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Chapter 10

Chapter 10. Long-Term Liabilities. Learning Objectives. LO1 Identify the components of the Long-Term Liability category of the balance sheet. LO2 Define the important characteristics of bonds payable. LO3 Determine the issue price of a bond using compound interest techniques.

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Chapter 10

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  1. Chapter 10 Long-Term Liabilities

  2. Learning Objectives LO1 Identify the components of the Long-Term Liability category of the balance sheet. LO2 Define the important characteristics of bonds payable. LO3 Determine the issue price of a bond using compound interest techniques. LO4 Show that you understand the effect on the balance sheet of the issuance of bonds. LO5 Find the amortization of premium or discount using the effective interest method. LO6 Find the gain or loss on retirement of bonds.

  3. Learning Objectives (continued) LO7 Determine whether a lease agreement must be reported as a liability on the balance sheet. LO8 Explain how investors use ratios to evaluate long term liabilities. LO9 Explain the effects that transactions involving long term liabilities have on the statement of cash flows. LO10 Explain deferred taxes and calculate the deferred tax liability.

  4. Module 1 Long-Term Liabilities Including Bonds Payable Long-term liabilities appear on the balance sheet Companies account for the issuance of bonds payable using compound interest techniques Module 1

  5. Long-Term Liabilities • Long-term liability: obligation that will not be satisfied within one year or the current operating cycle • Components: • Bonds or notes payable • Leases • Deferred taxes Module 1: LO 1

  6. Exhibit 10-1—PepsiCo’s Balance Sheet Module 1: LO 1

  7. Bonds Payable A bond is a security or financial instrument that allows firms to borrow large sums of money and repay the loan over a long period of time Module 1: LO 2

  8. Bonds Payable (continued) • Bonds are sold (issued) to investors who want a return on their investment • The borrower (issuing firm) promises to: • pay interest on specified dates • repay the principal on a specified date (due date or maturity date) Module 1: LO 2

  9. Bonds Payable: Characteristics • Face value or par value: the principal amount of the bond as stated on the bond certificate • Features that appear in the bond certificate are: • Collateral • represents assets that back the bonds in case the issuer must default on the loan • Due Date • date that the bond principal must be repaid • Other Features • Convertible bonds • Callable bonds Module 1: LO 2

  10. Bonds Payable: Characteristics (continued) Debenture bonds: are not backed by specific collateral Serial bonds: a portion of the bonds comes due each time period Convertible bonds: can be converted into common stock at a future time Callable bonds: can be redeemed or retired before their specified due date Module 1: LO 2

  11. Exhibit 10-2—Bond Certificate Module 1: LO 2

  12. Factors Affecting Bond Price • Face rate of interest: also called stated rate, nominal rate, contract rate, coupon rate • The rate of interest on the bond certificate • Market rate of interest: also called effective rate, bond yield • The rate that investors could obtain by investing in other bonds • Bond issue price: the present value of the annuity of interest payments plus the present value of the principal Module 1: LO 3

  13. Example 10-1— Calculating Bond Issuance at a Discount Suppose that on January 1, 2016, Discount Firm wants to issue bonds with a face value of $10,000 at an 8% rate of interest and with interest paid annually for four years when the bonds come due Assume that the market rate of interest for other similar bonds is currently 10% Calculate the amount that will be obtained from the issuance of Discount Firm’s bonds Module 1: LO 3

  14. Example 10-1— Calculating Bond Issuance at a Discount (continued) • Discount’s bond will produce two sets of cash flows for the investor: • An annual interest payment of $800 ($10,000 x 8%) per year for four years • Repayment of the principal of $10,000 at the end of the fourth year • To calculate the issue price, calculate the present value of the two sets of cash flows as follows: Present Value of Annuity of $1 $800 x 3.16987 $2,536 Present Value of $1 $10,000 0.68301 6,830 Issue price $9,366 Module 1: LO 3

  15. Exhibit 10-3—Listing of Bonds on the Bond Market Module 1: LO 3

  16. Premium or Discount on Bonds • Premium: excess of the issue price over the face value of the bonds Premium = Issue Price – Face Value • Discount: excess of the face value of bonds over the issue price Discount = Face Value – Issue Price Module 1: LO 4

  17. Recording Bond Issuance at Discount Discount Firm would record both the discount and the issuance of the bonds in the following journal entry: Module 1: LO 4

  18. Recording Bond Issuance at Discount • Long-term liabilities category of the balance sheet: Long-term liabilities: Bonds payable $10,000 Discount on bonds payable 634 $ 9,366 Module 1: LO 4

  19. Example 10-2— Calculating Bond Issuance at a Premium Suppose that on January 1, 2016, Premium Firm wants to issue bonds with a face value of $10,000 at an 8% rate of interest and with interest paid annually for four years when the bonds come due Assume that the market rate of interest for other similar bonds is currently 6% Calculate the amount that will be obtained from the issuance of Discount Firm’s bonds Module 1: LO 4

  20. Example 10-2— Calculating Bond Issuance at a Premium • Premium’s bond will produce two sets of cash flows for the investor: • An annual interest payment of $800 ($10,000 x 8%) per year for four years • Repayment of the principal of $10,000 at the end of the fourth year • To calculate the issue price, calculate the present value of the two sets of cash flows as follows: Present Value of Annuity of $1 $800 x 3.46511 $ 2,772 Present Value of $1 $10,000 0.79209 7,921 Issue price $10,693 Module 1: LO 4

  21. Example 10-2— Calculating Bond Issuance at a Premium (continued) The premium is recorded at the time of bond issuance in the following entry: Module 1: LO 4

  22. Example 10-2— Calculating Bond Issuance at a Premium (continued) • Long-term liabilities category of the balance sheet: Long-term liabilities: Bonds payable $10,000 Premium on bonds payable 693 $ 10,693 Module 1: LO 4

  23. Premium and Discount • To determine whether a bond will sell at a premium or a discount: • If Market Rate = Face Rate, THEN bonds are issued at face value amount • If Market Rate > Face Rate, THEN bonds are issued at a discount • If Market Rate < Face Rate, THEN bonds are issued at a premium Module 1: LO 4

  24. Premium and Discount (continued) • The relationship between interest rates and bond prices is always inverse: • As interest rates decrease, prices on the bond markets increase • As interest rates increase, prices on the bond markets decrease Module 1: LO 4

  25. Module 2 Bond Amortization and Bond Retirement A company amortizes the premium or discount on bonds payable and accounts for the retirement of bonds Module 2

  26. Bond Amortization Process of transferring an amount from the discount or premium account to interest expense each time period This method results in a constant effective interest rate Module 2: LO 5

  27. Bond Amortization (continued) • Effective interest method of amortization: produces a constant effective interest rate from period to period Effective Rate = Annual Interest Expense/Carrying Value • Carrying value: the face value of a bond plus the amount of unamortized premium or minus the amount of unamortized discount Carrying Value = Face Value - Unamortized Discount Carrying Value = Face Value + Unamortized Premium Module 2: LO 5

  28. Exhibit 10-4—Discount Amortization: Effective Interest Method of Amortization Module 2: LO 5

  29. Example 10-3—Recording Amortization of Discount Discount Firm would record an entry for amortization for 2016 as follows: Module 2: LO 5

  30. Exhibit 10-5—Premium Amortization: Effective Interest Method of Amortization Module 2: LO 5

  31. Example 10-4—Recording Amortization of a Premium Premium Firm would record an entry for amortization for 2016 as follows: Module 2: LO 5

  32. Redemption of Bonds • Retirement of bonds by repayment of the principal • If redeemed at maturity, no gain or loss occurs • If retired before maturity, a gain or loss occurs • The gain or loss on bond redemption is shown on the income statement Module 2: LO 6

  33. Retired Early at a Gain or a Loss • Gain or loss on redemption: Difference between the carrying value and the redemption price at the time bonds are redeemed Gain = Carrying Value - Redemption Price Loss = Redemption Price - Carrying Value Module 2: LO 6

  34. Example 10-5—Recording Amortization of a Premium Assume that on December 31, 2016, Premium Firm wants to retire its bonds due in 2019 Assume that the bonds were issued at a premium of $692 at the beginning of 2016 Premium Firm has used the effective interest method of amortization and has recorded the interest and amortization entries for the year This has resulted in a balance of $535 in the Premium on Bonds Payable account as of December 31, 2016 Also, assume that Premium Firm’s bond certificates indicate that the bonds may be retired early at a call price of 102 (meaning 102% of face value) Thus, the redemption price is 102% of $10,000, or $10,200 Module 2: LO 6

  35. Example 10-5—Recording Amortization of a Premium (continued) • Premium Firm’s retirement of bonds would result in a gain which can be calculated using two steps: • The carrying value of Premium Firm’s bonds at that date is calculated as follows: Carrying Value = Face Value + Unamortized Premium = $10,000 + $535 = $10,535 • Calculate the gain: Gain = Carrying Value - Redemption Price = $10,535 - ($10,000 x 1.02) = $10,535 - $10,200 = $335 Module 2: LO 6

  36. Example 10-6—Calculating a Loss on Bond Redemption • Assume that Premium Firm retires bonds at December 31, 2016, however, assume that the call price for the bonds is 107 • The calculations can be performed in two steps: • Carrying Value = Face Value + Unamortized Premium = $10,000 + $535 = $10,535 • Calculate the loss: Loss = Redemption Price - Carrying Value = ($10,000 x 1.07) - $10,535 = $10,700 - $10,535 = $165 Module 2: LO 6

  37. Module 3 Liability for Leases Financial arrangements such as leases as a means of financing a company are important Module 3

  38. Leases • Contractual arrangement between two parties • Allows the lessee the right to use an asset in exchange for making payments to its owner, the lessor Module 3: LO 7

  39. Lease Criteria • Operating lease: off-balance-sheet financing • The lessee acquires the right to use an asset for a limited period of time • The lessee is not required to record the right to use the property as an asset • Or record the obligation for payments as a liability • Capital lease • Recorded as an asset by the lessee • The lessee has the right of ownership and control Module 3: LO 7

  40. Criteria for Lease Capitalization • One or more of the following criteria must be met: • Transfer of ownership of property to the lessee at the end of the lease term • Contains a bargain-purchase option to purchase the asset for lower than its fair market value • The lease term is 75% or more of property’s economic life • The present value of payments is 90% or more of property’s fair market value at the inception of the lease Module 3: LO 7

  41. Exhibit 10-6—Target’s Note Disclosure of Leases, February 1, 2014 Although operating leases are not recorded on the balance sheet, FASB requires note disclosure Module 3: LO 7

  42. Example 10-7—Recording an Operating Lease Suppose that Lessee Firm wants to lease a car for a new salesperson A lease agreement is signed with Lessor Dealer on January 1, 2016, to lease a car for the year for $4,000, payable on December 31, 2016 Typically, a car lease does not transfer title at the end of the term, does not include a bargain-purchase price, and does not last for more than 75% of the car’s life In addition, the present value of the lease payments is not 90% of the car’s value Because the lease does not meet any of the specified criteria, it should be presented as an operating lease Lessee Firm would simply record lease expense (or rent expense) of $4,000 for the year Module 3: LO 7

  43. Example 10-8—Lease Amortization: Effective Interest Method of Amortization • Assume that on January 1, 2016, Lessee signs a lease agreement with Lessor Dealer and the terms of the agreement specify that Lessee will make annual lease payments of $4,000 per year for five years, payable each December 31 • Also, assume that the lease specifies that at the end of the lease agreement, the title to the car is transferred to Lessee Firm • The lease should be treated as a capital lease by Lessee because it meets at least one of the four criteria • A capital lease must be recorded at its present value by Lessee as an asset and as an obligation • Assume an interest rate of 8% • As of January 1, 2016, the present value of the annual payments is $15,972 ($4,000 x an annuity factor of 3.99271) Module 3: LO 7

  44. Example 10-8—Lease Amortization: Effective Interest Method of Amortization (continued) The first entry is made on the basis of the present value as follows: Module 3: LO 7

  45. Example 10-8—Lease Amortization: Effective Interest Method of Amortization (continued) On December 31, 2016, Lessee records depreciation of $3,194 ($15,972/5 years), assuming that the straight-line method is adopted: Module 3: LO 7

  46. Exhibit 10-7—Lease Amortization: Effective Interest Method of Amortization Module 3: LO 7

  47. Example 10-8—Lease Amortization: Effective Interest Method of Amortization (continued) The $4,000 payment in 2016 is interest of $1,278 (8% of $15,972) and reduction of principal of $2,722 On December 31, 2016, Lessee Firm records the following entry for the annual payment: Module 3: LO 7

  48. IFRS and Leasing • U.S. accounting standards: rule based • If lease meets any of the criteria—capital lease • Does not meet any criteria—operating lease • IFRS: criteria are used as ‘‘guidelines’’ rather than rigid rules • More flexibility in applying the lease standards Module 3: LO 7

  49. Module 4 Analysis of Long-TermLiabilities and Cash Flow Issues Financial arrangements such as leases are a means of financing a company and long-term liabilities affect a company’s cash flows Module 4

  50. Debt-to-Equity Ratio • Measures the proportion of a company’s debt to its equity Debt-to-Equity Ratio = Total Liabilities Total Stockholders’ Equity Module 4: LO 8

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