Chapter 11. Long-Term Liabilities Notes, Bonds, and Leases

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2 Chapter 11 Long-Term Liabilities Notes, Bonds, and Leases 2

3 Long-Term Liabilities 3

4 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 4

borrowing costs Management has strong incentive to

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). 5

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.

6 Figure

7 Accounting for Long-Term Notes Payable 7

8 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 8

Two components determine the time value of money: interest (discount) rate number of

9 Present Value of a Single Sum 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 718, Table 4 3. Financial Calculator (time value of money). 9

There are 3 different ways you can calculate the PV1: 1.

10 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 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? 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 10

What is the cash equivalent price of the land, if a 6 percent discount rate is assumed? PV1 = 50,000 x ( 0.

11 Problem 1 Solution, continued The Effective Interest Method: 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 11

(Portion of year) Where carrying value = face - discount.

12 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) 12

value on B/S at 12/31/2008: Notes Payable $50,000 Discount

13 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 13

2,376 Discount on N/P 2,376 Carrying value on B/S at 12/31/2009: Notes Payable $50,000

14 Bond Terminology 14

15 Bonds Payable Example 15

16 Bond Prices 16

17 2. Present Value of an Ordinary Annuity(PVOA) 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 719, Table 5 3. Financial Calculator (time value of money). 17

number of periods of discounting. There are 3 different ways you can calculate PVOA: 1.

18 Problem 2: Bonds Payable 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 18

Calculate the issue price of the bond: (1) What are the cash flows and factors?

Problem 2 - calculations PV of interest annuity: PVOA Table PVOA = 3,500 (8.53020) = $29,856 i = 3%, n = 10 PV of face value: PV1 Table PV = 100,000 (0.

19 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. 19

74409)=$74,409 i=3%, n=10 Total issue price = $104,265 Issued at a premium of $4,265 because the

20 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 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. 20

) 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)

21 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 21

22 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. 22

23 Cash Flows for Bonds Payable 23

24 Bonds Issued at Face Value 24

25 Bonds Payable 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. 25

26 Bonds Issued at a Discount 26

27 Bond Amortization Table 27

28 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 28

29 Capital Lease 29

30 Capital Lease Criteria 30

31 Leases 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. Requirements of SFAS No 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. 31

32 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. 32

33 Appendix 11A Determine the Effective (Actual) Rate of Return Determine the Required Rate of Return Determine the Risk-Free Return Determine the Risk Premium Compare the Effective Rate to the Required Rate 33

34 Appendix 11B 34

35 Appendix 11C Interest Rate Swaps A common method used by companies to reduce such risks is called hedging, where a company enters into a contract that creates risks that counteract or balance the risks attempted to be hedged (reduced). The most common method of hedging market interest rate risk is called an interest rate swap. 35

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Appendix C- 1. Time Value of Money. Appendix C- 2. Financial Accounting, Fifth Edition

Appendix C- 1. Time Value of Money. Appendix C- 2. Financial Accounting, Fifth Edition C- 1 Time Value of Money C- 2 Financial Accounting, Fifth Edition Study Objectives 1. Distinguish between simple and compound interest. 2. Solve for future value of a single amount. 3. Solve for future