Chapter 15 Long-Term Liabilities Prepared by: Debbie Musil Kwantlen University College

Agenda Learning goals Vocabulary Lesson

Learning goals Compare the impact of issuing debt instead of equity Account for bonds payable Account for long-term notes payable Account for lease Explain and illustrate the methods for the presentation and analysis of long-term liabilities

Vocabulary Effective-interest method of amortization Bearer bonds Mortgage note payable Bond Off-balance sheet financing Face value Bond certificate Financial leverage Operating lease Capital lease Fixed interest rate Premium Contractual interest rate Floating interest rate Present value Convertible bonds Interest coverage ratio Redeemable bonds Debenture bonds Registered bonds Lessee Debt to total assets Retractable bonds Lessor Discount (on bonds payable) Secured bonds Market interest rate Serial bonds EBIT Maturity date Term bonds Unsecured bonds

Long-Term Liabilities Long- term liability: No likely to be paid within a year Can not be paid for existing current assets Long-term liability is also known as financial liability, because there is a contract between two or more parties to pay cash in the future Long-term debt such as bonds, help to finance large deals like corporate buyout and major projects As we have learned in ch 13 companies can issue shares that this is known as equity capital or they can issue bonds and that is know as debt capital

Long-Term Liabilities Advantages of debt over equity Shareholder control is not affected: debt holder do not have voting rights so shareholder can still keep control of the company Income tax saving results: Interest expense is deductible for income tax purposes, dividends are not Earnings per share may be higher: because no additional common share issued. Return on equity may be higher:

Why not only issue debt capital? HIGH RISK Debt must be repaid If the corporation fails to repay the debt or pay interest the creditors can force the company into liquidation With shares the company doesn’t have to pay dividends. If they fail to pay dividends the shareholder cannot force the company into liquidation

Long-Term Liabilities “Using other people’s money to make money” Financial leverage: borrowing at one rate and investing at a different rate. Rate of borrowing should be lower than rate of investing.

Long-Term Liabilities Bond: represent a promise to repay a principal amount at a specific maturity date Common types: Bonds payable Face value: principal amount due at maturity Contractual interest rate (coupon rate): rate used to calculate amount of interest on bond Usually an annual rate but paid semi-annually Maturity date: date when final payment is due All of this information is included in bond certificate Notes payable Capital leases

Bonds Payable Bonds are traded on the stock exchange just like shares Bond holders can sell the bond, at market price, at any time and receive cash for it Issuer Coupon Maturity Date Price Yield Bell CDA 6.100 2035-Mar-16 103.20 5.87 Bond prices are usually quoted in demonization of 1000. Meaning this price is 103.20%*1000 = $1032

Determining the Market Value of Bonds Market value (present value) depends on three factors: Dollar amounts to be received Length of time (n) until the amounts are received Market (effective) rate of interest (i), which investors demand for loaning funds to the corporation Present value tables or formulas are used to determine present value

Determining the Market Value of Bonds January 1, 2008, Candlestick issued $1million of 5% bonds due in five years, with interest payable semi-annually. The purchaser of the bonds would receive two cash inflows: (1) the principal of $1million to be paid at maturity and (2) ten $25,000 interest payment ($1,000,000*5%*6/12)

Determining the Market Value of Bonds 2 Market value of a bond = the present value of all future cash payments promised by the bond: Periodic interest payments Repayment of principal when bond matures Where n = number of interest periods I = interest rate Use table 1 on page 786 for PV of principal payment Use table 2 on page 786 for PV of interest payments

Determining the Market Value of Bonds 3 Bonds may be issued at face value, a discount (< face value), or a premium (> face value) Due to contractual rate being higher or lower than market interest rate: Discount Premium Face Value 6% 4% 5% Bond Contractual Interest Rate 5% Issued when Market Interest Rate Bonds Sell at

Types of Bonds Secured versus unsecured (debentures) Specific assets are pledged as collateral for the bond versus no specific collateral Term versus serial Mature on a single date versus in instalments Registered versus bearer (or coupon) Registered: Issued with the name of the owner, interest payments on registered bonds are made by cheque or direct deposit to registered bondholders Bearer: doesn’t have the name of the owner and the holder of the bond must send in coupons to receive interest payments

Types of Bonds Convertible Redeemable versus retractable Can be converted into shares by bondholder Can receive interest until the bond is converted Redeemable versus retractable Redeemable: just like shares can be bought back by the issuer at a stated dollar amount before they mature Retractable: just like share can be sold back by the buyer to the issuers at a stated dollar amount before they mature

Issuing Bonds at Face Value If market interest rate = contractual rate, bonds are issued at face value: Semi-annual interest payments ($1,000,000 x 5% x 6/12 = $25,000) are recorded as follows Bonds payable are reported as a long-term liability if maturity date is more than one year away

Issuing Bonds at a Discount If market interest rate > contractual rate, bonds are issued at a discount Selling price is determined as follows: Difference between selling price and face value of bonds is the amount of the discount = $1,000,000 face value - $957,345 selling price = $42,655 discount

Issuing Bonds at a Discount 2 Entry to record bonds issued at a discount: Discount on Bonds Payable is a contra liability account Deducted from face value of bonds payable on balance sheet An additional cost of borrowing that must be recognized Allocated to interest expense (amortized 15A) over the term of the bond, using the effective interest method:

Issuing Bonds at a Premium If market interest rate < contractual rate, bonds are issued at a premium Selling price is determined as follows: Difference between selling price and face value of bonds is the amount of the premium = $1,044,915 selling price - $1,000,000 face value = $44,915 premium

Issuing Bonds at a Premium 2 Entry to record bonds issued at a premium: Premium on Bonds Payable is added to the face value of bonds payable reported on balance sheet A reduction in the cost of borrowing that is recognized Allocated to interest expense (amortized) over the term of the bond, using the effective interest method:

Bond Retirements: Redeeming Bonds at Maturity A bond may be retired: Maturity When it is bought back by the issuer Carrying value of bonds at maturity will equal their face value Regardless of the issue price of bonds Entry to record redemption of bonds at maturity: After last interest payment has been recorded

Bond Retirements: Redeeming Bonds before Maturity Why would a company want to have the option to retire its bond early? Interest rate drop, so it can purchase it and reissue a new with lower rate Company has the financial ability to pay it back To entice investors to sell the bonds the issue pays a few % above the market price.

Bond Retirements: Redeeming Bonds before Maturity To record redemption of bonds: Update any unrecorded interest If redeemed between semi-annual interest payment dates Eliminate carrying value of bonds at redemption date = face value of bonds - (+) unamortized discount (premium) Record cash paid Recognize gain or loss on redemption Gain (loss) if cash paid < (>) carrying value of bonds

Bond Retirements: Redeeming Bonds before Maturity Assume that Candlestick sells its bonds at a premium as described in the last section. It retires its bonds at 103 at the end of the fourth year (8 periods) after paying the semi-annual interest. Assume also that the carrying value of the bonds at the redemption date is $1,009,709. That is, the face value of the bands is $1,000,000 and the unamortized premium is $9,709.

Bond Retirements: Redeeming Bonds before Maturity When you sell assets, you gain when the cash received is greater than the carrying value. When you retire a liability, you gain when the cash paid is less than the carrying value

Check for understanding On January 1, 2015, R&B Inc, issues $500,000 of 10 year, 4% bonds at 92.2. Interest is paid semi-annually on January 1 and July 1. On July 1, 2009, the company records the semi-annual interest and amortization(the semi-annual amortization amount for this period is $1,859. On this same date, the company redeems the bond at 99. The carrying value of the bond is $476,214 on this date. Prepare the entry to record (a) the issue of the bonds on January 1, 2005 (b) the payment of interest and amortization of any bond discount or premium on July 1, 2009. and (c) the redemption of the bond on July 1, 2009 (p 771)

Practice questions Self study questions: 1-5 Questions 2, 3, 7 BE 15-1  6 E 15-15

Long-term Notes Payable Similar to short-term notes payable except term exceeds one year Interest rate can be fixed or variable (floating) over the term of the note May be unsecured or secured by specific assets (collateral) Secured notes are commonly known as mortgages

Long-term Notes Payable Each payment on a note payable consists of Part payment of interest Part is put towards repaying the principle of the loan The payment could be either Fixed principal payments plus interest, or Blended principal and interest payments

Notes Payable: Fixed Principal Payments Periodic payments vary due to change in interest owed: Principal is repaid in equal periodic amounts Interest is calculated on the outstanding principal balance January 1, 2008, Belanger Ltee issues a $120,000 5-year, 7% note payable to finance a new research laboratory.

Notes Payable: Fixed Principal Payments The terms of the note provide for equal monthly instalment payments of $2,000 (120,000/60 monthly periods) on the firs of each month, plus interest of 7% on the outstanding principal balance by the interest rate

Notes Payable: Fixed Principal Payments

Notes Payable: Blended Payments Equal periodic payments that include principal and interest: Amount of interest and principal changes with each payment Interest decreases and principal increases each period To illustrate assume that instead of fixed principal payment, Belanger Ltee repays its $120,000 notes payable in blended payment of $2,376 each month.

Notes Payable: Blended Payments

Check for understanding On December 31, 2007, Tian Inc, issued a $500,000 , 15-year 8% mortgage note payable. The terms provide for semi-annual blended payment of $28,915, on June 30 and December 31. (a) Prepare instalment payment schedule for the first two years of the note (b) Prepare the journal entries required to record the issue of the note on December 31, 2007, and the first two instalment payment (c) Show the presentation of the liability on the balance sheet at December 31, 2008 (p 775)

Practice questions Self study questions: 6 + 7 Questions 11+12 BE 15-79 E 15-68

Lease Liabilities Lease: contractual arrangement between two parties: Lessor: owner of the asset Lessee: allowed to use the asset in return for a series of periodic payments Advantages of leasing: Reduced risk of obsolescence (asset becomes out of date before it wears out) 100-percent financing: do not need to borrow large sum of money to buy the asset Income tax advantages: can deduct the whole amount of lease payment which is larger than amortization expense Two types of leases: operating and capital

Lease Liabilities: Operating Leases Characteristics: Lessee has temporary use of asset only Lessor continues to own asset The lease payment are recorded as an expense by the lessee. Western Inc. leases a car from Hertz Car Rental at the airport on July 17. Hertz charges a total of $275.

Lease Liabilities: Operating Leases Operating lease that cover a long period of time are sometimes seen as: Known as off-balance sheet financing (operating lease) But detailed disclosure in notes to financial statements is required

Lease Liabilities: Capital Leases Benefits and risks of ownership are transferred from lessor to lessee One of the following conditions must be met: Ownership of property is transferred to lessee at the end of the term Lessee has the option to purchase the item during the term Lease term is ≥ 75% of economic life of leased property Present value of lease payments ≥ 90% of fair market value of leased property Leased asset is recorded as an asset; lease obligation is recorded as a liability

Lease Liabilities: Capital Leases Fortune Ltd. Decides to lease new equipment on November 27. The lease period is four years and the economic life of the leased equipment is estimated to five years. The present value of the lease payment is $190,000 and the fair market value of the equipment is $200,000. There is no transfer of ownership during the lease term Condition 3 + 4 have been meet for capital lease.

Check for understanding The Alert Company has the following two leasing options to acquire a new machine: (778-9) Lease Option 1 Lease Option 2 Transfer of ownership No Bargain purchase option Lease term 4 years 3 years Estimated useful life 5 years Fair market value $20,000 Present value $15,000

Statement Presentation Long-term liabilities are reported in a separate section of the balance sheet, immediately after current liabilities

Analysis: Debt to Total Assets Measures the percentage of total assets financed by creditors (not shareholders) Higher the percentage, greater the risk of company defaulting on its obligations Debt to Total Assets ÷ = Total Liabilities Total Assets

Analysis: Return on Equity Also called return on investment Considered to be the most important measure of a firm’s profitability It evaluates how many dollars are earned for each dollar invested by shareholders Average Shareholders’ Equity ÷ = Net income Return on Equity

Analysis: Interest Coverage Interest coverage ratio indicates company’s ability to meet interest payments as they come due Uses EBIT: Earnings before interest and tax = Net income + interest expense + income tax expense ÷ = EBIT Interest Expense Interest Coverage

Practice questions Self-study questions: 8+9 Questions: 16+17 BE 15-1013 E 15-9,10,12