1 - Cengage



Chapter 10

Long-Term Liabilities

Review of Learning Objectives

LO1 Identify the management issues related to long-term debt.

Long-term debt is used to finance assets and business activities, such as research and development, that will produce income in future years. The management issues related to long-term debt are whether to take on long-term debt, how much debt to carry, and what types of debt to incur. The advantages of issuing long-term debt are that common stockholders do not relinquish any control, interest on debt is tax-deductible, and financial leverage can increase earnings. The disadvantages are that interest and principal must be paid on time and financial leverage can work against a company if an investment is not successful. The level of debt can be evaluated using the debt to equity ratio and the interest coverage ratio. Common types of long-term debt are bonds, notes, mortgages, long-term leases, pension liabilities, other postretirement benefits, and deferred income taxes.

LO2 Describe the features of a bond issue and the major characteristics of bonds.

A bond is a security that represents money borrowed from the investing public. When a corporation issues bonds, it enters into a contract, called a bond indenture, with the bondholders. The bond indenture defines the terms of the bond issue. A bond issue is the total value of bonds issued at one time. The prices of bonds are stated in terms of a percentage of the face value, or principal, of the bonds. The face interest rate is the fixed rate of interest paid to bondholders based on the face value. The market interest rate is the rate of interest paid in the market on bonds of similar risk. If the market rate fluctuates from the face interest rate before the bond issue date, the bonds will sell at either a discount or a premium.

A corporation can issue several types of bonds, each having different characteristics. For example, a bond issue may or may not require security (secured versus unsecured bonds). It may be payable at a single time (term bonds) or at several times (serial bonds). And the holder may receive interest automatically (registered bonds) or may have to return coupons to receive interest payable (coupon bonds). Bonds may also be callable and convertible.

LO3 Record bonds issued at face value and at a discount or premium.

Bondholders pay face value for bonds when the interest rate on the bonds approximates the market rate for similar investments. The issuing corporation records the bond issue at face value as a long-term liability in the Bonds Payable account. Bonds are issued at a discount when their face interest rate is lower than the market rate for similar investments. The difference between the face value and the issue price is debited to Unamortized Bond Discount. Bonds are issued at a premium when their face interest rate is greater than the market interest rate on similar investments. The difference between the issue price and the face value is credited to Unamortized Bond Premium.

LO4 Use present values to determine the value of bonds.

The value of a bond is determined by summing the present values of (1) the series of fixed interest payments of the bond issue and (2) the single payment of the face value at maturity. Tables 3 and 4 in the appendix on future value and present value tables should be used in making these computations.

LO5  Amortize bond discounts and bond premiums using the straight-line and effective interest methods.

The straight-line method allocates a fixed portion of a bond discount or premium each interest period to adjust the interest payment to interest expense. The effective interest method, which is used when the effects of amortization are material, applies a constant rate of interest to the carrying value of the bonds. To find interest and the amortization of discounts or premiums, the effective interest rate is applied to the carrying value of the bonds (face value minus the discount or plus the premium) at the beginning of the interest period. The amount of the discount or premium to be amortized is the difference between the interest figured by using the effective rate and that obtained by using the face rate. The results of using the effective interest method on bonds issued at a discount or a premium are summarized below and compared with issuance at face value:

| |Bonds Issued At |

| |Face Value |Discount |Premium |

|Trend in carrying value over bond term |Constant |Increasing |Decreasing |

|Trend in interest expense over bond term |Constant |Increasing |Decreasing |

|Interest expense versus interest payments |Interest expense = interest |Interest expense > interest |Interest expense < interest |

| |payments |payments |payments |

|Classification of bond discount or premium |Not applicable |Contra-liability (deducted |Liability (added to Bonds |

| | |from Bonds Payable) |Payable) |

LO6 Account for the retirement of bonds and the conversion of bonds into stock.

Callable bonds can be retired before maturity at the option of the issuing corporation. The call price is usually an amount greater than the face value of the bonds, in which case the corporation recognizes a loss on the retirement of the bonds. Sometimes, a rise in the market interest rate causes the market value of the bonds to fall below face value. If a company purchases its bonds on the open market at a price below carrying value, it recognizes a gain on the transaction.

Convertible bonds allow the bondholder to convert bonds to the issuing corporation’s common stock. When bondholders exercise this option, the common stock issued is recorded at the carrying value of the bonds being converted. No gain or loss is recognized.

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