Financial Accounting Fifth Edition

Long-Term Liabilities

9
CHAPTER BUSF-SHU250
Jing Dai

5-1
Part A
TYPES OF LONG-TERM DEBT

9-2
 Which one would you choose to finance?

Capital structure: mixture of liabilities and

stockholders’ equity a business uses
• Cost of financing
q Debt: interest expense (tax-deductible)

q Equity: dividends (not tax-deductible)

• When do you have to resort to equity?

• Risk
• Examples of debt
q Notes, leases, and bonds

9-3
Concept Check 9–1
Which of the following statements is true?
a. Profits generated by a company are a source of
external financing.
b. Dividends paid are a tax-deductible expense.
c. Interest paid on debt is a tax-deductible expense.
d. All of the above are true.

9-4
 What is bond?

• Formal debt instrument that obligates the borrower to

repay a stated amount at a specified maturity date.
• The borrower also agrees to pay interest over the life of
the bond
• Traditionally, interest on bonds is paid twice a year
(semiannually) on designated interest dates, beginning
six months after the original bond issue date
• Most common form of corporate debt, issued by
medium and large-sized companies.
• Why popular ? It breaks large liability into many smaller
manageable parts ($1000 or $5000).
− $400 million from a single lender vs. 400,000 $1,000 bonds
 LO14-1
Terminology

Issuing Obligated to repay:

corporation
Principal, par value, A face amount at a
stated amount, or specified maturity date
maturity value +
Periodic interest for the
Stated rate, coupon
time between the issue
rate, or nominal rate
dated and maturity

14-06
Bond Basics

LO 4
Bond Basics

Issuing Procedures
u State laws grant corporations the power to issue bonds.
u Board of directors and stockholders must approve bond
issues.

u Board of directors must stipulate number of bonds to be

authorized, total face value, and contractual interest
rate.

u Bond terms set forth in legal document known as a bond

indenture.
u Bond certificate, typically a $1,000 face value.
LO 4
Bond Characteristics

Collateral What is the point of collateral?

What is the most common collateral
Restrictive covenants. Examples limited dividends, borrowing,
salary
Callable Bonds: Borrower can CALL (repay) whenever they want.
If interest rates drop, call the bonds and issue new bonds at the
new, lower interest rate.
Convertible Bonds: Lender can convert each bond into a specified
number of shares of common stock whenever they want.
9
Concept Check 9–4
Which of the following bonds always matures on a
single date?
a. A serial bond
b. A term bond
c. A secured bond
d. A convertible bond

9-10
 Bond transactions
v General transactions for normal bonds:
v (1) Company issue bonds to the public
(begin).
v (2) Company pay interest periodically
(during).
v (3) Company pay back/retire the bonds
(result).
• (3a) at maturity
• (3b) before maturity (early extinguishment)
• (3c) bond restructuring
Part B
Issuance- Pricing a Bond

9-12
 What is interest rate？
• The cost of using others’ capital for a period.
• How much is the cost? The return required by investors to
that they are willing to invest in your bonds/lend you the
money for a period)
• Determined by how risky the investors consider your
bonds. (debtholders care about risk, for example, default
risk)
• The riskier the bonds, the more return they required.
Stated interest rate vs. market interest rate
Ø Stated interest rate
• return offered by issuer: the return the issuer thinks the market wants to ask
for
• annual interest rate appeared on the bond contract
• reflects the future periodic interest payment to investors
• predetermined by issuing companies before issuing bonds
Ø Market interest rate
• return required by investors/market/bondholders: the actual interest
required by the market investors to invest in this or the similar bond.
• not contracted
• Determine the price of the bond
• usually influenced by the general market condition, the characteristics of the
bonds, the creditworthiness of issuing companies
Ø Stated interest rate = Market interest rate ?
• Often not. Why?
• The inevitable delay between the terms of the issue are established and the
date the issue comes to market.
Timeline of a Bond Issue
Issue $100,000 10 year bond at 7%, with interest payment semiannually on
June 30 and December 31 each year
Face amount : $100,000 we will pay in 10 years
Semiannual Stated Interest Rate (r): 3.5% (7%×1/2) we will pay
$3,500 (coupon payment $100,000×3.5%) every six months for 10
years
Semiannual Market Interest Rate (i): What the market will pay for
this cash flow? ->Determine the price of a bond
The number of periods to maturity (n): 20 (10*2)

Cash Flow

15
 Determining the Selling Price (continued)

Present value of the Present value of the

Bond
= principal payable at + periodic cash
price
maturity interest payments

Discounted at the market rate

Face amount × Stated rate

14-16
 Calculating the Issue Price of a
Bond
𝑃𝑟𝑖𝑐𝑒 = 𝑃𝑉 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 + 𝑃𝑉(𝐹𝑎𝑐𝑒 𝐴𝑚𝑜𝑢𝑛𝑡)
$
1 1
𝑃𝑟𝑖𝑐𝑒 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡× 7 + 𝐹𝑎𝑐𝑒 𝐴𝑚𝑜𝑢𝑛𝑡×
(1 + 𝑖)! (1 + 𝑖)!
!"#
𝑃𝑟𝑖𝑐𝑒 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡×𝑃𝑉𝐹1 + 𝐹𝑎𝑐𝑒 𝐴𝑚𝑜𝑢𝑛𝑡×𝑃𝑉𝐹2
100,000 = 3,500×14.21240+$100,000×0.50257

Pricing Bonds
Issued at Face
Amount (i=3.5%）
Using Present
Value Tables
$100,000 × 7% × 1/2 year =
$3,500
Table 2, i = 3.5%, n = 20
Table 4, i = 3.5%, n = 20

9-17
Key Points
• When the market rate(i) equals the bond’s
stated rate(r), the issue price equals the face
amount.

• What if the market interest rate(i) is different

from stated interest rate (r)?
q When the market rate is greater than (less than)
the stated rate, the bonds will issue at a discount
(premium).

18
Pricing Bonds Issued at a Discount
Ø Stated interest rate r (7%) < market interest rate i (8%)
Ø When the annual market interest rate is 8% (4% every semiannual
period), it indicates that investors can purchase bonds of similar
risk that are paying the higher 8% rate.
Ø To make the bond at 7% as attractive as these at 8%,
what would a firm do?
• Discount this bond (issue this bond below its $100,000 face
amount).
=>
1 1
93,205 = 3,500× ) => + 100,000×
(1 + 0.04) (1 + 0.04)=>
:;<
Ø What is the effective return of an investor (or effective interest
rate of the firm)?
• When market interest rate is 8%, Bond ($93,205,7%)= Bond
($100,000,8%)

19
Pricing Bonds Issued at a Premium
Ø r (7%) > i (6%)
Ø When the annual market interest rate is 6% (3% every semiannual
period), it indicates that investors can only purchase bonds of
similar risk that are paying the lower 6% rate.
Ø What would a firm do when its bond is more attractive
than the bonds of similar risk?
• Charge a premium on this bond ( issue this bond above its
$100,000 face amount).
=>
1 1
107,439 = 3,500× ) => + 100,000×
(1 + 0.03) (1 + 0.03)=>
:;<

Ø What is the effective return of an investor ( or effective interest

rate of the firm)?
• When market interest rate is 6%, Bond ($107,439,7%)= Bond
($100,000,6%)
20
Common Mistake
The interest rate we use to calculate the bond
issue price is always the market rate, never the
stated rate. Some students get confused and
incorrectly use the stated rate to calculate
present value. Use the stated rate to calculate
the interest payment each period, but use the
market rate to calculate the present value of the
cash flows.

9-21
Stated Rate, Market Rate, and the Bond
Issue Price

Bonds Issued at a Bonds Issued at Bonds Issued at a

Discount Face Amount Premium

Stated rate (7%) Stated rate (7%) Stated rate (7%)

less than equal to greater than
Market rate (8%) Market rate (7%) Market rate (6%)

9-22
How to report bonds?-> Carrying
Value
Ø The book value of bonds reported on balance sheet.
Ø The carrying value (or "book value") of the bond at
a given point in time is its face value minus any
remaining discount or plus any remaining premium

23
Concept Check 9–6
Which of the following statements is true for bonds
issued at a discount?
a. The stated interest rate > market rate
b. The stated interest rate < market rate
c. The stated interest rate = market rate
d. The stated interest rate is unrelated to the
market rate

9-24
Part C
ACCOUNTING FOR BONDS PAYABLE

9-25
 Amortize Discounts or Premium

In essence, we can treat discounts (premium) as an

expenditure.
• Allocate them to the periodic interest expense over the
life of the bond.->Amortization
o Allocating the discounts to interest expense will increase
interest expense, decrease unamortized discounts, increase
the carrying value of bonds.
o Allocating the premium to interest expense will decrease
interest expense, decrease unamortized premium, decrease
the carrying value of bonds.

9-26
Bonds Issued at Face Amount

27
Bonds Issued at
a Discount

Discounts on
bonds payable is
the contra
liabilities
account

28
Bonds Issued at
a Premium

Premium on
bonds
payable is
added to
bonds
payable.
29
Common Mistake
Students sometimes incorrectly record
interest expense using the stated rate
rather than the market rate. Remember that
interest expense is the carrying value times
the market rate, while the cash paid for
interest is the face amount times the stated
rate.

9-30
Bonds at face amount: the carrying value and the
corresponding interest expense remain constant over
time.
Bonds at a discount: the carrying value and the
corresponding interest expense increase over time.
Bonds at a premium: the carrying value and the
corresponding interest expense decrease over time. 9-31
Concept Check 9–5
If a 10-year bond is issued with a stated rate of 9%
when the market rate is 8%, the bonds will be issued
at ______?
a. A premium
b. A discount
c. Face amount
d. Cannot determine with information given

9-32
Retirement of Bonds
• Company buys back its bonds from investors.
• If bonds are retired at maturity, the carrying
value will equal the face amount. The bond
payable is debited and cash is credited.
• Bonds can be retired before maturity by
q Exercising the call feature included in the bond
contract or buying the bonds in the open market
q Retirement before maturity is called early
extinguishment of debt, and may result in a gain or
loss equal to the difference between the book value of
the bond and the price paid to retire the bond.
9-33
Bond Retirements at Maturity
• Bond retirements occur when the issuing
corporation buys back its bonds from the
investors
• Assume $100,000 in bonds are retired at
maturity (December 31, 2030)
December 31, 2030 Debit Credit
Bonds Payable …………………...……..….….….…. 100,000
Cash ……………………………………………………… 100,000
(Retire bonds at maturity)

No gain or loss is recorded on bonds retired at maturity.

9-34
 Bond Retirements before Maturity
What if the market interest rate
drops to 5% on December 31, 2021?
Price (100,000,3500,
18,2.5%)=114,353

u ce carr yin g value

Re d
s to zero 31, 2021
of the bondDecember Debit Credit
Bonds Payable (account balance) ..….….….…… 100,000
Premium on Bonds Payable ….….….……………… 6,877
Loss (difference) ….….….……………………………….. 7,476
Cash (amount paid) …………………………………. 114,353
(Retire bonds before maturity)

Since the firm suffers loss from retiring bonds

before maturity, why does it do so?
9-35
Why Buy Back Debt Early?
• Reissue debt at new, lower interest rates.
This type of buyback and reissue lowers future
interest expense.
• Improve the company’s debt ratios
• Earnings Manipulation. Since bonds payable
are reported at carrying values and not market
values, firms can time their repurchase of bonds
to help meet earnings expectations. For instance,
when interest rates go up, bond prices go down.
In this case, a company will record a gain rather
than a loss on early extinguishment.
9-36
Concept Check 9–7
A company retires a $50 million bond issue before
maturity when the carrying value is $48 million, but
the market value is $54 million. The company will
record:
a. A loss of $6 million
b. A gain of $6 million
c. Neither a gain nor a loss
d. A debit to Cash of $54 million

9-37
End of Chapter 9

9-38
Alternative ways to calculate the
issue price
q Use a financial calculator
q Use Excel (Illustration 9–10)

9-39
Pricing Bonds Issued at Face Amount Using
a Financial Calculator

CALCULATOR INPUT
Bond characteristics Key Amount
1. Face amount FV $100,000
2. Interest payment PMT $3,500 = 100,000 × 7% × 1/2 year
3. Number of periods N 20 = 10 years × 2 periods each year
4. Market interest rate I 3.5 = 7% ÷ 2 periods each year

CALCULATOR OUTPUT
Issue price PV $100,000

9-40
Pricing Bonds Issued at A Discount Using a
Financial Calculator

CALCULATOR INPUT
Bond characteristics Key Amount
1. Face amount FV $100,000
2. Interest payment PMT $3,500 = 100,000 × 7% × 1/2 year
3. Number of periods N 20 = 10 years × 2 periods each year
4. Market interest rate I 4 = 8% ÷ 2 periods each year

CALCULATOR OUTPUT
Issue price PV $93,205

9-41
Pricing Bonds Issued at A Premium Using a
Financial Calculator

CALCULATOR INPUT
Bond characteristics Key Amount
1. Face amount FV $100,000
2. Interest payment PMT $3,500 = 100,000 × 7% × 1/2 year
3. Number of periods N 20 = 10 years × 2 periods each year
4. Market interest rate I 3 = 6% ÷ 2 periods each year

CALCULATOR OUTPUT
Issue price PV $107,439

9-42
Pricing Bonds Issued at Face Amount Using
Excel

$100,000
$3,500
20
0.035

$100,000

9-43
Pricing Bonds Issued at a Discount Using
Excel

$100,000
$3,500
20
0.04

$93,205

9-44
Pricing Bonds Issued at a Premium Using
Excel

$100,000
$3,500
20
0.03

$107,439

9-45
Analysis
DEBT ANALYSIS
Coca-Cola vs. PepsiCo

9-46
 Debt Analysis
Solvency: Ability to pay Long-Term Debt
Debt to equity ratio= Liabilities/Stockholders’ Equity
• What if SE=0, or SE<0?
Debt to asset ratio= Liabilities/Asset
Times interest earned ratio=(NI+Interest Exp+Tax Exp)/Interest Exp

9-47
 Downside and Upside of Debt
• Downside: Default or perhaps even bankruptcy.
• Upside: It can enhance the return to
stockholders.
Average Return
($ in Net
÷ Total = on
millions) Income
Assets Assets
Coca-
$6,550 ÷ $88,633 = 7.4%
Cola
$71,898
PepsiCo $6,379 ÷ = 8.9%

• For both companies, the return on assets exceeds the cost

of borrowing (<4%). Therefore, both companies increase
their total return by borrowing at a low rate and then
earning a higher return on those borrowed funds.
• What if the cost of borrowing is 10%? 9-48
• Window Dressing: Transactions that
make statements pretty

49
Concept Check 9–8
Which of the following ratios best measures
financial leverage?
a. Return on assets
b. Inventory turnover
c. Times interest earned
d. Debt to equity ratio

The debt to equity ratio is a measure of financial leverage.

9-50
Learning Objective 2

LO9–2 Account for installment notes payable.

9-51
Installment Notes
• Most car loans and home loans call for
payment in monthly installments rather than
by a single amount at maturity
• Each installment payment includes both:
1. Interest on borrowed amount
2. Reduction of outstanding loan balance
• Companies, too, often borrow cash using
installment notes.

9-52
Amortization Schedule for an
Installment Note
Assume a $25,000, 6%, four-year loan for a new delivery truck
on November 1, 2021. Payments of $587.13 are required at
the end of each month for 48 months.
(1) (2) (3) (4) (5)
Interest Decrease in
Date Cash Paid Expense Carrying Value Carrying Value
Carrying Value × Prior Carrying
Interest Rate (2) – (3) Value – (4)
11/1/2021 Carrying value × 6% × 1/12 $25,000.00
11/30/2021 $ 587.13 $125.00 $462.13 24,537.87
12/31/2021 587.13 122.69 464.44 24,073.43
* * * * *
12/31/2022 587.13 94.04 493.09 18,315.65
* * * * *
9/30/2025 587.13 5.83 581.30 584.21
10/31/2025 587.13 2.92 584.21 0
9-53
Installment Loan Transactions
Establishment of the Note Payable
November 1, 2021 Debit Credit
Cash …………………...……..….….….……………………………….. 25,000
Notes Payable ………………………………………………….. 25,000
(Issue a note payable)
First two monthly payments
November 30, 2021 Debit Credit
Interest Expense (= $25,000 × 6% × 1/12) ……………… 125.00
Notes Payable (difference) ……………………………..……… 462.13
Cash (monthly payment) ………………………….………… 587.13
(Pay monthly installment on note)
$25,000 − $462.13
December 31, 2021
Interest Expense (= $24,537.87 × 6% × 1/12) …………… 122.69
Notes Payable (difference) ……………………………..……….. 464.44
Cash (monthly payment) ………………………….………….. 587.13
(Pay monthly installment on note)
9-54
Key Point
Most notes payable require periodic installment
payments. Each installment payment includes an
amount that represents interest expense and an
amount that represents a reduction of the
carrying value (remaining loan balance).

9-55
Concept Check 9–2
Tropical Paradise borrows $24,000 and agrees to a
5%, five-year installment loan with the bank.
Payments of $452.91 are due at the end of each
month. How much interest should be recorded for
the first month?
a. All $452.91 is attributable to interest.
b. $100.00 The payment of $452.91 includes payment for both
c. $352.91 interest expense and a portion of the principal. The
interest expense for the first month is the carrying
d. $0 value multiplied by (the interest rate × 1/12):
$24,000 × 5% × 1/12 = $100.00
The remaining portion of the payment ($352.91)
reduces the carry value.
9-56
Learning Objective 3

LO9–3 Understand how leases are recorded.

9-57
Leases
• Contractual arrangement by which the lessor
(owner) provides the lessee (user) the right to
use an asset for a specified period of time
• Leases are recorded by the lessee as a debit to
lease asset and a credit to lease payable
q for the present value of the lease payments
q at the beginning of the lease term

9-58
Decision Maker’s Perspective
Why Do Many Companies Lease Rather Than Buy?
1. Leasing reduces the upfront cash needed
to use an asset.
2. Lease payments often are lower than
installment payments.
3. Leasing offers flexibility and lower costs
when disposing of an asset.
4. Leasing may offer protection against the
risk of declining asset values.
9-59
Calculating the Present Value of
Lease Payments (Annuity)
• Table 4 at the back of the book provides present
values of annuities of $1 (ordinary annuity).
• These values are multiplied by the monthly lease
payment to get the present value of the total lease
payments.
• To use the table, you need to know n (time periods)
and i (interest rate.)
• For combinations of n and i not shown, you can
calculate the present value of the lease payments
using a financial calculator or Excel.
9-60
Present Value of Lease Payments Using a
Financial Calculator

• A company agrees to make lease payments of

$352.28 at the end of each month for 48 months,
assuming a 6% borrowing rate.
CALCULATOR INPUT
Lease characteristics Key Amount
1. Future value FV $0
2. Lease payment PMT $352.28
3. Number of payments N 48 = 4 years × 12 periods each year
4. Interest rate I 0.5 = 6% ÷ 12 periods each year
CALCULATOR OUTPUT
Present value of payments PV $15,000

9-61
Present value of Lease Payments Using Excel

Formula

$0
$352.28
48
Inputs
0.005

$15,000 PV

9-62
Recording Lease Payable
• At the beginning of the lease, record:
q Lease asset – right to use the asset over lease period
q Lease payable – present value of obligation to make payments

November 1, 2021 Debit Credit

Lease Asset ….…………………………………………….. 15,000
Lease Payable ……………………………………… 15,000
(Record the lease)
($15,000 = present value of lease payments*)

*present value of ordinary annuity; n = 48, i = 6% ÷ 12.

8-63
Key Point
While not transferring ownership as in a
purchase, a lease gives the lessee (user) the
right to use the asset over the lease period. This
right is recorded as an asset, and the obligation
to make lease payments is recorded as a liability.

9-64
Concept Check 9–3
Which of the following is an advantage of leasing an asset over
purchasing an asset on the installment basis?
a. Leasing reduces the upfront cash needed to use an
asset.
b. Lease payments are usually higher than installment
payments.
c. Leased assets do not result in liabilities on the
balance sheet.
d. The leased asset carrying value includes interest in
the asset account rather than an expense account.
Instead of paying cash upfront for the full purchase of an asset, only the first month’s lease payment is
needed to begin using the asset. Answer a. is correct.
Lease payments are usually lower than installment payments. Leased assets do result in liabilities;
the initial recording includes a debit to lease asset and credit to lease payable for the present value of
the payments. Interest is not included in the asset amount; the asset is recorded at present value and
interest is calculated each period and charged to expense.

9-65