Long-Term Liabilities 10

Management Issues Related to Issuing Long-Term Debt OBJECTIVE 1: Identify the management issues related to long-term debt.

Key Ratios Debt to equity ratio Interest coverage ratio

Figure 1: Average Debt to Equity for Selected Industries

Table 1: Monthly Payment Schedule on a $100,000, 9 Percent Mortgage

Table 2: Payment Schedule on an 8 Percent Capital Lease

Management Issues Related to Issuing Long-Term Debt Long-term debt is used to finance long- term assets and activities with long-run earnings potential. –Management concerns related to issuing long- term debt include the following: Whether to take on long-term debt How much long-term debt to carry What types of long-term debt to incur

Management Issues Related to Issuing Long-Term Debt Deciding to issue long-term debt –Advantages of long-term debt financing No loss of stockholder control Beneficial tax effect Financial leverage

Management Issues Related to Issuing Long-Term Debt Deciding to issue long-term debt (cont.) –Disadvantages of long-term debt financing Interest and principal must be repaid on schedule. Financial leverage can work against a company if its projects are unsuccessful or its operations are subject to ups and downs.

Management Issues Related to Issuing Long-Term Debt Evaluating long-term debt –The most common types of long-term debt are bonds and long-term notes payable.

Management Issues Related to Issuing Long-Term Debt Evaluating long-term debt (cont.) –A mortgage is a long-term debt secured by real property.

Management Issues Related to Issuing Long-Term Debt Evaluating long-term debt (cont.) –A lease is a contract for the use of an asset. A capital lease is in substance a sale, and an asset and a related liability should be recorded by the lessee. An operating lease is more analogous to rent.

Management Issues Related to Issuing Long-Term Debt

Evaluating long-term debt (cont.) –A pension plan is a retirement program for employees. Benefits are paid out of a pension fund. Distinguish between defined contribution plans and defined benefit plans. Other post-retirement benefits should be expensed when earned.

Management Issues Related to Issuing Long-Term Debt Evaluating long-term debt –Deferred income taxes are the result of using different accounting methods on the income state and income tax liability on the income tax return.

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The Nature of Bonds OBJECTIVE 2: Describe the features of a bond issue and the major characteristics of bonds.

The Nature of Bonds Bonds represent long-term borrowing, with periodic interest payments. –A bond indenture is the bond contract. –A bond certificate is evidence of the corporation’s debt to the bondholders.

The Nature of Bonds Bond issue: prices and interest rate –Bond prices are expressed as a percentage of face value. –Face interest rate: fix rate of interest paid to bondholders base on face value of bond

The Nature of Bonds Bond issue: prices and interest rate (cont.) –Market interest rate: effective interest rate –Discount equals the excess of the face value over the issue price –Premium equals the excess of the issue price over the face value

The Nature of Bonds Characteristics of bonds –Unsecured bonds (also called debenture bonds) are issued on a corporation's general credit, whereas secured bonds give the bondholders a claim to certain assets of the organization on default.

The Nature of Bonds Characteristics of bonds (cont.) –When all the bonds of an issue mature on the same date, they are called term bonds. When the bonds in an issue have several maturity dates, they are called serial bonds.

The Nature of Bonds Characteristics of bonds(cont.) –Some bonds may be bought back and retired by the company prior to their maturity date, called early extinguishment of debt. –Callable bonds give the issuer the right to buy back and retire bonds before maturity at a call price, which is a specified price usually above face value. –Convertible bonds can be exchanged for common stock or other securities at the option of the bondholder.

The Nature of Bonds Characteristics of bonds (cont.) –When registered bonds are issued, the organization maintains a record of all bondholders and pays interest by check to the bondholders of record. –Coupon bonds entitle the bearer to interest when the detachable coupons are deposited at a bank.

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Accounting for the Issuance of Bonds OBJECTIVE 3: Record bonds issued at face value and at a discount or premium.

Accounting for the Issuance of Bonds Issuance of bonds at face value.

Accounting for the Issuance of Bonds

Unamortized Bond Discount is a contra- liability account to Bonds Payable.

Accounting for the Issuance of Bonds Issuance of bonds at a premium.

Accounting for the Issuance of Bonds Unamortized Bond Premium is added to Bonds Payable on the balance sheet.

Accounting for the Issuance of Bonds Bond issue costs –Can amount to as much as 5 percent of bond issue –Include fees of underwriters

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Using Present Value to Value a Bond OBJECTIVE 4: Use present values to determine the value of bonds.

Figure 2: Using Present Value to Value a $20,000, 7 Percent, Five-Year Bond

Using Present Value to Value a Bond The theoretical value of a bond contains two components. –Present value of periodic interest payments –Present value of single payment of principal at maturity

Using Present Value to Value a Bond The current market rate of interest should be used for the foregoing computations.

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Amortization of Bond Discounts and Premiums OBJECTIVE 5: Amortize bond discounts and bond premiums using the straight-line and effective interest methods.

Table 3: Interest and Amortization of a Bond Discount: Effective Interest Method

Figure 3: Carrying Value and Interest Expense—Bonds Issued at a Discount

Table 4: Interest and Amortization of a Bond Premium: Effective Interest Method

Figure 4: Carrying Value and Interest Expense—Bonds Issued at a Premium

Amortization of Bond Discounts and Premiums When bonds are issued at a discount, the total interest cost equals interest payments over the life of the bond plus the original discount amount.

Amortization of Bond Discounts and Premiums Explain the features and handling of zero coupon bonds. A bond discount or premium can be amortized using the straight-line method.

Amortization of Bond Discounts and Premiums The effective interest method is theoretically better than the straight-line method. –Use the effective interest method to amortize a bond discount. First, determine the market rate of interest. Refer to Table 3 in the text for an excellent illustration. The amortized discount increases the interest expense recorded. Journalize the amortization. The carrying value at maturity equals the face value.

Amortization of Bond Discounts and Premiums

When bonds are issued at a premium, the total interest cost equals interest payments over the life of the bond minus the original premium amount. Use the straight-line method to amortize a bond premium.

Amortization of Bond Discounts and Premiums Use the effective interest method to amortize a bond premium. –Amortizing a premium is the same as amortizing a discount, except that the amortized premium decreases the interest expense recorded (see Table 4). –Journalize the amortization. –The carrying value at maturity equals the face value.

Amortization of Bond Discounts and Premiums

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Retirement of Bonds Supplemental Objective 6: Account for the retirement of bonds and the conversion of bonds into stock.

Retirement of Bonds Callable bonds may be retired by the corporation prior to maturity. –When bonds are called (for whatever reason), an entry is needed to eliminate Bonds Payable and any unamortized premium or discount and to record the payment of cash at the call price. In addition, an extraordinary gain or loss on the retirement of the bonds is recorded.

Retirement of Bonds

Convertible bonds can be exchanged for stock by the bondholder. –The common stock is recorded at the carrying value of the bonds.

Retirement of Bonds Convertible bonds can be exchanged for stock by the bondholder. (cont.) –When a bondholder converts his or her bonds into common stock, the common stock is recorded by the company at the carrying value of the bonds. Specifically, the entry eliminates Bonds Payable and any unamortized discount or premium and records Common Stock and Paid-in Capital in Excess of Par Value, Common; no gain or loss is recorded.

Retirement of Bonds

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Other Bonds Payable Issues Supplemental Objective 7: Record bonds issued between interest dates and year-end adjustments.

Figure 5: Interest Expense When Bonds Are Issued Between Interest Dates

Other Bonds Payable Issues When bonds are issued between interest dates, the interest that has accrued since the last interest date is collected from the investor on issue and returned to the investor (along with the interest earned) on the next interest date.

Other Bonds Payable Issues

Make adjustments when the accounting period ends between interest dates, including premium or discount amortization.

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