Accounting for Long Term Liabilities Ch 10 – Acc 1a

Different Ways to Finance a Company  Borrowing from a Bank (Ch 9): Notes Payable – More expensive and restrictive than bonds.  Selling Stock (Ch 11): Gives up ownership shares, but does NOT require interest or principal repayments.  Issuing Bonds (Ch 10): Easier to deal with than bank loans, require interest & principal repayment.

Bonds A borrowing/lending arrangement Advantages Bonds do not affect stockholder control. Bonds do not affect stockholder control. Interest on bonds is tax deductible. Interest on bonds is tax deductible. Can increase return on equity. Can increase return on equity. Disadvantages Bonds require payment of both periodic interest and par value at maturity. Bonds require payment of both periodic interest and par value at maturity. Can decrease return on equity. Can decrease return on equity.

Secured and Unsecured Term and Serial Registered and Bearer Convertible and Callable Types of Bonds A2 10-4

...an investment firm called an underwriter. The underwriter sells the bonds to... A trustee monitors the bond issue. A company sells the bonds to investors Bond Issuing Procedures A1 10-5

Issuing Bonds at PAR  Par Value: $1,000,000  Stated Interest Rate = Market Rate of 10%  Interest Payment Dates: 6/30 & 12/31  Bond Issuance Date: Jan 1, 2012  Maturity Date: Dec 31, 2031 (20 years) DR CR 1/1/12Cash1,000,000 Bonds Payable1,000,000 Bonds Issued at Par (Honda)

Interest Expense on Par Value Bonds The entry to record each interest payment on 6/30 and 12/31 of each year is: DR CR 6/30Bond Interest Expense50,000 12/31Cash50,000 Paid semi-annual interest $1,000,000 x 10% x ½ year = $50,000 This entry is made every six months until the bonds mature.

Bond Retirement at Maturity On Dec 31, 2031 the bonds mature and the following entry is made by the issuer: DR CR 1/1/12Bonds Payable1,000,000 Cash1,000,000 Paid bond principal at maturity.

Ex 10-1, Parts 1 & 2

Interest Rates & Bonds  Stated Rate : used to determine the amount of the interest payment (par value x stated interest rate x [1/# interest pymts per year])  Market Rate : determines the selling price of the bond and is the interest rate used for Tables B1 & B3.

Bond Discount or Premium P Net Carrying Value of Bond = Bond Payable – Unamortized Discount Bond Payable + Unamortized Premium

Ex 10-1, Part 3b

Issuing Bonds at a PREMIUM Par value: $1,000,000 Issue Price: % Stated Interest Rate: 10% Market Interest Rate: 8% Interest Payment Dates: 6/30 & 12/31 Bond Date:1/1/12 Maturity Date:12/31/16 (5 yrs) DR CR 1/1/12Cash1,081,145 Bonds Payable1,000,000 Premium on Bonds Payable 81,145 Bonds Issued at Premium (Porsche)

Interest Expense on PREMIUM Value Bonds The entry to record each interest payment on 6/30 and 12/31 of each year is: DR CR 6/30Bond Interest Expense41,885 (plug) &Premium on Bond Payable 8,115* 12/31Cash50,000** Paid semi-annual interest & amortized premium $81,145 / 10 interest payments = $8,115* (rounded) $1,000,000 x 10% x ½ year = $50,000** This entry is made every six months until the bonds mature.

Prepare the entry for Jan. 1, 2012, to record the following bond issue by Rose Co. Par Value = $1,000,000 Issue Price = % of par value Stated Interest Rate = 10% Market Interest Rate = 12% Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2013 (5 years) Prepare the entry for Jan. 1, 2012, to record the following bond issue by Rose Co. Par Value = $1,000,000 Issue Price = % of par value Stated Interest Rate = 10% Market Interest Rate = 12% Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2013 (5 years) Issuing Bonds at a Discount } Bond will sell at a discount. P Contra- Liability Account Account

$73,595 ÷ 10 periods = $7,360 (rounded) $1,000,000 × 10% × ½ = $50,000 $73,595 ÷ 10 periods = $7,360 (rounded) $1,000,000 × 10% × ½ = $50,000 Make the following entry every six months to record the cash interest payment and the amortization of the discount. Issuing Bonds at a Discount P

Bond Issuance Journal Entry Discounted Bond (Hyundai) on Jan 1: Cash $926,405 Discount on Bond* 73,595 Bond Payable $1,000,000 Premium Bond (Porsche) on Jan 1: Cash $1,081,145 Premium on Bond* 81,145 Bond Payable $1,000,000 *The Bond’s Discount or Premium accounts are Contra Liability accounts. Cash $1,000,000 Bond Payable $1,000,000 Cash $1,000,000 Bond Payable $1,000,000 Bond at Par Value (Honda): Bond has a 5-yr term & pays interest 2x per year

Interest Expense Journal Entry Discounted Bond Int Exp. (plug) $57,360 Cash*$50,000 Discount on BP** $7,360 Premium Bond Int Exp. (plug) $41,885 Prem on BP** $ 8,115 Cash* $50,000 * Par value x Interest rate % x 1/# pymts per year ** The amortization of the Discount or Premium is calculated: (Discount or Premium) / (# of Interest Pymts to be Made over Bond Life) NOTE: The carrying value of the bond must be equal to the par value at maturity. In other words, the discount or premium must be ZERO at maturity. Interest Exp*$50,000 Cash* $50,000 Interest Exp*$50,000 Cash* $50,000 Par Value Bond **Bond is a 5-yr bond with interest payment 2x per year.

Amortization of Bond Discount Interest Expense Journal Entry for a Discounted Bond Int Exp. (plug) $57,360 Cash*$50,000 Discount on BP** $7,360 ** The amortization of the Discount or Premium is calculated: (Discount or Premium) / (# of Interest Pymts to be Made over Bond Life) NOTE: The carrying value (Bond Payable – Discount) of the bond must be equal to the par value at maturity. In other words, the discount or premium must be ZERO at maturity. Bond is a 5-yr bond with interest payment 2x per year. Bond Payable (L) $1,000,000 Bond Discount (CL) $73,595 $7,360.. Until account is Zero

P

Amortization of Bond Premium Interest Expense Journal Entry for a Premium Bond ** The amortization of the Discount or Premium is calculated: (Discount or Premium) / (# of Interest Pymts to be Made over Bond Life) NOTE: The carrying value (Bond Payable + Premium) of the bond must be equal to the par value at maturity. In other words, the discount or premium must be ZERO at maturity. Bond is a 5-yr bond with interest payment 2x per year. Bond Payable (L) $1,000,000 Bond Premium (CL) $81,145 $8,115.. Until account is Zero

P

Bond Maturity Journal Entry Discounted Bond (Hyundai) on Jan 1: Bond Payable $1,000,000 Cash $1,000,000 Premium Bond (Porsche) on Jan 1: Bond Payable $1,000,000 Cash $1,000,000 Bond Payable$1,000,000 Cash $1,000,000 Bond Payable$1,000,000 Cash $1,000,000 Bond at Par Value (Honda):

Basics of Bond Valuation The value of a bond investment is based on the SUM of Stream of interest payments made/received over the the life of the bond Use the market rate interest and Table B3. PLUS Single lump sum payment (par value) made at the bond’s maturity. Use the market rate interest and Table B1.

The Four Components of Time Value Calculations:  PV – Present Value, what is it worth today?  FV – Future Value, what is it worth in the future?  n – number of periods (i.e. months, quarter, year)  i – interest rate % earned for each n

Calculate the issue price of Rose Inc.s bonds. Par Value = $1,000,000 Issue Price = ? Stated Interest Rate = 10% Market Interest Rate = 12% Interest Dates = 6/30 and 12/31 Bond Date = Jan. 1, 2012 Maturity Date = Dec. 31, 2016 (5 years) Calculate the issue price of Rose Inc.s bonds. Par Value = $1,000,000 Issue Price = ? Stated Interest Rate = 10% Market Interest Rate = 12% Interest Dates = 6/30 and 12/31 Bond Date = Jan. 1, 2012 Maturity Date = Dec. 31, 2016 (5 years) Example of Calculating the Present Value of a Discount Bond Appendix B C

Present Value of a Discount Bond 1.Semiannual rate = 6% (Market rate 12% ÷ 2) 2.Semiannual periods = 10 (Bond life 5 years × 2) 1.Semiannual rate = 6% (Market rate 12% ÷ 2) 2.Semiannual periods = 10 (Bond life 5 years × 2) $1,000,000 × 10% (stated rate) × ½ = $50,000 C

Ex 10-9

Appendix B Tables  Table B1 & B2: Single payments/Receipts  Table B3 & B4: Multiple payments/receipts  Table B1 & B3: PV unknown  Table B2 & B4: FV unknown

Time Value of Money  Sch B-1 & B-2: A single payment  B-1: If I wanted to have $xx (known factor) in a future period, how much would I have to deposit today? I.e., If I need $5,000 for a down payment in 2 years, how much do I need to deposit in the bank today?  B-2: If I deposited $xx (known factor) today, how much would I have in the future? I.e., If I deposit $3,000 today, how much will I have in 2 years for the down payment on my car?

Table B1 & B2 Single Payment/Receipt Table B1 PV Unknown FV Known Table B2 PV Known FV Unknown

Time Value of Money  Sch B-3 & B-4:  Sch B-3: If I want to have a future series of $xx payments (known factor) in the future, how much would I have to deposit today? I.e., If I want to have $1,000 paid to me every month during my retirement of 20 years, how much do I have to deposit today?  Sch B-4: If I deposit a series of $xx payments, how much will I have in the future? I.e., if I deposit $100 every month for the next 30 years, how much will I have saved for retirement?

Table B3 & B4 Multiple Payments/Receipts of Constant Dollar Amount & Intervals PV Unknown Table B3 FV known Table B4 PV known FV Unknown

Vocabulary  Annuity  Net Carrying Value  Bond Premium, Discount or Par  Bond types (know what each is)(p. 426): Secured & Unsecured; Term & Serial; Registered & Bearer; Convertible & Callable  Debt to Equity Ratio

Mortgage Notes and Bonds  A legal agreement that helps protect the lender if the borrower fails to make the required payments.  Gives the lender the right to be paid out of the cash proceeds from the sale of the borrower’s assets specifically identified in the mortgage contract.  A legal agreement that helps protect the lender if the borrower fails to make the required payments.  Gives the lender the right to be paid out of the cash proceeds from the sale of the borrower’s assets specifically identified in the mortgage contract. C

Note Maturity Date Company Lender Note Date Long-Term Notes Payable Regular Payments of Principal plus Interest Payments can either be equal principal payments plus interest or equal payments. Regular Payments of Principal plus Interest C

Installment Notes with Equal Payments The principal payments increase each year. Interest expense decreases each year. Annual payments are constant. C

Debt-to- Equity Ratio Total Liabilities Total Equity = This ratio helps investors determine the risk of investing in a company by dividing its total liabilities by total equity. Debt-to-Equity Ratio A