved in two projects, each of which has implications for the accounting for liabilities. One project is investigating approaches to differentiate between debt and equity instruments. The other project, the elements phase of the conceptual framework project, will evaluate the definitions of the fundamental building blocks of accounting. The results of these projects could change the classification of many debt and equity securities.
In addition to these projects, the FASB and IASB have also identified leasing as one of the most problematic areas of accounting. A joint project is now focused on lessee accounting. One of the first areas studied is, “What are the assets and liabilities to be recognized related to a lease contract?” Should the focus remain on the leased item or the right to use the leased item? This question is tied to the Boards’ joint project on the conceptual framework—defining an “asset” and a “liability.”
IFRS Practice
IFRS Self-Test Questions
1. The accounting for bonds payable is:
(a) essentially the same under IFRS and GAAP.
(b) differs in that GAAP requires use of the straight-line method for amortization of bond premium and discount.
(c) the same except that market prices may be different because the present value calculations are different between IFRS and GAAP.
(d) not covered by IFRS.
2. Stevens Corporation issued 5% convertible bonds with a total face value of $3,000,000 for $3,000,000. If the bonds had not had a conversion feature, they would have sold for $2,600,000. Under IFRS, the entry to record the transaction would require a credit to:
(a) Bonds Payable for $3,000,000.
(b) Bonds Payable for $400,000.
(c) Share Premium—Conversion Equity for $400,000.
(d) Discount on Bonds Payable for $400,000.
3. Under IFRS, if preference shares (preferred stock) have a requirement to be redeemed at a specific point in time in the future, they are treated:
(a) as a type of asset account.
(b) as ordinary shares (common stock).
(c) in the same fashion as other types of preference shares.
(d) as a liability.
4. The leasing standards employed by IFRS:
(a) rely more heavily on interpretation of the conceptual meaning of assets and liabilities than GAAP.
(b) are more “rules based” than those of GAAP.
(c) employ the same “bright-line test” as GAAP.
(d) are identical to those of GAAP.
5. The joint projects of the FASB and IASB could potentially:
(a) change the definition of liabilities.
(b) change the definition of equity.
(c) change the definition of assets.
(d) All of the above.
IFRS Exercises
IFRS15-1 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to the accounting for liabilities.
IFRS15-2 Ratzlaff Company issues (in euros) €2 million, 10-year, 8% bonds at 97, with interest payable on July 1 and January 1.
Instructions
(a) Prepare the journal entry to record the sale of these bonds on January 1, 2014.
(b) Assuming instead that the above bonds sold for 104, prepare the journal entry to record the sale of these bonds on January 1, 2014.
IFRS15-3 Archer Company issued (in pounds) £4,000,000 par value, 7% convertible bonds at 99 for cash. The net present value of the debt without the conversion feature is £3,800,000. Prepare the journal entry to record the issuance of the convertible bonds.
International Financial Statement Analysis: Zetar plc
IFRS15-4 The financial statements of Zetar plc are presented in Appendix F. Instructions for accessing and using the company's complete annual report, including the notes to its financial statements, are also provided in Appendix F.
Instructions
Use the company's annual report to answer the following questions.
(a) According to the notes to the financial statements, what types of transactions do trade payables relate to? What was the average amount of time it took the company to pay its payables?
(b) Note 4.2 discusses provisions that the company records for certain types of activities. What do the provisions relate to, what are the estimates based on, and what could cause those estimates to change in subsequent periods?
(c) What was the average interest rate paid on bank loans and overdrafts?
Answers to IFRS Self-Test Questions
1. a 2. c 3. d 4. a 5. d
Remember to go back to The Navigator box on the chapter opening page and check off your completed work.
__________
1 The difference of .00001 between 2.48686 and 2.48685 is due to rounding.