1 / 35

Long-Term Liabilities: Notes, Bonds, and Leases

Long-Term Liabilities: Notes, Bonds, and Leases. Long-term liabilities are recorded at the present value of the future cash flows. The subject of calculation of present value is covered in Appendix A. Long-Term Liabilities: Notes, Bonds, and Leases.

shania
Download Presentation

Long-Term Liabilities: Notes, Bonds, and Leases

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

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

  2. Long-term liabilities are recorded at the present value of the future cash flows. The subject of calculation of present value is covered in Appendix A. Long-Term Liabilities: Notes, Bonds, and Leases

  3. The value of a dollar today will decrease over time. Why? Two components determine the “time value” of money: interest (discount) rate number of periods of discounting For financial reporting, we are concerned primarily with present value concepts. Present Value ConceptsAppendix A (Pages 654-676)

  4. To record activities in the general ledger dealing with future cash flows, we should calculate the present value of the future cash flows using present value formulas or techniques. Types of activities that require PV calculations: notes payable bonds payable and bond investments capital leases Present Value Concepts

  5. PV of a single sum (PV1): Discounting a future value of a single amount that is to be paid in the future (ex: notes payable, bonds payable). PV of an ordinary annuity (PVOA): Discounting a set of payments, equal in amount over equal periods of time, where the first payment is made at the end of each period (ex: interest on bonds payable). PV of an annuity due (PVAD): Discounting a set of payments, equal in amount over equal periods of time, where the first payment is made at the beginning of each period (ex: lease payments). Types of Present Value Calculations

  6. All present value calculations presume a discount rate (i) and a number of periods of discounting (n).There are 3 different ways you can calculate the PV1: 1. Formula: PV1 = FV1 [1/(1+i)n] 2. Tables: See Page 674, Table 4 3.Calculator if it has time value of money functions. 1.Present Value of a Single Sum

  7. Usually issued to financial institutions. May be interest bearing or non-interest bearing (we will look at non-interest bearing). May be serial notes (periodic payments) or term notes (balloon payments). We will look at balloon payments here. Problem 1: On January 2, 2005, Pearson Company purchases a section of land for its new plant site. Pearson issues a 5 year non-interest bearing note, and promises to pay $50,000 at the end of the 5 year period. What is the cash equivalent price of the land, if a 6 percent discount rate is assumed? Long-term Notes Payable

  8. See Page 674, Table 4 PV1 Table PV1 = FV1( ) i, n PV1 Table PV1 = 50,000 ( 0.74726) = $37,363 i=6%, n=5 Journal entry Jan. 2, 2005: Land 37,363 Discount on N/P 12,637 Notes Payable 50,000 Problem 1 Solution

  9. What amount would be recognized for interest expense at December 31, 2005? In this chapter we will use the effective interest method to calculate interest expense. The formula for interest is: Interest Expense = Carrying value x Interest rate x Time period (CV) (Per year) (Portion of year) Where carrying value = face - discount. For Example 1, CV= 50,000 - 12,637 = 37,363 Interest expense = 37,363 x 6% per year x 1year = $2,242 Problem 1 Solution, continued

  10. Journal entry, December 31, 2005: Carrying value on B/S at 12/31/2005? (Discount = $12,637 - 2,242 = $10,395) Interest expense 2,242 Discount on N/P 2,242 Notes Payable $50,000 Discount on N/P (10,395) $39,605 Problem 1 Solution, continued

  11. Interest expense at Dec. 31, 2006: 39,605 x 6% x 1 = $2,376 Journal entry, December 31, 2006: Carrying value on B/S at 12/31/2006? (Discount = 10,395 - 2,376) Carrying value on 12/31/2009 (before retirement)? Interest expense 2,376 Discount on N/P 2,376 Notes Payable $50,000 Discount on N/P (8,019) $41,981 Problem 1 Solution, continued $50,000

  12. PVOA calculations presume a discount rate (i), where (A) = the amount of each annuity, and (n) =the number of annuities (or rents), which is the same as the number of periods of discounting. There are 3 different ways you can calculate PVOA: 1. Formula: PVOA = A [1-(1/(1+i)n)] / i 2. Tables: see page 675, Table 5 PVOA Table PVOA = A( ) i, n 3.Calculator if it has time value of money functions. 2. Present Value of an Ordinary Annuity(PVOA)

  13. 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: PVOA and PV1. Bonds Payable

  14. 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 Problem 2: Bonds Payable

  15. 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. Problem 2 - calculations

  16. To recognize interest expense using the effective interest method, an amortization schedule must be constructed. (This expands the text discussion.) 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 differencebetween cash paid and interest expense is the periodic amortization of premium. Note that the carrying value is amortizeddownto face value by maturity. Problem 2 - Amortization Schedule

  17. 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 Problem 2 - Amortization Schedule

  18. 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

  19. 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. Bonds Payable at a Discount.

  20. 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. Retirement of Bonds

  21. 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). Retirement of Bonds

  22. 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

  23. The difference between an ordinary annuity and an annuity due is the timing of the periodic payments: an annuity due has payments (rents, annuities) at the beginning of each period. The result is that there is one less period of discounting. There are 3 different ways you can calculate PVAD: 1. Formula: PVAD = A [((1-(1/(1+i)n-1)) / i) + 1] 2. Tables: see page 708, Table 6 PVAD Table PVAD = A( ) i, n where n = number of payments (not periods) 3.Calculator if it has time value of money functions. 3.PV of an Annuity Due (PVAD)

  24. 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. Leases

  25. 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. Leases

  26. Requirements of SFAS No. 13 - record as capital lease for the lessee if any one of the following is present in the lease: Title transfers at the end of the lease period, The lease contains a bargain purchase option, The lease life is at least 75% of the useful life of the asset, or The lessee pays for at least 90% of the fair market value of the lease. Leases

  27. Payments under a lease agreement may include: Periodic rental payments (an annuity) and: Bargain purchase option (BPO): An end of lease payment to purchase the asset at significantly below market OR Guaranteed residual value (GRV): A minimum amount (of cash and asset) required by the lessor if the asset is returned to the lessor. Leases

  28. The amount to capitalize (record for asset and related liability) is the present value of the minimum lease payments: PVMLP = PV RENTS + PVBPO or GRV If lease contains both BPO and GRV, include only BPO. The assumption is that a rational lessee would exercise the BPO and not have to pay an GRV. If the rents occur at the beginning of each period, like most leases, the PV RENTS is an annuity due. Leases

  29. Lee Company (the lessee) signed a contract to lease equipment from Lawrence Company (the lessor). The terms of the lease were as follows: 1. Four year lease starting January 1, 2005. 2. Annual lease payments of $6,000. The first payment is due at lease inception (January 1, 2005), with subsequent payments on December 31, 2005, 2006, and 2007. 3. Bargain purchase option of $1,000 at end of lease (December 31, 2008). Other information: Lee’s borrowing rate: 8% Useful life of equipment: 6 years with no salvage value. Problem 3 - Leases

  30. Requirement 1: Calculate the PVMLP (Note that the lease payments are an annuity due.) PVMLP = PV RENTS + PVBPO PVAD Table PVAD Table PV RENTS =PVAD= A( ) = 6,000(3.5771) = $21,463 i, n i =8%, n=4 PV1 Table PV1 Table PVBPO = PV1 = FV1( ) = 1,000(0.73503) = $ 735 i, ni = 8%, n = 4 The present value of the minimum lease pmts = $22,198 Problem 3 - Leases

  31. Requirement 2: Prepare the amortization schedule (effective interest method) to recognize the interest payments and principal payments over the life of the lease. This is similar to the amortization schedule for the bonds payable (cash paid is constant, and interest expense = CV x MR x T), except that the lease payment includes both an interest payment and a principal payment. The “difference” in this case is the principal reduction each period. Problem 3 - Leases

  32. Cash Interest Carrying Date Paid Expense DifferenceValue 1/01/05 22,198 1/01/05 6,000 -0- 1 6,000 16,198 12/31/05 6,000 1,2962 4,704 11,494 12/31/06 6,000 920 5,080 6,414 12/31/07 6,000 513 5,487 927 12/31/08 1,000 733 927 -0- 1No interest at 1/1/05, because no time has passed. This is equivalent to a “down payment” which immediately reduces the total liability. 2Int. Expense = CV x MR x T = 16,198 x 8% x 1 year 3Rounding difference of $1 absorbed in calculation. Problem 3 - Leases

  33. Requirement 3: Prepare the following journal entries for the year 2005: Initial lease at 1/1/05: First payment at 1/1/05: Second payment at 12/31/05: Equipment 22,198 Lease Liability 22,198 Lease Liability 6,000 Cash 6,000 Interest Expense 1,296 Lease Liability 4,704 Cash 6,000 Problem 3 - Leases

  34. For the last entry, we must calculate straight-line depreciation on leased asset at 12/31/05. Since we are recording an asset, we must depreciate the asset. Note that the calculation here is based on the length of time that the lessee will actually use the asset (6 years here because of the BPO). (Cost-SV)/Est. life =(22,198 - 0)/6 = $3,700 JE for Depreciation at 12/31/05: Problem 3 - Leases Depreciation expense 3,700 Accumulated Depr. 3,700

  35. 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. Comments on Leases

More Related