Please read the attachment chapters and answer the following questions with at least 50 words.

Depreciation discussion

What are the various methods of determining depreciation and amortization expenses?

Payables discussion

How would you describe the accounting procedures for notes payable and accounts payable and accrued expenses?

Bonds discussion

Please discuss some part of the journalization of the issuance of bonds, the periodic interest, and amortization of bond.

CHAPTER 1 0 REPORTING AND ANALYZING LIABILITIES The Navigator Scan Learning Objectives Read Feature Story Scan Preview Read Text and Answer CURRENT LIABILITIES WAGES AND PAYROLL TAXES BOND TERMINOLOGY BOND ISSUANCE BOND REDEMPTION Work Using the Decision Toolkit Review Summary of Learning Objectives Work Comprehensive Answer SelfTest Questions Complete Assignments Read A Look at IFRS LEARNING 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. 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. 7. Identify the requirements for the financial statement presentation and analysis of liabilities. Chapter Opener Video: Chapter 10 Feature Story AND THEN THERE WERE TWO Debt can help a company acquire the things it needs to grow, but it is often the very thing that kills a company. A brief history of Maxwell Car Company illustrates the role of debt in the U.S. auto industry. In 1920, Maxwell Car Company was on the brink of financial ruin. Because it was unable to pay its bills, its creditors stepped in and took over. They hired a formerGeneral Motors (GM) executive named Walter Chrysler to reorganize the company. By 1925, he had taken over the company and renamed it Chrysler. By 1933, Chrysler was booming, with sales surpassing even those of Ford. But the next few decades saw Chrysler make a series of blunders. By 1980, with its creditors pounding at the gates, Chrysler was again on the brink of financial ruin. At that point, Chrysler brought in a former Ford executive named Lee Iacocca to save the company. Iacocca argued that the United States could not afford to let Chrysler fail because of the loss of jobs. He convinced the federal government to grant loan guaranteespromises that if Chrysler failed to pay its creditors, the government would pay them. Iacocca then streamlined operations and brought out some profitable products. Chrysler repaid all of its governmentguaranteed loans by 1983, seven years ahead of the scheduled final payment. To compete in today's global vehicle market, you must be bigreally big. So in 1998, Chrysler merged with German automaker DaimlerBenz to form DaimlerChrysler. For a time, this left just two U.S. based auto manufacturersGM and Ford. But in 2007, DaimlerChrysler sold 81% of Chrysler to Cerberus, an investment group, to provide muchneeded cash infusions to the automaker. In 2009, Daimler turned over its remaining stake to Cerberus. Three days later, Chrysler filed for bankruptcy. But by 2010, it was beginning to show signs of a turnaround. The car companies are giants. GM and Ford typically rank among the top five U.S. firms in total assets. But GM and Ford accumulated truckloads of debt on their way to getting big. Although debt made it possible to get so big, the Chrysler story, and GM's recent bankruptcy, make it clear that debt can also threaten a company's survival. INSIDE CHAPTER 10... When Convertible Bonds Don't Debt Masking \"CovenantLite\" Debt PREVIEW OF CHAPTER 10 The Feature Story suggests that General Motors (GM) and Ford accumulated tremendous amounts of debt in their pursuit of auto industry dominance. It is unlikely that they could have grown so large without this debt, but at times the debt threatens their very existence. Given this risk, why do companies borrow money? Why do they sometimes borrow shortterm and other times longterm? Besides bank borrowings, what other kinds of debts do companies incur? In this chapter, we address these issues. The content and organization of the chapter are as follows. Current Liabilities WHAT IS A CURRENT LIABILITY? LEARNING OBJECTIVE Explain a current liability and identify the major types of current liabilities. 1 You have learned that liabilities are defined as \"creditors' claims on total assets\" and as \"existing debts and obligations.\" Companies must settle or pay these claims, debts, and obligations at some time in the future by transferring assets or services. The future date on which they are due or payable (the maturity date) is a significant feature of liabilities. As explained in Chapter 2, a current liability is a debt that a company reasonably expects to pay (1) from existing current assets or through the creation of other current liabilities, and (2) within one year or the operating cycle, whichever is longer. Debts that do not meet both criteria are longterm liabilities. Financial statement users want to know whether a company's obligations are current or longterm. A company that has more current liabilities than current assets often lacks liquidity, or shortterm debtpaying ability. In addition, users want to know the types of liabilities a company has. If a company declares bankruptcy, a specific, predetermined order of payment to creditors exists. Thus, the amount and type of liabilities are of critical importance. The different types of current liabilities include notes payable, accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest. In the sections that follow, we discuss a few of the common types of current liabilities. Helpful Hint In previous chapters, we explained the entries for accounts payable and the adjusting entries for some current liabilities. NOTES PAYABLE LEARNING OBJECTIVE 2 Describe the accounting for notes payable. Companies record obligations in the form of written notes as notes payable. They often use notes payable instead of accounts payable because notes payable provide written documentation of the obligation in case legal remedies are needed to collect the debt. Companies frequently issue notes payable to meet shortterm financing needs. Notes payable usually require the borrower to pay interest. Notes are issued for varying periods of time. 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 on September 1, 2014, Cole Williams Co. signs a $100,000, 12%, fourmonth note maturing on January 1 with First National Bank. When a company issues an interestbearing note, the amount of assets it receives generally equals the note's face value. Cole Williams Co. therefore will receive $100,000 cash and will make the following journal entry. Sept. 1 Cash 100,000 Notes Payable 100,000 (To record issuance of 12%, 4month note to First National Bank) Interest accrues over the life of the note, and the issuer must periodically record that accrual. (You may find it helpful to review the discussion of interest computations that was provided in Chapter 8, with regard to notes receivable.) If Cole Williams Co. prepares financial statements annually, it makes an adjusting entry at December 31 to recognize four months of interest expense and interest payable of : Dec. 31 Interest Expense 4,000 Interest Payable 4,000 (To accrue interest for 4 months on First National Bank note) In the December 31 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. At maturity (January 1), Cole Williams Co. must pay the face value of the note ($100,000) plus $4,000 interest . It records payment of the note and accrued interest as follows. Jan. 1 Notes Payable Interest Payable Cash (To record payment of First National Bank interestbearing note and accrued interest at maturity) 100,000 4,000 104,000 Appendix 10C at the end of this chapter discusses the accounting for longterm installment notes payable. SALES TAXES PAYABLE LEARNING OBJECTIVE 3 Explain the accounting for other current liabilities. Many of the products we purchase at retail stores are subject to sales taxes. Many states are now implementing sales taxes on purchases made on the Internet as well. Sales taxes are expressed as a percentage of the sales price. The selling company collects the tax from the customer when the sale occurs and periodically (usually monthly) remits the collections to the state's department of revenue. Collecting sales taxes is important. For example, the State of New York recently sued Sprint Nextel Corporation for $300 million for its alleged failure to collect sales taxes on phone calls. Under most state laws, the selling company must enter 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 Revenue and Sales Taxes Payable. For example, if the March 25 cash register readings for Cooley Grocery show sales of $10,000 and sales taxes of $600 (sales tax rate of 6%), the journal entry is: Mar. 25 Cash 10,600 Sales Revenue 10,000 Sales Taxes Payable 600 (To record daily sales and sales taxes) When the company remits the taxes to the taxing agency, it decreases (debits) Sales Taxes Payable and decreases (credits) Cash. The company does not report sales taxes as an expense. It simply forwards to the government the amount paid by the customer. Thus, Cooley Grocery serves only as a collection agent for the taxing authority. Sometimes companies do not enter 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. For example, assume that Cooley Grocery enters total receipts of $10,600. Because the amount received from the sale is equal to the sales price (100%) plus 6% of sales, or 1.06 times the sales total, we can compute sales as follows: . Thus, we can find the sales tax amount of $600 by either (1) subtracting sales from total receipts multiplying sales by the sales tax rate or (2) . Helpful Hint Check your sales receipts from local retailers to see whether the sales tax is computed separately. UNEARNED REVENUES A magazine publisher such as Sports Illustrated collects cash when customers place orders for magazine subscriptions. An airline company such as American Airlines often receives cash when it sells tickets for future flights. Season tickets for concerts, sporting events, and theatre programs are also paid for in advance. How do companies account for unearned revenues that are received before goods are delivered or services are performed? 1. When the company receives an advance, it increases (debits) Cash and increases (credits) a current liability account identifying the source of the unearned revenue. 2. When the company recognizes revenue, it decreases (debits) the unearned revenue account and increases (credits) a revenue account. To illustrate, assume that Superior University sells 10,000 season football tickets at $50 each for its fivegame home schedule. The university makes the following entry for the sale of season tickets. Aug. 6 Cash Unearned Ticket Revenue 500,000 500,000 (To record sale of 10,000 season tickets) As each game is completed, Superior records the recognition of revenue with the following entry. Sept. 7 Unearned Ticket Revenue 100,000 Ticket Revenue 100,000 (To record football ticket revenues) The account Unearned Ticket Revenue represents unearned revenue, and Superior reports it as a current liability. As the school recognizes revenue, it reclassifies the amount from unearned revenue to Ticket Revenue. Unearned revenue is material for some companies. In the airline industry, tickets sold for future flights represent almost 50% of total current liabilities. At United Air Lines, unearned ticket revenue is its largest current liability, recently amounting to more than $1 billion. Illustration 101 shows specific unearned revenue and revenue accounts used in selected types of businesses. Illustration 10-1 Unearned revenue and revenue accounts CURRENT MATURITIES OF LONG-TERM DEBT Companies often have a portion of longterm debt that comes due in the current year. As an example, assume that Wendy Construction issues a fiveyear, interestbearing $25,000 note on January 1, 2013. This note specifies that each January 1, starting January 1, 2014, Wendy should pay $5,000 of the note. When the company prepares financial statements on December 31, 2013, it should report $5,000 as a current liability and $20,000 as a longterm liability. (The $5,000 amount is the portion of the note that is due to be paid within the next 12 months.) Companies often identify current maturities of longterm debt on the balance sheet as long term debt due within one year. In a recent year, General Motors had $724 million of such debt. It is not necessary to prepare an adjusting entry to recognize the current maturity of longterm debt. At the balance sheet date, all obligations due within one year are classified as current, and all other obligations are longterm. CURRENT LIABILITIES You and several classmates are studying for the next accounting examination. They ask you to answer the following questions. 1. If cash is borrowed on a $50,000, 6month, 12% note on September 1, how much interest expense would be incurred by December 31? 2. How is the sales tax amount determined when the cash register total includes sales taxes? 3. If $15,000 is collected in advance on November 1 for 3months' rent, what amount of rent should be recognized by December 31? Action Plan Use the interest formula: . Divide total receipts by 100% plus the tax rate to determine sales; then subtract sales from the total receipts. Determine what fraction of the total unearned rent should be recognized this year. Solution 1. 2. First, divide the total cash register receipts by 100% plus the sales tax percentage to find the sales amount. Second, subtract the sales amount from the total cash register receipts to determine the sales taxes. 3. Related exercise material: BE102, BE103, BE104, and E107. 101, E101, E102, E103, E104, E106, PAYROLL AND PAYROLL TAXES PAYABLE Assume that Susan Alena works 40 hours this week for Pepitone Inc., earning a wage of $10 per hour. Will Susan receive a $400 check at the end of the week? Not likely. The reason: Pepitone is required to withhold amounts from her wages to pay various governmental authorities. For example, Pepitone will withhold amounts for Social Security taxes1 and for federal and state income taxes. If these withholdings total $100, Susan will receive a check for only $300. Illustration 102 summarizes the types of payroll deductions that normally occur for most companies. Illustration 10-2 Payroll deductions As a result of these deductions, companies withhold from employee paychecks amounts that must be paid to other parties. Pepitone therefore has incurred a liability to pay these third parties and must report this liability in its balance sheet. As a second illustration, assume that Cargo Corporation records its payroll for the week of March 7 with the journal entry shown below. Mar. 7 Salaries and Wages Expense 100,000 FICA Taxes Payable 7,650 Federal Income Taxes Payable 21,864 State Income Taxes Payable 2,922 Salaries and Wages Payable 67,564 (To record payroll and withholding taxes for the week ending March 7) Cargo then records payment of this payroll on March 7 as follows. Mar. 7 Salaries and Wages Payable 67,564 Cash 67,564 (To record payment of the March 7 payroll) In this case, Cargo reports $100,000 in salaries and wages expense. In addition, it reports liabilities for the salaries and wages payable as well as liabilities to governmental agencies. Rather than pay the employees $100,000, Cargo instead must withhold the taxes and make the tax payments directly. In summary, Cargo is essentially serving as a tax collector. In addition to the liabilities incurred as a result of withholdings, employers also incur a second type of payroll related liability. With every payroll, the employer incurs liabilities to pay variouspayroll taxes levied upon the employer. These payroll taxes include the employer's share of Social Security (FICA) taxes and state and federal unemployment taxes. Based on Cargo Corp.'s $100,000 payroll, the company would record the employer's expense and liability for these payroll taxes as follows. Mar. 7 Payroll Tax Expense 13,850 FICA Taxes Payable 7,650 Federal Unemployment Taxes Payable 800 State Unemployment Taxes Payable 5,400 (To record employer's payroll taxes on March 7 payroll) Companies classify the payroll and payroll tax liability accounts as current liabilities because they must be paid to employees or remitted to taxing authorities periodically and 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. ANATOMY OF A FRAUD Art was a custodial supervisor for a large school district. The district was supposed to employ between 35 and 40 regular custodians, as well as 3 or 4 substitute custodians to fill in when regular custodians were missing. Instead, in addition to the regular custodians, Art \"hired\" 77 substitutes. In fact, almost none of these people worked for the district. Instead, Art submitted time cards for these people, collected their checks at the district office, and personally distributed the checks to the \"employees.\" If a substitute's check was for $1,200, that person would cash the check, keep $200, and pay Art $1,000. Total take: $150,000 THE MISSING CONTROLS Human Resource Controls. Thorough background checks should be performed. No employees should begin work until they have been approved by the Board of Education and entered into the payroll system. No employees should be entered into the payroll system until they have been approved by a supervisor. All paychecks should be distributed directly to employees at the official school locations by designated employees. Independent internal verification. Budgets should be reviewed monthly to identify situations where actual costs significantly exceed budgeted amounts. Source: Adapted from Wells , Fraud Casebook (2007), pp. 164-171. WAGES AND PAYROLL TAXES During the month of September, Lake Corporation's employees earned wages of $60,000. Withholdings related to these wages were $3,500 for Social Security (FICA), $6,500 for federal income tax, and $2,000 for state income tax. Costs incurred for unemployment taxes were $90 for federal and $150 for state. Prepare the September 30 journal entries for (a) salaries and wages expense and salaries and wages payable, assuming that all September wages will be paid in October, and (b) the company's payroll tax expense. Action Plan Remember that wages earned are an expense to the company, but withholdings reduce the amount due to be paid to the employee. Payroll taxes are taxes the company incurs related to its employees. Solution (a) To determine wages payable, reduce wages expense by the withholdings for FICA, federal income tax, and state income tax. Sept. 30 Salaries and Wages Expense 60,000 FICA Taxes Payable 3,500 Federal Income Taxes Payable 6,500 State Income Taxes Payable 2,000 Salaries and Wages Payable 48,000 (b) Payroll taxes would be for the company's share of FICA, as well as for federal and state unemployment tax. Sept. 30 Payroll Tax Expense 3,740 FICA Taxes Payable 3,500 Federal Unemployment Taxes Payable 90 State Unemployment Taxes Payable 150 Related exercise material: BE105, BE106, 102, and E105. Bonds: Long-Term Liabilities LEARNING OBJECTIVE 4 Longterm liabilities are obligations that a company expects to pay more than one year in the future. In this section, we explain the accounting for the principal types of obligations reported in the longterm liabilities section of the balance sheet. These obligations often are in the form of bonds or longterm notes. Bonds are a form of interestbearing note payable issued by corporations, universities, and governmental agencies. Bonds, like common stock, are sold in small denominations (usually $1,000 or multiples of $1,000). As a result, bonds attract many investors. When a corporation issues bonds, it is borrowing money. The person who buys the bonds (the bondholder) is investing in bonds. TYPES OF BONDS Bonds may have different features. In the following sections, we describe some commonly issued types of bonds. Secured and Unsecured Bonds Secured bonds have specific assets of the issuer pledged as collateral for the bonds. Unsecured bonds are issued against the general credit of the borrower. Large corporations with good credit ratings use unsecured bonds extensively. For example, at one time DuPont reported more than $2 billion of unsecured bonds outstanding. Convertible and Callable Bonds Bonds that can be converted into common stock at the bondholder's option are convertible bonds. Bonds that the issuing company can redeem (buy back) at a stated dollar amount prior to maturity are callable bonds. Convertible bonds have features that are attractive both to bondholders and to the issuer. The conversion feature often gives bondholders an opportunity to benefit if the market price of the common stock increases substantially. Furthermore, until conversion, the bondholder receives interest on the bond. For the issuer, the bonds sell at a higher price and pay a lower rate of interest than comparable debt securities that do not have a conversion option. Many corporations, such as USAir, United States Steel Corp., and General Motors Corporation, have issued convertible bonds. Accounting Across the Organization When Convertible Bonds Don't During the boom times of the late 1990s, many rapidly growing companies issued large quantities of convertible bonds. Investors found the convertible bonds attractive because they paid regular interest but also had the upside potential of being converted to stock if the stock price increased. At the time, stock prices were increasing rapidly, so many investors viewed convertible bonds as a cheap and safe way to buy stock. As a consequence, companies were able to pay much lower interest rates on convertible bonds than on standard bonds. When the bonds were issued, company managers assumed that the bonds would be converted. Thus, the company would never have to repay the debt with cash. It seemed too good to be trueand it was. When stock prices plummeted in the early 2000s, investors no longer had an incentive to convert, since the market price was below the conversion price. When many of these massive bonds came due, companies were forced either to pay them off or to issue new debt at much higher rates. The drop in stock prices did not change the debt to assets ratios of these companies. Discuss how the perception of a high debt to assets ratio changed before and after the fall in stock prices. ISSUING PROCEDURES A bond certificate is issued to the investor to provide evidence of the investor's claim against the company. As Illustration 103 shows, the bond certificate provides information such as the name of the company that issued the bonds, the face value of the bonds, the maturity date of the bonds, and the contractual interest rate. The face value is the amount of principal due at the maturity date. The maturity date is the date that the final payment is due to the investor from the issuing company. The contractual interest 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, and interest is generally paid semiannually. (We use annual payments in our examples to simplify.) Alternative Terminology The contractual rate is often referred to as the stated rate. Illustration 10-3 Bond certificate DETERMINING THE MARKET PRICE 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 zerointerest (pays no interest) bond with a face value of $1,000,000 due in 20 years. For this bond, the only cash you receive is $1 million at the end of 20 years. Would you pay $1 million for this bond? We hope not because $1 million received 20 years from now is not the same as $1 million received today. The term time value of money is used to indicate the relationship between time and moneythat a dollar received today is worth more than a dollar promised at some time in the future. If you had $1 million today, you would invest it and earn interest so that at the end of 20 years, your investment would be worth much more than $1 million. Thus, if someone is going to pay you $1 million 20 years from now, you would want to find its equivalent today, or its present value. In other words, you would want to determine the value today of the amount to be received in the future after taking into account current interest rates. The current market price (present value) of a bond is therefore a function of three factors: (1) the dollar amounts to be received, (2) the length of time until the amounts are received, and (3) the market interest rate. The market interest rate is the rate investors demand for loaning funds. The process of finding the present value is referred to as discounting the future amounts. To illustrate, assume that Acropolis Company on January 1, 2014, issues $100,000 of 9% bonds, due in five years, with interest payable annually at yearend. The purchaser of the bonds would receive the following two types of cash payments: (1) principal of $100,000 to be paid at maturity, and (2) five $9,000 interest payments over the term of the bonds. Illustration 104 shows a time diagram depicting both cash flows. Illustration 10-4 Time diagram depicting cash flows The current market price of a bond is equal to the present value of all the future cash payments promised by the bond. Illustration 105 lists and totals the present values of these amounts, assuming the market rate of interest is 9%. Illustration 10-5 Computing the market price of bonds Tables are available to provide the present value numbers to be used, or these values can be determined mathematically or with financial calculators.2 Appendix D, near the end of the textbook, provides further discussion of the concepts and the mechanics of the time value of money computations. BOND TERMINOLOGY State whether each of the following statements is true or false. ________ 1. Secured bonds have specific assets of the issuer pledged as collateral. ________ 2. Callable bonds can be redeemed by the issuing company at a stated dollar amount prior to maturity. ________ 3. The contractual 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. ________ 5. The market price of a bond is equal to its maturity value. Action Plan Review the types of bonds and the basic terms associated with bonds. Solution 1. True. 2. True. 3. False. The contractual interest rate is used to determine the amount of cash interest the borrower pays. 4. True. 5. False. The market price of a bond is equal to the present value of all the future cash payments promised by the bond. Related exercise material: 103. Accounting for Bond Issues LEARNING OBJECTIVE 5 Prepare the entries for the issuance of bonds and interest expense. A corporation records bond transactions when it issues (sells) or redeems (buys back) bonds and when bondholders convert bonds into common stock. If bondholders sell their bond investments to other investors, the issuing firm receives no further money on the transaction, nor does the issuing corporation journalize the transaction (although it does keep records of the names of bondholders in some cases). Bonds may be issued at face value, below face value (discount), or above face value (premium). Bond prices for both new issues and existing bonds are quoted as a percentage of the face value of the bond. Face value is usually $1,000. Thus, 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. ISSUING BONDS AT FACE VALUE To illustrate the accounting for bonds issued at face value, assume that Devor Corporation issues 100, five year, 10%, $1,000 bonds dated January 1, 2014, at 100 (100% of face value). The entry to record the sale is: Jan. 1 Cash 100,000 Bonds Payable 100,000 (To record sale of bonds at face value) Devor reports bonds payable in the longterm liabilities section of the balance sheet because the maturity date is January 1, 2019 (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 earlier. If we assume that interest is payable annually on January 1 on the bonds described above, Devor accrues interest of on December 31. At December 31, Devor recognizes the $10,000 of interest expense incurred with the following adjusting entry. Dec. 31 Interest Expense 10,000 Interest Payable 10,000 (To accrue bond interest) The company classifies interest payable as a current liability because it is scheduled for payment within the next year. When Devor pays the interest on January 1, 2015, it decreases (debits) Interest Payable and decreases (credits) Cash for $10,000. Devor records the payment on January 1 as follows. Jan. 1 Interest Payable 10,000 Cash 10,000 (To record payment of bond interest) DISCOUNT OR PREMIUM ON BONDS The previous illustrations assumed that the contractual (stated) interest rate and the market (effective) interest rate paid on bonds 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 individual performance all affect market interest rates. As a result, the contractual and market interest rates often differ. To make bonds salable when the two rates differ, bonds 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. When a bond is sold for less than its face value, the difference between the face value of a bond and its selling price is called 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 price on the bonds will be bid up. When a bond is sold for more than its face value, the difference between the face value and its selling price is called a premium. Illustration 106 shows these relationships graphically. Illustration 10-6 Interest rates and bond prices Issuance of 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 issuance of bonds at a discount does not mean that the financial strength of the issuer is suspect. Conversely, the sale of bonds at a premium does not indicate that the financial strength of the issuer is exceptional. Helpful Hint Bond prices vary inversely with changes in the market interest rate. As market interest rates decline, bond prices increase. When a bond is issued, if the market interest rate is below the contractual rate, the bond price is higher than the face value. Helpful Hint Some bonds are sold at a discount by design. \"Zerocoupon\" bonds, which pay no interest, sell at a deep discount to face value. ISSUING BONDS AT A DISCOUNT To illustrate the issuance of bonds at a discount, assume that on January 1, 2014, Candlestick Inc. sells $100,000, fiveyear, 10% bonds at 98 (98% of face value) with interest payable on January 1. The entry to record the issuance is: Jan. 1 Cash 98,000 Discount on Bonds Payable 2,000 Bonds Payable 100,000 (To record sale of bonds at a discount) Although Discount on Bonds Payable has a debit balance, it is not an asset. Rather it is a contra account, which is deducted from bonds payable on the balance sheet as shown in Illustration 107. Illustration 10-7 Statement presentation of discount on bonds payable The $98,000 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 value causes the total cost of borrowing to differ from the bond interest paid. That is, the issuing corporation not only must pay the contractual interest rate over the term of the bonds but also must pay the face value (rather than the issuance price) at maturity. Therefore, the difference between the issuance price and the face value of the bondsthe discountis an additional cost of borrowing. The company records this cost as interest expense over the life of the bonds. The total cost of borrowing $98,000 for Candlestick Inc. is $52,000, computed as shown in Illustration 108. Illustration 10-8 Computation of total cost of borrowingbonds issued at discount Alternatively, we can compute the total cost of borrowing as shown in Illustration 109. Illustration 10-9 Alternative computation of total cost of borrowingbonds issued at discount To follow the expense recognition principle, companies allocate bond discount to expense in each period in which the bonds are outstanding. This is referred to as amortizing the discount. Amortization of the discount increases the amount of interest expense reported each period. That is, after the company amortizes the discount, the amount of interest expense it reports in a period will exceed the contractual amount. As shown in Illustration 108, for the bonds issued by Candlestick Inc., total interest expense will exceed the contractual interest by $2,000 over the life of the bonds. As the discount is amortized, its balance declines. As a consequence, the carrying value of the bonds will increase, until at maturity the carrying value of the bonds equals their face amount. This is shown in Illustration 1010. Appendices 10A and 10B at the end of this chapter discuss procedures for amortizing bond discount. Illustration 10-10 Amortization of bond discount Helpful Hint The 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. ISSUING BONDS AT A PREMIUM We can illustrate the issuance of bonds at a premium by now assuming the Candlestick Inc. bonds described above sell at 102 (102% of face value) rather than at 98. The entry to record the sale is: Jan. 1 Cash 102,000 Bonds Payable 100,000 Premium on Bonds Payable 2,000 (To record sale of bonds at a premium) Candlestick adds the premium on bonds payable to the bonds payable amount on the balance sheet, as shown in Illustration 1011. Illustration 10-11 Statement presentation of bond premium The sale of bonds above face value causes the total cost of borrowing to be less than the bond interest paid because the borrower is not required to pay the bond premium at the maturity date of the bonds. Thus, the premium is considered to be a reduction in the cost of borrowing that reduces bond interest expense over the life of the bonds. The total cost of borrowing $102,000 for Candlestick Inc. is $48,000, computed as in Illustration 1012. Illustration 10-12 Computation of total cost of borrowingbonds issued at a premium Alternatively, we can compute the cost of borrowing as shown in Illustration 1013. Illustration 10-13 Alternative computation of total cost of borrowingbonds issued at a premium Similar to bond discount, companies allocate bond premium to expense in each period in which the bonds are outstanding. This is referred to as amortizing the premium. Amortization of the premium decreases the amount of interest expense reported each period. That is, after the company amortizes the premium, the amount of interest expense it reports in a period will be less than the contractual amount. As shown in Illustration 1012, for the bonds issued by Candlestick Inc., contractual interest will exceed the interest expense by $2,000 over the life of the bonds. As the premium is amortized, its balance declines. As a consequence, the carrying value of the bonds will decrease, until at maturity the carrying value of the bonds equals their face amount. This is shown in Illustration 1014. Appendices 10A and 10B at the end of this chapter discuss procedures for amortizing bond premium. Illustration 10-14 Amortization of bond premium Helpful Hint Both a discount and a premium account are valuation accounts. Avaluation account is one that is needed to value properly the item to which it relates. BOND ISSUANCE 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. 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 189,000 Discount on Bonds Payable 11,000 Bonds Payable 200,000 (To record sale of bonds at a discount) (b) Longterm liabilities Bonds payable $200,000 Less: Discount on bonds payable 11,000 $189,000 Related exercise material: BE108, BE109, BE1010, 104, E108, E109, and E1010. Accounting for Bond Redemptions LEARNING OBJECTIVE 6 Describe the entries when bonds are redeemed. Bonds are redeemed when the issuing corporation buys them back. The appropriate entries for these transactions are explained next. REDEEMING BONDS AT MATURITY 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: Bonds Payable 100,000 Cash 100,000 (To record redemption of bonds at maturity) REDEEMING BONDS BEFORE MATURITY Bonds may be redeemed before maturity. A company may decide to redeem bonds before maturity in order to reduce interest cost and remove debt from its balance sheet. A company should redeem debt early only if it has sufficient cash resources. When bonds are redeemed 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 at the end of the fourth period, Candlestick Inc., having sold its bonds at a premium, redeems the $100,000 face value bonds at 103 after paying the annual interest. Assume that the carrying value of the bonds at the redemption date is $100,400 (principal $100,000 and premium $400). Candlestick records the redemption at the end of the fourth interest period (January 1, 2018) as: Jan. 1 Bonds Payable 100,000 Premium on Bonds Payable 400 Loss on Bond Redemption 2,600 Cash 103,000 (To record redemption of bonds at 103) Note that the loss of $2,600 is the difference between the $103,000 cash paid and the $100,400 carrying value of the bonds. BOND REDEMPTION R & B Inc. issued $500,000, 10year bonds at a discount. Prior to maturity, when the carrying value of the bonds is $496,000, the company redeems the bonds at 98. Prepare the entry to record the redemption of the bonds. 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). Solution There is a gain on redemption. The cash paid, , is less than the carrying value of $496,000. The entry is: Bonds Payable 500,000 Cash 490,000 Discount on Bonds Payable 4,000 Gain on Bond Redemption 6,000 (To record redemption of bonds at 98) Related exercise material: BE1011, 105, E1013, and E1014. Financial Statement Presentation and Analysis BALANCE SHEET PRESENTATION LEARNING OBJECTIVE 7 Identify the requirements for the financial statement presentation and analysis of liabilities. Current liabilities are the first category under \"Liabilities\" on the balance sheet. Companies list each of the principal types of current liabilities separately within the category. Within the current liabilities section, companies often list notes payable first, followed by accounts payable. Companies report longterm liabilities in a separate section of the balance sheet immediately following \"Current liabilities.\" Illustration 1015 shows an example. Illustration 10-15 Balance sheet presentation of liabilities Disclosure of debt is very important. Failures at Enron, WorldCom, and Global Crossing have made investors very concerned about companies' debt obligations. Summary data regarding debts may be presented in the balance sheet with detailed data (such as interest rates, maturity dates, conversion privileges, and assets pledged as collateral) shown in a supporting schedule in the notes. Companies should report current maturities of longterm debt as a current liability. Ethics Note Some companies try to minimize the amount of debt reported on their balance sheet by not reporting certain types of commitments as liabilities. This subject is of intense interest in the financial community. ANALYSIS Careful examination of debt obligations helps you assess a company's ability to pay its current and longterm obligations. It also helps you determine whether a company can obtain debt financing in order to grow. We will use the following information from the financial statements of the nonfinancial services division (primarily the Automotive Division) of Toyota Motor Corporation to illustrate the analysis of a company's liquidity and solvency. Illustration 10-16 Simplified balance sheets for Toyota Motor Corporation Liquidity Liquidity ratios measure the shortterm ability of a company to pay its maturing obligations and to meet unexpected needs for cash. A commonly used measure of liquidity is the current ratio (presented in Chapter 2). The current ratio is calculated as current assets divided by current liabilities. Illustration 1017 presents the current ratio for the Automotive Division of Toyota along with the industry average. Illustration 10-17 Current ratio Toyota's current ratio declined from 1.49:1 to 1.30:1 from 2010 to 2011. Although Toyota's ratio declined, it still exceeds the industry average current ratio for manufacturers of autos and trucks of 1.00:1. Toyota's current ratio, like the industry average, is quite low. Many companies today minimize their liquid assets (such as accounts receivable and inventory) in order to improve profitability measures, such as return on assets. This is particularly true of large companies such as Ford, GM, and Toyota. Companies that keep fewer liquid assets on hand must rely on other sources of liquidity. One such source is a bank line of credit. A line of credit is a prearranged agreement between a company and a lender that permits the company, should it be necessary, to borrow up to an agreedupon amount. For example, a recent disclosure regarding debt in Toyota's financial statements states that it has $23.5 billion of unused lines of credit. This represents a substantial amount of available cash. DECISION TOOLKIT DECISION INFO NEEDED CHECKPOINTS FOR DECISION Can the company obtain Available lines of shortterm financing when credit, from notes to necessary? the financial statements. TOOL TO USE FOR HOW TO EVALUATE DECISION RESULTS Compare available lines of If liquidity ratios are low, credit to current liabilities. then lines of credit should Also, evaluate liquidity be high to compensate. ratios. Solvency Solvency ratios measure the ability of a company to survive over a long period of time. The Feature Story in this chapter mentioned that, although there once were many U.S. automobile manufacturers, only three U.S. based companies remain today. Many of the others went bankrupt. This highlights the fact that when making a longterm loan or purchasing a company's stock, you must give consideration to a company's solvency. To reduce the risks associated with having a large amount of debt during an economic downturn, some U.S. automobile manufacturers took two precautionary steps while they enjoyed strong profits. First, they built up large balances of cash and cash equivalents to avoid a cash crisis. Second, they were reluctant to build new plants or hire new workers to meet their production needs. Instead, they asked workers to put in overtime, or they \"outsourced\" work to other companies. In this way, when the economic downturn occurred, they hoped to avoid having to make debt payments on idle production plants and to minimize layoffs. As a result, when the crisis first hit, Ford had cash of $29 billion, about double the amount of cash it would expect to use over a two year period. In Chapter 2, you learned that one measure of a company's solvency is the debt to assets ratio. This is calculated as total liabilities (debt) divided by total assets. This ratio indicates the extent to which a company's assets are financed with debt. Another useful solvency measure is the times interest earned. It provides an indication of a company's ability to meet interest payments as they come due. It is computed by dividing income before interest expense and income taxes by interest expense. It uses income before interest expense and taxes because this number best represents the amount available to pay interest. We can use the balance sheet information presented and the additional information below to calculate solvency ratios for the Automotive Division of Toyota. ($ in millions) 2011 2010 Net income $2,254 $904 Interest expense 350 560 Income tax expense 2,150 455 The debt to assets ratios and times interest earned for the Automotive Division of Toyota and averages for the industry are shown in Illustration 1018. Illustration 10-18 Solvency ratios Toyota's debt to assets ratio was 42%. The industry average for manufacturers of autos and trucks is 62%. Thus, Toyota is less reliant on debt financing than the average firm in the auto and truck industry. Toyota's times interest earned increased from 3.4 times in 2010 to 13.6 in 2011. This means that in 2011 Toyota had earnings before interest and taxes that were more than 13 times the amount needed to pay interest. The higher the multiple, the lower the likelihood that the company will default on interest payments. Because many of the companies in this industry were still recovering from the recent recession, the industry average was only 3.2. This suggests that while Toyota's ability to meet interest payments was high, the average company in the industry had a lower ability to meet interest payments in 2011. Investor Insight Debt Masking In the wake of the financial crisis, many financial institutions are wary of reporting too much debt on their financial statements, for fear that investors will consider them too risky. The Securities and Exchange Commission (SEC) is concerned that some companies engage in \"debt masking\" to make it appear that they use less debt than they actually do. These companies enter into transactions at the end of the accounting period that essentially remove debt from their books. Shortly after the end of the period, they reverse the transaction and the debt goes back on their books. The Wall Street Journal reported that 18 large banks \"had consistently lowered one type of debt at the end of each of the past five quarters, reducing it on average by 42% from quarterly peaks.\" Source: Tom McGinty, Kate Kelly, and Kara Scannell, \"Debt 'Masking' Under Fire,\" Wall Street Journal Online (April 21, 2010). What implications does debt masking have for an investor that is using the debt to assets ratio to evaluate a company's solvency? DECISION TOOLKIT DECISION INFO NEEDED FOR CHECKPOINTS DECISION Can the company meet its Interest expense and net obligations in the long term? income before interest and taxes TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS High ratio indicates ability to meet interest payments as scheduled. OFF-BALANCE-SHEET FINANCING A concern for analysts when they evaluate a company's liquidity and solvency is whether that company has properly recorded all of its obligations. The bankruptcy of Enron Corporation, one of the largest bankruptcies in U.S. history, demonstrated how much damage can result when a company does not properly record or disclose all of its debts. Many would say Enron was practicing offbalancesheet financing. Offbalancesheet financing is an intentional effort by a company to structure its financing arrangements so as to avoid showing liabilities on its balance sheet. Two common types of offbalancesheet financing result from unreported contingencies and lease transactions. Contingencies One reason a company's balance sheet might not fully reflect its potential obligations is due to contingencies. Contingencies are events with uncertain outcomes that may represent potential liabilities. A common type of contingency is lawsuits. Suppose, for example, that you were analyzing the financial statements of a cigarette manufacturer and did not consider the possible negative implications of existing unsettled lawsuits. Your analysis of the company's financial position would certainly be misleading. Other common types of contingencies are product warranties and environmental cleanup obligations. For example, in a recent year, Novartis AG began offering a moneyback guarantee on its bloodpressure medications. This guarantee would necessitate an accrual for the estimated claims that will result from returns. Accounting rules require that companies disclose contingencies in the notes. In some cases, they must accrue them as liabilities. For example, suppose that Waterbury Inc. is sued by a customer for $1 million due to an injury sustained by a defective product. If at the company's yearend the lawsuit had not yet been resolved, how should Waterbury account for this event? If the company can determine a reasonable estimate of the expected loss and if it is probable it will lose the suit, then the company should accrue for the loss. It records the loss by increasing (debiting) a loss account and increasing (crediting) a liability such as Lawsuit Liability. If both of these conditions are not met, then the company discloses the basic facts regarding this suit in the notes to its financial statements. Leasing One common type of offbalancesheet financing results from leasing. Most lessees do not like to report leases on their balance sheets because the lease increases the company's total liabilities. Recall from Chapter 9 that operating leases are treated like rentalsno asset or liabilities show on the books. Capital leases are treated like a debtfinanced purchaseincreasing both assets and liabilities. As a result, many companies structure their lease agreements to avoid meeting the criteria of a capital lease. Recall from Chapter 9 that many U.S. airlines lease a large portion of their planes without showing any debt related to them on their balance sheets. For example, the total increase in assets and liabilities that would result if Southwest Airlines recorded on the balance sheet its offbalancesheet \"operating\" leases would be approximately $2.3 billion. Illustration 1019 presents Southwest Airlines' debt to assets ratio for a recent year using the numbers presented in its balance sheet. It also shows the ratio after adjusting for the offbalance sheet leases. After those adjustments, Southwest has a ratio of 62% versus 67% before. This means that of every dollar of assets, 67 cents was funded by debt. This would be of interest to analysts evaluating Southwest's solvency. Illustration 10-19 Debt to assets ratio adjusted for leases Critics of offbalancesheet financing contend that many leases represent unavoidable obligations that meet the definition of a liability. Therefore, companies should report them as liabilities on the balance sheet. To reduce these concerns, companies are required to report their operating lease obligations for subsequent years in a note. This allows analysts and other financial statement users to adjust a company's financial statements by adding leased assets and lease liabilities if they feel that this treatment is more appropriate. Ethics Note Accounting standardsetters are attempting to rewrite rules on lease accounting because of concerns that abuse of the current standards is reducing the usefulness of financial statements. International Note GAAP accounting for leases is more \"rulesbased\" than IFRS. GAAP relies on precisely defined cutoffs to determine whether an item is treated as a capital or operating lease. This rulesbased approach may enable companies to structure leases \"around the rules.\" Creating a jointly prepared leasing standard is a top priority for the IASB and FASB. DECISION TOOLKIT DECISION INFO NEEDED FOR CHECKPOINTS DECISION Does the company have any Knowledge of events TOOL TO USE FOR DECISION Notes to financial HOW TO EVALUATE RESULTS If negative outcomes are DECISION CHECKPOINTS contingent liabilities? INFO NEEDED FOR DECISION with uncertain negative outcomes TOOL TO USE FOR DECISION statements and financial statements Does the company have significant offbalance sheet financing, such as unrecorded lease obligations? Information on unrecorded obligations, such as a schedule of minimum lease payments from the notes to the financial statements Compare liquidity and solvency ratios with and without unrecorded obligations included HOW TO EVALUATE RESULTS possible, determine the probability, the amount of loss, and the potential impact on financial statements. If ratios differ significantly after including unrecorded obligations, these obligations should not be ignored in analysis. Investor Insight \"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, 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 then 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, however, when there was lots of cash available, lenders began reducing or completely eliminating covenants from loan agreements in order to be more competitive with other lenders. When the economy declined, these lenders lost big money when companies defaulted. 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? USING THE DECISION TOOLKIT Ford Motor Company has enjoyed some tremendous successes, including its popular Taurus and Explorer vehicles. Yet observers are looking for the next big hit. Development of a new vehicle costs billions. A flop is financially devastating, and the financial effect is magnified if the company has large amounts of outstanding debt. The balance sheets provide financial information for the Automotive Division of Ford Motor Company as of December 31, 2011 and 2010. We have chosen to analyze only the Automotive Division rather than the total corporation, which includes Ford's giant financing division. In an actual analysis, you would want to analyze the major divisions individually as well as the combined corporation as a whole. Instructions 1. Evaluate Ford's liquidity using appropriate ratios, and compare to those of Toyota and to industry averages. 2. Evaluate Ford's solvency using appropriate ratios, and compare to those of Toyota and to industry averages. 3. Comment on Ford's available lines of credit. Solution 1. Ford's liquidity can be measured using the current ratio: 2011 2010 Current ratio Ford's current ratio improved from 2010 to 2011. Ford's 2011 current ratio exceeds the industry average of but is somewhat less than Toyota's. These are increasingly common levels for large companies that have reduced the amount of inventory and receivables they hold. As noted earlier, these low current ratios are not necessarily cause for concern, but they do require more careful monitoring. Ford must also make sure to have other shortterm financing options available, such as lines of credit. 2. Ford's solvency can be measured with the debt to assets ratio and the times interest earned: Debt to assets ratio 2011 2010 Times interest earned The debt to assets ratio suggests that Ford relies very heavily on debt financing. The ratio decreased from 2010 to 2011, indicating that the company's solvency improved slightly. In 2010, it exceeded 100%. This is possible because we have calculated the ratio for the Automotive Division only, rather than for the whole company. The debt to assets ratio for the entire company in 2011 is 92%. This is extremely high. The times interest earned is 9.4 times in 2011 and 3.5 times in 2010. This exceeds the industry average of 3.2 times. It is likely that the company's solvency was a concern to investors and creditors during the recession and was closely monitored. However, as Ford's income rose in 2010 and 2011, its solvency improved. 3. Ford has available lines of credit of $9 billion. These financing sources significantly improve its liquidity and help reduce the concerns of its shortterm creditors. Appendix 10A Straight-Line Amortization AMORTIZING BOND DISCOUNT LEARNING OBJECTIVE 8 Apply the straightline method of amortizing bond discount and bond premium. To follow the expense recognition principle, companies allocate bond discount to expense in each period in which the bonds are outstanding. The straightline method of amortization allocates the same amount to interest expense in each interest period. The calculation is presented in Illustration 10A1. Illustration 10A-1 Formula for straight-line method of bond discount amortization In the Candlestick Inc. example, the company sold $100,000, fiveyear, 10% bonds on January 1, 2014, for $98,000. This resulted in a $2,000 bond discount . The bond discount amortization is for each of the five amortization periods. Candlestick records the first accrual of bond interest and the amortization of bond discount on December 31 as follows. Dec. 31 Interest Expense 10,400 Discount on Bonds Payable 400 Interest Payable 10,000 (To record accrued bond interest and amortization of bond discount) Over the term of the bonds, the balance in Discount on Bonds Payable will decrease annually by the same amount until it has a zero balance at the maturity date of the bonds. Thus, the carrying value of the bonds at maturity will be equal to the face value of the bonds. Preparing a bond discount amortization schedule, as shown in Illustration 10A2, is useful to determine interest expense, discount amortization, and the carrying value of the bond. As indicated, the interest expense recorded each period is $10,400. Also note that the carrying value of the bond increases $400 each period until it reaches its face value of $100,000 at the end of period 5. Alternative Terminology The amount in the Discount on Bonds Payable account is often referred to as Unamortized Discount on Bonds Payable. Illustration 10A-2 Bond discount amortization schedule AMORTIZING BOND PREMIUM The amortization of bond premium parallels that of bond discount. Illustration 10A3 presents the formula for determining bond premium amortization under the straightline method. Illustration 10A-3 Formula for straight-line method of bond premium amortization Continuing our example, assume Candlestick Inc., sells the bonds described above for $102,000, rather than $98,000. This results in a bond premium of . The premium amortization for each interest period is . Candlestick records the first accrual of interest on December 31 as follows. Dec. 31 Interest Expense 9,600 Premium on Bonds Payable 400 Interest Payable 10,000 (To record accrued bond interest and amortization of bond discount) Over the term of the bonds, the balance in Premium on Bonds Payable will decrease annually by the same amount until it has a zero balance at maturity. A bond premium amortization schedule, as shown in Illustration 10A4, is useful to determine interest expense, premium amortization, and the carrying value of the bond. As indicated, the interest expense Candlestick records each period is $9,600. Note that the carrying value of the bond decreases $400 each period until it reaches its face value of $100,000 at the end of period 5. Illustration 10A-4 Bond premium amortization schedule Summary of Learning Objective for Appendix 10A 8. Apply the straight-line method of amortizing bond discount and bond premium. The straightline method of amortization results in a constant amount of amortization and interest expense per period. Appendix 10B Effective-Interest Amortization LEARNING OBJECTIVE 9 Apply the effectiveinterest method of amortizing bond discount and bond premium. To follow the expense recognition principle, companies allocate bond discount to expense in each period in which the bonds are outstanding. However, to completely comply with the expense recognition principle, interest expense as a percentage of carrying value should not change over the life of the bonds. This percentage, referred to as the effectiveinterest rate, is established when the bonds are issued and remains constant in each interest period. Unlike the straightline method, the effectiveinterest method of amortization accomplishes this result. Under the effectiveinterest method, the amortization of bond discount or bond premium results in periodic interest expense equal to a constant percentage of the carrying value of the bonds. The effectiveinterest method results in varying amounts of amortization and interest expense per period but a constant percentage rate. In contrast, the straightline method results in constant amounts of amortization and interest expense per period but a varying percentage rate. Companies follow three steps under the effectiveinterest method: 1. Compute the bond interest expense by multiplying the carrying value of the bonds at the beginning of the interest period by the effectiveinterest rate. 2. Compute the bond interest paid (or accrued) by multiplying the face value of the bonds by the contractual interest rate. 3. Compute the amortization amount by determining the difference between the amounts computed in steps (1) and (2). Illustration 10B1 depicts these steps. Illustration 10B-1 Computation of amortization using effective-interest method Both the straightline and effectiveinterest methods of amortization result in the same total amount of interest expense over the term of the bonds. Furthermore, interest expense each interest period is generally comparable in amount. However, when the amounts are materially different, generally accepted accounting principles (GAAP) require use of the effectiveinterest method. AMORTIZING BOND DISCOUNT In the Candlestick Inc. example, the company sold $100,000, five year, 10% bonds on January 1, 2014, for $98,000. This resulted in a $2,000 bond discount . This discount results in an e