Chapter:5 Long-Term Liabilities
NG OBJECTIVES
After studying this chapter, you should be able to:
1 Describe the formal procedures associated with issuing
long-term debt.
Identify various types of bond issues.
Describe the accounting valuation for bonds at date of
issuance.
Apply the methods of bond discount and premium
amortization.
Describe the accounting for the extinguishment of debt.
Explain the accounting for long-term notes payable.
9 Indicate how to present and analyze long-term debt.
BONDS PAYABLE
Long-term debt consists of probable future sacrifices of economic benefits arising
from present obligations that are not payable within a year or the operating cycle
of the company, whichever is longer.
Examples of long-term liabilities.
Bonds payable,
long-term notes payable,
mortgages payable,
pension liabilities, and lease liabilities
Generally, long-term debt has various covenants or restrictions that protect both
lenders and borrowers. The indenture or agreement often includes
the amounts authorized to be issued,
interest rate, due date(s),
call provisions,
property pledged as security
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sinking fund requirements
TYPES OF BONDS
1. SECURED AND UNSECURED BONDS.
Secured bonds are backed by a pledge of some sort of collateral Mortgage
bonds are secured by a claim on real estate.
Bonds not backed by collateral are unsecured. A debenture bond is unsecured.
2. TERM, SERIAL BONDS, AND CALLABLE BONDS
Bond issues that mature on a single date are called term bonds.
Bond issues that mature in installments are called serial bonds.
Callable bonds give the issuer the right to call and retire the bonds prior to
maturity.
3. CONVERTIBLE, COMMODITY-BACKED, AND DEEP-DISCOUNT BONDS
If bonds are convertible into other securities of the corporation for a specified
time after issuance, they are convertible bonds
Commodity-backed bonds (also called asset-linked bonds) are redeemable
in measures of a commodity, such as, tons of coal, or ounces of rare metal.
These deep-discount bonds, also referred to as zero-interest debenture
bonds, are sold at a discount that provides the buyer’s total interest payoff at
maturity.
1. REGISTERED AND BEARER (COUPON) BONDS
Bonds issued in the name of the owner are registered bonds
A bearer or coupon bond, however, is not recorded in the name of the owner
and may be transferred from one owner to another
2. INCOME AND REVENUE BONDS
Income bonds pay no interest unless the issuing company is
profitable
Revenue bonds, so called because the interest on them is paid from specified
revenue sources.
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ISSUING BONDS
•Bond Certificate: A bond certificate is a legal document that specifies the face value,
the annual interest rate, the maturity date, and other characteristics of the bond issue.
Each bond usually has a bond indenture.
• Bond Indenture: A bond indenture is a document (contract) that defines the rights of
the bondholders. Bond indenture also a known as contract. bond represents a promise to
pay:
1. a sum of money at a designated maturity date, plus
2. periodic interest at a specified rate on the maturity amount (face value).
Individual bonds are evidenced by a paper certificate and typically have a $1,000 face
value.
Bond Issues: Parties to the Contract
VALUATION OF BONDS PAYABLE—DISCOUNT AND PREMIUM
Investment community values a bond at the present value of its expected
future cash flows, which consist of (1) interest and (2) principal.
The interest rate written in the terms of the bond indenture (and often printed on the
bond certificate) is known as the stated, coupon, or nominal rate.
The issuer of the bonds sets this rate.
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The stated rate is expressed as a percentage of the face value of the bonds (also
called the par value, principal amount, or maturity value).
If the rate employed by the investment community (buyers) differs from the stated
rate, the present value of the bonds computed by the buyers (and the current
purchase price) will differ from the face value of the bonds.
The difference between the face value and the present value of the bonds determines
the actual price that buyers pay for the bonds. This difference is either a discount or
premium
If the bonds sell for less than face value, they sell at a discount.
If the bonds sell for more than face value, they sell at a premium.
The rate of interest actually earned by the bondholders is called the effective yield
or market rate
If bonds sell at a discount, the effective yield exceeds the stated rate.
if bonds sell at a premium, the effective yield is lower than the stated rate
There is an inverse relationship between the market interest rate and the
price of the bond.
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Determining the bond price (present value of the bond)
Market rate 8% ( PV for 3 periods)
Principal $100,000 x .79383 = 79383
Interest $8000 x 2.57710 = 20,617
Present value = $100,000
Face value= $100000
Discount or premium $0
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Present value of 1 table
Period 3 6% 0.83962
Present value of an ordinary annuity
Period 3 6% 2.67301
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Problems
. Assume that ServiceMaster issues $100,000 in bonds, due in five years with 9 percent
interest payable annually at year-end. Determine the bond price use table. If the market
rate for such bonds is a.
A. 11 percent
B. 5 percent
C. 9 percent
Problem 2
Circle the correct one
1. The term used for bonds that are unsecured is:
(a) callable bonds.
(c) debenture bonds.
(b) U.S. Treasury bonds.
(d) convertible bonds.
2. The market interest rate:
(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.
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(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:
(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 January 1. The entry to accrue bond interest at
December 31 includes a:
(a) debit to Interest Payable.
(b) credit to Cash.
c) credit to Interest Expense.
(d) credit to Interest Payable
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