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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Sources of Capital: Debt © The McGraw-Hill Companies, Inc., 1999 8 Part One: Financial Accounting

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Loss Contingency Slide 8-1 1.Information available prior to issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has incurred. 2.The amount of loss can be reasonable estimated. A loss contingency is recorded as a liability if both of the following conditions are met:

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 a specified sum of money at a stated date, called the maturity datea specified sum of money at a stated date, called the maturity date interest at a stated rate until the maturity dateinterest at a stated rate until the maturity date a specified sum of money at a stated date, called the maturity datea specified sum of money at a stated date, called the maturity date interest at a stated rate until the maturity dateinterest at a stated rate until the maturity date Bonds Slide 8-2 A bond is a certificate promising to pay its holder-- Bond

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Mortgage bond Secured bond Debenture bond Sinking fund bond Serial bonds Callable bonds Zero-coupon bonds Convertible bonds Subordinated bonds Types and Features of Bonds Slide 8-3 A bond can have a combination of these features. A bond can have a combination of these features.

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Recording a Bond Issue Slide 8-4 Mason Corporation’s 10% bonds, for which investors paid $851 each, also had issue costs to Mason averaging $21 per bond, resulting in a net cash inflow to Mason of $830 per bond. Cash83,000 Bond Discount14,900 Deferred Charges2,100 Bonds Payable100,000

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Recording a Bond Issue Slide 8-5 By contrast, if prevailing rates for similar bonds had been 9 percent, the bonds would have been issued at a premium of $91 per bond. Cash107,000 Deferred Charges2,100 Bond Premium9,100 Bonds Payable100,000

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Balance Sheet Presentation Slide 8-6 If a Discount: Bonds payable: Face value$100,000 Less: Unamortized discount 14,900 $ 85,100 If a Premium Bonds payable: Face value$100,000 Plus: Unamortized premium 9,100 $109,100

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Slide 8-7 Bond Interest Expense The first year’s interest expense for the 10 percent Mason Corporation bonds (issued at a discount; effective rate is 12 percent). Bond Interest Expense10,212 Bond Discount212 Cash10,000 $85,100 x.12 $100,000 x.10

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Adjusting Entries Slide 8-8 The bonds were issued on October 1. The interest date is September 30, and the fiscal year ends on December 31. The adjusting entry at December 31 would be-- Bond Interest Expense2,553 Bond Discount53 Accrued Interest Payable2,500 $85,100 x.12 x 3/12 $100,000 x.10 x 3/12

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Interest Payment Entry Slide 8-9 Payment of interest is made to bondholders on September 30. Bond Interest Expense7,659 Accrued Interest Payable2,500 Bond Discount159 Cash10,000 $85,100 x.12 x 9/12 $100,000 x.10

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Refunding a Bond Issue Slide 8-10 One hundred Mason Corporation bonds are called at the end of five years at a price of $1,050 per bond. Miscellaneous refunding costs amount to $1,000. Reacquisition price ($105,000 + $1,000)$106,000 Net carrying amount: Face value$100,000 Less: Unamortized discount(13,553) Less: Unamortized issuance cost (1,575) 84,872 Loss on retirement of bond$ 21,128

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Refunding a Bond Issue Slide 8-10 One hundred Mason Corporation bonds are called at the end of five years at a price of $1,050 per bond. Miscellaneous refunding costs amount to $1,000. Bonds Payable100,000 Loss on Retirement of Bonds21,128 Cash106,000 Bond Discount13,553 Deferred Charges (Issuance Costs)1,575

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Ownership is transferred to the the lessee at the end of the term of the lease The lessee has an option to purchase the asset at a “bargain” price The term of the lease is 75 percent or more of the economic life of the asset The present value of the lease payments is 90 percent or more of the fair value of the property Capital Leases Slide 8-11 The Financial Accounting Standards Board has ruled that a lease is a capital lease if one or more of the following criteria are met:

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Slide 8-12 A company leases equipment whose useful life is 10 years. Lease payments are $1,558 per year payable at the end of each of the next 10 years. The fair value of the equipment is $10,000. Capital Leases Equipment10,000 Capital Lease Obligations10,000 What is the journal entry to record acquiring the equipment?.

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Slide 8-13 The first annual lease payment consists of $900 of interest expense and $658 to reduce the liability. Capital Leases Interest Expense900 Capita Lease Obligations658 Cash1,558 Assuming straight-line depreciation, the following adjusting entry is made to record annual depreciation. Depreciation Expense1,000 Accumulated Depreciation1,000

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Debt/Equity Ratio Total liabilities Shareholders’ equity Debt/Equity Ratio = $3,400 $3,600 Debt/Equity Ratio = = 94 percent Excluding current liabilities, the ratio changes to 50 percent Excluding current liabilities, the ratio changes to 50 percent Slide 8-14

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Times Interest Earned Slide 8-15 Pre-tax income before interest Interest expense Times Interest Earned= $1,000 $200 Times Interest Earned= 5.0 timesTimes Interest Earned=

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Future Value--Compound Interest Slide 8-16 FV = p(1 + i) n where: p = Principal (initial investment) i = Interest rate n = Number of periods The future value of $1,000 invested at 5 percent for 10 years is given by: FV = $1,000(1 + 0.05) = $1,628.89 10

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Present Value of a Future Amount Slide 8-17 PV = p (1 + i) n What is the present value of $400 to be received 10 years hence, discounted at a rate of 8 percent? PV = p (1 + i) n Amount to be received in future Amount to be received in future From Table A, we find the 10 year/8% factor to be 0.463. From Table A, we find the 10 year/8% factor to be 0.463. $185.20 =$400 x 0.463

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 1$1,7500.909$1,591 21,7500.8261,446 31,7500.7511,314 41,7500.683 1,195 Present value of series$5,546 Present Value of a Series of Payments Slide 8-18 What would be the present value of a series of equal payments of $1,750 for 10 years (assume 10 percent)? Year Payment (Table A) Value Present

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Present Values and Liabilities Slide 8-19 Kinnear Company borrowed $25,000, with interest at 10 percent to be paid annually and the principal to be repaid in one lump sum at the end of ten years. What balance sheet liability would be reported at the inception of the debt? Interest, $2,500*3.791 (Table B)$ 9,478 Principal, $25,000*0.621 (Table A)15,575 Total present value$25,003 * *Does not add exactly to $25,000 due to rounding

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Present Values and Liabilities Slide 8-20 Kinnear Company borrowed $25,000, with interest at 10 percent to be repaid in equal annual amounts at the end of each of the next five years. How much is each equal annual payment? PV of the annuity = Table B Value x Annual for 10 percent/5 payment year factor $25,000 = 3.791 x ? $25,000 = 3.791 x $6,595

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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Chapter 8 The End

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