Accounting for Long-Term Debt Acct 2210 Chp 10 & Appendix “F” (pg ) McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Show how an installment note affects financial statements. LO

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 10-2

Applying payments to principal and interest  Identify the unpaid principal balance.  Calculate the 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.  Calculate the 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 10-3

On January 1, 2013, Blair Company issued a $100,000 face value long-term note to National Bank. The note had a 9% 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, 2013, Blair Company issued a $100,000 face value long-term note to National Bank. The note had a 9% 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 10-4

Long-Term Notes Payable 10-5

The amount applied to the principal increases each year. The amount of interest decreases each year. Annual payments are constant. Long-Term Notes Payable 10-6

Long-Term Notes Payable Issuing the note has the following effect on Blair’s 2013 financial statements: The December 2013 cash payment has the following effect on Blair’s 2013 financial statements: 10-7

Impact on Financial Statements 10-8

Show how a line of credit affects financial statements. LO

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

Describe bond features and show how bonds issued at face value affect financial statements. LO

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 10-12

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 10-13

Bond Certificate at Face Value Bond Certificate at Face Value Bond Issue Date Bond Selling Price CorporationInvestors Bond Liabilities 10-14

Bond Issue Date Bond Interest Payments CorporationInvestors Interest Payment = Principal × Interest Rate × Time Interest Payment = Principal × Interest Rate × Time Bond Liabilities 10-15

Bond Issue Date Bond Principal at Maturity Date Bond Maturity Date CorporationInvestors Bond Liabilities 10-16

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

Secured and Unsecured Term and Serial Convertible and Callable Characteristics of Bonds 10-18

Mason Company issues bonds on January 1, Principal = $100,000 Stated Interest Rate = 9% Interest Paid Annually on 12/31 Maturity Date = December 31, 2017 (5 years) Mason Company issues bonds on January 1, Principal = $100,000 Stated Interest Rate = 9% Interest Paid Annually on 12/31 Maturity Date = December 31, 2017 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Bonds Issued at Face Value 10-19

Bonds Issued at Face Value Issuing the bonds has the following effect on Mason’s 2013 financial statements: To record the bond issue, Mason makes the following entry on January 1, 2013: To record the bond issue, Mason makes the following entry on January 1, 2013: 10-20

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,

Bonds Issued at Face Value The December 31, 2013, 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: 10-22

Bonds Issued at Face Value Bond Principal at Maturity Date Mason Company Investors On December 31, 2017, Mason will return the $100,000 principal amount to the investors

Bonds Issued at Face Value The principal repayment on December 31, 2017, will have the following effect on Mason’s 2017 financial statements: To record an the principal repayment, Mason Company would make the following entry on December 31, 2017: 10-24

Bonds Issued at Face Value 10-25

Bonds Issued at a Discount If bonds of other companies are yielding more than 9%, investors will be unwilling to pay the full face amount for Mason’s 9% bonds. The issue price of Mason’s 9% 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%, investors will be unwilling to pay the full face amount for Mason’s 9% bonds. The issue price of Mason’s 9% 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

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, 2017 (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, 2017 (5 years) The only change from previous Mason example

Bonds Issued at a Discount Issuing the bonds at a discount has the following effect on Mason’s 2013 financial statements: To record the bond issue, Mason Company would make the following entry on January 1, 2013: 10-28

Face Value Carrying Value Bonds Issued at a Discount 10-29

The principal repayment on December 31, 2017, will have the following effect on Mason’s 2017 financial statements: To record an the principal repayment, Mason Company would make the following entry on December 31, 2017: Bonds Issued at a Discount 10-30

Bonds Issued at a Premium If bonds of other companies are yielding less than 9%, investors will be willing to pay more than the face amount for Mason’s 9 percent bonds. The issue price of Mason’s 9% bonds will rise because of investor demand for the 9% 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%, investors will be willing to pay more than the face amount for Mason’s 9 percent bonds. The issue price of Mason’s 9% bonds will rise because of investor demand for the 9% 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

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, 2017 (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, 2017 (5 years) The only change from the original Mason example. Bonds Issued at a Premium 10-32

Issuing the bonds at a premium has the following effect on Mason’s 2013 financial statements: To record the bond issue, Mason Company would make the following entry on January 1, 2013: Bonds Issued at a Premium 10-33

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

The principal repayment on December 31, 2017, will have the following effect on Mason’s 2017 financial statements: To record an the principal repayment, Mason Company would make the following entry on December 31, 2017: Bonds Issued at a Premium 10-35

L.O.5: Considering 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. = > < > < = 10-36

Use the “effective interest rate” method to amortize bond discounts and premiums. LO 5: We will use this method for our in-class case study 10-37

Effective Interest Rate Method: See pg 553/554 example discussion 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: See pg 553/554 example discussion Let’s assume Mason Company uses the effective interest method on its $100,000 bond. Step 1: Determine the cash payment for interest. Note: the ONLY time the stated (contract) rate is used is for this one calculation (to determine the actual interest to be paid). ALL other calculations use the market rate because we are “tailoring” the bond to the investor’s required rate of return. Step 1: Determine the cash payment for interest. Note: the ONLY time the stated (contract) rate is used is for this one calculation (to determine the actual interest to be paid). ALL other calculations use the market rate because we are “tailoring” the bond to the investor’s required rate of return. 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,

Effective Interest Rate Method: See pg 553/554 example discussion Step 2: Determine the amount of interest expense, assuming the investor requires a market (effective) rate of return of 10.33%. Complete this example in conjunction with the pg 554 discussion in our text as you work through these slides. Step 2: Determine the amount of interest expense, assuming the investor requires a market (effective) rate of return of 10.33%. Complete this example in conjunction with the pg 554 discussion in our text as you work through these slides. 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 10-40

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, ,000 $ 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 $ $ 95,000 $ 95,814 $ $ 95,000 $ 95,

Effective Interest Rate Method * The decrease in the amount of the discount increases the amount of the bond liability

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

Explain the advantages and disadvantages of debt financing. LO

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

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

End of Chapter Ten 10-47