Long-Term Liabilities: Notes, Bonds, and Leases

1. Long-Term Liabilities:Notes, Bonds, and Leases

2. Key Points • Long-term notes payable, bonds payable, and leasehold obligations, and how companies use these instruments as important sources of financing. • Economic consequences created by borrowing. • Different forms of contractual obligations. • The effective interest rate and how it is determined for contractual obligations. • The effective interest method. • How changes in market interest rates can lead to misstated balance sheet values for long-term liabilities. • Operating leases, capital leases, and off-balance-sheet financing.

3. Long-Term Liabilities: Notes, Bonds, and Leases • Long-term liabilities are recorded at the present value of the future cash flows. • Look at the relationship of long-term liabilities to total assets, total liabilities and stockholders’ equity on page 450

4. Basic Definitions and Different Contractual Forms • Installment notes • Cash (bank loan) • Noncash (lease or real estate purchase) • Non-interest-bearing notes • Cash (zero coupon bond) • Noncash (equipment purchase) • Interest-bearing notes • Cash (bond) • Noncash (equipment purchase) • Look at the question box on p. 453

5. The Time Value of Money • The use of money over time will result in incurring interest • Individuals prefer to receive a specific sum of money now rather than in the future because of the interest factor. That is, if they have the money now they can invest it and earn interest.

6. Distinguish Between Simple and Compound Interest • Simple interestis interest on the principal amount only • It is calculated I = PRT • Compound interestis interest on the principal plus any previously accumulated interest • It is calculated p(1+i)n Where: i = the interest rate and n = the number of periods • Let’s look at an example

7. Simple Interest Vs.Compound Interest • Invest $10,000 at 6% for 3 years • Simple Interest Year 1 $10,000 X .06 = $ 600 Year 2 10,000 X .06 = 600 Year 3 10,000 X .06 = 600 $1,800

8. Compound Interest Year 1 $10,000 X .06 = $ 600.00 Year 2 10,600 X .06 = 636.00 Year 3 11,236 X .06 = 674.16 $1,910.16 Let’s look at this issue more closely

9. Calculate Amounts Using the Future Value and Present Value Concepts • Future value concepts involve determining how much a periodic payment will grow to given a known interest rate • Present value conceptsinvolve determining how much is needed today to be able to have a certain amount available in the future if interest rates are known. • There are four types of compound interest issues we will examine

10. Types of Compound Interest Issues • Future value of a single sum • Future amount of an annuity • Present value of a single sum • Present value of an annuity • First let’s look at how these values might be calculated

11. Methods of Calculation of Compound Interest • Arithmetically • Formula • Table approach • Let’s illustrate each for the future value of a single sum

12. Future Value of a Single Sum • Asks the question: If I invest a certain amount ($10,000) at a known interest rate (6%) for a fixed period (3 years); how much will I have at the end of this period? • Arithmetically We just did this Year 1 $10,000 X .06 = $ 600.00 Year 2 10,600 X .06 = 636.00 Year 3 11,236 X .06 = 674.16 $1,910.16

13. 2 Formula FV = (1 + i)n x amount invested FV = (1.06)3 x $10,000 FV = (1.06) (1.06) (1.06) x $10,000 FV =1.19102 (rounded) x $10,000 FV = $11,910.20

14. 3 Table Approach • Need to know n = number of periods i = interest rate Look up appropriate table value at intersection of n and i in Table 1 on page 671 N = 3 and i = 6% is 1.19102 which is the value we just calculated within the parentheses for the formula approach $10,000 X 1.19102 is $11,910.20

15. Future Value of a Single Sum To review, let’s assume a $10,000 investment for 8 years with an interest rate of 6%. What is the table value

16. Compounding Periods of Less Than One Year • The tables assume a compounding period of one year • How do you use the tables when there is more than one compounding period in a year? For example, 20%compounded quarterly for five years? n x compoundings per year = 4 X 5 = 20 i / compoundings per year = 20 % / 4 = 5% = 2.65330

17. What Is an Annuity? • A series of periodic payments typically termed rents • There are two questions regarding annuities • How much will a periodic investment grow to over a specified period of time at a specified interest rate -The future value of an annuity • How much must I invest now at a specified rate of interest to be able to withdraw a specific sum of money out over a specified number of periods? The present value of an annuity

18. Future Value of an Annuity • Asks the question how much will a periodic payment grow to over a specified number of periods at a given rate of interest? • For example, what will $2,000 invested semiannually for 4 years grow to if I can earn 8% annually. Must adjust n and i and look in Table 2, page 672 n = 8, i = 4% = 9.21423 $2,000 X 9.214 = $18,428

19. Variables Fundamental to Solving Present Value Problems • The process of determining an amount to be received in the future is called discounting the future amount • As with future value must know: • Amount to be received • Length of time until amount is received • Interest rate

20. Present Value of a Single Sum • Asks the question, How much do I need to invest now to have $20,000 5 years from now if I can earn 10% interest annually? • Use Table 4 on page 674 n = 5, i = 10% = .62092 .62092 X 20,000 = $12,418.40

21. Present Value of an Annuity • Asks the question, what must I invest now to be able to make a series of withdrawals in the future? • For example, what must I invest now to allow my daughter to withdraw $5,000 per year at the end of each of the next 4 years to finance her college education if the fund earns 6% annually? • Use Table 5 page 675 n = 4, i = 6% = 3.46511 $5,000 X 3.46511 = $17,325.55 • Let’s now return to accounting for long-term liabilities

22. Bonds Payable • Bonds payable are issued by a company (usually to the marketplace) to generate cash flow. • The bonds represent a promise by the company to pay a stated interest each period (yearly, semiannually, quarterly), and pay the face amount of the bond at maturity. • The marketplace values bonds by discounting the cash flows using the market rate of interest. This is also called the yield rate, discount rate, or effective rate. • There are two types of cash flows with bonds: • The present value of the principal • The present value of the interest payments • Let’s look at the question box on page 460.

23. Problem 2: Bonds Payable • On July 1, 2005, Mustang Corporation issues $100,000 of its 5-year bonds which have an annual stated rate of 7%, and pay interest semiannually each June 30 and December 31, starting December 31, 2005. The bonds were issued to yield 6% annually. • Calculate the issue price of the bond: (1) What are the cash flows and factors? Face value at maturity = $100,000 Stated Interest = Face value x stated rate x time period 100,000 x 7% x (1/2) = $3,500 Number of periods = n = 5 years x 2 = 10 Discount rate = 6% / 2 = 3% per period

24. Problem 2 - calculations PV of interest annuity: PVOA Table PVOA Table PVOA = A( ) = 3,500 (8.53020) = $29,856 i, ni = 3%, n = 10 PV of face value: PV1 Table PV1 Table PV =FV1( ) = 100,000 (0.74409) = $74,409 i, n i=3%, n=10 Total issue price = $104,265 Issued at a premium of $4,265 because the company was offering an interest rate greater than the market rate, and investors were willing to pay more for the higher interest rate.

25. Problem 2 - Amortization Schedule To recognize interest expense using the effective interest method, an amortization schedule must be constructed. To calculate the columns (see next slide): Cash paid = Face x Stated Rate x Time = 100,000 x 7% x 1/2 year = $3,500 (this is the same amount every period) Int. Expense = CV x Market Rate x Time at 12/31/05 = 104,265 x 6% x 1/2 year = 3,128 at 6/30/06 = 103,893 x 6% x 1/2 year = 3,117 The difference between cash paid and interest expense is the periodic amortization of premium. Note that the carrying value is amortizeddown to face value by maturity.

26. Problem 2 - Amortization Schedule Cash Interest Carrying Date Paid ExpenseDifference Value 7/01/05 104,265 12/31/05 3,500 3,128 372 103,893 6/30/06 3,500 3,117 383 103,510 12/31/06 3,500 3,105 395 103,115 6/30/07 3,500 3,093 407 102,708 12/31/07 3,500 3,081 419 102,289 6/30/08 3,500 3,069 431 101,858 12/31/08 3,500 3,056 444 101,414 6/30/09 3,500 3,042 458 100,956 12/31/09 3,500 3,029 471 100,485 6/30/10 3,500 3,015 485 100,000

27. JE at 7/1/05 to issue the bonds: JE at 12/31/05 to pay interest: Note that the numbers for each interest payment come from the lines on the amortization schedule. Cash 104,265 Premium on B/P 4,265 Bonds Payable 100,000 Interest Expense 3,128 Premium on B/P 372 Cash 3,500 Problem 2 - Journal Entries

28. Bonds Payable at a Discount. • If bonds are issued at a discount, the carrying value will be below face value at the date of issue. • The Discount on B/P account has a normal debit balance and is a contra to B/P (similar to the Discount on N/P). • The Discount account is amortized with a credit. Note that the difference between Cash Paid and Interest Expense is still the amount of amortization. • Interest expense for bonds issued at a discount will be greater than cash paid. • The amortization table will show the bonds amortized up to face value.

29. Retirement of Bonds • Bonds are retired when the company pays the investors the amount owed. • If bonds are held to maturity, the amount on the books is face value and the amount paid is face value. • If bonds are retired before maturity, the amount on the books is the carrying value, and the amount paid is the market value at the point of retirement. Because these two amounts are seldom the same, a gain or loss must be recognized.

30. Retirement of Bonds • The gain or loss is the difference between carrying value and cash paid. • If cash paid is greater than CV, recognize loss (paid more than book liability). • If cash paid is less than CV, recognize gain (paid less than book liability). • When recording the early retirement, we must remove both Bonds Payable (face amount) and the related Premium or Discount (remaining unamortized amount). • The gain or loss is recognized as part of Income from Continuing Operations (Other Revenues and Gains or Other Expenses and Losses). • Let’s look at the question box on p. 468

31. Assume that Mustang’s bonds were retired on June 30, 2006 (after the interest payment). Mustang Corporation paid $104,000 to retire the bonds from the marketplace. Record the entries on June 30, 2006. JE at 6/30/06 to pay the interest: JE at 6/30/06 to retire the bonds: Interest Expense 3,117 Premium on B/P 383 Cash 3,500 Bonds Payable 100,000 Premium on B/P 3,510 Loss on Retirement 490 Cash 104,000 Problem 2 - Retirement of Bonds

32. Leases • Off-balance-sheet financing • Companies historically liked to contract for leases rather than asset purchases, to keep the liability off the books. • FASB issued SFAS No. 13, which requires certain leases to be recorded as capital leases. • Capital leases record the leased asset as a capital asset, and reflect the present value of the related payment contract as a liability.

33. Leases • Operating leases • Lessee assumes no risk of ownership. • Recognize rent expense as each payment made. • At end of lease term, right to use the property reverts to the owner. • Capital leases • Effectively an installment purchase. • Lessee assumes rights and risks of ownership. • Treated as asset purchased with related liability and depreciation. • Look at question boxes on pages 470 and 471

34. Comments on Leases • Many companies still have many leases that qualify as operating leases for financial reporting. • Comparison to companies with capital leases is difficult (different asset and liability structures). • Disclosure information regarding operating lease components makes it possible for analysts to “capitalize” the operating leases for financial statement comparison. • Let’s do ID 11-11