Long-Term Debt Financing Long-Term Debt Financing C H A P T E R 10

Learning Objective 1 Use present value concepts to measure long-term liabilities.

Define Long-Term Liabilities 4 Notes payable 4 Bonds payable 4 Mortgages payable 4 Lease payments 4 Pension obligations Debts and other obligations that will not be paid in cash or satisfied with other assets or services within one year.

Accounting for Long-Term Liabilities Measurement and recording of long-term liabilities are based on the time value of money concept. If money can earn 10% per year, $100 to be received 1 year from now is approximately equal to $90.91 received today. Present value of $1 is the value today of $1 to be received or paid in the future, given a specific interest rate.

Present and Future Value Tables Present Value Table l Locate the number of periods in the left column and the interest rate in the row at the top of the table. l This intersection is the factor representing the present value of $1. l Discounting—present value amount is the amount that could be paid today to satisfy the obligation. Future Value Table l Locate the number of periods in the left column and the interest rate in the row at the top of the table. l This intersection is the factor representing the future value of $1. l Compounding—the frequency with which interest is added to the principal.

Present value of $100 paid in 5 years discounted at 10 percent. PV = $62.09 Today1234Future$100 Discount at 10% Present Value

Future value of $100 today compounded for 5 years at 10 percent. FV = $ Today1234Future$100 Future Value Compound at 10%

Value Table — Future Value Joan invested $2,000 for 3 years at 12 percent, compounded annually. Using the table below, what is the future value of the $2,000? Periods 6% 8% 10% 12% Future value = Amount x FV Factor Future value = $2,000 x Future value = $2,809.80

Joan invested $2,000 for 3 years at 12 percent, compounded semiannually. Using the table below, what is the future value of the $2,000? Periods 6% 8% 10% 12% Value Table — Future Value Future value = Amount x FV Factor Future value = $2,000 x Future value = $2,837

Computing the Interest Rate Provide the Appropriate Formula. Yearly interest rate Compounding periods per year Interest rate per compounding period = Number of interest periods = Compounding periods per year Number of years x

Define Annuities Annuity A series of equal amounts to be received or paid at the end of equal time intervals. Present Value of an Annuity The value today of a series of equally spaced, equal-amount payments to be made or received in the future given a specified interest rate.

Value Tables — Annuity Joan is paid $8,000 a year for 8 years at 10 percent interest per year. Using the table below, what is the present value of the annuity? Periods 6% 8% 10% 12% Present value = Amount x PV Factor Present value = $8,000 x Present value = $42,679.20

Learning Objective 2 Account for long-term liabilities, including notes payable and mortgages payable.

Time Line of Business Issues ChooseIssue Pay AmortizeRetire Note Payable Mortgage Payable Bond +–

Jan. 1Cash ,000 Note Payable ,000 Borrowed $20,000 for 3 years at 12%. Example: Interest-Bearing Notes Dec. 31Interest Expense.... 2,400 Cash ,400 Made interest payment ($20,000 x 0.12). On January 1, 2003, Silver Eagle Co. borrowed $20,000 for 3 years at 12 percent interest. The interest is payable on December 31 of each year. What entries are necessary for 2003?

Example: Interest-Bearing Notes Dec. 31Interest Expense ,400 Note Payable ,000 Cash ,400 Interest payment and repayment of loan. What entry is needed when Silver Eagle Co. repays the loan on December 31, 2002?

What is a Mortgage Payable? © A written promise to pay a stated amount of money at one or more specified future dates. © Secured by the pledging of certain assets, usually real estate, as collateral. © Generally requires periodic (usually monthly) payments of principal plus interest.

Jan. 1Cash ,000 Mortgage Payable..500,000 Borrowed $500,000 to purchase building. Example: Mortgages Payable Jan. 31Mortgage Payable Interest Expense , Cash , Made first month’s mortgage payment. On January 1, 2003, Blue Bird Corp. borrowed $500,000 to acquire a new building. The building was signed as collateral for the 30-year, 7 percent loan. Payments of $3, are to be made monthly. What are the January 2003 entries?

A mortgage amortization schedule shows the breakdown between interest and principal for each payment over the life of a mortgage. Monthly Principal Interest Mortgage Month Payment Paid Paid Balance 1 3, , , , , , , , , , , , , , , , , , Mortgages Payable

Learning Objective 3 Account for capital lease obligations and understand the significance of operating leases being excluded from the balance sheet.

Lease Obligations Match the Following Terms The party that is granted the right to use property under the terms of a lease The owner of property that is rented (leased) to another party. 3.A simple short-term rental agreement A leasing transaction that is recorded as a purchase by the lessee. 5.A contract that specifies the terms under which the owner of an asset agrees to transfer the right to use the asset to another party. Lessor Operating Lease Lease Lessee Capital Lease

Classifying Leases If the lease is cancelable or does not meet any of the four requirements, is it an operating lease? Yes No Transfer of Ownership? Bargain Purchase Option? Term  75% of Useful Life? PV Payment  90% of FMV? Capital Lease Operating Lease YE S

Example: Lease Obligations Jan. 1Leased Computer ,838 Lease Liability ,838 Leased a computer for company use. On January 1, 2003, The Cockatoo Company leased a computer. The lease requires annual payments of $5,000 for 8 years. The applicable interest rate is 12 percent. How is the lease recorded? What is the December 31, 2003 entry for interest expense? Dec. 31Lease Liability ,019 Interest Expense ,981 Cash ,000 Paid annual lease payment for computer.

Learning Objective 4 Account for bonds, including the original issuance, the payment of interest, and the retirement of bonds.

Bond A contract between a borrower (issuer) and a lender (investor). The borrower promises to pay a specified amount of interest for each period the bond is outstanding and to repay the principal at the maturity date. Unsecured Bonds (Debentures) Bonds for which no collateral has been pledged. Secured Bonds Bonds for which assets have been pledged in order to guarantee repayment. Coupon (Bearer) Bonds Unregistered bonds for which owners receive periodic interest payments by clipping a coupon from the bond and sending it to the issuer as evidence of ownership. Define These Types of Bonds

1.Bonds that mature in one lump sum on a specified future date. 2.Bonds that mature in a series of installments at specified future dates. 3.Bonds for which the issuer reserves the right to pay the obligation before its maturity date. 4.Bonds that can be traded for, or converted to, other securities after a specified period of time. 5.The names and addresses of the bondholders are kept on file by the issuing company. Types of Bonds Matching Serial Bonds Convertible Bonds Term Bonds Callable Bonds Registered Bonds

Zero-Coupon Bonds Bonds issued with no promise of interest payments; only a lump sum payment will be made. Junk Bonds Bonds issued by companies in weak financial condition with large amounts of debt already outstanding; these bonds yield high rates of return because of high risk. Types of Bonds

A contract between a bond issuer and a bond purchaser that specifies the terms of a bond. The amount that will be paid on a bond at the maturity date. The date at which a bond principal or face amount becomes payable. Characteristics of Bonds Match Correctly. Principal (face value or market value) Bond Indenture Bond Maturity Date A contract between a bond issuer and a bond purchaser that specifies the terms of a bond. The amount that will be paid on a bond at the maturity date. The date at which a bond principal or face amount becomes payable.

Price should equal: present value of the interest payments + present value of the bond’s lump-sum face value at maturity Market rate (effective rate or yield rate) of interest The interest rate investors expect to earn on their investment. Stated rate of interest The rate of interest printed on the bond. Determining Issuance Price

Correctly Define Each Term. Face Value The amount that will be paid on a bond at the maturity date. Bond Discount The difference between the face value and the sales price when bonds are sold below their face value. Bond Premium The difference between the face value and the sales price when bonds are sold above their face value.

Bond Stated Interest Rate 10% Market RateBond Sold at Characteristics of Bonds 8%Premium10%Face Value 12%Discount

Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective and stated rates are equal. Calculate the issue price. Example: Bond Issued at Face Value 1.Semiannual interest payments$ 25,000 Present value of interest annuity$193,043 2.Maturity value of bonds$500,000 Present value of bonds 306,957 3.Issuance price of bonds$500,000

Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 12 percent. Calculate the issue price of the bonds. Example: Bond Issued at a Discount 1.Semiannual interest payments$ 25,000 Present value of interest annuity$184,002 2.Maturity value of bonds$500,000 Present value of bonds 279,197 3.Issuance price of bonds$463,199

Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 8 percent. Calculate the issue price of the bonds. Example: Bond Issued at a Premium 1.Semiannual interest payments$ 25,000 Present value of interest annuity$202,772 2.Maturity value of bonds$500,000 Present value of bonds 337,782 3.Issuance price of bonds$540,554

Example: Accounting for Bonds Payable Jan. 1Cash ,000 Bonds Payable ,000 Issued $500,000, 10%, 5-year bonds. On January 1, 2003, Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 10 percent. What entry is needed to record the liability?

Example: Accounting for Bonds Payable Jun. 30Bond Interest Expense..25,000 Cash ,000 Paid interest ($500,000 x 0.10 x 0.5). On January 1, 2003, Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 10 percent. What entry is needed to record the first interest payment?

Example: Bond Retirements at Maturity Jan. 1Bond Interest Expense ,000 Bonds Payable ,000 Cash ,000 Retired 5-year, $500,000, 10% bonds; paid interest ($500,000 x 0.10 x 0.5). On January 1, 2003, Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 10 percent. What entry is needed to record the retirement of the bond on January 1, 2008?

Example: Bond Retirements Before Maturity Jan. 1Bonds Payable ,000 Loss on Bond Retirement.20,000 Cash (200,000 x 1.10). 220,000 Retired a callable bond at 110. The Great Owl Company issued $200,000, 14 percent bonds, which are now selling for 107 and are callable at 110. The bonds were issued at face value. If the company decides to call the bonds, what entry is needed?

Learning Objective 5 Use debt-related ratios to determine the degree of a company’s financial leverage and its ability to repay loans

Debt Ratio Measures the amount of assets supplied by lenders. Total Liabilities Total Assets

Debt-to-Equity Ratio Measures the balance of funds being provided by creditors and stockholders Total Liabilities Total stockholders’ equity

Times Interest Earned Ratio The ratio of income that is available for interest payments to the annual interest expense. Income before interest and taxes (operating profit) Annual interest expense

Expanded Material Learning Objective 6 Amortize bond discounts and bond premiums using either the straight-line method or the effective-interest method.

Define the Two Bond Premium/Discount Amortization Methods Straight-line Method A method of systematically writing off a bond premium or discount, resulting in equal amounts being amortized each period. Effective-interest Method A method of systematically writing off a bond premium or discount, taking into consideration the time value of money. GAAP prefers the effective- interest method. Which method is preferred by GAAP?

On January 1, 2003, The Ostrich Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. The company received $196,000 for the bonds. Make the entry to record the issuance of the bonds. Example: Bond Issued at a Discount Jan. 1Cash ,000 Discount on Bonds ,000 Bonds Payable ,000 Issued $200,000 at a discount.

On January 1, 2003, The Ostrich Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. Using straight-line amortization, what entry is made for the interest payment on June 30, 2003? Example: Bond Issued at a Discount Jun. 30Bond Interest Expense...10,200 Discount on Bonds Cash ,000 Paid interest ($200,000 x 0.10 x 0.5).

On January 1, 2003, The Ostrich Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. Using straight-line amortization, what adjusting entry is needed on December 31, 2003? Example: Bond Issued at a Discount Dec. 31Bond Interest Expense...10,200 Discount on Bonds Bond Interest Payable. 10,000 To recognize interest expense for 6 months.

On January 1, 2003, The Ostrich Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. What entry is necessary to retire the debt after 10 years? Example: Bond Issued at a Discount Jan. 1Bonds Payable ,000 Cash ,000 Retired a $200,000, 10-year, 10% bond.

Example: Bond Issued at a Premium Jan. 1Cash ,000 Premium on Bonds... 10,000 Bonds Payable ,000 Issued $200,000 at a premium. On January 1, 2003, The Parrot Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. The company received $210,000 for the bonds. Make the entry to record the issuance of the bonds.

Example: Bond Issued at a Premium Jun. 30Bond Interest Expense...9,500 Premium on Bonds Cash ,000 Paid interest ($200,000 x 0.10 x 0.5). On January 1, 2003, The Parrot Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. The company received $210,000 for the bonds. Using straight- line amortization, what entry is made for the interest payment on June 30, 2003?

Example: Bond Issued at a Premium Dec. 31Bond Interest Expense....9,500 Premium on Bonds Bond Interest Expense.10,000 To recognize interest expense for 6 months. On January 1, 2000, The Parrot Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. The company received $210,000 for the bonds. Using straight-line amortization, what entry is needed on December 31, 2000?

Example: Bond Issued at a Premium Jan. 1Bonds Payable ,000 Cash ,000 Retired a $200,000, 10-year, 10% bond. On January 1, 2003, The Parrot Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. The company received $210,000 for the bonds. What entry is necessary to retire the debt after 10 years?

Example: Effective-Interest Method The Woodpecker Company issued a $1,000, 8 percent bond. The market rate was 7 percent at the time of issuance. Create an effective- interest table. A B C D E (A-B) (D-C)(1,000+D) (1,000 x 0.04) (E x 0.035) Premium Amortization #Payment Interest Expense Unamortized Premium Bond Book $71.00$1, $40.00$37.49$ , , ,063.20