Chapter 10 Accounting for Debt Transactions LOANS & BONDS

Business Background l Capital structure is the mix of debt and equity used to finance a company. l Loans l Loans from banks, insurance companies, or pension funds are often used when borrowing small amounts of capital. l Bonds l Bonds are debt securities issued when borrowing large amounts of money. p Can be issued by either corporations or governmental units.

Characteristics of Bonds Payable principal l Bonds usually involve the borrowing of a large sum of money, called principal, for a fairly long time period. lump sum l The principal is usually paid back as a lump sum at the end of the bond period. par valueface value l Individual bonds are often denominated with a par value, or face value, of $1,000.

Characteristics of Bonds Payable stated rate of interest l Bonds usually carry a stated rate of interest. l Interest is normally paid semiannually. l Interest is computed as: Interest = Principal × Stated Rate × Time

Assume that all three bonds are issued today in equal quantities & that each carries identical risk. How much extra will you get in exchange for paying the highest possible interest? And, how much discount will get in exchange for paying the lowest possible interest? Bond A pays 10% Bond B pays 12% Bond C pays 14% 10 year, $1,000 Bonds offered to raise cash (annual interest)

Bonds Payable Journal Entries: Issuance: Dr CashAmntRec’d Dr Discount on Bonds PayableDif Cr Premium on Bonds PayableDif Cr Bonds PayableFace Interest Date: Dr Interest ExpenseEffRate Dr Premium on Bonds Payable Dif Dr Premium on Bonds Payable Dif Cr Discount on Bonds Payable Dif Cr CashAmntPd.

Bond A raises: $ 887 (discount = $113) Bond B raises: $1,000 (sells at its face value) Bond C raises: $1,113 (premium = $113) (A) Record the Issuance of Bonds A, B & C. (B) Record each interest payment & amortize the discount or premium (assume interest is paid at year-end) using the Effective Interest Method Bond A pays 10% Bond B pays 12% Bond C pays 14%

The time value of money... l Selling price of a bond = present value of future cash flows promised by the bonds, discounted using the market rate of interest

Measuring Bonds Payable and Interest Expense market interest rate l The interest rate used to compute the present value is the market interest rate. p Also called yield, effective rate, or true rate. l Creditors demand a certain rate of interest to compensate them for the risks related to bonds. stated ratecoupon rate l The stated rate, or coupon rate, is only used to compute the periodic cash interest payments.

Determining the Selling Price l Selling price = Present value of future cash flows promised by the bonds, using market rate for present- value calculations. (The Appendix demonstrates these calculations.) l Therefore, if p market % > stated %: Discount p market % < stated %: Premium p market % = stated %: Face or par

Measuring and Recording Interest on Bonds Issued at a Discount amortized l The discount must be amortized over the outstanding life of the bonds. interest expense l The discount amortization increases the periodic interest expense for the issuer. l Two methods are commonly used: p Straight-line amortization p Effective-interest amortization (in Appendix)

Straight-Line Amortization of Bond Discount l Identify the amount of the bond discount. l Divide the bond discount by the number of interest periods. l Include the discount amortization amount as part of the periodic interest expense entry. l The discount will be reduced to zero by the maturity date.

Carrying value of BONDS PAYABLE l While the specific long-term liability, Bonds Payable, is always recorded (and kept) at face value, the remaining balance (called the Unamortized balance) of the Discount or Premium will be either subtracted (if discount) or added (if premium) to the B/P-face amount to get the carrying value [also called “book” value] of the bonds at any given date.

Measuring and Recording Interest on Bonds Issued at a Premium amortized l The premium must be amortized over the term of the bonds. interest expense l The premium amortization decreases the periodic interest expense for the issuer. l Two methods are commonly used: p Straight-line amortization p Effective-interest amortization

Straight-Line Amortization of Bond Premium l Identify the amount of the bond premium. l Divide the bond premium by the number of interest periods. l Include the premium amortization amount as part of the periodic interest expense entry. l The premium will be reduced to zero by the maturity date.

Understanding Notes to Financial Statements l Effective-interest method of amortization is required by GAAP. (This method is in the Appendix.) l Straight-line amortization may be used if it is not materially different from effective interest amortization. l Most companies do not disclose the method used for bond interest amortization.

Loans: Long-term Mortgages l A mortgage is a special kind of “note” payable-- one issued for property. l It is repaid in equal installments, part of which are repayment of principal and part of which are interest.

How buying an asset using a mortgage is reflected in the financial statements: l Journal entry when the mortgage is issued: p Debit LAND or BLDG. p Credit Mortgage Payable l Journal entry to make a payment: p Debit Interest expense p Debit Mortgage Payable p Credit Cash.

Debt vs. Equity Financing Financing with debt Interest payments are tax deductible. Interest payments are tax deductible. Financing with Equity (additional owners’ capital investment) Distributions to owners (Dividends) are NOT tax deductible. Distributions to owners (Dividends) are NOT tax deductible.

Debt vs. Equity Financing Financing with debt Interest payments MUST BE PAID even if the company is losing money. Interest payments MUST BE PAID even if the company is losing money. Financing with Equity (additional owners’ capital investment) Distributions to owners (Dividends) could be reduced or eliminated in “bad times.” Distributions to owners (Dividends) could be reduced or eliminated in “bad times.”

Debt–to–Asset Ratio Total Liabilities Total Liabilities Total Assets = This ratio measures the percentage of assets being provided by creditors. It indicates the margin of safety to creditors

Times Interest Earned Ratio Earnings before Interest Expense and Income Taxes Interest Expense = Measures the ease in paying interest on debt