1. ©CourseCollege.com 1 16 Long Term Debt Long term debt - liabilities with due dates greater than one year. Learning Objectives 1.Explain accounting for long term note origination and interest accrual 2.Describe various note types, repayment structures, collateral and loan agreements 3.Explain accounting for capital and operating lease obligations 4.Describe the structure of bonds, their issuance and interest payments 5.Analysis: Compute and explain debt coverage and times interest earned ratios

2. ©CourseCollege.com 2 Objective 16.1: Explain accounting for long term note origination and interest accrual O16.1 Long term notes have due dates beyond the current fiscal period* *or the normal operating cycle whichever is longer

3. ©CourseCollege.com 3 Written promise to pay Long Term Notes Long term notes can be secured or unsecured Maker is borrower and signs note Payee is lender and holds note O16.1

4. ©CourseCollege.com 4 Why Borrow? All activities can require financing Investing activities –example: buy equipment Financing activities –example: payoff debt or fund owner withdrawals or dividends Operating Activities –example: buy inventory O16.1

5. ©CourseCollege.com 5 Calculate interest accrued using the following formula: With year end Dec 31, 2010, a 3 year note is signed Oct 1 for $100,000 at 8% with annual payments Oct 1 Interest expense and interest payable at year end: $100,000 x.08 x 90/360 = $2000 With year end Dec 31, 2010, a 3 year note is signed Oct 1 for $100,000 at 8% with annual payments Oct 1 Interest expense and interest payable at year end: $100,000 x.08 x 90/360 = $2000 Principal amount Annual Interest rate Time Period in years Interest X = Long Term Notes Payable Example X O16.1

6. ©CourseCollege.com 6 O16.1 Example: Origination of a $500,000 long term note

7. ©CourseCollege.com 7 Many note types Objective 16.2: Describe various note types, repayment structures, collateral and loan agreements O16.2 Installment notes Mortgage notes Single Pay notes Interest only notes

8. ©CourseCollege.com 8 Some long term note types O16.2 Installment notes Mortgage notes Single Pay notes Interest only notes Periodic interest payments with principal due at maturity Periodic interest payments with principal due at maturity Notes accompanying real estate mortgages which secure repayment Notes accompanying real estate mortgages which secure repayment Notes with a single payment of interest and principal at maturity Notes with a single payment of interest and principal at maturity Notes with regular periodic payments of interest and principal Notes with regular periodic payments of interest and principal

9. ©CourseCollege.com 9 Collateral Assets pledged by borrower to secure notes increasing the assurance of repayment Collateral pledged such as land, buildings, equipment or financial assets such as stock & bonds are common The pledge of collateral gives the lender specific legal rights to the collateral in the event of nonpayment Collateral pledged such as land, buildings, equipment or financial assets such as stock & bonds are common The pledge of collateral gives the lender specific legal rights to the collateral in the event of nonpayment Collateral reduces risk to the lender O16.2

10. ©CourseCollege.com 10 Installment Notes –equal principal payments O16.2 Installment Note Types –equal principal reductions Consider a 5 year long term note of $250,000 at 6% which requires annual payments for five years consisting of a $50,000 principal reduction plus all accrued interest to date. The interest calculations and resulting total payments are demonstrated below. $50,000 PrincipalInterest $15,000 Total payments decline due to declining total principal. O-16.2 Yr1 250,000 x.06 = 15,000 $50,000 $12,000 Yr2 (250,000- 50,000)x.06 = 12,000 $50,000 $9,000 Yr3 (200,000- 50,000) x.06 = 9,000 $50,000 $6,000 Yr4 (150,000- 50,000) x.06 = 6,000 $50,000 $1,500 Yr5 (100,000- 50,000) x.06 = 3,000 Declining total payments Long term notes with periodic equal principal reductions are a common note structure for commercial loans. They are typically not used in consumer transactions due to the uneven payment structure that results. Consumer and many commercial transactions prefer equal total principal plus interest payments as shown on the following page. Installment Note Types –equal principal reductions Consider a 5 year long term note of $250,000 at 6% which requires annual payments for five years consisting of a $50,000 principal reduction plus all accrued interest to date. The interest calculations and resulting total payments are demonstrated below. $50,000 PrincipalInterest $15,000 Total payments decline due to declining total principal. O-16.2 Yr1 250,000 x.06 = 15,000 $50,000 $12,000 Yr2 (250,000- 50,000)x.06 = 12,000 $50,000 $9,000 Yr3 (200,000- 50,000) x.06 = 9,000 $50,000 $6,000 Yr4 (150,000- 50,000) x.06 = 6,000 $50,000 $1,500 Yr5 (100,000- 50,000) x.06 = 3,000 Declining total payments Long term notes with periodic equal principal reductions are a common note structure for commercial loans. They are typically not used in consumer transactions due to the uneven payment structure that results. Consumer and many commercial transactions prefer equal total principal plus interest payments as shown on the following page. Installment Note Types –equal principal reductions Consider a 5 year long term note of $250,000 at 6% which requires annual payments for five years consisting of a $50,000 principal reduction plus all accrued interest to date. The interest calculations and resulting total payments are demonstrated below. $50,000 PrincipalInterest $15,000 Total payments decline due to declining total principal. O-16.2 Yr1 250,000 x.06 = 15,000 $50,000 $12,000 Yr2 (250,000- 50,000)x.06 = 12,000 $50,000 $9,000 Yr3 (200,000- 50,000) x.06 = 9,000 $50,000 $6,000 Yr4 (150,000- 50,000) x.06 = 6,000 $50,000 $1,500 Yr5 (100,000- 50,000) x.06 = 3,000 Declining total payments Long term notes with periodic equal principal reductions are a common note structure for commercial loans. They are typically not used in consumer transactions due to the uneven payment structure that results. Consumer and many commercial transactions prefer equal total principal plus interest payments as shown on the following page. $50,000 PrincipalInterest $15,000 $50,000 $12,000 $50,000 $9,000 $50,000 $6,000 $50,000 $3,000 Declining total payments Yr1 250,000 x.06 = 15,000 Yr2 (250,000- 50,000)x.06 = 12,000 Yr3 (200,000- 50,000) x.06 = 9,000 Yr4 (150,000- 50,000) x.06 = 6,000 Yr5 (100,000- 50,000) x.06 = 3,000 Equal principal payments

11. ©CourseCollege.com 11 Installment Notes –equal principal & interest payments O16.2 Installment Note Types –equal principal reductions Consider a 5 year long term note of $250,000 at 6% which requires annual payments for five years consisting of a $50,000 principal reduction plus all accrued interest to date. The interest calculations and resulting total payments are demonstrated below. $50,000 PrincipalInterest $15,000 Total payments decline due to declining total principal. O-16.2 Yr1 250,000 x.06 = 15,000 $50,000 $12,000 Yr2 (250,000- 50,000)x.06 = 12,000 $50,000 $9,000 Yr3 (200,000- 50,000) x.06 = 9,000 $50,000 $6,000 Yr4 (150,000- 50,000) x.06 = 6,000 $50,000 $1,500 Yr5 (100,000- 50,000) x.06 = 3,000 Declining total payments Long term notes with periodic equal principal reductions are a common note structure for commercial loans. They are typically not used in consumer transactions due to the uneven payment structure that results. Consumer and many commercial transactions prefer equal total principal plus interest payments as shown on the following page. Installment Note Types –equal principal reductions Consider a 5 year long term note of $250,000 at 6% which requires annual payments for five years consisting of a $50,000 principal reduction plus all accrued interest to date. The interest calculations and resulting total payments are demonstrated below. $50,000 PrincipalInterest $15,000 Total payments decline due to declining total principal. O-16.2 Yr1 250,000 x.06 = 15,000 $50,000 $12,000 Yr2 (250,000- 50,000)x.06 = 12,000 $50,000 $9,000 Yr3 (200,000- 50,000) x.06 = 9,000 $50,000 $6,000 Yr4 (150,000- 50,000) x.06 = 6,000 $50,000 $1,500 Yr5 (100,000- 50,000) x.06 = 3,000 Declining total payments Long term notes with periodic equal principal reductions are a common note structure for commercial loans. They are typically not used in consumer transactions due to the uneven payment structure that results. Consumer and many commercial transactions prefer equal total principal plus interest payments as shown on the following page. Installment Note Types –equal principal reductions Consider a 5 year long term note of $250,000 at 6% which requires annual payments for five years consisting of a $50,000 principal reduction plus all accrued interest to date. The interest calculations and resulting total payments are demonstrated below. $50,000 PrincipalInterest $15,000 Total payments decline due to declining total principal. O-16.2 Yr1 250,000 x.06 = 15,000 $50,000 $12,000 Yr2 (250,000- 50,000)x.06 = 12,000 $50,000 $9,000 Yr3 (200,000- 50,000) x.06 = 9,000 $50,000 $6,000 Yr4 (150,000- 50,000) x.06 = 6,000 $50,000 $1,500 Yr5 (100,000- 50,000) x.06 = 3,000 Declining total payments Long term notes with periodic equal principal reductions are a common note structure for commercial loans. They are typically not used in consumer transactions due to the uneven payment structure that results. Consumer and many commercial transactions prefer equal total principal plus interest payments as shown on the following page. Installment Note Types –equal total payments Consider a 5 year long term note of $250,000 at 6% which requires equal annual payments of $59,349 for five years to pay all principal and accrued interest. The principal and interest components of each payment are demonstrated below. $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 $44,349 $47,010 $15,000$12,339 $49,831 $9,518 $52,820 $6,529 $55,990 $3,359 PrincipalInterest Yr1 Yr2 Yr3 Yr4 Yr5 Equal total payments $59,349

12. ©CourseCollege.com 12 O16.2 Installment Note Types –equal principal reductions Consider a 5 year long term note of $250,000 at 6% which requires annual payments for five years consisting of a $50,000 principal reduction plus all accrued interest to date. The interest calculations and resulting total payments are demonstrated below. $50,000 PrincipalInterest $15,000 Total payments decline due to declining total principal. O-16.2 Yr1 250,000 x.06 = 15,000 $50,000 $12,000 Yr2 (250,000- 50,000)x.06 = 12,000 $50,000 $9,000 Yr3 (200,000- 50,000) x.06 = 9,000 $50,000 $6,000 Yr4 (150,000- 50,000) x.06 = 6,000 $50,000 $1,500 Yr5 (100,000- 50,000) x.06 = 3,000 Declining total payments Long term notes with periodic equal principal reductions are a common note structure for commercial loans. They are typically not used in consumer transactions due to the uneven payment structure that results. Consumer and many commercial transactions prefer equal total principal plus interest payments as shown on the following page. Installment Note Types –equal principal reductions Consider a 5 year long term note of $250,000 at 6% which requires annual payments for five years consisting of a $50,000 principal reduction plus all accrued interest to date. The interest calculations and resulting total payments are demonstrated below. $50,000 PrincipalInterest $15,000 Total payments decline due to declining total principal. O-16.2 Yr1 250,000 x.06 = 15,000 $50,000 $12,000 Yr2 (250,000- 50,000)x.06 = 12,000 $50,000 $9,000 Yr3 (200,000- 50,000) x.06 = 9,000 $50,000 $6,000 Yr4 (150,000- 50,000) x.06 = 6,000 $50,000 $1,500 Yr5 (100,000- 50,000) x.06 = 3,000 Declining total payments Long term notes with periodic equal principal reductions are a common note structure for commercial loans. They are typically not used in consumer transactions due to the uneven payment structure that results. Consumer and many commercial transactions prefer equal total principal plus interest payments as shown on the following page. Installment Note Types –equal principal reductions Consider a 5 year long term note of $250,000 at 6% which requires annual payments for five years consisting of a $50,000 principal reduction plus all accrued interest to date. The interest calculations and resulting total payments are demonstrated below. $50,000 PrincipalInterest $15,000 Total payments decline due to declining total principal. O-16.2 Yr1 250,000 x.06 = 15,000 $50,000 $12,000 Yr2 (250,000- 50,000)x.06 = 12,000 $50,000 $9,000 Yr3 (200,000- 50,000) x.06 = 9,000 $50,000 $6,000 Yr4 (150,000- 50,000) x.06 = 6,000 $50,000 $1,500 Yr5 (100,000- 50,000) x.06 = 3,000 Declining total payments Long term notes with periodic equal principal reductions are a common note structure for commercial loans. They are typically not used in consumer transactions due to the uneven payment structure that results. Consumer and many commercial transactions prefer equal total principal plus interest payments as shown on the following page. Installment Note Types –equal total payments Consider a 5 year long term note of $250,000 at 6% which requires equal annual payments of $59,349 for five years to pay all principal and accrued interest. The principal and interest components of each payment are demonstrated below. $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 Installment Note Types –equal total payments $44,349 PrincipalInterest $15,000 O-16.2 Yr1 $47,010 $12,339 Yr2 $49,831 $9,518 Yr3 $52,820 $6,529 Yr4 $55,990 $3,359 Yr5 Equal total payments $59,349 $44,349 $47,010 $15,000$12,339 $49,831 $9,518 $52,820 $6,529 $55,990 $3,359 PrincipalInterest Yr1 Yr2 Yr3 Yr4 Yr5 Equal total payments $59,349 Current portion of long term debt

13. ©CourseCollege.com 13 Objective 16.3: Explain accounting for capital and operating lease obligations A lease is a rental agreement between the user and the owner of an asset Depending on whether a transfer of ownership takes place, the lease may be an operating lease or a capital lease Accounting treatment is very different for the two types of leases Depending on whether a transfer of ownership takes place, the lease may be an operating lease or a capital lease Accounting treatment is very different for the two types of leases O16.3

14. ©CourseCollege.com 14 Parties involved in a lease O16.3 Lease Agreement Lessor:__________ Lessee:__________ Lease Agreement Lessor:__________ Lessee:__________ Lessee Uses the Asset Provides the Asset Lessor Lessee

15. ©CourseCollege.com 15 Capital or Operating Lease? O16.3 YES Operating Lease Capital Lease NO Virtually all benefits and risks of ownership transferred to Lessee? Capital lease is recorded on the balance sheet

16. ©CourseCollege.com 16 The 4 rules that qualify capital leases 1.The lease transfers ownership of the property to the lessee. Record the leased asset and liability on the balance sheet It’s a capital lease if: O16.3

17. ©CourseCollege.com 17 The 4 rules that qualify capital leases 2.The lease contains a bargain purchase option. Record the leased asset and liability on the balance sheet It’s a capital lease if: O16.3

18. ©CourseCollege.com 18 The 4 rules that qualify capital leases 3.The lease term is 75% or more of the estimated economic life of the leased asset. Record the leased asset and liability on the balance sheet It’s a capital lease if: O16.3

19. ©CourseCollege.com 19 The 4 rules that qualify capital leases 4.The present value of the minimum lease payments equals or exceeds 90% of the fair market value of the leased asset. Record the leased asset and liability on the balance sheet It’s a capital lease if: O16.3

20. ©CourseCollege.com 20 Operating lease -example O16.3 Cameron Construction signed a 24 month lease for a new compressor. There is no change in ownership and no bargain purchase option. The lease does not meet the 75% and 90% test as shown below. Therefore, this is an operating lease. No asset or liability is recorded, rental payments are expensed as incurred. Date of first payment

21. ©CourseCollege.com 21 Capital lease -example O16.3 Boone Excavating signed a 48 month lease for a new backhoe. There is no change in ownership and no bargain purchase option. The lease meets the 90% test as shown below. Therefore, this is a capital lease. Therefore, the present value of the lease payments is recorded as the leased asset and the lease obligation on the balance sheet as the journal entry below illustrates. Present value is greater than 90% of fair value, therefore this is a capital lease

22. ©CourseCollege.com 22 Objective 16.4: Describe the structure of bonds, their issuance and interest payments O16.4 Bonds are a common form of long term debt available, in general, to large publicly traded firms. The Securities and Exchange Commission regulates bond issuance by publicly traded firms

23. ©CourseCollege.com 23 Bonds differ from direct commercial loans in that the source of funds for bonds can consist of a large number individual and institutional investors, each of which would own a portion of the total bond debt. With direct commercial loans, the source of loan funds are from a single financial institution. Bonds compared to commercial loans O16.4

24. ©CourseCollege.com 24 Bond terminology O16.4 Bond Trustee Bond Holder Bond Indenture Bond Issuer The borrower who receives bond funds and promises repayment The borrower who receives bond funds and promises repayment The investor who provides bond funds and awaits repayment The investor who provides bond funds and awaits repayment The written agreement specifying terms of the bond issuance The written agreement specifying terms of the bond issuance Monitors the terms of the bond indenture for the bond holders Monitors the terms of the bond indenture for the bond holders Bond Underwriter Analyzes and accepts bond structure for bond broker or investment bank Analyzes and accepts bond structure for bond broker or investment bank

25. ©CourseCollege.com 25 Floating a bond issue O16.4 Trustee Bond Holder (Investor) Bond Issuer Underwriter Bond Indenture Bond Indenture Bond

26. ©CourseCollege.com 26 Genway Corporation successfully issued $1,500,000 bonds sold at par on July 1, interest rate 8%. Interest payments are promised July 1 and January 1 each year for the 5 years the bonds are outstanding. The journal entry for the issuance and the first interest payment is shown below. Genway Corporation successfully issued $1,500,000 bonds sold at par on July 1, interest rate 8%. Interest payments are promised July 1 and January 1 each year for the 5 years the bonds are outstanding. The journal entry for the issuance and the first interest payment is shown below. Bond issuance -journal entry O16.4

27. ©CourseCollege.com 27 Objective 16.5: Analysis: Compute and explain debt coverage and times interest earned ratios Compares adjusted earnings to payments required to creditors O16.5 Creditors are especially interested in These ratios which compare earnings to required debt payments.

28. ©CourseCollege.com 28 Times Interest Earned Ratio Adjusted accrual income = the sum of accrual net income + interest expense + income tax expense + non cash expenses such as depreciation, amortization and depletion. The higher the ratio, the more adequate earnings are to cover interest expense O16.5 Times interest earned Interest expense Adjusted accrual income =

29. ©CourseCollege.com 29 Debt Coverage Ratio Adjusted accrual income = the sum of accrual net income + interest expense + income tax expense + non cash expenses such as depreciation, amortization and depletion. The higher the ratio, the more adequate earnings are to cover debt service payments O16.5 Debt Coverage Principal & Interest payments Adjusted accrual income =

30. ©CourseCollege.com 30 Example -Times interest earned and Debt coverage ratios O16.5

31. ©CourseCollege.com 31 End Unit 16