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Accounting Fundamentals

Accounting Fundamentals. Dr. Yan Xiong Department of Accountancy CSU Sacramento The lecture notes are primarily based on Reimers (2003). 7/11/03. Chapter 8: Financing with Debt. Agenda Long-term Notes Payable and Mortgage Time Value of Money Bonds Payable. Agenda.

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Accounting Fundamentals

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  1. Accounting Fundamentals Dr. Yan Xiong Department of Accountancy CSU Sacramento The lecture notes are primarily based on Reimers (2003). 7/11/03

  2. Chapter 8: Financing with Debt Agenda • Long-term Notes Payable and Mortgage • Time Value of Money • Bonds Payable

  3. Agenda • Long-term Notes Payable and Mortgages

  4. Business Background Capital structure is the mix of debt and equity used to finance a company. • DEBT: • Loans from banks, insurance companies, or pension funds are often used when borrowing small amounts of capital. • Bonds are debt securities issued when borrowing large amounts of money. • Can be issued by either corporations or governmental units.

  5. Notes Payable and Mortgages • When a company borrows money from the bank for longer than a year, the obligation is called a long-term note payable. • A mortgage is a special kind of “note” payable--one issued for property. • These obligations are frequently repaid in equal installments, part of which are repayment of principal and part of which are interest.

  6. Example: Borrowing To Buy Land By Using A Mortgage • ABC Co. signed a $100,000, 3 yr. mortgage (for a piece of land) which carried an 8% annual interest rate. Payments are to be made annually on December 31 of each year for $38,803.35. • How would the mortgage be recorded? • What is the amount of the liability (mortgage payable) after the first payment is made?

  7. Recording the Mortgage • How would the mortgage be recorded in the journal? Date Transaction Debit Credit Jan 1 Land 100,000 Mortgage payable 100,000

  8. Example continued... • For Yr.1, the outstanding amount borrowed is $100,000 (at 8%), so the interest is: • $8,000 • Payment is $38,803.35, so the amount that will reduce the principal is • $30,803.35 • New outstanding principal amount is • $100,000 - 30,803.35 = $69,196.65

  9. Recording The First Payment On A Mortgage • How would the payment on the mortgage be recorded in the journal? Date Transaction Debit Credit Dec 31Mortgage payable 30,803.35 Interest expense 8,000.00 Cash 38,803.35

  10. Amortization Schedule Principle Balance Reduction in Principle Payment Interest 100,000.00 38,803.35 38,803.35 38,803.35 8,000.00 30,803.35 5,535.73* 33,267.62 69,196.65 2,874.32** 35,929.03 35,929.03 *69,196.65 x .08 **35,929.03 x .08 = 2,874.32

  11. Agenda • Time Value of Money

  12. Time Value of Money • The example of the mortgage demonstrates that money has value over time. • When you borrow $100,000 and pay it back over three years, you have to pay back MORE than $100,000. • Your repayment includes interest--the cost of using someone else’s money. • A dollar received today is worth more than a dollar received in the future. • The sooner your money can earn interest, the faster the interest can earn interest.

  13. Interest and Compound Interest • Interest is the return you receive for investing your money. You are actually “lending” your money, so you are paid for letting someone else use your money. • Compound interest -- is the interest that your investment earns on the interest that your investment previously earned.

  14. Future Value of a Single Amount How much will today’s dollar be worth in the future? ? TODAY FUTURE

  15. If You Deposit $100 In An Account Earning 6%, How Much Would You Have In The Account After 1 Year? n:i% = 6 PV = 100 N = 1 FV = 100 * 1.06 PV = FV = 100 106 0 1

  16. If You Deposit $100 In An Account Earning 6%, How Much Would You Have In The Account After 5 Years? Using a future value table i% = 6 PV = 100 n = 5 FV = 100 * (factor from FV of $1 table, where n = 5) PV = 100 FV = 0 5

  17. If You Deposit $100 In An Account Earning 6%, How Much Would You Have In The Account After 5 Years? n:i% = 6 PV = 100 N = 1 FV = 100 * 1.3382 PV = 100 FV = 0 1

  18. If You Deposit $100 In An Account Earning 6%, How Much Would You Have In The Account After 5 Years? n:i% = 6 PV = 100 N = 1 FV = 100 * (factor from FV of $1 table, where n = 5) PV = FV = 133.82 100 0 1

  19. The Value of a Series of Payments • The previous example had a single payment. Sometimes there is a series of payments. • Annuity: a sequence of equal cash flows, occurring at the end of each period. • When the payments occur at the end of the period, the annuity is also known as an ordinary annuity. • When the payments occur at the beginning of the period, the annuity is called an annuity due.

  20. 0 1 2 3 4 What An Annuity Looks Like

  21. Example • If you borrow money to buy a house or a car, you will pay a stream of equal payments. • That’s an annuity.

  22. 0 1 2 3 Future Value of an Annuity If you invest $1,000 at the end of the next 3 years, at 8%, how much would you have after 3 years? 1,000 1,000 1,000 n = 3 i = 8% Pmt. = 1,000

  23. 0 1 2 3 Future Value of an Annuity If you invest $1,000 at the end of the next 3 years, at 8%, how much would you have after 3 years? 1,000 1,000 1,000 FVA = 1,000 * [value from FVA table, 3yrs. 8%] FVA = 1,000 * 3.2464 = $3,246.40

  24. Future Value of an Ordinary Annuity (Annuity in Arrears) In the previous example, notice that the last payment is deposited on the last day of the last period. That means it doesn’t have time to earn any interest! This type of annuity is called an ordinary annuity, or an annuity in arrears.

  25. Future Value of an Annuity Due • Often, when the series of payments applies to money saved, an annuity due is a better description of what happens. • Suppose you decide to save $1,000 each year for three years, starting TODAY!

  26. 0 1 2 3 Future Value of an Annuity DueIf you invest $1,000 at the beginning of each of the next 3 years, at 8%, how much would you have after 3 years? Future value 1,000 1,000 1,000 Today FVA = 1,000 * [value from FVADue table, 3yrs. 8%] FVA = 1,000 * 3.50611 = $3,506.11

  27. Present Value of a Single Amount How much is $1 received in the future worth today?(COMPOUNDING) Figuring out how much a future amount is worth TODAY is called DISCOUNTING the cash flow. ? TODAY FUTURE

  28. If you will receive $100 one year from now, what is the PV of that $100 if the relevant interest rate is 6%? ioi% = 6% N = 1 FV = 100 PV = ?? PV = FV = 100 0 1

  29. If you will receive $100 one year from now, what is the PV of that $100 if the relevant interest rate is 6%? PV (1 + 0.06) = 100 (which is the FV) PV = 100 / (1.06)1 = $94.34 OR PV = FV (PV factor i, n ) PV = 100 (0.9434 ) (from PV of $1 table) PV = $94.34 PV = 94.34 FV = 100 0 1

  30. The Value of a Series of Payments • The previous example had a single payment. Sometimes there is a series of payments. • Annuity: a sequence of equal cash flows, occurring at the end of each period. • When the payments occur at the end of the period, the annuity is also known as an ordinary annuity.

  31. 0 1 2 3 4 Present Value of an Annuity • Finding the present value of a series of cash flows is called discounting the cash flows. • What is the series of future payments worth today?

  32. 0 1 2 3 What is the PV of $1,000 at the end of each of the next 3 years, if the interest rate is 8%? i% = 8 N = 3 PMT = 1,000 PV = ?? 1000 1000 1000

  33. 0 1 2 3 What is the PV of $1,000 at the end of each of the next 3 years, if the interest rate is 8%? PVA = 1,000 (3 yrs., 8% factor from the PVA table) PVA = 1,000 * (2.5771) PVA = $2,577.10 Present Value 1000 1000 1000

  34. Agenda • Bonds Payable

  35. Characteristics of Bonds Payable • Bonds usually involve the borrowing of a large sum of money, called principal. • The principal is usually paid back as a lump sum at the end of the bond period. • Individual bonds are often denominated with a par value, or face value, of $1,000.

  36. Characteristics of Bonds Payable • Bonds usually carry a stated rate of interest. • Interest is normally paid semiannually. • Interest is computed as: Interest = Principal × Stated Rate × Time

  37. Measuring Bonds Payable and Interest Expense The selling price of the bond is determined by the market based on the time value of money. Today Future . . . principal payment dates of interest payments

  38. Who Would Buy My Bond? • $1,000, 6% stated rate. • The market rate of interest is 8%. • Who would buy my bond? • Nobody---so I’ll have to sell (issue) it at a discount. • e.g., bondholders would give me something less for the bond.

  39. Who Would Buy My Bond? • $1,000, 6% stated rate. • The market rate of interest is 4%. • Who would buy these bonds? • EVERYONE! • So the market will bid up the price of the bond; e.g., I’ll get a littlepremium for it since it has such good cash flows. • Bondholders will pay more than the face.

  40. Determining the Selling Price • Bonds sell at: • “Par” (100% of face value) • less than par (discount) • more than par (premium) • Market rate of interest vs. bond’s stated rate of interest determines the selling price (market price of the bond) • Therefore, if • market % > stated %: Discount • market % < stated %: Premium

  41. The time value of money... Selling price of a bond = present value of future cash flows promised by the bonds, discounted using the market rate of interest

  42. Finding The Proceeds Of A Bond Issue • To calculate the issue price of a bond, you must find the present value of the cash flows associated with the bond. • First, find the present value of the interest payments using the market rate of interest. Do this by finding the PV of an annuity. • Then, find the present value of the principal payment at the end of the life of the bonds. Do this by finding the PV of a single amount.

  43. Selling Bonds -- Example On May 1, 1991, Clock Corp. sells $1,000,000 in bonds having a stated rate of 6% annually. The bonds mature in 10 years, and interest is paid semiannually. The market rate is 8% annually. Determine the proceeds from this bond issue.

  44. First, what are the cash flows associated with this bond? • Interest payments of $60,000 (that’s 6% of the $1 million face value) each year for 10 years. AND • A lump sum payment of $1,000,000 (the face amount of the bonds) in 10 years.

  45. The PV of the future cash flows = issue price of the bonds • The present value of these cash flows will be the issue price of the bonds. • That is the amount of cash the bondholders are willing to give TODAY to receive these cash flows in the future.

  46. INTEREST PAYMENTS PV of an ordinary annuity of $60,000 for 10 periods at an interest rate of 8%: Use a calculator or a PV of an annuity table: 60,000 (PVA,,8%, 10)= 60,000 (6.7101) = 402,606 PRINCIPAL PAYMENT PV of a single amount of $1 million ten years in the future at 8%: Use a calculator or a PV of a single amount table: 1,000,000 (PV,,8%, 10) = 1,000,000 (.46319)= 463,190 Two parts to the cash flows:

  47. Selling Bonds -- Example • The sum of the PV of the two cash flows is $865,796. • The bonds would be described as one that sold for “87.” We’ll round to a whole number just to make the example easier to follow. What does that mean? It means the bonds sold for 87% of their par or face value.

  48. Selling Bonds -- Example If the bonds sold for 87% of their face value, the proceeds would be approximately $870,000 (rounded) for $1,000,000-face bonds.

  49. Recording Bonds Sold at a Discount • The balance sheet would show the bonds at their face amount minus any discount. • The discount on bonds payable is called a contra-liability, because it is deducted from the liability. • Cash would be recorded for the difference, that is, the proceeds.

  50. Recording Bonds Sold at a Discount • How would the issuance of the bonds at a discount be recorded in the journal? Date Transaction Debit Credit May 1 Cash 870,000 Discount on bond payable 130,000 Bonds payable 1,000,000

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