Participation Questions – Chapter 9  The capital structure of an organization is the mixture of debt funding and equity funding. T/F  Ford Automotive uses a higher level of equity funding in comparison to debt funding. T/F  “Coupon Rate” is the same as which of the following on a bond: Market interest rate Stated interest rate The Dow Jones interest rate LIBOR interest rate  How much did the Hersey bar cost from the 1950’s as shown in the Seinfeld episode?  The cash amount of interest paid to a bond holder is based on which of the following under the effective interest rate method? Face Value Carrying Value

Announcements  Assignments – Due 4/10/16 Chapter 9 Homework (Connect) – unlimited attempts Participation questions for Chapter 9 (Webcourses) – 1 attempt Syllabus Quiz #2 (Webcourses) – 2 attempts  Assignments – Due 4/17/16 Chapter 10 Homework (Connect) – unlimited attempts Participation questions for Chapter 10 (Webcourses) – 1 attempt Definitions Quiz (Webcourses) – 2 attempts Short tutorials in Class Materials

Questions to be Answered Overall - How has society shaped today’s financial reporting? Chapter 9 – How do companies use the different types of long-term financing (bonds, notes, and leases) and what are the impacts to the income statement and balance sheet?

Part A Overview of Long Term Debt 9-5

Accounting Equation

LO1 Explain financing alternatives oFinancing Options oDebt Financing - borrowing money (liabilities) oBonds – most common form of Lg. Corp debt oNotes Payable (typically bank financing) oLeases oEquity Financing - obtaining additional investment from stockholders (stockholders’ equity) oCapital Structure - the careful balance between equity and debt that a business uses to finance its assets, day-to-day operations, and future growth. oThe capital structure influences everything from the firm’s risk profile, how easy it is to get funding, how expensive that funding is, the return its investors and lenders expect, and its degree of insulation from both microeconomic business decisions and macroeconomic downturns. 9-7

Starbucks 2014

Ford Automotive

What is a (Bail) bond and how are they issued? Bond – formal debt instrument that obligates the borrower to repay a stated amount at a specified maturity date. Company (Borrower) – receives cash in exchange for issuing bond contract to investor Investor (Lender) – Lends company $ to receive periodic interest payments over time and a return of original principal at bond maturity.

FYI - Why Bonds versus Bank Borrowing? In the world of corporate finance, many chief financial officers (CFOs) view banks as lenders of last resort because of the restrictive debt covenants that banks place on direct corporate loans. Covenants - rules placed on debt that are designed to stabilize corporate performance and reduce the risk to which a bank is exposed.  Cannot issue any more debt until loan is paid off  Cannot participate in any share offerings until loan is paid off  Cannot acquire any companies until loan is paid off, and so on.  Debt to Equity cannot exceed 3 to 1.  Current assets to current liabilities must exceed a ratio of 1.5.  Some of the more restrictive covenants may state that the interest rate on the debt increases substantially should the (CEO) quit, or should earnings per share drop in a given time period.

Bonds Definition - Formal debt instrument that obligates the borrower to repay a stated amount, referred to as the principal or face amount, at a specified maturity date. Important topics for our class today on bonds: 1. Bonds terms and characteristics 2. Bond Issuances (how we account for them) 1. Pricing Interpretation - Pricing calculations will not be covered, but you will need to be able to interpret the price. 2. Record bond issuance 3. Record interest payments 4. Record repayment of bonds

Item #1 - Bond Terms and Characteristics 13

Terms  Bond certificate states: Company name (Borrower) Face Value (Principal amount) – Usually $1,000 Maturity date (Term) Interest rate (stated or coupon rate) Interest payment dates (usually twice a year) 14

Bond listing in Financial Statement Notes 

Characteristics of Bonds Issued 1. Collateral? 2. Principal and Interest Payments 3. Additional Features 1. Callable 2. Convertible

Bond Characteristics oCollateral oSecured Bonds - supported by specific assets the issuer (borrower) has pledged as collateral. oUnsecured bonds - referred to as debentures, are not backed by a specific asset. 9-18

Bond Characteristics 9-19 Bond Issue Secured Unsecured SerialTermSerial Term oPrincipal and Interest 1.Serial bonds - require payments in instalments over a series of years.  Interest typically paid annually or semi-annually 2.Term bonds - require payment of the full principal amount of the bond at a single maturity date.  Interest typically paid annually or semi-annually

Bond Characteristics – Cont. oCallable - Allows the borrower to repay the bonds before their scheduled maturity date at a specified call price. oCall price is stated in the bond oConvertible bonds - allow the lender to convert each bond into a specified number of shares of common stock. 9-20

Summary of Bond Characteristics 9-21

1. BOND ISSUANCE PRICING (Interpretation Only)

Bond Interest Rates  Two separate interest rates set bond issuance price Stated Rate – (rate on the face of the bond)  The rate ‘stated’ in the bond contract  The rate used to calculate the cash interest payments.  Market Rate – (also known as the effective interest rate)  True interest rate used by investors to value bond issue.  What investors are seeking as a return.

Time Value of Money – (FYI) What is the BIG Idea? - Present value (PV) is the current worth of a future sum of money or stream of cash flows given a specified rate of return. 1.) Value of $1,000 in terms of todays money 2.) Dollar invested earns income 24

Time Value of Money (Cont.) Present value depends on:  Amount of future payment (aka principal)  Length of time  Interest rate

Cash Value of Bonds at Issuance Bond value at issuance is always based on Market Rate & Present Value. Based on the comparison of stated rate and market rate, the following three terms describe the issuance: 1. Par - stated interest rate equals the market interest rate. The bond is issued for face value of bonds. 2. Premium – stated interest rate exceeds the market interest rate. The bond is issued for more than the face value of bonds. 3. Discount – stated interest rate is below the market interest rate. The bond is issued for less than the face value of bonds.

 On January 1, 2012, 10 year bonds were issued at Par  $100,000 Face Value  7% stated interest rate  7% market interest rate  Interest paid semi-annually (Face value * Annual interest rate * Time) $100,000

However, stated rate almost always differs from market rate

In-Class Short Exercise

Interpreting Bond Quotes 31 In the financial press, bond prices are always quoted in relation to 100 to signify if they are sold at a premium, discount, or at par. The price quote is related to the face value, but is not the face value – it is really the % percentage of face value. Price Quote Par = 100 (100% of face value) Premium = 105 (105% of face value) Discount = 95 (95% of face value)

Bond Pricing from Financial Mkt. (Cont.) 32 RateMaturityBidAsk/yld 7 ¾Feb /8Feb

Total Value of Bond Issuance ($ received by issuing company)

34 Copyright © 2010 Pearson Education Inc. Publishing as Prentice Hall.

Check-ins 1. The most common bond characteristics are a serial or term bond that is secured or unsecured? (Circle the two correct answers in bold) 2. A bond issued at a discount will have a market rate that is higher or lower than the stated rate on the bond. (Circle the one correct answers in bold). 3. If a bond issuance with a face value of $1,000 has an issue price of 98, how much cash will the organization receive at the time of issuance?

1. BOND ISSUANCE 2. INTEREST PAYMENTS 3. REPAYMENT

Bonds issued at Par - Steps Par - stated interest rate equals the market interest rate. The bond is issued for face value of bonds. Therefore, the amount of cash the organization receives from lenders (investors) will equal the face value of the bonds. Steps for original issuance: 1. Debit Cash for amount received 2. Credit Bonds Payable for amount of cash received. Steps for semi-annual interest payments: 1. Calculate ‘cash’ interest expense/payments using stated rate and our typical formula. 2. Debit Interest Expense 3. Credit Cash Steps for final repayment of bond at maturity to lenders (investors): 1. Debit Bonds Payable for face value of bond 2. Credit cash for amount of repayment.

Bond issued at Par - Example 10 year $100,000 term bonds with stated rate of interest of 7% issued at par on 1/1/12. Interest is payable semi- annually. Original transaction, 1st interest payment, and maturity of bond in 10 years.

Issuance of a bond at a Discount/Premium Discount – stated interest rate is below the market interest rate. The bond is issued for less than the face value of bonds. Therefore, the amount of cash the organization receives from lenders (investors) will be less than the face value of the bonds. Steps for original issuance: 1. Debit Cash for amount received 2. Credit Bonds Payable for amount of cash received. Steps for semi-annual interest payments: 1. Use the ‘Effective Interest Rate Method” Steps for final repayment of bond at maturity to lenders (investors): 1. Debit Bonds Payable for face value of bond 2. Credit cash for amount of repayment.

Carrying Value The balance in the bonds payable account is the carrying value.  We initially record the bonds payable account at $93,205. The carrying value will increase from the amount originally borrowed ($93,205) to the amount due at maturity ($100,000) over the 10-year life of the bonds using the effective interest rate method.

Effective Interest Method The effective interest method for bonds provides an ‘amortization’ of the discount (or premium) over the term of the bond so that the bond payable account equals face value at maturity. Very important – ‘CASH’ interest payments to investors are a different amount than the ‘INTEREST EXPENSE’ we record semi-annually. Steps: 1. Calculate ‘Cash Interest Payment’ (Credit to Cash account) Formula - Face Value * Stated Interest * Time Period 2. Calculate amount recorded as ‘Interest Expense’ (Debit the expense account) Formula - Carrying Value * Market Interest * Time Period 3. Difference between Interest Payment and Interest Expense is either Credited (discount) or Debited (premium) to Bonds Payable. 4. Calculate new carrying value after discount or premium is amortized. 41

Issuance - Recording Bonds Issued at a Discount o In the preceding example we assumed the stated interest rate (7%) and the market interest rate (7%) were the same. o If the market interest rate is 8%, the bonds will issue at only $93,205. o This is less than $100,000. The bonds are paying only 7%, while investors can purchase bonds of similar risk paying 8%. o The entry RC Enterprises makes to record the bond issue at a discount is: 9-42

Effective Interest Method Step 1: Interest Payment – Credit Cash Interest payment (CASH) Interest payment (CASH) Face value Stated (coupon) interest rate 1/2 $3,500 $100,000 7% 1/2

Effective Interest Method Step 2: Interest Expense (Debit) $3,728 $93,205 Market (effective) interest rate 1/2 Interest expense Carrying value 8% 1/2

Recording Bonds Issued at a Discount Step 2: We calculate interest expense as the carrying value (the amount actually owed during that period) times the market rate. Step 1: Cash paid for interest is equal to the face amount times the stated rate (3.5% semi-annually or 7% annually, in our example). Step 3: On June 30, 2012, RC Enterprises the interest payment and expense. Interest expense= Carrying value of bondX Market interest rate per period $3,728=$93,205 8% x ½ Cash paid for Interest= Face amount of bondX Stated interest rate per period $3,500=$100,000 7% x ½ June 30, 2012DebitCredit Interest Expense ($93,205 x 8% x ½) 3,728 Bonds Payable (difference) 228 Cash ($100,000 x 7% x ½) 3,500 (Record semiannual interest payment) 9-45

Amortization Schedule for Bonds Issued at a Discount o An amortization schedule provides a nice summary of the cash interest payments, interest expense, and changes in carrying value for each semi- annual interest period. o The amounts for the June 30, 2012 and the December 31, 2012 semi- annual interest payment entries can be taken directly from the amortization schedule. (1) Date (2) Cash Paid for interest (3) Interest Expense (4) Increase in Carrying Value (5) Carrying Value Face Amount x Stated Rate Carrying Value x Market Rate (3) – (2)Prior Carrying Value + (4) 1/1/2012 $93,205 6/30/2012$3,500$3,728$22893,433 12/31/20123,5003, ,670 * * * * * * * * * 99,057 6/30/20213,5003, ,519 12/31/20213,5003,981481$100,

Recording Bonds Issued at a Premium o RC Enterprises issues $100,000 of 7% bonds when other bonds of similar risk are paying only 6%. o The bonds will issue at $107,439. Investors will pay more than $100,000 for these 7% bonds because bonds of similar risk are paying only 6% interest. o The entry to record the bond issue at a premium is: January 1, 2012DebitCredit Cash107,439 Bonds Payable 107,439 (Bonds issued at a premium) June 30, 2012DebitCredit Interest Expense ($107,439 x 6% x ½) 3,223 Bonds Payable (difference) 277 Cash ($100,000 x 7% x ½) 3,500 (Semi-annual interest payment) On June 30, 2012, RC Enterprises records interest expense. 9-47

Amortization Schedule for Bonds Issued at a Premium o An amortization schedule provides a nice summary of the cash interest payments, interest expense, and changes in carrying value for each semi-annual interest period. o The amounts for the June 30, 2012 and the December 31, 2012 semi-annual interest payment entries can be taken directly from the amortization schedule. (1) Date (2) Cash Paid for interest (3) Interest Expense (4) Decrease in Carrying Value (5) Carrying Value Face Amount x Stated Rate Carrying Value x Market Rate (2) – (3)Prior Carrying Value + (4) 1/1/2012 $107,439 6/30/2012$3,500$3,223$277107,162 12/31/20123,5003, ,877 * * * * * * * * * 100,956 6/30/20213,5003, ,485 12/31/20213,5003,015485$100,

Changes in Carrying Value Over Time 9-49

Examples : $200,000 of bonds issued with a stated interest rate of 9%. Interest due semi-annually. Due in 10 years 1. Market Rate = 9%. Record the bond issue on and the first 2 interest payments on 6/30/12 and 12/31/ Market Rate = 10%. Record the bond issue in the amount of $187,538 on 1/1/12 and the first 2 interest payments on 6/30/12 and 12/31/ Market Rate = 8%. Record the bond issue in the amount of $213,590 on 1/1/12 and the first 2 interest payments on 6/30/12 and 12/31/

Example 1 – Bonds issued at ___________

Example 2 – Bonds issued at ___________

Bond Issued at Discount – Amortization Schedule Cash Increase Interest in CarryingCarrying DatePaidExpenseValue 1/1/ ,538 6/30/2012 9,000 9, ,915 12/31/2012 9,000 9, ,311 6/30/2013 9,000 9, ,726 12/31/2013 9,000 9, ,163 6/30/2014 9,000 9, ,621 12/31/2014 9,000 9, ,102 6/30/2015 9,000 9, ,607 12/31/2015 9,000 9, ,137 6/30/2012Interest Payment = 200,000 x.09 x 1/2 = 9,000 Interest Expense = 187,538 x.10 x 1/2 = 9,377

Example 3 – Bonds issued at ___________

Bond Issued at Premium – Amortization Schedule Cash Decrease Interest in CarryingCarrying DatePaidExpenseValue 1/1/ ,590 6/30/2012 9,000 8,544 (456) 213,134 12/31/2012 9,000 8,525 (475) 212,659 6/30/2013 9,000 8,506 (494) 212,165 12/31/2013 9,000 8,487 (513) 211,652 6/30/2014 9,000 8,466 (534) 211,118 12/31/2014 9,000 8,445 (555) 210,563 6/30/2015 9,000 8,423 (577) 209,985 12/31/2015 9,000 8,399 (601) 209,385 6/30/2012Interest Payment = 200,000 x.09 x 1/2 = 9,000 Interest Expense = 213,590 x.08 x 1/2 = 8,544

Changes in Carrying Value Over Time 9-56 $213,590 $187,538 $200,000

1. BOND ISSUANCE 2. INTEREST PAYMENTS 3. REPAYMENT

Payment of Bond Principal at Maturity DateAccountDebitCredit 12/31/2021Bonds Payable 200,000 Cash 200,000 Payment of maturity

Part D Other Long-Term Liabilities

Installment Notes Each installment payment includes both interest and principal: o Calculate the amount that represents interest expense. o Step 1 - Calculated as Carrying Value * annual interest rate * time (x/12) o Calculate the amount that represents a reduction of the outstanding loan balance. o Step 2 - Subtract the monthly interest from the total payment and the remainder is a principal reduction. o RC Enterprises obtains a $25,000, 6%, four-year loan for a truck on January 1, o Payments of $ (principal and interest) are required at the end of each month for 48 months. o We record the note and the first two monthly payments as: 9-60

Installment Notes Each installment payment includes both: o An amount that represents interest. o An amount that represents a reduction of the outstanding loan balance. o RC Enterprises obtains a $25,000, 6%, four-year loan for a truck on January 1, o Payments of $ are required at the end of each month for 48 months. o We record the note and the first two monthly payments as: January 1, 2012DebitCredit Cash25,000 Notes Payable25,000 (Issue a note payable) January 31, 2012 Interest Expense ($25,000 x 6% x 1/12) Notes Payable (difference) Cash (monthly payment) (Record first monthly payment) February 28, 2012 Interest Expense ($24, x 6% x 1/12) Notes Payable (difference) Cash (monthly payment) (Record second monthly payment) 9-61

Leases o A lease is a contractual agreement by which the lessor (owner) provides the lessee (user) the right to use an asset for a specific period of time. o For accounting purposes, we have two basic types of leases: o Operating Leases: This type of a lease is similar to a rental. Example: Car rentals and short-term apartment leases. o Payments are expenses on income statement. Is not recorded on the balance sheet. o Capital Leases: Occurs when a lessee buys an asset and borrows the money through a lease to pay for the asset. Example: A borrower signs a four-year lease for a car that automatically transfers ownership at the end of the lease term. o Recorded on the balance sheet. 9-62

1- 63 J C Penney Operating Lease Obligations – Notes to the Financial Statements

Exercise 9-8 Pretzelmania, Inc., issues 8%, 10-year bonds with a face amount of $90,000 for $90,000 on January 1, The market interest rate for bonds of similar risk and maturity is 8%. Interest is paid annually on December 31. Record initial transaction and first interest payment.

Exercise 9-9 Pretzelmania, Inc., issues 5%, 10-year bonds with a face amount of $70,000 for $55,909 on January 1, The market interest rate for bonds of similar risk and maturity is 8%. Interest is paid annually on December 31. Show bond issue and first two interest payment based on amortization table. Record journal entries.

Exercise 9-10 Pretzelmania, Inc., issues 5%, 10-year bonds with a face amount of $80,000 for $101,558 on January 1, The market interest rate for bonds of similar risk and maturity is 2%. Interest is paid annually on December 31. Show bond issue and first two interest payment based on amortization table. Record journal entries.

Operating Lease versus Capital Lease Chunky Cheese Pizza has $60 million in bonds payable. The bond indenture states that the debt to equity ratio cannot exceed 4. Chunky’s total assets are $350 million, and its liabilities other than the bonds payable are $220 million. The company is considering some additional financing through leasing. What does the stockholders’ equity total? Debt to equity? The company enters a lease agreement requiring lease payments with a present value of $6 million. Will this lease agreement affect the debt to equity ratio differently if the lease is recorded as an operating lease versus a capital lease? Yes. The debt to equity ratio will not be affected under an operating lease. However, under a capital lease, assets and liabilities will both increase $6 million while stockholders’ equity will remain unchanged. The increase in liabilities will increase the debt to equity ratio.

Long-term Notes Payable On December 1, 2012, Stoops Entertainment purchases a building for $450,000, paying $100,000 down and borrowing the remaining $350,000, signing a 9%, 15-year mortgage. How much interest is accrued at the end of the month for the preparation of the financial statements.

Participation Questions – Chapter 9  The capital structure of an organization is the mixture of debt funding and equity funding. T/F  Ford Automotive uses a higher level of equity funding in comparison to debt funding. T/F  “Coupon Rate” is the same as which of the following on a bond: Market interest rate Stated interest rate The Dow Jones interest rate LIBOR interest rate  How much did the Hersey bar cost from the 1950’s as shown in the Seinfeld episode?  The cash amount of interest paid to a bond holder is based on which of the following? Face Value Carrying Value