Financial accounting 9th jamie pratt chapter 11

 Long-term liabilities are recorded at the present value of the future cash flows. Two components determine the “time value” of money:  interest discount rate  number of periods of d

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Chapter 11 Long-Term Liabilities Notes, Bonds, and Leases

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Long-Term Liabilities

 Many companies finance their operations and growth opportunities through the use of long term debt

instruments:

dollar amounts and larger amount of notes

use of an asset

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The Relative Size of Long-Term Liabilities

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Figure 11-1 Long-term liabilities as a percentage of total assets, total liabilities, and shareholders’ equity

Economic Consequences of Reporting Long-Term Liabilities

Basic Definitions and Different Contractual Forms

• These contractual forms may contain additional terms that specify assets pledged as security or collateral in case the required cash payments are not met (default), as well as additional provisions (restrictive covenants).

Basic Definitions and Different Contractual Forms

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Figure 11-2 Six possible kinds of notes

 Long-term liabilities are recorded at the present value of the future cash flows.

 Two components determine the “time value” of money:

 interest (discount) rate

 number of periods of discounting

 Types of activities that require PV calculations:

Accounting for Long-Term Notes Payable

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Figure 11-3 Accounting for non-interest-bearing note in exchange for equipment

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 – near the back of your book

3 Financial Calculator (time value of money)

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Long-term Notes Payable

Example Problem 1: On January 2, 2014, 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?

Long-term Notes Payable – Ex Prob 1 cont’d

The Effective Interest Method:

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= 50,000 - 12,637 = 37,363 Interest expense = 37,363 x 6% per year x 1year

= $2,242

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Long-term Notes Payable – Ex Prob 1 cont’d

Long-term Notes Payable – Ex Prob 1 cont’d

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$50,000

Interest expense at Dec 31, 2015:

39,605 x 6% x 1 = $2,376 Journal entry, December 31, 2015:

Carrying value on B/S at 12/31/2015:

(Discount = 10,395 - 2,376) Carrying value on 12/31/2018 (before retirement)?

Discount on N/P (8,019) $41,981

Bonds Payable

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Figure 11-4 (partial) Bond Terminology

Bonds Payable Example

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Figure 11-5 Example of bond issuance: Northern States Power Company (dollars in thousands)

The Price of a Bond

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Figure 11-6 Bond prices and the relationship between the effective rate and the stated rate (bond terms: $1,000 face value, a 6 percent stated rate, and

a five-year life)

Case 1: Bonds at Par Case 2: Bonds at a Discount

Cash Flows for Bonds Payable

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Figure 11-7 Cash flows for bonds payable: Two cases compared

Case 1: Bonds Issued at Par

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Figure 11-8 Bonds issued

at face value: Case 1

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

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Case 2: Bonds Issued at a Discount

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Figure 11-9 Bonds issued

at a discount: Case 2

Issuing Bonds at Par and at a Discount: A ComparisonAmortization Tables

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Figure 11-10 Bonds amortization tables

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: near the back of you book

3 Financial Calculator (time value of money).

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Accounting for Bonds Payable

Example Problem 2: On July 1, 2014, 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, 2014 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 = 10Discount rate = 6% / 2 = 3% per period

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Accounting for Bonds Payable – Ex Prob 2 cont’d

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.

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Accounting for Bonds Payable – Ex Prob 2 cont’d

To recognize interest expense using the effective interest method, an amortization schedule must be constructed

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

Accounting for Bonds Payable – Ex Prob 2 cont’d Amortization Table

Cash Interest Premium Net Book Date Paid Expense Amortized Value 7/01/14 104,265

12/31/14 3,500 3,128 372 103,893 6/30/15 3,500 3,117 383 103,510 12/31/15 3,500 3,105 395 103,115 6/30/16 3,500 3,093 407 102,708 12/31/16 3,500 3,081 419 102,289 6/30/17 3,500 3,069 431 101,858 12/31/17 3,500 3,056 444 101,414 6/30/18 3,500 3,042 458 100,956 12/31/18 3,500 3,029 471 100,485 6/30/19 3,500 3,015 485 100,000

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Accounting for Bonds Payable – Ex Prob 2 cont’d Journal Entries

Interest Expense 3,128 Premium on B/P 372

Cash 3,500

• To illustrate the redemption of a bond issuance prior

to maturity at a loss, assume that bonds with a

$100,000 face value and a $5,000 unamortized discount are redeemed for $102,000 The $7,000 loss on redemption would decrease net income

specified period of time in exchange for rent payments

• Buildings

• Machinery

• Equipment

Operating Leases – pure rental agreement where the

lessor maintains all ownership responsibilities

Off-Balance-Sheet Financing

Capital Leases – Risks and benefits of ownership have

effectively transferred to the lessee

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Leases (cont’d)

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.

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.

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Capital Lease

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Figure 11-11 Accounting for a capital lease: Hitzelberger Supply

International Perspective

 The accounting disclosure requirements in non-U.S

countries and IFRS are not as comprehensive as those in the United States, partially because the information

needs of the major capital providers (i.e., banks) are satisfied in a relatively straightforward way—through personal contact and direct visits

 A second way in which the heavy reliance on debt affects non-U.S accounting systems is that the required

disclosures and regulations tend to be designed either to protect the creditor or to help in the assessment of

solvency

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Appendix 11A – The Determination of Bond Prices

 Determine the Effective (Actual) Rate of Return

 Determine the Required Rate of Return

 Determine the Risk-Free Return

 Determine the Risk Premium

 Compare the Effective Rate to the Required Rate

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Appendix 11B – Investing in Bonds

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Figure 11B-1 Accounting for held-to-maturity bond

investments

Appendix 11C – Interest Rate Swaps and Hedging

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such risks is called hedging, where a company

enters into a contract that creates risks that counteract or balance the risks attempted to be hedged (reduced) The most common method of hedging market interest rate risk is called an

interest rate swap.

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