Chapter 10

Liabilities
Section 1

Slide
10-1
 Learning
Learning Objectives
Objectives
1. Explain a current liability, and identify the major types of current liabilities.
2. Describe the accounting for notes payable.
3. Explain the accounting for other current liabilities.
4. Explain why bonds are issued, and identify the types of bonds.
5. Prepare the entries for the issuance of bonds and interest expense.
6. Describe the entries when bonds are redeemed or converted.
7. Describe the accounting for long-term notes payable (theory only)
8. Identify the methods for the presentation and analysis of long-term liabilities
(theory only)
9. (not covered – Appendix 10-A)
10. (not covered – Appendix 10-B
11. Apply the straight line method of amortizing bond discount and bond premium
(Appendix 10-C)

Slide
10-2
 Section 1 Current Liabilities
Current
Current Liabilities:
Liabilities:

A Current Liability is a debt that:

1. Will be paid from existing current assets or
through the creation of other current liabilities.

2. Company will pay the debt within one year or the

operating cycle, whichever is longer.

Current liabilities include notes payable, accounts payable, unearned

revenues, and accrued liabilities such as taxes payable, salaries payable,
and interest payable.

Slide
10-3
 Current
Current Liability
Liability –– NOTES
NOTES PAYABLE
PAYABLE

Notes Payable
Written promissory note.
Require the borrower to pay interest.
Issued for varying periods.

Slide
10-4
 NOTES
NOTES PAYABLE
PAYABLE -- EXAMPLE
EXAMPLE

Illustration: On March 1, 2011, Jorge Estevez borrows

$100,000 from First National Bank on a 4-month, 12% note.
Instructions
a) Prepare the entry on March 1.
b) Prepare the adjusting entry on June 30, assuming
monthly adjusting entries have not been made.
c) Prepare the entry at maturity (July 1).

Slide
10-5
 NOTES
NOTES PAYABLE
PAYABLE –– EXAMPLE
EXAMPLE -- journals
journals

Illustration: On March 1, 2011, Jorge Estevez borrows

$100,000 from First National Bank on a 4-month, 12% note.
a) Prepare the entry on March 1.
Cash 100,000
Notes payable 100,000

b) Prepare the adjusting entry on June 30.

$100,000 x 12% x 4/12 = $4,000

Interest expense 4,000

Interest payable 4,000
Slide
10-6
 NOTES
NOTES PAYABLE
PAYABLE –– EXAMPLE
EXAMPLE -- journals
journals
Illustration: On March 1, 2011, Jorge Estevez borrows
$100,000 from First National Bank on a 4-month, 12% note.
c) Prepare the entry at maturity (July 1).

Notes payable 100,000

Interest payable 4,000
Cash 104,000

Slide
10-7
 SALES
SALES TAX
TAX PAYABLE
PAYABLE

Sales Tax Payable

Sales taxes are expressed as a stated percentage of
the sales price.

Either rung up separately or included in total

receipts.
Retailer collects tax from the customer.

Retailer remits the collections to the state’s department of

revenue.

Slide
10-8
 SALES TAX – IT’S THE LAW!
 Failure to charge the customer for sales tax
does NOT mean the retailer is exempt from
paying it.
 The state will calculate the taxes owed on
your receipts as if you had collected it.

Slide
10-9
 Sales
Sales Tax
Tax PAYABLE
PAYABLE –– EXAMPLE
EXAMPLE -- journals
journals

Illustration: The March 25 cash register reading for the

Macrina Bakery shows sales of $10,000 and sales taxes of
$600 (sales tax rate of 6%), the journal entry is:

Cash 10,600
Sales 10,000
Sales tax payable 600

Slide
10-10
SO 3 Explain the accounting for other current liabilities.
 PAYROLL
PAYROLL TAXES
TAXES PAYABLE
PAYABLE

Payroll and Payroll Taxes Payable

Salaries - managerial, administrative, and
sales personnel (monthly or yearly
rate).
OR
Wages - store clerks, factory employees,
and manual laborers (rate per hour).
Determining the payroll involves computing three
amounts: (1) gross earnings, (2) payroll deductions, and
(3) net pay (WE CALL IT “TAKE HOME PAY”).

Slide
10-11
 PAYROLL
PAYROLL TAXES
TAXES PAYABLE
PAYABLE -- Example
Example
Illustration: Assume a corporation records its payroll
for the week of March 7,
• Remember, you will be preparing the Journal Entry for
the corporation, not the employee.
•The corporation owes its employees $100,000.
•The corporation will PAY its employees $67,564.
Why?

See Course
Let’s do the Journal Entries. Pack

Slide
10-12
 PAYROLL
PAYROLL TAXES
TAXES PAYABLE
PAYABLE -- Example
Example
WARNING:
•The corporation must PAY the difference to various
authorities (e.g., IRS, social security, union, health
insurance company). If it doesn’t?
Failure to remit payroll
taxes results in immediate
action by the IRS! They
will go after your savings,
your spouse’s paycheck
and could result in
Jailtime…

See Course
Pack
Let’s do the Journal Entries.
Slide
10-13
 PAYROLL
PAYROLL TAXES
TAXES PAYABLE
PAYABLE -- Example
Example
Illustration: Assume a corporation records its payroll
for the week of March 7 as follows:
PAYCHECK: 3/7/2011            
GROSS PAY (assume a LOT of
employees!) $amount  

  avg rate $ 20 /hour 5,000 hours $100,000  

FICA (soc + medicare) $ 7,650 7.65% up to a cap
Amount varies per
FIT (fed'l income tax withholding) $21,864 employee
SIT (state income tax withholding) $ 2,922 Note: Not Wash State!
Medical 0 Assume zero   See Course
Union dues 0 Assume zero   Pack
Retirment contribution 0 (32,436) Total withheld

NET PAY ($ AMOUNT OF PAYCHECK) $67,564 “Take Home Pay” 

   
Employee receives paycheck for the net amount.  
Employer withholds the difference between Gross and Net and then remits to various authorities.
Although it is a withholding from the employee's paycheck; it is the employer's job to withhold and remit.
                 

Record the accrual of this payroll on March 7.

Slide
10-14
 PAYROLL
PAYROLL TAXES
TAXES PAYABLE
PAYABLE -- Example
Example
Illustration: Assume a corporation records its payroll
for the week of March 7 as follows:

Mar. 7 Salaries and wages expense 100,000

FICA tax payable 7,650
Federal income tax payable 21,864
State income tax payable 2,922
Salaries and wages payable 67,564

Record the payment of this payroll on March 11.

See Course
Pack

Slide
10-15
 PAYROLL
PAYROLL TAXES
TAXES PAYABLE
PAYABLE -- Example
Example
Illustration: Assume a corporation records its payroll
for the week of March 7 as follows:

Mar. 7 Salaries and wages expense 100,000

FICA tax payable 7,650
Federal income tax payable 21,864
State income tax payable 2,922
Salaries and wages payable 67,564

Record the payment of this payroll on March 11.

Mar. 11 Salaries and wages payable 67,564
Cash 67,564
Slide
10-16
 PAYROLL
PAYROLL TAXES
TAXES PAYABLE
PAYABLE -- Example
Example
Payroll tax expense results from three taxes that
governmental agencies levy on employers.

These taxes are:

FICA tax (7.65% up to a cap)
Federal unemployment tax (.008%)
State unemployment tax (.054%)
Based on the corporation’s $100,000 payroll, record the
employer’s expense and liability for these payroll taxes.
See Course
Pack

Slide
10-17
 PAYROLL
PAYROLL TAXES
TAXES PAYABLE
PAYABLE -- Example
Example

Illustration: Based on the corporation’s $100,000

payroll, the company would record the employer’s
expense and liability for these payroll taxes as follows.

Payroll tax expense 13,850

FICA tax payable 7,650
Federal unemployment tax payable 800
State unemployment tax payable 5,400

Slide
10-18
SO 3 Explain the accounting for other current liabilities.
 UNEARNED
UNEARNED REVENUE
REVENUE

Revenues that are received (advance payments of cash)

before the company delivers goods or provides
services. Examples:
1. Company debits Cash, and
•Season Tickets sold, e.g.,
credits a current liability
Sports, Drama
account (Unearned •Airline tickets sold
Revenue). •Magazine Subscription sold
•Insurance coverage sold (by
2. When the company earns the
insurance company
revenue, it debits the •Vacation (hotel, tours,
Unearned Revenue cruise)
account,
This is aand credits
liability becauseathe
Revenue • Advance payments (even if

account.
customer service or product and only partial payment) for
hasn’t provided it yet. merchandise. (e.g., an
Slide Airplane).
10-19
 UNEARNED
UNEARNED REVENUE-
REVENUE- Example
Example
Illustration: Assume that the Seattle Mariners sells 100
season baseball tickets at $1,782 each (outfield reserve)
for its 81-game home schedule. The Mariners make the
following entry for the sale of season tickets:
Jan. 6 Cash 178,200
Unearned revenue

178,200
As the end of the first month of games (April) the Mariners
plays 13 home games, it would record the revenue earned.

Apr 30 Unearned revenue 28,600

Ticket revenue

Slide Calc: $178,200/81

28,600= $2,200 x 13 = $28,600
10-20
 UNEARNED
UNEARNED REVENUE-
REVENUE- Example
Example
Unearned Revenue

28,600 178,200

149,600 Balance left of unearned

revenue. This is a liability
because the Mariners owe
the ticketholders games.

Calc: $149,600= $2,200 x 68 games left to play

Slide
10-21
 Current
Current Maturities
Maturities of
of Long-Term
Long-Term Debt
Debt

Portion of long-term debt that comes due in the

current year.

No adjusting entry required.

Slide
10-22
 Statement
Statement Presentation
Presentation and
and Analysis
Analysis
Analysis
Illustration 10-6
Liquidity refers to the
ability to pay maturing
obligations and meet
unexpected needs for
cash.

The current ratio Illustration 10-7

permits us to compare
the liquidity of
different-sized
companies and of a single
company at different
times.

Slide
10-23
 End
End of
of Section
Section 11

Go on to Section 2

Slide
10-24
 Chapter 10
Liabilities
Section 2 (of 4)
Use Table of Contents to go to different slides

Slide
10-25
 Study
Study Objectives
Objectives
1. Explain a current liability, and identify the major types of current liabilities.
2. Describe the accounting for notes payable.
3. Explain the accounting for other current liabilities.
4. Explain why bonds are issued, and identify the types of bonds.
5. Prepare the entries for the issuance of bonds and interest expense.
6. Describe the entries when bonds are redeemed or converted.
7. Describe the accounting for long-term notes payable (theory only)
8. Identify the methods for the presentation and analysis of long-term liabilities
(theory only)
9. (not covered – Appendix 10-A)
10. (not covered – Appendix 10-B
11. Apply the straight line method of amortizing bond discount and bond premium
(Appendix 10-C)

Slide
10-26
 Section 22 Long-Term
Section Long-Term Liabilities
Liabilities Bond
Bond Basics
Basics
WHAT IS A BOND?
Bonds are long-term debt agreements, a form of LONG TERM
interest bearing Notes Payable.

The Company borrows money and issues the lender a bond (or
bonds). The Company pays the bond holder interest.

The contractual agreement specifies:

 A series of either annual or semi-annual interest payments

(INTEREST EXPENSE)
 A lump sum payment (face value) (PAYING BACK THE

PRINCIPAL)

Slide
10-27
 No, not this Bond. . . .

Slide
10-28
 Bond
Bond Basics
Basics

Principal = $1,000 (face value on bond)

Interest rate = 3.5% annually = $35, or semi-annually $17.50.
Period: 20 years (interest is paid for 20 years and on the 20th
payment, the bond is redeemed).
Slide
10-29
 Why
Why issue
issue Bonds
Bonds and
and not
not Common
Common Stock?
Stock?

Three advantages of Bond Financing (debt)

over selling additional shares of stock, Stock
Financing (equity):
1. Stockholder control is not affected
2. Tax savings result
3. Earnings per share may be higher

Slide
10-30
 Advantages of Bond
Financing over Common Stock
 Stockholder control
Issuing Bonds brings money into the company (via
debt) but does NOT bring more owners into the
company. More voters mean more votes.
More votes mean loss of Control….so Bond
Financing is better than Stock Financing which
increases the # of voters.

Slide
10-31
 Advantages of Bond
Financing over Common Stock
 Tax expense (hence a deduction!!)
Interest Expense is deductible. By the way,
dividends (currently) are NOT deductible. )….so
Bond Financing is better than Stock Financing
because it gives the company a deduction, which
effectively reduces the cost of the debt.

Slide
10-32
 Advantages of Bond
Financing over Common Stock
 Earnings per Earnings Per Share =
Net Income
share # Shares outstanding

Having debtors does NOT The more Shares

increase the number of outstanding, the LOWER
shareholders. Hence, does the EPS
not affect the EPS….so Bond
Financing is better than Stock
Financing which DOES
increase # shareholders and
can reduce EPS

Slide
10-33
 Bond
Bond Basics
Basics

Types of Bonds
Secured and Unsecured (debenture) bonds.
Term and Serial bonds.
Registered and Bearer (or coupon) bonds.
Convertible and Callable bonds.

Slide
10-34
 Secured Bonds...
Have specific assets of
the issuer pledged as
collateral for bonds,
e.g., real estate, or
sinking fund

Slide
10-35
 Unsecured or Debenture Bonds...
Are issued against
the general credit
of the borrower.

Slide
10-36
 Term Bonds...

Are due for payment (mature) at

a single specified future date.

Slide
10-37
 Serial Bonds...

Mature in
installments.

Slide
10-38
 Registered & Bearer Bonds...

Registered Bonds are issued in

the name of the owner.

Bearer Bonds are

unregistered. Also
called Coupon Bonds

Slide
10-39
 Convertible or Callable Bonds...
Convertible into Stock at
Bondholders option.

Callable – retired early at

Issuing Company’s
option

Read the bond indenture!

Slide
10-40
 Bond
Bond Basics
Basics

The Bond Contract… Known as a the Bond Indenture.

The Board of Directors approves new Bond Issuances --

(If the Company is trying to raise $5,000,000 in bonds,
they would authorize issuing 5,000 bonds (at $1,000 par
value).
The Bond Indenture includes the terms of the Bond
Terms include:
(1) Face Value of total issuance e.g., $5,000,000
(2) Interest rate, also called the “contractual (stated)
rate on the maturity amount (face value).
(3) Life of bond (3,5,7 years, etc.)
Slide
10-41
 Bond
Bond Basics
Basics

Interest is calculated on the Face Value of

the Bond… If the Face Value of total issuance e.g.,
$5,000,000 and annual interest is 8%
The Interest PAID TO THE BONDHOLDERS (in total) would be:

$5,000,000 x 8% = $400,000 annually (usually paid semiannually at

$200,000, every six months.

Slide
10-42
 Bond
Bond Basics-
Basics- terms
terms are
are shown
shown on
on bond
bond

2013

Issuer
Issuer of
of
Bonds
Bonds
DUE 2013

Maturity
Maturity
Date
Date DUE 1976

Face
Face or
or
Par
Par Value
Value
== $1,000 Contractual
Contractual
$1,000
Interest
Interest
Rate
Rate == 3.5%
3.5%
Slide
10-43
 How do you keep them straight?
 Indenture? – Bond Contract
 Debenture? – Type of bond (issued on
general credit of company)

Slide
10-44
 Indenture

Think pilgrims,
think servants,
think indentured
servants. . ..

An indentured servant
worked 7 years to pay for
his trip to America. He/she
signed a CONTRACT.

Slide
10-45
 DEBENTURE – DIE HARD
 Open the Safe!

Okay, maybe you

didn’t see the movie,
but they robbed the
safe of millions of
dollars worth of
bonds, debenture
bonds…..

Slide
10-46
 End
End of
of Section
Section 22

Go on to Section 3

Slide
10-47
 Chapter 10
Liabilities
Section 3 (of 4)
Use Table of Contents to go to an individual slide

Slide
10-48
 Study
Study Objectives
Objectives
1. Explain a current liability, and identify the major types of current liabilities.
2. Describe the accounting for notes payable.
3. Explain the accounting for other current liabilities.
4. Explain why bonds are issued, and identify the types of bonds.
5. Prepare the entries for the issuance of bonds and interest expense.
6. Describe the entries when bonds are redeemed or converted.
7. Describe the accounting for long-term notes payable (theory only)
8. Identify the methods for the presentation and analysis of long-term liabilities
(theory only)
9. (not covered – Appendix 10-A)
10. (not covered – Appendix 10-B
11. Apply the straight line method of amortizing bond discount and bond premium
(Appendix 10-C)

Slide
10-49
 Section
Section 3:
3: Accounting
Accounting for
for Bond
Bond Issues
Issues

JOURNAL ENTRIES:
Issuing Bonds
Paying semi annual interest
Accruing semi annual interest
Retiring Bonds
See Course Pack for summary on bond
and journal entries

Slide
10-50
 Face Value...
The amount of principal due at
maturity date.
Contractual Interest Rate... (Face
Interest Rate)

Is the rate used to determine the amount of cash

interest the borrower pays and investor receives.
Slide
10-51
Market Interest Rate...

The rate that investors demand for loaning

funds.

Not the same as contract (bond

indenture) rate.

Slide
10-52
 Accounting for Bond Issues

Bonds may be issued at:

 Face value – (e.g., 10% contract rate)
 Below face value-discount
or (e.g, market is 12%)
 Above face value-premium
(e.g., market is 8%)

Slide
10-53
 Accounting
Accounting for
for Bond
Bond Issues
Issues
CHAPTER 10 - LIABILITIES -- Accounting for Bonds
Determining the Market Value of bonds

Contract Market Bonds Sell at:    

issue date: 1/1/2011 10% < 10% Premium to charge buyer for higher contract int. rate

100 five year, 10%, payable semiannually 10% = 10% Face Value      
$1000 bonds at 100 (face value) 10% > 10% Discount to attract buyer    

1/1/2011 face value -- issue at: 100.00   discount --issue at: 92.639   premium -- issue at: 108.111  
Cash 100,000   Cash 92,639   Cash 108,111  

Bond Payable 100,000 Discount on B/Pay 7,361   Premium on Bond Pay 8,111
    Bond Payable 100,000 Bond Payable 100,000
To record sale of bonds
   
 
     
 
 
 
   
 
  See Course Pack for
                   
7/1/2011 Bond Interest Exp.
Cash
5,000  
5,000
Bond Interest Exp.
Discount on B/Pay
5,736  
736
Bond Interest Exp.
Premium on B/Pay
4,189
811
 
 
summary on bond and
    Cash 5,000 Cash 5,000
journal entries
To record payment of interest   To record payment of interest/amort of disc. To record payment of interest/amort of premium
                   

12/31/2011 Bond Interest Exp. 5,000   Bond Interest Exp. 5,736   Bond Interest Exp. 4,189  
Bond Int. Payable 5,000 Discount on B/Pay 736 Premium on B/Pay 811  
    Bond Int. Payable 5,000 Bond Int. Payable 5,000

To record accrual of interest
1/1/2012 Bond Int. Payable
Cash
To record payment of interest
Cost of borrowing:
Total Payments
 
 
  To record accrual of interest/amort of disc. To record accrual of interest/amort of premium
5,000   Bond Int. Payable 5,000   Bond Int. Payable 5,000  
5,000 Cash 5,000 Cash 5,000
  To record payment of interest   To record payment of interest  
5,000   Cost of borrowing: 5,000   Cost of borrowing: 5,000  
10   Total Payments 10   Total Payments 10  
    50,000     50,000  
  Plus discount 7,361   Less: premium (8,111)  

Total cost of borrowing 50,000   Total cost of borrowing 57,361   Total cost of borrowing 41,889  
                 

At maturity Bond Payable 100,000 Bond Payable 100,000 Bond Payable 100,000
Cash 100,000 Cash 100,000 Cash 100,000

Slide
10-54
 Accounting
Accounting for
for Bond
Bond Issues
Issues

Issuing Bonds at Face Value

Illustration: On January 1, 2011, Willis

Inc. issues $100,000, five-year, 10% bonds at 100
(100% of face value). Interest payable semiannually.
The entry to record the sale is:

Jan. 1 Cash 100,000

Bonds payable 100,000

Slide
10-55
 Issuing
Issuing Bonds
Bonds at
at Face
Face Value
Value

Illustration: On January 1, 2011, Willis

Inc. issues $100,000, five-year, 10% bonds at 100
(100% of face value). Assume that interest is
payable semiannually on January 1 and July 1. Prepare
the entry to record the payment of interest on July 1,
2011, assume no previous accrual.

July 1 Bond interest expense 5,000

Cash 5,000

Slide
10-56
 Issuing
Issuing Bonds
Bonds at
at Face
Face Value
Value

Illustration: On January 1, 2011, Willis

Inc. issues $100,000, five-year, 10% bonds at 100
(100% of face value). Assume that interest is
payable semiannually on January 1 and July 1. Prepare
the entry to record the accrual of interest on
December 31, 2011, assume no previous accrual:

Dec. 31 Bond interest expense 5,000

Bond interest payable 5,000

Slide
10-57
 Issuing
Issuing Bonds
Bonds at
at Face
Face Value
Value

Question: What is the TOTAL cost of borrowing?

$5,000 x 10 periods = $50,000

Bond interest expense

Slide
10-58
 Bond
Bond Basics
Basics

Determining the Market Value of Bonds

Market value is a function of the three factors that
determine :

1. The selling price when the bond was sold

2. The life of the bond (in # of interest payments )

3. The market rate of interest for bonds of similar risk

Note: whether a bond is callable, convertible, restricted, etc, can

also affect the market value of the bond

Slide
10-59
 Bond prices react inversely to Market
Interest rates

 Bond
prices react
inversely to
Market
Interest
rates

See top page 9 of

coursepack for
example of contract
interest rate vs.
market rate
Slide
10-60
 Bond Discount...

When the Market Rate

is HIGHER than the
Bond contract rate,
the bond is sold for
less than its face
value. WHY?
To adjust the
contractual interest to
the market interest
rate.

Slide
10-61
 Accounting
Accounting for
for Bond
Bond Issues
Issues -- Discount-JE
Discount-JE

Issuing Bonds at a Discount

Illustration: On January 1, 2011, Willis, 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:

Jan. 1 Cash 92,639

Discount on bonds payable 7,361
Bond payable 100,000

Slide
10-62
 Bonds
Bonds at
at aa Discount
Discount –– statement
statement presentation
presentation

Statement Presentation

Willis Inc.
Balance Sheet (partial)
January 1, 2011

Liabilities Book Value @

Bonds Payable $ 100,000
time of issuance
Less: Discounts on Bonds Payable 7,361 $ 92,639

Slide
10-63
 Bonds
Bonds at
at aa Discount
Discount –– Cost
Cost of
of Borrowing
Borrowing
Cost of Borrowing – what was the true interest cost?

Cost of Borrowing:
Principal at maturity $ 100,000
Semiannual interest payments
($5,000 x 10 periods*) 50,000
Total $ 150,000

Money received from bondholders $ 92,639

Cost of borrowing**
 
$ 57,361
Note that when
you issue at
* = 5 years x 2 interest payments/year Discount, it
**= Interest and discount
increases your
interest cost

Slide
10-64
 Bond Premium...

When the Market

Rate is LOWER
than the Bond
contract rate, the
bond is sold for
MORE than its
face value.
WHY? To adjust
the contractual
interest to the
market interest
rate.

Slide
10-65
 Accounting
Accounting for
for Bond
Bond Issues
Issues –– Premium
Premium -JE
-JE

Issuing Bonds at a Premium

Illustration: On January 1, 2011, Willis, Inc. sells
$100,000, five-year, 10% bonds for $108,111 (108.111%
of face value). Interest is payable on July 1 and
January 1. The entry to record the issuance is:

Jan. 1 Cash 108,111

Bonds payable 100,000
Premium on bond payable 8,111

Slide
10-66
 Bonds
Bonds at
at aa Premium
Premium –– Statement
Statement Presentation
Presentation

Statement Presentation

Willis Inc.
Balance Sheet (partial)
January 1, 2011

Liabilities Book Value @

Bonds Payable $ 100,000
time of issuance
Plus: Premium on Bonds Payable 8,111 $ 108,111

Slide
10-67
 Why
Why aren’t
aren’t all
all bonds
bonds issued
issued at
at Face
Face Value?
Value?

It’s a timing issue. By the time a company prints

the bond certificates and markets the bonds, it
would be highly unusual if the market rate and
the contractual rate are the same.

Slide
10-68
 Bonds
Bonds at
at aa Premium
Premium –– Cost
Cost of
of Borrowing
Borrowing
Cost of Borrowing – what was the true interest cost?

Cost of Borrowing:
Principal at maturity $ 100,000
Semiannual interest payments
($5,000 x 10 periods*) 50,000
Total $ 150,000

Money received from bondholders $ 108,111

Cost of borrowing**
 
$ 41,889
Note that when
you issue at
* = 5 years x 2 interest payments/year Premium, it
**= Interest less premium
decreases your
interest cost

Slide
10-69
 Bond
Bond Basics
Basics

Bond Trading
Bonds are also traded on national securities exchanges.
Bond prices are found online at investment firm website
(e.g., www.fidelity.com (or in newspapers and financial
publications)

Read as: Outstanding 5.125%, $1,000 bonds that mature in 2014.

Currently yield a 5.747% return. On this day, $33,965,000 of
these bonds were traded. Closing price was 96.595% of face value,
or $965.95 (per bond). “Bond Speak”
Slide
10-70
 End
End of
of Chapter
Chapter 10
10 –Part
–Part 33

Go on to Part 4

Slide
10-71
 Chapter 10
Liabilities
Section 4
Use Table of Contents to go to an individual slide

Slide
10-72
 Study
Study Objectives
Objectives
1. Explain a current liability, and identify the major types of current liabilities.
2. Describe the accounting for notes payable.
3. Explain the accounting for other current liabilities.
4. Explain why bonds are issued, and identify the types of bonds.
5. Prepare the entries for the issuance of bonds and interest expense.
6. Describe the entries when bonds are redeemed or converted.
7. Describe the accounting for long-term notes payable (theory only)
8. Identify the methods for the presentation and analysis of long-term liabilities
(theory only)
9. (not covered – Appendix 10-A)
10. (not covered – Appendix 10-B
11. Apply the straight line method of amortizing bond discount and bond premium
(Appendix 10-C)

Slide
10-73
 Amortizing Bond Discount - Appendix 10-C –
back of chapter

Although Bond Discounts eventually get

written off to Bond Interest Expense, this
must be Amortized over the life of the
Bond:

Slide
10-74
 Amortizing Bond Discount

Willis Inc. would amortize the $7,361

discount as follows:

$7,361 ÷ 10 Interest Periods

= $736 Semiannually

Slide
10-75
 Straight-Line
Straight-Line Amortization
Amortization –– Bond
Bond Discount
Discount
Appendix 10C
Amortizing Bond Discount

Willis, Inc., sold $100,000, five-year, 10% bonds on January 1,

2011, for $92,639 (discount of $7,361). Interest is payable on
July 1 and January 1. The bond discount amortization for each
interest period is $736 ($7,361/10).

Why can’t Willis, Inc. write the $7,361 OFF to Interest

Expense when they sell the bond? Why is it necessary to
amortize the expense over the life of the bond?
Because the expense cannot be booked to one period alone
when it affects the life of the bond.
Slide
10-76
 Straight-Line
Straight-Line Amortization
Amortization –– Amortization
Amortization
Schedule
Schedule -- DISCOUNT
DISCOUNT
BOND AMORTIZATION - AT
Appendix 10C
DISCOUNT
  A B C D E F
  Cash  
Interest to  
Carrying be Paid Amount of Interest Unamortiz'd Bond Carrying
Semi-annual Valued –beg (reduction Prem or Disc Expense to Premium or Value—end of
int. period of period to cash) Amortization be Recorded Discount period
   
Issue dt     7,361 92,639

1 92,639 5,000 736 5,736 6,625 93,375

2 93,375 5,000 736 5,736 5,889 94,111

3 94,111 5,000 736 5,736 5,153 94,847

4 94,847 5,000 736 5,736 4,417 95,583

5 95,583 5,000 736 5,736 3,681 96,320

6 96,320 5,000 736 5,736 2,944 97,056

7 97,056 5,000 736 5,736 2,208 97,792

8 97,792 5,000 736 5,736 1,472 98,528

9 98,528 5,000 736 5,736 736 99,264 Book Value will

10 99,264 5,000 736 5,736 (0) 100,000
equal Face Value
when bond is
mature.
Slide
10-77
 Straight-Line
Straight-Line Amortization
Amortization –– Discount
Discount -JE
-JE

Amortizing Bond Discount

Willis, Inc., sold $100,000, five-year, 10% bonds on January 1,
2011, for $92,639 (discount of $7,361). Interest is payable on
July 1 and January 1. The bond discount amortization for each
interest period is $736 ($7,361/10).

Journal entry on July 1, 2011, to record the interest payment

and amortization of discount is as follows: Note: Interest is
HIGHER when you
July 1 Interest Expense 5,736 sell at Discount

Discount on Bonds Payable 736

Cash 5,000

Slide
10-78
 Accounting
Accounting for
for Bond
Bond Retirements
Retirements

Redeeming Bonds at Maturity

Assuming that the company pays and records separately
the interest for the last interest period, Willis records
the redemption of its bonds at maturity as follows:

Bond payable 100,000

Cash 100,000

Slide
10-79
 Note!

Be sure to understand how to amortize a

bond at Premium also AND book the
interest expense.

$8,111 ÷ 10 Interest Periods

= $811 Semiannually

Slide
10-80
 Straight-Line
Straight-Line Amortization
Amortization –– Premium
Premium -JE
-JE

Amortizing Bond Premium

On January 1, 2011, Willis, Inc. sells $100,000, five-year, 10%
bonds for $108,111 (108.111% of face value). Interest is payable
on July 1 and January 1. The bond discount amortization for
each interest period is $811 ($8,111/10).

Journal entry on July 1, 2011, to record the interest payment

and amortization of discount is as follows: Note: Interest is
LOWER when you
July 1 Interest Expense 4,189 sell at Premium

Premium on Bonds Payable 811

Cash 5,000

Slide
10-81
 Straight-Line
Straight-Line Amortization
Amortization –– Amortization
Amortization
Schedule
Schedule -- PREMIUM
PREMIUM
Appendix 10C

BOND AMORTIZATION - AT PREMIUM

  A B C D E F
  Cash  
Interest to
Carrying be Paid Amount of Interest Unamortiz'd Bond Carrying
Semi-annual Valued –beg (reduction to Prem or Disc Expense to Premium or Value—end of
int. period of period cash) Amortization be Recorded Discount period
Issue dt         8,111 108,111

1 108,111 5,000 811 4,189 7,300 107,300

2 107,300 5,000 811 4,189 6,489 106,489

3 106,489 5,000 811 4,189 5,678 105,678

4 105,678 5,000 811 4,189 4,867 104,867

5 104,867 5,000 811 4,189 4,056 104,056

6 104,056 5,000 811 4,189 3,244 103,244

7 103,244 5,000 811 4,189 2,433 102,433

8 102,433 5,000 811 4,189 1,622 101,622

9 101,622 5,000 811 4,189 811 100,811 Book Value will

10 100,811 5,000 811 4,189 (0) 100,000 equal Face Value
 
 
 
 
      when bond is
mature.
Slide
10-82
 Accounting
Accounting for
for Bond
Bond Retirements
Retirements

Redeeming Bonds before Maturity – you must:

1. Eliminate the carrying value of the bonds at the
redemption date: If you have to retire a bond before
maturity, you will need to refer to
• Bonds Payable the Amortization Schedule to obtain
the balance in the Discount or
• Discount or
Premium account (the balance in
• Premium Bonds Payable will not change)

2. Record the Cash paid to bondholder

Note: This is
3. Book the Gain or Loss on redemption.
similar to
retiring an
asset
Slide
10-83
 Accounting
Accounting for
for Bond
Bond Retirements
Retirements
Illustration: Assume Willis, Inc. has sold its bonds at a
premium. At the end of the eighth period, Willis retires
these bonds at 103 after paying the semiannual interest. The
carrying value of the bonds at the redemption date is
$101,623. Willis makes the following entry to record the
redemption at the end of the eighth interest period
(January 1, 2015):

Bonds payable 100,000

Premium on bonds payable 1,622
Loss on redemption 1,378
Cash 103,000

Slide
10-84
 Converting
Converting Bonds
Bonds into
into Common
Common Stock
Stock
Until conversion, the bondholder receives interest on the
bond.

For the issuer, the bonds sell at a higher price and pay a
lower rate of interest than comparable debt securities
without the conversion option.

Upon conversion, the company transfers the carrying value

of the bonds to paid-in capital accounts. No gain or loss is
recognized.

Note: Know theory, not Journal Entry

Slide
10-85
 Accounting
Accounting for
for Long-Term
Long-Term Notes
Notes Payable
Payable

Long-Term Notes Payable

May be secured by a mortgage that pledges title to
specific assets as security for a loan
Typically, the terms require the borrower to make
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.

Companies initially record mortgage notes payable at

face value.
Note: Know theory, not Journal Entry
Slide
10-86
 Statement
Statement Presentation
Presentation and
and Analysis
Analysis

Analysis/Key Ratios – Measuring long term

solvency and debt paying ability

1. Debt to Total debt

=
total assets
Total assets

Question: Is higher better? NO! Means more

debt, more risk.

Slide
10-87
 Statement
Statement Presentation
Presentation and
and Analysis
Analysis

Analysis/Key Ratios – Measuring short term

liquidity

Income before income taxes

2. Times and interest expense
interest =
earned Interest expense

Indicates the company’s ability to meet interest

payments as they come due.

Slide
10-88
 Advantages of Bond Financing over
Common Stock, an illustration
 Stockholder control
 Tax expense
 Earnings per share

Slide
10-89
 Advantages of Bond Financing over
Common Stock, an illustration
Let's compare Stock vs. Bond Financing.

Situation: You are the Chief Financial Officer at Willis , Inc.. You are forecasting next
year's Income Statement. You are going to need to raise $5,000,000 in financing, either
by 1) selling $5,000,000 in bonds (assume Face Value, 5,000 bonds) or2) selling
$5,000,000 in stock (assume at $25 average selling price, or 200,000 shares of common
stock).

Currently, Willis , Inc. has 100,000 shares of Common Stock outstanding and zero bonds
outstanding.

Assumptions: Bonds will be issued at 8% interest rate. You do not need to know the life
of the bond as you are only forecasting one year out. Assume a 30% income tax rate.

Required: Prepare an Income Statement under each financing method. Note that the
income statement's will be identical up to Income before income and taxes. After this
point, they will be different. Calculate Earnings per share under each assumption. Note
that with Stock financing the number of outstanding shares will increase by 200,000

Slide
10-90
 Advantages of Bond Financing over
Common Stock, an illustration
Forecast Income Statement - Next Year

Stock Financing Bond Financing

Sales $ 7,500,000 $ 7,500,000 Note: WITH BOND

COGS 3,375,000 3,375,000 FINANCING:
Gross Margin (or Gross Profit) $ 4,125,000 $ 4,125,000 •EPS is HIGHER (in this example)
Selling, General, Administrative •You have MORE control (less
Expenses 2,625,000 2,625,000 shares outstanding)
Income before interest and taxes $ 1,500,000 $ 1,500,000 •Your tax expense is lower.

Interest Expense (8% annually) - 400,000

Income before income taxes $ 1,500,000 $ 1,100,000
Income tax expense (30%) 450,000 330,000

Net Income $ 1,050,000 $ 770,000

Outstanding Shares 300,000 100,000

Earnings Per Share $ 3.50 $ 7.70

Slide
10-91
 End
End of
of Chapter
Chapter 10
10

Good Bye and Good Luck!

Solutions to Bond exercises next

Slide
10-92
 Chapter 10: Bonds! Solutions to exercise
THREE INDEPENDENT SCENARIOS
Scenario #1 Scenario #2 Scenario #3
Face Value of a single Bond $1,000 $1,000 $1,000
Coupon Rate 10% 10% 10%
Term of the Bond (life)/ Date Issued, 5 year/ 1/1/2001, every 6 5 year/ 1/1/2001, every 6 5 year/ 1/1/2001, every 6
frequency of interest months months months
How many bonds did you issue? 1,000 1,000 1,000

What is the face value of the bond $1,000,000 $1,000,000 $1,000,000

issuance?
Market interest rate for bonds of similar 10% 10.52% 9.49%
risk?
Which bond is more attractive to buyer Neither Market Ours!
and why?
How often is interest paid? Yearly or Every 6 months Jan 1 and Every 6 months Jan 1 and Every 6 months Jan 1 and
semiannually? When do you pay interest? July 1 July 1 July 1

How much interest do you pay? $50,000 $50,000 $50,000

Selling price per bond, In “bondspeak” 100 98 102

What was your Selling price (average) in $ $1,000 $980 $1,020

per bond?
How much did you receive for all of the $1,000,000 $980,000 $1,020,000
bonds?
At the end of the life of the bond, what is $1,000,000 $1,000,000 $1,000,000
the principal that you OWE the
bondholders?

How much did this bond COST you? $500,000 $520,000 $480,000

Slide
10-93
 Chapter 10: Bonds! Solutions to exercise

Accounting 202 – BOND REVIEW

On January 1st, 2001, Yao Corporation issued 6 year, $200,000 face value bonds (5% coupon) at 93.69. Interest is payable semiannually
on January 1 and July 1.
•Prepare the journal entry to record the issuance of the bonds on January 1, 2001 (2 pts)
•Prepare the journal entry to record the first interest payment on July 1, 2001 (3 pts)
•Prepare the journal entry to record the accrual of interest on December 31, 2001 (3 pts)
•Prepare the journal entry to record the retirement of the bond on Jan 1, 2007, after the last interest payment has been made (2 pts).
•Calculate the total interest expense recorded on the books of Yao Clothes and the total cash paid for interest during the life of the bond.
If the amounts differ, calculate the difference and explain what caused it. (2 pts)
•Show an Amortization Schedule for this bond

Slide
10-94
 Chapter 10: Bonds! Solutions to exercise

# DATE Account Titles AND Description Debit Credit

a 1/1/01 Cash 187,380

Discount on Bonds Payable 12,620
Bonds Payable 200,000
To record bonds issued at discount

b 07/01/01 Bond Interest Expense 6,052

Discount on Bonds Payable 1,052
Cash 5,000
To record semiannual interest payment

c 12/31/01 Bond Interest Expense 6,052

Discount on Bonds Payable 1,052
Interest Payable 5,000
To record semiannual accrual of interest

d 01/01/07 Bonds Payable 200,000

Cash 200,000
To record retirement of bonds

e INTEREST EXP = $5,000 * 12 = $60,000 + $12,620 = $72,620

CASH INTEREST PAID = $5,000 * 12 = $60,000

The difference is the discount amount which cost the company an

additional interest amount of $12,620.

Slide
10-95
 Chapter 10: Bonds! Solutions to exercise

2) Prepare a BOND AMORTIZATION Schedule

A B C D E

Interest to be
Paid Interest Amount of
Semi-annual (reduction Expense to be Prem/Disc Unamortiz'd
int. period to cash) Recorded Amortization Prem/Disc Bond Carrying Value
Issue 187,380
dt1/1/01       12,620
188,432
07/01/01  5,000 1,052 6,052 11,568
01/01/02  5,000 1,052 6,052 10,516 189,484
07/01/02  5,000 1,052 6,052 9,464 190,536
01/01/03  5,000 1,052 6,052 8,412 191,588
07/01/03  5,000 1,052 6,052 7,360 192,640
01/01/04  5,000 1,052 6,052 6,308 193,692
07/01/04  5,000 1,052 6,052 5,256 194,744
01/01/05  5,000 1,052 6,052 4,204 195,796
07/01/05  5,000 1,052 6,052 3,152 196,848
01/01/06  5,000 1,052 6,052 2,100 197,900
07/01/06  5,000 1,052 6,052 1,048 198,952
01/01/07  5,000 1,048* 6,048 0 200,000
         

Slide
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