Accounting 2120

1. Accounting 2120 Chapter 14 – Long-term Liabilities

2. Financing of Corporations • Debt versus Equity • Debt must be repaid (stock investments do not have to be repaid). • Debt must pay interest (Stocks do not have to pay dividends). • Interest expense is tax-deductible (dividends are not.) • Debt holders (called creditors) are not owners as are stockholders. • Debt does not dilute ownership percentages as does the issuance of stock.

3. Bonds Payable • What are bonds? • Long-term liabilities • Generally “sold” or issued to the public • Generally issued in face values of $1,000 • Have principal and interest components • Principal must be repaid along with some form of interest payments

4. Bond Prices • Bonds are often actively traded on stock exchanges • Quoted at prices representing percentages • Example: “100” = face value,“98” = less than face value, “102 = more than face value • Price reflects the PRESENT VALUE of future cash flows (interest payments and principal) which may be different from the face value of the bond and interest payments.

5. Bonds Payable • FACE VALUE = Par value or principal to be repaid • MATURITY DATE = date bond payable is due • CONTRACT OR STATED INTEREST RATE = interest rate on the face of the bond • MARKET INTEREST RATE = going interest rate on comparable bonds (fluctuates daily). • Interest payments - ALWAYS based on the stated interest rate • Interest = Principal X Interest Rate x Time

6. Bond Journal Entries • Example: Issued $100,000 Bonds Payable, 9% interest, 5 years, at face value on July 1, 2013 • July. 1, 2013 Issuance: • Cash 100,000 • Bonds Payable 100,000 • December 31, 2013 Semiannual Interest Payment (100,000 x .09 x 1/2): • Interest expense 4,500 • Cash 4,500

7. Bond Journal Entries • Semiannual Interest Payments-every 6 months for 5 years): • Interest expense 4,500 • Cash 4,500 • June 30, 2018 Repayment: • Bonds payable 100,000 • Cash 100,000

8. Bonds issued at a discount • Market rate > stated interest rate • 10% 9% • Bonds issued at a discount (below face amount) - Received $98,000 • Cash 98,000 • Discount on bonds payable 2,000 • Bonds payable 100,000

9. Bond Discount • We received $2,000 less than face value for the privilege of issuing 9% bonds instead of 10% bonds. • Bond discount is a CONTRA-LIABILITY • Balance sheet: • Bonds Payable 100,000 • Less discount ( 2,000) • Carrying value 98,000

10. Discount Amortization • Discount must be amortized over the life of the bonds to expense • Straight-line or effective interest method used to amortize bond discount • After 10 periods, bond discount = 0 and we pay back $100,000 notes payable face value

11. Bond Discount • Straight-line method: 2,000/10 = 200 each period • Semiannual interest payment: • Interest expense 4,700 • Discount on bond payable 200 • Cash 4,500 • (same payment as with no discount) • (Interest expense is higher than cash paid because bond discount increases interest expense)

12. Bond Premium • Market rate > stated interest rate • 7% 9% • Bonds issued at a premium (more than face amount) - Received $108,317 • Cash 108,317 • Premium on bonds payable 8,317 • Bonds payable 100,000

13. Bond Premium • Semiannual interest payment: • 8,317/10 = 832 each period • Interest expense 3,668 • Premium on bond payable 832 • Cash 4,500 • (Interest expense is lower than cash paid because bond premium reduces interest expense)

14. Bond Premium • We received $8,317 more than face value for issuing 9% bonds instead of 7% bonds. • Bond premium is added to the liability balance to get the carrying value. • Balance sheet: • Bonds Payable 100,000 • Plus Premium 8,317 • Carrying value 108,317 • Bond premium is amortized over the 10 periods and then we pay back $100,000 notes payable face value.

15. Bond Retirement • At maturity (simply pay the face value of the $100,000 bond): • Bonds Payable 100,000 • Cash 100,000

16. Bond Retirement • Before maturity: • Pay the fair value of the bond • Debit the bonds payable for the face amount • Debit (credit) the balance in the premium (discount) on bond payable account • The difference will be a gain or loss

17. Bond Retirement • Some bonds can be convertible into shares of equity • Instead of crediting cash, credit the par value and paid in excess of the new shares issued • Debit bonds payable for face amount • Debit (credit) premium (discount) on bonds payable

18. Features of Bonds and Notes • Secured or Unsecured • Term or Serial • Registered or Bearer • Convertible and/or Callable

19. Debt to Equity Ratio • Debt to equity Ratio: • Total liabilities • Total equity • Compares the financing options. • High debt to equity ratios indicate a riskier company because more debt is used to finance assets.

20. Determining the Price of a Bond • PV of two cash streams: • 1 – Principal payment • (one time lump sum at the maturity date) • + • 2 – Interest payments • (Annuity generally since the same amount received each payment date)

21. Time Value of Money • |-------------------------------------------------| • Present value Future value • Present value = current value of a sum in the future • Future value = worth of a sum in the future • Future value always > than present value due to the interest it can earn • Annuities – series of equal payments

22. Effective Interest Method • If the straight-line method of amortization does not reflect the reality of the bond discount or premium values, you must use the effective interest method. • The effective-interest method is based on amortization tables.

23. Interest Expense and Payments • The portion of the payment for interest is determined first and is based on the outstanding carrying value. • Interest expenseis determined by the following formula: • $108,317 x .07 x ½ year = $3,791 Carrying value X Market interest rate X Time

24. The payments for the $100,000 bond are to be paid over 5 years twice a year. The interest payment is based on the stated interest, NOT THE MARKET INTEREST RATE. This payment is split between interest (just calculated) and principal (the remainder of the payment). The amortization for the first month is as follows: Debt Payments

25. Since we just reduced a portion of the $108,371, our new carrying value is $108,371 - $709 = $107,608. Our second payment will include less interest since the carrying value has been reduced. The new interest is: $107,608 x .07 x 1/2 = $3,766 (Principal) (Market Interest rate) (Time) Next Payment

26. Amortization • We again amortized a portion of the carrying value, so our new carrying value is $107,608 - $734 = $106,874 • With each payment, the carrying value goes down, so the amount of the payment for interest expense goes down and the amount of the payment attributable to the principal goes up until the loan balance reflects the face value of the bond of $100,000. • A schedule showing the principal balance along with the payment and interest for each month is called an AMORTIZATION SCHEDULE.

27. Amortization Schedule$100,000 Face Value Bond, sold at a Premium of $8,317

28. Other Long-term Liabilities • Notes Payable • Mortgage Notes • Leases • Pensions

29. Issuing Bonds Between Interest Payment Dates • For record keeping purposes, if bonds are sold in between the payment dates: • Interest is collected up front from buyer • Entire six month interest payment is paid to the new buyer • Example: • Bond payments are 12/31 and 6/30 • Bond sold on 1/31 • Collect 31 days of interest • Pay 6 months of interest on 6/30

30. Interest Accrual • If payment dates straddle a year end, you must accrue interest expense. • Issuance date = November 1 instead • Accrual = 2 months interest • (100,000 x .09 x 2/12 = 1500) • Interest expense 1,500 • Interest payable 1,500