Principles of financial accounting 12e by needles crosson chapter 14

– A bond entails a promise to repay the amount borrowed, called the principal, on a specified date and to pay interest at a specified rate at specified times, usually semiannually.– Whe

Concepts Underlying Long-Term Liabilities

 Lo ng-te rm liabilitie s are debts and obligations that a company expects to satisfy in more than one year or beyond its normal operating cycle, whichever is longer

– Generally accepted accounting principles require that

long-term liabilities be recognized and recorded when an

obligation occurs even though the obligation may not be due for many years

– Long-term liabilities are generally valued at the amount of

money needed to pay the debt or at the fair market value of the goods or services to be delivered

– A liability is classified as long-term when it is due beyond

one year or beyond the normal operating cycle

– Because of the complex nature of many long-term liabilities,

extensive disclosure in the notes to the financial statements

are often required

Types of Long-Term Debt

 Bo nd payable —the most common type of long-term debt; a more complex financial instrument than a

note; usually involves debt to many creditors

 No te payable —a promissory note that represents a loan from a bank or other creditor

 Mo rtgag e —a long-term debt secured by real

property; usually paid in equal monthly installments; each payment includes interest on the debt and a

reduction in the debt

Other Long-Term Obligations

 Long-term leases—When a lease has a term that corresponds closely to the life of the asset and, thus, is more like a purchase

of an asset than a shorter-term lease, it is called a c apital

le as e

 Pension liabilities—arise from contracts that require a company

to make payments to its employees have they retire

 Other post-retirement benefits—arise from contracts that

require a company to provide medical and other benefits to its employees after they retire

 Deferred income taxes—result from using different accounting methods to calculate income taxes on the income statement

and income tax liability on the income tax return; this is

considered a liability because these taxes will eventually have

to be paid

The Nature of Bonds

 A bo nd is a security, usually long-term, representing money that a corporation borrows from the investing public

– A bond entails a promise to repay the amount borrowed,

called the principal, on a specified date and to pay interest

at a specified rate at specified times, usually semiannually.– When a public corporation decides to issue bonds, it must receive approval from the SEC to borrow the funds The SEC reviews the corporation’s financial health and the specific terms of the bo nd inde nture, which is a contract that defines the rights, privileges, and limitations of the bondholders, including such things as the maturity date, interest payment dates, and the interest rate

– As evidence of debt to the bondholders, the corporation

provides each of them with a bo nd c e rtific ate

Bond Issue: Prices and Interest Rates

 A bond is s ue is the total value of bonds

issued at one time

– Prices of bonds are stated in terms of a

percentage of the face value, or principal, of the bonds.

 A bond issue quoted at 103 ½ means that a $1,000 bond costs $1,035 ($1,000 X 1.035)

 When a bond sells at exactly 100, it is said to sell at

fac e value (or par value ).

 A $1,000 bond quoted at 87.62 would be selling at a discount and would cost the buyer $876.20

Bond Issue: Prices and Interest Rates

 The face inte re s t rate is the fixed rate of interest

paid to bondholders based on the face value of the bonds.

 The marke t inte re s t rate (or effective interest rate )

is the rate of interest paid in the market on bonds of similar risk.

– The market interest rate fluctuates daily This fluctuation may cause bonds to sell at either a discount or a premium

 A dis c o unt equals the excess of the face value over the issue price The issue price will be less than the face value when the market interest rate is higher than the face interest rate.

 A pre mium equals the excess of the issue price over the face value The issue price will be more than the face value when the market interest rate is lower than the face interest rate.

Characteristics of Bonds

(slide 1 of 2)

 Uns e cure d bo nds (or debenture bonds ) are issued

on the basis of a corporation’s general credit.

 Se c ure d bo nds carry a pledge of certain corporate assets as a guarantee of repayment.

 When all bonds of an issue mature at the same time, they are called te rm bo nds

 When the bonds of an issue mature on different

dates, they are called s e rial bo nds

 Callable bo nds give the issuer the right to buy back and retire the bonds before maturity at a specified

c all price , which is usually above face value

Characteristics of Bonds

(slide 2 of 2)

– When a company retires a bond issue before its maturity date, it is called e arly e xting uis hme nt o f de bt

 Co nve rtible bo nds allow the bondholder to

exchange a bond for a specified number of shares of common stock.

 Re gis te re d bo nds are issued in the names of the bondholders The issuing organization keeps a

record of the bondholders’ names and addresses

and pays them interest by check.

 Co upo n bo nds are not registered with the

organization Instead, they bear coupons that the

bondholder removes on the interest payment dates and presents at a bank for collection.

Using Present Value to Value a Bond

 A bond’s value is determined by summing the

following two present value amounts:

– a series of fixed interest payments

– a single payment at maturity

 The amount of interest a bond pays is fixed over its life.

 The market interest rate varies from day to day and

is the rate used to determine the bond’s present

Using Present Value to Value a $20,000,

9 Percent, Five-Year Bond

Amortizing a Bond Discount

(slide 1 of 2)

 The bond discount affects interest expense each

year and should be amortized over the life of the

bond issue

– To have each year’s interest expense reflect the market

interest rate, the discount must be allocated over the remaining life of the bonds as an increase in the interest expense each period Thus, interest expense for each period will exceed the actual payment of interest by the amount of the bond discount amortized over the period

This process is called amortization of the bond discount.

– In this way, the unamortized bond discount will decrease gradually over time, and the carrying value of the bond issue (face value less unamortized discount) will increase gradually By the maturity date, the carrying value of the bond issue will equal its face value, and the unamortized

Amortizing a Bond Discount

– Ze ro c o upo n bo nds do not require periodic interest

payments They are issued at a large discount because the only interest the buyer earns or the issuer pays is the

discount

Amortizing a Bond Premium

 Like a discount, a bond premium must be amortized over the life of the bonds so that it can be matched to its effects on interest expense during that period.

– The premium is in effect a reduction, in advance, of the total interest paid on the bonds over the life of the bond issue – Under the straight-line method, the bond premium is spread evenly over the life of the bond issue

– With the effective interest method, the interest expense

decreases slightly each period because the amount of the bond premium amortized increases slightly This occurs because a fixed rate is applied each period to the gradually decreasing carrying value This rate is based on the actual market rate at the time of the bond issue

Retirement and Conversion of Bonds

 Two ways a company can reduce its bond debt are by:

– Retiring the bonds

company’s advantage For example, when interest rates drop, many companies refinance their bonds at the lower rate

them back from bondholders on the open market.

– Converting the bonds into common stock

company records the common stock at the carrying value of the bonds

are written off the books For this reason, no gain or loss on the transaction is recorded.

Sale of Bonds Between Interest Dates

 When corporations issue bonds between interest

payment dates, they generally collect from the

investors the interest that would have accrued for the partial period preceding the issue date.

– At the end of the first interest period, they pay the interest for the entire period In other words, the interest collected when bonds are sold is returned to investors on the next interest payment date

– There are two reasons for this procedure:

 It saves on the bookkeeping costs that would be required if the interest due each bondholder had to be computed for a different time period.

 When accrued interest is collected in advance, the amount is subtracted from the full interest paid on the interest payment date, and the resulting interest expense represents the amount for the time the money was borrowed.

Year-End Accrual of Bond Interest Expense

 Bond interest payment dates rarely

correspond with a company’s fiscal year.

– Therefore, an adjustment must be made to accrue the interest expense on the bonds from the last interest payment date to the end of the fiscal year – In addition, any discount or premium on the bonds must be amortized for the partial period.

Long-Term Leases

 A company can obtain an operating asset by:

– Borrowing money and buying the asset

 The risks of ownership of the asset remain with the lessor (the owner), and lease is shorter than the asset’s useful life.

– Obtaining the asset on a long-term lease

 Accounting standards require that a long-term lease be treated as a capital lease when it meets all of the following conditions:

– It cannot be canceled.

– Its duration is about the same as the useful life of the asset.

– It stipulates that the lessee has the option to buy the asset at a nominal price at the end of the lease.

 Structuring long-term leases in such a way that they do not appear as liabilities on the balance sheet is called off-balanc e -s hee t financ ing.

– There are two kinds of pension plans:

annual contribution, usually a percentage of the employee’s gross pay Retirement payments vary depending on how much the employee’s retirement account earns.

annually to fund estimated future pension liability.

– Employers whose pension plans do not have sufficient assets to cover the present value of their pension obligations must record the amount of the shortfall as a liability.

Evaluating the Decision to Issue

Long-Term Debt

debt:

– Permanent financing—Common stock does not have to be paid back.

– Dividend payment is optional.

– Common stockholders do not relinquish any of their control over the

company because bondholders and creditors do not have voting rights.

– The interest on debt is tax-deductible, whereas dividends are not.

– If a corporation earns more from the funds it raises by incurring long-term debt than it pays in interest on the debt, the excess will increase its

earnings for the stockholders This concept is called financ ial le ve rage.

 Financial leverage is advantageous as long as a company is able to make timely interest payments and repay the debt at maturity

 Because failure to do so can force a company into bankruptcy, a company must assess the financial risk involved.

Debt to Equity Ratio

 To assess how much debt to carry, managers

compute the de bt to e quity ratio , which shows

the amount of debt a company carries in relation

to its stockholders’ equity The higher this ratio,

the greater the financial risk.

Interest Coverage Ratio

 The inte re s t co ve rag e ratio measures the degree

of protection a company has from default on interest payments The lower the ratio, the greater the

financial risk.