1. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Chapter 10 Reporting and Interpreting Long-Term Debt

2. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Business Background The mixture of debt and equity used to finance a company’s operations is called the capital structure: Debt - funds from creditors Equity - funds from owners

3. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Significant debt needs of a company are often filled by issuing notes and bonds. Business Background Capital Structure – Long-Term Debt Notes & Bonds Cash

4. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Financial Leverage Capital Structure ________________________ Total assets = $600,000 50% Debt 100% Equity 50% Equity Income before interest and taxes $ 100,000 $ 100,000 Interest expense ($300,000 x 10%) -0- 30,000 100,000 70,000 Income tax expense (@40%) 40,000 28,000 Net income $ 60,000 $ 48,000 Owners’ equity $ 600,000 $ 300,000 Return on equity (Net income/Owners’ equity)10% 16%

5. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Key Ratio Analysis The debt-to-equity ratio is an important measure of the balance between debt and equity. High debt-to-equity ratios indicate more leverage and risk.

6. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Types of Long-Term Debt Long-term debt is available to companies in various forms:  Bank loans  Notes  Mortgage Notes  Bonds and Debentures http://www.aliant.ca/english/ir/index.shtml Refer to Exhibit 10-2 (page 526) for alternative note repayment schedules.

7. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Business Background liquidity Bonds can be traded on established exchanges that provide liquidity to bondholders. As liquidity increases...... Cost of borrowing decreases.

8. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Business Background Advantages of bonds: Bonds are debt, not equity, so the ownership and control of the company are not diluted. Interest expense is tax-deductible. The low interest rates on bonds allow for positive financial leverage. Advantages of bonds: Bonds are debt, not equity, so the ownership and control of the company are not diluted. Interest expense is tax-deductible. The low interest rates on bonds allow for positive financial leverage.

9. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Business Background Disadvantages of bonds: The scheduled interest payments are legal obligations and must be paid each period. A single, large principal payment is required at the maturity date. Disadvantages of bonds: The scheduled interest payments are legal obligations and must be paid each period. A single, large principal payment is required at the maturity date.

10. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Characteristics of Bonds Payable Company Issuing Bonds $ Bond Issue Price $ Investor Buying Bonds Bond Certificate At Bond Issuance Date Bonds payable are long-term debt for the issuing company.

11. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Characteristics of Bonds Payable Company Issuing Bonds Periodic Interest Payments $$ Investor Buying Bonds Face Value Payment at End of Bond Term $$

12. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson 1. Face Value = Maturity or Par Value, Principal 2. Maturity Date 3. Stated Interest Rate 4. Interest Payment Dates 5. Bond Date Characteristics of Bonds Payable Other Factors: 6. Market Interest Rate 7. Issue Date BOND PAYABLE Face Value $1,000 Interest 10% 6/30 & 12/31 Maturity Date 1/1/10Bond Date 1/1/01

13. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Characteristics of Bonds Payable When issuing bonds, potential buyers of the bonds are given a prospectus. The company’s bonds are issued to investors through an underwriter. The trustee makes sure the issuer fulfills all of the provisions of the bond indenture. For example, see Prospectus Supplement, dated May 11, 2001 of Aliant Telecom Inc. on the SEDAR website. When issuing bonds, potential buyers of the bonds are given a prospectus. The company’s bonds are issued to investors through an underwriter. The trustee makes sure the issuer fulfills all of the provisions of the bond indenture. For example, see Prospectus Supplement, dated May 11, 2001 of Aliant Telecom Inc. on the SEDAR website.

14. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Bond Classifications Debenture bondsDebenture bonds Not secured with the pledge of a specific asset. RetractableRetractable May be retired at the option of the bondholder. Redeemable (Callable) bondsRedeemable (Callable) bonds May be turned in at any time for repayment at the option of the issuer. Convertible bondsConvertible bonds May be exchanged for other securities of the issuer (usually common shares) at the option of the bondholder. Debenture bondsDebenture bonds Not secured with the pledge of a specific asset. RetractableRetractable May be retired at the option of the bondholder. Redeemable (Callable) bondsRedeemable (Callable) bonds May be turned in at any time for repayment at the option of the issuer. Convertible bondsConvertible bonds May be exchanged for other securities of the issuer (usually common shares) at the option of the bondholder.

15. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Senior DebtSenior Debt receives preference over other creditors in the event of bankruptcy or default. Subordinated DebtSubordinated Debt is riskier than senior debt. Senior DebtSenior Debt receives preference over other creditors in the event of bankruptcy or default. Subordinated DebtSubordinated Debt is riskier than senior debt. Bond Classifications

16. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Measuring Bonds Payable and Interest Expense The issue price of the bond is determined by the market, based on the time value of money. market interest rate The interest rate used to compute the present value is the market interest rate.

17. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Measuring Bonds Payable and Interest Expense stated rate The stated rate is only used to compute the periodic interest payments.

18. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Bond Premium and Discounts = > < > < =

19. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds On Jan 1, 20A, Aliant’s issues $400,000 in bonds having a stated rate of 5% semi- annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 12% annually. Are Aliant’s bonds issued at par, at a discount, or at a premium?

20. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson On Jan 1, 20A, Aliant’s issues $400,000 in bonds having a stated rate of 5% semi- annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 12% annually. Issuing Bonds <<

21. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds On Jan 1, 20A, Aliant’s issues $400,000 in bonds having a stated rate of 5% semi- annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 12% annually. Compute the issue price of Aliant’s bonds.

22. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds  Compute the present value of the principal. Use the present value of a single amount table to find the appropriate factor.

23. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds  Compute the present value of the principal. Use the market rate of 12% to determine the present value. Interest is paid semiannually, so the rate is i=6% (12% ÷ 2 interest periods per year).

24. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds  Compute the present value of the principal. Though the maturity period is 10 years, there are 2 interest periods per year. For the present value computation, use n=20 (10 years × 2 periods per year).

25. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds  Compute the present value of the principal.

26. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds  Compute the present value of the interest payments. The interest payment is computed as: $400,000 × 5% × 6/12 = $20,000 The interest payment is computed as: $400,000 × 5% × 6/12 = $20,000

27. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds  Compute the present value of the interest payments. Use the same i=6.0% and n=20 used for the present value of the principal, but use the present value of an annuity table.

28. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds  Compute the present value of the interest payments. Now, the issue price of the bonds can be computed.

29. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds  Compute the issue price of the bonds.

30. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds  Compute the issue price of the bonds. The $354,118 is less than the face amount of $400,000, so the bonds are issued at a discount of $45,882

31. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Recording Bonds Issued at a Discount  Prepare the journal entry to record the issuance of the bonds. This is a contra-liability account and appears in the liability section of the balance sheet.

32. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Bonds Issued at a Discount Financial Statement Presentation The discount will be amortized over the 10- year life of the bonds.

33. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Bonds Issued at a Discount Financial Statement Presentation Two methods of amortization are commonly used: Straight-line or Interest Method

34. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Straight-Line Amortization of Bond Discount  Identify the amount of the bond discount.  Divide the bond discount by the number of interest periods.  Include the discount amortization amount as part of the periodic interest expense entry. The discount will be reduced to zero by the maturity date.  Identify the amount of the bond discount.  Divide the bond discount by the number of interest periods.  Include the discount amortization amount as part of the periodic interest expense entry. The discount will be reduced to zero by the maturity date.

35. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Straight-Line Amortization of Bond Discount Aliant’s issued its bonds on Jan 1, 2001. The discount was $45,882. The bonds have a 10-year maturity and $20,000 interest is paid semiannually. Compute the periodic discount amortization using the straight-line method.

36. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Aliant’s issued its bonds on Jan 1, 2001. The discount was $45,882. The bonds have a 10-year maturity and $20,000 interest is paid semiannually. Compute the periodic discount amortization using the straight-line method. Straight-Line Amortization of Bond Discount

37. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Aliant’s issued its bonds on Jan 1, 2001. The discount was $45,882. The bonds have a 10-year maturity and $20,000 interest is paid semiannually. Compute the periodic discount amortization using the straight-line method. Straight-Line Amortization of Bond Discount

38. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Straight-Line Amortization of Bond Discount Prepare the journal entry to record the payment of interest and the discount amortization for the six months ending on July 1, 2001.

39. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Bonds Issued at a Discount Financial Statement Presentation As the discount is amortized, the carrying amount of the bonds increases.

40. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Zero Coupon Bonds Zero coupon bonds do not pay periodic interest. Because there is no interest annuity... deep discount bondThis is called a deep discount bond. PV of the Principal = Issue Price of the Bonds

41. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds at a Premium = > < > < =

42. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds at a Premium On Jan 1, 20A, Aliant’s issues $400,000 in bonds having a stated rate of 5% semi- annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 8.5% annually. Are Aliant’s bonds issued at par, at a discount, or at a premium?

43. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson On Jan 1, 20A, Aliant’s issues $400,000 in bonds having a stated rate of 5% semi- annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 8.5% annually. Issuing Bonds at a Premium >> Let’s compute the issue price of the bonds.

44. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds at a Premium  Compute the present value of the principal. Use the present value of a single amount table to find the appropriate factor.

45. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds at a Premium  Compute the present value of the principal. Use the market rate of 8.5% to determine present value. Interest is paid semiannually, so the rate is i=4.25% (8.5% ÷ 2 interest periods per year).

46. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds at a Premium  Compute the present value of the principal. The maturity period is 10 years, there are 2 interest periods per year. For the present value computation, use n=20 (10 years × 2 periods).

47. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds at a Premium  Compute the present value of the principal. Next, we compute the present value of the interest payments.

48. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds at a Premium  Compute the present value of the interest payments. The interest payment is computed as: $400,000 × 10% × 6/12 = $20,000 The interest payment is computed as: $400,000 × 10% × 6/12 = $20,000

49. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds at a Premium  Compute the present value of the interest payments. Use the same i=4.25% and n=20 that were used to compute the present value of the principal. Now, however, the factor comes from the present value of an annuity table.

50. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds at a Premium  Compute the present value of the interest payments. Now, the issue price of the bonds can be computed.

51. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds at a Premium  Compute the issue price of the bonds. The $439,888 is greater than the face amount of $400,000, so the bonds are issued at a premium of $39,888.

52. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Issuing Bonds at a Premium  Prepare the journal entry to record the issuance of the bonds. This is called an adjunct account that appears in the liability section as an addition to Bonds Payable.

53. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Bonds Issued at a Premium Financial Statement Presentation The premium will be amortized over the 10-year life of the bonds.

54. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Bonds Issued at a Variable Interest Rate To compensate creditors for the effect of unexpected inflation, some debt is issued with a variable interest rate.

55. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Key Ratio Analysis Times Interest Earned = Net income + Interest expense + Income tax expense Interest expense The ratio shows the amount of added value generated for each dollar of interest expense. In general, a high ratio is viewed more favourable than a low ratio.

56. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Focus on Cash Flows Financing activities –  Issuance of long-term debt (a cash inflow)  Retirement of debt (a cash outflow)  Repayment of principal at maturity (a cash outflow)

57. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Effective-Interest Amortization of Bond Discounts and Premiums Bond Carrying Value × Market Rate The effective-interest method computes interest as: Principal amount of the bonds less any unamortized discount or plus any unamortized premium.

58. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Effective-Interest Amortization of Bond Discounts and Premiums This is the same market rate used to determine the present value of the bond. Bond Carrying Value × Market Rate The effective-interest method computes interest as:

59. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Effective-Interest Method Recall our first example of Aliant’s. On Jan 1, 20A, Aliant’s issues $400,000 in bonds having a stated rate of 5% semi-annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 12% annually.

60. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Effective-Interest Method Interest is paid semi- annually, so the market rate is 12% ÷ 2 = 6%. The cash paid to bond holders is $20,000 ($400,000 × 5%)

61. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Effective-Interest Method The journal entry to record the first interest payment is:

62. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Effective-Interest Method The new bond carrying value of the next interest payment period is:

63. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Understanding Alternative Amortization Methods The effective-interest method of amortization is preferred by GAAP. The straight-line amortization may be used if it is not materially different from the effective interest amortization. The effective-interest method of amortization is preferred by GAAP. The straight-line amortization may be used if it is not materially different from the effective interest amortization.

64. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Early Retirement of Debt callOccasionally, the issuing company will call (repay early) some or all of its bonds. extraordinary itemGains/losses incurred as a result of retiring bonds, should be reported as an extraordinary item on the income statement. callOccasionally, the issuing company will call (repay early) some or all of its bonds. extraordinary itemGains/losses incurred as a result of retiring bonds, should be reported as an extraordinary item on the income statement.

65. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Bond Sinking Funds A special fund to be used to retire bonds at maturity. Normally, periodic cash contributions are made to the fund. Usually reported on the balance sheet as a noncurrent asset. A special fund to be used to retire bonds at maturity. Normally, periodic cash contributions are made to the fund. Usually reported on the balance sheet as a noncurrent asset.

66. © McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson End of Chapter 10