© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 9: Long-Term Liabilities Cornerstones of Financial and Managerial Accounting, 2e

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objectives 1.Describe debt securities and the markets in which they are issued. 2.Account for the issuance of long-term debt. 3.Use the straight-line method to account for premium/discount amortization. 4.Use the effective interest rate method to account for premium/discount amortization. 5.Determine the after-tax cost of financing with debt and explain financial leverage. 6.Compare and contrast operating and capital leases. 7.Analyze a company’s long-term solvency using information related to long-term liabilities. 8.(Appendix 9A) Calculate the market price of long-term debt using present value techniques.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bonds Payable and Notes Payable ► Long-term debt generally refers to obligations that extend beyond one year, based on a formal agreement or contract. Bonds, long- term notes, debentures, and capital leases belong in this category of liabilities. ► When a company borrows money from a bank, it typically signs a formal agreement or contract called a ‘‘note.’’ Notes are also issued in exchange for a noncash asset such as equipment. Collectively, we refer to these notes as notes payable. ► A bond is a type of note that requires the issuing entity to pay the face value of the bond to the holder when it matures and usually to pay interest periodically at a specified rate. A bond issue essentially breaks down a large debt into smaller chunks (usually $1,000) because the total amount borrowed is too large for a single lender. 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bonds Payable and Notes Payable (continued) ► All debt contracts require the borrower to repay the face value (also called par value or principal). Typically the face value is repaid at maturity, which is a specified date in the future. ► However, some contracts require the principal to be repaid in, for example, monthly installments. These contracts typically require equal payments to be made each period. A portion of each payment is interest and a portion is principal. ► Most debt contracts also require that the borrower make regular interest payments. The amount of each interest payment can be calculated from the face amount, the interest rate, and the number of payments per year, all stated in the debt contract. ► The interest rate identified in a debt contract goes by various names, including stated rate, coupon rate, and contract rate. 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Long-Term Debt Terms 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Selling New Debt Securities ► Borrowing, through the use of notes or bonds, is attractive to businesses as a source of money because the relative cost of issuing debt (such as the interest payments) is often lower than the cost of issuing equity (such as giving up ownership shares). ► Underwriters examine the provisions of the instrument (secured or unsecured, callable or not callable, convertible or not convertible), the credit standing of the borrowing business, and the current conditions in the credit markets and the economy as a whole to determine the market rate of interest (or yield) for the bond. 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Relationships between Stated Interest Rate and Yield 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 You Decide Fixed versus Variable-Rate Debt

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accounting for Issuance of Long-Term Debt ► There are three basic cash flows for which the issuing corporation must account: ► Issuance: the cash received when the bonds are issued (the issue or selling price) ► Interest: the interest payments ► Repayment: the repayment of the principal (or face value) ► If a corporation issues bonds of $500,000 (face), with a stated rate of 6.5% payable annually, and the principal is due in five years. Here are all three cash flows: 2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Recording Issuance of Long-Term Debt ► The market price for debt is typically quoted as a percentage of face value. ► If $100,000 face value bonds are issued at 103, their selling price is 103 percent of face value, or $103,000. Any amount paid above the face value is called a premium. ► If the bond is issued below face value, this difference is called a discount. For example, if these $100,000 face value bonds were issued at 96, there would be a $4,000 discount. ► Any premium or discount is recorded in a separate account called Premium on Bonds Payable or Discount on Bonds Payable. 2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Cornerstone 9-1 Recording the Issuance of Bonds

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Recognizing Interest Expense and Repayment of Principal ► When an obligation extends over several interest periods, the amount of interest associated with each period must be determined. ► Interest amortization is the process used to determine the amount of interest to be recorded in each of the periods the liability is outstanding. ► This allocation has two parts: 1.the actual interest payment made to the lender during the period, and 2.amortizing any premium or discount on the bond. 3

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest Amortization Methods ► There are two methods for amortizing any premium or discount: 1.The effective interest rate method is based on compound interest calculations. Interest expense for the period is always the yield (the effective interest rate) times the carrying (or book) value of the bonds at the beginning of the period. 2.The straight-line method, on the other hand, represents a simple approximation of effective interest amortization. Equal amounts of premium or discount are amortized to interest expense each period. 3

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Straight-Line Method ► Using the straight-line method we account for: ► Debt with regular interest payments sold at their face or par value. ► Debt with regular interest payments sold for more (a premium) or less (a discount) than the face or par value. ► When debt is sold at par there is no premium or discount to amortize. ► In this case, the interest expense reported on the income statement is equal to the interest payment(s) made to the creditor during the period. 3

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Cornerstone 9-2 Recording Interest Expense for Bonds Sold at Par

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Cornerstone 9-2 Recording Interest Expense for Bonds Sold at Par (continued)

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Debt with Regular Interest Payments Sold at a Premium or Discount ► The sale of a bond at a discount or premium affects the borrower’s interest expense because the total interest expense is the difference between the payments to the lenders and the amount received by the borrowing business. ► Let us compare a $1,000,000, 10 percent, five-year bond contract with semiannual interest payments that are sold at a $10,000 discount (99 percent of par) with the same issue sold at a $20,000 premium (102 percent of par). 3

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Cornerstone 9-3 Recording Interest Expense for Bonds Sold at a Discount Using the Straight-Line Method

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Cornerstone 9-3 Recording Interest Expense for Bonds Sold at a Discount Using the Straight-Line Method (continued)

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Cornerstone 9-3 Recording Interest Expense for Bonds Sold at a Discount Using the Straight-Line Method (continued)

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Cornerstone 9-4 Recording Interest Expense for Bonds Sold at a Premium Using the Straight-Line Method

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Cornerstone 9-4 Recording Interest Expense for Bonds Sold at a Premium Using the Straight-Line Method (continued)

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Cornerstone 9-4 Recording Interest Expense for Bonds Sold at a Premium Using the Straight-Line Method (continued)

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accruing Interest ► Assume that on September 1, 2011, Fry Communications borrows $120,000,000 on a three-year, 7 percent note. The note requires annual interest payments and repayment of the principal plus the final year’s interest at the end of the third year. ► Even though no payment is due on Dec. 31, interest must be accrued for the period. 3

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 You Decide Financial Statement Effects of Refinancing

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Effective Interest Rate Method: Recognizing Interest Expense and Repayment of Principal ► The straight-line and effective interest rate methods are identical when a bond is issued at par because there are no premiums or discounts to amortize. ► Even when premiums or discounts exist, the total interest expense over the life of the bonds is identical. ► To use the effective interest method, you must distinguish between interest payments, which are calculated as follows: Face Value x Stated Rate x Time (in Years) and effective interest expense which is calculated as: Carrying Value x Yield Rate x Time (in Years) 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Cornerstone 9-5 Recording Interest Expense for Bonds Sold at a Discount Using the Effective Interest Rate Method

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Cornerstone 9-5 Recording Interest Expense for Bonds Sold at a Discount Using the Effective Interest Rate Method (continued)

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Cornerstone 9-6 Recording Interest Expense for Bonds Sold at a Premium Using the Effective Interest Rate Method

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Cornerstone 9-6 Recording Interest Expense for Bonds Sold at a Premium Using the Effective Interest Rate Method (continued)

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Long-Term Debt Carrying Value Using Straight-Line and Effective Interest Methods to Amortize Premium and Discount 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Installment Debt ► Instead of paying off the principal at maturity, some debt requires a portion of the principal to be paid off each period (usually monthly), along with some interest. ► Classic installment debt payments are home mortgages or car payments. ► Installment debt payments are the same each period, but the portion that is considered interest changes because the outstanding principal balance is changing. ► Initial monthly payments have a relatively high portion allocated to interest because the outstanding loan balance is relatively high. On the other hand, the last few payments have a relatively low portion allocated to interest because the outstanding loan balance is relatively low. 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Pros and Cons of Debt Financing ► A business must weigh both the negative and positive aspects of debt financing in deciding whether or not to take the risk. ► One advantage of financing with debt rather than stock is that the interest expense on debt is deductible for income tax purposes. ► Another potential advantage of debt is that it fixes the amount of compensation to the lender. Thus, if the borrowed capital generates income in excess of the interest on the debt, the firm’s stockholders benefit. The use of borrowed capital to produce more income than needed to pay the interest on the debt is called leverage. ► A third advantage of financing with debt is that in periods of inflation, debt permits the borrower to repay the lender in dollars that have declined in purchasing power. ► The primary negative attribute of debt is the inflexibility of the payment schedule, which could force borrowers into bankruptcy. 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Leases ► Many companies choose to lease, instead of purchase, some of their assets. ► In an operating lease, the lessor (the legal owner of the asset) retains substantially all of the risks and obligations of ownership, while the lessee uses the asset during the term of the lease. ► A capital lease, on the other hand, is a noncancelable agreement that is in substance a purchase of the leased asset. ► If a lease has any of the following characteristics, it is essentially a purchase, and is therefore considered a capital lease: ► A transfer of the leased asset to the lessee occurs at the end of the lease at no cost or at a ‘‘bargain price.’’ ► The term for the lease is at least 75 percent of the economic life of the leased asset. ► The present value of the lease payments is at least 90 percent of the fair value of the leased asset. 6

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Ratio Analysis ► Although long-term creditors are concerned with a company’s short-term liquidity, they are primarily concerned with its long- term solvency. ► As such, long-term creditors focus on ratios that are used to analyze a company’s debt load and ability to cover interest payment (coverage). (1) Ratios to analyze debt load: (2) Coverage ratios: 7 Times Interest Earned (Accrual Basis) = Operating Income ÷ Interest Expense Times Interest Earned (Cash Basis) = (Operating Cash Flows + Interest and Taxes Paid) ÷ Interest Payments

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Ethical Decisions ► When evaluating a company’s solvency, a major concern is whether all debt was properly recorded. ► Companies have long engaged in transactions designed to hide debt. Such transactions are typically called off-balance-sheet financing. ► Interestingly, many such transactions are legal and considered to be ethical by most. ► For example, many companies structure their lease agreements to avoid meeting the criteria for capital leases that require recording an asset and liability related to the future lease obligation. Because these leases are then treated as operating leases, no asset or liability is recorded on the books. 7

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Cornerstone 9-7 Calculating and Analyzing Long-Term Debt Ratios

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Cornerstone 9-7 Calculating and Analyzing Long-Term Debt Ratios (continued)

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Appendix 9A: Pricing Long-Term Debt ► Debt agreements create contractually defined cash flows for the lender. ► Specifically, lenders typically receive ► periodic interest payments and ► repayment of the loan principal at some future date (loan maturity). ► To receive these cash flows, the lender must decide how much to lend. ► A lender decides how much to lend based on the present value of future cash flows arising out of such lending. Two kinds of cash flows arise—the periodic interest payments (an annuity) and the repayment of the principal (a lump sum). ► For example, an investor values a bond at the present value of the two future cash flows—the periodic interest payments and the repayment of the principal. 8

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Cornerstone 9-8 Determining the Market Value of a Bond

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Cornerstone 9-8 Determining the Market Value of a Bond (continued)