FADM-2

Accounting for
Long-Term
Debt

McGraw-Hill/Irwin Copyright 2016 by McGraw-Hill Education. All rights reserved.

LO 1 LO 1

Show how an
installment note
affects financial
statements.

10-1
 Long-Term Notes Payable
Long-term notes are liabilities that usually
have terms from two to five years.
Principal

Payments
Company
Lender

Each payment covers interest With each payment, the interest

for the period and a portion of portion gets smaller and the principal
the principal. portion gets larger.

10-2
Long-Term Notes Payable
Applying payments to principal and interest
Identify the unpaid principal balance.
Amount applied to interest = Unpaid principal
balance Interest rate.
Amount applied to principal = Cash payment
Amount applied to interest in .
Unpaid principal balance = Unpaid principal
balance in Amount applied to principal
in .

10-3
Long-Term Notes Payable
On January 1, 2016, Blair Company issued a
$100,000 face value long-term note to National
Bank. The note had a 9% annual interest rate and
a five-year term. The loan agreement called for
five equal payments of $25,709 to be made on
December 31 of each year.
Prepare an amortization table for Blairs note.

10-4
Long-Term Notes Payable

10-5
Long-Term Notes Payable
$30,000
Annual
payments are
$25,000
constant.
$20,000
Interest
$15,000
Principal
$10,000

$5,000
$-
Year 1 Year 2 Year 3 Year 4 Year 5
The amount applied to the principal increases each
year. The amount of interest decreases each year.
10-6
 Long-Term Notes Payable
Issuing the note has the following effect
on Blairs 2016 financial statements:

Assets = Liab. + Equity Rev. Exp. = Net Inc. Cash Flow

100,000 = 100,000 + NA NA NA = NA 100,000 FA

The December 2016 cash payment has the following

effect on Blairs 2016 financial statements:

Assets = Liab. + Equity Rev. Exp. = Net Inc. Cash Flow

(25,709) = (16,709) + (9,000) NA 9,000 = (9,000) (9,000) OA

(16,709) FA

10-7
Impact on Financial Statements

10-8
LO 2 LO 1

Show how a line of

credit affects
financial statements.

10-9
 Line of Credit
Enable the company to borrow and repay
funds.
Usually specify a maximum credit line.
Normally used for short-term borrowing to
finance seasonal business needs.

10-10
LO 3 LO 1

Describe bond
features and show
how bonds issued at
face value affect
financial statements.

10-11
 Bond Liabilities

Long-term borrowing of a large

sum of money, called the
principal.
Principal is usually paid back as
a lump sum at maturity.
Individual bonds are often
denominated with a face value of
$1,000.

10-12
 Bond Liabilities
Periodic interest payments based on a
stated rate of interest.
Interest is paid semiannually.
Interest paid is computed as:
Interest = Principal Stated Interest Rate Time
Bond prices are quoted as a percentage of
the face amount.
For example, a $1,000 bond priced at 104 would
sell for $1,040.

10-13
 Bond Liabilities
Bond Selling Price

Corporation
Bond Certificate Investors
at Face Value

Bond Issue
Date

10-14
 Bond Liabilities
Bond Interest
Payments

Corporation Investors
Bond Interest Payments

Interest Payment =
Bond Issue Principal Interest Rate Time
Date

10-15
 Bond Liabilities
Bond Principal
at Maturity Date

Corporation Investors

Bond Issue Bond Maturity

Date Date

10-16
 Bond Liabilities

Advantages of bonds
Longer term to maturity than
notes payable issued to banks.
Bond interest rates are usually
lower than bank loan rates.

10-17
 Characteristics of Bonds

Term and
Serial

Secured and Convertible

Unsecured and Callable

10-18
 Bonds Issued at Face Value
Mason Company issues bonds on January 1, 2016.
Principal = $100,000
Stated Interest Rate = 9%
Interest Paid Annually on 12/31
Maturity Date = December 31, 2020 (5 years)

Bond Selling Price

Bond Certificate
Mason Company Investors
at Face Value
10-19
 Bonds Issued at Face Value
Issuing the bonds has the following effect
on Masons 2016 financial statements:

Assets = Liab. + Equity Rev. Exp. = Net Inc. Cash Flow

100,000 = 100,000 + NA NA NA = NA 100,000 FA

To record the bond issue, Mason makes

the following entry on January 1, 2016:

Account Title Debit Credit

Cash 100,000
Bonds Payable 100,000

10-20
 Bonds Issued at Face Value
On each interest payment date, Mason will pay
$9,000 in interest. The amount is computed as
follows:
$100,000 9% = $9,000

Bond Interest Payments

Mason Company Investors

10-21
 Bonds Issued at Face Value
The December 31, 2016, interest payment (and all other annual interest
payments) has the following effect on Masons financial statements:

Assets = Liab. + Equity Rev. Exp. = Net Inc. Cash Flow

(9,000) = NA + (9,000) NA 9,000 = (9,000) (9,000) OA

To record an interest payment, Mason makes the following entry

on each December 31:

Account Title Debit Credit

Interest Expense 9,000
Cash 9,000

10-22
 Bonds Issued at Face Value
On December 31, 2020, Mason will return the
$100,000 principal amount to the investors.

Bond Principal
at Maturity Date

Mason Company Investors

10-23
 Bonds Issued at Face Value
The principal repayment on December 31, 2020, will have the
following effect on Masons 2020 financial statements:

Assets = Liab. + Equity Rev. Exp. = Net Inc. Cash Flow

(100,000) = (100,000) + NA NA NA = NA (100,000) FA

To record an the principal repayment, Mason Company would make

the following entry on December 31, 2020:

Account Title Debit Credit

Bonds Payable 100,000
Cash 100,000

10-24
Bonds Issued at Face Value

10-25
LO 4 LO 1

Use the straight-line

method to amortize
bond discounts.

10-26
 Bonds Issued at a Discount

If bonds of other companies are yielding more

than 9%, investors will be unwilling to pay the
full face amount for Masons 9% bonds. The
issue price of Masons 9% bonds will have to be
lower to entice investor interest. The difference
between the lower issue price and the principal
of $100,000 is called a discount.

Lets continue the Mason Company example.

10-27
 Bonds Issued at a Discount
Mason Company issues bonds on January 1, 2016.
Principal = $100,000 The only change from
Issue Price = $95,000 previous Mason example.
Stated Interest Rate = 9%
Interest Date = 12/31
Maturity Date = Dec. 31, 2020 (5 years)

Cash
Principal Proceeds Discount
$ 100,000 - $ 95,000 = $ 5,000
10-28
 Bonds Issued at a Discount
Issuing the bonds at a discount has the following
effect on Masons 2016 financial statements:

Assets = Liabilities + Equity Rev. Exp. = Net Inc. Cash Flow

Cash Bonds Pay. Discount + Ret. Earn.

95,000 = 100,000 5,000 + NA NA NA = NA 95,000 FA

To record the bond issue, Mason Company would

make the following entry on January 1, 2016:

Account Title Debit Credit

Cash 95,000
Discount on Bonds Payable 5,000
Bonds Payable 100,000

10-29
 Bonds Issued at a Discount

Partial Balance Sheet as of January 1, 2016

Long-term Liabilities:
Bonds Payable $ 100,000
Less: Discount on Bonds Payable 5,000 $ 95,000

Face Value
Carrying Value

10-30
 Bonds Issued at a Discount
Amortizing the discount over the term of the
bond increases Interest Expense each
interest payment period.

Using the straight-line method, the

discount amortization will be $1,000
every year.
$5,000 5 years = $1,000

10-31
 Bonds Issued at a Discount
The December 31, 2016, interest payment (and all other annual
interest payments) has the following effect on Masons financial
statements:
Assets = Liabilities + Equity Rev. Exp. = Net Inc. Cash Flow
Cash Bonds Pay. Discount + Equity
(9,000) = NA (1,000) + (10,000) NA 10,000 = (10,000) (9,000) OA

To record an interest payment, Mason Company would make

the following entry on each December 31:

Account Title Debit Credit

Interest Expense 10,000
Discount on Bonds Payable 1,000
Cash 9,000
10-32
 Bonds Issued at a Discount
$5,000 $1,000 = $4,000

Partial Balance Sheet as of December 31, 2016

Long-term Liabilities:
Bonds Payable $ 100,000
Less: Discount on Bonds Payable 4,000 $ 96,000

Face Value
The carrying value will
increase to exactly $100,000
Carrying Value
on the maturity date.

10-33
 Bonds Issued at a Discount
The principal repayment on December 31, 2020, will have the
following effect on Masons 2020 financial statements:

Assets = Liab. + Equity Rev. Exp. = Net Inc. Cash Flow

(100,000) = (100,000) + NA NA NA = NA (95,000) FA

(5,000) OA

To record an the principal repayment, Mason Company would make

the following entry on December 31, 2020:

Account Title Debit Credit

Bonds Payable 100,000
Cash 100,000

10-34
Effect of Semiannual Interest
Payments
For semiannual interest payments, the company
would make payments of $4,500 on June 30 and
December 31 of each year.

10-35
LO 5 LO 1

Use the straight-line

method to amortize
bond premiums.

10-36
 Bonds Issued at a Premium

If bonds of other companies are yielding less

than 9%, investors will be willing to pay more
than the face amount for Masons 9 percent
bonds. The issue price of Masons 9% bonds
will rise because of investor demand for the 9%
bonds. The difference between the higher
issue price and the principal of $100,000 is
called a premium.

Lets continue the Mason Company example.

10-37
 Bonds Issued at a Premium
Mason Company issues bonds on January 1, 2016.
Principal = $100,000 The only change from the
Issue Price = $105,000 original Mason example.
Stated Interest Rate = 9%
Interest Date = 12/31
Maturity Date = Dec. 31, 2020 (5 years)

Cash Bonds
Proceeds Payable Premium
$ 105,000 - $ 100,000 = $ 5,000
10-38
 Bonds Issued at a Premium
Issuing the bonds at a premium has the following
effect on Masons 2016 financial statements:

Assets = Liabilities + Equity Rev. Exp. = Net Inc. Cash Flow

Cash Bonds Pay. + Premium + Equity
105,000 = 100,000 + 5,000 + NA NA NA = NA 105,000 FA

To record the bond issue, Mason Company would

make the following entry on January 1, 2016:

Account Title Debit Credit

Cash 105,000
Premium on Bonds Payable 5,000
Bonds Payable 100,000

10-39
 Bonds Issued at a Premium

Partial Balance Sheet as of January 1, 2016

Long-term Liabilities:
Bonds Payable $ 100,000
Add: Premium on Bonds Payable 5,000 $ 105,000

Face Value
Carrying Value

10-40
 Bonds Issued at a Premium
Amortizing the premium over the term of
the bond decreases Interest Expense each
interest payment period.

Using the straight-line method, the

premium amortization will be
$1,000 every year.
$5,000 5 periods = $1,000

10-41
 Bonds Issued at a Premium
The December 31, 2016 interest payment (and all other annual
interest
payments) has the following effect on Masons financial statements:
Assets = Liabilities + Equity Rev. Exp. = Net Inc. Cash Flow
Cash Bonds Pay. + Premium + Ret. Earn.

(9,000) = NA + (1,000) + (8,000) NA 8,000 = (8,000) (9,000) OA

To record an interest payment, Mason Company would make

the following entry on each December 31:

Account Title Debit Credit

Interest Expense 8,000
Premium on Bonds Payable 1,000
Cash 9,000
10-42
 Bonds Issued at a Premium
$5,000 $1,000 = $4,000

Partial Balance Sheet as of December 31, 2016

Long-term Liabilities:
Bonds Payable $ 100,000
Add: Premium on Bonds Payable 4,000 $ 104,000

Face Value
The carrying value will
decrease to exactly $100,000
Carrying Value
on the maturity date.

10-43
 Bonds Issued at a Premium
The principal repayment on December 31, 2020, will have the
following effect on Masons 2020 financial statements:

Assets = Liab. + Equity Rev. Exp. = Net Inc. Cash Flow

(100,000) = (100,000) + NA NA NA = NA (100,000) FA

To record an the principal repayment, Mason Company would make

the following entry on December 31, 2020:

Account Title Debit Credit

Bonds Payable 100,000
Cash 100,000

10-44
 The Market Rate of Interest
The selling price of a bond is determined by
the market rate of interest versus the stated
rate of interest.
Interest Bond Accounting for
Rates Price the Difference
Stated Market Bond Face Value There is no difference
Rate = Rate Price = of the Bond to account for.
Stated Market Bond Face Value The difference is accounted
Rate < Rate Price < of the Bond for as a bond discount.
Stated Market Bond Face Value The difference is accounted
Rate > Rate Price > of the Bond for as a bond premium.

10-45
 Bond Redemptions

Companies may redeem bonds with a

call provision prior to the maturity date.

Gains or losses incurred as a result of early

redemption of bonds should be reported as
other income or other expense on the
income statement.

10-46
 Bond Redemptions
On January 1, 2019, 3 years after issue, Mason
Company redeems its 9% bonds that were
sold at a discount. The bonds have a call provision
requiring Mason to pay a call price of $1,030 for
each $1,000 bond. On the call date, the bonds
have a carrying value of $98,000.

10-47
 Bond Redemptions
The bond redemption on January 1, 2019, will have
the following effect on Masons 2016 financial statements:
Assets = Liabilities + Equity Rev. Exp. = Net Inc. Cash Flow
Cash Bonds Pay. Discount + Ret. Earn.

103,000 = (100,000) 2,000 + (5,000) NA 5,000 = (5,000) (103,000) FA

To record the bond redemption, Mason Company would make

the following entry on January 1, 2019.

Account Title Debit Credit

Bonds Payable 100,000
Loss on Bond Redemption 5,000
Discount on Bonds Payable 2,000
Cash 103,000
10-48
LO 6 LO 1

Use the effective

interest rate method
to amortize bond
discounts.

10-49
Effective Interest Rate Method

Effective interest is a
more accurate way to
amortize bond
discounts and
premiums.

It correctly reflects the

bonds changing
carrying value.

10-50
 Effective Interest Rate Method

Lets assume Mason Company uses the effective

interest method on its $100,000 bond.

Step 1:
Determine the cash payment for interest.

Face value of bond $ 100,000

X Stated rate of interest X .09
Cash payment $ 9,000

10-51
 Effective Interest Rate Method

Step 2:
Determine the amount of interest expense.

$100,000 face value - $5,000 discount = $95,000 carrying value

Carrying value of bond liability $ 95,000

X Effective rate of interest X .1033
Interest expense $ 9,814

10-52
Effective Interest Rate Method
Step 3:
Determine the amortization of the bond discount.

Interest expense $ 9,814

- Cash payment - 9,000
Discount amortization $ 814

Step 4:
Update the carrying value of the bond liability.

Discount amortization $ 814

+ Beginning carrying value + $ 95,000
Ending carrying value $ 95,814

10-53
Effective Interest Rate Method

* The decrease in the amount of the discount increases the

amount of the bond liability.

10-54
 Effective Interest Rate Method

Notice that when using the

effective interest method,
interest expense increases
each year. 10-55
LO 7 LO 1

Use the effective

interest rate method
to amortize bond
premiums.

10-56
Effective Interest Rate Method for
Bond Premiums

Notice that when using the

effective interest method to
amortize a bond premium,
interest expense decreases 10-57
Effective Interest Rate Method for
Bond Premiums

* The decrease in the amount of the premium decreases

the amount of the bond liability.

10-58
LO 8 LO 1

Explain the
advantages and
disadvantages of
debt financing.

10-59
 Financial Leverage and Tax
Advantage of Debt Financing
Financial leverage: Debt financing can increase return on equity when the
borrower earns more on the borrowed funds than it pays in interest. As this
example shows, the cost of financing is the same, but debt financing has a tax
advantage.

10-60
 Times Interest Earned Ratio
Numerator is commonly called EBIT,
Earnings before interest and taxes.

Net income + Interest expense + Income

Times Interest tax expense
Earned =
Interest expense

The ratio shows the amount of resources generated for each

dollar of interest expense. In general, a high ratio is viewed
more favorable than a low ratio.

10-61