Figure 8-4:
Recording accrued and actual warranty expense.
Warranty Expense 20,000.00 Estimated Warranty Liability
To record estimated warranty expense for September
Estimated Warranty Liability 5,000.00
Labor Expense 2,000.00 Materials Expense 3,000.00
To record actual warranty cost for September
20,000.00
Planning for Long-Term Obligations
If you own a car you financed, you’re probably all too familiar with long-term debt: loans that won’t be paid off by the end of the next 12-month period.
Companies have long-term debt, too. While a company usually uses current debt as a vehicle to meet short-term obligations like payroll, it may incur long-term debt for the financing of company assets.
Managing long-term debt
If the company needs to raise cash and decides to do so by accumulating debt, the most common types are mortgages, notes payable, capitalized leases, and bonds. Following is your financial accounting guide to the first three of these categories of long-term debt. Bonds are a much more compli- cated subject, and I devote the upcoming “Accounting for Bond Issuances”
section to them.
Any type of debt instrument between a lender and a borrower specifies prin- cipal (the amount borrowed), rate (how much interest the company pays to borrow the money), and time (the length of the note). So any repayment of the debt is broken out between principal and interest according to the terms of the debt instrument.
Mortgages
Mortgages are used to finance the purchase of real property assets (see Chapter 13). The property collateralizes the mortgage, which means the prop- erty is held as security on the mortgage. If the company defaults on the mort- gage, the lending institution seizes the property and sells it in an attempt to pay off the loan.
Mortgages require a formal closing procedure that’s typically done at the offices of a title company: an independent middleman that coordinates the rights and obligations during the sale for the buyer, seller, and mortgage company. Much like during the purchase of a personal residence, reams of paperwork (such as the mortgage document and the transfer of the prop- erty’s title) are passed back and forth among the buyer, seller, and closing agent for approval and signature.
Notes payable
Notes payable are formal written documents that spell out how money is being borrowed. In the earlier section “Other short-term liabilities,” I explain that the part of a note payable that’s going to be paid off within the 12 months following the financial report release is classified as short-term debt.
The remainder of the note is considered a long-term debt.
Capitalized leases
Another type of long-term debt involves capitalized leases. A company doesn’t always buy its fixed assets (see Chapter 7); sometimes it leases them. Doing so makes sense for any fixed asset that needs to be frequently replaced. For example, leasing computers makes sense for businesses that need to stay current with computer processing technology.
Capital leases have characteristics of ownership, which means the cost of the leased capital asset goes on the balance sheet as a depreciable asset. I offer a full discussion of accounting for leases in Chapter 19.
Anticipating contingent liabilities
A contingent liability is a noncurrent liability that exists when a company has an existing circumstance as of the date of the financial statements that may cause a future loss depending on events that have not yet happened (and indeed may never happen). Here are two examples of common contingent liabilities:
✓ Pending litigation: This means the company is actively involved in a lawsuit that is not yet settled.
✓ Guarantee of obligations: This circumstance occurs when a business agrees to step in and satisfy the debt of another company if need be.
You typically record contingent liabilities in the footnotes to the financial statements (see Chapter 15) rather than as an actual part of the financial statements. However, if a loss due to a contingent liability meets two criteria, it should be accrued and reported in the company’s financial statements. Here are the two criteria:
✓ The chance of the loss event happening is probable, which means that the future event will likely occur. Consider the guarantee of obligation example: If the debtor business has gone out of business and the owners have disappeared into the night, the lender will probably come after the back-up guarantor to pay off the remaining amount of the loan.
✓ The amount of the loss can be reasonably estimated, which means you can come up with a highly accurate loss dollar amount. Continuing with the guarantee of obligation example, the loss is reasonably estimated because it should be the remaining balance on the loan plus any addi- tional charges tacked on by the lender in accordance with the obligatory note.
If the loss contingency meets these two standards for accrual, the journal entry involves a debit to a relevant loss account (see Chapter 10) and a credit to a liability account. For example, the company could take the debit to “loss on guaranteed debt” and to some sort of noncurrent liability account such as
“amount due on guaranteed obligation.”
Accounting for Bond Issuances
Well, I saved the best for last! I say that tongue-in-cheek because bonds are a somewhat thorny financial accounting issue. However, if you can get the gist of this section, you’ll be a-okay for this topic in your financial accounting class.
Understanding bond basics
Bonds are long-term lending agreements between borrowers and lenders. An example of a bond is when a municipality (such as a city or village) needs to build new roads or a hospital, and it issues bonds to finance the project.
Corporations generally issue bonds to raise money for capital expenditures, operations, and acquisitions.
The person who purchases a bond receives interest payments during the bond’s term (or for as long as he holds the bond) at the bond’s stated inter- est rate. When the bond matures (the term of the bond expires), the company pays the bondholder back the bond’s face value.
A bond is either a source of financing or an investment, depending on which side of the transaction you’re looking at. The company issuing the bond incurs the long-term liability. The person or company acquiring the bond uses it as an investment; for a business, this investment is an asset (see Chapter 7).
A company can issue bonds to sell at:
✓ Face value (also known as par value): The principal amount printed on the bond
✓ A discount: Less than face value ✓ A premium: More than face value
Usually face value is set in denominations of $1,000. In the sections that follow, I explain what it means to the accountant when the company sells at face value, at a premium, or at a discount.
A bond with a face value and market value of $1,000 has a bond price of 100 (no percent sign or dollar sign — just 100). Bonds issued at a premium have a bond price of more than 100. Issued at a discount, the bond price is less than 100. Keep reading to find out how discounts and premiums work.
The rate of interest that investors actually earn is known as the effective yield or market rate. If the bond sells for a premium, the bond market rate is gener- ally lower than the rate stated on the bond. For example, if the face rate of the bond is 10 percent and the market rate is 9 percent, the bond sells at a premium. That’s because the investor receives higher interest income on this bond than can be expected when factoring in the conditions of the current bond market; the investor is willing to pay more than face value for the bond.
On the flip side, if a bond sells at a discount, its market rate is higher than the rate stated on the bond. For example, if the face rate of the bond is 10 percent and the market rate is 11 percent, the bond sells at a discount. In this case, the investor is making less interest income than can be expected when factoring in the conditions of the current bond market. So, to offset that dis- advantage, the investor pays less than face value for the bond.
Accounting for bonds sold at face value
The easiest type of bond transaction to account for is when the company sells bonds at face value. The journal entry to record bonds a company issues at face value is to debit cash and credit bonds payable. So if the corpo- ration issues bonds for $100,000 with a five-year term, at 10 percent, the jour- nal entry to record the bonds is to debit cash for $100,000 and credit bonds payable for $100,000.
Addressing interest payments
Let’s say the terms of the bond call for interest to be paid semi-annually, which means every six months. Suppose the bonds I introduce in the previ- ous section are issued on July 1 and the first interest payment is not due until December 31. The interest expense is principal ($100,000) multiplied by rate (10 percent) multiplied by time (1/2 year). So your journal entry on December 31 is to debit bond interest expense for $5,000 and credit cash for $5,000.
Getting and amortizing a premium
When a bond is issued at a premium, its market value is more than its face value. To make the concept come alive for you, let’s walk through a common example you will see in your financial accounting textbook. How would you handle journal entries for this situation?
Penway Manufacturing issues bonds with a face value of $500,000 at 102.
“At 102” means the bonds are issued at 102 percent of face value, which means the bonds are issued at a premium.
The journal entry to record this transaction is to debit cash for $510,000 ($500,000 times 1.02). You have two accounts to credit: “bonds payable” for the face amount of $500,000 and “premium on bonds payable” for $10,000, which is the difference between face and cash received at issuance.
The premium of $10,000 has to be amortized for the time the bonds are out- standing. Amortization (writing off the premium over time) means that every year, over the life of the bond, you write off a portion of the premium. The term on these bonds is ten years, so using the straight-line method (which means you write off the same amount each period), the amount you have to amortize each year is $1,000 ($10,000 premium divided by the 10-year term).
Finally, to book interest payable on these bonds for each year, you credit
“bond interest payable” for $50,000 (figured by multiplying the face of
$500,000 times the rate of 10 percent). You also debit “premium on bond pay- able” for $1,000 (see the calculation in the previous paragraph) and “interest expense” for the $49,000 difference.
GAAP prefer the effective interest amortization method when accounting for bonds issued at a discount or premium. However, using the straight-line method is okay when the results of the straight-line versus effective interest method are materially the same. I use straight-line in this chapter because the straight-line method is often the method used for financial accounting test questions and homework assignments.
Reporting a bond discount
Okay, now let’s go through an example of a bond discount, which means the bonds are issued at less than face value. Here’s the situation:
Penway Manufacturing issues $500,000 face value bonds at 97. The term is ten years.
Remember that “at 97” means 97 percent of face value. The journal entry to record this transaction is to debit cash for $485,000 ($500,000 times .97) and debit “discount on bonds payable” for $15,000, which is the difference between face of $500,000 and cash received of $485,000. You also have to credit “bonds payable” for the face amount of $500,000. The term on these bonds is ten years, so using the straight-line method, the amount amortized for bond discount each year is $1,500 ($15,000 discount divided by the 10-year term).
Then, to book interest payable on these bonds for each year, you credit
“bond interest payable” for $50,000 (figured by multiplying the face of
$500,000 times the rate of 10 percent) and credit “discount on bonds pay- able” for $1,500. You then debit “interest expense” for $51,500.
Retiring and converting bonds
All good things must come to an end. At the end of the ten years, Penway Manufacturing has to retire the bonds (pay back the investors). At that point, bonds payable and all the other bond accounts (like bond premium or discount) have to be reduced to zero and the investors paid back for the amount of their investment in the bonds.
If the bonds are retired at full term (maturity), your regular amortization jour- nal entries should have already zeroed out the discount or premium on bonds payable.
Also, if the bonds are retired at full term, the bonds’ value on the balance sheet should be equal to the face amount, so it’s an easy journal entry just debiting bonds payable and crediting cash. For the Penway Manufacturing bonds, the debit and credit amount is $500,000.
If a bond is callable — meaning the issuer pays off the bonds before the matu- rity date — any unamortized bond premium or discount must be written off (reduced to zero) as part of the transaction. This action may trigger a gain or loss on the transaction.
Convertible bonds (debt) can be converted into common shares of stock (equity) at the option of the owner of the bonds. The conversion feature makes convertible bonds more attractive to potential investors because it’s possible to reap the benefits of the following circumstances:
✓ If the amount of dividends regularly being paid to shareholders is higher than the interest earned on the bonds, the investor gets increased cash by converting to stock.
✓ The investor also benefits if the value of the company’s common stock increases over the value of the bonds.