McGraw-Hill/Irwin 14-1 © The McGraw-Hill Companies, Inc., 2005 Long-Term Liabilities Chapter 14

McGraw-Hill/Irwin 14-2 © The McGraw-Hill Companies, Inc., 2005 Bonds do not affect stockholder control. Interest on bonds is tax deductible. Bonds can increase return on equity. Advantages of Bonds A bond is its issuer’s written promise to pay an amount identified as the par value of the bond with interest.

McGraw-Hill/Irwin 14-3 © The McGraw-Hill Companies, Inc., 2005 OriginalExpand by equity financing Expand by bond financing Income before interest expense 100,000225,000 Interest expense//(50,000) Net income100,000225,000175,000 Equity1,000,0001,500,0001,000,000 Return on equity10%15%17.5% Invest 500,000 in a new project that can yield $125,000 income. Financing by equity or bond?

McGraw-Hill/Irwin 14-4 © The McGraw-Hill Companies, Inc., 2005 Bonds require payment of both periodic interest and par value at maturity. Bonds can decrease return on equity when the company pays more in interest than it earns on the borrowed funds. Disadvantages of Bonds

McGraw-Hill/Irwin 14-5 © The McGraw-Hill Companies, Inc., 2005 Types of Bonds Secured bonds have specific assets of the issuer pledged (or mortgaged) as collateral. Unsecured bonds (debentures) are backed by the issuer’s general credit standing. Convertible bonds can be exchanged for a fixed number of shares of the issuing corporation’s common stock. Callable bonds have an option exercisable by the issuer to retire them at a stated dollar amount prior to maturity.

McGraw-Hill/Irwin 14-6 © The McGraw-Hill Companies, Inc., 2005 Bond Certificate at Par Value Bond Certificate at Par Value Bond Issue Date Bond Selling Price CorporationInvestors Basics of Bonds

McGraw-Hill/Irwin 14-7 © The McGraw-Hill Companies, Inc., 2005 Bond Issue Date Bond Par Value at Maturity Date Bond Maturity Date CorporationInvestors Basics of Bonds

McGraw-Hill/Irwin 14-8 © The McGraw-Hill Companies, Inc., 2005 Bond Issue Date Bond Interest Payments CorporationInvestors Interest Payment = Bond Par Value  Stated Interest Rate Interest Payment = Bond Par Value  Stated Interest Rate Basics of Bonds

McGraw-Hill/Irwin 14-9 © The McGraw-Hill Companies, Inc., an investment firm called an underwriter. The underwriter sells the bonds to... A company sells the bonds to investors. Bond Issuing Procedures

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., an investment firm called an underwriter. The underwriter sells the bonds to... A trustee monitors the bond issue. A company sells the bonds to investors Bond Issuing Procedures

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 King Co. issues the following bonds on January 1, 2005 Par Value = $1,000,000 Stated Interest Rate = 10% Interest Dates = 6/30 and 12/31 Bond Date = Jan. 1, 2005 Maturity Date = Dec. 31, 2024 (20 years) King Co. issues the following bonds on January 1, 2005 Par Value = $1,000,000 Stated Interest Rate = 10% Interest Dates = 6/30 and 12/31 Bond Date = Jan. 1, 2005 Maturity Date = Dec. 31, 2024 (20 years) Issuing Bonds at Par

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 $1,000,000 × 10% × ½ year = $50,000 $1,000,000 × 10% × ½ year = $50,000 This entry is made every six months until the bonds mature. Issuing Bonds at Par The entry on June 30, 2005 to record the first semiannual interest payment is...

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 On Dec. 31, 2024, the bonds mature, King Co. makes the following entry... Issuing Bonds at Par The debt has now been extinguished.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Bond Discount or Premium Prepare the entry for Jan. 1, 2005 to record the following bond issue by Rose Co. Par Value = $1,000,000 Issue Price = % of par value Stated Interest Rate = 10% Market Interest Rate = 12% Interest Dates = 6/30 and 12/31 Bond Date = Jan. 1, 2005 Maturity Date = Dec. 31, 2009 (5 years)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Amortizing the discount increases Interest Expense over the outstanding life of the bond. $1,000,000  % Issuing Bonds at a Discount

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Contra-LiabilityAccountContra-LiabilityAccount On Jan. 1, 2005 Rose Co. would record the bond issue as follows. Issuing Bonds at a Discount

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Maturity Value Carrying Value Issuing Bonds at a Discount Using the straight-line method, the discount amortization will be $7,360 every six months. $73,595 ÷ 10 periods = $7,360* *(rounded) Using the straight-line method, the discount amortization will be $7,360 every six months. $73,595 ÷ 10 periods = $7,360* *(rounded)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 $73,595 ÷ 10 periods = $7,360 (rounded) $1,000,000 × 10% × ½ = $50,000 $73,595 ÷ 10 periods = $7,360 (rounded) $1,000,000 × 10% × ½ = $50,000 Make the following entry every six months to record the cash interest payment and the amortization of the discount. Issuing Bonds at a Discount

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Prepare the entry for Jan. 1, 2005 to record the following bond issue by Rose Co. Par Value = $1,000,000 Issue Price = % of par value Stated Interest Rate = 10% Market Interest Rate = 8% Interest Dates = 6/30 and 12/31 Bond Date = Jan. 1, 2005 Maturity Date = Dec. 31, 2009 (5 years) Issuing Bonds at a Premium

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Amortizing the premium decreases Interest Expense over the life of the bond. $1,000,000  % Issuing Bonds at a Premium

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Adjunct-LiabilityAccountAdjunct-LiabilityAccount On Jan. 1, 2005 Rose Co. would record the bond issue as follows. Issuing Bonds at a Premium

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Using the straight-line method, the premium amortization will be $8,115 every six months. $81,145 ÷ 10 periods = $8,115 (rounded) Using the straight-line method, the premium amortization will be $8,115 every six months. $81,145 ÷ 10 periods = $8,115 (rounded) Issuing Bonds at a Premium

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 $81,145 ÷ 10 periods = $8,115 (rounded) $1,000,000 × 10% × ½ = $50,000 $81,145 ÷ 10 periods = $8,115 (rounded) $1,000,000 × 10% × ½ = $50,000 This entry is made every six months to record the cash interest payment and the amortization of the premium. Issuing Bonds at a Premium

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Accrued interest Investor pays bond purchase price + accrued interest. Jan. 1, 2005 Bond Date Apr. 1, 2005 Bond Issue Date June 30, 2005 First Interest Payment Issuing Bonds Between Interest Dates

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Accrued interest Jan. 1, 2005 Bond Date Apr. 1, 2005 Bond Issue Date June 30, 2005 First Interest Payment Issuing Bonds Between Interest Dates Investor receives 6 months’ interest. Earned interest

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Prepare the entry to record the following bond issue by King Co. on Apr. 1, Par Value = $1,000,000 Stated Interest Rate = 10% Market Interest Rate = 10% Interest Dates = 6/30 and 12/31 Bond Date = Jan. 1, 2005 Maturity Date = Dec. 31, 2009 (5 years) Issuing Bonds Between Interest Dates

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 At the date of issue the following entry is made: Issuing Bonds Between Interest Dates The first interest payment on June 30, 2005 is:

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Jan. 1Apr. 1 Dec. 31 End of accounting period Oct. 1 Interest Payment Dates At year-end, an adjusting entry is necessary to recognize bond interest expense accrued since the most recent interest payment. 3 months’ accrued interest Accruing Bond Interest Expense

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005  At Maturity  Before Maturity Carrying Value > Retirement Price = Gain Carrying Value < Retirement Price = Loss Bond Retirement

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Are you ready to discuss long- term notes payable?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Note Maturity Date Note Payable Cash CompanyLender Note Date When is the repayment of the principal and interest going to be made? Long-Term Notes Payable

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Note Maturity Date CompanyLender Note Date Long-Term Notes Payable Single Payment of Principal plus Interest

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Note Maturity Date CompanyLender Note Date Long-Term Notes Payable Regular Payments of Principal plus Interest Payments can either be equal principal payments or equal payments. Regular Payments of Principal plus Interest

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Installment Notes with Equal Principal Payments The principal payments are $10,000 each year. Interest expense decreases each year. The principal payments are $10,000 each year. Interest expense decreases each year. Annual payments decrease.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Installment Notes with Equal Payments The principal payments increase each year. Interest expense decreases each year. Annual payments are constant.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005  A legal agreement that helps protect the lender if the borrower fails to make the required payments.  Gives the lender the right to be paid out of the cash proceeds from the sale of the borrower’s assets specifically identified in the mortgage contract.  A legal agreement that helps protect the lender if the borrower fails to make the required payments.  Gives the lender the right to be paid out of the cash proceeds from the sale of the borrower’s assets specifically identified in the mortgage contract. Mortgage Notes and Bonds

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Pledged Assets to Secured Liabilities Book Value of Pledged Assets Book Value of Secured Liabilities = This ratio helps creditors determine whether the pledged assets of a debtor provide adequate security for secured debt obligations. Pledged Assets to Secured Liabilities

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Homework for Chapter 14  Ex 14-8,  Problem 14-2A  Due on July 12, 2006 (Wed)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 End of Chapter 14