Horngren's Accounting Chapter 15 - Long-Term Liabilities PDF

Horngren’s Accounting Volume Two, Eleventh Canadian Edition Chapter 15 Long-Term Liabilities Copyright © 2020 Pearson Canada Inc. 15 - 1  Welcome & Administration - Icebr...

Horngren’s Accounting Volume Two, Eleventh Canadian Edition Chapter 15 Long-Term Liabilities Copyright © 2020 Pearson Canada Inc. 15 - 1  Welcome & Administration - Icebreaker - Term Test 1 Results - Please take out the piece of paper that I asked you at the beginning of the first class to write down the grade in this course that you wanted and what you will willing to do to obtain that grade. - Moment of reflection. Copyright © 2020 Pearson Canada Inc. 15 - 2  Learning Objectives 1) Define bonds payable and the types of bonds. 2) Determine the price of a bond, and account for basic bond transactions. 3) Amortize a bond discount and premium by the straight- line amortization method and the effective-interest amortization method. 4) Account for retirement and conversion of bonds. 5) Show the advantages and disadvantages of borrowing. 6) Account for other long-term liabilities. 7) Account for operating leases and for assets acquired through a capital lease. 8) Identify the effects of IFRS on long-term liabilities. Copyright © 2020 Pearson Canada Inc. 15 - 3  Learning Objective 1 Define bonds payable and the types of bonds What are bonds? Copyright © 2020 Pearson Canada Inc. 15 - 4 Bonds: An Introduction A bond is a formal arrangement between the issuer of the bond and the holder of the bond The bondholder lends a fixed amount to the issuer, and the issuer promises to pay a fixed amount at some later date, along with regular payments of interest over the life of the bond Bonds payable are groups of notes payable issued to multiple lenders called bondholders Copyright © 2020 Pearson Canada Inc. 15 - 5 Bond Fundamentals Principal value: Also called the maturity or par or face value – the amount the borrower must pay back to the bondholders at maturity. Maturity date: The date on which the borrower must pay the principal amount to the lender. Coupon rate: The interest rate that the issuer will pay the bondholder and the dates that the interest payments are due (generally twice a year). Copyright © 2020 Pearson Canada Inc. 15 - 6 Types of Bonds Copyright © 2020 Pearson Canada Inc. 15 - 7 Learning Objective 2 Determine the price of a bond, and account for basic bond transactions How do we account for the sale of a bond? Copyright © 2020 Pearson Canada Inc. 15 - 8 Bond Interest Rates (1 of 2) The market price of a bond is the amount that investors are willing to pay for the present value of 1) the principal payment plus 2) the cash interest payments Two interest rates work to set the price of the bond – Stated or contract rate: this determines the cash interest paid by the borrower – Market or effective rate: this is the rate investors demand for lending their money Copyright © 2020 Pearson Canada Inc. 15 - 9 Bond Interest Rates (2 of 2) Example: Bond with a stated (contract) interest rate of 9% Copyright © 2020 Pearson Canada Inc. 15 - 10 Bond Prices (1 of 3) Bonds are sold at their market price, which is the amount that investors are willing to pay at any given time. Bonds sell at a premium or a discount when the interest rate that will be paid on the bond, the stated or contract rate, is different from the interest rate available to investors elsewhere in the market at the time of the bond issuance Copyright © 2020 Pearson Canada Inc. 15 - 11 Bond Prices (2 of 3) There are 3 categories of bond prices. A bond can be issued at: – Maturity (par, face, or principal) value: A $1,000 bond issued for $1,000. – Discount: A price below maturity. A $1,000 bond issued for $980; the discount is $20 – Premium: A price above maturity. A $1,000 bond issued for $1,015; the premium is $15 Copyright © 2020 Pearson Canada Inc. 15 - 12 Bond Prices (3 of 3) Bond prices are quoted at a percentage of their maturity value A $1,000 bond quoted at 100 is bought or sold for 100% of maturity value ($1,000) A $1,000 bond quoted at 101.5 has a price of $1,015 ($1,000 × 1.015); sold at a premium A $1,000 bond quoted at 98.5 has a price of $985 ($1,000 × 0.985); sold at a discount Copyright © 2020 Pearson Canada Inc. 15 - 13 Bond Prices Example Copyright © 2020 Pearson Canada Inc. 15 - 14 Present Value – An Introduction A dollar received today is worth more than a dollar received in the future. Present valued, defined: The amount invested at the present time to receive a greater amount in the future Future value = present value + interest earned The present value is always less than the future value Copyright © 2020 Pearson Canada Inc. 15 - 15 Present Value The exact present value of any future amount depends on: 1. The amount of the future payment (or receipt) 2. The length of time from the investment to the date when the future amount is to be received (or paid) 3. The interest rate during the period Copyright © 2020 Pearson Canada Inc. 15 - 16 Issuing Bonds at Par Value Assume UVW Corporation issued $100 million in 6% bonds at par that mature in 10 years on Jan. 2, 2020 Interest is paid semi-annually on Jan. 2 and July 2 The issuance entry is: Copyright © 2020 Pearson Canada Inc. 15 - 17 Issuing Bonds at Par (1 of 2) Assume UVW Corporation issued $100 million in 6% bonds at par that mature in 10 years on Jan.2, 2019; interest is paid semi-annually on Jan.2 and July 2 To record the first semi-annual interest payment, July 2, 2020: Copyright © 2020 Pearson Canada Inc. 15 - 18 Issuing Bonds at Par (2 of 2) To record the principal payment at maturity, Jan. 2, 2030: Copyright © 2020 Pearson Canada Inc. 15 - 19 Issuing Bonds and Notes Between Interest Dates (1 of 5) Assume Manitoba Hydro issues $200 million, 5%, 6-year bonds dated June 15, 2020; the issue date is July 15. Interest is paid semiannually; the bondholders are paid the full semiannual interest amount at the interest payment date (December 15) Copyright © 2020 Pearson Canada Inc. 15 - 20 Issuing Bonds and Notes Between Interest Dates (2 of 5) On July 15, Manitoba Hydro sells $100,000 of its bonds one month after the bond issue date of June 15; the market price of the bonds on July 15 is the face value (the price of the bond is “100 plus accrued interest”) Manitoba Hydro receives 1 month of interest in addition to the principal amount Copyright © 2020 Pearson Canada Inc. 15 - 21 Issuing Bonds and Notes Between Interest Dates (3 of 5) Copyright © 2020 Pearson Canada Inc. 15 - 22 Issuing Bonds and Notes Between Interest Dates (4 of 5) On July 15, Manitoba Hydro sells $100,000 of its bonds one month after the bond issue date of June 15; the market price of the bonds on July 15 is the face value (the price of the bond is “100 plus accrued interest”) The entry to record the issuance of the bonds payable is: Copyright © 2020 Pearson Canada Inc. 15 - 23 Issuing Bonds and Notes Between Interest Dates (5 of 5) On July 15, Manitoba Hydro sells $100,000 of its bonds one month after the bond issue date of June 15; the market price of the bonds on July 15 is the face value The entry to record the first semiannual interest payment is: Copyright © 2020 Pearson Canada Inc. 15 - 24 Issuing Bonds at a Discount (1 of 2) Assume UVW Corporation issues $1 million of its 6%, 10-year bonds at 98% of face value on Jan. 2 The entry to record the issuance is: Copyright © 2020 Pearson Canada Inc. 15 - 25 Issuing Bonds at a Discount (2 of 2) Discount on Bonds Payable is a contra account to Bonds Payable Book value, or Carrying value = Bonds payable minus the discount Copyright © 2020 Pearson Canada Inc. 15 - 26 Issuing Bonds at a Premium (1 of 2) Assume the market interest rate is 5.5% when UVW Corporation issues its 6%, 10-year bonds; the bonds are priced at 103.81 The entry to record the issuance is: Copyright © 2020 Pearson Canada Inc. 15 - 27 Issuing Bonds at a Premium (2 of 2) Premium on Bonds Payable is a contra account to Bonds Payable Book value, or Carrying value = Bonds payable plus the premium Copyright © 2020 Pearson Canada Inc. 15 - 28 Learning Objective 2 – Practice Questions S15-9 (Part A only) P. 857 (4 Minutes then demo). S15-10 (Part A only) P. 857 (4 minutes then demo). Copyright © 2020 Pearson Canada Inc. 15 - 29  Learning Objective 3 Amortize a bond discount and premium by the straight-line amortization method and the effective-interest amortization method How do we allocate a bond discount or premium over the life of a bond? Copyright © 2020 Pearson Canada Inc. 15 - 30 Straight-Line Amortization of a Bond Discount (1 of 4) Assume UVW Corporation issues $1 million of its 6%, 10-year bonds at 98.00 The beginning discount is $20,000; there are 20 semiannual interest periods during the bonds’ 10-year life The discount is amortized each interest period ($20,000 ÷ 20 periods = $1,000 per period), with the entry as follows: Copyright © 2020 Pearson Canada Inc. 15 - 31 Straight-Line Amortization of a Bond Discount (2 of 4) Copyright © 2020 Pearson Canada Inc. 15 - 32 Straight-Line Amortization of a Bond Discount (3 of 4) Since Discount on Bonds Payable is a contra account, each reduction in its balance increases the book value or carrying value of Bonds Payable. Immediately after amortizing the bond discount on July 2nd, the balance sheet would report the following: Copyright © 2020 Pearson Canada Inc. 15 - 33 Straight-Line Amortization of a Bond Discount (4 of 4) Twenty amortization entries will decrease the discount balance to zero, which means that the Bond Payable will have a face value of $1,000,000 by the maturity date. Copyright © 2020 Pearson Canada Inc. 15 - 34  Straight Line Amortization of a Bond Discount – Practice Question S15-9 (Part B only) P. 857 (7 Minutes then demo). Copyright © 2020 Pearson Canada Inc. 15 - 35 Straight-line Amortization on a Bond Premium Assuming the market interest rate is 5.5% when UVW Corp. issues its 6%, 10-year bond; the bonds are priced at 103.81 The beginning premium is $38,100 and there are 20 semiannual interest periods during the bonds’ 10-year life; the amortized premium is 1/20th of $8,100 = $1,905; the entry is: Copyright © 2020 Pearson Canada Inc. 15 - 36 Reporting Bonds Payable (1 of 2) Bonds payable are reported on the balance sheet at their maturity amount plus any unamortized premium or minus any unamortized discount Immediately after amortizing the bond discount on July 2nd, the bonds have a carrying amount of: Copyright © 2020 Pearson Canada Inc. 15 - 37 Reporting Bonds Payable (2 of 2) At maturity, the bond premium will have been fully amortized and the bonds carrying amount will be the face value of $1,000,000. Copyright © 2020 Pearson Canada Inc. 15 - 38  Straight Line Amortization of a Bond Premium – Practice Question S15-10 (Part B only) P. 857 (7 Minutes then demo). Copyright © 2020 Pearson Canada Inc. 15 - 39 Effective-Interest Method of Amortization This method keeps each interest expense amount at the same percentage of the bonds’ carrying value or book value for every interest payment over the bonds’ life. IFRS requires to use of the effective-interest method because it does a better job of matching the interest expense to the revenue earned. ASPE allows either the straight line method or the effective interest method. Copyright © 2020 Pearson Canada Inc. 15 - 40 Effective-Interest Method of Amortizing a Bond Discount (1 of 5) Assume that on Jan. 2, 2020, UVW Corp. issues $1 million 5-year, 5% bonds at the time when market interest rates are 6%; the interest is paid semiannually The issue price is $957,349, resulting in a discount of $42,651 Jan. 2 Cash 957,349 Discount on Bond Payable 42,651 Bond Payable 1,000,000 To issue 5%, 5-year bonds, yielding a 6% return. Copyright © 2020 Pearson Canada Inc. 15 - 41 Effective-Interest Method of Amortizing a Bond Discount (2 of 5) What is the interest expense at the end of period one? – $957,349 × 6% (market rate) × 6/12 = $28,720 What is the interest payment at the end of period one? – $1,000,000 × 5% (stated rate ) × 6/12 = $25,000 Amortization = $28,720 − $25,000 = $3,720 Copyright © 2020 Pearson Canada Inc. 15 - 42 Effective-Interest Method of Amortizing a Bond Discount (3 of 5) Copyright © 2020 Pearson Canada Inc. 15 - 43 Effective-Interest Method of Amortizing a Bond Discount (4 of 5) Copyright © 2020 Pearson Canada Inc. 15 - 44 Effective-Interest Method of Amortizing a Bond Discount (5 of 5) Copyright © 2020 Pearson Canada Inc. 15 - 45  Amortization of a Bond Discount – Effective Interest Method: Practice Question E15-12 P. 861 Requirement #1 & 2 (15 Minutes then demo). Copyright © 2020 Pearson Canada Inc. 15 - 46 Effective-Interest Method of Amortizing a Bond Premium (1 of 4) Assume on April 30 UVW Corp. issues $1 million 5-year, 5% bonds that pay interest semiannually Market interest rate is 4%, and the issue price is $1,044,913 Copyright © 2020 Pearson Canada Inc. 15 - 47 Effective-Interest Method of Amortizing a Bond Premium (2 of 4) Copyright © 2020 Pearson Canada Inc. 15 - 48 Effective-Interest Method of Amortizing a Bond Premium (3 of 4) Copyright © 2020 Pearson Canada Inc. 15 - 49 Effective-Interest Method of Amortizing a Bond Premium (4 of 4) Copyright © 2020 Pearson Canada Inc. 15 - 50  Amortization of a Bond Premium – Effective Interest Method: Practice Question S15-12 P. 857 (18 Minutes then demo). Copyright © 2020 Pearson Canada Inc. 15 - 51 Current Portion of Long-Term Debt Different bond issues may mature at different times The portion payable within one year is a current liability The remaining debt is long term Copyright © 2020 Pearson Canada Inc. 15 - 52 Adjusting Entries for Interest Expense Using the Straight-line Method (1 of 2) Assume Kind Animations Inc. issues $50 million 8%, 10- year bonds at a discount of $200,000 on October 1, 2020 Interest payments are on March 31 and Sept. 30 each year Three months of interest is recorded on December 31st: Copyright © 2020 Pearson Canada Inc. 15 - 53 Adjusting Entries for Interest Expense Using the Straight-line Method (2 of 2) Copyright © 2020 Pearson Canada Inc. 15 - 54 Adjusting Entries for Interest Expense Using the Straight Line Method: Practice Question E15-8 P. 860 (10 Minutes then demo). Copyright © 2020 Pearson Canada Inc. 15 - 55 Adjusting Entries Using the Effective- Interest Method (1 of 4) Assume Kind Animations Inc. issues $1 million 5%, 5-year bonds at a premium of $44,413 on May 1, 2020. Interest payments are on October 31 and April 30 each year. – The last interest payment occurred on Oct. 31. – The adjustment must cover two months, or one-third of a semi-annual period. Copyright © 2020 Pearson Canada Inc. 15 - 56 Adjusting Entries Using the Effective- Interest Method (2 of 4) Refer to Slide 48. On Dec. 31: – Interest payable would be: $25,000 × 2/6 = $8,334 – Interest expense would be: $20,816 × 2/6 = $6,939 – Premium amortization would be: $4,184 × 2/6 = $1,395 The adjusting entry would be: Copyright © 2020 Pearson Canada Inc. 15 - 57 Adjusting Entries Using the Effective- Interest Method (3 of 4) The entry for the 2nd interest payment, on Apr. 30, would be: Copyright © 2020 Pearson Canada Inc. 15 - 58 Adjusting Entries Using the Effective- Interest Method (4 of 4) In summary: Copyright © 2020 Pearson Canada Inc. 15 - 59  Learning Objective 4 Account for retirement and conversion of bonds How do we account for changes in a bond issue? Copyright © 2020 Pearson Canada Inc. 15 - 60 Retirement of Bonds (1 of 2) To retire a bond early, the issuer can: – Purchase the bonds on the open market at their current market price, or – Exercise a call option When bonds are redeemable, the buyer may retire the bonds at a specified price, prior to maturity When bonds are callable, the issuer may call or pay off those bonds at a specified price Whether the bonds are purchased or “called,” the journal entry is the same in either case Copyright © 2020 Pearson Canada Inc. 15 - 61 Retirement of Bonds (2 of 2) When bonds are retired before maturity: 1. Record a partial-period amortization of the premium or discount 2. Write off the portion of the premium or discount that relates to the portion of bonds being retired 3. Calculate any gain or loss on retirement Copyright © 2020 Pearson Canada Inc. 15 - 62 Retirement of Bonds, Example (1 of 3) $10 million of callable bonds with an unamortized discount of $40,000 is retired the market price is 99.50 and the call price is 103.00  which alternative will the company choose? Retiring the bonds at 99.50 results in a gain of $10,000 Copyright © 2020 Pearson Canada Inc. 15 - 63 Retirement of Bonds, Example (2 of 3) The entry to record the retirement of the bonds is: Copyright © 2020 Pearson Canada Inc. 15 - 64 Retirement of Bonds, Example (3 of 3) ASPE requires that gains and losses on early retirement of debt that are both abnormal in size and unusual be reported separately on the income statement, before income tax and discontinued operations Copyright © 2020 Pearson Canada Inc. 15 - 65  Retirement of Bonds: Practice Question E15-14 P. 861 (14 Minutes then demo). Copyright © 2020 Pearson Canada Inc. 15 - 66 Convertible Bonds and Notes Convertible bonds and notes give the holder the option of exchanging the bond for a specified number of common shares. This gives the bondholder an opportunity to achieve higher gains from increases in the share value. If a bond issue or a note payable is converted into common shares, shareholders’ equity is increased by the carrying amount of the bonds converted. Copyright © 2020 Pearson Canada Inc. 15 - 67  Convertible Bonds Practice Question E15-15 P. 861 demo. Copyright © 2020 Pearson Canada Inc. 15 - 68  Learning Objective 5 Show the advantages and disadvantages of borrowing How do we decide whether to issue debt versus equity? Copyright © 2020 Pearson Canada Inc. 15 - 69 Advantages and Disadvantages of Issuing Bonds versus Shares (1 of 3) Copyright © 2020 Pearson Canada Inc. 15 - 70 Advantages and Disadvantages of Issuing Bonds versus Shares (2 of 3) Kind Animations Inc. has net income of $600,000 and 200,000 common shares outstanding; it needs $1 million for expansion Kind is considering two options: – Plan 1 – issue $1 million of 10% bonds – Plan 2 – issue 100,000 common shares for $1 million Copyright © 2020 Pearson Canada Inc. 15 - 71 Advantages and Disadvantages of Issuing Bonds versus Shares (3 of 3) Copyright © 2020 Pearson Canada Inc. 15 - 72  Learning Objective 6 Account for long-term notes payable How do we account for other long-term liabilities? Copyright © 2020 Pearson Canada Inc. 15 - 73 Mortgages and Other Long-Term Liabilities (1 of 3) A mortgage is a loan secured by real property, using a note. – Repaid in equal monthly installments (blended payments), part interest and part principal. – Payments can be monthly, weekly, or biweekly Example: A mortgage signed on Oct. 1, 2020 for $200,000, for 10 years at 5% with monthly blended payments of $2,121. The entry for the first payment is: Copyright © 2020 Pearson Canada Inc. 15 - 74 Mortgages and Other Long-Term Liabilities (2 of 3) Copyright © 2020 Pearson Canada Inc. 15 - 75 Mortgages and Other Long-Term Liabilities (3 of 3) The Balance Sheet presentation divides the liability into the current and long-term portions, and interest due is a payable Copyright © 2020 Pearson Canada Inc. 15 - 76  Long-Term Note Practice Question S15-19 (Jan. 1st, 31st and Feb. 29th payments only) P. 861 (12 Minutes then demo) Copyright © 2020 Pearson Canada Inc. 15 - 77 Learning Objective 7 Account for operating leases and for assets acquired through a capital lease How do we account for leases? Copyright © 2020 Pearson Canada Inc. 15 - 78 Lease Liabilities Lease, defined: An agreement in which the asset user (lessee) agrees to make regular periodic payments to the property owner (lessor) in exchange for the exclusive use of the asset Accountants divide leases into two types of leases: – Operating lease – Capital lease – further divided into two types  Sales-type lease  Direct financing lease Copyright © 2020 Pearson Canada Inc. 15 - 79 Operating Leases Usually short-term or cancellable Gives the lessee the right to use the asset with no continuing rights to the asset Lessor retains usual risks and rewards of ownership To account for an operating lease for rental property, the lessee:  debits Rent Expense (or Lease Expense) and  credits Cash Lease commitments should be stated in the notes to the financial statements as the lessee’s books report neither the leased asset nor any lease liability. Copyright © 2020 Pearson Canada Inc. 15 - 80 Capital Leases (1 of 3) A capital lease substantially transfers all the risks and benefits of ownership to the lessee. From the perspective of the lessee, if any one of the following are present at the beginning of the lease, it is a capital lease: 1. There is reasonable assurance that the lessee will obtain ownership of the leased asset at the end of the term 2. The lease term covers 75% or more of the estimated useful life of the asset 3. The lessor would recover the original investment plus earn a return on the investment from the lease Copyright © 2020 Pearson Canada Inc. 15 - 81 Capital Leases (2 of 3) From the perspective of the lessor, if any one of the following are present at the beginning of the lease: 1. There is reasonable assurance that the lessee will obtain ownership of the leased asset at the end of the term 2. The lease term covers 75% or more of the estimated useful life of the asset 3. The lessor would recover the original investment plus earn a return on the investment from the lease Copyright © 2020 Pearson Canada Inc. 15 - 82 Capital Leases (3 of 3) AND BOTH OF THE FOLLOWING ARE PRESENT: The credit risk associated with the lease is normal The amount of any un-reimbursable cost (to the lessor) can be estimated … Then it is a capital lease Copyright © 2020 Pearson Canada Inc. 15 - 83 Cost of a Capital Lease The lessee must record the leased asset at the present value of the lease liability The cost of the asset to the lessee is the sum of: – Any payment made at the beginning of the lease period, and – The present value of the future lease payments The lease payments are equal amounts occurring at regular intervals (annuity payments) Copyright © 2020 Pearson Canada Inc. 15 - 84 Accounting for a Capital Lease (1 of 3) Accounting for a capital lease is similar to recording a purchase of an asset The lessee debits the asset and credits a liability account (“capital lease liability”) The interest resulting from the lease is embedded in the payments, but the interest must be accrued, and the entries would debit Interest Expense and credit Capital Lease Liability The leased asset must be amortized over the term of the lease Copyright © 2020 Pearson Canada Inc. 15 - 85 Accounting for a Capital Lease (2 of 2) Sierra Wireless signs a 20 year building lease, with 20 annual payments of $20,000, beginning immediately If the interest rate is 10%, the PV of the remaining lease payments is $167,298 Assuming it meets the second criteria, the capital lease would be recorded as follows: Copyright © 2020 Pearson Canada Inc. 15 - 86 Accounting for a Capital Lease (3 of 3) Since this is a capital lease, Sierra Wireless must take amortization over the life of the lease agreement The total value of the building is the first payment of $20,000, plus $167,298, the PV of the remaining lease payments The entry would be recorded as follows: Copyright © 2020 Pearson Canada Inc. 15 - 87  Capital Lease Practice Question E15-22 Requirement 1 (P. 863) Demo. Copyright © 2020 Pearson Canada Inc. 15 - 88  Learning Objective 8 Identify the effects on long-term liabilities of international financial reporting standards (IFRS) How does IFRS affect long-term liabilities? Copyright © 2020 Pearson Canada Inc. 15 - 89 The Effects on Long-Term Liabilities of International Financial Reporting Standards (IFRS) Copyright © 2020 Pearson Canada Inc. 15 - 90  Practice Questions Ex. 15-6, 15-7,15-9 (P. 860) E15-13 (P. 861) E15-20 (P. 862) E15-23 (P. 863) P15-4A (P.866) P15-7A (P. 867) Copyright © 2020 Pearson Canada Inc. 15 - 91  Wrap-Up Take out your Exam Review Sheet, add “ Chapter 15” as a title and write down quantitative items that we discussed that you think could be on Term Test 2. Copyright © 2020 Pearson Canada Inc. 15 - 92