Chapter 10:Accounting for Long-Term Liabilities Note

Bond Financing Characteristics & Valuation

  • Advantages of Bond Financing:

    • Does not affect owner control.

    • Interest expense is tax-deductible.

    • Can increase return on equity (ROE\text{ROE}) through financial leverage (e.g., Plan C bond financing yields 17.5%17.5\% ROE\text{ROE} versus 15.0%15.0\% for Plan B equity financing and 10.0%10.0\% for Plan A no expansion).

  • Disadvantages of Bond Financing:

    • Requires payment of periodic interest and par value at maturity.

    • Can decrease return on equity if interest expense exceeds income generated from borrowed funds.

  • Bond Pricing Determination:

    • Contract Rate > Market Rate: Bond sells at a premium.

    • Contract Rate = Market Rate: Bond sells at par.

    • Contract Rate < Market Rate: Bond sells at a discount.


Bond Price Determination Diagram

Accounting for Bonds Payable

  • Issuing Bonds at Par:

    • Issuance: Debit Cash (100,000100,000), Credit Bonds Payable (100,000100,000).

    • Interest Payment Calculation:         Interest Payment=Bond Par Value×Contract Interest Rate×Time\text{Interest Payment} = \text{Bond Par Value} \times \text{Contract Interest Rate} \times \text{Time}

    • Semiannual Entry: Debit Bond Interest Expense (4,0004,000), Credit Cash (4,0004,000).

  • Discount Bonds:

    • Issued below par value when market rate exceeds contract rate (e.g., Fila 8%8\% bonds issued at 96.400%96.400\% for 96,40096,400 proceeds).

    • Contra-Liability Account: Discount on Bonds Payable is debited for 3,6003,600.

    • Carrying Value Formula:         Carrying Value=Par Value−Unamortized Discount\text{Carrying Value} = \text{Par Value} - \text{Unamortized Discount}

    • Straight-Line Interest Expense:         Bond Interest Expense=Cash Interest Paid+Discount Amortization\text{Bond Interest Expense} = \text{Cash Interest Paid} + \text{Discount Amortization}

  • Premium Bonds:

    • Issued above par value when contract rate exceeds market rate (e.g., Adidas 12%12\% bonds issued at 103.600%103.600\% for 103,600103,600 proceeds).

    • Adjunct-Liability Account: Premium on Bonds Payable is credited for 3,6003,600.

    • Carrying Value Formula:         Carrying Value=Par Value+Unamortized Premium\text{Carrying Value} = \text{Par Value} + \text{Unamortized Premium}

    • Straight-Line Interest Expense:         Bond Interest Expense=Cash Interest Paid−Premium Amortization\text{Bond Interest Expense} = \text{Cash Interest Paid} - \text{Premium Amortization}

  • Bond Retirement:

    • At Maturity: Carrying value equals par value; Debit Bonds Payable (100,000100,000), Credit Cash (100,000100,000).

    • Before Maturity:         Gain/Loss=Carrying Value−Retirement Price\text{Gain/Loss} = \text{Carrying Value} - \text{Retirement Price}         (Example: Carrying value of 104,500104,500 retired for 103,000103,000 cash results in a 1,5001,500 Gain on Bond Retirement).

Long-Term Notes Payable & Financial Analysis

  • Installment Notes:

    • Require periodic payments of principal plus interest over the term.

    • Periodic Payment Calculation:         Payment=PrincipalPresent Value Factor\text{Payment} = \frac{\text{Principal}}{\text{Present Value Factor}}

    • (Example: Foghog borrows 60,00060,000 at 8%8\% for 33 years; annual payment is $60,0002.5771=$23,282\frac{\$60,000}{2.5771} = \$23,282).

    • Each payment includes decreasing interest expense and an increasing principal allocation.

  • Mortgages:

    • Legal agreements securing a note by giving the lender rights to specific borrower assets if payments are defaulted.

  • Debt-to-Equity Ratio:

    • Used to evaluate financial risk and capital structure efficiency.         Debt-to-Equity Ratio=Total LiabilitiesTotal Equity\text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Total Equity}}

Effective Interest Amortization, Leases, and Pensions

  • Effective Interest Method:

    • Bond Interest Expense Calculation:         Bond Interest Expense=Prior Carrying Value×Semiannual Market Interest Rate\text{Bond Interest Expense} = \text{Prior Carrying Value} \times \text{Semiannual Market Interest Rate}

    • Amortization amount is the difference between computed interest expense and cash interest paid.

  • Leases:

    • Finance Lease: Long-term lease transferring substantially all risks and benefits of ownership to the lessee.

    • Operating Lease: Long-term lease not meeting finance criteria; requires recognizing Right-of-Use Asset amortization.

  • Pensions:

    • Defined Benefit Plans: Reported as an underfunded liability when the accumulated benefit obligation exceeds plan assets, or as an overfunded asset when plan assets exceed the obligation.