Long-Term Liabilities Chapter 09 Long-Term Liabilities This chapter is divided into 4 parts Part A: Overview of Long Term Debt Part B: Pricing a Bond Part C: Recording Bonds Payable Part D: Other Long-Term Liabilities McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Overview of Long Term Debt Part A Overview of Long Term Debt Part A provides an overview of bonds and their basic characteristics. 9-2

LO1 Explain financing alternatives Financing Options Debt Financing - borrowing money (liabilities) Equity Financing - obtaining additional investment from stockholders (stockholders’ equity) Capital Structure - is the mixture of liabilities and stockholders’ equity used by a business Financing options available for a growing company include: Debt Financing – borrowing money (liabilities) Equity Financing – obtaining additional investment from stockholders (stockholders’ equity) Capital Structure is the mixture of liabilities and stockholders’ equity used by a business. Accounting Equation 9-3 3

What is a Bond? A 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. In return, the borrower agrees to pay interest over the life of the bond. Similar to notes payable, except bonds are usually issued to many lenders at the same time. Traditionally, interest on bonds is paid twice a year (semi-annually). Bonds are sold or underwritten by investment houses like JPMorgan, Citibank and Bank of America. Bonds are very similar to notes. Bonds, though, usually are issued to many lenders, while notes most often are issued to a single lender such as a bank. Traditionally, interest on bonds is paid twice a year (semi-annually) on designated interest dates, beginning six months after the original bond issue date. Bonds provide a way to borrow the money needed from many community members, each willing to lend a small amount. In return, those investing in the bonds receive interest over the life of the bonds, say 20 years, and repayment of the principal amount at the end of the bonds’ life. 9-4

Part B Pricing a Bond Part B: Bond Pricing 9-5

LO3 Determine the price of a bond issue Issue price is calculated as the present value of the face amount plus the present value of the periodic interest payments. Bonds can be issued at: Face amount Below face amount (discount) Above face amount (premium) Ways to determine the issue price of bonds: Financial calculator Excel Spreadsheet Calculate the price of the bonds using present value tables Issue price is calculated as the present value of the face amount plus the present value of the periodic interest payments. Bonds can be issued at: Face amount Below face amount (at a discount) Above face amount (at a premium) One way to determine the issue price of bonds is to use your financial calculator. An alternative to using a financial calculator is to calculate the price of the bonds using present value tables. 9-6

Determine the price of a bond issue (Cont.) Market Interest Rate – true interest rate used by investors to value a company’s bond issue. The higher the market interest rate, the lower will be the bond issue price. Stated Interest Rate – rate quoted in the bond contract used to calculate the cash payments for interest. Periods to Maturity – number of years to maturity multiplied by the number of interest payments per year. Market Interest Rate – represents the true interest rate used by investors to value a company’s bond issue. The higher the market interest rate, the lower will be the bond issue price. Stated Interest Rate – is the rate quoted in the bond contract used to calculate the cash payments for interest. Periods to Maturity – is the number of years to maturity multiplied by the number of interest payments per year. 9-7

Recording Bonds Payable Part C Recording Bonds Payable Part C: Recording Bonds Payable 9-8

LO4 Account for the issuance of bonds On January 1, 2012, RC Enterprises issues $100,000 of 7% bonds, due in 10 years, with interest payable semi-annually on June 30 and December 31 each year. The bonds issue for exactly $100,000, assuming a 7% market interest rate. RC Enterprises records the bond issue as: January 1, 2012 Debit Credit Cash 100,000 Bonds Payable (Issued bonds at face amount) Let’s return to our initial example. On January 1, 2012, RC Enterprises issues $100,000 of 7% bonds, due in 10 years, with interest payable semi-annually on June 30 and December 31 each year. The bonds issue for exactly $100,000, assuming a 7% market interest rate. RC Enterprises reports bonds payable in the long-term liabilities section of the balance sheet. Nine years from now, the firm will reclassify the bonds to the current liabilities section because they will then mature within one year. On June 30, 2012, RC Enterprises records the first semi-annual interest payment. The firm will make this same entry again on December 31, 2012, to record the second semi-annual interest payment. In fact, it will make the same entry at the end of every six-month period for the next 10 years. On June 30, 2012, RC Enterprises records the first semi annual interest payment: June 30, 2012 Debit Credit Interest Expense 3,500 Cash (Record semiannual interest payment) ($100,000 x 7% 3 1/2 = $3,500) 9-9 9

LO5 Record the retirement of bonds When the issuing corporation buys back its bonds from the investors, it is said that the company has retired those bonds. It can wait until the bonds mature to retire them, or in most cases, the issuer will choose to buy the bonds back early BOND RETIREMENTS AT MATURITY Regardless of whether bonds are issued at face amount, a discount, or a premium, their carrying value at maturity will equal their face amount. RC Enterprises records the retirement of its bond at maturity as: When the issuing corporation buys back its bonds from the investors, we say the company has retired those bonds. The corporation can wait until the bonds mature to retire them, or frequently, for reasons we describe below, the issuer will choose to buy the bonds back early. BOND RETIREMENTS AT MATURITY Regardless of whether bonds are issued at face amount, a discount, or a premium, their carrying value at maturity will equal their face amount. The entry to record the retirement of bonds at maturity is provided. December 31, 2021 Debit Credit Bonds Payable 100,000 Cash (Retire bonds at maturity) 9-10 10

Bond Retirements Before Maturity When the issuer retires debt of any type before its scheduled maturity date, the transaction is called an early extinguishment of debt. When interest rates go down, bond prices go up. If the market rate drops to 6%, it will now cost $106,877 to retire the bonds on December 31, 2012. The bonds have a carrying value on December 31, 2012, of $93,670, but it will cost the issuing company $106,877 to retire them. RC Enterprises will record the retirement before maturity as follows: When interest rates go down, bond prices go up. If the market rate drops to 6%, it will now cost $106,877 to retire the bonds on December 31, 2012. The bonds have a carrying value on December 31, 2012, of only $93,670, but it will cost the issuing company $106,877 to retire them. RC Enterprises will record a loss for the difference. December 31, 2012 Debit Credit Bonds Payable (account balance) 93,670   Loss (difference) 13,207 Cash (amount paid) 106,877 (Retire bonds before maturity) 9-11

Other Long-Term Liabilities Part D Other Long-Term Liabilities Part D: Other Long-Term Liabilities and Debt Analysis Companies report many long-term liabilities other than bonds payable. In this section, we briefly discuss three of them: long-term notes payable, leases, and deferred taxes. 9-12

LO6 Identify other major long-term liabilities Common long-term liabilities other than bonds payable are: Installment notes Leases Companies report many long-term liabilities other than bonds payable. In this section, we briefly discuss two of them: installment notes and leases. 9-13

LO7 Make financial decisions using long-term liability ratios Debt Analysis Business decisions include risk. Failure to properly consider risk in those decisions is one of the most costly, yet most common, mistakes investors and creditors make. Long-term debt is one of the first places decision makers should look when trying to manage risk. To measure a company’s risk, we calculate the debt to equity ratio and the times interest earned ratio. Business decisions include risk. Failure to properly consider risk in those decisions is one of the most costly, yet most common, mistakes investors and creditors make. Long-term debt is one of the first places decision makers should look when trying to get a handle on risk. To measure a company’s risk, we calculate the debt to equity ratio and the times interest earned ratio. 9-14

End of chapter 09 9-15