Act 211, Chapter 9

Views:
 
Category: Entertainment
     
 

Presentation Description

No description available.

Comments

Presentation Transcript

Chapter 09 :

Chapter 09 Long-Term Liabilities

Part A:

Part A Overview of Long Term Debt 9- 2

LO1 Explain financing alternatives:

LO1 Explain financing alternatives Financing Options Debt Financing - borrowing money (liabilities) Equity Financing - obtaining additional investment from stockholders (stockholders’ equity) Capital Structure - is the mixture of liabilities and stockholders’ equity used by a business Accounting Equation 9- 3

What is a Bond? :

A formal debt instrument that obligates the borrower to repay a stated amount, referred to as the principal or face amount, at a specified maturity date . In return, the borrower agrees to pay interest over the life of the bond. Similar to notes payable, except bonds are usually issued to many lenders at the same time, and bonds are typically for a longer term . Traditionally, interest on bonds is paid twice a year ( semi-annually ). Bonds are sold or underwritten by investment houses like JPMorgan , Citibank and Bank of America . What is a Bond? 9- 4

PowerPoint Presentation:

The borrower pays a fee for underwriting services. Other costs include legal, accounting, registration, and printing fees. To keep costs lower (they can be up to 5% of the issuance), the issuing company may choose to sell the debt securities directly to a single investor . This is referred to as a Private placement . Issue costs are lower because privately placed securities are not subject to the costly and lengthy process of registering with the SEC that is required of all public offerings. What is a Bond? (Cont.) 9- 5

LO2 Identify the characteristics of bonds :

LO2 Identify the characteristics of bonds A bond indenture is a contract between a firm issuing bonds (corporations, governments, universities, etc.) and the corporations or individuals who purchase the bonds as investments. Often sold in $1,000 denominations or multiples of $1,000 Bonds may be secured or unsecured , term or serial , callable , or convertible . 9- 6

Long-Term Debt (Bonds):

Long-Term Debt (Bonds) 7 $1000 Jan. 1, 2011 ABC Co. ABC Co. agrees to pay 8% of face to the holder of this instrument, payable in semiannual installments, in addition to the face value 10 years from the date found on this instrument. Ralph Ajax, Chairman Face Value Issue Date (possibly) Maker (Debtor) Term Stated Rate or Coupon Rate or Contract Rate Annuity Frequency Market Rate =10% Tell me more about this! Secured or Unsecured Term Bond Important Types of Bonds Convertible Callable

Bond: Long-Term Liabilities:

Bond: Long-Term Liabilities Maturity Date Illustration 10-3 Contractual Interest Rate Face or Par Value Issuer of Bonds

Secured and Unsecured Bonds:

Secured and Unsecured Bonds Secured Bonds - supported by specific assets the issuer has pledged as collateral. Mortgage bonds are backed by specific real estate assets. If the borrower defaults on the payments, the lender is entitled to the real estate pledged as collateral. Unsecured bonds - referred to as debentures , these are not backed by a specific asset. Secured only by the “full faith and credit” of the borrower. 9- 9

Term and Serial Bonds :

Term and Serial Bonds Term bonds require payment of the full principal amount of the bond at a single maturity date. Most bonds have this characteristic. To ensure that sufficient funds are available to repay the amount at maturity, the borrower sets aside money in a “ sinking fund .” A sinking fund is an investment fund used to set aside money to pay the outstanding debt as it comes due. Serial bonds require payments in installments over a series of years. It makes it easier for the borrower to meet its bond obligations as they become due. 9- 10

Callable Bonds:

Callable Bonds Most corporate bonds are callable , or redeemable. Allows the borrower to repay the bonds before their scheduled maturity date at a specified call price. Call price is stated in the bond contract and usually exceeds the bond’s face amount . It helps protect the borrower against future decreases in interest rates. If interest rates decline, the borrower can buy back the high-interest rate bonds at a fixed price and issue new bonds at the new, lower interest rate. 9- 11

Convertible Bonds:

Convertible Bonds While callable bonds benefit the borrower, convertible bonds benefit both the borrower and the lender. Convertible bonds allow the lender to convert each bond into a specified number of shares of common stock. The borrower also benefits. Convertible bonds sell at a higher price and require a lower interest rate than bonds without a conversion feature. Using IFRS, we would divide the issue price of convertible debt into its liability (bonds) and equity (conversion option) elements. Under U.S. GAAP, the entire issue price is recorded as a liability. 9- 12

Summary of Bond Characteristics:

Summary of Bond Characteristics 9- 13

PowerPoint Presentation:

i >clicker question

Part B:

Part B Pricing a Bond 9- 15

LO3 Determine the price of a bond issue:

LO3 Determine the price of a bond issue Issue price is calculated as the present value of the face amount plus the present value of the periodic interest payments . Bonds can be issued at: Face amount Below face amount ( discount ) Above face amount ( premium ) Ways to determine the issue price of bonds: Financial calculator Excel Spreadsheet Calculate the price of the bonds using present value tables 9- 16

PowerPoint Presentation:

Stated Interest Rate – rate quoted in the bond contract used to calculate the cash payments for interest. Market Interest Rate – true interest rate used by investors to value a company’s bond issue. The higher the market interest rate, the lower will be the bond issue price . Periods to Maturity – number of years to maturity multiplied by the number of interest payments per year. Determine the price of a bond issue (Cont.) 9- 17

Accounting for Bond Issues:

8% 10% 12% Premium Face Value Discount Assume Stated (Contractual) Rate of 10% SO 5 Prepare the entries for the issuance of bonds and interest expense. Bonds Sold At Market Interest Accounting for Bond Issues 18

Bonds Issued at Face Amount:

Bonds Issued at Face Amount Pricing Bonds Issued at Face Amount Using a Financial Calculator Illustration of RC Enterprises: The face amount equals $100,000. The interest payment every six months is $3,500 (= $100,000 x 7% x ½ year). The market rate can be equal to, less than, or greater than the stated 7% interest rate paid to investors. Let’s first assume the market interest rate is 7%. RC’s bonds pay interest semi-annually for 10 years . 9- 19

PowerPoint Presentation:

Bonds Issued at Face Amount An alternative to using a financial calculator is to calculate the issue price of the bonds using present value tables . Present value of face amount = $100,000 x 0.50257* $ 50,257 Present value of interest payments = $3,500 1 x 14.21240** 49,743 Issue price of the bonds $100,000 1 $100,000 x 7% x ½ year = $3,500 * Table 2, i = 3.5% , n = 20 ** Table 4, i = 3.5% , n = 20 9- 20

Bonds Issued at a Discount:

Bonds Issued at a Discount RC Enterprises issues the same $100,000 of 7% bonds when other bonds of similar risk and maturity are paying 8% . RC’s bonds are less attractive to investors because they can purchase bonds of similar risk that are paying the higher 8% rate. RC will have to issue its 7% bonds below its $100,000 face amount. Bonds issued below face amount are said to be issued at a discount . Pricing Bonds Issued at a Discount Using a Financial Calculator 9- 21

PowerPoint Presentation:

Bonds Issued at a Discount Pricing bonds issued at a discount using present value tables. The bond issue price is below the face amount of $100,000. The issuing company receives only $93,205 from investors, but will pay back $100,000 when the bonds mature in 10 years. Present value of principal = $100,000 x 0.45639* $45,639 Present value of interest payments = $3,500 1 x 13.59033** 47,566 Issue price of the bonds $93,205 1 $100,000 x 7% x ½ year = $3,500 * Table 2, i = 4% , n = 20 ** Table 4, i = 4% , n = 20 9- 22

Bonds issued at a Premium :

Bonds issued at a Premium RC Enterprises issues $100,000 of 7% bonds when other bonds of similar risk and maturity are paying only 6% . Investors will pay more than $100,000 for 7% bonds since they look relatively attractive compared with bonds paying only 6%. These bonds will sell for a premium . A premium occurs when the issue price of a bond is above its face amount. In this case, RC’s bonds will sell for more than $100,000. Pricing of Bonds Issued at a Premium using a Financial Calculator shown below 9- 23

PowerPoint Presentation:

Bonds issued at a Premium The bond issue price is above the face amount of $100,000. RC Enterprises receives $107,439 from investors, but will need to pay back only $100,000 when the bonds mature in 10 years. Pricing bonds issued at a premium using present value tables. Present value of principal = $100,000 x 0.55368* $ 55,368 Present value of interest payments = $3,500 1 x 14.87747** 52,071 Issue price of the bonds $107,439 1 $100,000 x 7% x ½ year = $3,500 * Table 2, i = 3% , n = 20 ** Table 4, i = 3% , n = 20 9- 24

PowerPoint Presentation:

i >clicker question

Part C:

Part C Recording Bonds Payable 9- 26

LO4 Account for the issuance of bonds:

LO4 Account for the issuance of bonds On January 1, 2012, RC Enterprises issues $100,000 of 7% bonds, due in 10 years, with interest payable semi-annually on June 30 and December 31 each year. The bonds issue for exactly $100,000, assuming a 7% market interest rate. RC Enterprises records the bond issue as: On June 30, 2012, RC Enterprises records the first semi- annual interest payment: January 1, 2012 Debit Credit Cash 100,000 Bonds Payable 100,000 (Issued bonds at face amount) June 30, 2012 Debit Credit Interest Expense 3,500 Cash 3,500 ( Record semiannual interest payment ) ( $100,000 x 7% x 1/2 = $3,500 ) January 1, 2012 Debit Credit Cash 100,000 Bonds Payable 100,000 (Issued bonds at face amount) 9- 27

Recording Bonds Issued at a Discount:

Recording Bonds Issued at a Discount In the preceding example we assumed the stated interest rate ( 7% ) and the market interest rate (7%) were the same. If the market interest rate is 8% , the bonds will issue at only $93,205. This is less than $100,000. The bonds are paying only 7%, while investors can purchase bonds of similar risk paying 8%. The entry RC Enterprises makes to record the bond issue at a discount is: We initially record the bonds payable account at $93,205. The balance in the bonds payable account is the carrying value . The carrying value will increase from the amount originally borrowed ($93,205) to the amount due at maturity ($100,000) over the 10-year life of the bonds. January 1, 2012 Debit Credit Cash 93,205 Bonds Payable 93,205 (Issued bonds at a discount) 9- 28

Recording Bonds Issued at a Discount:

Recording Bonds Issued at a Discount We calculate interest expense as the carrying value (the amount actually owed during that period) times the market rate (4% semi-annually or 8% annually, in our example) Cash paid for interest is equal to the face amount times the stated rate (3.5% semi-annually or 7% annually, in our example). On June 30, 2012, RC Enterprises records interest expense. Interest expense = Carrying value of bond X Market interest rate per period $3,728 = $93,205 8% x ½ Cash paid for Interest = Face amount of bond X Stated interest rate per period $3,500 = $100,000 7% x ½ June 30, 2012 Debit Credit Interest Expense ($93,205 x 8% x ½) 3,728 Bonds Payable (difference) 228 Cash ($100,000 x 7% x ½) 3,500 (Record semiannual interest payment) 9- 29

PowerPoint Presentation:

Amortization Schedule for Bonds Issued at a Discount An amortization schedule provides a nice summary of the cash interest payments, interest expense, and changes in carrying value for each semi-annual interest period. The amounts for the June 30, 2012 and the December 31, 2012 semi-annual interest payment entries can be taken directly from the amortization schedule. (1) Date (2) Cash Paid for interest (3) Interest Expense (4) Increase in Carrying Value (5) Carrying Value Face Amount x Stated Rate Carrying Value x Market Rate (3) – (2) Prior Carrying Value + (4) 1/1/2012 $93,205 6/30/2012 $3,500 $3,728 $228 93,433 12/31/2012 3,500 3,737 237 93,670 * * * * * * * * * 99,057 6/30/2021 3,500 3,962 462 99,519 12/31/2021 3,500 3,981 481 $100,000 9- 30

Recording Bonds Issued at a Premium:

Recording Bonds Issued at a Premium RC Enterprises issues $100,000 of 7% bonds when other bonds of similar risk are paying only 6% . The bonds will issue at $107,439. Investors will pay more than $100,000 for these 7% bonds because bonds of similar risk are paying only 6% interest. The entry to record the bond issue at a premium is: January 1, 2012 Debit Credit Cash 107,439 Bonds Payable 107,439 (Bonds issued at a premium) June 30, 2012 Debit Credit Interest Expense ($107,439 x 6% x ½) 3,223 Bonds Payable (difference) 277 Cash ($100,000 x 7% x ½) 3,500 (Semi-annual interest payment) On June 30, 2012, RC Enterprises records interest expense. 9- 31

Amortization Schedule for Bonds Issued at a Premium:

Amortization Schedule for Bonds Issued at a Premium An amortization schedule provides a nice summary of the cash interest payments, interest expense, and changes in carrying value for each semi-annual interest period. The amounts for the June 30, 2012 and the December 31, 2012 semi-annual interest payment entries can be taken directly from the amortization schedule. (1) Date (2) Cash Paid for interest (3) Interest Expense (4) Increase in Carrying Value (5) Carrying Value Face Amount x Stated Rate Carrying Value x Market Rate (2) – (3) Prior Carrying Value + (4) 1/1/2012 $107,439 6/30/2012 $3,500 $3,223 $277 107,162 12/31/2012 3,500 3,215 285 106,877 * * * * * * * * * 100,956 6/30/2021 3,500 3,029 471 100,485 12/31/2021 3,500 3,015 485 $100,000 9- 32

Changes in Carrying Value Over Time:

Changes in Carrying Value Over Time 9- 33

LO5 Record the retirement of bonds:

LO5 Record the retirement of bonds When the issuing corporation buys back its bonds from the investors, it is said that the company has retired those bonds. It can wait until the bonds mature to retire them, or in most cases, the issuer will choose to buy the bonds back early BOND RETIREMENTS AT MATURITY Regardless of whether bonds are issued at face amount, a discount, or a premium, their carrying value at maturity will equal their face amount. RC Enterprises records the retirement of its bond at maturity as: December 31, 2021 Debit Credit Bonds Payable 100,000 Cash 100,000 (Retire bonds at maturity) 9- 34

Bond Retirements Before Maturity:

Bond Retirements Before Maturity When the issuer retires debt of any type before its scheduled maturity date, the transaction is called an early extinguishment of debt . When interest rates go down, bond prices go up. If the market rate drops to 6%, it will now cost $106,877 to retire the bonds on December 31, 2012. The bonds have a carrying value on December 31, 2012, of $93,670, but it will cost the issuing company $106,877 to retire them. RC Enterprises will record the retirement before maturity as follows: December 31, 2012 Debit Credit Bonds Payable (account balance) 93,670 Loss on Extinguishment of Debt (difference) 13,207 Cash (amount paid) 106,877 (Retire bonds before maturity) 9- 35

PowerPoint Presentation:

i >clicker question

Part D:

Part D Other Long-Term Liabilities

LO6 Identify other major long-term liabilities:

LO6 Identify other major long-term liabilities Common long-term liabilities other than bonds payable are: Installment notes Leases 9- 38

Installment Notes:

Installment Notes Each installment payment includes both : An amount that represents interest. An amount that represents a reduction of the outstanding loan balance. RC Enterprises obtains a $25,000, 6%, four-year loan for a truck on January 1, 2012. Payments of $587.13 are required at the end of each month for 48 months. We record the note and the first two monthly payments as: January 1, 2012 Debit Credit Cash 25,000 Notes Payable 25,000 (Issue a note payable) January 31, 2012 Interest Expense ($25,000 x 6% x 1/12) 125.00 Notes Payable (difference) 462.13 Cash (monthly payment) 587.13 (Record first monthly payment) February 28, 2012 Interest Expense ($24,537.87 x 6% x 1/12) 122.69 Notes Payable (difference) 464.44 Cash (monthly payment) 587.13 (Record second monthly payment) 9- 39

Leases:

Leases A lease is a contractual agreement by which the lessor (owner) provides the lessee (user) the right to use an asset for a specific period of time. For accounting purposes, we have two basic types of leases: Operating Leases : This type of a lease is similar to a rental. Example: Car rentals and short-term apartment leases. Capital Leases : Occurs when a lessee buys an asset and borrows the money through a lease to pay for the asset. Example: A borrower signs a four-year lease for a car that automatically transfers ownership at the end of the lease term. 9- 40

LO7 Make financial decisions using long-term liability ratios:

LO7 Make financial decisions using long-term liability ratios Debt Analysis Business decisions include risk. Failure to properly consider risk in those decisions is one of the most costly, yet most common, mistakes investors and creditors make. Long-term debt is one of the first places decision makers should look when trying to manage risk. To measure a company’s risk, we calculate the debt to equity ratio and the times interest earned ratio . 9- 41

Debt to equity ratio:

Debt to equity ratio Debt requires payment on specific dates. Failure to repay a debt or the interest on the debt on a timely basis may result in default or in some cases bankruptcy. A company’s risk increases as it accumulates more debt. Debt can also be an advantage. This occurs when a company earns a return that is greater than the cost of borrowing those funds, thereby increasing the return to stockholders. We calculate the debt to equity ratio as: Debt to equity ratio = Total liabilities Stockholders’ equity 9- 42

Times interest earned ratio:

Times interest earned ratio Lenders require interest payments in return for the use of their money. Failure to pay interest when it is due may invoke penalties, possibly leading to bankruptcy. The times interest earned ratio compares interest expense with income available to pay those charges. To measure the amount available to pay interest we need to add interest expense back to net income. Similarly, because interest expense is deductible for income tax purposes, we need to add back tax expense as well. We calculate the times interest earned ratio as: Times interest earned ratio = Net income + Interest expense + Tax expense Interest expense 9- 43

PowerPoint Presentation:

i >clicker question

PowerPoint Presentation:

Good Luck on the Chapter 9 Homework !

authorStream Live Help