Accounting for Long-Term Debt

Accounting for Long-Term Debt
Chapter Ten Accounting for Long-Term Debt In Chapter Ten, we will learn about two types of long-term debt: notes payable and bonds payable. We will examine issuing bonds at face value, at a discount and at a premium.

Long-Term Notes Payable
Long-term notes are liabilities that usually have terms from two to five years. Principal Payments Company Part I Long-term notes are liabilities that usually have terms from two to five years. Part II The principal balance is repaid with a series of equal payments. Each payment includes some payment on the principal and some payment for interest. Most car loans and home loans are set up with installment payments. Part III For each payment that is made, the amount applied to the principal increases and the amount of the interest decreases. Lender Each payment covers interest for the period and a portion of the principal. With each payment, the interest portion gets smaller and the principal portion gets larger.

Applying payments to principal and interest Identify the unpaid principal balance. Amount applied to interest = Unpaid principal balance × Interest rate. Amount applied to principal = Cash payment – amount applied to interest in . Unpaid principal balance = Unpaid principal balance in  – amount applied to principal in . To determine the portion of each payment that is interest and the portion to apply to the principal, follow these four steps:  Identify the unpaid principal balance.  Multiply the unpaid principal balance times the interest rate to find the portion of the payment that is interest.  Subtract the portion of the payment that is interest in  from the total cash payment to find the portion of the payment to apply to the principal.  The updated unpaid principal balance equals the unpaid principal balance in  minus the portion of the payment applied to the principal in . Let’s look at an example.

Prepare an amortization table for Blair’s note.
Long-Term Notes Payable On January 1, 2005, Blair Company issued a $100,000 face value long-term note to National Bank. The note had a 9 percent annual interest rate and a five year term. The loan agreement called for five equal payments of $25,709 to be made on December 31 of each year. Prepare an amortization table for Blair’s note. Take a minute and review this information for Blair Company. On January 1, 2005, Blair Company borrowed one hundred thousand dollars from National Bank. The loan has a nine percent interest rate and will be repaid with five annual payments of twenty-five thousand seven hundred nine dollars each. Let’s look at the amortization table for this loan.

Cash payment determined using present value concepts presented in Chapter 10 appendix. Notice that the annual payment is always twenty-five thousand seven hundred nine dollars. Also notice that for each payment the interest portion decreases and the principal portion increases. Let’s review how to get the amount applied to interest and the amount applied to principal for the first payment on this note. The interest portion is calculated by multiplying the one hundred thousand dollar unpaid balance at the beginning of the period times nine percent to get nine thousand dollars. The principal portion is calculated by subtracting nine thousand dollars from twenty-five thousand seven hundred nine dollars to get sixteen thousand seven hundred nine dollars. You should verify the remain computations in the amortization table before advancing. All computations rounded to the nearest dollar.

Annual payments are constant.
Long-Term Notes Payable Annual payments are constant. The graph on your screen shows that the amount of each payment applied to the principal increases each year, while the amount of interest decreases each year. The amount applied to the principal increases each year. The amount of interest decreases each year.

Issuing the note has the following effect on Blair’s 2005 financial statements: The December 2005 cash payment has the following effect on Blair’s 2005 financial statements: Part I Issuing the note payable increases both assets (Cash) and liabilities (Notes Payable). There is no effect on the Income Statement when the note is issued. The cash inflow is reported in the financing section of the Statement of Cash Flows. Part II Each payment decreases assets (Cash) by the amount of the payment. Liabilities (Notes Payable) decrease by the amount of the payment applied to principal. Equity (Retained Earnings) decreases by the amount of the payment that is interest. Net income decreases by the amount of interest. The portion of the payment that is interest is reported in the operating section of the Statement of Cash Flows. The portion of the payment applied to principal is reported in the financing section of the Statement of Cash Flows.

Security for Bank Loan Agreements
To reduce the risk that they will not be repaid, lenders often: Require debtors to pledge collateral to secure the loan Include covenants in the loan agreement restricting: Additional borrowing Dividends Salary increases. To reduce the risk that they will not be paid, creditors frequently require debtors to pledge designated assets as collateral for loans. You may have experienced this when purchasing a car if the financing institution retained title to your car until all payments were made. In addition to requiring collateral from companies borrowing money, banks often include covenants in loan agreements that restrict additional borrowing, dividend payments to owners, and salary increases.

Line of Credit Lines of credit are pre-approved financing plans that allow companies to borrow and repay funds as needed up the maximum credit line set by the creditor. Lines of credit are normally used for relatively short-term borrowing to finance seasonal business needs. Lines of credit are pre-approved financing plans that allow companies to borrow and repay funds as needed up the maximum credit line set by the creditor. Lines of credit are normally used for relatively short-term borrowing to finance seasonal business needs. For an individual, overdraft protection on a checking account is similar to a business line of credit.

Significant debt needs of a company are often filled by issuing bonds.
Bond Liabilities Significant debt needs of a company are often filled by issuing bonds. Bonds Cash When a company has a relatively small need for cash, the need can usually be met by a single lender, such as a bank. However, when a company needs large amounts of cash, one creditor may not be able to loan the amount required, or may not be willing to take on all the risk of such a large loan. So, in this case, many companies issue bonds to lots of different people and institutions to acquire the needed funds.

Bond Liabilities Bonds involve the long-term borrowing of a large sum of money, called the principal. The principal is usually paid back as a lump sum at maturity. Individual bonds are often denominated with a face value, of $1,000. When companies need large amounts of cash for longer periods of time, they often issue bonds. The principal on bonds is typically paid at the end of the bond period. Each bond in the total bond issue is usually denominated with a face value of one thousand dollars.

Bond Liabilities Bonds usually have periodic interest payments based on a stated rate of interest. Interest is normally paid semiannually. Interest paid is computed as: Interest = Principal × Stated Rate × Time Bond prices are usually quoted as a percentage of the face amount. For example, a $1,000 bond priced at 104 would sell for $1,040. Bonds normally have an interest rate that is called a stated rate. Interest is normally paid semiannually and is computed as Principal times Rate times Time. This computation should look familiar to you. Since bonds are bought and sold in the market, they have a market value, or price. For convenience, bond market values are expressed as a percent of their face value.

Bond Liabilities Bond Certificate at Face Value Corporation Investors
Bond Selling Price Bond Certificate at Face Value Corporation Investors On the issue date, the bondholders give the company the market value, or selling price of the bond issue. The company gives the bondholders a bond certificate promising to pay periodic interest and to return the principal on the maturity date. Bond Issue Date

Bond Liabilities Corporation Investors Bond Interest Payments
At regularly scheduled dates during the life of the bond, the company pays the bondholders interest. Interest is calculated as bond face value times the stated interest rate on the bond times the time the bond has been outstanding during the year. Interest Payment = Principal × Interest Rate × Time Bond Issue Date

Bond Liabilities Corporation Investors Bond Issue Date
Bond Principal at Maturity Date Corporation Investors At the maturity date, the company pays the bondholders the bond’s face value. Bond Issue Date Bond Maturity Date

Bond Liabilities Advantages of bonds
Bonds usually have longer terms to maturity than notes payable issued to banks. Bond interest rates are usually lower than bank loan rates. Bonds offer advantages for the issuing company. They usually usually have longer terms to maturity than notes payable issued to banks, often twenty or thirty years. In addition, bond interest rates are usually lower than bank loan rates.

Characteristics of Bonds
Term and Serial Secured and Unsecured Convertible and Callable There are several common types of bonds. Secured bonds, sometimes called mortgage bonds, have specific assets of the issuer pledged as collateral. Unsecured bonds, sometimes called debentures, are backed by the issuer’s general credit standing. Term bonds are scheduled for maturity on one specified date. Serial bonds mature at more than one date. Convertible bonds can be exchanged for a fixed number of common shares of the issuing corporation. Callable bonds have an option exercisable by the issuer to retire them at a stated dollar amount prior to maturity.

Bonds Issued at Face Value
Blair Company issues bonds on January 1, 2005. Principal = $1,000,000 Stated Interest Rate = 9% Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2024 (20 years) Blair Company issues bonds at face value. This means that the stated interest rate on the bond and the market interest rate on the bond are equal. Blair’s bonds have a face value of one million dollars, a stated interest rate of nine percent with interest payable on June 30 and December 31 of each year. The bonds are issued on January 1, 2005, and mature twenty years later on December 31, 2024. On the issue date, the bondholders give Blair Company the selling price of the bond issue, and Blair Company gives the bondholders a bond certificate promising to pay periodic interest and to return the principal on the maturity date. Bond Selling Price Bond Certificate at Face Value Blair Company Investors

Issuing the bonds has the following effect on Blair’s 2005 financial statements: To record the bond issue, Blair Company would make the following entry on January 1, 2005: Part I Issuing the bond payable increases both assets (Cash) and liabilities (Bonds Payable). There is no effect on the income statement when the note is issued. The cash inflow is reported in the financing section of the Statement of Cash Flows. Part II On the issue date, Blair Company would debit Cash and credit Bonds Payable for one million dollars. The Bonds Payable account is always credited for the face value, or maturity value, of the bonds.

On each interest payment date, Blair Company will pay $45,000 in interest. The amount is computed as follows: $1,000, 000 × 9% × 6/12 = $45,000 On the each interest payment date for the twenty-year term of the bond issue, Blair will pay the bondholders a total of forty-five thousand dollars in interest. The interest is calculated by multiplying one million dollars times nine percent times six months divided by twelve months. Bond Interest Payments Blair Company Investors

The June 30, 2005 interest payment (and all other semiannual interest payments) has the following effect on Blair’s financial statements: To record an interest payment, Blair Company would make the following entry on each June 30 and December 31: Part I Each interest payment decreases assets (Cash) and decreases Equity (Retained Earnings) by the amount of the interest payment. Net income also decreases by the amount of the interest payment. The interest payment is reported in the operating section of the Statement of Cash Flows. Part II On the each interest payment date for the twenty-year term of the bond issue, Blair will debit Bond Interest Expense and credit Cash for forty-five thousand dollars.

On December 31, 2024, Blair Company will return the $1,000,000 principal amount to the investors. On the maturity date, Blair Company will pay the bondholders one million dollars, the face amount of the bonds. At this time, the debt is extinguished. Bond Principal at Maturity Date Blair Company Investors

The principal repayment on December 31, 2024 will have the following effect on Blair’s 2024 financial statements: To record an the principal repayment, Blair Company would make the following entry on December 31, 2024: Part I The repayment at maturity decreases assets (Cash) and decreases liabilities (Bonds Payable) by one million dollars. Net income is not effected by the repayment. The repayment is reported in the financing section of the Statement of Cash Flows. Part II On the maturity date, Blair Company will record the payment of the face amount of the bonds by debiting Bonds Payable and crediting Cash for one million dollars.

Bonds Issued at a Discount
If bonds of other companies are yielding more than 9 percent, investors will be unwilling to pay the full face amount for Blair’s 9 percent bonds. The issue price of Blair’s 9 percent bonds will have to be lower to entice investor interest. The difference between the lower issue price and the principal of $1,000,000 is called a discount. Let’s continue the Blair Company example. In almost all cases, the stated rate and the market rate of interest will not agree. When these two interest rates are different, it might make sense to you for us to just change our stated rate to equal the market rate and then everything would be fine. Well, we can’t do that. The bond certificate lists all of the specifics about the bond including the stated interest rate. Because we have to print the bond certificates in advance, we are stuck having to pay the interest printed on the bond certificate. The only thing that is not printed on the bond certificate is the selling price. So, the issuing company and the bond investors come to an agreement on the selling price that incorporates the difference in the stated interest rate and the market interest rate at the time of issue. For example, if the market rate of interest is more than nine percent, investors will be unwilling to pay the full face amount of one million dollars for Blair’s nine percent bonds. The issue price of Blair’s nine percent bonds will have to be lower to entice investor interest. The difference between the lower issue price and the face amount of one million dollars is called a discount. Let’s continue the Blair Company example.

Blair Company issues bonds on January 1, 2005. Principal = $1,000,000 Issue price = $950,000 Stated Interest Rate = 9% Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2024 (20 years) The only change from previous Blair example. Because the market rate of interest is more than nine percent, Blair must reduce the issue price of its nine percent bonds from one million dollars to nine hundred fifty thousand dollars to attract investors. The difference between the one million dollar face value of the bonds and the cash issue price of nine hundred fifty thousand dollars is the fifty thousand dollar discount that Blair offers to the bond investors.

Issuing the bonds at a discount has the following effect on Blair’s 2005 financial statements: To record the bond issue, Blair Company would make the following entry on January 1, 2005: Part I Issuing the bonds at a discount increases assets (Cash) by nine hundred fifty thousand dollars. Liabilities (Bonds Payable) are increased by one million dollars less the Bond Discount that is increased by fifty thousand dollars. There is no effect on the Income Statement when the bonds are is issued. The cash inflow is reported in the financing section of the Statement of Cash Flows. Part II On the issue date, Blair will debit Cash for the nine hundred fifty thousand dollars of cash received, credit Bonds Payable for the face amount of one million dollars, and debit Discount on Bonds Payable for the fifty thousand dollar difference. Discount on Bonds Payable is a contra-liability account and has a normal debit balance.

On the balance sheet, the discount account is subtracted from the face value of the bonds to arrive at the current carrying value of the bonds. Maturity Value Carrying Value

Amortizing the discount over the term of the bond increases Interest Expense each interest payment period. Using the straight-line method, the discount amortization will be $1,250 every six months. $50,000 ÷ 40 periods = $1,250 The discount represents an additional interest factor that will be amortized to Interest Expense over the life of the bond. Amortizing the discount will increase the total Interest Expense recorded for the bond each interest payment period. Using the straight-line method to amortize the discount, Blair Company will divide the total discount by the number of interest payment periods to get the the amount of the discount amortized each interest payment period. Since this is a twenty-year bond and it pays interest semiannually, there are forty interest payment periods. This calculation determines that the discount amortization will be one thousand two hundred fifty dollars at each interest payment date.

The June 30, 2005 interest payment (and all other semiannual interest payments) has the following effect on Blair’s financial statements: To record an interest payment, Blair Company would make the following entry on each June 30 and December 31: Part I Each interest payment decreases assets (Cash) by forty-five thousand dollars cash paid and reduces the Discount on Bonds Payable by one thousand two hundred fifty dollars. Equity (Retained Earnings) is reduced by the total Interest Expense of forty six thousand two hundred fifty dollars. Net income also decreases by the total amount of Interest Expense. The forty-five thousand dollar cash interest payment is reported in the operating section of the Statement of Cash Flows. Part II Every six months, Blair Company will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. The credit to Discount on Bonds Payable is determined using the straight-line method we discussed on the previous slide. The debit to Bond Interest Expense is the total of the two credit amounts in this entry.

$50,000 – $1,250 – $1,250 On the balance sheet, the discount account is subtracted from the par value of the bonds to arrive at the current carrying value of the bonds. As the discount is amortized, the carrying value will increase to exactly one million dollars on the maturity date. Maturity Value Carrying Value The carrying value will increase to exactly $1,000,000 on the maturity date.

Bonds Issued at a Premium
If bonds of other companies are yielding less than 9 percent, investors will be willing to pay more than the face amount for Blair’s 9 percent bonds. The issue price of Blair’s 9 percent bonds will rise because of investor demand for the 9 percent bonds. The difference between the higher issue price and the principal of $1,000,000 is called a premium. Let’s continue the Blair Company example. Remember that in almost all cases, the stated rate and the market rate of interest will not agree. When this happens, the issuing company and the bond investors come to an agreement on the selling price that incorporates the difference in the stated interest rate and the market interest rate at the time of issue. For example, if the market rate of interest is less than nine percent, investors will be willing to pay more than the full face amount of one million dollars for Blair’s nine percent bonds. The issue price of Blair’s nine percent bonds will rise because of investor demand for the nine percent bonds. The difference between the higher issue price and the face amount of one million dollars is called a premium. Let’s continue the Blair Company example.

Blair Company issues bonds on January 1, 2005. Principal = $1,000,000 Issue price = $1,050,000 Stated Interest Rate = 9% Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2024 (20 years) The only change from previous Blair example. Because the market rate of interest is less than nine percent, Blair will increase the issue price of its nine percent bonds from one million dollars to one million fifty thousand dollars. The difference between the one million dollar face value of the bonds and the cash issue price of one million fifty thousand dollars is the fifty thousand dollar premium.

Issuing the bonds at a premium has the following effect on Blair’s 2005 financial statements: To record the bond issue, Blair Company would make the following entry on January 1, 2005: Part I Issuing the bonds at a premium increases assets (Cash) by one million fifty thousand dollars. Liabilities (Bonds Payable) are increased by one million dollars plus the Bond Premium that is increased by fifty thousand dollars. There is no effect on the income statement when the bonds are issued. The cash inflow is reported in the financing section of the Statement of Cash Flows. Part II On the issue date, Blair will debit Cash for the one million fifty thousand dollars of cash received, credit Bonds Payable for the face amount of one million dollars, and credit Premium on Bonds Payable for the fifty thousand dollar difference. Premium on Bonds Payable is a adjunct-liability account and has a normal credit balance.

On the balance sheet, the premium is added to the face value of the bonds to arrive at the current carrying value of the bonds. Maturity Value Carrying Value

Amortizing the premium over the term of the bond decreases Interest Expense each interest payment period. Using the straight-line method, the premium amortization will be $1,250 every six months. $50,000 ÷ 40 periods = $1,250 The premium represents a reduction in interest that will be amortized to Interest Expense over the life of the bond. Amortizing the premium will decrease the total Interest Expense recorded for the bond each interest payment period. Using the straight-line method to amortize the premium, Blair Company will divide the total premium by the number of interest payment periods to get the the amount of the premium amortized each interest payment period. Since this is a twenty-year bond and it pays interest semiannually, there are forty interest payment periods. This calculation determines that the premium amortization will be one thousand two hundred fifty dollars at each interest payment date.

The June 30, 2005 interest payment (and all other semiannual interest payments) has the following effect on Blair’s financial statements: To record an interest payment, Blair Company would make the following entry on each June 30 and December 31: Part I Each interest payment decreases assets (Cash) by forty-five thousand dollars cash paid and reduces the Premium on Bonds Payable by one thousand two hundred fifty dollars. Equity (Retained Earnings) is reduced by forty three thousand seven hundred fifty dollars of Interest Expense which is the difference between the cash interest payment and the amount of premium amortization. Net income also decreases by the total amount of Interest Expense. The forty-five thousand dollar cash interest payment is reported in the operating section of the Statement of Cash Flows. Part II Every six months, Blair Company will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. The debit to Premium on Bonds Payable is determined using the straight-line method we discussed on the previous slide. The debit to Interest Expense is the difference between the forty five thousand dollars of cash paid and the one thousand two hundred fifty dollars of premium amortization.

$50,000 – $1,250 – $1,250 On the balance sheet, the premium account is added to the face value of the bonds to arrive at the current carrying value of the bonds. As the premium is amortized, the carrying value will decrease to exactly one million dollars on the maturity date. Maturity Value Carrying Value The carrying value will decrease to exactly $1,000,000 on the maturity date.

The Market Rate of Interest
The selling price of a bond is determined by the market rate of interest versus the stated rate of interest. = = The issue price of a bond is determined by comparing the market interest rate with the stated interest rate on the bond. If the stated interest rate on the bond is equal to the market interest rate, then the bond issue sells at face value. If the stated interest rate on the bond is less than the market interest rate, then the bond issue sells at a discount. If the stated interest rate on the bond is greater than the market interest rate, then the bond issue sells at a premium. < < > >

Bond Redemptions Companies may redeem bonds with a call provision prior to the maturity date. Gains or losses incurred as a result of early redemption of bonds should be reported as other income or other expense on the income statement. Callable bonds have an option exercisable by the issuer to retire them at a stated dollar amount prior to maturity. The call provision usually requires the issuer to pay a call premium to retire the bonds. If bonds are retired before the maturity date, a gain or loss is recorded. The gain or loss is determined by comparing the carrying value of the bond on the retirement date with the cash price paid to retire the bonds. Gains or losses due to bond retirement should be reported as other income or other expense on the income statement.

Bond Redemptions On December 31, 2014, 10 years after issue, Blair Company redeems its 9 percent bonds that were sold at a discount. The bonds have a call provision requiring Blair to pay a call price of $1,040 for each $1,000 bond. On the call date, the bonds have a carrying value of $975,000. Part I On December 31, 2014, ten years after issue, Blair Company redeems its nine percent bonds that were sold at a discount. The bonds have a call provision requiring Blair to pay a call price of one thousand forty dollars for each one thousand dollar bond. On the call date, the bonds have a carrying value of nine hundred seventy-five thousand dollars. Part II The sixty-five thousand dollar loss on redemption is equal to the total amount paid, one million forty thousand dollars, minus the carrying value of nine hundred seventy-five thousand dollars.

Bond Redemptions The bond redemption on December 31, 2014, will have the following effect on Blair’s 2014 financial statements: To record an the bond redemption, Blair Company would make the following entry on December 31, 2014: Part I The bond redemption on December 31, 2014, decreases assets (Cash) by one million forty thousand dollars and decreases liabilities (Bonds Payable) by one million dollars. Bond Discount is also reduced by the twenty-five thousand dollars of unamortized discount. Net income is reduced by the sixty-five thousand dollar loss. The one million forty thousand dollars cash payment is is reported in the financing section of the Statement of Cash Flows. Part II On December 31, 2014, Blair Company will record the redemption by debiting Bonds Payable for one million dollars, debiting Loss on Bond Redemption for sixty-five thousand dollars, crediting Discount on Bonds Payable for twenty-five thousand dollars, and crediting Cash for one million forty thousand dollars.

Financial Leverage and Tax Advantage of Debt Financing
Financial leverage: Debt financing can increase return on equity when the borrower earns more on the borrowed funds than it pays in interest. Consider the following example with $100,000 of debt financing. Part I An additional advantage of debt financing is financial leverage. Debt financing can increase return on equity if the borrower is able to earn more on the borrowed funds than is paid in interest. Let’s look at an example. Part II In the example on your screen, income of fifty thousand is the same in both situations, but the return on equity with debt is sixteen point eight percent with one hundred thousand dollars of debt financing, compared to twelve percent with one hundred thousand dollars of equity financing. Study the example carefully and you will find that although interest must be paid on the debt financing, resulting in a lower after-tax net income, the return on equity is higher because the amount of equity is less with debt financing. However, this is a warning as not all debt financing produces a greater return on equity. Financial leverage can have the opposite effect if the borrower earns less on the borrowed funds than is paid in interest.

Times Interest Earned Ratio
Numerator is commonly called EBIT, Earnings before interest and taxes. Net income + Interest expense + Income tax expense Times Interest Earned = Interest expense Long-term creditors are particularly interested in the ability of a company to meet periodic interest payments. Times interest earned is a ratio that is important to creditors. The ratio is calculated by dividing earnings before interest and taxes by interest expense for the period. The ratio shows the amount of resources generated for each dollar of interest expense. In general, a high ratio is viewed more favorable than a low ratio. The ratio shows the amount of resources generated for each dollar of interest expense. In general, a high ratio is viewed more favorable than a low ratio.

End of Chapter Ten In this chapter, we will learned about two types of long-term debt: notes payable and bonds payable. We examined issuing bonds at face value, at a discount, and at a premium.

Accounting for Long-Term Debt

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