1. Copyright © Cengage Learning. All rights reserved. Chapter 10 Long-Term Liabilities

2. Copyright © Cengage Learning. All rights reserved. 10-2 Management Issues Related to Issuing Long-Term Debt Objective 1 –Identify the management issues related to long-term debt.

3. Copyright © Cengage Learning. All rights reserved. 10-3 Long-Term Liabilities - These are obligations of the business that are due to be paid after one year or beyond the normal operating cycle, whichever is longer. How a company finances its operations is one of the most important factor in the company’s long-term viability. The amount and type of debt a company incurs depends on: –The nature of the business –Its competitive environment –The state of the financial markets –The predictability of its earnings

4. Copyright © Cengage Learning. All rights reserved. 10-4 Long-Term Funding Key sources of long-term funds include: –Issuance of capital stock; and –Issuance of long-term debt such as bonds, notes, mortgages, and leases.

5. Copyright © Cengage Learning. All rights reserved. 10-5 Management Issues Related to Issuing Long-Term Debt These issues include: 1.Whether to take on long-term debt; 2.How much long-term debt to carry; and 3.What types of long-term debt to carry.

6. Copyright © Cengage Learning. All rights reserved. 10-6 Deciding to Issue Long-Term Debt A key management decision regarding long-term funding for the company is: Stockholders’ equity versus long-term debt. Advantages of common stock over debt –It does not have to be paid back –Dividends are paid only if the company earns sufficient income Advantages of long-term debt over common stock –Stockholder control Creditors do not elect directors –Tax effects Interest is tax deductible –Financial leverage After interest is paid, all excess earnings accrue to stockholders

7. Copyright © Cengage Learning. All rights reserved. 10-7 Disadvantages of Debt Financing FINANCIAL RISK Cash is required: for periodic interest payments and to pay back the principal amount Company can become overcommitted High levels of debt exposes a company to financial risk NEGATIVE FINANCIAL LEVERAGE Financial leverage can work against a company –If the earnings from its investments do not exceed its interest payments

8. Copyright © Cengage Learning. All rights reserved. 10-8 Many companies use the debt to equity ratio when assessing how much debt to carry. McDonald’s also has long-term leases that do not appear on the balance sheet, called off-balance sheet financing. Debt to Equity Ratio McDonald’s Ratio = $4.498.5 + $9,613.4 = 0.9 times $15,279.8

9. Copyright © Cengage Learning. All rights reserved. 10-9 Financial statement users should review the notes to financial statements for information about any leases that may have the effect of long-term liabilities Off-Balance Sheet Financing A legal way of structuring a lease commitment so that it does not have to be included on the balance sheet as a liability.

10. Copyright © Cengage Learning. All rights reserved. 10-10 Average Debt to Equity for Selected Industries

11. Copyright © Cengage Learning. All rights reserved. 10-11 Measures the degree of protection a company has from default on interest payments Interest Coverage Ratio Measures how much risk a company is undertaking with its debt. Roughly equal to EBIT/Interest

12. Copyright © Cengage Learning. All rights reserved. 10-12 McDonald’s 2007 annual report shows that the company had income before taxes of $3,572.1 million and interest expense of $410.1 million. McDonald’s interest expense was covered 9.7 times in 2007. However, if we add the company’s off-the-balance sheet rent expense of $1,053.8 to its interest expense. This procedure decreases the coverage ratio to less than 3 times, still adequate to cover interest payments. Interest Coverage Ratio Illustrated = $3,572.1 + $410.1 $410.1 = 9.7 times

13. Copyright © Cengage Learning. All rights reserved. 10-13 Types of Long-Term Debt 3Bonds Payable 3Notes Payable 3Long-term Leases 3Pension Liabilities 3Other Postretirement Benefits 3Deferred Income Taxes

14. Copyright © Cengage Learning. All rights reserved. 10-14 Long-Term Debt Bonds PayableNotes Payable  Most common type of long-term debt  May be convertible to common stock  Involves a debt to many creditors  Represents a loan from a bank or other creditor Deutsche Telekom International Finance recently raised $14.6 billion by issuing a series of long- term notes denominated in dollars, Euros, pounds, and yen. Some notes were due in 2005, 2010, and 2030.

15. Copyright © Cengage Learning. All rights reserved. 10-15 Mortgages Payable Long-term debt secured by real property. Usually repaid in equal monthly installments that include interest on the debt and a reduction in the initial debt. Illustration: Monthly Payment Schedule on a $100,000, 12% mortgage Payment date Unpaid Bal. at Beg. Of Period Monthly payment Interest for 1 month at 1% on unpaid balance Reduction in debt Unpaid balance at end of period 6/1$100,000 7/1$100,000$1,600$1,000$ 600$99,400 8/1$99,400$1,600$ 994$ 606$98,794 9/1$98,794$1,600$ 988$ 612$98,182

16. Copyright © Cengage Learning. All rights reserved. 10-16 Long-Term Leases Companies may obtain an operating asset in three ways: 3Borrow the money and buy the asset. 3Rent the asset on a short-term lease (operating lease; payments are treated as rent expense). 3Obtain the asset on a long-term lease (may be structured as a capital lease or an operating lease).

17. Copyright © Cengage Learning. All rights reserved. 10-17 Accounting standards require that a lease be treated as a capital lease if the lease: Cannot be cancelled. Its duration is about the same as the useful life of the asset. It stipulates that the lessee has the option to buy the asset at a nominal price at the end of the lease. Accounting for a Capital Lease The lessee should: 1)Record the asset. 2)Record depreciation on the asset. 3)Record a liability equal to the present value of the total lease payments during the lease term. Capital Leases

18. Copyright © Cengage Learning. All rights reserved. 10-18 Polany Manufacturing Co. enters into a long-term lease for a machine. The lease terms call for an annual payment of $8,000 for six years, which approximates the useful life of the machine. At the end of the lease period, the title to the machine passes to Polany. Use present value techniques to place a value on the asset and on the corresponding liability. Assume that the interest cost on the unpaid part of the obligation is 16 percent. (Factor of 3.685) $8,000 x 3.685 = $29,480 Capital Lease Illustrated

19. Copyright © Cengage Learning. All rights reserved. 10-19 Each year, Polany must record depreciation on the leased asset. Assume the company uses the straight-line method and no residual value. Polany must also record interest expense for the lease. The interest expense for each year is computed by multiplying the interest rate by the amount of remaining lease obligation. Capital Lease Illustrated (cont’d)

20. Advantages of Operating Lease Reduces Liabilities Reduces Assets (so that ROA is higher) Copyright © Cengage Learning. All rights reserved. 10-20

21. Copyright © Cengage Learning. All rights reserved. 10-21 Pension plans Require a company to pay benefits to employees after they retire Some companies pay full cost of pension plan Employees often share the cost of pension plans Pension Fund Employer contributions Employee contributions Pension benefits paid to retired employees Pension Liabilities

22. Copyright © Cengage Learning. All rights reserved. 10-22 Defined Contribution PlanDefined Benefit Plan Employer makes variable payments required to fund the estimated future pension liability arising from current employment Retirement benefits are fixed More complex accounting required Employer makes fixed, agreed- on, annual contribution Retirement payments vary depending on how much the fund earns Employees usually control their own accounts and can transfer funds if they leave the firm Examples: 401(K) plans, profit- sharing plans, ESOPs Pension Plans

23. Copyright © Cengage Learning. All rights reserved. 10-23 A company might use straight-line depreciation for financial reporting and accelerated method for income tax purposes. The difference in taxes resulting from the two methods is listed as a long-term liability. Deferred Income Taxes Results from using different accounting methods to calculate income taxes on the income statement and income tax liability on the income tax return

24. Copyright © Cengage Learning. All rights reserved. 10-24 The Nature of Bonds Objective 2 –Describe the features of a bond issue and the major characteristics of bonds.

25. Copyright © Cengage Learning. All rights reserved. 10-25 Bonds Are securities, usually long term, representing money borrowed from the investing public by a corporation or some other entity. Bonds are promises to repay the amount borrowed (principal) and interest at a specified rate on specified future dates. Bonds must be repaid at a specified time and require periodic (usually semiannual) payments of interest.

26. Copyright © Cengage Learning. All rights reserved. 10-26 The Nature of Bonds Bondholders –Are creditors of the issuing company. –Receive a bond certificate or registration number as evidence of the organization's debt. Bond Issue –Total number of bonds issued at one time. –Face value usually $1,000 or some multiple of $1,000. Bond indenture –Defines the rights, privileges, and limitations of the bondholders. –Describes the maturity date, interest payment dates, interest rate, and other characteristics of the bonds.

27. Copyright © Cengage Learning. All rights reserved. 10-27 Bond Issue: Prices Stated in terms of a percentage of face value Bonds selling at 100 –Sell at face or par value Bonds selling above 100 –Sell at a premium Bonds selling below 100 –Sell at a discount

28. Copyright © Cengage Learning. All rights reserved. 10-28 A bond issue is quoted at 103 ½ What is the selling price of a $1,000 bond? A bond issue quoted at 103 ½ means that the bond sells at 103.5 percent of its face value This bond sells at a premium and would cost the buyer $1,035. Selling Price of Bonds

29. Copyright © Cengage Learning. All rights reserved. 10-29 Face Interest and Market Interest Rate Face Interest Rate –Fixed rate of interest paid to bondholders based on the face value of the bonds; determined in advance of the issue. Market Interest Rate –Rate of interest paid in the market on bonds of similar risk; also called the effective interest rate.

30. Copyright © Cengage Learning. All rights reserved. 10-30 Discounts and Premiums Discount –Excess of the face value over the issue price –When market interest rate is higher than face interest rate, the issue price will be less than the face value of the bond. Premium –Excess of the issue price over the face value –When market interest rate is lower than face interest rate, the issue price will be more than the face value of the bond.

31. Copyright © Cengage Learning. All rights reserved. 10-31 Gives issuer the right to buy back and retire the bonds before maturity at a specified call price Bonds of an issue mature on different dates Allows bondholder to exchange a bond for a specified number of shares of common stock Issued to a specific bondholder All bonds of an issue mature at the same time Not registered with the organization Issued on the basis of a firm’s general credit Carry a pledge of certain corporate assets as a guarantee of repayment Callable Serial Convertible Registered Term Bearer Bond Unsecured Secured Bond Characteristics

32. Copyright © Cengage Learning. All rights reserved. 10-32 Accounting for the Issuance of Bonds Objective 3 –Record bonds issued at face value and at a discount or premium.

33. Copyright © Cengage Learning. All rights reserved. 10-33 Bharath Corporation issues $200,000 of 9 percent, 5-year bonds on January 1, 2010, and sells them on the same date for their face value. The bond indenture states that interest is to be paid on January 1 and July 1 of each year. Record a semiannual interest payment: Bonds Issued at Face Value

34. Copyright © Cengage Learning. All rights reserved. 10-34 Bharath Corporation issues $200,000 of 9 percent, 5-year bonds at 96.149 on January 1, 2010, when the market rate is 10 percent. Record the issuance of the bonds at a discount: Unamortized Bond Discount is a contra-liability account Carrying Value of Bonds = Face Value – Unamortized Bond Discount Bonds Issued at a Discount

35. Copyright © Cengage Learning. All rights reserved. 10-35 Bharath Corporation issues $200,000 of 9 percent, 5-year bonds for $208,200 on January 1, 2010, when the market rate is 8 percent. Record the issuance of the bonds at a premium: Carrying Value of Bonds = Face Value + Unamortized Bond Premium = $200,000 + $8,200 = $208,200 Bonds Issued at a Premium Unamortized Bond Premium is a contra-Asset account

36. Copyright © Cengage Learning. All rights reserved. 10-36 Using Present Value to Value a Bond Objective 4 –Use present values to determine the value of bonds.

37. Copyright © Cengage Learning. All rights reserved. 10-37 Using Present Value to Value a Bond The value of a bond is based on the present value of two components of cash flow: –A series of fixed interest payments –A single payment at maturity The amount of interest a bond pays is fixed over its life. Market interest rate varies from day to day.

38. Copyright © Cengage Learning. All rights reserved. 10-38 Influence of the Market Interest Rate The market interest rate varies from day to day and therefore what investors are willing to pay changes as well. –If current market interest rate > bond’s interest rate, investors are willing to pay less. –If current market interest rate < bond’s interest rate, investors are willing to pay more.

39. Copyright © Cengage Learning. All rights reserved. 10-39 A bond has a face value of $20,000 and pays fixed interest of $900 every six months (a 9 percent annual rate). The bond is due in 5 years, and the market interest rate is 12 percent. What is the present value of the bond? Determine the interest rate and number of periods to use in the present value tables Divide the annual interest rate by the number of periods in the year 12% ÷ 2 = 6% Multiply the number of periods in one year by the number of years 2 x 5 = 10 periods Market interest rate > Face interest rate Case 1: Market Rate Above Present Value

40. Copyright © Cengage Learning. All rights reserved. 10-40 A bond has a face value of $20,000 and pays fixed interest of $900 every six months (a 9 percent annual rate). The bond is due in 5 years, and the market interest rate is 8 percent. What is the present value of the bond? Market interest rate < Face interest rate Case 2: Market Rate Below Face Rate

41. Copyright © Cengage Learning. All rights reserved. 10-41 Stop & Review Q.A corporation sold $500,000 of 5%, $1,000 bonds on the interest payment date. What would the proceeds from the sale be if the bonds were issued at 95, at 100, and at 102? A. The proceeds from the sale at 95 would be $475,000; at 100, $500,000; and at 102, $510,000

42. Copyright © Cengage Learning. All rights reserved. 10-42 Amortization of Bond Discounts and Premiums Objective 5 –Amortize bond discounts and bond premiums using the straight-line and effective interest methods.

43. Copyright © Cengage Learning. All rights reserved. 10-43 Bond Discount or Premium Represents the amount by which the total interest cost is higher or lower than the total interest payments. The discount or premium is amortized over the life of the bonds. –Properly records interest cost. –Ensures that the carrying value of bonds payable equals its face value at maturity. Use straight-line or effective interest method.

44. Copyright © Cengage Learning. All rights reserved. 10-44 Amortizing a Bond Discount When a bond is sold at a discount, the discount affects interest expense in each year of the bond issue. Discount should be amortized (reduced gradually) over the life of the issue. Carrying value = Face value – Discount Unamortized bond discount decreases gradually over time. Carrying value increases gradually. By maturity date: –The carrying value of the issue equals the face value amount of the bonds. –The unamortized bond discount is zero.

45. Copyright © Cengage Learning. All rights reserved. 10-45 Bharath Corporation issues $200,000 of 9 percent, 5-year bonds at a time when the market rate of 10 percent exceeded the face interest rate of 9 percent. The bonds sold for $192,298 resulting in an unamortized bond discount of $7,702. The bonds were issued at a discount: The interest rate paid by the company is greater than the face interest rate on the bonds Although the company does not receive the full face value of the bonds on issue, it still must pay back the full face value at maturity Calculating Total Interest Cost

46. Copyright © Cengage Learning. All rights reserved. 10-46 Bharath Corporation issues $200,000 of 9 %, 5-year bonds at 96.149 when the market rate is 10 percent. The bonds sold for $192,298, resulting in an unamortized bond discount of $7,702. The bond discount increases the interest paid on the bonds from the stated interest rate to the effective interest rate. Determining Total Interest Cost Cash to be paid to bond holders Face value at maturity$200,000 Interest payments ($200,000 x 0.09 x 5 years)90,000 Total cash paid to bondholders$290,000 Less cash received from bondholders192,298 Total interest cost$97,702 Or, alternatively: Interest payments ($200,000 x 0.09 x 5 years)$90,000 Bond discount7,702 Total interest cost$97,702

47. Copyright © Cengage Learning. All rights reserved. 10-47 Effective Interest Rate = Stated Rate + Discount Accounting for Total Interest Cost Amortization of the bond discount –Must be allocated over the remaining life of the bonds as an increase in the interest expense each period –Interest expense for each period will exceed the actual payment of interest by the amount of the bond discount amortized over the period Zero coupon bonds are issued by some companies and governmental units –Do not require periodic interest payments –Represent a promise to pay a fixed amount at the maturity date

48. Copyright © Cengage Learning. All rights reserved. 10-48 Face value = $200,000 Face Interest rate = 9% Life of bond = 5 years Interest payments = Semiannual Bond Discount = $7,702 Step 1: Determine the total number of interest payments Step 2: Determine the amount of bond discount to amortize each interest period Equal amortization of the bond discount for each interest period Straight-Line Method

49. Copyright © Cengage Learning. All rights reserved. 10-49 Step 3: Determine the cash interest payment amount Step 4: Determine the total interest expense per interest period Record first semiannual interest payment and amortization of bond discount Straight-Line Method (cont’d)

50. Copyright © Cengage Learning. All rights reserved. 10-50 Weaknesses of the Straight-Line Method When used to amortize a discount, the carrying value goes up each period, but the bond interest expense stays the same; thus, the rate of interest falls over time. When used to amortize a premium, the rate of interest rises over time. Can be used only when it does not lead to a material difference from the effective interest method, per APB.

51. Copyright © Cengage Learning. All rights reserved. 10-51 Rate equals the market, or effective, rate at the time the bonds were issued Amount amortized is the difference between interest computed and actual interest paid to bondholders Effective Interest Method Applies a constant interest rate to the carrying value of bonds at the beginning of the interest period.

52. Copyright © Cengage Learning. All rights reserved. 10-52 Interest and Amortization of a Bond Discount: Effective Interest Method

53. Copyright © Cengage Learning. All rights reserved. 10-53 Face value = $200,000 Face Interest rate = 9% Life of bond = 5 years Interest payments = Semiannual Bond Discount = $7,702 Column B – Use market interest rate ($192,298 x.10 x 6/12 = $9,615) Column C – Use face interest rate on bond ($200,000 x.09 x 6/12 = $9,000) Column A Carrying value = Face value – Unamortized bond discount Bond Amortization – Effective Interest Method

54. Copyright © Cengage Learning. All rights reserved. 10-54 Notice that the sum of the carrying value and the unamortized discount always equals the face value of the bonds Column D Discount amortized = Effective interest expense – Actual interest payment to bondholders ($9,615 - $9,000 = $615) Column F Carrying value at beg. of period + Amort. during the pd ($192,298 + $615 = $192,913) Column E Bond discount at beg. of period – Current pd amort. ($7,702 - $615 = $7,087) Bond Amortization – Effective Interest Method (cont’d)

55. Copyright © Cengage Learning. All rights reserved. 10-55 Record first semiannual interest payment and amortization of bond discount: It is not necessary to prepare an interest and amortization table to determine amortization of a discount for the period Bond Amortization – Effective Interest Method (cont’d)

56. Copyright © Cengage Learning. All rights reserved. 10-56 Carrying Value and Interest Expense – Bonds Issued at a Discount

57. Copyright © Cengage Learning. All rights reserved. 10-57 Bond Premiums Bondholders pay more than face value for bonds. Premium is an amount that bondholders will receive at maturity (it is a reduction, in advance, of the total interest paid on bonds over life of issue).

58. Copyright © Cengage Learning. All rights reserved. 10-58 Bharath Corporation issues $200,000 of 9 percent, 5-year bonds at 104.1, when the market rate is 8 percent. The bonds sold for $208,200 resulting in an unamortized bond premium of $8,200. The bond premium decreases the interest paid on the bonds from the stated interest rate to the effective interest rate. Calculation of Total Interest Cost Cash to be paid to bond holders Face value at maturity$200,000 Interest payments ($200,000 x 0.09 x 5 years)90,000 Total cash paid to bondholders$290,000 Less cash received from bondholders208,200 Total interest cost$81,800 Or, alternatively: Interest payments ($200,000 x 0.09 x 5 years)$90,000 Less bond premium8,200 Total interest cost$81,800

59. Copyright © Cengage Learning. All rights reserved. 10-59 Interest and Amortization of a Bond Premium: Effective Interest Method

60. Copyright © Cengage Learning. All rights reserved. 10-60 Record first semiannual interest payment and amortization of bond premium: It is not necessary to prepare an interest and amortization table to determine amortization of a premium for the period Bond Amortization – Effective Interest Method (cont’d)

61. Copyright © Cengage Learning. All rights reserved. 10-61 Carrying Value and Interest Expense – Bonds Issued at a Premium

62. Copyright © Cengage Learning. All rights reserved. 10-62 Stop & Review Q. When using the effective interest method, what amount is amortized? A. Amount amortized is the difference between interest computed and actual interest paid to bondholders.

63. Copyright © Cengage Learning. All rights reserved. 10-63 Chapter Review 1.Identify the management issues related to long- term debt. 2.Describe the features of a bond issue and the major characteristics of bonds. 3.Record bonds issued at face value and at a discount or premium. 4.Use present values to determine the value of bonds.

64. Copyright © Cengage Learning. All rights reserved. 10-64 Chapter Review (cont’d) 5.Amortize bond discounts and bond premiums using the straight-line and effective interest methods.