1 Long-Term Liabilities: Notes, Bonds, and Leases

2 Long-term liabilities are recorded at the present value of the future cash flows. The subject of calculation of present value is covered in Appendix A.

3 Present Value Concepts Appendix A (Pages ) The value of a dollar today will decrease over time. Why? Two components determine the “time value” of money: – interest (discount) rate – number of periods of discounting For financial reporting, we are concerned primarily with present value concepts.

4 Present Value Concepts To record activities in the general ledger dealing with future cash flows, we should calculate the present value of the future cash flows using present value formulas or techniques. Types of activities that require PV calculations: – notes payable – bonds payable and bond investments – capital leases

5 Types of Present Value Calculations PV of a single sum (PV1): Discounting a future value of a single amount that is to be paid in the future (ex: notes payable, bonds payable). PV of an ordinary annuity (PVOA): Discounting a set of payments, equal in amount over equal periods of time, where the first payment is made at the end of each period (ex: interest on bonds payable). PV of an annuity due (PVAD): Discounting a set of payments, equal in amount over equal periods of time, where the first payment is made at the beginning of each period (ex: lease payments).

6 1.Present Value of a Single Sum All present value calculations presume a discount rate (i) and a number of periods of discounting (n).There are 3 different ways you can calculate the PV1: 1. Formula: PV1 = FV1 [1/(1+i) n ] 2. Tables: See Page 674, Table 4 3.Calculator if it has time value of money functions.

7 Long-term Notes Payable Usually issued to financial institutions. May be interest bearing or non-interest bearing (we will look at non-interest bearing). May be serial notes (periodic payments) or term notes (balloon payments). We will look at balloon payments here. Problem 1: On January 2, 2005, Pearson Company purchases a section of land for its new plant site. Pearson issues a 5 year non-interest bearing note, and promises to pay $50,000 at the end of the 5 year period. What is the cash equivalent price of the land, if a 6 percent discount rate is assumed?

8 Problem 1 Solution See Page 674, Table 4 PV1 Table PV1 = FV1( ) i, n PV1 Table PV1 = 50,000 ( ) = $37,363 i=6%, n=5 Journal entry Jan. 2, 2005: Land37,363 Discount on N/P12,637 Notes Payable 50,000

9 Problem 1 Solution, continued What amount would be recognized for interest expense at December 31, 2005? In this chapter we will use the effective interest method to calculate interest expense. The formula for interest is: Interest Expense = Carrying value x Interest rate x Time period (CV) (Per year) (Portion of year) Where carrying value = face - discount. For Example 1, CV= 50, ,637 = 37,363 Interest expense = 37,363 x 6% per year x 1year = $2,242

10 Problem 1 Solution, continued Journal entry, December 31, 2005: Carrying value on B/S at 12/31/2005? (Discount = $12, ,242 = $10,395) Interest expense2,242 Discount on N/P 2,242 Notes Payable$50,000 Discount on N/P (10,395) $39,605

11 Problem 1 Solution, continued $50,000 Interest expense at Dec. 31, 2006: 39,605 x 6% x 1 = $2,376 Journal entry, December 31, 2006: Carrying value on B/S at 12/31/2006? (Discount = 10, ,376) Carrying value on 12/31/2009 (before retirement)? Interest expense2,376 Discount on N/P 2,376 Notes Payable$50,000 Discount on N/P (8,019) $41,981

12 2. Present Value of an Ordinary Annuity(PVOA) PVOA calculations presume a discount rate (i), where (A) = the amount of each annuity, and (n) = the number of annuities (or rents), which is the same as the number of periods of discounting. There are 3 different ways you can calculate PVOA: 1. Formula: PVOA = A [1-(1/(1+i) n )] / i 2. Tables: see page 675, Table 5 PVOA Table PVOA = A( ) i, n 3.Calculator if it has time value of money functions.

13 Bonds Payable Bonds payable are issued by a company (usually to the marketplace) to generate cash flow. The bonds represent a promise by the company to pay a stated interest each period (yearly, semiannually, quarterly), and pay the face amount of the bond at maturity. The marketplace values bonds by discounting the cash flows using the market rate of interest. This is also called the yield rate, discount rate, or effective rate. There are two types of cash flows with bonds: PVOA and PV1.

14 Problem 2: Bonds Payable On July 1, 2005, Mustang Corporation issues $100,000 of its 5-year bonds which have an annual stated rate of 7%, and pay interest semiannually each June 30 and December 31, starting December 31, The bonds were issued to yield 6% annually. Calculate the issue price of the bond: (1) What are the cash flows and factors? Face value at maturity = $100,000 Stated Interest = Face value x stated rate x time period 100,000 x 7% x (1/2) = $3,500 Number of periods = n = 5 years x 2 = 10 Discount rate = 6% / 2 = 3% per period

15 Problem 2 - calculations PV of interest annuity: PVOA Table PVOA Table PVOA = A( ) = 3,500 ( ) = $29,856 i, n i = 3%, n = 10 PV of face value: PV1 Table PV1 Table PV =FV1( ) = 100,000 ( )=$74,409 i, n i=3%, n=10 Total issue price = $104,265 Issued at a premium of $4,265 because the company was offering an interest rate greater than the market rate, and investors were willing to pay more for the higher interest rate.

16 Problem 2 - Amortization Schedule To recognize interest expense using the effective interest method, an amortization schedule must be constructed. (This expands the text discussion.) To calculate the columns (see next slide): Cash paid = Face x Stated Rate x Time = 100,000 x 7% x 1/2 year = $3,500 (this is the same amount every period) Int. Expense = CV x Market Rate x Time at 12/31/05 = 104,265 x 6% x 1/2 year = 3,128 at 6/30/06 = 103,893 x 6% x 1/2 year = 3,117 The difference between cash paid and interest expense is the periodic amortization of premium. Note that the carrying value is amortized down to face value by maturity.

17 Problem 2 - Amortization Schedule Cash Interest Carrying Date Paid Expense Difference Value 7/01/05 104,265 12/31/05 3,500 3, ,893 6/30/06 3,500 3, ,510 12/31/06 3,500 3, ,115 6/30/07 3,500 3, ,708 12/31/07 3,500 3, ,289 6/30/08 3,500 3, ,858 12/31/08 3,500 3, ,414 6/30/09 3,500 3, ,956 12/31/09 3,500 3, ,485 6/30/10 3,500 3, ,000

18 Problem 2 - Journal Entries JE at 7/1/05 to issue the bonds: JE at 12/31/05 to pay interest: Note that the numbers for each interest payment come from the lines on the amortization schedule. Cash 104,265 Premium on B/P 4,265 Bonds Payable 100,000 Interest Expense 3,128 Premium on B/P 372 Cash 3,500

19 Bonds Payable at a Discount. If bonds are issued at a discount, the carrying value will be below face value at the date of issue. The Discount on B/P account has a normal debit balance and is a contra to B/P (similar to the Discount on N/P). The Discount account is amortized with a credit. Note that the difference between Cash Paid and Interest Expense is still the amount of amortization. Interest expense for bonds issued at a discount will be greater than cash paid. The amortization table will show the bonds amortized up to face value.

20 Retirement of Bonds Bonds are retired when the company pays the investors the amount owed. If bonds are held to maturity, the amount on the books is face value and the amount paid is face value. If bonds are retired before maturity, the amount on the books is the carrying value, and the amount paid is the market value at the point of retirement. Because these two amounts are seldom the same, a gain or loss must be recognized.

21 Retirement of Bonds The gain or loss is the difference between carrying value and cash paid. – If cash paid is greater than CV, recognize loss (paid more than book liability). – If cash paid is less than CV, recognize gain (paid less than book liability). When recording the early retirement, we must remove both Bonds Payable (face amount) and the related Premium or Discount (remaining unamortized amount). The gain or loss is recognized as part of Income from Continuing Operations (Other Revenues and Gains or Other Expenses and Losses).

22 Problem 2 - Retirement of Bonds Assume that Mustang’s bonds were retired on June 30, 2006 (after the interest payment). Mustang Corporation paid $104,000 to retire the bonds from the marketplace. Record the entries on June 30, JE at 6/30/06 to pay the interest: JE at 6/30/06 to retire the bonds: Interest Expense3,117 Premium on B/P 383 Cash 3,500 Bonds Payable 100,000 Premium on B/P3,510 Loss on Retirement 490 Cash 104,000

23 3.PV of an Annuity Due (PVAD) The difference between an ordinary annuity and an annuity due is the timing of the periodic payments: an annuity due has payments (rents, annuities) at the beginning of each period. The result is that there is one less period of discounting. There are 3 different ways you can calculate PVAD: 1. Formula: PVAD = A [((1-(1/(1+i) n-1 )) / i) + 1] 2. Tables: see page 708, Table 6 PVAD Table PVAD = A( ) i, n where n = number of payments (not periods) 3.Calculator if it has time value of money functions.

24 Leases Operating leases – Lessee assumes no risk of ownership. – Recognize rent expense as each payment made. – At end of lease term, right to use the property reverts to the owner. Capital leases – Effectively an installment purchase. – Lessee assumes rights and risks of ownership. – Treated as asset purchased with related liability and depreciation.

25 Leases Off-balance-sheet financing – Companies historically liked to contract for leases rather than asset purchases, to keep the liability off the books. – FASB issued SFAS No. 13, which requires certain leases to be recorded as capital leases. – Capital leases record the leased asset as a capital asset, and reflect the present value of the related payment contract as a liability.

26 Leases Requirements of SFAS No record as capital lease for the lessee if any one of the following is present in the lease: – Title transfers at the end of the lease period, – The lease contains a bargain purchase option, – The lease life is at least 75% of the useful life of the asset, or – The lessee pays for at least 90% of the fair market value of the lease.

27 Leases Payments under a lease agreement may include: – Periodic rental payments (an annuity) and: – Bargain purchase option (BPO): An end of lease payment to purchase the asset at significantly below market OR – Guaranteed residual value (GRV): A minimum amount (of cash and asset) required by the lessor if the asset is returned to the lessor.

28 Leases The amount to capitalize (record for asset and related liability) is the present value of the minimum lease payments: PV MLP = PV RENTS + PV BPO or GRV If lease contains both BPO and GRV, include only BPO. The assumption is that a rational lessee would exercise the BPO and not have to pay an GRV. If the rents occur at the beginning of each period, like most leases, the PV RENTS is an annuity due.

29 Problem 3 - Leases Lee Company (the lessee) signed a contract to lease equipment from Lawrence Company (the lessor). The terms of the lease were as follows: 1.Four year lease starting January 1, Annual lease payments of $6,000. The first payment is due at lease inception (January 1, 2005), with subsequent payments on December 31, 2005, 2006, and Bargain purchase option of $1,000 at end of lease (December 31, 2008). Other information: Lee’s borrowing rate: 8% Useful life of equipment: 6 years with no salvage value.

30 Problem 3 - Leases Requirement 1: Calculate the PV MLP (Note that the lease payments are an annuity due.) PV MLP = PV RENTS + PV BPO PVAD Table PVAD Table PV RENTS =PVAD= A( ) = 6,000(3.5771) = $21,463 i, n i =8%, n=4 PV1 Table PV1 Table PV BPO = PV1 = FV1( ) = 1,000( ) = $ 735 i, n i = 8%, n = 4 The present value of the minimum lease pmts = $22,198

31 Problem 3 - Leases Requirement 2: Prepare the amortization schedule (effective interest method) to recognize the interest payments and principal payments over the life of the lease. This is similar to the amortization schedule for the bonds payable (cash paid is constant, and interest expense = CV x MR x T), except that the lease payment includes both an interest payment and a principal payment. The “difference” in this case is the principal reduction each period.

32 Problem 3 - Leases Cash Interest Carrying Date Paid Expense Difference Value 1/01/05 22,198 1/01/05 6, ,000 16,198 12/31/05 6,000 1, ,704 11,494 12/31/06 6, ,080 6,414 12/31/07 6, , /31/08 1, No interest at 1/1/05, because no time has passed. This is equivalent to a “down payment” which immediately reduces the total liability. 2 Int. Expense = CV x MR x T = 16,198 x 8% x 1 year 3 Rounding difference of $1 absorbed in calculation.

33 Problem 3 - Leases Requirement 3: Prepare the following journal entries for the year 2005: Initial lease at 1/1/05: First payment at 1/1/05: Second payment at 12/31/05: Equipment 22,198 Lease Liability 22,198 Lease Liability 6,000 Cash6,000 Interest Expense 1,296 Lease Liability 4,704 Cash6,000

34 Problem 3 - Leases For the last entry, we must calculate straight- line depreciation on leased asset at 12/31/05. Since we are recording an asset, we must depreciate the asset. Note that the calculation here is based on the length of time that the lessee will actually use the asset (6 years here because of the BPO). (Cost-SV)/Est. life =(22, )/6 = $3,700 JE for Depreciation at 12/31/05: Depreciation expense3,700 Accumulated Depr. 3,700

35 Comments on Leases Many companies still have many leases that qualify as operating leases for financial reporting. Comparison to companies with capital leases is difficult (different asset and liability structures). Disclosure information regarding operating lease components makes it possible for analysts to “capitalize” the operating leases for financial statement comparison.