Accounting for Long- Term Debt Acct 2210 Chp 10 & Appendix “F” (pg 773-779) McGraw-Hill/Irwin McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Dec 26, 2015
Accounting for Long-Term
Debt
Acct 2210 Chp 10 &
Appendix “F” (pg 773-779)
McGraw-Hill/IrwinMcGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Long-term “notes” are liabilities that usually
have terms from two to five years.
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.
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.
With each payment, the interest portion gets smaller and the principal portion gets larger.
Principal
CompanyLender
Payments
Long-Term Notes Payable
10-3
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 principalin .
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 principalin .
Long-Term Notes Payable
10-4
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
10-5
$-
$5,000
$10,000
$15,000
$20,000
$25,000
$30,000
Year 1 Year 2 Year 3 Year 4 Year 5
Interest
Principal
The amount applied to the principal increases each year. The amount of interest
decreases each year.
The amount applied to the principal increases each year. The amount of interest
decreases each year.
Annual payments
are constant.
Long-Term Notes Payable
10-7
Long-Term Notes Payable
Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow
100,000 = 100,000 + NA NA – NA = NA 100,000 FA
Issuing the note has the following effecton Blair’s 2013 financial statements:Issuing the note has the following effecton Blair’s 2013 financial statements:
Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow
(25,709) = (16,709) + (9,000) NA – 9,000 = (9,000) (9,000) OA
(16,709) FA
The December 2013 cash payment has the followingeffect on Blair’s 2013 financial statements:The December 2013 cash payment has the followingeffect on Blair’s 2013 financial statements:
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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.
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Describe bond features and
show how bonds issued at face value affect
financial statements.
LO 3
10-12
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
10-13
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
10-14
Bond Certificateat Face Value
Bond Certificateat Face Value
Bond Issue Date
Bond Selling Price
Corporation Investors
Bond Liabilities
10-15
Bond Issue Date
Bond Interest Payments
Bond Interest Payments
Corporation Investors
Interest Payment = Principal × Interest Rate × Time
Interest Payment = Principal × Interest Rate × Time
Bond Liabilities
10-16
Bond Issue Date
Bond Principalat Maturity Date
Bond Maturity
Date
Corporation Investors
Bond Liabilities
10-17
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.
10-18
Secured and Unsecured
Secured and Unsecured
Term and Serial
Term and Serial
Convertible and CallableConvertible and Callable
Characteristics of Bonds
10-19
Mason Company issues bonds on January 1, 2013.Principal = $100,000Stated Interest Rate = 9%Interest Paid Annually on 12/31Maturity Date = December 31, 2017 (5 years)
Mason Company issues bonds on January 1, 2013.Principal = $100,000Stated Interest Rate = 9%Interest Paid Annually on 12/31Maturity Date = December 31, 2017 (5 years)
Bond Certificateat Face Value
Bond Certificateat Face Value
Bond Selling Price
Mason Company Investors
Bonds Issued at Face Value
10-20
Bonds Issued at Face Value
Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow
100,000 = 100,000 + NA NA – NA = NA 100,000 FA
Issuing the bonds has the following effecton Mason’s 2013 financial statements:Issuing the bonds has the following effecton 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:
Account Title Debit CreditCash 100,000 Bonds Payable 100,000
10-21
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:
On each interest payment date, Mason will pay $9,000 in interest. The amount is computed as follows:
$100,000 × 9% = $9,000 $100,000 × 9% = $9,000
10-22
Bonds Issued at Face Value
Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow
(9,000) = NA + (9,000) NA – 9,000 = (9,000) (9,000) OA
The December 31, 2013, interest payment (and all other annual interestpayments) has the following effect on Mason’s financial statements:
The December 31, 2013, interest payment (and all other annual interestpayments) 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:
Account Title Debit CreditInterest Expense 9,000 Cash 9,000
10-23
Bonds Issued at Face Value
Bond Principalat Maturity Date
Mason Company
Investors
On December 31, 2017, Mason will return the $100,000 principal amount to the
investors.
On December 31, 2017, Mason will return the $100,000 principal amount to the
investors.
10-24
Bonds Issued at Face Value
Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow
(100,000) = (100,000) + NA NA – NA = NA (100,000) FA
The principal repayment on December 31, 2017, will have thefollowing effect on Mason’s 2017 financial statements:
The principal repayment on December 31, 2017, will have thefollowing effect on Mason’s 2017 financial statements:
To record an the principal repayment, Mason Company would makethe following entry on December 31, 2017:
To record an the principal repayment, Mason Company would makethe following entry on December 31, 2017:
Account Title Debit CreditBonds Payable 100,000 Cash 100,000
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 $100,000 is called a discount.
Let’s continue the Mason Company example. 10-27
Principal
Cash Proceeds Discount
100,000$ - 95,000$ = 5,000$
Bonds Issued at a Discount
Mason Company issues bonds on January 1, 2013.Principal = $100,000Issue Price = $95,000Stated Interest Rate = 9%Interest Date = 12/31Maturity Date = Dec. 31, 2017 (5 years)
Mason Company issues bonds on January 1, 2013.Principal = $100,000Issue Price = $95,000Stated Interest Rate = 9%Interest Date = 12/31Maturity Date = Dec. 31, 2017 (5 years)
The only change fromprevious Mason example.
10-28
Bonds Issued at a Discount
Assets = + Equity Rev. – Exp. = Net Inc. Cash Flow
Cash Bonds Pay. – Discount + Ret. Earn.
95,000 = 100,000 – 5,000 + NA NA – NA = NA 95,000 FA
Liabilities
Issuing the bonds at a discount has the followingeffect on Mason’s 2013 financial statements:Issuing the bonds at a discount has the followingeffect on Mason’s 2013 financial statements:
To record the bond issue, Mason Company wouldmake the following entry on January 1, 2013:To record the bond issue, Mason Company wouldmake the following entry on January 1, 2013:
Account Title Debit CreditCash 95,000 Discount on Bonds Payable 5,000 Bonds Payable 100,000
10-29
Partial Balance Sheet as of January 1, 2013
Long-term Liabilities: Bonds Payable 100,000$ Less: Discount on Bonds Payable 5,000 95,000$
Face ValueFace Value
Carrying ValueCarrying Value
Bonds Issued at a Discount
10-30
Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow
(100,000) = (100,000) + NA NA – NA = NA (95,000) FA (5,000) OA
The principal repayment on December 31, 2017, will have thefollowing effect on Mason’s 2017 financial statements:The principal repayment on December 31, 2017, will have thefollowing effect on Mason’s 2017 financial statements:
To record an the principal repayment, Mason Company would makethe following entry on December 31, 2017:To record an the principal repayment, Mason Company would makethe following entry on December 31, 2017:
Account Title Debit CreditBonds Payable 100,000 Cash 100,000
Bonds Issued at a Discount
10-31
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 $100,000 is called a premium.
Let’s continue the Mason Company example.
10-32
Cash Proceeds
Bonds Payable Premium
105,000$ - 100,000$ = 5,000$
Mason Company issues bonds on January 1, 2013.Principal = $100,000Issue Price = $105,000Stated Interest Rate = 9%Interest Date = 12/31Maturity Date = Dec. 31, 2017 (5 years)
Mason Company issues bonds on January 1, 2013.Principal = $100,000Issue Price = $105,000Stated Interest Rate = 9%Interest Date = 12/31Maturity Date = Dec. 31, 2017 (5 years)
The only change from theoriginal Mason example.
Bonds Issued at a Premium
10-33
Assets = + Equity Rev. – Exp. = Net Inc. Cash Flow
Cash Bonds Pay. + Premium + Equity
105,000 = 100,000 + 5,000 + NA NA – NA = NA 105,000 FA
Liabilities
Issuing the bonds at a premium has the followingeffect on Mason’s 2013 financial statements:Issuing the bonds at a premium has the followingeffect on Mason’s 2013 financial statements:
To record the bond issue, Mason Company wouldmake the following entry on January 1, 2013:To record the bond issue, Mason Company wouldmake the following entry on January 1, 2013:
Account Title Debit CreditCash 105,000 Premium on Bonds Payable 5,000 Bonds Payable 100,000
Bonds Issued at a Premium
10-34
Partial Balance Sheet as of January 1, 2013
Long-term Liabilities: Bonds Payable 100,000$ Add: Premium on Bonds Payable 5,000 105,000$
Face ValueFace Value
Carrying ValueCarrying Value
Bonds Issued at a Premium
10-35
Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow
(100,000) = (100,000) + NA NA – NA = NA (100,000) FA
The principal repayment on December 31, 2017, will have thefollowing effect on Mason’s 2017 financial statements:The principal repayment on December 31, 2017, will have thefollowing effect on Mason’s 2017 financial statements:
To record an the principal repayment, Mason Company would makethe following entry on December 31, 2017:To record an the principal repayment, Mason Company would makethe following entry on December 31, 2017:
Account Title Debit CreditBonds Payable 100,000 Cash 100,000
Bonds Issued at a Premium
10-36
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.
Interest Bond Accounting forRates Price the Difference
Stated Market Bond Face Value There is no differenceRate Rate Price of the Bond to account for.
Stated Market Bond Face Value The difference is accountedRate Rate Price of the Bond for as a bond discount.
Stated Market Bond Face Value The difference is accountedRate Rate Price of the Bond for as a bond premium.
=
>
<
>
<
=
10-37
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
10-38
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.
10-39
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 bondX Stated rate of interest
Cash payment
Face value of bondX Stated rate of interest
Cash payment
$ 100,000X .09$ 9,000
$ 100,000X .09$ 9,000
10-40
Effective Interest Rate Method: See pg 553/554 example discussion
Step 2: Determine the amount of interest expense, assumingthe investor requires a market (effective) rate of return of 10.33%.Complete this example in conjunction with the pg 554 discussionin our text as you work through these slides.
Step 2: Determine the amount of interest expense, assumingthe investor requires a market (effective) rate of return of 10.33%.Complete this example in conjunction with the pg 554 discussionin our text as you work through these slides.
Carrying value of bond liabilityX Effective rate of interest
Interest expense
Carrying value of bond liabilityX Effective rate of interest
Interest expense
$ 95,000X .1033$ 9,814
$ 95,000X .1033$ 9,814
$100,000 face value - $5,000 discount = $95,000 carrying value$100,000 face value - $5,000 discount = $95,000 carrying value
10-41
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
$ 9,814- 9,000$ 814
$ 9,814- 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
$ 814+ $ 95,000
$ 95,814
$ 814+ $ 95,000
$ 95,814
10-42
Effective Interest Rate Method
* The decrease in the amount of the discount increases the amount of the bond liability.
10-43
Effective Interest Rate Method
Notice that when using the effective interest
method, interest expense increases each year.
Notice that when using the effective interest
method, interest expense increases each year.
10-44
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.
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.
10-46
Times Interest Earned Ratio
Times InterestEarned =
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.
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.Numerator is commonly called EBIT,Earnings before interest and taxes.
10-47