BUS512M Session 9. Accounting for Financing Decisions: Long-Term Liabilities and Stockholders Equity

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1 BUS512M Session 9 Accounting for Financing Decisions: Long-Term Liabilities and Stockholders Equity

2 Liabilities Current or Short-term Liabilities Long-term Debt (borrowed funds) Lease Liabilities Deferred Taxes Contingencies and Commitments Accounting for liabilities is a subject that can be very technical. There is a tendency for some institutions to create exotic instruments for marketing of funds in recent years. Despite this, there are some basic principles that govern the accounting for liabilities.

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4 Basis for Valuing Liabilities Because money has time value, the amount of money needed today to pay a future debt is less than the future obligation. Historically, the best basis for valuing a liability was its economic present value (the present value of the future cash flows, i.e., the amount of money that would have to be set aside today to accumulate to the future cash flows required to pay the interest and the principal of the debt). Most current liabilities are reported on the BS at their face (or nominal value) the amount that will be paid. Most Long-term liabilities are reported on the BS at their present value (the time-discounted value of the future cash flows).

5 Basic Definitions and Different Contractual Forms Some contracts, called interest-bearing obligations, require periodic (annual or semiannual) cash payments (called interest) that are determined as a percentage of the face, principal, or maturity value, which must be paid at the end of the contract period. Non-interest-bearing obligations, on the other hand, require no periodic payments, but only a single cash payment at the end of the contract period. These contractual forms may contain additional terms that specify assets pledged as security or collateral in case the required cash payments are not met (default), as well as additional provisions (restrictive covenants).

6 Short-term Liabilities Report at Face value: Accounts payable, Accrued expenses, Unearned revenue, Taxes payable, Warranties payable Non-interest bearing ST Notes Payable generally are reported at maturity value less any unamortized interest discount. i.e., BS shows either: Note payable $950 or Note payable $1,000 less Unamortized discount $50. Interest-bearing ST Notes Payable generally are reported at the maturity (face) value plus any accrued interest. i.e., Note Payable $1,000 and Interest payable $50 on BS. Short-term debt which company has no intentions of liquidating, but plans to continually refinance, should be classified as long-term. Also, the current portion (the amount that will be paid within one year) of any longterm debt should be classified on the BS as a current liability.

7 Long-term Debts Since interest accounts for the difference between the amount received and the amount paid back, the interest rate is the basis for computing interest. On all long-term debt contracts there are two interest rates: The stated rate and the effective rate, they may not be the same The stated rate is the interest rate on interest-bearing debt that is used to calculate the amount of cash interest payments that will be made to the lender. The effective rate is the compounded interest rate that mathematically accounts for the total difference between the amount borrowed and the amount repaid.

8 Bond Terminology

9 Key Questions: -Present Value? Issue value or Proceeds -Future Value? Maturity value or Face value -n= number of periods? -r=effective or market interest rate? -Bond or Note stated rate or face rate? -Single payment or Ordinary annuity (multiple payments)? -Interest bearing or Noninterest bearing? What is the interest payment? How often? Draw a Timeline and fill in: -Issue date -When pay interest and amortize discount or premium -Maturity date

10 BE11-2 Bond Terms In October 1997 HP issued zero-coupon bonds with a face of 1.8 billion, due in 2017, for proceeds of $968 million. a. What is the life of these bonds? b. What is the stated rate on these bonds? c. Estimate the effective interest rate of these bonds. (hint: $PV/$FV = approximate Table value) d. How many bonds did HP issue? e. What entry did HP make when the bonds were issued?

11 The Time Value of Money and Non-Interest bearing Long-term Debt

12 Accounting for Non-Interest Bearing Notes Payable Recap

13 E11-8 Present Value of a Non-interest-bearing Note Purchased a building in exchange for a 3 year non-interest-bearing note with a face of $693,000. Building appraisal is $550,125. a. What amount should this building be capitalized?

14 E11-8 Present Value of a Non-interest-bearing Note Purchased a building in exchange for a 3 year non-interestbearing note with a face of $693,000. Building appraisal is $550,125. b. Compute the present value of the note s future cash flows, using the following discount rates: 1. 6 percent 2. 8 percent percent c. What is the effective rate of this note? d. Explain how one could more quickly compute the effective interest rate on the note.

15 E11-5 Discounted Non-interest-bearing Notes Purchase equipment with a FMV of $11,348 in exchange for a 5 year non-interest-bearing note with a face of $20,000. a. Compute the effective interest rate on the note payable. b. Prepare entry to record the purchase.

16 E11-5 Discounted Non-interest-bearing Notes Purchase equipment with a FMV of $11,348 in exchange for a 5 year non-interest-bearing note with a face of $20,000. c. How much interest expense should be recognized in the first year? d. What is the BS value of the note at the end of the first year? e. Will the interest expense recognized in the second year be greater, equal, or less than the interest expense recognized in the first year? Why? f. Will the interest expense recognized in the third year be greater, equal, or less than the interest expense recognized in the second year? Why?

17 E11-4 Non-interest-bearing Note Payable Proceeds Compute the proceeds from the following notes payable. Interest payments are made annually. PV Principal PV Interest Payments = Proceeds Stated Rate Effective Rate Face Value Life 0% 8% $1,000 4 years 0% 6% $5,000 6 years

18 Your Turn E11-9 Effective Interest Rate What is the effective interest rate on the note payable? Balance Sheet Note Payable $200,000 $200,000 Less: Discount on NP 12,000 14,400 Income Statement Interest Expense 16,400 16,200 Prepare the journal entry to record 2016 interest expense.

19 Recap: Non-Interest Bearing Notes and Bonds >Issue date >Amortize discount >Maturity date

20 Sample Non-interest bearing Long-term Notes Payable Problem 1: On January 2, 2008, Pearson Company purchases a section of land for its new plant site. Pearson issues a 5 year noninterest 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? PV1 = 50,000 x ( ) = $37,363 [ i=6%, n=5] Journal entry Jan. 2, 2008: Dr. Land 37,363 Dr. Discount on N/P 12,637 Cr. Notes Payable 50,000

21 Sample Problem 1 Solution, continued The Effective Interest Method: Interest Expense = Carrying value x Effective 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

22 Sample Problem 1 Solution, continued Journal entry, December 31, 2008: Interest expense 2,242 Discount on N/P 2,242 Carrying value on B/S at 12/31/2008: Notes Payable $50,000 Discount on N/P (10,395) $39,605 (Discount = $12,637-2,242 = $10,395)

23 Sample Problem 1 Solution, continued Interest expense at Dec. 31, 2009: 39,605 x 6% x 1 = $2,376 Journal entry, December 31, 2009: Interest expense 2,376 Discount on N/P 2,376 Carrying value on B/S at 12/31/2009: Notes Payable $50,000 Discount on N/P (8,019) $41,981 (Discount = 10,395-2,376) Carrying value on 12/31/2012 (before retirement)? $50,000

24 Time Value of Money and Interest bearing Long- Term Liabilities: Notes, Bonds, and Leases Long-term liabilities are recorded at the present value of the future cash flows. Two components determine the time value of money: interest (discount) rate number of periods of discounting Types of activities that require PV calculations: notes payable bonds payable and bond investments capital leases

25 Interest bearing: Bond Prices

26 E 11-3 Bond Terms The stated and effective interest rates for several notes and bonds follow: Is Note or Bond issued a Par, Premium, or Discount? Bond Stated Interest Rate Effective or Market Interest Rate 1. 10% 10% 2. 7% 8% 3. 9% 8% % 9%

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28 E11-4 Interest-bearing and Non-interest-bearing Note Payable Proceeds Compute the proceeds from the following notes payable. Interest payments are made annually. PV Principal PV Interest Payments = Proceeds Stated Rate Effective Rate Face Value Life 4% 12% $8,000 6 years 8% 8% $3,000 7 years 10% 6% $10, years

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30 Bonds Payable Issued at a Discount 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.

31 E11-13 Bonds issued at a Discount Issued 500 five-year bonds on Interest payments are due semiannually at 1.1 and 7.1 at an interest rate of 6%. The effective rate is 8%. The face value of each bond is $1,000. a entry when bonds are issued? b entry at yearend?

32 E11-13 Bonds issued at a Discount Issued 500 five-year bonds on Interest payments are due semiannually at 1.1 and 7.1 at an interest rate of 6%. The effective rate is 8%. The face value of each bond is $1,000. c Balance sheet value? d. PV of bonds remaining cash flows as of ?

33 Your Turn

34 E11-14 Bonds issued at a Premium Issued 100 ten-year bonds on Interest payments are due semiannually (1.1 and 7.1) at an annual rate of 8%. The effective rate is 6%. The face of each bond is $1,000. a entry to issue bonds? b entry?

35 E11-14 Bonds issued at a Premium Issued 100 ten-year bonds on Interest payments are due semiannually (1.1 and 7.1) at an annual rate of 8%. The effective rate is 6%. The face of each bond is $1,000. c balance sheet value? d. PV of remaining cash flows as of ?

36 Your Turn

37 Investor s Bond Yield= annual cash received/note price The yield on a 10 year note, which was hovering at about 2.2% before the release of the non-farm report [on Friday] plummeted to about 2.07% in a matter of minutes. Yields, which move in the opposite direction to prices, continued to move lower, ending the day at 2.056%, compared with 2.173% late Thursday. Page B2, The Wall Street Journal,

38 Sample Problem 2: Bonds Payable issued at Premium, semiannual interest payments On July 1, 2007, 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, 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

39 Sample Problem 2 - calculations PV of interest annuity: PVOA Table PVOA = 3,500 ( ) = $29,856 i = 3%, n = 10 PV of face value: PV1 Table PV = 100,000 ( )=$74,409 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.

40 Sample Problem 2 - Amortization Schedule 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 interest 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 12/31/07 = 104,265 x 6% x 1/2 year = 3,128 at 6/30/08 = 103,893 x 6% x 1/2 year = 3,117 The difference between cash paid and interest expense is the periodic amortization of premium. Note that the carrying value is amortized down to face value by maturity.

41 Sample Problem 2 - Amortization Schedule Cash Interest Carrying Date Paid Expense Premium Value 7/01/07 104,265 12/31/07 3,500 3, ,893 6/30/08 3,500 3, ,510 12/31/08 3,500 3, ,115 6/30/09 3,500 3, ,708 12/31/09 3,500 3, ,289 6/30/10 3,500 3, ,858 12/31/10 3,500 3, ,414 6/30/11 3,500 3, ,956 12/31/11 3,500 3, ,485 6/30/12 3,500 3, ,000

42 Sample Problem 2 - Journal Entries JE at 7/1/07 to issue the bonds: Cash 104,265 Premium on B/P 4,265 Bonds Payable 100,000 JE at 12/31/07 to pay interest: Interest Expense 3,128 Premium on B/P 372 Cash 3,500 Note that the numbers for each interest payment come from the lines on the amortization schedule.

43 Sample Bonds Issued at Face Value

44 Sample Bonds Issued at a Discount

45 Sample Bond Amortization Table

46 Recap: Interest Bearing Notes and Bonds >Issue date >Pay interest and amortize discount or premium >Maturity date

47 Bond Redemptions When bonds are redeemed at the maturity date, the issuing company simply pays cash to the bondholders in the amount of the face value and removes the bond payable from the balance sheet. To illustrate the redemption of a bond issuance prior to maturity at a loss, assume that bonds with a $100,000 face value and a $5,000 unamortized discount are redeemed for $102,000. The $7,000 loss on redemption would decrease net income

48 P11-10 Callable Bond Redemptions account balances are: Bond payable $500,000 Premium on bond payable $ 12,600 The bonds have an annual stated rate of 8% and an effective rate of 6%. Interest is paid 6.30 and a. Compute the gain or loss if the bonds are called for 104 on ?

49 P11-10 Callable Bond Redemptions account balances are: Bond payable $500,000 Premium on bond payable $ 12,600 The bonds have an annual stated rate of 8% and an effective rate of 6%. Interest is paid 6.30 and b. Compute the gain or loss if the bonds are called for 108 on ? c. Compute the gain or loss if the bonds are called for 110 on ?

50 Bond Conversions The Jolly Corporation has $400,000 of 6 percent bonds outstanding. There is $20,000 of unamortized discount remaining on these bonds after the July 1, 2011, semiannual interest payment. The bonds are convertible at the rate of 20 shares of $5 par value common stock for each $1,000 bond. On July 1, 2011, bondholders presented $300,000 of the bonds for conversion. 1. Is there a gain or loss on conversion, and if so, how much is it? 2. How many shares of common stock are issued in exchange for the bonds? 3. In dollar amounts, how does this transaction affect the total liabilities and the total stockholders' equity of the company? In your answer, show the effects on four accounts.

51 International Perspective The accounting disclosure requirements in non-u.s. countries and IFRS are not as comprehensive as those in the United States, partially because the information needs of the major capital providers (i.e., banks) are satisfied in a relatively straightforward way through personal contact and direct visits. A second way in which the heavy reliance on debt affects non- U.S. accounting systems is that the required disclosures and regulations tend to be designed either to protect the creditor or to help in the assessment of solvency.

52 Economic Consequences of Reporting Long-Term Liabilities Improved credit ratings can lead to lower borrowing costs Management has strong incentive to manage the balance sheet by using off-balance-sheet financing i.e., operating leases

53 Stockholders Equity

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55 Chapter 12: Shareholders Equity How to Finance the Corporation? Borrow Notes, Bonds, Leases The debt holders are legally entitled to repayment of their principal and interest claims Issue Equity Common and Preferred Stock The shareholders, as owners, have voting rights, limited liability, and a residual interest in the corporate assets Retained Earnings

56 Debt versus Equity Debt Formal legal contract Fixed maturity date Fixed periodic payments Security in case of default No voice in management Interest expense deductible Equity No legal contract No fixed maturity date Discretionary dividends Residual asset interest Voting rights - common Dividends not deductible Double taxation

57 Distinctions between Debt and Equity Interested Party Debt Equity Investors / Creditors Management Accountants/ Auditors Lower investment risk Fixed cash receipts Contractual future cash payments Effects on credit rating Interest is tax deductible Liabilities section of the balance sheet Income statement effects from debt Higher investment risk Variable cash receipts Dividends are discretionary Effects of dilution/ takeover Dividends are not tax deductible Shareholders equity of the balance sheet No income statement effects from equity

58 Preferred Stock vs Common Stock Preferred Stock Common Stock Advantages Preference over common in liquidation Stated dividend Preference over common in dividend payout Voting Rights Rights to residual profits (after preferred) Disadvantages Subordinate to debt in liquidation Last in liquidation Debt or Equity? Stated dividend can be skipped No voting rights (versus common) Components of both Usually classified as equity No guaranteed return

59 E12-3 Authorizing and Issuing Stock Prepare entries for each event: 1. Authorized to issue: (a) 100,000 shares of $100 par value, 8% preferred stock (b) 150,000 shares of no-par, $5 preferred stock; and (c) 250,000 shares of $5 par value common stock. 2. Issued 10,000 shares of $5 par value common stock for $30 per share.

60 E12-3 Authorizing and Issuing Stock Prepare entries for each event: 3. Issued 25,000 shares of the $100 par value preferred stock for $150 per share. 4. Issued 50,000 shares of no-par preferred stock for $50 each.

61 Treasury Stock Created when a company buys back shares of its own common stock. Reasons for buyback? The debit balance account called Treasury Stock is reported in shareholders equity as a contra account to SE. Note: Treasury Stock is not an asset. The stock remains issued, but is no longer outstanding. does not have voting rights cannot receive cash dividends May be reissued (to the market or to employees) or retired. No gains or losses are ever recognized from these equity transactions.

62 E12-5 Treasury Stock Company was incorporated on and was authorized to issue 100,000 shares of $5 par value common stock and 10,000 shares of $8, no-par preferred stock. a. T accounts: 1. Issued 25,000 shares of common stock in exchange for $500,000 cash. 2. Issued 5,000 shares of preferred stock in exchange for $60,000 cash. 3. Purchased 3,000 common shares for $15 per share and held them in the treasury. 4. Sold 1,000 treasury shares for $18 per share. 5. Issued 1,000 treasury shares to executives who exercised stock options for a reduced price of $5 per share. b. Assume company generated $500,000 in net income in 2015 and did not declare any dividends. Prepare the stockholders equity section of the balance sheet as of

63 E12-6 Treasury Stock Shareholders section Common stock $80,000 Additional paid-in capital 10,000 Retained earnings 60,000 Total shareholders equity $150,000 During 2015, the company entered into the following transactions: 1. Purchased 1,000 shares of treasury stock for $60 per share. 2. As part of a compensation package, reissued half of the treasury shares to executives who exercised stock options for $20 per share. 3. Reissued the remainder of the treasury stock on the open market for $66 per share. a. Prepare the shareholders equity section of the balance sheet as of Company generated $20,000 in net income and did not declare dividends during 2015.

64 E12-6 Treasury Stock Shareholders section Common stock $80,000 Additional paid-in capital 10,000 Retained earnings 60,000 Total shareholders equity $150,000 b. What portion of the additional paid-in capital account is attributed to treasury stock transactions?

65 E12-9 Inferring Transactions from SHE Provide the journal entries for the following: a. Issuance of preferred stock during Preferred stock (no par) $ 700 $ 400 Common stock ($1 par value) 1, Additional paid-in capital: Common stock Treasury stock Less Treasury stock b. Issuance of common stock during c. Sale of treasury stock during 2015.

66 Cash Dividends and Stock Dividends: 3 Dates

67 BE12-2 Stock Splits and Market Value When Tandy (Radio Shack) Corporation announced a 2:1 stock split, it had 97 million shares outstanding, trading at $100 per share. a. Estimate the number of shares outstanding and market price per share immediately after the split. b. Estimate the company s overall market value, and explain whether you expect the company s overall market value to change due to the split.

68 E12-1 SHE Transactions For each transaction indicate which SHE accounts are affected, whether these accounts increase or decrease, and the transaction s effect on total SHE. 1. Issue common stock above par for cash. 2. Declare a 3-for-1 stock split. 3. Repurchase 10,000 shares of own stock for cash. 4. Declare and issue a stock dividend. Market>Par 5. Reissue 1,000 treasury shares for $75. Treasury stock had been previously acquired for $ Pay cash dividend that had been previously declared. 7. Generate net income of $250,000.

69 E12-13 Dividends in Arrears The company paid the following total cash dividends since 2011: 2011:$0; 2012:$30,000; 2013:$80,000; 2014:$15,000; and 2015:$40,000. Preferred stock-10,000 shares authorized, 5,000 issued, cumulative, nonparticipating, $5, $10 par. Common stock-500,000 shares authorized, 200,000 shares issued, 50,000 held in treasury, no par. a. Compute the dividends paid to the preferred and common shareholders for each year since b. Compute the balance of dividends in arrears at yearend. c. Should dividends in arrears be considered a liability?

70 E12-14 Stock Dividends and Stock Splits SHE as of : Common stock (10,000 shares par) $ 60,000 Additional paid in capital-common stock 100,000 Retained earnings 60,000 Less: Treasury stock $12) (24,000) Total shareholders equity $196,000 Prepare journal entries for the following independent transactions: a. Declare and distribute a 2% stock dividend when the market price of the stock was $70. b. Declare a 3:2 stock split. c. Declare a 10% stock dividend when the market price of the stock was $80. d. Declare a 2:1 stock split.

71 P12-10 Inferring Transactions from BS Preferred stock (9%, $100 par value) $200,000 $110,000 Common stock ($10 par value, 750,000 authorized, 90,000 issued, and 5,000 held in treasury 900, ,000 Additional paid in capital-preferred 150,000 35,000 Additional paid in capital-common 465, ,000 Retained earnings 575, ,000 Less: Treasury stock (110,000) Total shareholders equity $2,180,000 $1,688,000 a. How many shares of preferred stock were issued during 2015? What was the average issue price? b. How many shares of common stock were issued during 2015? What was the average issue price? c. Prepare the entry to record the repurchase of the company s own stock during 2015? What was the average repurchase price?

72 Sample Co. Shareholders Equity Common stock, $1 par value, 500,000 shares authorized, 80,000 shares issued, and 75,000 shares outstanding $ 80,000 Common stock dividends distributable 2,000 Preferred stock, $100 par value, 1,000 shares authorized, 100 shares issued and outstanding 10,000 Paid in capital on common $ 20,000 Paid in capital on preferred 3,000 Paid in capital on treasury stock 2,000 25,000 Retained earnings: Unappropriated $18,000 Appropriated 4,000 22,000 Less: Treasury stock, 5,000 shares (at cost) (6,000) Less: Other comprehensive income items (unrealized loss on AFS securities) (2,000) Total Shareholders Equity $131,000

73 Retained Earnings We will be expanding the basic retained earnings formula in this chapter. Now the Statement of Retained Earnings will include the following: RE, beginning (unadjusted) xx Add/Subtract: Prior period adjustment xx RE, beginning (restated) xx Add: net income xx Less dividends: Cash dividends-common xx Cash dividends - preferred xx Stock dividends xx Property dividends xx Less: Adjustment for TS transactions xx Appropriation of RE xx RE, ending xx

74 Other Comprehensive Income Other Comprehensive Income includes certain direct equity adjustments that are not part of the current income statement, but which may have an eventual effect on income. We already discussed one of these direct equity adjustments when reviewing Availablefor-sale Investments. We found that any unrealized gains/losses from revaluation to market are shown in SE (as other comprehensive income ) rather than on the income statement.

75 Stock Option Basics v. Restricted Stock Granted to employees as part of their compensation. Generally not transferable and must either be exercised prior to expiration date or allowed to expire as worthless on expiration day. May have a vesting period. When granted, company expenses options for their fair value on grant date [may be a complicated calculation]. Depending on the type of option granted, the employee may or may not be taxed when granted or exercised. Gives employees an incentive to behave in ways that will boost the company's stock price. If the company's stock market price rises above the exercise price stated in the option, the employee could exercise the option, pay the exercise price and would be issued ordinary shares in the company.

76 Homework see handout