4/2/14 1 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.
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4/2/14
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Accounting for Long Term Liabilities
Ch 10 – Acc 1a
Different Ways to Finance a Company u Borrowing from a Bank (Ch 9):
Notes Payable – More expensive and restrictive than bonds.
u Selling Stock (Ch 11): Gives up ownership shares, but does NOT require interest or principal repayments.
u Issuing Bonds (Ch 10): Easier to deal with than bank loans, require interest & principal repayment.
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Bonds A borrowing/lending arrangement
Advantages • Bonds do not
affect stockholder control.
• Interest on bonds is tax deductible.
• Can increase return on equity.
Disadvantages • Bonds require payment
of both periodic interest and par value at maturity.
• Can decrease return on equity.
Secured and Unsecured
Term and Serial
Registered and Bearer
Convertible and Callable
Types of Bonds A2
10-4
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. . .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
u Par Value: $1,000,000
u Stated Interest Rate = Market Rate of 10%
u Interest Payment Dates: 6/30 & 12/31
u Bond Issuance Date: Jan 1, 2012
u Maturity Date: Dec 31, 2031 (20 years)
DR CR 1/1/12 Cash 1,000,000
Bonds Payable 1,000,000 Bonds Issued at Par (Honda)
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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 6/30 Bond Interest Expense 50,000 12/31 Cash 50,000
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 1/1/12 Bonds Payable 1,000,000
Cash 1,000,000 Paid bond principal at maturity.
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Ex 10-1, Parts 1 & 2
Interest Rates & Bonds
u Stated Rate: used to determine the amount of the interest payment
(par value x stated interest rate x [1/# interest pymts per year])
u Market Rate: determines the selling price of the bond and is the interest rate used for Tables B1 & B3.
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Bond Discount or Premium
Contract/Stated rate is: Bond sells:Contract Rate > Market Rate At a premium (above par value) - Porsche Contract Rate = Market Rate At par value (equal to par value) - HondaContract Rate < Market Rate At a discount (below par value) - Vintage Hyundai
P1
10-11
Net Carrying Value of Bond = Bond Payable – Unamor2zed Discount Bond Payable + Unamor2zed Premium
$1,000,000 x 10% x ½ year = $50,000** This entry is made every six months until the bonds mature.
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Prepare the entry for Jan. 1, 2012, to record the following bond issue by Rose Co. Par Value = $1,000,000 Issue Price = 92.6405% 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.
P2
10-15
DR CR Jan. 1 Cash 926,405
Discount on bonds payable 73,595 Bonds payable 1,000,000
Sold bonds at a discount on issue date
Contra-Liability Account
DR CR June 30 Bond interest expense 57,360
Discount on bonds payable 7,360 Cash 50,000
Paid semi-annual interest and amortized discount
$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 P2
10-16
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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
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 amor2za2on 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
Par Value Bond **Bond is a 5-‐yr bond with interest
payment 2x per year.
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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 amor2za2on 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
Amortization of Bond Premium Interest Expense Journal Entry for a Premium Bond
Int Exp. (plug) $41,885
Prem on BP** $ 8,115
Cash* $50,000
** The amor2za2on 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
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 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.
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The Four Components of Time Value Calculations:
u PV – Present Value, what is it worth today?
u FV – Future Value, what is it worth in the future?
u n – number of periods (i.e. months, quarter, year)
u 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)
Example of Calculating the Present Value of a Discount Bond Appendix B
C2
10-26
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Cash Flow Table Table Value Amount
Present Value
Par value of the bond PV of $1 0.5584 1,000,000$ 558,400$
Interest (annuity) PV of an Annuity of $1 7.3601 50,000 368,005
Price of bond 926,405$
Present Value of a Discount Bond
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
C2
10-27
Ex 10-9
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Appendix B Tables
u Table B1 & B2: Single payments/Receipts
u Table B3 & B4: Multiple payments/receipts
u Table B1 & B3: PV unknown
u Table B2 & B4: FV unknown
Time Value of Money u Sch B-1 & B-2: A single payment
u 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?
u 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?
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Table B1 & B2 Single Payment/Receipt
Table B1 PV Unknown
FV Known
Table B2 PV Known
FV Unknown
Time Value of Money u Sch B-3 & B-4:
u 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?
u 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?
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Table B3 & B4 Multiple Payments/Receipts of Constant Dollar Amount & Intervals
PV Unknown Table B3
FV known
Table B4 PV known
FV Unknown
Vocabulary
u Annuity
u Net Carrying Value
u Bond Premium, Discount or Par
u Bond types (know what each is)(p. 426): Secured & Unsecured; Term & Serial; Registered & Bearer; Convertible & Callable
u Debt to Equity Ratio
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Mortgage Notes and Bonds
u A legal agreement that helps protect the lender if the borrower fails to make the required payments.
u Gives the lender the right to be paid out of the cash proceeds from the sale of the borrowerʼ’s assets specifically identified in the mortgage contract.
C1
10-35
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
C1
10-36
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Installment Notes with Equal Payments
$-
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
InterestPrincipal
The principal payments increase each year. Interest expense decreases each year.
Annual payments are
constant.
C1
10-37
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