Accounting for Long. Different Ways to Finance a Company. u Borrowing from a Bank (Ch 9): Notes Payable More expensive and restrictive than bonds.

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1 Accounting for Long Term Liabilities Ch 10 Acc 1a Different Ways to Finance a Company u Borrowing from a Bank (Ch 9): Notes Payable More expensive and restrictive than bonds. u Selling Stock (Ch 11): Gives up ownership shares, but does NOT require interest or principal repayments. u Issuing Bonds (Ch 10): Easier to deal with than bank loans, require interest & principal repayment. 1

Bonds A borrowing/lending arrangement Advantages

Disadvantages Bonds require payment of both

2 Bonds A borrowing/lending arrangement Advantages Bonds do not affect stockholder control. Interest on bonds is tax deductible. Can increase return on equity. Disadvantages Bonds require payment of both periodic interest and par value at maturity. Can decrease return on equity. A2 Types of Bonds Secured and Unsecured Convertible and Callable Term and Serial Registered and Bearer

3 A1 Bond Issuing Procedures A company sells the bonds to......an investment firm called an underwriter. The underwriter sells the bonds to investors A trustee monitors the bond issue Issuing Bonds at PAR u Par Value: $1,000,000 u Stated Interest Rate = Market Rate of 10% u Interest Payment Dates: 6/30 & 12/31 u Bond Issuance Date: Jan 1, 2012 u Maturity Date: Dec 31, 2031 (20 years) 1/1/12 Cash 1,000,000 Bonds Payable 1,000,000 Bonds Issued at Par (Honda) DR CR 3

4 Interest Expense on Par Value Bonds The entry to record each interest payment on 6/30 and 12/31 of each year is: 6/30 Bond Interest Expense 50,000 12/31 Cash 50,000 Paid semi-annual interest DR CR $1,000,000 x 10% x ½ year = $50,000 This entry is made every six months until the bonds mature. Bond Retirement at Maturity On Dec 31, 2031 the bonds mature and the following entry is made by the issuer: 1/1/12 Bonds Payable 1,000,000 Cash 1,000,000 Paid bond principal at maturity. DR CR 4

5 Ex 10-1, Parts 1 & 2 Interest Rates & Bonds u Stated Rate: used to determine the amount of the interest payment (par value x stated interest rate x [1/# interest pymts per year]) u Market Rate: determines the selling price of the bond and is the interest rate used for Tables B1 & B3. 5

6 P1 Bond Discount or Premium Contract/Stated rate is: Contract Rate > Market Rate Contract Rate = Market Rate Contract Rate < Market Rate Bond sells: At a premium (above par value) - Porsche At par value (equal to par value) - Honda At a discount (below par value) - Vintage Hyundai Net Carrying Value of Bond = Bond Payable Unamor2zed Discount Bond Payable + Unamor2zed Premium Ex 10-1, Part 3b 6

Issuing Bonds at a PREMIUM Par value: $1,000,000 Issue Price: 108.

7 Issuing Bonds at a PREMIUM Par value: $1,000,000 Issue Price: % Stated Interest Rate: 10% Market Interest Rate: 8% Interest Payment Dates: 6/30 & 12/31 Bond Date: 1/1/12 Maturity Date: 12/31/16 (5 yrs) 1/1/12 Cash 1,081,145 Bonds Payable 1,000,000 Premium on Bonds Payable 81,145 Bonds Issued at Premium (Porsche) DR CR Interest Expense on PREMIUM Value Bonds The entry to record each interest payment on 6/30 and 12/31 of each year is: 6/30 Bond Interest Expense 41,885 (plug) & Premium on Bond Payable 8,115* 12/31 Cash 50,000** Paid semi-annual interest & amortized premium DR CR $81,145 / 10 interest payments = $8,115* (rounded) $1,000,000 x 10% x ½ year = $50,000** This entry is made every six months until the bonds mature. 7

P2 Issuing Bonds at a Discount Prepare the entry for Jan.

6405% of par value Stated Interest Rate = 10% Bond will sell at a discount.

Sold bonds at a discount on issue date 10-15 P2 Issuing Bonds at a Discount Make the following entry

8 P2 Issuing Bonds at a Discount Prepare the entry for Jan. 1, 2012, to record the following bond issue by Rose Co. Par Value = $1,000,000 Issue Price = % of par value Stated Interest Rate = 10% Bond will sell at a discount. Market Interest Rate = 12% } Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2013 (5 years) DR Jan. 1 Cash 926,405 Contra- Liability Account CR Discount on bonds payable 73,595 Bonds payable 1,000,000 Sold bonds at a discount on issue date P2 Issuing Bonds at a Discount Make the following entry every six months to record the cash interest payment and the amortization of the discount. DR CR June 30 Bond interest expense 57,360 Discount on bonds payable 7,360 Cash 50,000 Paid semi-annual interest and amortized discount $73, periods = $7,360 (rounded) $1,000,000 10% ½ = $50,

Bond Issuance Journal Entry Bond at Par Value (Honda): Cash $1,000,000 Bond Payable $1,000,000 Bond has a 5- yr term & pays interest 2x per year Discounted Bond (Hyundai) on Jan 1: Cash $926,405

9 Bond Issuance Journal Entry Bond at Par Value (Honda): Cash $1,000,000 Bond Payable $1,000,000 Bond has a 5- yr term & pays interest 2x per year Discounted Bond (Hyundai) on Jan 1: Cash $926,405 Discount on Bond* 73,595 Bond Payable $1,000,000 Premium Bond (Porsche) on Jan 1: Cash $1,081,145 Premium on Bond* 81,145 Bond Payable $1,000,000 *The Bond s Discount or Premium accounts are Contra Liability accounts. Interest Expense Journal Entry Par Value Bond Interest Exp* $50,000 Cash* $50,000 **Bond is a 5- yr bond with interest payment 2x per year. Discounted Bond Int Exp. (plug) $57,360 Cash* $50,000 Discount on BP** $7,360 Premium Bond Int Exp. (plug) $41,885 Prem on BP** $ 8,115 Cash* $50,000 * Par value x Interest rate % x 1/# pymts per year ** The amor2za2on of the Discount or Premium is calculated: (Discount or Premium) / (# of Interest Pymts to be Made over Bond Life) NOTE: The carrying value of the bond must be equal to the par value at maturity. In other words, the discount or premium must be ZERO at maturity. 9

10 Amortization of Bond Discount Bond Payable (L) $1,000,000 Bond Discount (CL) Interest Expense Journal Entry for a Discounted Bond Int Exp. (plug) $57,360 Cash* $50,000 Discount on BP** $7,360 $73,595 $7,360 $7,360 $7, Un2l account is Zero Bond is a 5- yr bond with interest payment 2x per year. ** The amor2za2on of the Discount or Premium is calculated: (Discount or Premium) / (# of Interest Pymts to be Made over Bond Life) NOTE: The carrying value (Bond Payable Discount) of the bond must be equal to the par value at maturity. In other words, the discount or premium must be ZERO at maturity. P2 Straight-Line Amortization Table Interest Interest Discount Unamortized Carrying Date Payment Expense Amortization* Discount Value 1/1/12 $ 73,595 $ 926,405 6/30/12 $ 50,000 $ 57,360 $ 7,360 66, ,765 12/31/12 50,000 57,360 7,360 58, ,125 6/30/13 50,000 57,360 7,360 51, ,485 12/31/13 50,000 57,360 7,360 44, ,845 6/30/14 50,000 57,360 7,360 36, ,205 12/31/14 50,000 57,360 7,360 29, ,565 6/30/15 50,000 57,360 7,360 22, ,925 12/31/15 50,000 57,360 7,360 14, ,285 6/30/16 50,000 57,360 7,360 7, ,645 12/31/16 50,000 57,355 7, ,000,000 $ 500,000 $ 573,595 $ 73,595 * Rounded

11 Amortization of Bond Premium Bond Payable (L) $1,000,000 Bond Premium (CL) Interest Expense Journal Entry for a Premium Bond Int Exp. (plug) $41,885 Prem on BP** $ 8,115 Cash* $50,000 $81,145 $8,115 $8,115 $8, Un2l account is Zero Bond is a 5- yr bond with interest payment 2x per year. ** The amor2za2on of the Discount or Premium is calculated: (Discount or Premium) / (# of Interest Pymts to be Made over Bond Life) NOTE: The carrying value (Bond Payable + Premium) of the bond must be equal to the par value at maturity. In other words, the discount or premium must be ZERO at maturity. P3 Straight-Line Amortization Table Interest Interest Premium Unamortized Carrying Date Payment Expense Amortization* Premium Value 1/1/12 $ 81,145 $ 1,081,145 6/30/12 $ 50,000 $ 41,885 $ 8,115 73,030 1,073,030 12/31/12 50,000 41,885 8,115 64,915 1,064,915 6/30/13 50,000 41,885 8,115 56,800 1,056,800 12/31/13 50,000 41,885 8,115 48,685 1,048,685 6/30/14 50,000 41,885 8,115 40,570 1,040,570 12/31/14 50,000 41,885 8,115 32,455 1,032,455 6/30/15 50,000 41,885 8,115 24,340 1,024,340 12/31/15 50,000 41,885 8,115 16,225 1,016,225 6/30/16 50,000 41,885 8,115 8,110 1,008,110 12/31/16 50,000 41,890 8, ,000,000 $ 500,000 $ 418,855 $ 81,145 * Rounded

Bond Maturity Journal Entry Bond at Par Value (Honda): Bond Payable $1,000,000 Cash $1,000,000 Discounted Bond (Hyundai) on Jan 1: Bond Payable $1,000,000 Cash $1,000,000 Premium Bond (Porsche) on

12 Bond Maturity Journal Entry Bond at Par Value (Honda): Bond Payable $1,000,000 Cash $1,000,000 Discounted Bond (Hyundai) on Jan 1: Bond Payable $1,000,000 Cash $1,000,000 Premium Bond (Porsche) on Jan 1: Bond Payable $1,000,000 Cash $1,000,000 Basics of Bond Valuation The value of a bond investment is based on the SUM of Stream of interest payments made/ received over the the life of the bond Use the market rate interest and Table B3. PLUS Single lump sum payment (par value) made at the bond s maturity. Use the market rate interest and Table B1. 12

The Four Components of Time Value Calculations: u PV Present Value, what is it worth today? u FV Future Value, what is it worth in the future? u n number of periods (i.e. months, quarter, year) u i interest rate % earned for each n C2 Example of Calculating the Present Value of a Discount Bond Appendix B Calculate the issue price of Rose Inc.

13 The Four Components of Time Value Calculations: u PV Present Value, what is it worth today? u FV Future Value, what is it worth in the future? u n number of periods (i.e. months, quarter, year) u i interest rate % earned for each n C2 Example of Calculating the Present Value of a Discount Bond Appendix B Calculate the issue price of Rose Inc.s bonds. Par Value = $1,000,000 Issue Price =? Stated Interest Rate = 10% Market Interest Rate = 12% Interest Dates = 6/30 and 12/31 Bond Date = Jan. 1, 2012 Maturity Date = Dec. 31, 2016 (5 years)

3601 50,000 368,005 Price of bond $ 926,405 1. Semiannual rate = 6% (Market rate 12% 2) 2.

14 C2 Present Value of a Discount Bond Cash Flow Table Table Value Amount Present Value Par value of the bond PV of $ $ 1,000,000 $ 558,400 Interest (annuity) PV of an Annuity of $ , ,005 Price of bond $ 926, Semiannual rate = 6% (Market rate 12% 2) 2. Semiannual periods = 10 (Bond life 5 years 2) $1,000,000 10% (stated rate) ½ = $50, Ex

15 Appendix B Tables u Table B1 & B2: Single payments/receipts u Table B3 & B4: Multiple payments/receipts u Table B1 & B3: PV unknown u Table B2 & B4: FV unknown Time Value of Money u Sch B-1 & B-2: A single payment u B-1: If I wanted to have $xx (known factor) in a future period, how much would I have to deposit today? I.e., If I need $5,000 for a down payment in 2 years, how much do I need to deposit in the bank today? u B-2: If I deposited $xx (known factor) today, how much would I have in the future? I.e., If I deposit $3,000 today, how much will I have in 2 years for the down payment on my car? 15

16 Table B1 & B2 Single Payment/Receipt Table B1 PV Unknown Table B2 PV Known FV Known FV Unknown Time Value of Money u Sch B-3 & B-4: u Sch B-3: If I want to have a future series of $xx payments (known factor) in the future, how much would I have to deposit today? I.e., If I want to have $1,000 paid to me every month during my retirement of 20 years, how much do I have to deposit today? u Sch B-4: If I deposit a series of $xx payments, how much will I have in the future? I.e., if I deposit $100 every month for the next 30 years, how much will I have saved for retirement? 16

17 Table B3 & B4 Multiple Payments/Receipts of Constant Dollar Amount & Intervals PV Unknown Table B4 PV known Table B3 FV known FV Unknown Vocabulary u Annuity u Net Carrying Value u Bond Premium, Discount or Par u Bond types (know what each is)(p. 426): Secured & Unsecured; Term & Serial; Registered & Bearer; Convertible & Callable u Debt to Equity Ratio 17

18 C1 Mortgage Notes and Bonds u A legal agreement that helps protect the lender if the borrower fails to make the required payments. u Gives the lender the right to be paid out of the cash proceeds from the sale of the borrowerʼ s assets specifically identified in the mortgage contract C1 Long-Term Notes Payable Regular Payments of Principal plus Interest Company Lender Regular Payments of Principal plus Interest Note Date Payments can either be equal principal payments plus interest or equal payments. Note Maturity Date

19 C1 Installment Notes with Equal Payments $14,000 $12,000 $10,000 $8,000 $6,000 Annual payments are constant. Interest Principal $4,000 $2,000 $- Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 The principal payments increase each year. Interest expense decreases each year A3 Debt-to-Equity Ratio Debt-to- Equity Ratio = Total Liabilities Total Equity This ratio helps investors determine the risk of investing in a company by dividing its total liabilities by total equity

John J. Wild Sixth Edition

Financial Accounting John J. Wild Sixth Edition McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10 Reporting and Analyzing Long-Term Liabilities Conceptual