Prepared by: Robert G. Ducharme, MAcc, CA University of Waterloo, School of Accounting and Finance

1. FINANCIALACCOUNTINGThird Canadian EditionLIBBY, LIBBY, SHORT, KANAAN, GOWING Prepared by: Robert G. Ducharme, MAcc, CAUniversity of Waterloo, School of Accounting and Finance

2. Chapter 11 Reporting and Interpreting Long-term Liabilities

3. Understanding the Business Equity - funds from owners Debt - funds from creditors The acquisition of assets is financed from two sources: The mix of debt and equity for a company is called the capital structure.

4. Understanding the Business:Capital Structure – Long-term Debt Significant debt needs of a company are often filled by issuingnotes and bonds. Bonds Cash

5. Understanding the Business Advantages of bonds: • Bonds are debt, not equity, so the ownership and control of the company are not diluted. • Cash payments to the debt holders are limited to the scheduled payments of interest principal. • Interest expense is tax deductible. • The impact on earnings is positive (positive financial leverage) because money can often be borrowed at a low interest rate and invested at a higher interest rate.

6. Understanding the Business Disadvantages of bonds: • Risk of bankruptcy exists because the interest and principal are legal obligations and must be paid back as scheduled or creditors will force legal action. • A single, large principal payment is required at the maturity date. • Negative impact on cash flows exists because interest and principal must be repaid in the future.

7. Financial Leverage Financial Leverage is the use of borrowed funds to increase the rate of return on owner’s equity; it occurs when the interest rate on debts is lower than the rate of return on total assets.

8. Financial Leverage Capital Structure ________________________ Total assets = $600,000 50% Debt 100% Equity50% Equity Income before interest and taxes $ 100,000 $ 100,000 Interest expense ($300,000 x 10%) -0- 30,000 100,000 70,000 Income tax expense (@40%) 40,000 28,000 Net income $ 60,000 $ 42,000 Long-term debt $ 0 $ 300,000 Owners’ equity $ 600,000 $ 300,000 Return on equity (Net income/Owners’ equity) 10% 14%

9. Types of Long-Term Debt Long-term debt is available to companies in various forms: • Bank loans • Notes • Mortgages • Bonds and Debentures

10. Understanding the Business Bonds can be traded on established exchanges that provide liquidity to bondholders. As liquidity increases . . . . . . Cost of borrowing decreases.

11. Characteristics of Bonds Payable $ Bond Issue Price $ Company Issuing Bonds Investor Buying Bonds Bond Certificate At Bond Issuance Date Bonds payable are long-term debtfor the issuing company.

12. Characteristics of Bonds Payable PeriodicInterest Payments $ $ Company Issuing Bonds Investor Buying Bonds Principal Payment at End of Bond Term $ $

13. Characteristics of Bonds Payable Interest 10% Face Value $1,000 6/30 & 12/31 BOND PAYABLE Bond Date 1/1/06 Maturity Date 1/1/16 1. Face Value = Maturity or Par Value, Principal 2. Maturity Date 3. Stated Interest Rate 4. Interest Payment Dates 5. Bond Date Other Factors: 6. Market Interest Rate 7. Issue Date

14. Bond Classifications An indenture is a bond contract that specifies the legal provisions of a bond issue. • Debenture bonds • Not secured with the pledge of a specific asset. • Callable (redeemable) bonds • May be retired and repaid (called) at any time at the option of the issuer. • Retractable bonds • May be retired at the option of the bondholder. • Convertible bonds • May be exchanged for other securities of the issuer (usually common shares) at the option of the bondholder. Senior Debtreceives preference over other creditors in the event of bankruptcy or default. Subordinated Debtis riskier than senior debt.

15. Characteristics of Bonds Payable • When issuing bonds, potential buyers of the bonds are given a prospectus. • The company’s bonds are issued to investors through an underwriter. • The trustee makes sure the issuer fulfills all of the provisions of the bond indenture. For example, see Prospectus Supplement, dated May 12, 2005 of Petro-Canada on the SEDAR website (www.sedar.com).

16. Reporting Bond Transactions When a company issues bonds, it specifies two cash flows related to the transaction: Principal Interest Assume Dino Oil issues $100,000 in bonds at par on January 1, 2006. The bonds pay 8% interest annually on December 31. What journal entry should be made on January 1, 2006?

17. Reporting Bond Transactions Periodically, interest must be accrued and recorded. The annual interest payment is determined by multiplying the principal amount times the stated interest rate in the bond contract. Assume Dino Oil issues $100,000 in bonds at par on January 1, 2006. The bonds pay 8% interest annually on December 31. What journal entry should be made on December 31, 2006?

18. Reporting Bond Transactions The issue price of the bond is determined by the market, based on the time value of money. The interest rate used to compute the present value is the market interest rate.

19. Reporting Bond Transactions The stated rate is only used to compute the periodic interest payments.

20. Bond Premium and Discounts

21. Bonds Issued at Par = = On January 1, 2007, Petro-Canada issues $400,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 10% annually. This bond is issued at a par.

22. Bonds Issued at Par Here is the journal entry to record the issuance of the bonds.

23. Bonds Issued at Par Here is the entry made every six months to record the interest payment.

24. Bonds Issued at Par Here is the entry to record the maturity of the bonds.

25. Issuing Bonds On Jan 1, 2007, Petro-Canada issues $400,000 in bonds having a stated rate of 10%. The bonds mature in 10 years and interest is paid semiannually. The market rate is 12% annually. Are Petro-Canada bonds issued at par, at a discount, or at a premium?

26. Bonds Issued at a Discount < < On January 1, 2007, Petro-Canada issues $400,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2016) and interest is paid semiannually. The market rate is 12% annually. This bond is issued at a discount.

27. Bonds Issued at a Discount • The issue price of a bond is composed of the present value of two items: • Principal (a single amount) • Interest (an annuity) First, let’s compute the present value of the principal. Market rate of 12% ÷ 2 interest periods per year = 6% Bond term of 10 years × 2 periods per year = 20 periods Use the present value of a single amount table to find the appropriate factor.

28. Bonds Issued at a Discount • The issue price of a bond is composed of the present value of two items: • Principal (a single amount) • Interest (an annuity) Now, let’s compute the present value of the interest. Market rate of 12% ÷ 2 interest periods per year = 6% Bond term of 10 years × 2 periods per year = 20 periods Use the present value of an annuity table to find the appropriate factor.

29. Bonds Issued at a Discount • The issue price of a bond is composed of the present value of two items: • Principal (a single amount) • Interest (an annuity) Finally, we can determine the issue price of the bond. The $354,118 is less than the face amount of $400,000, so the bonds are issued at adiscountof $45,882.

30. Bonds Issued at a Discount Here is the journal entry to record the bond issued at a discount. This is a contra-liability account and appears in the liability section of the balance sheet.

31. Bonds Issued at a DiscountFinancial Statement Presentation The discount will be amortized over the 10-year life of the bonds. Two methods of amortization are commonly used: Straight-lineorEffective-interest.

32. Reporting Interest Expense: Straight-line Amortization • Identify the amount of the bond discount. • Divide the bond discount by the number of interest periods. • Include the discount amortization amount as part of the periodic interest expense entry. • The discount will be reduced to zero by the maturity date.

33. Reporting Interest Expense: Straight-line Amortization Petro-Canada issued their bonds on Jan. 1, 2007. The discount was $45,882. The bonds have a 10-year maturity and $20,000 interest is paid semiannually.Compute the periodic discount amortization using the straight-line method.

34. Reporting Interest Expense: Straight-line Amortization Here is the journal entry to record the payment of interest and the discount amortization for the six months ending on June 30, 2007.

35. Reporting Interest Expense: Straight-line Amortization As the discount is amortized, the carrying amount of the bondsincreases.

37. Reporting Interest Expense: Effective-interest Amortization • The effective interest method is the theoretically preferred method. • Compute interest expense by multiplying the current unpaid balance times the market rate of interest. • The discount amortization is the difference between interest expense and the cash paid (or accrued) for interest.

38. Reporting Interest Expense: Effective-interest Amortization Petro-Canada issued their bonds on Jan. 1, 2007. The issue price was $354,118. The bonds have a 10-year maturity and $20,000 interest is paid semiannually.Compute the periodic discount amortization using the effective interest method. Unpaid Balance × Effective Interest Rate × n/12 $354,118 × 12% × 1/2 = $21,247

39. Reporting Interest Expense: Effective-interest Amortization Here is the journal entry to record the payment of interest and the discount amortization for the six months ending on June 30, 2007.

40. Reporting Interest Expense: Effective-interest Amortization As the discount is amortized, the carrying amount of the bondsincreases.

42. Zero Coupon Bonds • Zero coupon bonds do not pay periodic interest. • Because there is no interest annuity . . . • This is called a deep discount bond. PV of the Principal = Issue Price of the Bonds

43. Bonds Issued at a Premium > > On January 1, 2007, Petro-Canada issues $400,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2016) and interest is paid semiannually. The market rate is 8% annually. This bond is issued at a premium.

44. Bonds Issued at a Premium • The issue price of a bond is composed of the present value of two items: • Principal (a single amount) • Interest (an annuity) First, let’s compute the present value of the principal. Market rate of 8% ÷ 2 interest periods per year = 4% Bond term of 10 years × 2 periods per year = 20 periods Use the present value of a single amount table to find the appropriate factor.

45. Bonds Issued at a Premium • The issue price of a bond is composed of the present value of two items: • Principal (a single amount) • Interest (an annuity) Now, let’s compute the present value of the interest. Market rate of 8% ÷ 2 interest periods per year = 4% Bond term of 10 years × 2 periods per year = 20 periods Use the present value of an annuity table to find the appropriate factor.

46. Bonds Issued at a Premium • The issue price of a bond is composed of the present value of two items: • Principal (a single amount) • Interest (an annuity) Finally, we can determine the issue price of the bond. The $454,366 is more than the face amount of $400,000, so the bonds are issued at apremiumof $54,366.

47. Bonds Issued at a Premium Here is the journal entry to record the bond issued at a discount. This is called an adjunct-liability account and appears in the liability section of the balance sheet as an addition to Bonds Payable.

48. Bonds Issued at a PremiumFinancial Statement Presentation The premium will be amortized over the 10-year life of the bonds. Let’s look at the amortization tables using Straight-lineandEffective-interest.

50. Reporting Interest Expense: Straight-line Amortization Here is the journal entry to record the payment of interest and the premium amortization for the six months ending on June 30, 2007.