Long-Term Liabilities

1. Long-Term Liabilities Chapter 15

2. Bonds: An Introduction Groups of notes payable issued to multiple lenders • principal • interest rate • interest payment dates

3. Advantages of Bonds • Do not affect stockholder control. • Interest on bonds is tax deductible. • Can increase return on equity.

4. Disadvantages of Bonds • Require payment of both periodic interest and par value at maturity. • Can decrease return on equity when company pays more in interest than it earns on the borrowed funds.

5. Types of Bonds • Secured bonds • Unsecured bonds

6. Types of Bonds • Term Bonds • Serial Bonds

7. Types of Bonds • Convertible bonds • Callable bonds

9. Bond Issuing Procedures • Company sells bonds to underwriter • Underwriter sells bonds to investors • Trustee monitors bond issue

10. Bond Prices Quoted as percent of its face value. • What is the issue price of a $2,000 bond sold at 98-1/4? $2,000 x .9825 = $1,965 • What is the issue price of a $6,000 bond sold at 101-1/2 $6,000 x 1.015 = $6,090

11. Bond Prices Affected by... • time to maturity. • credit rating of issuer. • interest rate.

12. Determining the Market Value of Bonds A function of three factors: 1) dollar amounts to be received 2) length of time until amounts are received 3) market rate of interest - rate investors demand for loaning funds

13. Determining the Market Value of a Bond Couric Company issues bonds with a par value (face value) of $100,000. The bonds mature in 3 years and pay 9% annual interest in semiannual payments. On the issue date, the annual market rate for the bonds is 10%. How much is an investor willing to pay?

14. Market Value of Bond • Determine dollar amounts to be paid in the future. • Determine length of time until amounts are to be received • Determine interest rate investors demand.

15. Present value of a bond 1 2 3 4 5 6 $100,000

16. Present value of a bond 1 2 3 4 5 6 $4,500 $4,500 $4,500 $4,500 $4,500 $4,500

17. $97,442 Present Value of a Bond Present value of $100,000 Present value of annuity of $4,500 Total present value $74,600 22,842

18. PROBLEM 15A-4 a. • Dollar amounts to be paid in future? • 88,000 lump sum • 5,280 interest payments • Length of time until amounts are to be received? • 88,000 in 20 periods • 5,280 semiannually. 20 times • What interest rate do investors demand? • 6% every six months

19. PROBLEM 15A-4 PV 88,000 = 88,000 x 0.312 = $27,456 PVA 5,280 = 5,280 x 11.470 = 60,562 $88,018 Note: the present value should be $88,000. The difference of $18 is due to rounding to three decimal places in the present value tables.

20. PROBLEM 15A-4 b • Determine dollar amounts to be paid in the future.88,000 lump sum5,280 interest payments • Determine length of time until amounts are to be received88,000 in 20 periods5,280 semiannually. 20 times • What interest rate do the investors demand? 7% every six months This is the only difference

21. PROBLEM 15A-4 PV 88,000 = 88,000 x 0.258 = $22,704 PVA 5,280 = 5,280 x 10.594 = 55,936 $78,640 These bonds are issued at a _________ Discount

22. PROBLEM 15A-4 • Determine dollar amounts to be paid in the future.88,000 lump sum5,280 interest payments • Determine length of time until amounts are to be received88,000 in 20 periods5,280 semiannually. 20 times • What interest rate do the investors demand? 5% every six months

23. PROBLEM 15A-4 PV 88,000 = 88,000 x 0.377 = $33,176 PVA 5,280 = 5,280 x 12.462 = 65,799 $98,975 These bonds are issued at a _________ Premium

24. Premium BOND CONTRACT INTEREST RATE 9% Face (Par) Value Discount Interest rates and bond prices Market Rates Bonds Sell at: Issued when: 8% 9% 10%

25. Issuing Bonds at Par – Exercise 15-1 Mar 31 Cash 500,000 Bonds Payable 500,000 Interest = 500,000 x .08 x ½ = 20,000 Sep 30 Interest Expense 20,000 Cash 20,000 Dec 31 Interest Expense 10,000 Interest Payable 10,000 Interest = 500,000 x .08 x 3/12 = 10,000

26. Exercise 15-4 a. Discount price b. Premium price c. Price equal to maturity (par) value d. Premium price e. Discount price

27. Contra-Liability Account Bond Discount – Exercise 15-5 Jan 2 Cash 279,600 Discount on Bonds Payable 20,400 Bonds Payable 300,000

28. Effective-Interest Amortization • Preferred method over straight-line • When amounts are materially different, GAAP requires effective-interest method • Allocates bond interest expense over life of bonds in a way that yields constant rate of interest. • In this course, we will use the effective interest method

29. Effective-interest Method • Interest expense = Carrying value x market rate of interest • Cash = Face Value x stated rate of interest • Difference is amount of premium or discount to amortize.

30. Amortization table

31. Exercise 15-5

32. Bond Discount – Exercise 15-5 Jul 2 Interest Expense 11,184 Cash 10,500 Discount on Bonds Payable 684

33. Face Value Carrying Value Balance Sheet Presentation as of July 2 Long-term liabilities: Bond payable $300,000 Less Discount on Bonds 19,716 $280,284

34. Adjunct Account Bond Premium – Exercise 15-6 Mar 31 Cash 220,000 Premium on Bonds Payable 20,000 Bonds Payable 200,000

35. Exercise 15-6

36. Bond Premium – Exercise 15-6 Sep 30 Interest Expense 7,700 Premium on Bonds Payable 300 Cash 8,000

37. Face Value Carrying Value Balance Sheet Presentation as of Sep 30 Long-term liabilities: Bond payable $200,000 Plus: Premium on bonds 19,700 $219,700

38. Issuing Bonds & Notes Payable Between Interest Dates

39. Corp. pays full 6 months’ of interest Investor pays face value + Accrued interest Exercise 15-9 April 30 Bond Date May 31 Issue Date Oct 31 Interest Payment Date

40. Exercise 15-9 May 31 Cash 402,000 Bonds payable 400,000 Interest payable 2,000 Oct 31 Interest Expense 10,000 Interest Payable 2,000 Cash 12,000

41. Retirement of Bonds Payable • To retire a bond early, issuer can ... • purchase bonds in the open market • exercise a call option • A call option is …..

42. Early Retirement of Bonds • Recognize interest expense and amortize discount or premium up to date of retirement • If carrying value of bond > cash paid = gain on early retirement of bonds • If carrying value of bond < cash paid = loss on early retirement of bonds • Gains or losses on early retirement of debt (if material in amount) are extraordinary items

43. Discount on bonds Bonds payable 12,000 400,000 Exercise 15-12 a. Carrying value of bonds Bonds payable 400,000 Less discount (12,000) 388,000 Retire half x ½ 194,000 Cash paid to retire debt 200,000 x 1.01 = 202,000 Loss of 8,000

44. Exercise 15-12 - retirement Oct 1 Bonds payable 200,000 Loss on retirement of bonds payable 8,000 Discount on bonds payable 6,000 Cash 202,000

45. Convertible Bonds and Notes • Holder has option of exchanging bond for specified number of shares of common stock • When converted - stockholders’ equity increased by carrying amount of bonds converted.

46. Exercise 15-12 - conversion Oct 1 Bonds payable 200,000 Discount on bonds payable 6,000 Common stock 50,000 Paid in capital in excess of par, common 144,000

47. Current Portion of Long-Term Debt

48. Reported as either current or long-term Current Liabilities: Notes payable, current………$200,000 Long-term Liabilities Notes payable, long-term…… $300,000 Report Liabilities on the Balance Sheet

49. Exercise 15-13 Current liabilities: Accounts payable………………….$ 50,000 Bonds payable, current…………… 30,000 Salary payable………………………. 14,000 Income tax payable………………….. 8,000 Interest payable……………………… 7,000 Long-term liabilities: Bonds payable…………………….. $270,000

50. End of Chapter 15 Problem 15-4A Problem 15-5A Problem 15-6A Problem 15-6B