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 Learning objectives 1. Basics of Bond 2. Bond Issuance 3. Bond Retirement 4. Long-term Note payable 5. Decision Analysis: Pledged assets to secured liability ratio

McGraw-Hill/Irwin 14-3 © The McGraw-Hill Companies, Inc., 2005 Bonds do not affect stockholder control. Interest on bonds is tax deductible. Bonds can increase return on equity. 1.Basics of Bond - 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 14-4 © 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 Return on equity10%15%17.5% Equity1,000,0001,500,0001,000,000 Debt00500,000 Invest 500,000 in a new project that can yield $125,000 income. Financing by equity or bond? (Bond interest rate 10%) 1.Basics of Bond - Advantages of Bonds

McGraw-Hill/Irwin 14-5 © 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. 1. Basics of Bond - Disadvantages of Bonds

McGraw-Hill/Irwin 14-6 © The McGraw-Hill Companies, Inc., 2005 Secured and Unsecured Term and Serial Registered and Bearer Convertible and Callable 1. Basics of Bond - Types of Bonds

McGraw-Hill/Irwin 14-7 © The McGraw-Hill Companies, Inc., Basics of Bond - 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 14-8 © The McGraw-Hill Companies, Inc., 2005 Bond market values are expressed as a percent of their par value. 1. Basics of Bond - Bond Trading

McGraw-Hill/Irwin 14-9 © The McGraw-Hill Companies, Inc., 2005 Bond Certificate at Par Value Bond Certificate at Par Value Bond Issue Date Bond Selling Price CorporationInvestors 1. Basics of Bond - Money Flow

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Bond Issue Date Bond Par Value at Maturity Date Bond Maturity Date CorporationInvestors 1. Basics of Bond - Money Flow

McGraw-Hill/Irwin © 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 1. Basics of Bond - Money Flow

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., an investment firm called an underwriter. The underwriter sells the bonds to... A company sells the bonds to investors. 2. Bond Issuance - 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) 2. Bond Issuance - 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., Bond Issuance - 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  % 2. Bond Issuance - 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 Both methods report the same amount of interest expense over the life of the bond. Straight-Line and Effective Interest Methods

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) 2. Bond Issuance - 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 2. Bond Issuance - 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 2. Bond Issuance - Accruing Bond Interest Expense

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Calculate the issue price of Rose Inc.’s bonds. Par Value = $1,000,000 Issue Price = ? 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) Calculate the issue price of Rose Inc.’s bonds. Par Value = $1,000,000 Issue Price = ? 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) 2. Bond Issuance - Present Value of a Discount Bond

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Present Value of a Discount Bond 1. Semiannual rate = 6% (Market rate 12% ÷ 2) 2. Semiannual periods = 10 (Bond life 5 years × 2) 1. Semiannual rate = 6% (Market rate 12% ÷ 2) 2. Semiannual periods = 10 (Bond life 5 years × 2) $1,000,000 × 10% × ½ = $50,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Present Value of a Discount Bond

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Present Value of a Discount Bond

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005  At Maturity  Before Maturity Carrying Value > Retirement Price = Gain Carrying Value < Retirement Price = Loss 3. 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? 4. Long-Term Notes Payable

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Note Maturity Date CompanyLender Note Date 4. Long-Term Notes Payable - Single payment Single Payment of Principal plus Interest

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Note Maturity Date CompanyLender Note Date 4. Long-Term Notes Payable - Installment Note 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. 4. Long-Term Notes Payable - 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. 5. Decision Analysis - Pledged Assets to Secured Liabilities

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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Investments and International Operations Chapter 15

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Learning objectives 1. Basics of Investments 2. Basic of Accounting for Investments 3. Accounting for AFS & Trading securities 4. Accounting for Influential Investments 5. Accounting Summary for security Investments 6. International Operation 7. Decision Analysis: Component of ROA

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Basics of Investments 1.Companies transfer excess cash into investments to produce higher income. 2.Some companies are setup to produce income from investments. 3.Companies make investments for strategic reasons. Motivation for Investments

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Basics of Investments Short-Term versus Long-Term Investments Short-term investments: are securities that management intends to convert to cash with one year or the operating cycle, whichever is longer. are readily convertible to cash. Short-term investments: are securities that management intends to convert to cash with one year or the operating cycle, whichever is longer. are readily convertible to cash. Long-term investments: are not readily convertible to cash. are not intended to be converted to cash. are reported in the noncurrent section of the balance sheet, often in its own category. Long-term investments: are not readily convertible to cash. are not intended to be converted to cash. are reported in the noncurrent section of the balance sheet, often in its own category.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Basics of Investments - Classes of and Reporting for Investments Held-To- Maturity Available- For-Sale Significant Influence Controlling Influence Consolidate Equity Method Market Value Method Trading Amortized Cost Class of Investment Reporting

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Accounting Treatment for Investments in Securities

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Basics of Accounting for Investments - Debt Securities Accounting Basics for Debt Securities Debt securities are recorded at cost when purchased. Interest revenue for investments in debt securities is recorded when earned. On January 1, 2005, Matrix, Inc. purchased $1,000,000 in bonds of Debt, Inc. Matrix paid $975,000 for the bonds and $25,000 in brokerage fees. The two-year bonds have a stated rate of 6% annually. Interest is paid semi-annually on June 30 and December 31.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Debt Security Purchase Accounting Basics for Debt Securities Held-to-maturity (HTM) debt securities are recorded at cost when purchased. Interest revenue for investments in debt securities is recorded when earned.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Debt Security Interest Accounting Basics for Debt Securities Debt securities are recorded at cost when purchased. Interest revenue for investments in debt securities is recorded when earned. The same entry would be made on December 31, 2005.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Debt Security Matured Accounting Basics for Debt Securities On January 1, 2007, the bonds mature and Matrix would make the following entry:

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Basics of Accounting for Investments - Equity Securities Equity securities are recorded at cost when acquired, including commissions or brokerage fees paid. Any cash dividends received are credited to Dividend Revenue and reported in the income statement. When the securities are sold, sales proceeds are compared with cost, and any gain or loss is recorded.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Equity Security Purchase On May 6, 2005, Matrix, Inc. purchased 10,000 shares of Apex, Inc. common stock for $250,000 in the open market. The securities are classified by manager of Matrix as “available-for-sale” (AFS).

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Equity Security Dividend On June 30, Apex pays a quarterly dividend to Matrix, Inc. of $0.50 per share. Matrix receives a dividend check for $5,000.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Equity Security Sales On December 18, Matrix, Inc. sells 1,000 shares of Apex, Inc. in the open market for $30 per share. $250,000 ÷ 10,000 shares = $25 per share cost

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005  Recorded at cost at acquisition  Interest revenue recorded as accrued (debt securities)  Dividends recorded as revenue (equity securities)  Carrying amount is adjusted to Market Value each period.  Recorded at cost at acquisition  Interest revenue recorded as accrued (debt securities)  Dividends recorded as revenue (equity securities)  Carrying amount is adjusted to Market Value each period. 3. Accounting for Available-for-Sale Securities Debt and equity securities that a company intends to sell in the future, before maturity.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Matrix, Inc. purchased 1,000 shares of Apex, Inc. at $5 per share during At December 31, 2005, the shares had increased in value to $9.50 per share. 3. Accounting for AFS Securities - Valuing and Reporting AFS Securities

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 { In some cases, influence or control may exist with less than 20% ownership. Investor Ownership of Investee Shares Outstanding 0%20%50%100% Cost or Market Value Method Equity Method Consolidated Financial Statements 4. Accounting for Influential Investments

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 { Significant influence is generally assumed with 20% to 50% ownership. Investor Ownership of Investee Shares Outstanding 0%20%50%100% Equity Method Consolidated Financial Statements 4. Accounting for Influential Investments Cost or Market Value Method

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005  Original investment is recorded at cost.  The investment account is increased by a proportionate share of investee’s earnings.  The investment account is decreased by dividends received.  Original investment is recorded at cost.  The investment account is increased by a proportionate share of investee’s earnings.  The investment account is decreased by dividends received. 4. Accounting for Influential Investments - Equity Securities with Significant Influence

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Investment in Equity Securities with Significant Influence On January 1, 2005, Matrix, Inc. buys 20% of the voting common stock of Apex, Inc. for $2,000,000 cash. 2,000,000 Long-Term Investment - Apex 2,000,000 Cash

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Investment in Equity Securities with Significant Influence On December 31, 2005, Apex reports net income for the year of $300,000, and pays total cash dividends of $50,000. $300,000 × 20% = $60,000 $50,000 × 20% = $10,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Investment in Equity Securities with Significant Influence Investment Earnings Dividends Balance

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Accounting for Influential Investments - Equity Securities with Controlling Influence oRequired when investor’s ownership exceeds 50% of investee. oEquity Method is used. oConsolidated financial statements show the financial position, results of operations, and cash flows of all entities under the parent’s control.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Accounting Summary for Investments in Securities

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 Comprehensive Income Includes: 1)Revenues, gains, expenses, and losses reported on the income statement, and 2)Gains and losses that bypass net income but affect equity. Includes: 1)Revenues, gains, expenses, and losses reported on the income statement, and 2)Gains and losses that bypass net income but affect equity. Accumulated Other Comprehensive Income appears in the equity section of the balance sheet.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Investments in International Operations (1) Accounting for sales and purchases listed in a foreign currency. (2) Preparing consolidated financial statements with international subsidiaries. Two major accounting challenges arise when companies have international operations:

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005  Each country uses its own currency for internal economic transactions.  To make transactions in another country, units of that country’s currency must be acquired.  The cost of those currencies is called the exchange rate.  Each country uses its own currency for internal economic transactions.  To make transactions in another country, units of that country’s currency must be acquired.  The cost of those currencies is called the exchange rate. Investments in International Operations - Exchange Rates Between Currencies

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 As the relative strength of a country’s economy changes the exchange rate of the local currency relative to other currencies also fluctuates. Foreign Exchange Markets

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., Decision Analysis - Components of Return on Total Assets Return on total assets = Profit Margin × Total asset turnover Net income Average total assets =× Net income Net sales Net sales Average total assets

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 End of Chapter 15