1. Participation Questions – Chapter 9
The capital structure of an organization is the mixture of debt funding and equity funding. T/F
Ford Automotive uses a higher level of equity funding in comparison to debt funding. T/F
“Coupon Rate” is the same as which of the following on a bond:
Market interest rate
Stated interest rate
The Dow Jones interest rate
LIBOR interest rate
How much did the Hersey bar cost from the 1950’s as shown in the Seinfeld episode?
The cash amount of interest paid to a bond holder is based on which of the following under the effective interest rate method?
Face Value
Carrying Value

2. Announcements Assignments – Due 11/20/16
Chapter 9 Homework (Connect) – unlimited attempts
Participation questions for Chapter 9 (Webcourses) – 1 attempt
Syllabus Quiz #2 (Webcourses) – 2 attempts
Assignments – Due 11/27/16
Chapter 10 Homework (Connect) – unlimited attempts
Participation questions for Chapter 10 (Webcourses) – 1 attempt
Definitions Quiz (Webcourses) – 2 attempts
Assignments – Due 12/4/16
Chapter 11 Homework (Connect) – unlimited attempts
SEC Financial Statement Assignment (Webcourses) – 1 attempt

3. Questions to be Answered
Chapter 9 – How do companies use the different types of long-term financing (bonds, notes, and leases) and what are the impacts to the income statement and balance sheet?

5. Overview of Long Term Debt
Part A
Overview of Long Term Debt
Part A provides an overview of bonds and their basic characteristics.
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6. Accounting Equation Debt funding and equity funding
Mixture of the two is called the capital structure

7. LO1 Explain financing alternatives
Financing Options
Debt Financing - borrowing money (liabilities)
Bonds – most common form of Lg. Corp debt
Notes Payable (typically bank financing)
Leases
Equity Financing - obtaining additional investment from stockholders (stockholders’ equity)
Capital Structure - the careful balance between equity and debt that a business uses to finance its assets, day-to-day operations, and future growth.
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.
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8. Ford Automotive

9. What is a (Bail) bond and how are they issued?
Bond – formal debt instrument that obligates the borrower to repay a stated amount at a specified maturity date.
Investor (Lender) – Lends company $ to receive periodic interest payments over time and a return of original principal at bond maturity.
Company (Borrower) – receives cash in exchange for issuing bond contract to investor

10. FYI - Why Bonds versus Bank Borrowing?
In the world of corporate finance, many chief financial officers (CFOs) view banks as lenders of last resort because of the restrictive debt covenants that banks place on direct corporate loans.
Covenants - rules placed on debt that are designed to stabilize corporate performance and reduce the risk to which a bank is exposed.
Cannot issue any more debt until loan is paid off
Cannot participate in any share offerings until loan is paid off
Cannot acquire any companies until loan is paid off, and so on.
Debt to Equity cannot exceed 3 to 1.
Current assets to current liabilities must exceed a ratio of 1.5.
Some of the more restrictive covenants may state that the interest rate on the debt increases substantially should the (CEO) quit, or should earnings per share drop in a given time period.
Covenants are a way for banks to mitigate the risk of holding debt, but for borrowing companies they are seen as an increased risk. 

11. Bonds
Definition - 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.
Important topics for our class today on bonds:
Bonds terms and characteristics
Bond Issuances (how we account for them)
Pricing Interpretation - Pricing calculations will not be covered, but you will need to be able to interpret the price.
Record bond issuance
Record interest payments
Record repayment of bonds

12. Item #1 - Bond Terms and Characteristics

13. Terms Bond certificate states: Company name (Borrower)
Face Value (Principal amount) – Usually $1,000
Maturity date (Term)
Interest rate (stated or coupon rate)
Interest payment dates (usually twice a year)
Each bond payable is, in effect, a note payable. Bonds payable are debts of the issuing company. Purchasers of bonds receive a bond’s certificate, which carries the issuing company’s name. The certificate also states the principal, which is typically stated in units of $1,000; principal is also called the bond’s face value, maturity value, or par value. The bond obligates the issuing company to pay the debt at a specific future time called the maturity date.
Interest is the rental fee on borrowed money. The bond certificate states the interest rate that the issuer will pay the holder and the dates that the interest payments are due (generally twice a year). Issuing bonds usually requires the services of a securities firm to act as the underwriter of the bond issue. The underwriter purchases the bonds from the issuing company and resells them to its clients, or it may sell the bonds on behalf of the company to its clients and earn a commission on the sale.

15. Characteristics of Bonds Issued
Collateral?
Principal and Interest Payments
Additional Features
Callable
Convertible

16. Bond Characteristics Collateral
Secured Bonds - supported by specific assets the issuer (borrower) has pledged as collateral.
Unsecured bonds (Debenture) - are not backed by a specific asset.
When you buy a house and finance your purchase with a bank loan, you sign a mortgage agreement assigning your house as collateral. If later you are unable to make the payments, the bank is entitled to take your house. Secured bonds are similar. They are supported by specific assets the issuer has pledged as collateral. For instance, mortgage bonds are backed by specific real estate assets. If the borrower defaults on the payments, the lender is entitled to the real estate pledged as collateral. However, most bonds are unsecured. Unsecured bonds, also referred to as debentures, are not backed by a specific asset. These bonds are secured only by the “full faith and credit” of the borrower.
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17. Bond Characteristics Principal and Interest
Serial bonds - require payments in instalments over a series of years.
Interest typically paid annually or semi-annually
Term bonds - require payment of the full principal amount of the bond at a single maturity date.
Bond Issue
Secured
Unsecured
Serial
Term
Serial
Term
When you buy a house and finance your purchase with a bank loan, you sign a mortgage agreement assigning your house as collateral. If later you are unable to make the payments, the bank is entitled to take your house. Secured bonds are similar. They are supported by specific assets the issuer has pledged as collateral. For instance, mortgage bonds are backed by specific real estate assets. If the borrower defaults on the payments, the lender is entitled to the real estate pledged as collateral. However, most bonds are unsecured. Unsecured bonds, also referred to as debentures, are not backed by a specific asset. These bonds are secured only by the “full faith and credit” of the borrower.
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18. Bond Characteristics – Cont.
Callable - Allows the borrower to repay the bonds before their scheduled maturity date at a specified call price.
Call price is stated in the bond
Convertible bonds - allow the lender to convert each bond into a specified number of shares of common stock.
Suppose your company issued bonds a few years ago that pay 12% interest. Now market interest rates have declined to 6%, but you’re obligated to pay 12% interest for the remaining time to maturity. How can you avoid this unfortunate situation?
Most corporate bonds are callable, or redeemable. This feature allows the borrower to repay the bonds before their scheduled maturity date at a specified call price. The call price is stated in the bond contract and usually exceeds the bond’s face amount.
The call feature helps protect the borrower against future decreases in interest rates. If interest rates decline, the borrower can buy back the high-interest rate bonds at a fixed price and issue new bonds at the new, lower interest rate. Just think about any loans that you may currently have, may be a car loan or credit card balance. If interest rates drop, wouldn’t it be nice to cancel your debt and re-establish it at the lower interest rate? Many home loans, in fact, provide the option to pay the loan early and refinance at a lower rate.
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19. Summary of Bond Characteristics
A summary of various bond characteristics is provided in the slide.
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20. BOND ISSUANCE PRICING (Interpretation Only)

21. Bond Interest Rates
Two separate interest rates set bond issuance price
Stated Rate – (rate on the face of the bond)
The rate ‘stated’ in the bond contract
The rate used to calculate the cash interest payments.
Market Rate – (also known as the effective interest rate)
True interest rate used by investors to value bond issue.
What investors are seeking as a return.

22. Bond listing in Financial Statement Notes

23. Time Value of Money – (FYI)
What is the BIG Idea? - Present value (PV) is the current worth of a future sum of money or stream of cash flows given a specified rate of return.
A dollar received today is worth more than a dollar to be received in the future. You can invest today’s dollar immediately and earn income from it. But if you must wait to receive the dollar, you forgo the interest revenue. Money earns income over time, a fact called the time value of money. The amount to invest now to receive more later is called the present value of a future amount. The exact present value of any future amount depends on
1. The amount of the future payment.
2. The length of time from the investment date to the date when the future amount is to be collected
3. The interest rate during the period

24. Time Value of Money (Cont.)
Present value depends on:
Amount of future payment (aka principal)
Length of time
Interest rate

25. Cash Value of Bonds at Issuance
Bond value at issuance is always based on Market Rate & Present Value.
Based on the comparison of stated rate and market rate, the following three terms describe the issuance:
Par - stated interest rate equals the market interest rate. The bond is issued for face value of bonds.
Premium – stated interest rate exceeds the market interest rate. The bond is issued (cash received by borrower) for more than the face value of bonds.
Discount – stated interest rate is below the market interest rate. The bond is issued (cash received by borrower) for less than the face value of bonds.

26. On January 1, 2012, 10 year bonds were issued at Par
$100,000 Face Value
7% stated interest rate
7% market interest rate
Interest paid semi-annually (Face value * Annual interest rate * Time)
$100,000
$100,000

27. However, stated rate almost always differs from market rate

29. Short Exercise A. Discount (Stated 4.5% < Market 5%)
B. Premium (7%>6.75%)
C. Face (5%=5%)
D. Discount (6% <7.25%)

30. Copyright © 2010 Pearson Education Inc. Publishing as Prentice Hall.

31. Check-ins
The most common bond characteristics are a serial or term bond that is secured or unsecured? (Circle the two correct answers in bold)
A bond issued at a discount will have a market rate that is higher or lower than the stated rate on the bond. (Circle the one correct answers in bold).

32. BOND ISSUANCE
INTEREST PAYMENTS
REPAYMENT

33. Bonds issued at Par - Steps
Par - stated interest rate equals the market interest rate. The bond is issued for face value of bonds. Therefore, the amount of cash the organization receives from lenders (investors) will equal the face value of the bonds.
Steps for original issuance:
Debit Cash for amount received
Credit Bonds Payable for amount of cash received.
Steps for semi-annual interest payments:
Calculate ‘cash’ interest expense/payments using stated rate and our typical formula.
Debit Interest Expense
Credit Cash
Steps for final repayment of bond at maturity to lenders (investors):
Debit Bonds Payable for face value of bond
Credit cash for amount of repayment.

34. Bond issued at Par - Example
10 year $100,000 term bonds with stated rate of interest of 7% issued at par on 1/1/17. Interest is payable semi-annually. Original transaction, 1st interest payment, and maturity of bond in 10 years.

35. Issuance of a bond at a Discount/Premium
Discount – stated interest rate is below the market interest rate. The bond is issued for less than the face value of bonds. Therefore, the amount of cash the organization receives from lenders (investors) will be less than the face value of the bonds.
Steps for original issuance:
Debit Cash for amount received
Debit Discount on Bonds Payable for the amount of discount
Credit Bonds Payable for the face value of the bond issuance.
Steps for semi-annual interest payments:
Use the ‘Effective Interest Rate Method”
Steps for final repayment of bond at maturity to lenders (investors):
Debit Bonds Payable for face value of bond
Credit cash for amount of repayment.

36. Carrying Value Long-term liabilities: Bonds payable $100,000
The balance in the bonds payable account less discounts OR plus premiums is the carrying value.
The carrying value will increase from the amount originally borrowed ($93,205) to the amount due at maturity ($100,000) over the 10-year life of the bonds using the effective interest rate method.
Long-term liabilities:
Bonds payable $100,000
Less: Discount on bonds payable (6,795)
Carrying value $ 93,205

37. Effective Interest Method
The effective interest method for bonds provides for cash interest payments and an ‘amortization’ of the discount (or premium) over the term of the bond so that the bond payable account equals face value at maturity.
Steps:
Step 1: Calculate Interest Payment (actual credit to Cash account)
Face Value * Stated Interest * Time Period
Step 2: Calculate Interest Expense (Actual debit to Expense account)
Carrying Amount * Market Interest * Time Period
Step 3: Difference between Interest Payment and Interest Expense is either credited (discount) or debited (premium) to Bonds Payable.
Step 4: Calculate new carrying amount after discount or premium is amortized.

38. Issuance - Recording Bonds Issued at a Discount
In the preceding example we assumed the stated interest rate (7%) and the market interest rate (7%) were the same.
If the market interest rate is 8%, the bonds will issue at only $93,205.
This is less than $100,000. The bonds are paying only 7%, while investors can purchase bonds of similar risk paying 8%.
The entry RC Enterprises makes to record the bond issue at a discount is:
In the preceding example we assumed the stated interest rate (7%) and the market interest rate (7%) were the same.
How will the entries differ if the market interest rate is 8%? The bonds will issue at only $93,205.
This is less than $100,000 because the bonds are paying only 7%, while investors can purchase bonds of similar risk paying 8%. When bonds issue at less than face value, we say they issue at a discount.
We initially record the bonds payable account at $93,205. The balance in the bonds payable account is the carrying value. The carrying value will increase from the amount originally borrowed ($93,205) to the amount due at maturity ($100,000) over the 10-year life of the bonds.
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39. Effective Interest Method Step 1: Interest Payment – Credit Cash
Stated (coupon) interest rate
Face value
1/2 7%
$3,500
$100,000
1/2
Each semiannual interest payment is set by the bond contract and therefore remains the same over the life of the bonds. However, interest expense for bonds issued at a discount increases as the bonds march toward maturity. For bonds issued at a premium, interest expense decreases as the bonds reach maturity. Using the effective interest rate method, interest expense is determined by multiplying the carrying amount by the market rate of interest cut in half.

40. Effective Interest Method Step 2: Interest Expense (Debit)
Market (effective) interest rate
Interest expense
Carrying value
1/2
$3,728 8%
$93,205
1/2
Each semiannual interest payment is set by the bond contract and therefore remains the same over the life of the bonds. However, interest expense for bonds issued at a discount increases as the bonds march toward maturity. For bonds issued at a premium, interest expense decreases as the bonds reach maturity. Using the effective interest rate method, interest expense is determined by multiplying the carrying amount by the market rate of interest cut in half.

41. Recording Bonds Issued at a Discount
Step 1: Cash paid for interest is equal to the face amount times the stated rate (3.5% semi-annually or 7% annually, in our example).
Cash paid for Interest =
Face amount of bond X
Stated interest rate per period
$3,500
$100,000
7% x ½
Step 2: We calculate interest expense as the carrying value (the amount actually owed during that period) times the market rate.
Interest expense =
Carrying value of bond X
Market interest rate per period
$3,728
$93,205
8% x ½
Step 3: On June 30, 2012, RC Enterprises the interest payment and expense.
June 30, 2012
Debit
Credit
Interest Expense ($93,205 x 8% x ½)
3,728
Discount on Bonds Payable (diff.)
228
Cash ($100,000 x 7% x ½)
3,500
(Record semiannual interest payment)
We calculate interest expense as the carrying value (the amount actually owed during that period) times the market rate (4% semi-annually or 8% annually, in our example).
However, the bond agreement specifies that cash paid for interest is equal to the face amount times the stated rate (3.5% semi-annually or 7% annually, in our example).
On June 30, 2012, RC Enterprises records interest expense, assuming the bonds were issued at a discount.
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42. Increase in Carrying Value
Amortization Schedule for Bonds Issued at a Discount
An amortization schedule provides a nice summary of the cash interest payments, interest expense, and changes in carrying value for each semi-annual interest period.
The amounts for the June 30, 2012 and the December 31, 2012 semi-annual interest payment entries can be taken directly from the amortization schedule.
(1)
Date
(2)
Cash Paid
for interest
(3)
Interest Expense
(4)
Increase in Carrying Value
(5)
Carrying
Value
Face Amount x Stated Rate
Carrying Value x Market Rate
(3) – (2)
Prior Carrying
Value + (4)
1/1/2012
$93,205
6/30/2012
$3,500
$3,728
$228
93,433
12/31/2012
3,500
3,737
237
93,670 *
99,057
6/30/2021
3,962
462
99,519
12/31/2021
3,981
481
$100,000
An amortization schedule provides a nice summary of the cash interest payments, interest expense, and changes in carrying value for each semi-annual interest period. The amounts for the June 30, 2012 and the December 31, 2012 semi-annual interest payment entries can be taken directly from the amortization schedule.
The amortization schedule shows interest calculations every six months because interest is paid semi-annually. The entire amortization schedule would be 20 rows long. To save space, we show only the amortization for the first and last years. The eight years in the middle are represented by asterisks. Cash paid is $3,500 ($100,000 x 7% x 1/2) every six months. Interest expense is the carrying value times the market rate. Interest expense for the six months ended 6/30/12 is $3,728 (= $93,205 x 4%). The difference between interest expense and the cash paid increases the carrying value of the bonds. At the maturity date, the carrying value will equal the face amount of $100,000.
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43. Recording Bonds Issued at a Premium
RC Enterprises issues $100,000 of 7% bonds when other bonds of similar risk are paying only 6%.
The bonds will issue at $107,439. Investors will pay more than $100,000 for these 7% bonds because bonds of similar risk are paying only 6% interest.
The entry to record the bond issue at a premium is:
January 1, 2012
Debit
Credit
Cash
107,439
Bonds Payable
(Bonds issued at a premium)
On June 30, 2012, RC Enterprises records interest expense.
June 30, 2012
Debit
Credit
Interest Expense ($107,439 x 6% x ½)
3,223
Premium on Bonds Payable (difference)
277
Cash ($100,000 x 7% x ½)
3,500
(Semi-annual interest payment)
Assume RC Enterprises issues $100,000 of 7% bonds when other bonds of similar risk are paying only 6%. The bonds will issue at $107,439. Investors will pay more than $100,000 for these 7% bonds because bonds of similar risk are paying only 6% interest. The entry by RC Enterprises to record the bond issue at a premium is presented.
Initially we record the bonds payable account at $107,439. RC will need to pay back only $100,000 when the bonds mature. Carrying value will decrease from $107,439 to $100,000 over the 10-year life of the bonds. We still calculate interest expense as the carrying value times the market rate.
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44. Amortization Schedule for Bonds Issued at a Premium
An amortization schedule provides a nice summary of the cash interest payments, interest expense, and changes in carrying value for each semi-annual interest period.
The amounts for the June 30, 2012 and the December 31, 2012 semi-annual interest payment entries can be taken directly from the amortization schedule.
(1)
Date
(2)
Cash Paid
for interest
(3)
Interest Expense
(4)
Decrease in Carrying Value
(5)
Carrying
Value
Face Amount x Stated Rate
Carrying Value x Market Rate
(2) – (3)
Prior Carrying
Value + (4)
1/1/2012
$107,439
6/30/2012
$3,500
$3,223
$277
107,162
12/31/2012
3,500
3,215
285
106,877 *
100,956
6/30/2021
3,029
471
100,485
12/31/2021
3,015
485
$100,000
When bonds are issued at a premium, the carrying value of the debt decreases over time. That’s why we debit bonds payable, because bonds payable is decreasing over time. Since the carrying value of the debt decreases over time, interest expense will also decrease each semi-annual interest period.
Just as in the discount example, the amounts for the June 30, 2012 and the December 31, 2012 semi-annual interest payments can be obtained directly from the amortization schedule. Now, however, with a bond premium, the difference between cash paid and interest expense decreases the carrying value each period from $107,439 at bond issue down to $100,000 (the face amount) at bond maturity.
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45. Changes in Carrying Value Over Time
Illustration showing Changes in Carrying Value Over Time
When bonds issue at face amount, the carrying value and the corresponding interest expense remain constant over time. When bonds issue at a discount (below face amount), the carrying value and the corresponding interest expense increase over time. When bonds issue at a premium (above face amount), the carrying value and the corresponding interest expense decrease over time.
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46. Examples
1-1-12: $200,000 of bonds issued with a stated interest rate of 9%. Interest due semi-annually. Due in 10 years
Market Rate = 9%. Record the bond issue on and the first 2 interest payments on 6/30/12 and 12/31/12.
Market Rate = 10%. Record the bond issue in the amount of $187,538 on 1/1/12 and the first 2 interest payments on 6/30/12 and 12/31/12.
Market Rate = 8%. Record the bond issue in the amount of $213,590 on 1/1/12 and the first 2 interest payments on 6/30/12 and 12/31/12.
Companies report many long-term liabilities other than bonds payable. In this section, we briefly discuss two of them: installment notes and leases.
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47. Example 1 – Bonds issued at ___________

48. Example 2 – Bonds issued at ___________

49. Bond Issued at Discount – Amortization Schedule
Cash
Increase
Interest
in Carrying
Carrying
Date
Paid
Expense
Value
1/1/2012
187,538
6/30/2012
9,000
9,377
377
187,915
12/31/2012
9,396
396
188,311
6/30/2013
9,416
416
188,726
12/31/2013
9,436
436
189,163
6/30/2014
9,458
458
189,621
12/31/2014
9,481
481
190,102
6/30/2015
9,505
505
190,607
12/31/2015
9,530
530
191,137
Interest Payment = 200,000 x .09 x 1/2 = 9,000
Interest Expense = 187,538 x .10 x 1/2 = 9,377

50. Example 3 – Bonds issued at ___________

51. Bond Issued at Premium – Amortization Schedule
Cash
Decrease
Interest
in Carrying
Carrying
Date
Paid
Expense
Value
1/1/2012
213,590
6/30/2012
9,000
8,544
(456)
213,134
12/31/2012
8,525
(475)
212,659
6/30/2013
8,506
(494)
212,165
12/31/2013
8,487
(513)
211,652
6/30/2014
8,466
(534)
211,118
12/31/2014
8,445
(555)
210,563
6/30/2015
8,423
(577)
209,985
12/31/2015
8,399
(601)
209,385
Interest Payment = 200,000 x .09 x 1/2 = 9,000
Interest Expense = 213,590 x .08 x 1/2 = 8,544

52. Changes in Carrying Value Over Time
$213,590
$200,000
$187,538
Illustration showing Changes in Carrying Value Over Time
When bonds issue at face amount, the carrying value and the corresponding interest expense remain constant over time. When bonds issue at a discount (below face amount), the carrying value and the corresponding interest expense increase over time. When bonds issue at a premium (above face amount), the carrying value and the corresponding interest expense decrease over time.
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53. BOND ISSUANCE
INTEREST PAYMENTS
REPAYMENT

54. Payment of Bond Principal at Maturity
Date
Account
Debit
Credit
12/31/2021
Bonds Payable
200,000
Cash
Payment of maturity

55. 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.

56. Installment Notes
Each installment payment includes both interest and principal:
Calculate the amount that represents interest expense.
Step 1 - Calculated as Carrying Value * annual interest rate * time (x/12)
Calculate the amount that represents a reduction of the outstanding loan balance.
Step 2 - Subtract the monthly interest from the total payment and the remainder is a principal reduction.
RC Enterprises obtains a $25,000, 6%, four-year loan for a truck on January 1, 2012.
Payments of $ (principal and interest) are required at the end of each month for 48 months.
We record the note and the first two monthly payments as:
Each installment payment includes both an amount that represents interest and an amount that represents a reduction of the outstanding loan balance. The periodic reduction of the balance is enough that at maturity the note is completely paid.
RC Enterprises obtains a $25,000, 6%, four-year loan on January 1, Payments of $ are required at the end of each month for 48 months.
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57. Installment Notes Each installment payment includes both:
An amount that represents interest.
An amount that represents a reduction of the outstanding loan balance.
RC Enterprises obtains a $25,000, 6%, four-year loan for a truck on January 1, 2012.
Payments of $ are required at the end of each month for 48 months.
We record the note and the first two monthly payments as:
January 1, 2012
Debit
Credit
Cash
25,000
Notes Payable
(Issue a note payable)
January 31, 2012
Interest Expense ($25,000 x 6% x 1/12)
125.00
Notes Payable (difference)
462.13
Cash (monthly payment)
587.13
(Record first monthly payment)
February 28, 2012
Interest Expense ($24, x 6% x 1/12)
122.69
464.44
(Record second monthly payment)
Each installment payment includes both an amount that represents interest and an amount that represents a reduction of the outstanding loan balance. The periodic reduction of the balance is enough that at maturity the note is completely paid.
RC Enterprises obtains a $25,000, 6%, four-year loan on January 1, Payments of $ are required at the end of each month for 48 months.
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58. Leases
Contractual arrangement by which the lessor (owner) provides the lessee (user) the right to use an asset for a specified period of time
Types:
Operating leases: lessor owns the asset, and the lessee simply uses the asset temporarily
Capital leases: lessee buys an asset and borrows the money through a lease to pay for the asset
If you have ever leased a car or an apartment, you are familiar with leasing. A lease is a contractual arrangement by which the lessor (owner) provides the lessee (user) the right to use an asset for a specified period of time. Leasing has grown to be the most popular method of external financing of corporate assets in America. In fact, many financing companies exist for the sole purpose of acquiring assets and leasing them to others.
For accounting purposes, we have two basic types of leases: operating leases and capital leases.
Operating leases are like rentals. The lessor owns the asset, and the lessee simply uses the asset temporarily. Over the lease term, the lessee records rent expense and the lessor records rent revenue. On the other hand, capital leases occur when the lessee essentially buys an asset and borrows the money through a lease to pay for the asset.

59. Balance Sheet Effects of Operating and Capital Leases
Assume a company has assets of $100 million, liabilities of $60 million, and stockholders’ equity of $40 million. The company then signs a new lease to purchase long-term assets valued at $10 million.
Assuming the lease is a(n)
($ in millions)
Total assets
Total liabilities
Stockholders’ equity
Total liabilities and equity
Total liabilities / Stockholders’ equity
Operating Lease Capital Lease
$100
$ 60 40
$60 / 40 = 1.5
$100 + $10 = $110
$ $10 = $ 70
40 + $ 0 = $ 40
$ 70 / 40 = 1.75
The ratio of liabilities to stockholders’ equity is higher under a capital lease.
Do companies acquiring assets through a lease prefer operating leases or capital leases? Let’s look at the effect of both operating and capital leases on the balance sheet to help us decide. Assume a company has assets of $100 million, liabilities of $60 million, and stockholders’ equity of $40 million. The company then signs a new lease to purchase long-term assets valued at $10 million. This illustration compares the balance sheet effects between the two methods.
Under an operating lease, the $10 million lease is not reported in the balance sheet. The company simply records rent expense as the payments are made and this expense is reported in the income statement. Under a capital lease, the $10 million lease is added to both assets and liabilities, to recognize the purchase of an asset and the incurrence of an additional lease liability. While stockholders’ equity remains the same for both types of leases, the relationship between total liabilities and stockholders’ equity differs. Under an operating lease, the ratio of total liabilities to stockholders’ equity is lower, making the company appear less risky to investors and lenders from the standpoint of potential bankruptcy. That’s why most companies prefer operating leases.

60. J C Penney Operating Lease Obligations – Notes to the Financial Statements

61. Final In-class Problem
UCF’s bicycle vending company is expanding and taking over other Florida Universities (USF, UF, FSU, etc.), so they need $ for expansion…. They contact their bank and investment banker and investigate a loan or a bond issuance. Prepare the journal entry for the first interest payment on both options. Which option should UCF take?
Loan $100,000 at 5% interest over a 10 year period. Monthly cash payment = $1,061
Term Debenture bond face value = $100,000, stated interest = 5%, but market interest in now 5.5%. Term = 10 years. Cash received at issuance = $99,000

62. Participation Questions – Chapter 9
The capital structure of an organization is the mixture of debt funding and equity funding. T/F
Ford Automotive uses a higher level of equity funding in comparison to debt funding. T/F
“Coupon Rate” is the same as which of the following on a bond:
Market interest rate
Stated interest rate
The Dow Jones interest rate
LIBOR interest rate
How much did the Hersey bar cost from the 1950’s as shown in the Seinfeld episode?
The cash amount of interest paid to a bond holder is based on which of the following?
Face Value
Carrying Value