Long-Term Liabilities Skyline College Lecture Notes Chapter 10 Long-Term Liabilities Skyline College Lecture Notes

How do companies raise long-term funds? Funding Growth Growth usually requires investment in long-term assets and research and development How do companies raise long-term funds? Issuance of capital stock Issuance of long-term debt Take on long-term debt? How much debt to carry? What types of debt to incur? Copyright © Houghton Mifflin Company. All rights reserved.

Deciding to Issue Long-Term Debt Advantages to consider Disadvantages to consider The interest on debt is tax-deductible If earnings on funds borrowed exceed interest on debt, financial leverage is gained No loss of stockholder control as when issuing stock If earnings on funds borrowed do not exceed interest on debt, negative financial leverage is experienced A high level of debt exposes a company to financial risk Copyright © Houghton Mifflin Company. All rights reserved.

Average Debt to Equity for Selected Industries Copyright © Houghton Mifflin Company. All rights reserved.

Evaluating Long-Term Debt Many companies use the debt to equity ratio when assessing how much debt to carry McDonald’s also has long-term leases that do not appear on the balance sheet, called off-balance sheet financing. Copyright © Houghton Mifflin Company. All rights reserved.

Interest Coverage Ratio Measures how much risk a company is undertaking with its long-term debt Measures the degree of protection a company has from default on interest payments Copyright © Houghton Mifflin Company. All rights reserved.

Interest Coverage Ratio Illustrated McDonald’s 2004 annual report shows that the company had income before income taxes of $3,202.4 million and interest expense of $358.4 million. McDonald’s interest expense was covered 9.9 times in 2004. However, management will add the company’s off-the-balance sheet rent expense of $1,003.2 to its interest expense. This procedure decreases the coverage ratio to 3.4 times, still adequate to cover interest payments. Copyright © Houghton Mifflin Company. All rights reserved.

Types of Long-Term Debt Bonds payable Notes payable Mortgages payable Long-term leases Pensions Other postretirement benefits Deferred income taxes Copyright © Houghton Mifflin Company. All rights reserved.

Long-Term Debt Bonds Payable Notes Payable Most common type of long-term debt May be convertible to common stock Involves a debt to many creditors Represents a loan from a bank or other creditor Deutsche Telekom International Finance recently raised $14.6 billion by issuing a series of long-term notes denominated in dollars, Euros, pounds, and yen. Copyright © Houghton Mifflin Company. All rights reserved.

Mortgages Payable Long-term debt secured by real property. Usually repaid in equal monthly installments that include interest on the debt and a reduction in the initial debt. Illustration: Monthly Payment Schedule on a $50,000, 12% mortgage Copyright © Houghton Mifflin Company. All rights reserved.

Leases Companies may obtain an operating asset in three ways: Borrow the money and buy the asset Rent the asset on a short-term lease (operating lease; payments are treated as rent expense) Obtain the asset on a long-term lease (may be structured as a capital lease or an operating lease) Copyright © Houghton Mifflin Company. All rights reserved.

Capital Leases Accounting standards require that a lease be treated as a capital lease if the lease: Accounting for a Capital Lease The lessee should: Record the asset Record depreciation on the asset Record a liability equal to the present value of the total lease payments during the lease term Cannot be cancelled Has about the same duration as the useful life of the asset Stipulates that the lessee has the option to buy the asset at a nominal price at the end of the lease Copyright © Houghton Mifflin Company. All rights reserved.

Capital Lease Illustrated Glenellen Manufacturing Company enters into a long-term lease for a machine. The lease terms call for an annual payment of $4,000 for six years, which approximates the useful life of the machine. At the end of the lease period, the title to the machine passes to Glenellen. Use present value techniques to place a value on the asset and on the corresponding liability. Assume that the interest cost on the unpaid part of the obligation is 16 percent. $4,000 x 3.685 = $14,740 Copyright © Houghton Mifflin Company. All rights reserved.

Capital Lease Illustrated (cont’d) Each year, Glenellen must record depreciation on the leased asset. Assume the company uses the straight-line method and no salvage value. Glenellen must also record interest expense for the lease. The interest expense for each year is computed by multiplying the interest rate by the amount of remaining lease obligation. Copyright © Houghton Mifflin Company. All rights reserved.

Off-Balance Sheet Financing A legal way of structuring a lease commitment so that it does not have to be included on the balance sheet as a liability Financial statement users should review the notes to the financial statements for information about any leases that may have the effect of long-term liabilities Copyright © Houghton Mifflin Company. All rights reserved.

Discussion: Ethics on the Job Cardle Industries plans to apply for a large loan from United Bank in 20x8. In 20x6, the controller recommends that the company renegotiate the duration of its leases so that the company may categorize them as operating leases. This will improve the company’s debt to equity ratio. Q. Do you think this recommendation is ethical? Copyright © Houghton Mifflin Company. All rights reserved.

Pension benefits paid to Pension Liabilities Pension plans Require a company to pay benefits to employees after they retire Some companies pay full cost of pension plan Employees often share the cost of pension plans Pension Fund Employer contributions Employee Pension benefits paid to retired employees Copyright © Houghton Mifflin Company. All rights reserved.

Pension Plans Defined Contribution Plan Defined Benefit Plan Employer makes fixed, agreed-upon, annual contribution Retirement payments depend on how much the fund earns Employees usually control their own accounts and can transfer funds if they leave the firm Employer makes variable payments required to fund the estimated future liability Retirement benefits are fixed More complex accounting required Examples: 401(K) plans, profit-sharing plans, and ESOPs Copyright © Houghton Mifflin Company. All rights reserved.

Other Postretirement Benefits Retired employees may also be provided health care benefits and other postretirement benefits Recent accounting standards hold postretirement benefits should be estimated and expensed during the time that employees are working in accordance with the matching rule. Estimates should account for retirement age, mortality, future trends in health care Future benefits should be discounted to the current period Copyright © Houghton Mifflin Company. All rights reserved.

Deferred Income Taxes Results from using different accounting methods to calculate income taxes on the income statement and income tax liability on the income tax return A company might use straight-line depreciation for financial reporting and an accelerated method for income tax purposes. The difference in taxes resulting from the two methods is listed as a long-term liability. Copyright © Houghton Mifflin Company. All rights reserved.

Bonds A security, usually long term, representing money that a corporation borrows from the investing public Governments and foreign countries also issue bonds to raise money Must be repaid at a specified time and require periodic payments of interest at a specified rate at specified times Copyright © Houghton Mifflin Company. All rights reserved.

What Is a Bond Issue? Prices of Bonds Stated in terms of a percentage of face value Bonds selling at 100 Sell at face or par value Bonds selling above 100 Sell at a premium Bonds selling below 100 Sell at a discount A bond issue is the total value of bonds issued at one time For example, a $1,000,000 bond issue could consist of one thousand, $1,000 bonds Copyright © Houghton Mifflin Company. All rights reserved.

Selling Price of Bond Illustrated A bond issue is quoted at 103 ½ What is the selling price of a $1,000 bond? A bond issue quoted at 103 ½ means that the bond sells at 103.5 percent of its face value This bond sells at a premium and would cost the buyer $1,035 Copyright © Houghton Mifflin Company. All rights reserved.

Interest Rates Face Interest Rate Market Interest Rate Fixed rate of interest paid to bondholders based on the face value of the bonds Rate of interest paid in the market on bonds of similar risk, also called the effective interest rate Copyright © Houghton Mifflin Company. All rights reserved.

Discounts and Premiums Equals the excess of the face value over the issue price. The issue price will be less than the face value when: Market > Face Premium Equals the excess of the issue price over the face value. The issue price will be more than the face value when Market < Face Copyright © Houghton Mifflin Company. All rights reserved.

Bond Characteristics Unsecured Callable Serial Convertible Registered Term Coupon Unsecured Issued on the basis of a firm’s general credit Carry a pledge of certain corporate assets as a guarantee of repayment Secured All bonds of an issue mature at the same time Bonds of an issue mature on different dates Gives issuer the right to buy back and retire the bonds before maturity at a specified call price Allows bondholder to exchange a bond for a specified number of shares of common stock Issued to a specific bondholder Not registered with the organization Copyright © Houghton Mifflin Company. All rights reserved.

Issuing Bonds Payable The board of directors must submit the appropriate legal documents to the Securities and Exchange Commission (SEC) for approval to issue bonds No journal entry is required for the authorization of the bond issue (most companies disclose in the notes to the financial statements) Copyright © Houghton Mifflin Company. All rights reserved.

Bonds Issued at Face Value Katakis Corporation issues $100,000 of 9 percent, 5-year bonds on January 1, 20x4 and sells them on the same date for their face value. The bond indenture states that interest is to be paid on January 1 and July 1 of each year. Record a semiannual interest payment: Copyright © Houghton Mifflin Company. All rights reserved.

Bonds Issued at a Discount Katakis Corporation issues $100,000 of 9 percent, 5-year bonds at 96.149 on January 1, 20x4, when the market rate is 10 percent. Record the issuance of the bonds at a discount: Unamortized Bond Discount is a contra-liability account Carrying Value of Bonds = Face Value – Unamortized Bond Discount Copyright © Houghton Mifflin Company. All rights reserved.

Bonds Issued at a Premium Katakis Corporation issues $100,000 of 9 percent, 5-year bonds for $104,100 on January 1, 20x4, when the market rate is 8 percent. Record the issuance of the bonds at a premium: Carrying Value of Bonds = Face Value + Unamortized Bond Premium = $100,000 + $4,100 = $104,100 Copyright © Houghton Mifflin Company. All rights reserved.

Can amount to as much as 5 percent Bond Issue Costs Can amount to as much as 5 percent of a bond issue Establish a long-term prepaid account for these costs and amortize over life of bonds or issue costs can be subtracted from the proceeds making the discount bigger or the premium smaller Copyright © Houghton Mifflin Company. All rights reserved.

Influence of the Market Interest Rate on Bonds The market interest rate varies from day to day and therefore what investors are willing to pay changes as well If current market interest rate > face interest investors are willing to pay less If current market interest rate < face interest investors are willing to pay more Copyright © Houghton Mifflin Company. All rights reserved.

Case 1: Present Value Market interest rate > Face interest rate A bond has a face value of $10,000 and pays fixed interest of $450 every six months (a 9 percent annual rate). The bond is due in 5 years and the market interest rate is 12 percent. What is the present value of the bond? Determine the interest rate and number of periods to use in the present value tables Divide the annual interest rate by the number of periods in the year 12% ÷ 2 = 6% Multiply the number of periods in one year by the number of years 2 x 5 = 10 periods Copyright © Houghton Mifflin Company. All rights reserved.

Case 2: Present Value Market interest rate < Face interest rate A bond has a face value of $10,000 and pays fixed interest of $450 every six months (a 9 percent annual rate). The bond is due in 5 years and the market interest rate is 8 percent. What is the present value of the bond? Copyright © Houghton Mifflin Company. All rights reserved.

Bond Discounts or Premiums Amount by which the total interest cost is higher or lower than the total interest payments Amortized over the life of the bonds Use straight-line or effective interest method Copyright © Houghton Mifflin Company. All rights reserved.

Total Interest Cost Illustrated Katakis Corporation issues $100,000 of 9 percent, 5-year bonds at 96.149 when the market rate is 10 percent. The bonds sold for $96,149 resulting in an unamortized bond discount of $3,851. The bonds were issued at a discount: Although the company does not receive the full face value of the bonds on issue, it still must pay back the full face value at maturity Copyright © Houghton Mifflin Company. All rights reserved.

Calculating Total Interest Cost Katakis Corporation issues $100,000 of 9 %, 5-year bonds at 96.149 when the market rate is 10 percent. The bonds sold for $96,149, resulting in an unamortized bond discount of $3,851. Or, alternately The bond discount increases the interest paid on the bonds from the stated interest rate to the effective interest rate. Copyright © Houghton Mifflin Company. All rights reserved.

Accounting for Total Interest Cost Effective Interest Rate = Stated Rate + Discount Amortization of the bond discount Must be allocated over the remaining life of the bonds as an increase in the interest expense each period Interest expense for each period will exceed the actual payment of interest by the amount of the bond discount amortized over the period Copyright © Houghton Mifflin Company. All rights reserved.

Zero Coupon Bonds Do not require periodic interest payments Represent a promise to pay a fixed amount at the maturity date Zero coupon bonds are issued by some companies and governmental units Copyright © Houghton Mifflin Company. All rights reserved.

Equal amortization of the bond discount for each interest period Straight-Line Method Equal amortization of the bond discount for each interest period Face value = $100,000 Face interest rate = 9% Life of bond = 5 years Interest payments = Semiannual Bond discount = $3,851 Step 1: Determine the total number of interest payments Step 2: Determine the amount of bond discount to amortize each interest period Copyright © Houghton Mifflin Company. All rights reserved.

Straight-Line Method (cont’d) Step 3: Determine the cash interest payment amount Step 4: Determine the total interest expense per interest period Record first semiannual interest payment and amortization of bond discount Copyright © Houghton Mifflin Company. All rights reserved.

Weaknesses of the Straight-Line Method When used to amortize a discount, the carrying value goes up each period, but the bond interest expense stays the same; thus, the rate of interest falls over time. When used to amortize a premium, the rate of interest rises over time. used only when it does not lead to a material difference from the effective interest method Copyright © Houghton Mifflin Company. All rights reserved.

Effective Interest Method Applies a constant interest rate to the carrying value of bonds at the beginning of the interest period Rate equals the market, or effective, rate at the time the bonds were issued. Amount amortized is the difference between interest computed and actual interest paid to bondholders Copyright © Houghton Mifflin Company. All rights reserved.

Interest and Amortization of a Bond Discount: Effective Interest Method Copyright © Houghton Mifflin Company. All rights reserved.

Bond Amortization – Effective Interest Method Face value = $100,000 Face Interest rate = 9% Life of bond = 5 years Interest payments = Semiannual Bond discount = $3,851 Column A Carrying value = Face value – Unamortized bond discount Column B – Use market interest rate ($96,149 x .10 x 6/12 = $4,807) Column C – Use face interest rate on bond ($100,00 x .09 x 6/12 = $4,500) Copyright © Houghton Mifflin Company. All rights reserved.

Bond Amortization – Effective Interest Method (cont’d) Column D Discount amortized = Effective interest expense – Actual interest payment to bondholders ($4,807 – $4,500 = $307) Column F Carrying value at beg. of period + Amort. during the period ($96,149 + $307 = $96,456) Column E Bond discount at beg. of period – Current pd amort. ($3,851 – $307 = $3,544) Notice that the sum of the carrying value and the unamortized discount always equals the face value of the bonds Copyright © Houghton Mifflin Company. All rights reserved.

Bond Amortization – Effective Interest Method (cont’d) Record first semiannual interest payment and amortization of bond discount: It is not necessary to prepare an interest and amortization table to determine amortization of a discount for the period Copyright © Houghton Mifflin Company. All rights reserved.

Bond Premiums Bondholders pay more than face value for bonds Premium is an amount that bondholders have prepaid their own interest over life of the issue Copyright © Houghton Mifflin Company. All rights reserved.

Total Interest Cost Katakis Corporation issues $100,000 of 9 percent, 5-year bonds at 104.1 on January 1, 20x4, when the market rate is 8 percent. The bonds sold for $104,100 resulting in an unamortized bond premium of $4,100. Or, alternately The bond premium decreases the interest paid on the bonds from the stated interest rate to the effective interest rate. Copyright © Houghton Mifflin Company. All rights reserved.

Interest and Amortization of a Bond Premium: Effective Interest Method Copyright © Houghton Mifflin Company. All rights reserved.

Bond Amortization – Effective Interest Method (cont’d) Record first semiannual interest payment and amortization of bond premium: It is not necessary to prepare an interest and amortization table to determine amortization of a premium for the period Copyright © Houghton Mifflin Company. All rights reserved.

Why call bonds before their maturity date? Calling Bonds Why call bonds before their maturity date? If bond interest rates drop, the company can call the bonds and reissue debt at a lower cost. Company has earned enough to pay off the debt. The reason for having the debt no longer exists. The company wants to restructure its debt to equity ratio. Copyright © Houghton Mifflin Company. All rights reserved.

Callable Bonds Illustrated The issuer has the right to buy back and retire bonds at a specified call price Katakis Corporation can call or retire at 105 the $100,000 of bonds it issued at a premium (104.1). It decides to do so on July 1, 20x7. The entry for the required interest payment and amortization of the premium has already been made. Record the retirement of the bonds: The loss occurs because the call price of the bonds is greater than the carrying value Copyright © Houghton Mifflin Company. All rights reserved.

Callable Bonds (Purchase) Katakis Corporation can call or retire at 105 the $100,000 of bonds it issued at a premium (104.1). Because of a rise in interest rates, Katakis is able to purchase the $100,000 bond issue on the open market for 85. The entry for the required interest payment and amortization of the premium has already been made. Record the purchase of the bonds: The gain occurs because the call price of the bonds is less than than the carrying value Copyright © Houghton Mifflin Company. All rights reserved.

Convertible Bonds Illustrated Katakis Corporation issued $100,000 of convertible bonds on January 1, 20x4, that can be converted to 40 shares of common stock for each $1,000 bond. The bondholders decide to convert all the bonds to $8 par value common stock on July 1, 20x7. Record the bond conversion: No loss or gain is recorded because the bond liability and the associated unamortized discount or premium are written off the books. Copyright © Houghton Mifflin Company. All rights reserved.

Sale of Bonds Between Interest Dates When a company sells a bond between interest dates… it collects the interest that would have accrued for the partial period preceding the issue date, and… at the end of the first period, it pays the interest for the entire period. Copyright © Houghton Mifflin Company. All rights reserved.

Sale of Bonds Between Interest Dates Illustrated Katakis Corporation sold $100,000 of 9 percent, 5-year bonds on May 1, 20x4 (after the January 1, 20x4 issue date). Record the sale of the bonds: Bond Interest Expense Bondholder pays interest that would have accrued for the partial period from the issue date to the sale date Bal. 0 May 1 3,000 Copyright © Houghton Mifflin Company. All rights reserved.

Sale of Bonds Between Interest Dates Illustrated (cont’d) Katakis Corporation sold $100,000 of 9 percent, 5-year bonds on May 1, 20x4 (after the January 1, 20x4 issue date). Record first semiannual interest payment: The bondholder is reimbursed for the partial interest payment made at time of sale ($3,000) plus paid interest for the partial period the bond was held ($1,500) Bond Interest Expense Corporation pays the bondholder interest for the entire period Bal. 0 May 1 3,000 July 1 4,500 Bal. 1,500 Copyright © Houghton Mifflin Company. All rights reserved.

Year-End Accrual of Bond Interest Expense Bond interest payment dates rarely correspond with a company’s fiscal year. A year-end adjustment is required. Katakis Corporation issues $100,000 of 9 percent, 5-year bonds at 104.1 on January 1, 20x4. The company’s fiscal year ends September 31, 20x4 Interest and amortization were recorded on July 1, 20x4. Three months of interest has accrued since then. Record the year-end accrual of bond interest expense: Copyright © Houghton Mifflin Company. All rights reserved.

Year-End Accrual of Bond Interest Expense (cont’d) Record second semiannual interest payment and amortization of bond premium: Copyright © Houghton Mifflin Company. All rights reserved.