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JWCL165_c10_444-505.qxd 8/12/09 7:24 AM Page 444 10 Liabilities Chapter STUDY OBJECTIVES After studying this chapter, you should be able to: 1 Explain a current liability, and identify the major types of current liabilities. 2 Describe the accounting for notes payable. 3 Explain the accounting for other current liabilities. 4 Explain why bonds are issued, and identify the types of bonds. 5 Prepare the entries for the issuance of bonds and interest expense. 6 Describe the entries when bonds are redeemed or converted. 7 Describe the accounting for long-term notes payable. 8 Identify the methods for the presentation and analysis of long-term liabilities. The Navigator Scan Study Objectives Read Feature Story Read Preview Read text and answer p. 453 p. 465 p. 458 Work Comprehensive Do it! p. 461 Do it! p. 463 p. 469 Review Summary of Study Objectives Answer Self-Study Questions Complete Assignments The Navigator Feature Story FINANCING HIS DREAMS What would you do if you had a great idea for a new product, but couldn't come up with the cash to get the business off the ground? Small businesses often cannot attract investors. Nor can they obtain traditional debt financing through bank loans or bond issuances. Instead, they often resort to unusual, and costly, forms of nontraditional financing. Such was the case for Wilbert Murdock. Murdock grew up in a New York housing project, and always had great ambitions. This ambitious spirit led him into some business ventures that failed: a medical diagnostic tool, a device to eliminate carpal-tunnel syndrome, custom-designed sneakers, and a device to keep people from falling asleep while driving. 444 JWCL165_c10_444-505.qxd 7/20/09 4:09 PM Page 445 Another idea was computerized golf clubs that analyze a golfer's swing and provide immediate feedback. Murdock saw great potential in the idea: Many golfers are willing to shell out considerable sums of money for devices that might improve their game. But Murdock had no cash to develop his product, and banks and other lenders had shied away. Rather than give up, Murdock resorted to credit cardsin a big way. He quickly owed $25,000 to credit card companies. While funding a business with credit cards might sound unusual, it isn't. A recent study found that one-third of businesses with fewer than 20 employees financed at least part of their operations with credit cards. As Murdock explained, credit cards are an appealing way to finance a start-up because \"credit-card companies don't care how the money is spent.\" However, they do care how they are paid. And so Murdock faced high interest charges and a barrage of credit card collection letters. Murdock's debt forced him to sacrifice nearly everything in order to keep his business afloat. His car stopped running, he barely had enough money to buy food, and he lived and worked out of a dimly lit apartment in his mother's basement. Through it all he tried to maintain a positive spirit, joking that, if he becomes successful, he might some day get to appear in an American Express commercial. Source: Rodney Ho, \"Banking on Plastic: To Finance a Dream, Many Entrepreneurs Binge on Credit Cards,\" Wall Street Journal, March 9, 1998, p. A1. The Navigator Inside Chapter 10... Taxes Are the Largest Slice of the Pie When to Go Long-Term (p. 457) Search for Your Best Rate \"Covenant-Lite\" Debt (p. 450) (p. 465) (p. 467) All About You: Your Boss Wants to Know If You Ran Today (p. 468) 445 JWCL165_c10_444-505.qxd 7/20/09 4:09 PM Page 446 Preview of Chapter 10 Inventor-entrepreneur Wilbert Murdock, as you can tell from the Feature Story, had to use multiple credit cards to finance his business ventures. Murdock's credit card debts would be classified as current liabilities because they are due every month. Yet by making minimal payments and paying high interest each month, Murdock used this credit source long-term. Some credit card balances remain outstanding for years as they accumulate interest. In Chapter 1, we defined liabilities as creditors' claims on total assets and as existing debts and obligations. These claims, debts, and obligations must be settled or paid at some time in the future by the transfer of assets or services. The future date on which they are due or payable (maturity date) is a significant feature of liabilities. This \"future date\" feature gives rise to two basic classifications of liabilities: (1) current liabilities and (2) long-term liabilities. Our discussion in this chapter is divided into these two classifications. The content and organization of Chapter 10 are as follows. Liabilities Current Liabilities Long-Term Liabilities Notes payable Sales taxes payable Payroll and payroll taxes Unearned revenues Current maturities of long-term debt Statement presentation and analysis Bond basics Accounting for bond issues Accounting for bond retirements Accounting for long-term notes payable Statement presentation and analysis SECTION 1 The Navigator Current Liabilities WHAT IS A CURRENT LIABILITY? As explained in Chapter 4, a current liability is a debt with two key features: (1) The company reasonably expects to pay the debt from existing Explain a current liability, and current assets or through the creation of other current liabilities. (2) The identify the major types of company will pay the debt within one year or the operating cycle, current liabilities. whichever is longer. Debts that do not meet both criteria are classified as long-term liabilities. Most companies pay current liabilities within one year out of current assets, rather than by creating other liabilities. Companies must carefully monitor the relationship of current liabilities to current assets. This relationship is critical in evaluating a company's short-term debtpaying ability. A company that has more current liabilities than current assets may not be able to meet its current obligations when they become due. Current liabilities include notes payable, accounts payable, and unearned revenues. They also include accrued liabilities such as taxes, salaries and wages, and interest payable. In previous chapters we explained the entries for accounts payable and adjusting entries for some current liabilities. In the following sections, we discuss other types of current liabilities. STUDY OBJECTIVE 1 446 JWCL165_c10_444-505.qxd 7/20/09 4:09 PM Page 447 What Is a Current Liability? 447 Notes Payable Companies record obligations in the form of written promissory notes, STUDY OBJECTIVE 2 called notes payable. Notes payable are often used instead of accounts Describe the accounting for payable because they give the lender formal proof of the obligation in case notes payable. legal remedies are needed to collect the debt. Notes payable usually require the borrower to pay interest. Companies frequently issue them to meet short-term financing needs. Notes are issued for varying periods. Those due for payment within one year of the balance sheet date are usually classified as current liabilities. To illustrate the accounting for notes payable, assume that First National Bank agrees to lend $100,000 on March 1, 2011, if Cole Williams Co. signs a $100,000, 12%, four-month note. With an interest-bearing promissory note, the amount of assets received upon issuance of the note generally equals the note's face value. Cole Williams Co. therefore will receive $100,000 cash and will make the following journal entry. A Mar. 1 Cash Notes Payable (To record issuance of 12%, 4-month note to First National Bank) \u0004 \u0003 L SE \u0003100,000 100,000 \u0003100,000 100,000 Cash Flows \u0003100,000 Interest accrues over the life of the note, and the company must periodically record that accrual. If Cole Williams Co. prepares financial statements on June 30, it makes an adjusting entry at June 30 to recognize interest expense and interest payable of $4,000 ($100,000 \u0002 12% \u0002 4/12). Illustration 10-1 shows the formula for computing interest, and its application to Cole Williams Co.'s note. Illustration 10-1 Formula for computing interest Annual Time in Face Value Interest Terms of Interest of Note Rate One Year $100,000 \u0002 12% \u0002 4/12 \u0004 $4,000 Cole Williams makes an adjusting entry as follows: A June 30 Interest Expense Interest Payable (To accrue interest for 4 months on First National Bank note) \u0004 L \u0003 SE \u00054,000 Exp 4,000 4,000 In the June 30 financial statements, the current liabilities section of the balance sheet will show notes payable $100,000 and interest payable $4,000. In addition, the company will report interest expense of $4,000 under \"Other expenses and losses\"in the income statement. If Cole Williams Co. prepared financial statements monthly, the adjusting entry at the end of each month would have been $1,000 ($100,000 \u0002 12% \u0002 1/12). At maturity (July 1, 2011), Cole Williams Co. must pay the face value of the note ($100,000) plus $4,000 interest ($100,000 \u0002 12% \u0002 4/12). It records payment of the note and accrued interest, as shown on the next page. \u00034,000 Cash Flows no effect JWCL165_c10_444-505.qxd 448 A 7/20/09 4:09 PM Page 448 Chapter 10 Liabilities \u0004 L \u0003 SE July 1 \u0005100,000 \u00054,000 \u0005104,000 Cash Flows \u0005104,000 Notes Payable Interest Payable Cash (To record payment of First National Bank interest-bearing note and accrued interest at maturity) 100,000 4,000 104,000 Sales Taxes Payable As a consumer, you know that many of the products you purchase at retail stores are subject to sales taxes. Many states also are now collecting sales Explain the accounting for other taxes on purchases made on the Internet. Sales taxes are expressed as a current liabilities. stated percentage of the sales price. The retailer collects the tax from the customer when the sale occurs. Periodically (usually monthly), the retailer remits the collections to the state's department of revenue. Under most state sales tax laws, the selling company must ring up separately on the cash register the amount of the sale and the amount of the sales tax collected. (Gasoline sales are a major exception.) The company then uses the cash register readings to credit Sales and Sales Taxes Payable. For example, if the March 25 cash register reading for Cooley Grocery shows sales of $10,000 and sales taxes of $600 (sales tax rate of 6%), the journal entry is: STUDY OBJECTIVE 3 A \u0004 L \u0003 SE \u000310,600 Mar. 25 \u000310,000 Rev \u0003600 Cash Flows \u000310,600 HELPFUL HINT Alternatively, Cooley could find the tax by multiplying sales by the sales tax rate ($10,000 .06). Cash Sales Sales Taxes Payable (To record daily sales and sales taxes) 10,600 10,000 600 When the company remits the taxes to the taxing agency, it debits Sales Taxes Payable and credits Cash. The company does not report sales taxes as an expense. It simply forwards to the government the amount paid by the customers. Thus, Cooley Grocery serves only as a collection agent for the taxing authority. Sometimes companies do not ring up sales taxes separately on the cash register. To determine the amount of sales in such cases, divide total receipts by 100% plus the sales tax percentage. To illustrate, assume that in the above example Cooley Grocery rings up total receipts of $10,600. The receipts from the sales are equal to the sales price (100%) plus the tax percentage (6% of sales), or 1.06 times the sales total. We can compute the sales amount as follows. $10,600 \u0006 1.06 \u0004 $10,000 Thus, Cooley Grocery could find the sales tax amount it must remit to the state ($600) by subtracting sales from total receipts ($10,600 \u0005 $10,000). Payroll and Payroll Taxes Payable Every employer incurs liabilities relating to employees' salaries and wages. One is the amount of wages and salaries owed to employeeswages and salaries payable. Another is the amount required by law to be withheld from employees' gross pay. Until a company remits these withholding taxes (federal and state income taxes, and Social Security taxes) to the governmental taxing authorities, they are credited to appropriate liability accounts. For example, if a corporation withholds taxes from its employees' wages and salaries, it would record accrual and payment of a $100,000 payroll, as shown on the next page. JWCL165_c10_444-505.qxd 8/7/09 3:15 PM Page 449 449 What Is a Current Liability? Mar. 7 Salaries and Wages Expense FICA Taxes Payable1 Federal Income Taxes Payable State Income Taxes Payable Salaries and Wages Payable (To record payroll and withholding taxes for the week ending March 7) 100,000 7,650 21,864 2,922 67,564 A \u0004 L \u0003 SE \u0005100,000 \u00037,650 \u000321,864 \u00032,922 \u000367,564 Cash Flows no effect Mar. 11 Salaries and Wages Payable Cash (To record payment of the March 7 payroll) 67,564 67,564 A \u0004 L \u0003 SE \u000567,564 \u000567,564 Cash Flows \u000567,564 Illustration 10-2 summarizes the types of payroll deductions. Mandatory Deductions Federal Income Tax FICA Taxes State and City Income Taxes Gross Pay Insurance and Pensions Charity Net Pay Union Dues Voluntary Deductions Also, with every payroll, the employer incurs liabilities to pay various payroll taxes levied upon the employer. These payroll taxes include the employer's share of Social Security taxes and the state and federal unemployment taxes. Based on the $100,000 payroll in the previous example, the company would make the following entry to record the employer's expense and liability for these payroll taxes. Mar. 7 1 Payroll Tax Expense FICA Taxes Payable Federal Unemployment Taxes Payable State Unemployment Taxes Payable (To record employer's payroll taxes on March 7 payroll) Illustration 10-2 Payroll deductions A \u0004 L \u0003 SE \u000513,850 13,850 7,650 800 5,400 In 2009 FICA includes 6.2% of the first $106,800 for Old-Age, Survivors, and Disability Insurance (OASDI) and 1.45% of all wages for Hospital Insurance (HI). \u00037,650 \u0003800 \u00035,400 Cash Flows no effect JWCL165_c10_444-505.qxd 450 7/20/09 8:58 PM Page 450 Chapter 10 Liabilities Illustration 10-3 Employer payroll taxes Illustration 10-3 shows the types of taxes levied on employers. FICA Taxes Federal Unemployment Taxes State Unemployment Taxes Computation Based on Wages Companies classify the payroll and payroll tax liability accounts as current liabilities because these amounts must be paid to employees or remitted to taxing authorities in the near term. Taxing authorities impose substantial fines and penalties on employers if the withholding and payroll taxes are not computed correctly and paid on time. ACCOUNTING ACROSS THE ORGANIZATION Taxes Are the Largest Slice of the Pie In 2008, Americans worked 74 days to afford their federal taxes and 39 more days to afford state and local taxes, according to the Tax Foundation. Each year this foundation calculates the mathematical average of tax collections in the United States, using a formula that divides the year's total tax collections (federal, state, and local taxes) by all income earned (the \"national income\"). The resulting national \"tax burden\"varies each year, and the tax burden also varies by state. National taxation in 2008 was a bigger burden than average expenditures on housing and household operation (60 days), health and medical care (50 days), food (35 days), transportation (29 days), recreation (21 days), or clothing and accessories (13 days). Source: www.taxfoundation.org/taxfreedomday (accessed June 2008). For a map of tax burden by states, see Figure 6 at that site. If the information on 2008 taxation depicted your spending patterns, on what date (starting on January 1) will you have earned enough to pay all of your taxes? This date is often referred to as Tax Freedom Day. Unearned Revenues A magazine publisher, such as Sports Illustrated, receives customers' checks when they order magazines. An airline company, such as American Airlines, receives cash when it sells tickets for future flights.Through these transactions, both companies have incurred unearned revenuesrevenues that are received before the company delivers goods or provides services. How do companies account for unearned revenues? JWCL165_c10_444-505.qxd 7/20/09 4:09 PM Page 451 What Is a Current Liability? 451 1. When a company receives the advance payment, it debits Cash, and credits a current liability account identifying the source of the unearned revenue. 2. When the company earns the revenue, it debits the Unearned Revenue account, and credits an earned revenue account. To illustrate, assume that Superior University sells 10,000 season football tickets at $50 each for its five-game home schedule. The university makes the following entry for the sale of season tickets: A Aug. 6 Cash Unearned Football Ticket Revenue (To record sale of 10,000 season tickets) \u0004 L \u0003 SE \u0003 SE \u0003500,000 500,000 \u0003500,000 500,000 Cash Flows \u0003500,000 As the school completes each of the five home games, it earns one-fifth of the revenue. The following entry records the revenue earned. A Sept. 7 Unearned Football Ticket Revenue Football Ticket Revenue (To record football ticket revenue earned) 100,000 100,000 \u0004 L \u0005100,000 \u0003100,000 Rev Cash Flows no effect Organizations report any balance in an unearned revenue account (in Unearned Football Ticket Revenue, for example) as a current liability in the balance sheet. As they earn the revenue, a transfer from unearned revenue to earned revenue occurs. Unearned revenue is material for some companies. In the airline industry, for example, tickets sold for future flights represent almost 30% of total current liabilities. At United Air Lines, unearned ticket revenue is the largest current liability, recently amounting to over $1.6 billion. Illustration 10-4 shows specific unearned and earned revenue accounts used in selected types of businesses. Account Title Type of Business Unearned Revenue Earned Revenue Airline Magazine publisher Hotel Insurance company Unearned Passenger Ticket Revenue Unearned Subscription Revenue Unearned Rental Revenue Unearned Premium Revenue Passenger Revenue Subscription Revenue Rental Revenue Premium Revenue Current Maturities of Long-Term Debt Companies often have a portion of long-term debt that comes due in the current year.That amount is considered a current liability. For example, assume that Wendy Construction issues a five-year interest-bearing $25,000 note on January 1, 2011. Each January 1, starting January 1, 2012, $5,000 of the note is due to be paid. When Wendy Construction prepares financial statements on December 31, 2011, it should report $5,000 as a current liability. It would report the remaining $20,000 on the note as a long-term liability. Current maturities of long-term debt are often termed long-term debt due within one year. It is not necessary to prepare an adjusting entry to recognize the current maturity of long-term debt. The company will recognize the proper statement classification of each balance sheet account when it prepares the balance sheet. Illustration 10-4 Unearned and earned revenue accounts JWCL165_c10_444-505.qxd 452 7/20/09 4:09 PM Page 452 Chapter 10 Liabilities STATEMENT PRESENTATION AND ANALYSIS Presentation As indicated in Chapter 4, current liabilities are the first category under liabilities on the balance sheet. Each of the principal types of current liabilities is listed separately. In addition, companies disclose the terms of notes payable and other key information about the individual items in the notes to the financial statements. Companies seldom list current liabilities in the order of liquidity. The reason is that varying maturity dates may exist for specific obligations such as notes payable. A more common method of presenting current liabilities is to list them by order of magnitude, with the largest ones first. Or, as a matter of custom, many companies show notes payable first, and then accounts payable, regardless of amount. Then the remaining current liabilities are listed by magnitude. (Use this approach in your homework.) The following adapted excerpt from the balance sheet of Caterpillar Inc. illustrates its order of presentation. Illustration 10-5 Balance sheet presentation of current liabilities CATERPILLAR INC. Balance Sheet (partial) (in millions) Assets Current assets Property, plant and equipment (net) Other long-term assets Total assets $20,856 7,682 14,553 $43,091 Liabilities and Stockholders' Equity HELPFUL HINT For other examples of current liabilities sections, refer to the PepsiCo and Coca-Cola balance sheets in Appendices A and B. Current liabilities Short-term borrowings (notes payable) Accounts payable Accrued expenses Accrued wages, salaries, and employee benefits Customer advances Dividends payable Deferred and current income taxes payable Long-term debt due within one year Total current liabilities Noncurrent liabilities Total liabilities Stockholders' equity Total liabilities and stockholders' equity $ 4,157 3,990 1,847 1,730 555 141 259 3,531 16,210 19,414 35,624 7,467 $43,091 Analysis Use of current and noncurrent classifications makes it possible to analyze a company's liquidity. Liquidity refers to the ability to pay maturing obligations and meet unexpected needs for cash. The relationship of current assets to current liabilities is critical in analyzing liquidity. We can express this relationship as a dollar amount (working capital) and as a ratio (the current ratio). The excess of current assets over current liabilities is working capital. Illustration 10-6 shows the formula for the computation of Caterpillar's working capital (dollar amounts in millions). JWCL165_c10_444-505.qxd 8/11/09 3:35 PM Page 453 Bond Basics 453 Illustration 10-6 Working capital formula and computation Current Current Working Assets Liabilities Capital $20,856 \u0005 $16,210 \u0004 $4,646 As an absolute dollar amount, working capital offers limited informational value. For example, $1 million of working capital may be far more than needed for a small company but be inadequate for a large corporation.Also, $1 million of working capital may be adequate for a company at one time but inadequate at another time. The current ratio permits us to compare the liquidity of different-sized companies and of a single company at different times. The current ratio is calculated as current assets divided by current liabilities. The formula for this ratio is illustrated below, along with its computation using Caterpillar's current asset and current liability data (dollar amounts in millions). Illustration 10-7 Current ratio formula and computation Current Current Current Assets Liabilities Ratio $20,856 \u0006 $16,210 \u0004 1.29:1 Historically, companies and analysts considered a current ratio of 2:1 to be the standard for a good credit rating. In recent years, however, many healthy companies have maintained ratios well below 2:1 by improving management of their current assets and liabilities. Caterpillar's ratio of 1.29:1 is adequate but certainly below the standard of 2:1. before you go on... Do it! You and several classmates are studying for the next accounting examination. They ask you to answer the following questions: (1) How is the sales tax amount determined when the cash register total includes sales taxes? (2) What is payroll tax expense related to Social Security taxes if salaries and wages for the week are $10,000? Solution 1. First, divide the total proceeds by 100% plus the sales tax percentage to find the sales amount. Second, subtract the sales amount from the total proceeds to determine the sales taxes. 2. Social Security taxes (FICA) \u0004 $10,000 \u0002 7.65% \u0004 $765. Related exercise material: BE10-1, BE10-2, BE10-3, BE10-4, BE10-5, BE10-6, E10-1, E10-2, E10-3, E10-4, E10-5, E10-6, E10-7, and Do it! 10-1. SECTION 2 Current Liabilities Action Plan Divide total receipts by 100% plus the tax rate to determine sales; then subtract sales from the total receipts. Multiply the FICA tax rate times the salary and wage expense amount. The Navigator Long-Term Liabilities Long-term liabilities are obligations that are expected to be paid after one year. In this section we will explain the accounting for the principal types of obligations reported in the long-term liability section of the balance sheet. These obligations often are in the form of bonds or long-term notes. BOND BASICS Bonds are a form of interest-bearing notes payable.To obtain large amounts of long-term capital, corporate management usually must decide whether to issue common stock (equity financing) or bonds. Bonds offer three advantages over common stock, as shown in Illustration 10-8 (page 454). STUDY OBJECTIVE 4 Explain why bonds are issued, and identify the types of bonds. JWCL165_c10_444-505.qxd 454 7/20/09 8:58 PM Page 454 Chapter 10 Liabilities Illustration 10-8 Advantages of bond financing over common stock Bond Financing Advantages 1. Stockholder control is not affected. Bondholders do not have voting rights, so current owners (stockholders) retain full control of the company. 2. Tax savings result. Bond interest is deductible for tax purposes; dividends on stock are not. 3. Earnings per share may be higher. Although bond interest expense reduces net income, earnings per share on common stock often is higher under bond financing because no additional shares of common stock are issued. As the illustration shows, one reason to issue bonds is that they do not affect stockholder control. Because bondholders do not have voting rights, owners can raise capital with bonds and still maintain corporate control. In addition, bonds are attractive to corporations because the cost of bond interest is tax-deductible. As a result of this tax treatment, which stock dividends do not offer, bonds may result in lower cost of capital than equity financing. To illustrate the third advantage, on earnings per share, assume that Microsystems, Inc. is considering two plans for financing the construction of a new $5 million plant. Plan A involves issuance of 200,000 shares of common stock at the current market price of $25 per share. Plan B involves issuance of $5 million, 8% bonds at face value. Income before interest and taxes on the new plant will be $1.5 million. Income taxes are expected to be 30%. Microsystems currently has 100,000 shares of common stock outstanding. Illustration 10-9 shows the alternative effects on earnings per share. Illustration 10-9 Effects on earnings per sharestocks vs. bonds Income before interest and taxes Interest (8% \u0002 $5,000,000) HELPFUL HINT Besides corporations, governmental agencies and universities also issue bonds to raise capital. Income before income taxes Income tax expense (30%) Net income Outstanding shares Earnings per share Plan A Issue Stock Plan B Issue Bonds $1,500,000 $1,500,000 400,000 1,500,000 450,000 1,100,000 330,000 $1,050,000 $ 770,000 300,000 $3.50 100,000 $7.70 Note that net income is $280,000 less ($1,050,000 \u0005 $770,000) with long-term debt financing (bonds). However, earnings per share is higher because there are 200,000 fewer shares of common stock outstanding. One disadvantage in using bonds is that the company must pay interest on a periodic basis. In addition, the company must also repay the principal at the due date. A company with fluctuating earnings and a relatively weak cash position may have great difficulty making interest payments when earnings are low. A corporation may also obtain long-term financing from notes payable and leasing. However, notes payable and leasing are seldom sufficient to furnish the amount of funds needed for plant expansion and major projects like new buildings. Bonds are sold in relatively small denominations (usually $1,000 multiples). As a result of their size, and the variety of their features, bonds attract many investors. JWCL165_c10_444-505.qxd 8/11/09 3:36 PM Page 455 455 Bond Basics Types of Bonds Bonds may have many different features. In the following sections, we describe the types of bonds commonly issued. SECURED AND UNSECURED BONDS Secured bonds have specific assets of the issuer pledged as collateral for the bonds. A bond secured by real estate, for example, is called a mortgage bond. A bond secured by specific assets set aside to retire the bonds is called a sinking fund bond. Unsecured bonds, also called debenture bonds, are issued against the general credit of the borrower. Companies with good credit ratings use these bonds extensively. For example, in a recent annual report, DuPont reported over $2 billion of debenture bonds outstanding. Secured Bonds No Asset as Collateral Unsecured Bonds TERM AND SERIAL BONDS Bonds that matureare due for paymentat a single specified future date are term bonds. In contrast, bonds that mature in installments are serial bonds. REGISTERED AND BEARER BONDS Bonds issued in the name of the owner are registered bonds. Interest payments on registered bonds are made by check to bondholders of record. Bonds not registered are bearer (or coupon) bonds. Holders of bearer bonds must send in coupons to receive interest payments. Most bonds issued today are registered bonds. CONVERTIBLE AND CALLABLE BONDS Bonds that can be converted into common stock at the bondholder's option are convertible bonds. The conversion feature generally is attractive to bond buyers. Bonds that the issuing company can retire at a stated dollar amount prior to maturity are callable bonds.A call feature is included in nearly all corporate bond issues. Issuing Procedures Bond Convert Stock Convertible Bonds \"Hey Harv, Call in those bonds\" Bond Bond State laws grant corporations the power to issue bonds. Both the board of directors and stockholders usually must approve bond issues. In authorizing the bond issue, Bond the board of directors must stipulate the number of bonds to be authorized, total face value, and contractual interest rate. The total bond authorization often exCallable Bonds ceeds the number of bonds the company originally issues. This gives the corporation the flexibility to issue more bonds, if needed, to meet future cash requirements. The face value is the amount of principal the issuing company must pay at the maturity date. The contractual interest rate, often referred to as the stated rate, is the rate used to determine the amount of cash interest the borrower pays and the investor receives. Usually the contractual rate is stated as an annual rate. Interest is generally paid semiannually. The terms of the bond issue are set forth in a legal document called a bond indenture. The indenture shows the terms and summarizes the rights of the bondholders and their trustees, and the obligations of the issuing company. The trustee (usually a financial institution) keeps records of each bondholder, maintains custody of unissued bonds, and holds conditional title ETHICS NOTE to pledged property. Some companies try to In addition, the issuing company arranges for the printing of bond minimize the amount of debt certificates. The indenture and the certificate are separate documents. As reported on their balance sheet shown in Illustration 10-10 (page 456), a bond certificate provides the fol- by not reporting certain types of lowing information: name of the issuer, face value, contractual interest commitments as liabilities. This rate, and maturity date. An investment company that specializes in selling subject is of intense interest in the financial community. securities generally sells the bonds for the issuing company. JWCL165_c10_444-505.qxd 456 7/20/09 9:34 PM Page 456 Chapter 10 Liabilities Issuer of bonds Maturity date Face or par value Contractual interest rate Illustration 10-10 Bond certificate Bond Trading Bondholders have the opportunity to convert their holdings into cash at any time by selling the bonds at the current market price on national securities exchanges. Bond prices are quoted as a percentage of the face value of the bond, which is usually $1,000. A $1,000 bond with a quoted price of 97 means that the selling price of the bond is 97% of face value, or $970. Newspapers and the financial press publish bond prices and trading activity daily as illustrated by the following. Illustration 10-11 Market information for bonds Bonds Maturity Close Yield Est. Volume (000) Boeing Co. 5.125 Feb. 15, 2014 96.595 5.747 33,965 This bond listing indicates that Boeing Co. has outstanding 5.125%, $1,000 bonds that mature in 2014. They currently yield a 5.747% return. On this day, $33,965,000 of these bonds were traded. At the close of trading, the price was 96.595% of face value, or $965.95. JWCL165_c10_444-505.qxd 7/20/09 8:58 PM Page 457 Bond Basics A corporation makes journal entries only when it issues or buys back bonds, or when bondholders convert bonds into common stock. For example, DuPont does not journalize transactions between its bondholders and other investors. If Tom Smith sells his DuPont bonds to Faith Jones, DuPont does not journalize the transaction. (DuPont or its trustee does, however, keep records of the names of bondholders in the case of registered bonds.) Determining the Market Value of Bonds If you were an investor wanting to purchase a bond, how would you determine how much to pay? To be more specific, assume that Coronet, Inc. issues a zero-interest bond (pays no interest) with a face value of $1,000,000 due in 20 years. For this bond, the only cash you receive is a million dollars at the end of 20 years. Would you pay a million dollars for this bond? We hope not! A million dollars received 20 years from now is not the same as a million dollars received today. The reason you should not pay a million dollars for Coronet's bond relates to what is called the time value of money. If you had a million dollars today, you would invest it. From that investment, you would earn interest such that at the end of 20 years, you would have much more than a million dollars. If someone is going to pay you a million dollars 20 years from now, you would want to find its equivalent today. In other words, you would want to determine how much you must invest today at current interest rates to have a million dollars in 20 years.The amount that must be invested today at a given rate of interest over a specified time is called present value. The present value of a bond is the value at which it should sell in the marketplace. Market value therefore is a function of the three factors that determine present value: (1) the dollar amounts to be received, (2) the length of time until the amounts are received, and (3) the market rate of interest. The market interest rate is the rate investors demand for loaning funds. Appendix 10A discusses the process of finding the present value for bonds. Appendix C (near the end of the book) also provides additional material for time value of money computations. ACCOUNTING ACROSS THE ORGANIZATION When to Go Long-Term A decision that all companies must make is to what extent to rely on short-term versus long-term financing. The critical nature of this decision was highlighted in the fall of 2001, after the World Trade Center disaster. Prior to September 11, short-term interest rates had been extremely low relative to long-term rates. In order to minimize interest costs, many companies were relying very heavily on short-term financing to purchase things they normally would have used long-term debt for. The problem with short-term financing is that it requires companies to continually find new financing as each loan comes due. This makes them vulnerable to sudden changes in the economy. After September 11, lenders and short-term investors became very reluctant to loan money. This put the squeeze on many companies: As short-term loans came due, they were unable to refinance. Some were able to get other financing, but at extremely high rates (for example, 12% as compared to 3%). Others were unable to get loans and instead had to sell assets to generate cash for their immediate needs. Source: Henny Sender, \"Firms Feel Consequences of Short-Term Borrowing,\"Wall Street Journal Online, October 12, 2001. Based on this story, what is a good general rule to use in choosing between short-term and long-term financing? 457 HELPFUL HINT (1) What is the price of a $1,000 bond trading at 9514? (2) What is the price of a $1,000 bond trading at 10178? Answers: (1) $952.50. (2) $1,018.75. 2011 $1 m illion 2031 $1 m illion Same dollars at different times are not equal. JWCL165_c10_444-505.qxd 458 7/20/09 4:09 PM Page 458 Chapter 10 Liabilities before you go on... Do it! Bond Terminology State whether each of the following statements is true or false. _____ 1. Mortgage bonds and sinking fund bonds are both examples of secured bonds. _____ 2. Unsecured bonds are also known as debenture bonds. _____ 3. The stated rate is the rate investors demand for loaning funds. _____ 4. The face value is the amount of principal the issuing company must pay at the maturity date. Action Plan Review the types of bonds and the basic terms associated with bonds. _____ 5. The bond issuer must make journal entries to record transfers of its bonds among investors. Solution 1. True. 2. True. 3. False. The stated rate is the contractual interest rate used to determine the amount of cash interest the borrower pays. 4. True. 5. False. The bond issuer makes journal entries only when it issues or buys back bonds, when it records interest, and when bonds are converted. Related exercise material: BE10-7, E10-8, E10-9, and Do it! 10-2. The Navigator ACCOUNTING FOR BOND ISSUES STUDY OBJECTIVE 5 Prepare the entries for the issuance of bonds and interest expense. Bonds may be issued at face value, below face value (at a discount), or above face value (at a premium). Issuing Bonds at Face Value To illustrate the accounting for bonds, assume that on January 1, 2011, Candlestick Corporation issues $100,000, five-year, 10% bonds at 100 (100% of face value). The entry to record the sale is: A \u0004 \u0003 L SE \u0003100,000 Jan. 1 \u0003100,000 Cash Flows \u0003100,000 A \u0004 L \u0003 SE \u00055,000 Exp \u00055,000 Cash Flows \u00055,000 Cash Bonds Payable (To record sale of bonds at face value) 100,000 100,000 Candlestick reports bonds payable in the long-term liabilities section of the balance sheet because the maturity date is more than one year away. Over the term (life) of the bonds, companies make entries to record bond interest. Interest on bonds payable is computed in the same manner as interest on notes payable, as explained on page 447. Assume that interest is payable semiannually on January 1 and July 1 on the bonds described above. In that case, Candlestick must pay interest of $5,000 ($100,000 \u0002 10% \u0002 6/12) on July 1, 2011. The entry for the payment, assuming no previous accrual of interest, is: July 1 Bond Interest Expense Cash (To record payment of bond interest) 5,000 5,000 JWCL165_c10_444-505.qxd 7/20/09 4:09 PM Page 459 459 Accounting for Bond Issues At December 31, Candlestick recognizes the $5,000 of interest expense incurred since July 1 with the following adjusting entry: Dec. 31 Bond Interest Expense Bond Interest Payable (To accrue bond interest) A \u0004 \u0003 L SE \u00055,000 Exp 5,000 \u00035,000 5,000 Cash Flows no effect Companies classify bond interest payable as a current liability, because it is scheduled for payment within the next year. When Candlestick pays the interest on January 1, 2012, it debits (decreases) Bond Interest Payable and credits (decreases) Cash for $5,000. Discount or Premium on Bonds Bond Contractual Interest Rate 10% Issued when Market Interest Rate Bonds Sell at 8% Premium 10% Face Value 12% Discount Issuing bonds at an amount different from face value is quite common. By the time a company prints the bond certificates and markets the bonds, it will be a coincidence if the market rate and the contractual rate are the same. Thus, the sale of bonds at a discount does not mean that the issuer's financial strength is suspect. Nor does the sale of bonds at a premium indicate exceptional financial strength. HELPFUL HINT Discount on Bonds Payable Increase Debit Decrease Credit In the Candlestick illustrations above, we assumed that the contractual (stated) interest rate paid on the bonds and the market (effective) interest rate were the same. Recall that the contractual interest rate is the rate applied to the face (par) value to arrive at the interest paid in a year. The market interest rate is the rate investors demand for loaning funds to the corporation.When the contractual interest rate and the market interest rate are the same, bonds sell at face value. However, market interest rates change daily. The type of bond issued, the state of the economy, current industry conditions, and the company's performance all affect market interest rates. Contractual and market interest rates often differ. As a result, bonds often sell below or above face value. To illustrate, suppose that a company issues 10% bonds at a time when other bonds of similar risk are paying 12%. Investors will not be interested in buying the 10% bonds, so their value will fall below their face value. In this case, we say the 10% bonds are selling at a discount. As a result of the decline in the bonds' selling price, the actual interest rate incurred by the company increases to the level of the current market interest rate. Conversely, if the market rate of interest is lower than the contractual interest rate, investors will have to pay more than face value for the bonds. That is, if the market rate of interest is 8% but the contractual interest rate on the bonds is 10%, the issuer will require more funds from the investor. In these cases, bonds sell at a premium. Illustration 10-12 shows these relationships graphically. Normal Balance Illustration 10-12 Interest rates and bond prices JWCL165_c10_444-505.qxd 460 7/20/09 4:09 PM Page 460 Chapter 10 Liabilities Issuing Bonds at a Discount To illustrate issuance of bonds at a discount, assume that on January 1, 2011, Candlestick, Inc. sells $100,000, five-year, 10% bonds for $92,639 (92.639% of face value). Interest is payable on July 1 and January 1.The entry to record the issuance is: A \u0004 L \u0003 SE \u000392,639 Jan. 1 \u00057,361 \u0003100,000 Cash Flows \u000392,639 Cash Discount on Bonds Payable Bonds Payable (To record sale of bonds at a discount) 92,639 7,361 100,000 Although Discount on Bonds Payable has a debit balance, it is not an asset. Rather, it is a contra account. This account is deducted from bonds payable on the balance sheet, as shown in Illustration 10-13. Illustration 10-13 Statement presentation of discount on bonds payable CANDLESTICK, INC. Balance Sheet (partial) Long-term liabilities Bonds payable Less: Discount on bonds payable HELPFUL HINT Carrying value (book value) of bonds issued at a discount is determined by subtracting the balance of the discount account from the balance of the Bonds Payable account. Illustration 10-14 Total cost of borrowing bonds issued at a discount $100,000 7,361 $92,639 The $92,639 represents the carrying (or book) value of the bonds. On the date of issue this amount equals the market price of the bonds. The issuance of bonds below face valueat a discountcauses the total cost of borrowing to differ from the bond interest paid. That is, the issuing corporation must pay not only the contractual interest rate over the term of the bonds, but also the face value (rather than the issuance price) at maturity.Therefore, the difference between the issuance price and face value of the bondsthe discountis an additional cost of borrowing. The company records this additional cost as bond interest expense over the life of the bonds.Appendices 10B and 10C show the procedures for recording this additional cost. The total cost of borrowing $92,639 for Candlestick, Inc. is $57,361, computed as follows. Bonds Issued at a Discount Semiannual interest payments ($100,000 \u0002 10% \u0002 12 \u0004 $5,000; $5,000 \u0002 10) Add: Bond discount ($100,000 \u0005 $92,639) Total cost of borrowing $50,000 7,361 $57,361 Alternatively, we can compute the total cost of borrowing as follows. Illustration 10-15 Alternative computation of total cost of borrowing bonds issued at a discount Bond Issued at a Discount Principal at maturity Semiannual interest payments ($5,000 \u0002 10) Cash to be paid to bondholders Cash received from bondholders Total cost of borrowing $100,000 50,000 150,000 92,639 $ 57,361 JWCL165_c10_444-505.qxd 7/20/09 4:09 PM Page 461 Accounting for Bond Issues 461 Issuing Bonds at a Premium To illustrate the issuance of bonds at a premium, we now assume the Candlestick, Inc. bonds described above sell for $108,111 (108.111% of face value) rather than for $92,639. The entry to record the sale is: A Jan. 1 Cash Bonds Payable Premium on Bonds Payable (To record sale of bonds at a premium) \u0004 L \u0003 SE \u0003108,111 108,111 100,000 8,111 \u0003100,000 \u00038,111 Cash Flows \u0003108,111 Candlestick adds the premium on bonds payable to the bonds payable amount on the balance sheet, as shown in Illustration 10-16 below. Illustration 10-16 Statement presentation of bond premium Balance Sheet (partial) Long-term liabilities Bonds payable Add: Premium on bonds payable $100,000 8,111 $108,111 The sale of bonds above face value causes the total cost of borrowing to be less than the bond interest paid. The bond premium is considered to be a reduction in the cost of borrowing. The company credits the bond premium to Bond Interest Expense over the life of the bonds. Appendices 10B and 10C show the procedures for recording this reduction in the cost of borrowing. The total cost of borrowing $108,111 for Candlestick, Inc. is computed as follows. HELPFUL HINT Premium on Bonds Payable Decrease Debit Increase Credit CANDLESTICK, INC. Normal Balance Illustration 10-17 Total cost of borrowing bonds issued at a premium Bonds Issued at a Premium Semiannual interest payments ($100,000 \u0002 10% \u0002 12 \u0004 $5,000; $5,000 \u0002 10) Less: Bond premium ($108,111 \u0005 $100,000) $50,000 8,111 Total cost of borrowing $41,889 Alternatively, we can compute the cost of borrowing as follows. Bonds Issued at a Premium Principal at maturity Semiannual interest payments ($5,000 \u0002 10) Cash to be paid to bondholders Cash received from bondholders Total cost of borrowing $100,000 50,000 Illustration 10-18 Alternative computation of total cost of borrowing bonds issued at a premium 150,000 108,111 $ 41,889 before you go on... Do it! Giant Corporation issues $200,000 of bonds for $189,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the balance sheet at the date of issuance. Bond Issuance JWCL165_c10_444-505.qxd 462 8/7/09 3:34 PM Page 462 Chapter 10 Liabilities Action Plan Record cash received, bonds payable at face value, and the difference as a discount or premium. Report discount as a deduction from bonds payable and premium as an addition to bonds payable. Solution (a) Cash Discount on Bonds Payable Bonds Payable (To record sale of bonds at a discount) 189,000 11,000 200,000 (b) Long-term liabilities Bonds payable Less: Discount on bonds payable $200,000 11,000 $189,000 Related exercise material: BE10-8, BE10-9, BE10-10, E10-10, E10-11, E10-12, and Do it! 10-2. The Navigator ACCOUNTING FOR BOND RETIREMENTS STUDY OBJECTIVE 6 Describe the entries when bonds are redeemed or converted. An issuing corporation retires bonds either when it redeems the bonds or when bondholders convert them into common stock. We explain the entries for these transactions in the following sections. Redeeming Bonds at Maturity A \u0004 L \u0003 Regardless of the issue price of bonds, the book value of the bonds at maturity will equal their face value. Assuming that the company pays and records separately the interest for the last interest period, Candlestick records the redemption of its bonds at maturity as follows: SE \u0005100,000 Bonds Payable Cash (To record redemption of bonds at maturity) \u0005100,000 Cash Flows \u0005100,000 100,000 100,000 Redeeming Bonds before Maturity HELPFUL HINT A bond is redeemed prior to its maturity date. Its carrying value exceeds its redemption price. Will the retirement result in a gain or a loss on redemption? Answer: Gain. A \u0004 L \u0003 SE \u0005100,000 \u00051,623 \u00051,377 Exp \u0005103,000 Cash Flows \u0005103,000 Bonds also may be redeemed before maturity. A company may decide to retire bonds before maturity to reduce interest cost and to remove debt from its balance sheet. A company should retire debt early only if it has sufficient cash resources. When a company retires bonds before maturity, it is necessary to: (1) eliminate the carrying value of the bonds at the redemption date; (2) record the cash paid; and (3) recognize the gain or loss on redemption. The carrying value of the bonds is the face value of the bonds less unamortized bond discount or plus unamortized bond premium at the redemption date. To illustrate, assume that Candlestick, Inc. has sold its bonds at a premium. At the end of the eighth period, Candlestick retires these bonds at 103 after paying the semiannual interest. Assume also that the carrying value of the bonds at the redemption date is $101,623. Candlestick makes the following entry to record the redemption at the end of the eighth interest period (January 1, 2015): Jan. 1 Bonds Payable Premium on Bonds Payable Loss on Bond Redemption Cash (To record redemption of bonds at 103) 100,000 1,623 1,377 103,000 JWCL165_c10_444-505.qxd 8/11/09 3:38 PM Page 463 Accounting for Long-Term Notes Payable 463 Note that the loss of $1,377 is the difference between the cash paid of $103,000 and the carrying value of the bonds of $101,623. Converting Bonds into Common Stock Convertible bonds have features that are attractive both to bondholders and to the issuer. The conversion often gives bondholders an opportunity to benefit if the market price of the common stock increases substantially. Until conversion, though, the bondholder receives interest on the bond. For the issuer of convertible bonds, the bonds sell at a higher price and pay a lower rate of interest than comparable debt securities without the conversion option. Many corporations, such as USAir, USX Corp., and Chrysler Corporation, have convertible bonds outstanding. When the issuing company records a conversion, the company ignores the current market prices of the bonds and stock. Instead, the company transfers the carrying value of the bonds to paid-in capital accounts. No gain or loss is recognized. To illustrate, assume that on July 1 Saunders Associates converts $100,000 bonds sold at face value into 2,000 shares of $10 par value common stock. Both the bonds and the common stock have a market value of $130,000. Saunders makes the following entry to record the conversion: A July 1 Bonds Payable Common Stock Paid-in Capital in Excess of Par Value (To record bond conversion) 100,000 20,000 80,000 \u0004 L \u0003 SE \u0005100,000 \u000320,000 CS \u000380,000 CS Cash Flows no effect Note that the company does not consider the current market price of the bonds and stock ($130,000) in making the entry. This method of recording the bond conversion is often referred to as the carrying (or book) value method. before you go on... Do it! R & B Inc. issued $500,000, 10-year bonds at a premium. Prior to maturity, when the carrying value of the bonds is $508,000, the company retires the bonds at 102. Prepare the entry to record the redemption of the bonds. Solution There is a loss on redemption: The cash paid, $510,000 ($500,000 \u0002 102%), is greater than the carrying value of $508,000. The entry is: Bonds Payable Premium on Bonds Payable Loss on Bond Redemption Cash (To record redemption of bonds at 102) Related exercise material: BE10-11, E10-13, E10-14, and Do it! 10-3. 500,000 8,000 2,000 Bond Redemption Action Plan Determine and eliminate the carrying value of the bonds. Record the cash paid. Compute and record the gain or loss (the difference between the first two items). 510,000 The Navigator ACCOUNTING FOR LONG-TERM NOTES PAYABLE The use of notes payable in long-term debt financing is quite common. Long-term notes payable are similar to short-term interest-bearing notes payable except that the term of the notes exceeds one year. STUDY OBJECTIVE 7 Describe the accounting for long-term notes payable. JWCL165_c10_444-505.qxd 464 8/7/09 3:37 PM Page 464 Chapter 10 Liabilities A long-term note may be secured by a mortgage that pledges title to specific assets as security for a loan. Individuals widely use mortgage notes payable to purchase homes, and many small and some large companies use them to acquire plant assets. At one time, approximately 18% of McDonald's long-term debt related to mortgage notes on land, buildings, and improvements. Mortgage loan terms may stipulate either a fixed or an adjustable interest rate. The interest rate on a fixed-rate mortgage remains the same over the life of the mortgage. The interest rate on an adjustable-rate mortgage is adjusted periodically to reflect changes in the market rate of interest. Typically, the terms require the borrower to make installment payments over the term of the loan. Each payment consists of (1) interest on the unpaid balance of the loan and (2) a reduction of loan principal. The interest decreases each period, while the portion applied to the loan principal increases. Companies initially record mortgage notes payable at face value. They subsequently make entries for each installment payment. To illustrate, assume that Porter Technology Inc. issues a $500,000, 12%, 20-year mortgage note on December 31, 2011, to obtain needed financing for a new research laboratory. The terms provide for semiannual installment payments of $33,231 (not including real estate taxes and insurance). The installment payment schedule for the first two years is as follows. Illustration 10-19 Mortgage installment payment schedule Semiannual Interest Period (A) Cash Payment (B) Interest Expense (D) 6% (C) Reduction of Principal (A) (B) (D) Principal Balance (D) (C) 12/31/11 06/30/12 12/31/12 06/30/13 12/31/13 $33,231 33,231 33,231 33,231 $30,000 29,806 29,601 29,383 $3,231 3,425 3,630 3,848 $500,000 496,769 493,344 489,714 485,866 Porter records the mortgage loan and first installment payment as follows. A \u0004 L \u0003 SE \u0003500,000 Dec. 31 \u0003500,000 Cash Flows \u0003500,000 June 30 A \u0004 L \u0003 SE \u000530,000 Exp \u00053,231 \u000533,231 Cash Mortgage Notes Payable (To record mortgage loan) Interest Expense Mortgage Notes Payable Cash (To record semiannual payment on mortgage) 500,000 500,000 30,000 3,231 33,231 Cash Flows \u000533,231 In the balance sheet, the company reports the reduction in principal for the next year as a current liability, and it classifies the remaining unpaid principal balance as a long-term liability. At December 31, 2012, the total liability is $493,344. Of that amount, $7,478 ($3,630 \u0003 $3,848) is current, and $485,866 ($493,344 \u0005 $7,478) is long-term. JWCL165_c10_444-505.qxd 8/11/09 3:38 PM Page 465 Statement Presentation and Analysis 465 before you go on... Do it! Cole Research issues a $250,000, 8%, 20-year mortgage note to obtain needed financing for a new lab. The terms call for semiannual payments of $12,631 each. Prepare the entries to record the mortgage loan and the first installment payment. Solution Cash Mortgage Notes Payable (To record mortgage loan) Interest Expense Mortgage Notes Payable Cash (To record semiannual payment on mortgage) 250,000 250,000 10,000* 2,361 Long-Term Note Action Plan Record the issuance of the note as a cash receipt and a liability. Record each installment payment that consists of interest and payment of principal. 12,361 *Interest expense \u0004 $250,000 \u0002 8% \u0002 6/12. Related exercise material: BE10-12, E10-15, and Do it! 10-4. The Navigator ACCOUNTING ACROSS THE ORGANIZATION Search for Your Best Rate Companies spend a great deal of time shopping for the best loan terms. You should do the same. Suppose that you have a used car that you are planning to trade in on the purchase of a new car. Experts suggest that you view this deal as three separate transactions: (1) the purchase of a new car, (2) the trade in or sale of an old car, and (3) shopping for an interest rate. Studies suggest that too many people neglect transaction number 3. One survey found that 63% of people planned on shopping for the best car-loan interest rate online the next time they bought a car. But a separate study found that only 15% of people who bought a car actually shopped around for the best online rate. Too many people simply take the interest rate offered at the car dealership. Many lenders will pre-approve you for a loan up to a specific dollar amount, and many will then give you a blank check (negotiable for up to that amount) that you can take to the car dealer. Source: Ron Lieber, \"How to Haggle the Best Car Loan,\"Wall Street Journal, March 25, 2006, p. B1. What should you do if the dealer \"trash-talks\" your lender, or refuses to sell you the car for the agreed-upon price unless you get your car loan through the dealer? STATEMENT PRESENTATION AND ANALYSIS Presentation Companies report long-term liabilities in a separate section of the balance sheet immediately following current liabilities, as shown in Illustration 10-20 on the next page.Alternatively, companies may present summary data in the STUDY OBJECTIVE 8 Identify the methods for the presentation and analysis of long-term liabilities. JWCL165_c10_444-505.qxd 466 7/20/09 4:10 PM Page 466 Chapter 10 Liabilities balance sheet, with detailed data (interest rates, maturity dates, conversion privileges, and assets pledged as collateral) shown in a supporting schedule. Companies report the current maturities of long-term debt under current liabilities if they are to be paid from current assets. Illustration 10-20 Balance sheet presentation of long-term liabilities LAX CORPORATION Balance Sheet (partial) Long-term liabilities Bonds payable 10% due in 2018 Less: Discount on bonds payable Mortgage notes payable, 11%, due in 2024 and secured by plant assets Lease liability $1,000,000 80,000 $ 920,000 500,000 440,000 Total long-term liabilities $1,860,000 Analysis Long-term creditors and stockholders are interested in a company's long-run solvency. Of particular interest is the company's ability to pay interest as it comes due and to repay the face value of the debt at maturity. Debt to total assets and times interest earned are two ratios that provide information about debt-paying ability and long-run solvency. The debt to total assets ratio measures the percentage of the total assets provided by creditors. As shown in the formula in Illustration 10-21, it is computed by dividing total debt (both current and long-term liabilities) by total assets. The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations. The times interest earned ratio indicates the company's ability to meet interest payments as they come due. It is computed by dividing income before income taxes and interest expense by interest expense. To illustrate these ratios, we will use data from Kellogg Company's recent annual report. The company had total liabilities of $8,871 million, total assets of $11,397 million, interest expense of $319 million, income taxes of $444 million, and net income of $1,103 million. Kellogg's debt to total assets ratio and times interest earned ratio are shown below. Illustration 10-21 Debt to total assets and times interest earned ratios, with computations Total Debt $8,871 Total Assets Debt to Total Assets \u0006 $11,397 \u0004 77.8% Income before Income Taxes and Interest Expense $1,103 \u0003 $444 \u0003 $319 \u0006 Interest Expense Times Interest Earned $319 \u0004 5.85 times Kellogg has a relatively high debt to total assets percentage of 77.8%. Its interest coverage of 5.85 times is considered safe. JWCL165_c10_444-505.qxd 7/20/09 4:10 PM Page 467 Statement Presentation and Analysis I N V E S T O R I N S I G H T \"Covenant-Lite\" Debt In many corporate loans and bond issuances the lending agreement specifies debt covenants. These covenants typically are specific financial measures, such as minimum levels of retained earnings, cash flows, times interest earned ratios, or other measures that a company must maintain during the life of the loan. If the company violates a covenant, it is considered to have violated the loan agreement; the creditors can demand immediate repayment, or they can renegotiate the loan's terms. Covenants protect lenders because they enable lenders to step in and try to get their money back before the borrower gets too deep into trouble. During the 1990s most traditional loans specified between three to six covenants or \"triggers.\" In more recent years, when lots of cash was available, lenders began reducing or completely eliminating covenants from loan agreements in order to be more competitive with other lenders. In a slower economy these lenders will be more likely to lose big money when companies default. Source: Cynthia Koons, \"Risky Business: Growth of 'Covenant-Lite' Debt,\" Wall Street Journal, June 18, 2007, p. C2. How can financial ratios such as those covered in this chapter provide protection for creditors? Be sure to read all about Y *U Your Boss Wants to Know If You Ran Today on page 468 for information on how topics in this chapter apply to you. 467 JWCL165_c10_444-505.qxd 7/20/09 4:10 PM all about Y Page 468 *U Your Boss Wants to Know If You Ran Today A As you saw in this chapter, compensation packages often include fringe benefits in addition to basic salary. Health insurance is one benefit that many employers offer. In recent years, as the cost of health insurance has sky-rocketed, many employers either have shifted some of the cost of health insurance onto employees, or have discontinued health insurance coverage altogether. In addition, some employees are encouraging and setting up preventive healthcare programs. Here are the percentages for five unhealthy behaviors for individuals with some college education: current cigarette smoker (22.9%), five or more alcoholic drinks at one sitting during at least once in the past year (30%), physically inactive (30%), obese (25.2%), or sleep less than 6 hours per day (30.3%). Some Facts * * For employers, the average cost of healthcare benefits per employee is about $6,700 per year. *About the Numbers As the graph below shows, private health insurance, such as that provided by employers, pays for less than half of healthcare costs in the U.S. If employers continue to cut their healthcare benefits, more of the burden will shift to the government or to individuals as out-of-pocket costs. The Nation's Healthcare Dollar: Where It Comes From* Other private 4.2% Other government programs 7.3% Out-of-pocket payments 14.3% Medicaid 16.2% * The rate of increase of employer healthcare costs has slowed somewhat as employers raised the employee share of premiums and raised deductibles (the amount of a bill that the employee pays before insurance coverage begins). * In 2008, it is estimated that the percentage of persons that did not have health insurance was 14.5% (43.3 million) for persons of all ages. Approximately 19.4% of persons under 65 years of age were covered by public health plans, and 65.5% were covered by private insurance. * Government is expected to become the largest source of funding for health care by 2016 and is projected to pay more than half of all national health spending by 2018. * As a percentage of payroll, the employer cost of health benefits has exploded over the past few decades. In addition, employer health costs for manufacturing firms in the U.S., $2.38 per worker per hour, were much higher than the foreign trade-weighted average of $0.96 per worker per hour in 2005. Employer health costs make the U.S. less competitive than it could otherwise be. * The costs and performance of America's healthcare system are putting workers and companies at a \"significant disadvantage\" in the global marketplace. The Business Roundtable, whose member companies provide healthcare plans for more than 35 million Americans, finds that compared with people in Canada, Japan, Germany, the United Kingdom, and France, Americans receive 23% less value from their healthcare system. When compared with emerging competitors like Brazil, India, and China, the U.S. receives 46% less value. This study finds that for every $1 the U.S. spends on health care, its five leading competitors spend $0.63, and the emerging competitors just $0.15. The study also notes that \"on the whole, our workforce is not as healthy\" as that of either group of competitors. Private health insurance 36.2% Medicare 21.8% * Does not add to 100% due to rounding. Source: Data for 2007