© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Accounting for Long- Term Debt Chapter Ten

10-2 LO 1 Show how the amortization of long- term notes affects financial statements. LO 1

10-3 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

10-4 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

10-5 On January 1, 2008, Blair Company issued a $100,000 face value long-term note to National Bank. The note had a 9 percent annual interest rate and a five year term. The loan agreement called for five equal payments of $25,709 to be made on December 31 of each year. Prepare an amortization table for Blair’s note. On January 1, 2008, Blair Company issued a $100,000 face value long-term note to National Bank. The note had a 9 percent annual interest rate and a five year term. The loan agreement called for five equal payments of $25,709 to be made on December 31 of each year. Prepare an amortization table for Blair’s note. Long-Term Notes Payable

10-6 Long-Term Notes Payable

10-7 The amount applied to the principal increases each year. The amount of interest decreases each year. Annual payments are constant. Long-Term Notes Payable

10-8 Long-Term Notes Payable Issuing the note has the following effect on Blair’s 2008 financial statements: The December 2008 cash payment has the following effect on Blair’s 2008 financial statements:

10-9 Impact on Financial Statements

10-10 Security for Bank Loan Agreements To reduce the risk that they will not be repaid, lenders often: Require debtors to pledge collateral to secure the loan Include covenants in the loan agreement restricting: Additional borrowing Dividends Salary increases. Include covenants in the loan agreement restricting: Additional borrowing Dividends Salary increases.

10-11 LO 1 Show how a line of credit affects financial statements. LO 2

10-12 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.

10-13 LO 1 Explain how bond liabilities and their related interest costs affect financial statements. LO 3

10-14 Significant debt needs of a company are often filled by issuing bonds. BondsCash Bond Liabilities

10-15 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

10-16 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

10-17 Bond Certificate at Face Value Bond Certificate at Face Value Bond Issue Date Bond Selling Price CorporationInvestors Bond Liabilities

10-18 Bond Issue Date Bond Interest Payments CorporationInvestors Interest Payment = Principal × Interest Rate × Time Interest Payment = Principal × Interest Rate × Time Bond Liabilities

10-19 Bond Issue Date Bond Principal at Maturity Date Bond Maturity Date CorporationInvestors Bond Liabilities

10-20 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.

10-21 Secured and Unsecured Term and Serial Convertible and Callable Characteristics of Bonds

10-22 Mason Company issues bonds on January 1, Principal = $100,000 Stated Interest Rate = 9% Interest Paid Annually on 12/31 Maturity Date = Dec. 31, 2012 (5 years) Mason Company issues bonds on January 1, Principal = $100,000 Stated Interest Rate = 9% Interest Paid Annually on 12/31 Maturity Date = Dec. 31, 2012 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Bonds Issued at Face Value

10-23 Bonds Issued at Face Value Issuing the bonds has the following effect on Mason’s 2008 financial statements: To record the bond issue, Mason makes the following entry on January 1, 2008: To record the bond issue, Mason makes the following entry on January 1, 2008:

10-24 Bonds Issued at Face Value Bond Interest Payments Mason Company Investors On each interest payment date, Mason will pay $9,000 in interest. The amount is computed as follows: $100,000 × 9% = $9,000

10-25 Bonds Issued at Face Value The December 31, 2008 interest payment (and all other annual interest payments) has the following effect on Mason’s financial statements: To record an interest payment, Mason makes the following entry on each December 31: To record an interest payment, Mason makes the following entry on each December 31:

10-26 Bonds Issued at Face Value Bond Principal at Maturity Date Mason Company Investors On December 31, 2012, Mason will return the $100,000 principal amount to the investors.

10-27 Bonds Issued at Face Value The principal repayment on December 31, 2012 will have the following effect on Mason’s 2012 financial statements: To record an the principal repayment, Mason Company would make the following entry on December 31, 2012:

10-28 Bonds Issued at Face Value

10-29 Bonds Issued at Face Value

10-30 LO 1 Use the straight-line method to amortize bond discounts and premiums. LO 4

10-31 Bonds Issued at a Discount If bonds of other companies are yielding more than 9 percent, investors will be unwilling to pay the full face amount for Mason’s 9 percent bonds. The issue price of Mason’s 9 percent bonds will have to be lower to entice investor interest. The difference between the lower issue price and the principal of $100,000 is called a discount. Let’s continue the Mason Company example. If bonds of other companies are yielding more than 9 percent, investors will be unwilling to pay the full face amount for Mason’s 9 percent bonds. The issue price of Mason’s 9 percent bonds will have to be lower to entice investor interest. The difference between the lower issue price and the principal of $100,000 is called a discount. Let’s continue the Mason Company example.

10-32 Bonds Issued at a Discount Mason Company issues bonds on January 1, Principal = $100,000 Issue price = $95,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2012 (5 years) Mason Company issues bonds on January 1, Principal = $100,000 Issue price = $95,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2012 (5 years) The only change from previous Mason example.

10-33 Bonds Issued at a Discount Issuing the bonds at a discount has the following effect on Mason’s 2008 financial statements: To record the bond issue, Mason Company would make the following entry on January 1, 2008:

10-34 Face Value Carrying Value Bonds Issued at a Discount

10-35 Amortizing the discount over the term of the bond increases Interest Expense each interest payment period. Bonds Issued at a Discount Using the straight-line method, the discount amortization will be $1,000 every year. $5,000 ÷ 5 years = $1,000 Using the straight-line method, the discount amortization will be $1,000 every year. $5,000 ÷ 5 years = $1,000

10-36 The December 31, 2008 interest payment (and all other annual interest payments) has the following effect on Mason’s financial statements: To record an interest payment, Mason Company would make the following entry on each December 31: Bonds Issued at a Discount Contra Liability – decrease with a credit

10-37 Face Value Carrying Value $5,000 – $1,000 = $4,000 The carrying value will increase to exactly $100,000 on the maturity date. Bonds Issued at a Discount

10-38 The principal repayment on December 31, 2012 will have the following effect on Mason’s 2012 financial statements: To record an the principal repayment, Mason Company would make the following entry on December 31, 2012: Bonds Issued at a Discount

Effect of Semiannual Interest Payments For semiannual interest payments, the company would make payments of $4,500 on June 30 and December 31 of each year.

10-40 LO 1 Use the straight-line method to amortize bond discounts and premiums. LO 4

10-41 Bonds Issued at a Premium If bonds of other companies are yielding less than 9 percent, investors will be willing to pay more than the face amount for Mason’s 9 percent bonds. The issue price of Mason’s 9 percent bonds will rise because of investor demand for the 9 percent bonds. The difference between the higher issue price and the principal of $100,000 is called a premium. Let’s continue the Mason Company example. If bonds of other companies are yielding less than 9 percent, investors will be willing to pay more than the face amount for Mason’s 9 percent bonds. The issue price of Mason’s 9 percent bonds will rise because of investor demand for the 9 percent bonds. The difference between the higher issue price and the principal of $100,000 is called a premium. Let’s continue the Mason Company example.

10-42 Mason Company issues bonds on January 1, Principal = $100,000 Issue price = $105,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2012 (5 years) Mason Company issues bonds on January 1, Principal = $100,000 Issue price = $105,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2012 (5 years) The only change from the original Mason example. Bonds Issued at a Premium

10-43 Issuing the bonds at a premium has the following effect on Mason’s 2008 financial statements: To record the bond issue, Mason Company would make the following entry on January 1, 2008: Bonds Issued at a Premium

10-44 Face Value Carrying Value Bonds Issued at a Premium

10-45 Amortizing the premium over the term of the bond decreases Interest Expense each interest payment period. Using the straight-line method, the premium amortization will be $1,000 every year. $5,000 ÷ 5 periods = $1,000 Using the straight-line method, the premium amortization will be $1,000 every year. $5,000 ÷ 5 periods = $1,000 Bonds Issued at a Premium

10-46 Bonds Issued at a Premium The December 31, 2008 interest payment (and all other annual interest payments) has the following effect on Mason’s financial statements: To record an interest payment, Mason Company would make the following entry on each December 31:

10-47 Bonds Issued at a Premium Face Value Carrying Value $5,000 – $1,000 = $4,000 The carrying value will decrease to exactly $100,000 on the maturity date.

10-48 The principal repayment on December 31, 2012 will have the following effect on Mason’s 2012 financial statements: To record an the principal repayment, Mason Company would make the following entry on December 31, 2012: Bonds Issued at a Premium

10-49 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. = > < > < =

10-50 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.

10-51 Bond Redemptions On January 1, 2011, 3 years after issue, Mason Company redeems its 9 percent bonds that were sold at a discount. The bonds have a call provision requiring Mason to pay a call price of $1,030 for each $1,000 bond. On the call date, the bonds have a carrying value of $98,000.

10-52 Bond Redemptions The bond redemption on January 1, 2011, will have the following effect on Mason’s 2011 financial statements: To record the bond redemption, Mason Company would make the following entry on January 1, 2011

10-53 LO 1 Explain the advantages and disadvantages of debt financing. LO 5

10-54 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. Consider the following example with $100,000 of debt financing.

10-55 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.

10-56 LO 1 Use the effective interest rate method to amortize bond discounts and premiums. (Appendix) LO 5

Effective Interest Rate Method (Appendix) Effective interest is a more accurate way to amortize bond discounts and premiums. It correctly reflects the bond’s changing carrying value.

Effective Interest Rate Method (Appendix) 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

10-59 Effective Interest Rate Method (Appendix) 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

Effective Interest Rate Method (Appendix) 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, ,000 $ 814 $ 9, ,000 $ 814

Effective Interest Rate Method (Appendix) 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 $ $ 95,000 $ 95,814 $ $ 95,000 $ 95,814

Effective Interest Rate Method (Appendix) * The decrease in the amount of the discount increases the amount of the bond liability.

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

10-64 End of Chapter Ten