Chapter 7

Chapter 7

LiabilitiesLiabilities

1. Explain the characteristics of a liability.

2. Account for compensated absences.

3. Understand and record payroll taxes and deductions.

4. Record property taxes.

5. Account for warranty costs.

7. Explain the terms “probable,” “reasonably possible,” and “remote” related to contingencies.

8. Record and report a loss contingency.

9. Disclose a gain contingency.

10. Explain the reasons for issuing long-term liabilities.

11. Understand the characteristics of bonds payable.

12. Record the issuance of bonds.

13. Amortize discounts and premiums under the straight-line method.

14. Compute the selling price of bonds.

15. Amortize discounts and premiums under the effective interest method.

16. Explain extinguishment of liabilities.

17. Understand bonds with equity characteristics.

18. Account for long-term notes payable.

19. Understand the disclosure of long-term liabilities.

Defined by SFAC No. 6 as: Probable future sacrifices of economic benefits

arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

LiabilitiesLiabilitiesLiabilitiesLiabilities

1. It involves a present duty or responsibility of the company to one or more entities that will be settled by the probable future transfer or use of assets at a specified or determinable date, on occurrence of a specific event, or on demand.

2. The duty or responsibility obligates the company, leaving it little or no discretion to avoid the future sacrifice.

3. The transaction or other event obligating the company has already happened.

Three Essential Characteristics of a LiabilityThree Essential Characteristics of a LiabilityThree Essential Characteristics of a LiabilityThree Essential Characteristics of a Liability

Interest that is not explicitly specified in the terms of the liability.

Need not be recognized.

Liabilities - Implicit InterestLiabilities - Implicit InterestLiabilities - Implicit InterestLiabilities - Implicit Interest

Current liabilities are

obligations whose

liquidation is expected

to require the use of

existing current assets

or the creation of other

current liabilities within

one year or an

operating cycle,

whichever is longer.

Current liabilities are

obligations whose

liquidation is expected

to require the use of

existing current assets

or the creation of other

current liabilities within

one year or an

operating cycle,

whichever is longer.

Current LiabilitiesCurrent LiabilitiesCurrent LiabilitiesCurrent Liabilities

Having Contractual Amount

Having Contractual Amount

Accounts payableNotes payableCurrently maturing portion of long-term debtDividends payableAdvances and refundable depositsAccrued itemsUnearned items

Accounts payableNotes payableCurrently maturing portion of long-term debtDividends payableAdvances and refundable depositsAccrued itemsUnearned items

Type of Current LiabilitiesType of Current Liabilities Type of Current LiabilitiesType of Current Liabilities

Amount Depends on Operations

Amount Depends on Operations

Sales (use) taxesPayroll taxesIncome taxesBonuses

Sales (use) taxesPayroll taxesIncome taxesBonuses


Amount Must Be Estimated

Amount Must Be Estimated

Property taxesWarrantiesPremiums and couponsOther contingencies

Property taxesWarrantiesPremiums and couponsOther contingencies


Obligations arising from the company’s ongoing operations

-- includes the acquisition of inventory, supplies, materials and services.

Commonly called trade payables.

Other current payables should be reported separately.

Accounts PayableAccounts Payable Accounts PayableAccounts Payable

Notes that arise from the same types of transactions as trade payables.

Can be secured or unsecured. Can be interest-bearing or

noninterest-bearing.

-- Interest-bearing notes carry a stated rate of interest.

-- Noninterest-bearing notes reflect an effective rate of interest or a yield.

Short-Term Notes PayableShort-Term Notes Payable Short-Term Notes PayableShort-Term Notes Payable

The rate of interest is specified and is called the stated rate.

The debtor (or borrower) receives cash, other assets, or services.

The debtor repays the face amount of the note plus interest at the stated rate.

Short-Term Notes PayableShort-Term Notes PayableInterest-BearingInterest-Bearing

Short-Term Notes PayableShort-Term Notes PayableInterest-BearingInterest-Bearing

On September 1, Eagle Boats borrows $80,000 from Cooke Bank. The note is due in 180 days and has a stated interest rate of 9%.

Record the borrowing on September 1.

Interest-Bearing NotesInterest-Bearing NotesExampleExample


How much interest is due to Cooke Bank at year-end, on December 31?

a. $2,400

b. $3,600

c. $7,200

d. $87,200



How much interest is due to Cooke Bank at year-end, on December 31?

a. $2,400

b. $3,600

c. $7,200

d. $87,200

Interest is calculated as:Principal Stated Portion

Amount Rate of of Year = of Note Interest Outstanding

$80,000 × 9% × 4/12 =

$2,400 interest due to Cooke Bank.

Interest is calculated as:Principal Stated Portion

Amount Rate of of Year = of Note Interest Outstanding

$80,000 × 9% × 4/12 =

$2,400 interest due to Cooke Bank.



Assume Eagle Boats’fiscal year-end is December 31.

Record the necessary adjustment at year-end.



Assume Eagle Boats’fiscal year-end is December 31.

Record the necessary journal entry when the note matures on February 28.



Notes without a stated interest rate carry an implicit, or effective, rate.

The face of the note includes the principal and the interest.

The borrower receives the difference between the face amount and the interest on the note.-- The cash received is the discounted present value

of the face of the note.

Short-Term Notes PayableShort-Term Notes PayableNoninterest-BearingNoninterest-Bearing

Short-Term Notes PayableShort-Term Notes PayableNoninterest-BearingNoninterest-Bearing

On May 1, 2007, Batter-Up, Inc. issued a one-year, noninterest-bearing note with a face amount of $10,000 in exchange for equipment valued at $9,434.

How much interest will Batter-Up pay on the note?

Noninterest-Bearing NotesNoninterest-Bearing NotesExampleExample



How much interest will Batter-Up pay on the note?

Interest = Face Amount - Amount Received

= $10,000 - $9,434

= $566




What is the implicit interest rate on the note?




What is the implicit interest rate on the note?

Present Value = Future value × PV Factor9,434.00$ = 10,000.00$ × PV Factor

0.9434 = PV Factor

From the Present Value table, we find that a PV factorof .9434 for 1 period represents an interest rate of 6%.



Scrip Dividends Payable

Accrued Liabilities

Advances and Returnable Deposits

Unearned Revenues

Short-Term LiabilitiesShort-Term Liabilities Short-Term LiabilitiesShort-Term Liabilities

Collected from customers on behalf of the state or local governments at the point of sale.

Requires a debit to cash and a credit to sales taxes payable.

Held in a liability account until time to make remittance to the taxing authority.

Requires a debit to sales taxes payable and a credit to cash.

Sales TaxesSales Taxes Sales TaxesSales Taxes

Selleroy Company sells merchandise for cash with a retail sales price of $50,000 on which a sales tax of 6% is levied. The company collects $53,000.

Selleroy Company sells merchandise for cash with a retail sales price of $50,000 on which a sales tax of 6% is levied. The company collects $53,000.

Cash 53,000 Sales

50,000 Sales Taxes Payable

3,000


At the end of January the Sales account is adjusted to record the tax on all goods sold [$169,000 - ($169,000 ÷ 1.06)] = $9,600.

At the end of January the Sales account is adjusted to record the tax on all goods sold [$169,000 - ($169,000 ÷ 1.06)] = $9,600.

Cash 169,000 Sales

169,000

If the sales tax is included in the price charged to the customer

If the sales tax is included in the price charged to the customer

Sales 9,600 Sales Taxes Payable

9,600


Withholdings from employee pay Employee’s portion of FICA

Employee Federal Income Tax Withholdings

Expenses deducted from income Employer portion of FICA

Federal Unemployment Tax (FUTA)

State Unemployment Tax (SUTA)

Payroll TaxesPayroll Taxes Payroll TaxesPayroll Taxes

Batter-Up, Inc. has 5 employees. Each employee receives a salary of $1,000 per week. The FICA rate is 7.65% and income tax is withheld at the rate of 20%.

Payroll Taxes - EmployeePayroll Taxes - EmployeeExamplecExamplec

Payroll Taxes - EmployeePayroll Taxes - EmployeeExamplecExamplec

Prepare the journal entry to record the payroll for Batter-Up for the week ending June 14, 2007.

GENERAL JOURNALPage: 15

Date Description PR Debit Credit

Payroll Taxes - EmployeePayroll Taxes - EmployeeExampleExample




14-Jun Salary Expense 5,000.00 FIT Withholding Payable 1,000.00 FICA Tax Payable 382.50 Cash 3,617.50 to record 6/14 payroll

Prepare the journal entry to record the payroll for Batter-Up for the week ending June 14, 2007.






Note: The expense to the company is $5,000

while the actual payment to the employees is

$3,617.50.






Note: The employer transfers the tax amounts

to the government on the employees’behalf.



Batter-Up, Inc. has also incurred FUTA of $50 and SUTA of $200.

Prepare Batter-Up’s journal entry for all of their taxes related to the June 16 payroll.

Payroll Taxes - EmployerPayroll Taxes - EmployerExampleExample




14-Jun Payroll Tax Expense 632.50 FUTA Payable 50.00 SUTA Payable 200.00 FICA Payable, employer 382.50 to record payroll taxes for6/14 payroll





14-Jun Payroll Tax Expense 632.50 FUTA Payable 50.00 SUTA Payable 200.00 FICA Payable, employer 382.50 to record payroll taxes for6/14 payroll

Note: The employer matchesmatches the FICA that was withheld

from the employees’paychecks. In effect, the total FICA

tax rate is 15.3%; half is paid by the employee (7.65%) and

half is paid by the employer (7.65%).

Note: The employer matchesmatches the FICA that was withheld

from the employees’paychecks. In effect, the total FICA

tax rate is 15.3%; half is paid by the employee (7.65%) and

half is paid by the employer (7.65%).



Ezzell Company closes its books annually each

December 31. The fiscal year for the town and county

in which the firm is located ends on June 30. The

estimated property taxes for the period July 1, 2007, to

June 30, 2008, are $7,200. The tax bill is mailed in

October with a requirement that the tax be paid before

December 31, 2007. The tax bill reported an actual tax

of $7,290, and the corporation pays this amount on

October 31, 2007.

Ezzell Company closes its books annually each

December 31. The fiscal year for the town and county

in which the firm is located ends on June 30. The

estimated property taxes for the period July 1, 2007, to

June 30, 2008, are $7,200. The tax bill is mailed in

October with a requirement that the tax be paid before

December 31, 2007. The tax bill reported an actual tax

of $7,290, and the corporation pays this amount on

October 31, 2007.

Property TaxesProperty Taxes Property TaxesProperty Taxes

Three Monthly Entries July 31-September 30, 2007

Property Tax Expense 600Property Taxes Payable 600

October 31, 2007: Payment of Property Taxes

Property Tax Payable 1,800Prepaid Property Taxes 5,490

Cash 7,290

Three Monthly Entries: October 31-Dec. 31, 2007

Property Tax Expense 610Prepaid Property Taxes 610

$7,200 ÷ 12

Property TaxesProperty Taxes Property TaxesProperty Taxes

Percentage of net income before the bonus-- Multiply the net income before the bonus by the

bonus percentage. Percentage of net income after the bonus

-- Algebraically expressed:

Bonus = % × (Net Income - Bonus)

Bonuses Based on IncomeBonuses Based on Income Bonuses Based on IncomeBonuses Based on Income

Linda Ball, Batter-Up’s CEO, Inc. gets a year-end bonus of 15% of net income after deducting her bonus. 2007 Net income is $250,000.

Compute Linda’s bonus for 2007.

BonusBonusExampleExample BonusBonus

ExampleExample

Linda Ball, Batter-Up’s CEO, Inc. gets a year-end bonus of 15% of net income after deducting her bonus. 2007 Net income is $250,000.

Compute Linda’s bonus for 2007.

Bonus = Bonus % × ( Net Income - Bonus ) = 15% × ( 250,000$ - Bonus ) = 37,500$ - ( .15Bonus )

1.15Bonus = 37,500$ Bonus = 37,500$ ÷ 1.15Bonus = 32,608.70$

BonusBonusExampleExample BonusBonus

ExampleExample

Occurs when unused vacation time is carried over to future years.

An expense/liability must be accrued if four criteria are met:

Absence relates to services already performed.

Benefits accumulate, or vest.

Payment is probable.

Amount can be reliably estimated.

Compensated-Absence LiabilityCompensated-Absence Liability Compensated-Absence LiabilityCompensated-Absence Liability

A vested right exists when an employer has an obligation to make payments to an employee that is not contingent on the employee’s future

services.

A vested right exists when an employer has an obligation to make payments to an employee that is not contingent on the employee’s future

services.


Accumulated rights are those that can be carried forward by the employee to future periods if not taken in the

period in which they are earned.

Accumulated rights are those that can be carried forward by the employee to future periods if not taken in the

period in which they are earned.


Milton Company has 100 employees who are paid an average

of $200 per day. Company policy allows each employee 12

days of paid vacation per year.

Milton Company has 100 employees who are paid an average

of $200 per day. Company policy allows each employee 12

days of paid vacation per year.

Sales Salaries Exp. Compensated Absences 30,000Office Salaries Exp. Compensated Absences 30,000 Liability for Employees’ Compensation for Future Absences (3/12 x $240,000) 60,000

March 31, 2008March 31, 2008March 31, 2008March 31, 2008


The $200,000 April 30, 2008, payroll, including paid vacation time taken by the sales and office staff, is as follows:

The $200,000 April 30, 2008, payroll, including paid vacation time taken by the sales and office staff, is as follows:

Payroll for

Time Worked Vacation Taken

Sales staff $194,000 $6,000Office staff 193,000 7,000

ContinuedContinuedContinuedContinued


Sales Salaries Expense 194,000Office Salaries Expense 193,000Liability for Employees’ Compen- sation for Future Absences 13,000

Cash 400,000

April 30, 2008April 30, 2008April 30, 2008April 30, 2008


The portion of long-term debt maturing within the next fiscal year is reported as a current liabilit

Long-term debts should not be reported as current

liabilities if:

1. they are retired by assets not classified as

current assets

2. they are refinanced by new issues of debt

3. they are converted into capital stock.

Current Maturities of Long-Term DebtCurrent Maturities of Long-Term Debt Current Maturities of Long-Term DebtCurrent Maturities of Long-Term Debt

Obligations that are payable on demand or that will become payable on demand within the next operating cycle.

Long-term obligations that are callable by the creditor due to a violation of underlying terms.

Obligations That Are Callable by the CreditorObligations That Are Callable by the Creditor Obligations That Are Callable by the CreditorObligations That Are Callable by the Creditor

A current liability may be reclassified to a noncurrent status to improve the company’s working capital position.

Generally, this is allowed if the short-term liability is expected to be refinanced long-term.

Short-Term Obligations Expected to Be Short-Term Obligations Expected to Be RefinancedRefinanced

Short-Term Obligations Expected to Be Short-Term Obligations Expected to Be RefinancedRefinanced

The expected refinancing is evidenced by actual refinancing before the statement issue date. OR

The expected refinancing is evidenced by good faith entrance into a long-term, noncancelable refinancing agreement with a viable lender.

Criteria for Reclassifying Short-Term Criteria for Reclassifying Short-Term LiabilitiesLiabilities

Criteria for Reclassifying Short-Term Criteria for Reclassifying Short-Term LiabilitiesLiabilities

SFAS No. 6 requires:

1. The agreement must be noncancelable by all parties and must extend beyond one year.

2. The company must not be in violation of the agreement on the balance sheet or the issue date.

3. The lender must be financially capable of honoring the agreement.

Refinancing Agreement CriteriaRefinancing Agreement Criteria Refinancing Agreement CriteriaRefinancing Agreement Criteria

“An existing condition, situation, or set of circumstances involving uncertainty as to possible gain or a loss to an enterprise that ultimately will be resolved when one or more future events occur or fail to occur.”

SFAS No. 5

ContingenciesContingencies ContingenciesContingencies

CONDITIONS: Probable

The future event is likely to occur. Reasonably Possible

The chance of occurrence of the future event is more

than remote, but less than likely. Remote

The chance of occurrence of the future event is

slight.

ContingenciesContingencies ContingenciesContingencies

The Contingent Amount Can Be Amount Cannot BeEvent Is: Reasonably Estimated Reasonably Estimated

Accrue a loss and a Do not accrue. Report asProbable liability, and report in the a note in the financial

body of the statements. statements.Reasonably Do not accrue. Report as Do not accrue. Report as

Possible a note in the financial a note in the financialstatements. statements.

No accrual or note is No accrual or note isRemote required. A note required. A note

is permitted. is permitted.

Loss ContingenciesLoss ContingenciesAccounting TreatmentsAccounting Treatments Loss ContingenciesLoss Contingencies

Accounting TreatmentsAccounting Treatments

• A warranty is a promise (future cost) made by a seller to a

buyer to make good on a deficiency.

• Under the cash basis method, warranty costs are charged

to the period in which the costs are paid.

• Under the accrual basis method:

1. warranty costs (for warranties sold with the product) are

estimated and matched with revenue.

2. extended warranty revenues are deferred and

recognized over the life of the warranty contract.

Warranty ObligationsWarranty Obligations Warranty ObligationsWarranty Obligations

Cash or Accounts Receivable 1,200,000Sales 1,200,000

Warranty cost per machine is estimated at $150.Warranty cost per machine is estimated at $150.

Warranty Expense 30,000Estimated Liability under Warranties 30,000

Expense Warranty Accrual MethodExpense Warranty Accrual MethodExpense Warranty Accrual MethodExpense Warranty Accrual Method

Anglee Machinery Corporation begins production on a new machine in April 2007 and sells 200 of these machines at $6,000 each by December 31, 2007.

Anglee Machinery Corporation begins production on a new machine in April 2007 and sells 200 of these machines at $6,000 each by December 31, 2007.


The corporation spent $5,000 in 2007 to fulfill warranty agreements for the 200 machines.


Estimated Liability under Warranties 5,000Cash (or other assets) 5,000



Estimated Liability under Warranties 25,000Warranty Expense 150

Cash (or other assets) 25,150


Anglee Machinery Corporation sells 200 machines for $6,000. This amount includes a service contract sale of $150 and a machine sale of $5,850.

Anglee Machinery Corporation sells 200 machines for $6,000. This amount includes a service contract sale of $150 and a machine sale of $5,850.

Cash or Accounts Receivable 1,200,000Sales ($5,850 x 200) 1,170,000Unearned Warranty Revenue 30,000

Sales Warranty Accrual MethodSales Warranty Accrual MethodSales Warranty Accrual MethodSales Warranty Accrual Method



Recognition of warranty expense for period, April-December, 2007.

Recognition of warranty expense for period, April-December, 2007.

Warranty Expense 5,000Cash (or other assets) 5,000

Recognition of warranty revenue for period, April-December, 2007.

Recognition of warranty revenue for period, April-December, 2007.

Unearned Warranty Revenue 5,000Warranty Revenue 5,000



Recognition of warranty expense during 2008.Recognition of warranty expense during 2008.

Warranty Expense 25,150Cash (or other assets) 25,150

Recognition of warranty revenue during 2008.Recognition of warranty revenue during 2008.

Unearned Warranty Revenue 25,000Warranty Revenue 25,000


On October 1, 2007, the American Meatball Corporation

began offering to customers a serving disk in return for 30

meatball can labels. The offer expires on April 1, 2008.

The cost of each premium serving disk is $2. It is estimated

that 60% of the labels will be redeemed.

Premium and Coupon ObligationsPremium and Coupon Obligations Premium and Coupon ObligationsPremium and Coupon Obligations

Purchased 12,000 serving dishes at $2 each.

Inventory of Premium Serving Dishes 24,000

Cash (or Accounts Payable) 24,000

Sold 300,000 cans of meatball at $1.80 each...

Cash (or Accounts Receivable) 540,000

Sales 540,000



Received 105,000 labels from customers:.

Premium Expense 7,000

Inventory of Premium Serving Dishes 7,000

Estimated that 75,000 labels will be submitted next year:

Premium Expense 5,000

Estimated Premium Claims Outstanding 5,000

Estimated labels that will be redeemed (300,000 x .60)Estimated labels that will be redeemed (300,000 x .60) 180,000180,000Deduct labels redeemed during 2007Deduct labels redeemed during 2007 (105,000(105,000))Estimated number of future label redemptionsEstimated number of future label redemptions 75,00075,000

Premium expense for estimated future redemptions:Premium expense for estimated future redemptions:

(75,000 ÷ 30) x $2(75,000 ÷ 30) x $2 $5,000$5,000

Premium expense for estimated future redemptions:Premium expense for estimated future redemptions:

(75,000 ÷ 30) x $2(75,000 ÷ 30) x $2 $5,000$5,000

(105,000 ÷ 30)(105,000 ÷ 30) x $2x $2


To determine whether a liability should be recorded,

evaluate:

1. The time period in which the underlying cause of action occurred

2. The probability of an unfavorable outcome

3. The ability to make a reasonable estimate of loss

Litigation, Claims and AssessmentsLitigation, Claims and Assessments Litigation, Claims and AssessmentsLitigation, Claims and Assessments

You said that I will owe you

$1,000,000 if I miss the next

putt.

So does that mean I have to

disclose a contingent loss

on my personal financial

statement?

Obligations that extend beyond one year or the operating cycle, whichever is longer

Long-term LiabilitiesLong-term Liabilities Long-term LiabilitiesLong-term Liabilities

1. Debt financing may be the only available

source of funds.

2. Debt financing may have a lower cost.

3. Debt financing offers the opportunity for

leverage.

4. Debt financing offers an income tax advantage.

5. The voting privilege is not shared.

Reasons for Issuance of Long-Term LiabilitiesReasons for Issuance of Long-Term Liabilities Reasons for Issuance of Long-Term LiabilitiesReasons for Issuance of Long-Term Liabilities

Record long-term liabilities at the fair value of the goods or services received.

Interest expense is based on the market interest rate on the date of the debt issuance and the beginning balance of the liability.

Book value is the present value of all future cash payments, discounted at the market interest rate at issuance.

Long-term LiabilitiesLong-term LiabilitiesMeasurement and ValuationMeasurement and Valuation

Long-term LiabilitiesLong-term LiabilitiesMeasurement and ValuationMeasurement and Valuation

Company Issuing Bonds

Investor Buying Bonds

Bond Selling Price

Bond Certificate

At Bond Issuance Date

Bonds PayableBonds PayableCash FlowCash Flow


Company Issuing Bonds

Investor Buying Bonds

Face Value Payment at End of Bond Term

Interest Payments Over Bond Term



Issuing Entity

Collateral

Purpose of Issue

Payment of Interest

Maturity

Bonds PayableBonds PayableClassificationClassification


Issuing EntityIndustrial Bonds

Municipal Bonds

CollateralSecured Bonds

－ Mortgage Bonds

－ Guaranteed Bonds

Debenture Bonds



Purpose of InterestPurchase Money Bonds

Refunding Bonds

Consolidated Bonds

Payment of InterestOrdinary Bonds

Income Bonds

Registered Bonds

Bearer Bonds



MaturityTerms Bonds

Serial Bonds

Callable Bonds

Redeemable Bonds

Convertible Bonds



BOND PAYABLE

Face Value $1,000 Interest 10%

6/30 & 12/31

Maturity Date 1/1/X5Bond Date 1/1/X0

1. Face Value = Maturity or Par Value2. Maturity Date3. Stated Interest Rate 4. Interest Payment Dates5. Bond Date

Bonds PayableBonds Payable Bonds PayableBonds Payable

BOND PAYABLE

Face Value $1,000 Interest 10%

6/30 & 12/31

Maturity Date 1/1/X5Bond Date 1/1/X0

1. Face Value = Maturity or Par Value2. Maturity Date3. Stated Interest Rate 4. Interest Payment Dates5. Bond Date

Other Factors:6. Market Interest Rate7. Issue Date

Bonds PayableBonds Payable Bonds PayableBonds Payable

Market rate = stated rateBonds sell at face or par value.

Market rate > stated rateBonds sell at a discount (below face value).

Market rate < stated rateBonds sell at a premium (above face value).

Bonds PricesBonds Prices Bonds PricesBonds Prices

On 12/31/X0 Graphics Inc. issues 10 bonds at face value. The market interest rate is 10%. The bonds have the following terms:

Face Value = $1,000

Maturity Date = 12/31/X5 (5 years)

Stated Interest Rate = 10%

Interest Dates = 6/30 & 12/31

Bond Date = 12/31/X0

Bonds Issued at Face Value on Bond DateBonds Issued at Face Value on Bond Date Bonds Issued at Face Value on Bond DateBonds Issued at Face Value on Bond Date

Prepare the journal entry to record the issuance of the bonds on 12/31/X0.


Prepare the journal entry to record the issuance of the bonds on 12/31/X0.

Long-term Liability


Prepare the journal entry required every 6/30 and 12/31 to pay interest.


Prepare the journal entry to record the maturity of the bond on 12/31/X5.


What happens when the market interest rates are different from the bond’s stated interest rate?

For example, the market is earning 8%. Would you want to invest in Graphics Inc.’s 10% bond?

Bonds Issued Above Face Value on Bond DateBonds Issued Above Face Value on Bond Date Bonds Issued Above Face Value on Bond DateBonds Issued Above Face Value on Bond Date



YES!


If the bond is paying 10% interest and the market is

paying 8% interest, Graphics Inc. would:

Sell the bond above face value--at a premium

BUT

Pay interest on only the face value

AND

Repay only the face value at maturity.


This arrangement will decrease the effective interest rate of Graphics Inc. bonds to the market rate.


On 12/31/X0 Graphics Inc. sells 1,000 bonds at 108.1105. The market interest rate is 8%. The bonds have the following terms:

Face Value = $1,000






How much cash is Graphics Inc. going to receive for the entire bond issue?



$1,000 face value ×1,000 sold = $1,000,000

$1,000,000 × 108.1105% = $1,081,105 cash


Graphics Inc. agrees to repay the full face value at maturity.

$1,000 face value × 1,000 sold = $1,000,000


The difference between the face value of the bonds and the cash received is the premium.

$1,081,105 - $1,000,000 = $81,105

The premium is a reduction in the interest factor for Graphics Inc. The premium will be amortized to Interest Expense.


Prepare the journal entry to record the issue of the bonds on 12/31/X0.



Adjunct-LiabilityAccount


Book Value

Partial Balance Sheet at 12/31/X0

Long-term Liabilities: Bonds Payable 1,000,000$ Add: Premium on Bonds Payable 81,105 1,081,105$

Maturity Value


Prepare the journal entries required every 6/30 and 12/31. Use straight-line amortization of the premium.

(The interest method will be discussed later in the lecture.)


In addition to the interest payment entry, we also need to amortize the premium to

Interest Expense.


Premium on Bonds Payable

81,105

8,111

72,994

As the premium account is amortized, the book value of the bonds payable decreases toward the maturity value.


Book Value


Long-term Liabilities: Bonds Payable 1,000,000$ Add: Premium on Bonds Payable 72,994 1,072,994$

Maturity Value


Now, let’s calculate how Graphics, Inc.

determined the selling price of the

bond.


Face Value 1,000,000$ Stated Interest Rate 10%Number of Periods (5 yrs. × 2) 10

Market Interest Rate 8%

Present Value of Bond on Issuance Date Principal 1,000,000$ PV $1, 10 periods, 4% .67556 PV of Principal 675,560$

Interest Payments 50,000$ PVA $1, 10 periods, 4% 8.11090 PV of Interest Payments 405,545

Selling Price of Bond 1,081,105$



Present Value of Bond on Issuance Date Principal 1,000,000$ PV $1, 10 periods, 4% .67556 PV of Principal 675,560$

Interest Payments 50,000$ PVA $1, 10 periods, 4% 8.11090 PV of Interest Payments 405,545

Selling Price of Bond 1,081,105$


Interest Expense for each period is calculated as follows:

Book Value of Bond at Beginning of Period

×Market Interest Rate at Date of Bond Issuance

Interest Expense The amortization for the discount or premium is

calculated as follows:

Cash Payment for Interest

- Interest Expense

Amortization Amount

Interest MethodInterest Method Interest MethodInterest Method

Interest MethodInterest Method Amortization TableAmortization Table


*

* Rounded





Bonds Issued Below Face Value on Bond DateBonds Issued Below Face Value on Bond Date Bonds Issued Below Face Value on Bond DateBonds Issued Below Face Value on Bond Date



NO!


If the bond is paying 10% interest and the market is paying 12% interest, Graphics Inc. would:

Sell the bond below face value--at a discount

BUT

Pay interest on the full face value

AND

Repay the full face value at maturity.


This arrangement will increase the effective interest rate of Graphics Inc. bonds to the market rate.


On 12/31/X0 Graphics Inc. sells 1,000 bonds at 92.6395. The market interest rate is 12%. The bonds have the following terms:

Face Value = $1,000







$1,000 face value × 1,000 sold = $1,000,000

$1,000,000 × 92.6395% = $926,395 cash


Graphics Inc. agrees to repay the full face value at maturity.

$1,000 face value × 1,000 sold = $1,000,000


The difference between the face value of the bonds and the cash received is the discount.

$1,000,000 - $926,395 = $73,605

The discount is an additional interest factor for Graphics Inc. The discount will be amortized to Interest Expense.



GENERAL JOURNAL Page 77

Date DescriptionPost. Ref. Debit Credit





Dec 31 Cash 926,395

Discount on Bonds Payable 73,605

Bonds Payable 1,000,000

To record bond issue at discount

Contra-LiabilityAccount


Book Value


Long-term Liabilities: Bonds Payable 1,000,000$ Less: Discount on Bonds Payable 73,605 926,395$

Maturity Value


Prepare the journal entries required every 6/30 and 12/31. Use straight-line amortization of the discount.

(The interest method will be discussed later in the lecture.)


In addition to the interest payment entry, we also need to amortize the discount to

Interest Expense.


Discount on Bonds Payable

73,605

7,360

66,245

As the discount account is amortized, the book value of

the bonds payable increases toward the maturity value.


Book Value


Long-term Liabilities: Bonds Payable 1,000,000$ Less: Discount on Bonds Payable 66,245 933,755$

Maturity Value


Calculate how Graphics, Inc.

determined the selling price of the

bond.




Present Value of Bond on Issuance Date Principal 1,000,000$ PV $1, 10 periods, 6% .55839 PV of Principal 558,390.00$

Interest Payments 50,000$ PVA $1, 10 periods, 6% 7.36009 PV of Interest Payments 368,004.50 Selling Price of Bond 926,394.50$



Present Value of Bond on Issuance Date Principal 1,000,000$ PV $1, 10 periods, 6% .55839 PV of Principal 558,390.00$

Interest Payments 50,000$ PVA $1, 10 periods, 6% 7.36009 PV of Interest Payments 368,004.50 Selling Price of Bond 926,394.50$


*

* Rounded



On 1/1/X1 Graphics Inc. issued $1,000,000, 10%, 5-year bonds at a discount of 92.6395. The bonds pay interest semiannually. The market interest rate was 12%. Using the effective interest method, what would be the interest expense for the first 6 months?

a. $60,000.00

b. $55,583.70

c. $73,605.00

d. $46,319.75

Interest MethodInterest Method QuestionQuestion


On 1/1/X1 Graphics Inc. issued $1,000,000, 10%, 5-year bonds at a discount of 92.6395. The bonds pay interest semiannually. The market interest rate was 12%. Using the effective interest method, what would be the interest expense for the first 6 months?

a. $60,000.00

b. $55,583.70

c. $73,605.00

d. $46,319.75

Face Value 1,000,000.00$ Discount 92.6395%

Book Value 926,395.00 Market Rate (12% × 2) 6%

6 Month Expense 55,583.70$



Using the effective interest method, determine the amortization for the discount for the first 6 months?

a. $5,583.70

b. $55,583.70

c. $50,000.00

d. $9,664.99



Using the effective interest method, determine the amortization for the discount for the first 6 months?

a. $5,583.70

b. $55,583.70

c. $50,000.00

d. $9,664.99

Interest Expense $55,583.70

Cash Payment - 50,000.00

Discount Amortized $ 5,583.70



Legal

Accounting

Underwriting

Commission

Engraving

Printing

Registration

Promotion

Bond Issue CostsBond Issue Costs Bond Issue CostsBond Issue Costs

On January 1, 2007, Bergen Company issues 10-year bonds

with a face value of $500,000 at 104. Expenditures connected

with the issue totaled $8,000.

On January 1, 2007, Bergen Company issues 10-year bonds

with a face value of $500,000 at 104. Expenditures connected

with the issue totaled $8,000.

Cash ($520,000 - $8,000) 512,000

Deferred Bond Issue Costs 8,000

Bonds Payable 500,000

Premium on Bonds Payable 20,000

0.04 0.04 x $500,000x $500,000


Each year for the ten years Deferred Bond Issue Costs is amortized on a straight-line

basis by charging Bond Interest Expense for $800.

Each year for the ten years Deferred Bond Issue Costs is amortized on a straight-line

basis by charging Bond Interest Expense for $800.

However, the FASB is planning to change GAAP, so that all debt issue costs are expensed as incurred.

However, the FASB is planning to change GAAP, so that all debt issue costs are expensed as incurred.


In the previous examples, the bonds were sold on the bond date.

But this is not always the case.

Are you ready to see what happens when we sell bonds between the bond’s interest dates?

When bonds are sold between the interest dates, the bond issuer collects cash for:

The cash (or selling) price of the bonds

AND

The accrued interest since the last interest payment date.

Bonds Issued Between Interest DatesBonds Issued Between Interest Dates Bonds Issued Between Interest DatesBonds Issued Between Interest Dates

The 6 month interest payment to the bondholders is composed of:

Repayment of the accrued interest received from the bondholders when the bonds were originally sold

AND

Interest earned by the bondholders since the bonds were purchased.


On 4/1/X1 Graphics Inc. issues 1,000 bonds at face value. The market interest rate was 12%. The bonds have the following terms:

Face Value = $1,000




Bond Date = 1/1/X1


Selling Price of BondsPV of Bonds at 1/1/X1 Principal (PV of $1, 10, 6%) 558,390$ Interest (PVA of $1, 10, 6%) 368,005

Total PV 926,395 Growth in PV 1/1/X1-4/1/X1 ($926,395 ×12% ×3/12) 27,792 Accrued Interest ($1,000,000 ×10% ×3/12) (25,000)

Selling Price of Bond 929,187

Selling Price of BondsPV of Bonds at 1/1/X1 Principal (PV of $1, 10, 6%) 558,390$ Interest (PVA of $1, 10, 6%) 368,005

Total PV 926,395 Growth in PV 1/1/X1-4/1/X1 ($926,395 ×12% ×3/12) 27,792 Accrued Interest ($1,000,000 ×10% ×3/12) (25,000)

Selling Price of Bond 929,187


Cash Price of Bonds

Accrued Interest

How much cash is Graphics Inc. going to receive for the entire issue of the bonds?


How much cash is Graphics Inc. going to receive for the entire issue of the bonds?

Cash Price of Bonds 929,187$

Accrued Interest$1,000,000 ×10% ×3/12 = 25,000

Total Cash Received 954,187$


What does the $25,000 in accrued interest represent for Graphics Inc.?


What does the $25,000 in accrued interest represent for Graphics Inc.?

Interest

Payable


Prepare the journal entry to record the bond issue on 4/1/X1.




Prepare the journal entry to record the bond issue on 4/1/X1.



Apr 1 Cash 954,187


Interest Payable 25,000

Bonds Payable 1,000,000

To record issue of bonds


Prepare the journal entry to record the bond interest payment on 6/30/X1. Use the straight-line method for amortization.






Date DescriptionPost.Ref. Debit Credit

Jun 30 Interest Expense 28,726



Cash 50,000

To record bond interest payment

$70,814 ÷ 57 months = $1,242

$1,242 × 3 months = $3,726





Jun 30 Interest Expense 28,726



Cash 50,000

To record bond interest payment

$1,242 × 3 months = $3,726

The discount is amortized over the bond term of 4 years and 9 months

(57 months).


Provide investors with opportunity to become a shareholder and participate in stock appreciation in addition to the principal and interest payments.

-- Nonconvertible bonds with detachable stock

warrants

-- Convertible bonds

Debt Securities With Equity RightsDebt Securities With Equity Rights Debt Securities With Equity RightsDebt Securities With Equity Rights

Some bonds are issued with rights, warrants, to acquire capital stock.

Stock warrants provide the option to purchase a specified number of shares of common stock at a designated price per share within a stated period.

A portion of the selling price of the bonds is allocated to the detachable stock warrants.

Credit Additional Paid-in Capital-Detachable Stock Warrants

Bonds Issued with Detachable Stock WarrantsBonds Issued with Detachable Stock Warrants Bonds Issued with Detachable Stock WarrantsBonds Issued with Detachable Stock Warrants

Some bonds are issued with rights, warrants, to acquire capital stock. If the warrants are detachable, a portion of the proceeds from selling the bonds must be allocated to the warrants.

Proportional method

Incremental method

Some bonds are issued with rights, warrants, to acquire capital stock. If the warrants are detachable, a portion of the proceeds from selling the bonds must be allocated to the warrants.

Proportional method

Incremental method

Bonds with Equity CharacteristicsBonds with Equity Characteristics Bonds with Equity CharacteristicsBonds with Equity Characteristics

Amount Assigned to

Bonds=

Market Value of Bonds Without Warrants


+ Market Value of Warrants

Issuance Price

x

Amount Assigned to Warrants

=Market Value of Warrants



Issuance Price

x


Paul Company sold $800,000 of

12% bonds at 101 ($808,000).

Each bond carried 10 warrants,

and each warrant allows the holder

to acquire one share of $5 par

common stock for $25 per share.

The bonds are quoted at 99 ex

rights and the warrants at $3 each.

Paul Company sold $800,000 of

12% bonds at 101 ($808,000).

Each bond carried 10 warrants,

and each warrant allows the holder

to acquire one share of $5 par

common stock for $25 per share.

The bonds are quoted at 99 ex

rights and the warrants at $3 each.


Amount Assigned to

Bonds=




Issuance Price

x

Amount Assigned to

Bonds=

$990 per bond x 800 bonds

($990 x 800) + ($3 x 800 x 10)$808,000x

Amount Assigned to

Bonds= $784,235.29



=Market Value of Warrants



Issuance Price

x


=$3 x 10 warrants x 800 bonds

($990 x 800) + ($3 x 800 x 10)$808,000x


= $23,764.71


Cash 808,000.00Discount on Bonds Payable 15,764.71 Bonds Payable 800,000.00 Common Stock Warrants 23,764.71

From last slideFrom last slide

$800,000.00 - $784,235.29$800,000.00 - $784,235.29


Cash 12,500.00Common Stock Warrants 1,485.50 Common Stock 2,500.00 Additional Paid-in Capital on Common Stock 11,485.50

Later, 500 warrants are exercised at $25 each. Later, 500 warrants are exercised at $25 each.

($23,765.71 ÷ 8,000) ($23,765.71 ÷ 8,000) x 500x 500

Common Stock Warrants 22,279.21 Additional Paid-in Capital from Expired Warrants 22,279.21

The remaining warrants expire.The remaining warrants expire. $23,764.71 - $1,485.50$23,764.71 - $1,485.50


If only the detachable stock warrants have a readily determinable market value, the bonds are valued at the difference between the selling price and the market value of the warrants (incremental method).

Bonds with Detachable Stock WarrantsBonds with Detachable Stock Warrants Bonds with Detachable Stock WarrantsBonds with Detachable Stock Warrants

Bond is exchangeable for capital stock of Bond is exchangeable for capital stock of

the issuer at the the issuer at the option of the investor.option of the investor.

Convertible BondsConvertible Bonds Convertible BondsConvertible Bonds

Why issue convertible

bonds?

Why issue convertible

bonds?


1. Avoid the downward price pressures on its stock that placing a large new issue of common stock on the market would cause.

2. Avoid the direct sale of common stock when it believes its stock currently is undervalued in the market.

3. Penetrate that segment of the capital market that is unwilling or unable to participate in a direct common stock issue.

4. Minimize the costs associated with selling securities.


APB Opinion No. 14 specifies that convertible bonds be recorded as debt.

Accounting for interest expense and amortization of discount or premium is not affected by convertibility.


When the bonds are converted, the issuer updates interest expense and amortization of discount or premium to the date of conversion.


Book value method Record new stock at the book value of the

convertible bonds. Recognize neither gain nor loss.

Market value method Record new stock at the market value of stock

or debt. Recognize gain or loss (Mkt. Value - Book Value)


Shannon Corporation has outstanding convertible bonds with a face value of $10,000 and a book value of $10,500. Each bond is convertible into 40 shares of $20 par common stock. The market price is $26.50 per share when the shares are converted.

Shannon Corporation has outstanding convertible bonds with a face value of $10,000 and a book value of $10,500. Each bond is convertible into 40 shares of $20 par common stock. The market price is $26.50 per share when the shares are converted.


Book Value Method- The market price is not considered.Bonds Payable 10,000Premium on Bonds Payable 500

Common Stock 8,000Additional-Paid-in Capital-plug 2,500

Book Value Method- The market price is not considered.Bonds Payable 10,000Premium on Bonds Payable 500

Common Stock 8,000Additional-Paid-in Capital-plug 2,500

Market Value Method-Equity accounts equal market price.Bonds Payable 10,000Premium on Bonds Payable 500Loss on Conversion 100

Common Stock 8,000Additional-Paid-in Capital 2,600

Market Value Method-Equity accounts equal market price.Bonds Payable 10,000Premium on Bonds Payable 500Loss on Conversion 100

Common Stock 8,000Additional-Paid-in Capital 2,600


A company that has convertible bonds may desire bondholders to convert the bonds to common stock.

A company that has convertible bonds may desire bondholders to convert the bonds to common stock.

To induce conversion, the company may add a “sweetener” to the convertible bond.

To induce conversion, the company may add a “sweetener” to the convertible bond.

The debtor recognizes an expense equal to the fair value

of the “sweetener” and is measured on the date the offer is accepted by the

bondholders.

The debtor recognizes an expense equal to the fair value

of the “sweetener” and is measured on the date the offer is accepted by the

bondholders.

Induced ConversionsInduced Conversions Induced ConversionsInduced Conversions

Assume that Harmon Company had $10,000 of outstanding

convertible bonds, which had been issued at par. The original

terms of issuance allowed each bond to be converted into 40

shares of no-par common stock. To induce conversion, the

terms were changed to offer 50 shares per bond. All shares

were converted when the market price was $30 per share.


Bond Conversion Expense 3,000

Common Stock, no par 13,000

Induced ConversionsInduced Conversions Induced ConversionsInduced Conversions

A liability is extinguished if one of the following criteria is met:

Debtor pays the creditor and is

relieved its obligation. Debtor is legally

released from being the primary obligor under the liability,

either judicially or by the creditor.

OR

Debt ExtinguishmentDebt Extinguishment SFAS No. 140SFAS No. 140

Debt ExtinguishmentDebt Extinguishment SFAS No. 140SFAS No. 140

Whether bonds are recalled, retired, or refunded prior to maturity, any gain or loss is reported as a component of

income from continuing operations in the current period.

Whether bonds are recalled, retired, or refunded prior to maturity, any gain or loss is reported as a component of

income from continuing operations in the current period.

Debt ExtinguishmentDebt Extinguishment Debt ExtinguishmentDebt Extinguishment

Update interest expense, amortization, and related issue costs to retirement date.

Remove liability accounts.

Record the transfer of cash, other resources, or debt securities.

Accounting for Debt ExtinguishmentAccounting for Debt Extinguishment Accounting for Debt ExtinguishmentAccounting for Debt Extinguishment

Channing Corporation originally issued $100,000 of 12%

bonds at 97 on January 1, 2002. The bonds have a 10-year

life, pay interest on January 1 and July 1, and are callable at

105 plus accrued interest. The company amortizes the

discount by the straight-line method.

Channing Corporation originally issued $100,000 of 12%

bonds at 97 on January 1, 2002. The bonds have a 10-year

life, pay interest on January 1 and July 1, and are callable at

105 plus accrued interest. The company amortizes the

discount by the straight-line method.


On June 30, 2007, the company recalls the bonds.On June 30, 2007, the company recalls the bonds.

Bonds Retired Prior to MaturityBonds Retired Prior to Maturity Bonds Retired Prior to MaturityBonds Retired Prior to Maturity

Interest Expense 6,150

Discount on Bonds Payable 150


First, Channing records the current interest expense and

liability, including the amortization of the discount that

expired since the last interest payment.

First, Channing records the current interest expense and

liability, including the amortization of the discount that

expired since the last interest payment.

($3,000 ÷ 10) ($3,000 ÷ 10) x 1/2x 1/2

$100,000 $100,000 x 0.12 x 1/2x 0.12 x 1/2




Loss on Bond Redemption 6,350


Cash 111,000

Channing then records the reacquisition of the bonds at

105 plus accrued interest of $6,000.

Channing then records the reacquisition of the bonds at

105 plus accrued interest of $6,000.

Original discountOriginal discount $ 3,000 $ 3,000 Less: AmortizationLess: Amortization for 5 1/2 yearsfor 5 1/2 years ((1,650)1,650)Unamortized discountUnamortized discount $1,350 $1,350


Present value techniques are used for valuation and interest recognition.

The procedures are similar to those we encountered with bonds.

Long-Term NotesLong-Term Notes Long-Term NotesLong-Term Notes

On January 1 of the current year, Johnson Company issues

a 3-year, non-interest-bearing note with a face value of

$8,000 and receives $5,694.24 in exchange.

On January 1 of the current year, Johnson Company issues

a 3-year, non-interest-bearing note with a face value of

$8,000 and receives $5,694.24 in exchange.

Cash 5,694.24

Discount on Notes Payable 2,305.76

Notes Payable 8,000.00

Contra account Contra account to Notes Payableto Notes Payable

Contra account Contra account to Notes Payableto Notes Payable

Notes Payable Issued for CashNotes Payable Issued for Cash Notes Payable Issued for CashNotes Payable Issued for Cash

Johnson Company records the interest expense on

the note for the first year.

Johnson Company records the interest expense on

the note for the first year.

Interest Expense 683.31

Discount on Notes Payable 683.31

Notes payable $8,000.00 Less: Unamortized discount (2,305.76)Carrying value at beginning of year $5,694.24 x Effective interest rate 0.12 Entry amount $ 683.31

Notes Payable Issued for CashNotes Payable Issued for Cash Notes Payable Issued for CashNotes Payable Issued for Cash

Verna Company borrows $100,000 by issuing a 3-year, non-

interest-bearing note to a customer. In addition, Verna

Company agrees to sell inventory to the customer at a

reduced price over a 5-year period. The firm’s incremental

borrowing rate is 12%.

Verna Company borrows $100,000 by issuing a 3-year, non-

interest-bearing note to a customer. In addition, Verna

Company agrees to sell inventory to the customer at a

reduced price over a 5-year period. The firm’s incremental

borrowing rate is 12%.

Cash 100,000.00



Unearned Revenue 28,822.00

$100,000- ($100,000 $100,000- ($100,000 x 0.711789)x 0.711789)$100,000- ($100,000 $100,000- ($100,000 x 0.711789)x 0.711789)

Notes Payable Issued for Cash or Rights and Notes Payable Issued for Cash or Rights and PrivilegesPrivileges


$71,178 $71,178 x 0.12x 0.12

Interest Expense 8,541.36 Discount on Notes Payable 8,541.36Unearned Revenue 5,764.40 Sales Revenue 5,764.40

End of First Year

$28,822 ÷ 5$28,822 ÷ 5Interest Expense 9,566.32 Discount on Notes Payable 9,566.32Unearned Revenue 5,764.40 Sales Revenue 5,764.40

End of Second Year

($71,178 + $8,541.36) ($71,178 + $8,541.36) x 0.12x 0.12



1. No interest is stated, or

2. The stated rate of interest is clearly unreasonable, or

3. The face value of the note is materially different from the cash sales price of the property, goods, or services, or the fair value of the note at the date of the transaction.

APB Opinion No. 21 states that the stipulated rate of

interest should be presumed fair. This presumption can be

overcome only if--

Notes Payable Exchanged for Property, Goods Notes Payable Exchanged for Property, Goods or Servicesor Services


A note payable is recorded at the fair value of the property, goods,

or services or the fair value of the note, whichever is more

reliable.

A note payable is recorded at the fair value of the property, goods,

or services or the fair value of the note, whichever is more

reliable.



On January 1, 2007, Marsden Company purchased used equipment from Joyce Company, issuing a 5 year, $10,000 non-interest-bearing note in exchange. Marsden’s incremental interest rate is 12%.

On January 1, 2007, Marsden Company purchased used equipment from Joyce Company, issuing a 5 year, $10,000 non-interest-bearing note in exchange. Marsden’s incremental interest rate is 12%.

Equipment 5,574.27



Present valuePresent value



Interest Expense 680.91 Discount on Notes Payable 680.91

December 31, 2007

($10,000 – $4,325.73) ($10,000 – $4,325.73) x 0.12x 0.12($10,000 – $4,325.73) ($10,000 – $4,325.73) x 0.12x 0.12

Interest Expense 762.62 Discount on Notes Payable 762.62

December 31, 2008

$10,000 – ($4,325.73 – $680.91) $10,000 – ($4,325.73 – $680.91) x 0.12x 0.12$10,000 – ($4,325.73 – $680.91) $10,000 – ($4,325.73 – $680.91) x 0.12x 0.12

Depreciation Expense 567.62 Accumulated Depreciation 567.43



On 1/1/X4 Dairy Farms Inc. issued a $100,000, 3-year, 6% note in exchange for equipment. Interest is paid every 12/31. The equipment does not have a ready market value. The appropriate rate of interest for notes of this type is 9%.

First, let’s determine the present value of the note and review the amortization table.

Long-Term NotesLong-Term NotesExampleExample


Present Value of Note Principal (PV $1, 3 periods, 9%) 77,218$ Interest ($6,000 year) (PVA $1, 3 periods, 9%) 15,188 PV of Note 92,406$

Present Value of Note Principal (PV $1, 3 periods, 9%) 77,218$ Interest ($6,000 year) (PVA $1, 3 periods, 9%) 15,188 PV of Note 92,406$



AMORTIZATION TABLE FOR NOTE PAYABLE

Interest Interest Discount Unamortized BookDate Payment Expense Amortization Discount Value1/1/X4 7,594$ 92,406$

12/31/X4 6,000$ 8,317$ 2,317$ 5,277 94,723 12/31/X5 6,000 8,525 2,525 2,752 97,248 12/31/X6 6,000 8,752 2,752 0 100,000

AMORTIZATION TABLE FOR NOTE PAYABLE

Interest Interest Discount Unamortized BookDate Payment Expense Amortization Discount Value1/1/X4 7,594$ 92,406$

12/31/X4 6,000$ 8,317$ 2,317$ 5,277 94,723 12/31/X5 6,000 8,525 2,525 2,752 97,248 12/31/X6 6,000 8,752 2,752 0 100,000





Jan 1 Equipment 92,406

Discount on Notes Payable 7,594

Notes Payable 100,000

To record purchase of equipment

Prepare the journal entry to record issuance of the note on January 1, X4.





Dec 31 Interest Expense 8,317

Discount on Notes Payable 2,317

Cash 6,000

To record interest payment

$92,406 ×9% = $8,317

$8,317 - $6,000 = $2,317

Prepare the journal entry for December 31, X4.





Dec 31 Notes Payable 100,000

Interest Expense 8,752

Notes PayableDiscount on Notes Payable 2,752

Cash 106,000

To record maturity of note

Prepare the journal entries for December 31, X6.



Unconditional purchase obligations

Exchangeable debenture

Interest rate swap

Off-Balance Sheet FinancingOff-Balance Sheet Financing Off-Balance Sheet FinancingOff-Balance Sheet Financing

Market value

Interest rates

Maturity dates

Debt restrictions

Call provisions

Conversion privileges

Collateral

Sinking-fund requirements for next 5 years

Long-Term LiabilitiesLong-Term LiabilitiesDisclosuresDisclosures

Long-Term LiabilitiesLong-Term LiabilitiesDisclosuresDisclosures

Chapter7

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Chapter 7

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