Chapter 16. Debentures: An Introduction. Non-current Liabilities. Horngren, Best, Fraser, Willett: Accounting 6e 2010 Pearson Australia.

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1 PowerPoint to accompany Non-current Liabilities Chapter 16 Learning Objectives 1. Account for debentures payable transactions 2. Measure interest expense by the straight line interest method 3. Account for redemption and conversion of debentures 4. Report liabilities on the balance sheet 5. Show the advantages and disadvantages of borrowing 6. Account for lease and superannuation liabilities Appendix present and future values Debentures: An Introduction A Debenture is an interest bearing noncurrent bonds payable. Debentures are borrowings from multiple lenders called debenture holders. Debentures have. principal (maturity value, face value) interest rate interest payment dates.

2 Types of Debentures Term Debentures Mortgage Debentures Serial Debentures Unsecured Note Debenture Prices A debenture is quoted as a percent of its maturity value. Debentures may be issued at a premium or discount. A quote of 99.5 means that a $1,000 debenture sells for $1, , or $995. Debenture prices are affected by: time to maturity, credit rating of issuer and, interest rate in the economy. Present Value A dollar received today is worth more than a dollar received in the future. Why because you can invest it and earn income from it. $100 5% for one year will give $105 in one years time. It depends upon... the length of time to the future receipt. the interest rate.

3 Debenture Interest Rates Debentures are sold at market price. Market price is determined by nominal or stated interest rate and, market or effective interest t rate. If market rates are higher than the nominal rate the debentures will be issued at a discount. A premium if the reverse. Debentures See the Esanda debenture certificate Exhibit 16-1 page 597 of your textbook. Esanda Finance Corporation Limited Esanda Certificate of Investment 85 Spring Street Melbourne Vic 3000 DEBENTURE STOCK Investor number: Certificate number: Date of issue: 01/07/06 Anne L Citizen 24 River St LISMORE NSW 2480 Objective 1 Account for debentures payable transactions.

4 Issuing Debentures to Borrow Money On January 1, Brisbane Limited issued $1,000,000 of 10%, 10-year debentures. January 1 Cash 1,000,000 Debentures Payable 1,000,000 To issue 10%, 10-year debentures Issuing Debentures to Borrow Money What is the entry for the interest payment of July 1? $1,000,000 10% 1/2 = $50,000 July 1 Interest Expense Cash 50,000 50,000 To record semiannual interest Issuing Debentures at a Discount A 10-year, $1,000,000 Debenture issue is sold by Hobart Limited at on January 1. Cash 992,500 Discount on Debentures 7,500 Debentures Payable 1,000,000 To issue 10%, 10-year debentures at a discount

5 Objective 2 Measure interest expense by the straight line ammortisation method. Straight-Line Amortisation of Debenture Discount This method amortises the debenture discount by dividing it into equal amounts for each interest period. Hobart Limited would amortise the $7,500 discount over 20 periods (not years). $7, = $375 per period. Straight-Line Amortisation of Debenture Discount July 1 Interest Expense 50,375 Cash 50, Discount on Debentures 375 Paid half-yearly interest and amortised discount on debentures payable

6 Issuing Debentures Payable at a Premium Darwin Limited sold a 10%, 10-year (20 periods),$1,000,000 debenture issue at a price of 101. Cash 1,010,000 Debentures Payable 1,000,000 Premium on Debentures 10,000 Issued debentures at a premium Issuing Debentures Payable at a Premium Darwin Limited Balance Sheet (immediately after issue of the debentures) Non-current liabilities: Debentures payable, 10%, due 2017 $1,000,000 Premium on debentures payable 10,000 $1,010,000 Straight-Line Amortisation of Debenture Premium July 1 Interest Expense 49,500 Premium on Debentures 500 Cash 50,000 Paid half-yearly interest and amortised premium on debentures payable

7 Reporting Debentures Payable Darwin Limited Balance Sheet (one year after issue of the debentures) Non-current liabilities: Debentures payable, 10%, due 2016 $1,000,000 Premium on debentures payable 9,000 $1,009,000 Objective 3 Account for redemption and conversion of debentures. Adjusting Entries for Interest Expense Canberra Limited issued $150,000 of its 8%, 10-year debentures at a $3,000 discount on April 1, The interest payments occur on March 31 and September 30 each year. Canberra Limited s financial year ends on June 30. What accounts are involved?

8 Adjusting Entries for Interest Expense Interest Payable: $150,000 8% 3/12 = $3,000. Discount Amortisation: $3, (years) 3/12 = $75. Interest Expense: $3,000 + $75 = $3,075. What is the adjusting entry? Adjusting Entries for Interest Expense June 30, 2010 Interest Expense 3,075 Interest Payable 3,000 Discount on Debentures 75 Accrued three months interest and amortised discount on debentures payable What is the entry on October 31, 2010? Adjusting Entries for Interest Expense October 31, 2010 Interest Expense 3,075 Interest Payable 3,000 Cash 6,000 Discount on Debentures Payable 75 Paid half-yearly interest, half of which was accrued, and amortised three months discount on debentures payable

9 Issuing Debentures Between Interest Dates On March 31, Brisbane Limited sells $1,000,000 of 10%, 10-year debentures dated January 1. March 31 Cash 1,025,000 Debentures Payable 1,000,000 Interest Payable 25,000 To issue 10%, 10-year debentures at par (maturity value) three months after original issue date. Issuing Debentures Between Interest Dates What is the July 1 interest expense? $1,000,000 10% 1/4 = $25,000. Jl July 1 Interest Expense 25,000 Interest Payable 25,000 Cash 50,000 To pay semiannual interest Redemption of Debentures To redeem a debenture early, the issuer can purchase the debentures in the open market, or exercise a call option. A call option is a clause that allows the debenture issuer to redeem the debentures at a specified price (usually above maturity or par value) on or after a specified date. The journal entry is the same in either case.

10 Redemption of Debentures Example $500,000 of 12% debentures with an unamortised premium of $20,000 are purchased for $498,000 and retired. Debentures Payable 500,000 Premium of Debentures 20,000 Cash 498,000 Gain on Redemption of Debentures 22,000 Redeemed debentures Convertible Debentures and Notes Convertible debentures (or notes) give the holder the option of exchanging the debenture for a specified number of ordinary shares. If a debenture is converted into ordinary shares, shareholders equity is increased by the carrying amount of the debentures converted. Objective 4 Reporting liabilities on the balance sheet.

11 Current Portion of Long-term Debt Serial debentures and serial notes are payable in instalments. The portion payable within one year is a current liability. The remaining debt is long term. Objective 5 Show the advantages and disadvantages of borrowing. Issuing Debentures versus Shares Equity financing creates no liabilities and no interest burden. It is less risky to the issuing company. It may dilute ownership interest of existing shareholders. Debt financing does not dilute control. It usually results in higher earnings per share. It reduces total net profits and may impose financial restrictions on the company.

12 Advantage of Issuing Debentures versus Shares Example Suppose that Vista Limited, with net profits of $300,000 and with 100,000 ordinary shares, needs $500,000 for expansion. Money can be borrowed at 10% interest. The income tax rate is 30%. Or.. Advantage of Issuing Debentures versus Shares Example.50,000 ordinary shares can be issued for $500,000. Management believes that the new cash can be invested in operations to earn profits of $200,000 before interest and taxes. Should the company borrow the money or issue additional ordinary shares? Advantage of Issuing Debentures versus Shares Example Borrow $500,000 Expected net profit on the new project $200,000 Interest expense 50, Project profit before income tax $150,000 Income tax expense 45,000 Project net profit $ 105,000 Net profit before expansion $300,000 Total profit $405,000

13 Advantage of Issuing Debentures versus Shares Example Issue 50,000 ordinary shares at $10 per share Expected net profit on the new project $200,000 Income tax expense 60,000 Project net profit $140,000 Net profit before expansion $300,000 Total profit $440,000 Advantage of Issuing Debentures versus Shares Example Borrow $500,000: $405, ,000 = $4.05 earnings per share Issue $500,000 ordinary shares (50,000 shares): $440, ,000 = $2.93 earnings per share But what if the project earned 5% i.e. $50,000? Appendix Present and future values.

14 Appendix There are two directions we can consider: future values (compounding interest) and present values (discounting back). There are two types: single sum either now or in the future, and stream of money, known as an annuity. The four tables on pages save the once complex calculations (which today financial calculators can also easily do). Appendix Future Value What is the future of an amount of $1,000 invested today for 10 periods if interest rates are 6%? The future value annuity table (page 625 of your textbook) indicates that is the factor for 10 periods at 6%. The future value in 10 years will be $1,791. Appendix Future Value What if I am willing to save $1,000 each year for 10 years and interest rates are 6%? The future value annuity table (page 627) indicates that is the factor for 10 periods at 6%. In 10 years I will have $13,181. ($1,000 for 10 years = $1,791 plus $1,000 for 9 years = $1,618 plus for 8 years = $1,594 etc)

15 Appendix Present Value What is the present value of a single (lump) sum of $1,000 in 10 years from now, if interest rates were 10%? The present value table (p 628) indicates that.386 is the factor to be used. $1, = $386. (This also means if you invested $386 today at 10% in 10 years you would have $1,000 in the bank.) Appendix Present Value What is the present value of an amount of $4,500 to be received for 10 periods if interest rates are 5%? The present value annuity table (page 627 of your textbook) indicates that is the factor for 10 periods at 5%. The present value of the 10 year stream of money is $4, = $34,749. Appendix Present Value The present value of the 10 year stream of money is $4, = $34,749. That is if I invested $34,749 in the bank at 5%, at the end of each year I could go and take out $4,500 and in the 10 th year when I withdrew the $4,500 there would be no money left in the bank. I would have withdrawn a total of $45,000.

16 Objective Appendix Measure interest expense by the effective interest ammortisation method. Effective-Interest Method of Amortisation The effective-interest method keeps interest expense at the same percentage over any debenture s life. Generally accepted accounting principles require that interest expense be measured using the effective interest method. Effective-Interest Method: Debenture Discount Assume that Wellington Limited issues $100,000 of its 9% debentures at a discount of $3,851, at a time when the market rate of interest is 10%. These debentures mature in five years and pay interest half-yearly.

17 Effective-Interest Method: Debenture Discount Cash 96,149 Discount on Debentures 3,851 Debentures Payable 100,000 To issue 10%, 10-year debentures at a discount Effective-Interest Method: Debenture Discount What is the interest expense at the end of period one? $96,149 10% 6/12 = $4,807. What is the interest payment at the end of period one? $100,000 9% 6/12 = $4,500. The difference $4,807 $4,500 = $307 amortisation. Effective-Interest Method: Debenture Discount Interest Expense 4,807 Discount on Debentures 307 Cash 4,500 To pay half yearly interest and amortise discount on debentures

18 Effective-Interest Method: Debenture Discount $4,807 $4,500 = $307 amortisation. Therefore the amount borrowed has increased by $307 from $96,149 to $96,456. Interest next period will be; $96,456 10% 6/12 = $4,823. And so on. Effective-Interest Method: Debenture Discount End of Carrying Interest Cash Period Value Expense Paid Amortisation Issue 96,149 Date 1 96,456 4,807 4, ,779 4,823 4, ,118 4,839 4, ,474 4,856 4, Effective-Interest Method: Debenture Premium Assume Auckland Limited issues a $100,000, 5-year, 9% Debenture to yield 8%, at a premium of $4,100. The first period interest expense is calculated as follows: $104,100 8% 6/12 = $4,164.

19 Effective-Interest Method: Debenture Premium End of Carrying Interest Cash Period Value Expense Paid Amortisation Issue 104,100 Date 1 103,764 4,164 4, ,415 4,151 4, ,052 4,137 4, ,674 4,122 4, PowerPoint to accompany End of Chapter 16

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