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Long-Term Debt Financing

11. C H A P T E R. Long-Term Debt Financing. Learning Objective 1. Use present value concepts to measure long-term liabilities. Define Long-Term Liabilities. Debts and other obligations that will not be paid in cash or satisfied with other assets or services within one year. Notes payable

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Long-Term Debt Financing

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  1. 11 • C H A P T E R Long-Term Debt Financing

  2. Learning Objective 1 • Use present value concepts to measure long-term liabilities.

  3. Define Long-Term Liabilities Debts and other obligations that will not be paid in cash or satisfied with other assets or services within one year. Notes payable Bonds payable Mortgages payable Lease payments Pension obligations

  4. Present value of $1 is the value today of $1 to be received or paid in the future, given a specific interest rate. Accounting forLong-Term Liabilities • Measurement and recording of long-term liabilities are based on the time value of money concept. If money can earn 10% per year, $100 to be received 1 year from now is approximately equal to $90.91 received today.

  5. Present Value Table Locate the number of periods in the left column and the interest rate in the row at the top of the table. This intersection is the factor representing the present value of $1. Discounting—present value amount is the amount that could be paid today to satisfy the obligation. Present and FutureValue Tables Future Value Table Locate the number of periods in the left column and the interest rate in the row at the top of the table. This intersection is the factor representing the future value of $1. Compounding—the frequency with which interest is added to the principal.

  6. Today 1 2 3 4 Future Discount at 10% $82.64 $100 PresentValue Present value of $100 paid in 5 years discounted at 10 percent. PV = $62.09 $90.90

  7. Today 1 2 3 4 Future Compound at 10% $100 $121 Future Value Future value of $100 today compounded for 5 years at 10 percent. $110 FV = $161.05

  8. Value Table — Future Value Joan invested $2,000 for 3 years at 12 percent, compounded annually.Using the table below, what is the future value of the $2,000? Periods 6% 8% 10% 12% 3 1.1910 1.2597 1.3310 1.4049 4 1.2625 1.3605 1.4641 1.5735 5 1.3382 1.4693 1.6105 1.7623 6 1.4185 1.5869 1.7716 1.9738 Future value = Amount x FV Factor Future value = $2,000 x1.4049 Future value = $2,809.80

  9. Value Table — Future Value Joan invested $2,000 for 3 years at 12 percent, compounded semiannually. Using the table below, what is the future value of the $2,000? Periods 6% 8% 10% 12% 3 1.1910 1.2597 1.3310 1.4049 4 1.2625 1.3605 1.4641 1.5735 5 1.3382 1.4693 1.6105 1.7623 6 1.4185 1.5869 1.7716 1.9738 Future value = Amount x FV Factor Future value = $2,000 x1.4185 Future value = $2,837

  10. Yearly interest rate Compounding periods per year Compounding periods per year Number of years x Computing the Interest RateProvide the Appropriate Formula. Interest rate per compounding period = Number of interest periods =

  11. Define Annuities • Annuity • A series of equal amounts to be received or paid at the end of equal time intervals. • Present Value of an Annuity • The value today of a series of equally spaced, equal-amount payments to be made or received in the future given a specified interest rate.

  12. Value Tables — Annuity Joan is paid $8,000 a year for 8 years at 10 percent interest per year. Using the table below, what is the present value of the annuity? Periods 6% 8% 10% 12% 7 5.5824 5.2064 4.8684 4.5683 8 6.2098 5.7466 5.3349 4.9676 9 6.8017 6.2469 5.7590 5.3282 10 7.3601 6.7101 6.1446 5.6502 Present value = Amount x PV Factor Present value = $8,000 x5.3349 Present value = $42,679.20

  13. Learning Objective 2 • Account for long-term liabilities, including notes payable and mortgages payable.

  14. + Bond Bond Note Payable – Mortgage Payable Bond Pay Choose Issue Amortize Retire Time Line ofBusiness Issues

  15. On January 1, 2004, Silver Eagle Co. borrowed $20,000 for 3 years at 12 percent interest. The interest is payable on December 31 of each year. What entries are necessary for 2004? Jan. 1 Cash. . . . . . . . . . . . . . . . . 20,000 Note Payable . . . . . . . 20,000 Borrowed $20,000 for 3 years at 12%. Dec. 31 Interest Expense . . . . 2,400 Cash. . . . . . . . . . . . . . 2,400 Made interest payment ($20,000 x 0.12). Example: Interest-Bearing Notes

  16. What entry is needed when Silver Eagle Co. repays the loan on December 31, 2005? Dec. 31 Interest Expense . . . . . . . 2,400 Note Payable. . . . . . . . . . 20,000 Cash. . . . . . . . . . . . . . 22,400 Interest payment and repayment of loan. Example: Interest-Bearing Notes

  17. What is a Mortgage Payable? A written promise to pay a stated amount of money at one or more specified future dates. Secured by the pledging of certain assets, usually real estate, as collateral. Generally requires periodic (usually monthly) payments of principal plus interest.

  18. Jan. 1 Cash. . . . . . . . . . . . . . . 500,000 Mortgage Payable. . 500,000 Borrowed $500,000 to purchase building. Jan. 31 Mortgage Payable . . . . 409.84 Interest Expense . . . . . 2,916.67 Cash. . . . . . . . . . . . 3,326.51 Made first month’s mortgage payment. Example: Mortgages Payable On January 1, 2006, Blue Bird Corp. borrowed $500,000 to acquire a new building. The building was signed as collateral for the 30-year, 7 percent loan. Payments of $3,326.51 are to be made monthly. What are the January 2006 entries?

  19. Mortgages Payable A mortgage amortization schedule shows the breakdown between interest and principal for each payment over the life of a mortgage. Monthly Principal Interest Mortgage MonthPayment Paid Paid Balance 1 3,326.51 409.84 2,916.67 499,590.16 2 3,326.51 412.23 2,914.28 499,177.93 3 3,326.51 414.64 2,911.87 498,763.29 4 3,326.51 417.06 2,909.45 498,346.23 5 3,326.51 419.49 2,907.02 497,926.74 6 3,326.51 421.94 2,904.57 497,504.80

  20. Learning Objective 3 Account for capital lease obligations and understand the significance of operating leases being excluded from the balance sheet.

  21. Lease ObligationsMatch the Following Terms. Lessor Operating Lease Lease Lessee Capital Lease • The party that is granted the right to use property under the terms of a lease. • The owner of property that is rented (leased) to another party. • A simple short-term rental agreement. • A leasing transaction that is recorded as a purchase by the lessee. • A contract that specifies the terms under which the owner of an asset agrees to transfer the right to use the asset to another party.

  22. YES Yes No Transfer of Ownership? Yes No Bargain Purchase Option? No Yes Term ³ 75% of Useful Life? No Yes Capital Lease Operating Lease PV Payment ³ 90% of FMV? Classifying Leases • If the lease is cancelable or does not meet any of the four requirements, is it an operating lease?

  23. Jan. 1 Leased Computer . . . . . . . 24,838 Lease Liability . . . . . . . 24,838 Leased a computer for company use. Dec. 31 Lease Liability . . . . . . . . . . 2,019 Interest Expense . . . . . . . . 2,981 Cash. . . . . . . . . . . . . . . 5,000 Paid annual lease payment for computer. Example: Lease Obligations On January 1, 2006, The Cockatoo Company leased a computer. The lease requires annual payments of $5,000 for 8 years. The applicable interest rate is 12 percent. How is the lease recorded? What is the December 31, 2006 entry for interest expense?

  24. Learning Objective 4 • Account for bonds, including the original issuance, the payment of interest, and the retirement of bonds.

  25. Define These Types of Bonds Bond A contract between a borrower (issuer) and a lender (investor). The borrower promises to pay a specified amount of interest for each period the bond is outstanding and to repay the principal at the maturity date. Unsecured Bonds (Debentures) Bonds for which no collateral has been pledged. Secured Bonds Bonds for which assets have been pledged in order to guarantee repayment. Coupon (Bearer) Bonds Unregistered bonds for which owners receive periodic interest payments by clipping a coupon from the bond and sending it to the issuer as evidence of ownership.

  26. Types of Bonds Matching • Bonds that mature in one lump sum on a specified future date. • Bonds that mature in a series of installments at specified future dates. • Bonds for which the issuer reserves the right to pay the obligation before its maturity date. • Bonds that can be traded for, or converted to, other securities after a specified period of time. • The names and addresses of the bondholders are kept on file by the issuing company. Serial Bonds Convertible Bonds Term Bonds Callable Bonds Registered Bonds 2. 4. 1. 3. 5.

  27. Discuss These Types of Bonds Zero-Coupon Bonds Bonds issued with no promise of interest payments; only a lump sum payment will be made. Junk Bonds Bonds issued by companies in weak financial condition with large amounts of debt already outstanding; these bonds yield high rates of return because of high risk.

  28. Principal (face value or market value) Bond Maturity Date Bond Indenture Characteristics of Bonds Match Correctly. A contract between a bond issuer and a bond purchaser that specifies the terms of a bond. The amount that will be paid on a bond at the maturity date. The date at which a bond principal or face amount becomes payable. A contract between a bond issuer and a bond purchaser that specifies the terms of a bond. The amount that will be paid on a bond at the maturity date. The date at which a bond principal or face amount becomes payable.

  29. How Do You Determine Issuance Price? Price should equal: present value of the interest payments + present value of the bond’s lump-sum face value at maturity Market rate (effective rate or yield rate) of interest The interest rate investors expect to earn on their investment. Stated rate of interest The rate of interest printed on the bond.

  30. Determining Issuance Price Correctly Define Each Term Face Value The amount that will be paid on a bond at the maturity date. Bond Discount The difference between the face value and the sales price when bonds are sold below their face value. Bond Premium The difference between the face value and the sales price when bonds are sold above their face value.

  31. 8% Premium 10% Face Value 12% Discount Characteristics of Bonds Complete the Chart Market Rate Bond Sold at Bond Stated Interest Rate 10%

  32. 1. Semiannual interest payments $ 25,000 Present value of interest annuity $193,043 2. Maturity value of bonds $500,000 Present value of bonds 306,957 3. Issuance price of bonds $500,000 Example: Bond Issued at Face Value Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective and stated rates are equal. Calculate the issue price.

  33. 1. Semiannual interest payments $ 25,000 Present value of interest annuity x 7.2601 $184,002 2. Maturity value of bonds $500,000 Present value of bonds x .5584 279,197 3. Issuance price of bonds $463,199 Example: Bond Issuedat a Discount Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 12 percent. Calculate the issue price of the bonds.

  34. 1. Semiannual interest payments $ 25,000 Present value of interest annuity x 8.1109 $202,772 2. Maturity value of bonds $500,000 Present value of bonds x .6756 337,782 3. Issuance price of bonds $540,554 Example: Bond Issuedat a Premium Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 8 percent. Calculate the issue price of the bonds.

  35. Jan. 1 Cash . . . . . . . . . . . . . . . . 500,000 Bonds Payable. . . . . . . 500,000 Issued $500,000, 10%, 5-year bonds. Example: Accounting for Bonds Payable On January 1, 2006, Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 10 percent. What entry is needed to record the liability?

  36. Jun. 30 Bond Interest Expense . . 25,000 Cash. . . . . . . . . . . . . . 25,000 Paid interest ($500,000 x 0.10 x 0.5). Example: Accounting for Bonds Payable On January 1, 2006, Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 10 percent. What entry is needed to record the first interest payment?

  37. Jan. 1 Bond Interest Expense. . . . . 25,000 Bonds Payable. . . . . . . . . . . . 500,000 Cash. . . . . . . . . . . . . . 525,000 Retired 5-year, $500,000, 10% bonds; paid interest ($500,000 x 0.10 x 0.5). Example: Bond Retirements at Maturity On January 1, 2006, Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 10 percent. What entry is needed to record the retirement of the bond on January 1, 2011?

  38. Jan. 1 Bonds Payable. . . . . . . . . 200,000 Loss on Bond Retirement. 20,000 Cash (200,000 x 1.10) . 220,000 Retired a callable bond at 110. Example: Bond Retirements Before Maturity The Great Owl Company issued $200,000, 14 percent bonds, which are now selling for 107 and are callable at 110. The bonds were issued at face value. If the company decides to call the bonds, what entry is needed?

  39. Learning Objective 5 Use debt-related ratios to determine the degree of a company’s financial leverage and its ability to repay loans

  40. Define Debt Ratio Measures the amount of assets supplied by lenders. Total Liabilities Total Assets

  41. Total liabilities Total stockholders’ equity Define Debt-to-Equity Ratio Measures the balance of funds being provided by creditors and stockholders

  42. Times Interest Earned Ratio Income before interest and taxes (operating profit) Annual interest expense The ratio of income that is available for interest payments to the annual interest expense.

  43. Expanded MaterialLearning Objective 6 • Amortize bond discounts and bond premiums using either the straight-line method or the effective-interest method.

  44. Which method is preferred by GAAP? Define the Two Bond Premium/Discount Amortization Methods • Straight-line Method • A method of systematically writing off a bond premium or discount, resulting in equal amounts being amortized each period. • Effective-interest Method • A method of systematically writing off a bond premium or discount, taking into consideration the time value of money. GAAP prefers the effective-interest method.

  45. Jan. 1 Cash. . . . . . . . . . . . . . . . . 196,000 Discount on Bonds. . . . . . 4,000 Bonds Payable . . . . . . . 200,000 Issued $200,000 at a discount. Example: Bond Issuedat a Discount On January 1, 2006, The Ostrich Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. The company received $196,000 for the bonds. Make the entry to record the issuance of the bonds.

  46. Jun. 30 Bond Interest Expense . . . 10,200 Discount on Bonds. . . . 200 Cash. . . . . . . . . . . . . . . 10,000 Paid interest ($200,000 x 0.10 x 0.5). Example: Bond Issuedat a Discount On January 1, 2006, The Ostrich Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. Using straight-line amortization, what entry is made for the interest payment on June 30, 2006?

  47. Dec. 31 Bond Interest Expense . . . 10,200 Discount on Bonds. . . . 200 Bond Interest Payable . 10,000 To recognize interest expense for 6 months. Example: Bond Issuedat a Discount On January 1, 2006, The Ostrich Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. Using straight-line amortization, what adjusting entry is needed on December 31, 2006?

  48. Jan. 1 Bonds Payable. . . . . . . . . . 200,000 Cash . . . . . . . . . . . . . . . 200,000 Retired a $200,000, 10-year, 10% bond. Example: Bond Issuedat a Discount On January 1, 2006, The Ostrich Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. What entry is necessary to retire the debt after 10 years?

  49. Jan. 1 Cash. . . . . . . . . . . . . . . . . 210,000 Premium on Bonds. . . 10,000 Bonds Payable . . . . . . . 200,000 Issued $200,000 at a premium. Example: Bond Issuedat a Premium On January 1, 2006, The Parrot Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. The company received $210,000 for the bonds. Make the entry to record the issuance of the bonds.

  50. Jun. 30 Bond Interest Expense. . . 9,500 Premium on Bonds. . . . . . 500 Cash . . . . . . . . . . . . . . 10,000 Paid interest ($200,000 x 0.10 x 0.5). Example: Bond Issuedat a Premium On January 1, 2006, The Parrot Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. The company received $210,000 for the bonds. Using straight-line amortization, what entry is made for the interest payment on June 30, 2006?

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