1. Accounting for Long-Term Debt Chapter Ten McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Long-term notes are liabilities that usually have terms from two to five years. Each payment covers interest for the period and a portion of the principal. With each payment, the interest portion gets smaller and the principal portion gets larger. Principal Company Lender Payments Long-Term Notes Payable 10-1

3. Applying payments to principal and interest  Identify the unpaid principal balance.  Amount applied to interest = Unpaid principal balance × Interest rate.  Amount applied to principal = Cash payment – Amount applied to interest in .  Unpaid principal balance = Unpaid principal balance in  – Amount applied to principal in . Applying payments to principal and interest  Identify the unpaid principal balance.  Amount applied to interest = Unpaid principal balance × Interest rate.  Amount applied to principal = Cash payment – Amount applied to interest in .  Unpaid principal balance = Unpaid principal balance in  – Amount applied to principal in . Long-Term Notes Payable 10-2

4. The amount applied to the principal increases each year. The amount of interest decreases each year. Annual payments are constant. Long-Term Notes Payable 10-3

5. Line of Credit Enable the company to borrow and repay funds. Usually specify a maximum credit line. Normally used for short-term borrowing to finance seasonal business needs. Enable the company to borrow and repay funds. Usually specify a maximum credit line. Normally used for short-term borrowing to finance seasonal business needs. 10-4

6. Long-term borrowing of a large sum of money, called the principal. Principal is usually paid back as a lump sum at maturity. Individual bonds are often denominated with a face value of $1,000. Long-term borrowing of a large sum of money, called the principal. Principal is usually paid back as a lump sum at maturity. Individual bonds are often denominated with a face value of $1,000. Bond Liabilities 10-5

7. Periodic interest payments based on a stated rate of interest. Interest is paid semiannually. Interest paid is computed as: Interest = Principal × Stated Interest Rate × Time Bond prices are quoted as a percentage of the face amount. For example, a $1,000 bond priced at 104 would sell for $1,040. Periodic interest payments based on a stated rate of interest. Interest is paid semiannually. Interest paid is computed as: Interest = Principal × Stated Interest Rate × Time Bond prices are quoted as a percentage of the face amount. For example, a $1,000 bond priced at 104 would sell for $1,040. Bond Liabilities 10-6

8. Bond Issue Date Bond Interest Payments CorporationInvestors Interest Payment = Principal × Interest Rate × Time Interest Payment = Principal × Interest Rate × Time Bond Liabilities 10-7

9. Bond Liabilities Advantages of bonds Longer term to maturity than notes payable issued to banks. Bond interest rates are usually lower than bank loan rates. Advantages of bonds Longer term to maturity than notes payable issued to banks. Bond interest rates are usually lower than bank loan rates. 10-8

10. Secured and Unsecured Term and Serial Convertible and Callable Characteristics of Bonds 10-9

11. The Market Rate of Interest The selling price of a bond is determined by the market rate of interest versus the stated rate of interest. = > < > < = 10-10

12. Gains or losses incurred as a result of early redemption of bonds should be reported as other income or other expense on the income statement. Bond Redemptions Companies may redeem bonds with a call provision prior to the maturity date. 10-11

13. Effective Interest Rate Method Effective interest is a more accurate way to amortize bond discounts and premiums. It correctly reflects the bond’s changing carrying value. 10-12

14. Effective Interest Rate Method Let’s assume Mason Company uses the effective interest method on its $100,000 bond. Step 1: Determine the cash payment for interest. Step 1: Determine the cash payment for interest. Face value of bond X Stated rate of interest Cash payment Face value of bond X Stated rate of interest Cash payment $ 100,000 X.09 $ 9,000 $ 100,000 X.09 $ 9,000 10-13

15. Effective Interest Rate Method Step 2: Determine the amount of interest expense. Step 2: Determine the amount of interest expense. Carrying value of bond liability X Effective rate of interest Interest expense Carrying value of bond liability X Effective rate of interest Interest expense $ 95,000 X.1033 $ 9,814 $ 95,000 X.1033 $ 9,814 $100,000 face value - $5,000 discount = $95,000 carrying value 10-14

16. Effective Interest Rate Method Step 3: Determine the amortization of the bond discount. Step 3: Determine the amortization of the bond discount. Interest expense - Cash payment Discount amortization Interest expense - Cash payment Discount amortization $ 9,814 - 9,000 $ 814 $ 9,814 - 9,000 $ 814 Step 4: Update the carrying value of the bond liability. Step 4: Update the carrying value of the bond liability. Discount amortization + Beginning carrying value Ending carrying value Discount amortization + Beginning carrying value Ending carrying value $ 814 + $ 95,000 $ 95,814 $ 814 + $ 95,000 $ 95,814 10-15

17. Effective Interest Rate Method * The decrease in the amount of the discount increases the amount of the bond liability. 10-16

18. Effective Interest Rate Method (Appendix) Notice that when using the effective interest method, interest expense increases each year. 10-17

19. Financial Leverage and Tax Advantage of Debt Financing Financial leverage: Debt financing can increase return on equity when the borrower earns more on the borrowed funds than it pays in interest. As this example shows, the cost of financing is the same, but debt financing has a tax advantage. 10-18

20. Times Interest Earned Ratio Times Interest Earned = Net income + Interest expense + Income tax expense Interest expense The ratio shows the amount of resources generated for each dollar of interest expense. In general, a high ratio is viewed more favorable than a low ratio. Numerator is commonly called EBIT, Earnings before interest and taxes. 10-19

21. End of Chapter Ten 10-20