Bonds Long-term borrowing arrangement Interest paid at stated rate and times Principal repaid at maturity date Investor Borrower LO2
Bond Features Collateralized backed by specific assets in event of default Term: entire principal due on a specific single date Debentures backed only by general creditworthiness of issue Serial: principal repaid in installments over time
Bond Features Convertible into common stock Callable / Redeemable may be retired before maturity date
Bonds Sold at Face Value Cash 10,000 Bonds Payable 10,000 To record the issuance of bonds at face value. Face value of bonds = Sales price
Bond Interest Rates Face rate of interest the rate specified on the bond certificate also called: stated rate coupon rate nominal rate contract rate Market rate of interest the rate that investors could obtain by investing in other bonds similar to the issuing firm’s bonds also called: effective rate yield LO3
Two sets of cash flows PV = ? Calculating Bond Prices $$ ( 2 ) Principal due at maturity PV = ? $$$$$ ( 1 ) Interest payments made each period etc. $$
Determining Bond Prices On 1/1/10, Discount Firm issues: $10,000, 8% bonds Due December 31, 2011 Interest payable annually Market rate of interest = 10% Calculate the issue price of the bonds. Example:
PV = ? Calculating Bond Prices $800 (1) Interest payments (4 payments @ $800) 2010 201120122013 $800 Interest is always paid at rate stated on bonds ($10,000 @ 8%) $800
Calculating Bond Prices (2) Principal of $10,000 due at end of 2013 2013 PV = ?$10,000 (1) Interest payments (4 payments @ $800) PV = ? 2010 201120122013 $800
Present value: Interest payments: $800 × 3.170 = $2,536 (PV; n = 4; i = 10%) Principal payment: $10,000 × 0.683 = 6,830 (PV; n = 4; i = 10%) Bond issue price: $9,366 Example of Price Calculation …but discount @ market rate Compute interest payment at stated rate (i.e., 8%)...
Recording Bond Discounts Cash 9,366 Discount on Bonds Payable 634 Bonds Payable 10,000 To record the issuance of bonds payable. Assets = Liabilities + Owners’ Equity +9,366 = –634 +10,000 LO4
Balance Sheet Presentation of Bond Discount Long-term liabilities: Bonds payable $10,000 Less: Discount on bonds payable 634 $ 9,366
Determining Bond Prices Assume Premium Firm sells the same $10,000, 8% bonds when the market rate on similar bonds is 6%.
Present value: Interest payments: $800 × 3.465 = $ 2,772 (PV; n = 4; i = 6%) Principal payment: $10,000 × 0.792 = 7,920 (PV; n = 4; i = 6%) Bond issue price: $10,692 Example of Price Calculation …but discount @ market rate Compute interest payment at stated rate (i.e., 8%)...
Recording Bond Premiums Cash 10,692 Bonds Payable 10,000 Premium on Bonds Payable 692 To record the issuance of bonds payable. Assets = Liabilities + Owners’ Equity +10,692 = +10,000 + 692
Balance Sheet Presentation of Bond Premium Long-term liabilities: Bonds payable $10,000 Plus: Premium on bonds payable 692 $10,692
Interest Rates and Bond Prices Above face value (at a premium) At face value Below face value (at a discount) = MARKET RATE BONDS ISSUED: IF STATED RATE: > MARKET RATE < MARKET RATE
Amortization of Bond Premiums and Discounts Transferring an amount from the discount or premium account to interest expense over the life of the bond using the effective interest method Discount increases interest expense Premium reduces interest expense LO5
Redemption of Bonds Reasons for early redemption: Excess cash Changing interest rates Gain = Carrying Value – Redemption Price Loss = Redemption Price – Carrying Value LO6
Leases Contractual arrangement Grants right to use asset in exchange for payments Form of financing LesseeLessor LO7
Operating Leases Record as rent (lease) expense each period Disclose future lease obligations in financial statement notes OFFICE SPACE FOR LEASE
Capital Lease Record as asset and corresponding liability (as if purchased through borrowings) Depreciate asset over lease term Separate payments into principal and interest components using the effective interest method
Criteria for Lease Capitalization Transfers ownership of property Contains a bargain-purchase option Term is >75% of property’s life Present value of payments is >90% of property’s fair market value Lease meets one or more:
IFRS and Leases In U.S., if any of the previous criteria are present, the lease is considered a capital lease IFRS considers these criteria as “guidelines” rather than rigid rules Because of these differences, there is much more flexibility with international standards.
Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity How much have creditors contributed as compared to owners? LO 8
Times Interest Earned Ratio Income Before Interest and Tax Interest Expense Will they be able to pay the interest on their debt?
Debt Service Coverage Ratio Cash Flow from Operations Before Interest and Tax Interest and Principal Payments Will they be able to repay the principal on their loan?
Long-Term Liabilities on the Statement of Cash Flows Operating Activities Net income xxx Increase in current liability + Decrease in current liability – Investing Activities Financing Activities Increase in long-term liability + Decrease in long-term liability – LO 9
Deferred Tax Used to reconcile the differences between the accounting for book purposes and for tax purposes Should reflect temporary differences but not permanent differences LO 10 Permanent difference – affects the tax records but not the accounting records, or vice versa Temporary difference – affects both book and tax records but not in the same period
Deferred Income Taxes Sales Depreciation Expense Taxable Income × Tax Rate Tax Payable to IRS Book Tax$6,000 2,500 4,000 3,500 2,000 40% 40% $1,400$ 800 $ 600 Difference recorded as deferred tax
Deferred Income Taxes Income tax Book Tax $1,400$ 800 Tax Expense 1,400 Tax Payable 800 Deferred Tax 600 To record income tax for the year. $ 600