Chapter 11

1. 1,000 Chapter 11 Long-Term Liabilities Adapted from Financial Accounting 4e by Porter and Norton

2. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 Balance Sheet Classifications Current Liabilities: Long-Term Liabilities: due within one year of the balance sheet date due beyond one year

3. Long-Term Liabilities • Bonds Payable • Notes Payable • Leases • Deferred Taxes • Pensions • Other Postretirement Benefits

4. 1,000 $10,000 9% Bond Due 2019 Interest for Investor Borrower Bonds • Long-term borrowing arrangement • Interest paid at stated rate and times • Principal repaid at maturity date Investor Borrower

5. Collateralized - backed by specific assets in event of default Debentures -backed only by general credit-worthiness of issuer Bond Features

6. Term- Entire principal due on a specific single date Serial- Principal repaid in installments over time 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 Bond Features

7. Convertible - into common stock Callable / Redeemable - may be retired before maturity date Common Stock 1,000 Bond Features

8. Face Rate - interest is paid at the rate specified on the bond Market Rate - the interest rate the bond will yield after selling at a discount or premium Date Dept.. of Treasurer Jane Doe Paycheck for 8% Return Bond Interest Rates

9. Interest Rates and Bond Prices BONDS ISSUED: IF STATED RATE: Above face value (at a premium) At face value Below face value (at a discount) > MARKET RATE = MARKET RATE < MARKET RATE

10. Bonds Sold at Face Value Cash 10,000 Bonds Payable 10,000 To record issuance of bonds at face value. Face Value of Bonds = Sales Price

11. Market Interest Rates Bond Prices Relationship of Interest Rates and Bond Prices Market Interest Rates Bond Prices

12. Calculating Bond Prices - two sets of cash flows (1) Interest Payments made each period (annuity) PV = ? etc. $$ $$ $$ $$ (2) Principal due at maturity(single sum) $$$$$ PV = ?

13. Determining Bond Prices Example: On 1/1/04, Discount Firm issues: • $10,000; 8% bonds. • due December 31, 2007 • Interest payable annually • Market rate of interest = 10% Calculate the issue price of the bonds.

14. 2005 2006 2007 2004 Calculating Bond Prices (1) Interest Payments (4 payments @ $800) PV = ? $800 $800 $800 $800 Interest is always paid at rate stated on bonds ($10,000 @ 8%) 14

15. 2005 2006 2007 2004 Calculating Bond Prices (1) Interest Payments (4 payments @ $800) PV = ? $800 $800 $800 $800 (2) Principal of $10,000 due at end of 2007 2007 $10,000 PV = ? 15

16. Compute interest payment at stated rate (i.e. 8%) ... …but discount @ market rate Example of Price Calculation • Present value: • interest payments - • $ 800 x 3.170 = $ 2,536 • (PV; n=4;i = 10%) • principal payment - • $ 10,000 x 0.683 = 6,830 • (PV; n=4;i = 10%) • Bond issue price: $ 9,366

17. Recording Bond Discounts Cash 9,366 Discount on Bonds Payable 634 Bonds Payable 10,000 To record the issuance of bonds at a discount. Assets = Liabilities + Owners’ Equity + 9,366 + 10,000 - 634

18. Balance Sheet Presentation of Bond Discount At Date Upon of SaleMaturity Long-term Liabilities: Bonds Payable $10,000 $10,000 Less: Discount on Bonds Payable (634) - 0 - $ 9,366$10,000 amortize to Interest Expense over the life of the bond

19. Determining Bond Prices Assume Premium Firm sells the same $10,000; 8% bonds when the market rate on similar bonds is 6%.

20. Compute interest payment at stated rate (i.e. 8%) ... …but discount @ market rate Example of Price Calculation • Present value: • interest payments - • $ 800 x 3.465 = $ 2,772 • (PV; n=4;i = 6%) • principal payment - • $ 10,000 x 0.792 = 7,920 • (PV; n=4;i = 6%) • Bond issue price: $10,692

21. Recording Bond Premiums Cash 10,692 Bonds Payable 10,000 Premium on Bonds Payable 692 To record the issuance of bonds at a premium. Assets = Liabilities + Owners’ Equity +10,692 + 10,000 + 692

22. Balance Sheet Presentation of Bond Premium At Date Upon of SaleMaturity Long-term Liabilities: Bonds Payable $10,000 $10,000 Plus: Premium on Bonds Payable 692 - 0 - $10,692$10,000 amortize to Interest Expense over the life of the bond

23. Amortization of Bond Premiums and Discounts Transfer to interest expense over the life of the bond using effective interest method Premium reduces interest expense Discount increases interest expense

24. Amortization Schedule - Discount Cash Interest Discount Carrying DateInterest ExpenseAmortizedValue 1/1/04 – – – $ 9,366 12/31/04 $ 800 $ 937 $ 137 9,503 12/31/05 800 950 150 9,653 12/31/06 800 965 165 9,818 12/31/07 800 982 182 10,000 (rounded) 24

25. Amortization Schedule - Premium Cash Interest Premium Carrying DateInterest ExpenseAmortizedValue 1/1/04 – – – $ 10,692 12/31/04 $ 800 $ 642 $ 158 10,534 12/31/05 800 632 168 10,366 12/31/06 800 622 178 10,188 12/31/05 800 612 188 10,000 (rounded) 25

26. Redemption of Bonds • Reasons for early redemption: • Excess cash • Changing Interest Rates Gain = Carrying Value - Redemption Price (Loss) = Redemption Price- Carrying Value

27. Rights Leases • Contractual arrangement • Grants right to use asset in exchange for payment • Form of financing Lessor Lessee

28. Capital Lease • Record as asset and corresponding liability (as if purchased through borrowings) • Depreciate asset over lease term • Separate payments into principal and interest components using the effective interest method

29. Title 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 Date Dept. of Treasurer Jane Doe Paycheck for Criteria for Lease Capitalization Lease meets one or more: • Transfers ownership of property • Contains bargain purchase option • Term is > 75% of property’s life • PV of payments > 90% of property FMV

30. OFFICE SPACE FOR LEASE Operating Leases • Record as rent (lease) expense each period • Disclose future lease obligations in footnotes

31. Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity How much have creditors contributed as compared to owners?

32. Long-Term Liabilities on the Statement of Cash Flows Operating Activities Net income xxx Increase in current liability + Decrease in current liability - Investing Activities Financing Activities Increase in long-term liability + Decrease in long-term liability - 32

33. Appendix Accounting Tools: Other Liabilities

34. = Income Statement Expense ABC Co. IRS Pay to the order of: Deferred Taxes • Reflects temporary differences between book and tax accounting methods • Book tax expense Cash paid to IRS Tax Return Liability

35. Sales Depreciation expense Income before tax Tax rate Income tax BookTax $6,000 $6,000 2,500 4,000 3,500 2,000 40% 40% $1,400 $ 800 Deferred Income Taxes Difference recorded as deferred tax $ 600

36. Income tax BookTax $1,400 $ 800 Deferred Income Taxes $ 600 Journal Entry: Dr.Cr. Tax Expense 1,400 Tax Payable 800 Deferred Tax 600

37. Date Date XYZ Corp. Date Dept. of Treasurer Pension Fund Dept. of Treasurer Date Jane Doe Paycheck for Dept. of Treasurer Jane Doe Paycheck for Dept. of Treasurer Jane Doe Paycheck for Pensions Pays benefits to retired employees Employer contributes to Pension Fund

38. = Pensions • Expense accrued in period employee earns benefits (regardless of when paid) • Expense may amount funded

39. ASSETS Prepaid Pension Cost $$ LIABILITIES Accrued Pension Cost $$ Pensions on the Balance Sheet Funding > Expense Expense > Funding

40. Postretirement Benefits • Benefits paid to employees after retirement • e.g., health costs • Record expense when employee earns benefits, not when paid (matching principle)

41. 1,000 End of Chapter 11