Financial accounting the impact on decision makers 9e chapter 10

Factors Affecting Bond Price Face rate of interest: also called stated rate, nominal rate, contract rate, coupon rate  The rate of interest on the bond certificate  Market rate of int

Chapter 10

Long-Term Liabilities

Bonds Payable

 A security or financial instrument that allows firms to borrow large sums of money and repay the loan over a long period of time

 The borrower (issuing company) agrees to pay interest

on specific dates, usually semiannually or annually

 The borrower also agrees to repay the principal at the maturity, or due date, of the bond

 Face value or par value: The denomination of the bond

is usually referred to as the face value or par value,

usually in denominations of $1,000

LO 2

Bonds Payable—Characteristics

 Debenture bonds: not backed by specific collateral

 Secured bond: the certificate indicates specific

assets that serve as collateral in case of default

 Term bonds: entire principal amount is due on a

single date

 Serial bonds: a portion of the bonds comes due each time period

Bonds Payable—Characteristics

(continued)

 Convertible bonds: can be converted into common stock at a future time

 Callable bonds: redeemed or retired before their

specified due date

Exhibit 10.2—Bond Certificate

Factors Affecting Bond Price

 Face rate of interest: also called stated rate,

nominal rate, contract rate, coupon rate

 The rate of interest on the bond certificate

 Market rate of interest: also called effective rate, bond yield

 The rate that investors could obtain by investing in other bonds

 Bond issue price: the present value of the

annuity of interest payments plus the present

value of the principal

LO 3

Premium or Discount on Bonds

LO 4

If Market Rate = Face Rate

If Market Rate > Face Rate

If Market Rate < Face Rate

issued at face value

issued at a discount

issued at a premium

Discount = Face Value − Issue Price

Premium = Issue Price − Face Value

The relationship between interest rates and bond prices is always inverse

Recording Bond Issuance at Discount

 Discount Firm could identify and analyze the effect of the issuance of the bonds as follows:

Recording Bond Issuance at Discount

(continued)

 The Discount on Bonds Payable account is shown as a contra

liability on the balance sheet as a deduction from Bonds

Payable If Discount Firm prepared a balance sheet immediately after the bond issuance, the following would appear in the Long- Term Liabilities category of the balance sheet:

Example 10.2—Calculating Bond

Issuance at a Premium

 On January 1, 2014, Premium Firm wants to issue the same bonds as in

Example 10-1: $10,000 face value bonds with an 8% face rate of interest and with interest paid annually each year for four years Assume, however, that the market rate of interest is 6% for similar bonds The issue price is

calculated as the present value of the annuity of interest payments plus the present value of the principal at the market rate of interest The calculations are as follows:

 We have calculated that the bonds would be issued for $10,693 The amount

of the premium is calculated as follows:

Bond Issuance at a Premium

 Premium Firm could identify and analyze the effect of the issuance of the bonds as follows:

Bond Issuance at a Premium

 The account Premium on Bonds Payable is an addition

to the Bonds Payable account If Premium Firm

presented a balance sheet immediately after the bond issuance, the Long-Term Liabilities category of the

balance sheet would appear as follows:

Bond Amortization

 Process of transferring an amount from the

discount or premium account to interest

expense each time period

 Effective interest rate: produces a constant

effective interest rate from period to period

 Carrying value:

• Carrying Value = Face Value − Unamortized Discount OR

• Carrying Value =Face Value + Unamortized Premium

LO 5

Effective Rate = Annual Interest Expense/Carrying Value

Exhibit 10.4—Discount Amortization:

Effective Interest Method of

Amortization

Example 10.3—Recording Amortization

of Discount

 Exhibit 10-4 is the basis for determining the effect of amortization on the

firm’s financial statements

Amortization of Discount

 On the balance sheet presented as of December 31,

2014, the unamortized portion of the discount appears

as the balance of the Discount on Bonds Payable

account as follows:

Exhibit 10.5—Premium Amortization:

Effective Interest Method of

Amortization

Example 10.4—Recording Amortization

of a Premium

 Exhibit 10-5 is the basis for determining the effect of

amortization of a premium on the firm’s financial statements Premium Firm could identify and analyze the effect of the

payment of interest and amortization of premium as follows:

Amortization of a Premium

 In Example 10-4, the December 31, 2014, balance represents the amount unamortized, or the amount that will be amortized in future time periods On

December 31, 2014, the unamortized portion of the premium appears as the balance of the Premium on Bonds Payable account as follows:

Redemption of Bonds

 Retirement of bonds by repayment of the

principal

 If redeemed at maturity, no gain or loss occurs

 If retired before maturity, a gain or loss occurs

 The gain or loss on bond redemption is shown

on the income statement

LO 6

Gain = Carrying Value − Redemption Price Loss = Redemption Price − Carrying Value

Liability for Leases

 Contractual arrangement between two parties

 Allows the lessee the right to use an asset in

exchange for making payments to its owner, the

Liability for Leases

 Operating lease: off-balance-sheet financing

 The lessee acquires the right to use an asset for a limited period of time

 The lessee is not required to record the right to use the property as an asset or record the obligation for payments as a liability

 Capital lease:

 Recorded as an asset by the lessee

 The lessee has the right of ownership and control

Criteria for Lease Capitalization

 One or more of the following criteria must be met:

 Transfer of ownership of property to the lessee at the end of the lease term

 Contains a bargain-purchase option to purchase the asset for lower than its fair market value

 The lease term is 75% or more of property’s economic life

 The present value of payments is 90% or more of

property’s fair market value at the inception of the

lease

Exhibit 10.6—Gap, Inc.’s 2011 Note

Disclosure of Leases

 Although operating leases are not recorded on the balance sheet, FASB requires note disclosure

Example 10.8—Calculating the Amount

to Capitalize for a Lease

 Suppose a lease agreement is signed with Lessor Dealer on January 1,

2014, to lease a car for the year for $4,000, payable on December 31,

2014 The terms of the agreement specify that Lessee will make

annual lease payments of $4,000 per year for five years, payable each December 31 Also, assume that the lease specifies that at the end of the lease agreement, the title to the car is transferred to Lessee Firm

 The lease should be treated as a capital lease by Lessee because it meets at least one of the four criteria(It meets the first criteria concerning transfer of title)

 A capital lease must be recorded at its present value by Lessee as an asset and as

Capital Lease

 For Example 10-8, the first entry is made on the basis

of the present value

Capital Lease (continued)

 Because the leased asset represents depreciable property, depreciation (or

amortization) must be reported for each of the five years of asset use as follows On December 31, 2014, Lessee records depreciation of $3,194 ($15,972/5 years),

assuming that the straight-line method is adopted.

Exhibit 10.7—Lease Amortization: Effective

Interest Method of Amortization

Lease Amortization: Effective Interest

Method of Amortization

 On December 31, 2014, Lessee Firm records the

following entry for the annual payment

IFRS and Leasing

 U.S accounting standards: rule based

 If lease meets any of the criteria—capital lease

 Does not meet any criteria—operating lease

 IFRS: criteria are used as ‘‘guidelines’’ rather than rigid rules

 More flexibility in applying the lease standards

Analyzing Debt to Assess a Firm’s

Ability to Pay Its Liabilities

 Long-term liabilities are a component of the

‘‘capital structure’’ of the company and are

included in the calculation of the debt-to-equity ratio

 Another ratio used to measure the degree of

debt obligation is the times interest earned

ratio

LO 8

Debt-to-Equity ratio

 Measures the proportion of a company’s debt

to its equity

Times Interest Earned Ratio

 Measures a company’s ability to meet interest obligations as they come due

The Ratio Analysis Model

1 What is the amount of debt in relation to the total

equity of a company? Will the company be able to meet its obligations?

2 Gather the information about total debt and total

equity, income before interest and tax, and interest

The Business Decision Model

1. If you were a lender, would you be willing to

lend money to a company?

2. Gather information from the financial

statements and other sources

3. Compare the company's ratios with industry

averages and look at trends

4. Lend money or find an alternative use for the

money

5. Monitor your investment periodically

Exhibit 10.8—Long-Term Liabilities on

the Statement of Cash Flows

LO 9

Exhibit 10.9—The Coca-Cola Company and Subsidiaries’

2011 Consolidated Statements of Cash Flows (Partial)

Other Liabilities—Deferred Tax

 Reconciles the differences between the

accounting done for financial reporting

purposes and tax purposes

 Reconcile the difference between the income tax

expense and income tax payable

 Permanent difference: affects the tax records

and not the accounting records, or vice versa

 Temporary difference: affects both book and

tax records but not in the same time period

LO 10

Example 10.9—Calculation and

Reporting Deferred Tax

 Assume that Startup Firm begins business on January 1, 2014 During 2014, the firm has sales of $6,000 and has no expenses other than depreciation and income tax at the rate of 40% Startup has depreciation on only one asset That asset was purchased on January 1, 2014, for $10,000 and has a four-

year life Startup has decided to use the straight-line depreciation method for financial reporting purposes Startup’s accountants have chosen to use

MACRS for tax purposes, however, resulting in $4,000 depreciation in 2014 and a decline of $1,000 per year thereafter

Example 10.9—Calculation and Reporting Deferred Tax (continued)

 Startup’s tax calculation for 2014 is based on the accelerated depreciation of $4,000

 Startup’s income statement for 2014

Deferred Tax

 In Example 10-9, Startup must make an accounting entry to record the amount of tax expense and tax payable for 2014

End of Chapter 10