1 chapter 22 long-term debt and other financing issues

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CHAPTER 22

LONG-TERM DEBT AND OTHER

FINANCING ISSUES

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Chapter Overview

How does a corporation compute the periodic payment, the interest expense, and the repayment of a principal on a loan?

What is a bond, what are its characteristics, and why does a corporation issue bonds?

What are the factors that affect long-term interest rates?

Why does a corporation issue bonds at less or more than their face value?

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Chapter Overview

How does the interest expense each period compare with the interest paid in that period when a corporation issues bonds at a discount or premium?

What are zero-coupon bonds, and how does a corporation account for the interest on them?

How do long-term debt and interest expense disclosures help external users evaluate a corporation?

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Chapter Overview

What is a lease? What is a capital lease, and what impact does it have on a lessee’s financial statements?

Why do deferred income taxes arise, and how does a corporation report them in its financial statements?

What is a defined-benefit pension plan, and how does a corporation account for it?

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A company using GAAP is required to base its accounting for long-term debt on three accounting concepts discussed in earlier chapters: historical cost, the concept of a transaction, and matching.

Historical cost states that a company records its transactions on the basis of the dollars exchanged. For long-term debt, this usually means the amount recorded is the debt originally acquired.

Historical cost provides the most reliable and objective value for measuring a company’s liquidity even though some experts believe fair market value should be used.

Reporting Long-Term Debt

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The concept of a transaction means that a company must have engaged in a transaction in order to record a liability (or an asset).

Thus, budgeted cash flows for an amount that a company will borrow in the future do not create a liability until the amount is borrowed.

The matching principle states that the cost of producing revenues for an accounting period must be deducted from the revenue earned.

Therefore, the amount of interest that accrues on debt must be recognized in the current period even if payment occurs at another time.

Reporting Long-Term Debt

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Individuals and businesses have many type of loans, but all loans have similar characteristics.

The typical loan requires equal monthly payments of principal and interest and there is a stated interest rate on the loan. From an accounting perspective, the equal monthly payments are annuity payments because they are all the same amount and occur at equal intervals over time.

Car dealers and banks determine the amount of these payments using present value principles we discussed in Chapter 20.

Loan Payments and Interest

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Recall that the present value of an annuity is computed as follows:


Periodic PaymentPeriodic

Payment X Present Value of Annuity Factor

Present Value of Annuity Factor

Since the amount borrowed is the present value amount, the periodic payment is computed as:

Periodic PaymentPeriodic Payment =

Amount Borrowed


Amount Borrowed


Based on the interest rate and life of the loan

=Present Value of Annuity

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So if you are borrowing $20,000 today for 4 years, with one payment per year,at a 10% rate of interest, the $20,000 is the present value amount borrowed:


Periodic PaymentPeriodic Payment =

$6,309.35$6,309.35=$20,000

3.1699

$20,000

3.1699

Amount Borrowed


Amount Borrowed


Using Table 20-2, 10%, for 4 periods

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Each periodic payment of $6,309.15 on the loan consists of two components: (1) interest expense, and (2) a portion of the principal balance borrowed.

The interest expense is based on the interest rate and the balance (called the book value) in the liability account at the beginning of the period:


Periodic Interest

Rate

Periodic Interest

RateX

Book Value of Loan at Beg. of

Period


Period=

Interest Expense

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The interest expense for the first year is then

computed as follows:


XBook Value of

Loan at Beg. of Period


Period=

Interest Expense

X $20,000$20,000 = $2,00010%10%

Periodic Interest

Rate

Periodic Interest

Rate

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By reviewing a loan amortization schedule (a schedule of how a loan is repaid and the allocation of principal and interest), it is easier to see how the pieces fit together:


LoanPeriodic Interest book

Date payment expense Principal value1-Jan-04 Borrowed $ 20,000 20,000$ 1-Jan-05 6,309$ 2,000$ 4,309$ 15,691$ 1-Jan-06 6,309$ 1,569$ 4,740$ 10,950$ 1-Jan-07 6,309$ 1,095$ 5,214$ 5,736$ 1-Jan-08 6,309$ 574$ 5,736$ 0$

Interest on each payment is

computed as 10% X the loan

book value immediately before the payment.

In four years, the loan is fully repaid with interest.

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Bond Characteristics Virtually every company borrows money. When a company borrows a large

amount of money from investors for a long time, it usually issues bonds.

A bond is a type of note in which a company agrees to pay the holders of the bond its face value at the maturity date and to pay interest on the face value periodically at a specified rate.

Thus, the company is the borrower, receives money when it sells the bonds to the holder (purchaser) of the bond, the lender.

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Bond Characteristics The face value (also called the par value) is the amount that the issuer promises to pay on the

maturity date.

The maturity date is the date on which the issuer of the bond agrees to pay the face value to the holder.

The contract rate (also called the stated or nominal rate) is the rate at which the issuer of the bond pays interest on the face value each period until the maturity date.

A bond certificate is a serially numbered legal document that specifies the face value, the annual interest rate, and the maturity value.

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Bond Characteristics A company usually sells bonds with a face value of $1,000 each. It sells the

entire issue of bonds to one purchaser or numerous individual purchasers.

In addition, the bond issue usually specifies that interest be paid twice a year (semiannually), although it may state the contract rate in annual terms on the bond certificate.

If you purchased a $1,000 bond which pays 10% interest semiannually, how much would you receive on each payment date?

$1,000 X 10% = $100 / 2 payments = $50

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Financial Leverage The main reason why the managers of a corporation may decide to issue bonds instead of

raising cash through the sale of common stock is that the earnings available to the common stockholders can be increased through leverage.

Leverage is the use of borrowing by a corporation to increase the return to common stockholders – it is also called trading on equity.

If a corporation can borrow money by issuing bonds and can use the money to invest in the business at a rate of return greater than the cost of the borrowing, the stockholders benefit because earnings grow.

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Use of Leverage Through Bond Financing

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If, on January 1, 2004, Unlimited

Decadence issues 10%, 10-year bonds with

a face value of $200,000, how is this

recorded?

Recording Bonds Issued at Face Value

+$200,000 (Cash)

Assets = Liabilities + Stockholders’ Equity+$200,000

(Bonds Payable)

This is a long-term liability of the company which must be

repaid to bondholders on January 1, 2014.

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When Unlimited Decadence has to make

the first semiannual interest payment due to

bondholders on June 30, what is the

amount and how is it recorded?

Recording Interest Paid on Bonds Issued at Face Value

-$10,000 (Cash)

Assets = Liabilities + Stockholders’ Equity

-$10,000 (+Interest Expense)

Interest expense = $200,000 X (10%/2), or $10,000 semiannually

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Assume Layth Company issued 12%, 10-year bonds with a face value of $300,000 on September 1, 2004. Interest is paid semiannually on February 28 and August 31.

At the end of 2004, the company has not paid any interest but 4 months has accrued (September 1 – December 31). How is this recorded?

Accrual of Interest

+$12,000 (Interest Payable)

Assets = Liabilities + Stockholders’ Equity-$12,000

(+Interest Expense)

Interest expense accrued = $300,000 X (12%/2) X 4/6, or $12,000

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When the first semiannual interest payment is

due to Layth’s bondholders on February 28,

the interest payable liability is eliminating and

the remaining interest expense is recorded.

Accrual and Payment of Interest

-$18,000 (Cash)

Assets = Liabilities + Stockholders’ Equity-$6,000

(+Interest Expense)

Interest expense = $300,000 X (12%/2) X 2/6, or $6,000

-$12,000 (Interest Payable)

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Factors Affecting Interest Rates

Several factors affect interest rates, including the policies of the Federal Reserve Board, federal regulations, and the budget surplus or deficit in the federal government.

Long-term interest rates for corporations include three primary factors:

The risk-free rate The expected inflation rate The risk premium

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Factors Affecting Bond Interest Rates

The risk-free rate is the rate when there is no risk of default by the borrower and when no inflation is expected.

While the U. S. government is considered a risk-free borrower, the United States is not inflation free. The interest rate includes the expected inflation rate so that the borrower pays additional interest to compensate for the expected inflation over the life of the borrowing.

The risk premium is the additional interest a borrower pays when there is a possibility of default. The higher the risk of default, the higher the premium.

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To illustrate these three components, at the time of writing this book, the following rates (called yields) existed on the following borrowings:

Borrower Maturity YieldU.S. Government (inflation-indexed) 2028 3.2%U.S. Government 2028 5.7%Bell South 2005 6.2%Bell South 2028 6.8%Lucent 2028 13.5%

Risk free rate 3.2%; expected inflation 2.5%

= 5.7% rate

Lucent risk premium is higher that the Bell South’s risk premium for the same date maturities, meaning Lucent’s

risk of default is significantly higher than Bell South’s.

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Continuing our analysis, lets look at the Bell South rate now.

Borrower Maturity YieldU.S. Government (inflation-indexed) 2028 3.2%U.S. Government 2028 5.7%Bell South 2005 6.2%Bell South 2028 6.8%Lucent 2028 13.5%

Bell South has some risk of default because of higher rates (6.8%) that the U.S. Government inflation adjusted rate (5.7%), but much less that Lucent (13.5%) for the same date maturities.

Also, on its 2005 maturity date debt, Bell South is perceived as “at risk” for financial trouble for a shorter period of time, so the

rate is slightly lower that its 2028 maturity.

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Bonds Issued at Less Than or More Than Face Value

A company must follow certain steps when it issued bonds, such as receiving approval from the regulatory authorities (for example, the Securities and Exchange Commission).

It must also publish the terms of the bond issue, such as the contract rate, maturity date, and interest payment dates, and print the bond certificates.

When a company decides to issue the bonds, it usually deals with a securities broker(s) or investment banker(s), who sell the bonds to customers.

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Bonds Issued at Less Than or More Than Face Value

The broker and the company base the selling price on the terms of the bond issue, the components of long-term interest rates, and market conditions.

A rate is determined (called a yield) that they believe best reflects current market conditions. This is the market rate at which the bonds will be issued.

The yield is oftentimes more or less than the contract rate set by the company on the bond certificate.

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Bond Selling Prices - Discounts If the yield is greater than the contract price, the company will receive (and the purchasers

of the bonds will pay) a selling price that is less than the face value of the bonds. In this case, a discount on the bonds results.

Bond selling prices are quoted as a percentage of face value. A bond selling at face value would be quoted at 100. When a bond discount arises, the bond sells at less than 100.

For example, a bond issue with a face value of $200,000 that sells at 97 (97% of face value), sells for $194,000 with a discount of $6,000.

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When a company sells a $200,000 bond

issue at 97, how is this recorded?

$200,000 X .97 = $194,000

Recording Bonds Issued at a Discount

+$194,000 (Cash)


(Bonds Payable)

The face value of the bonds $200,000 less the $6,000 discount.

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Bond Selling Price - Premiums

If the yield is less than the contract price, the company will receive (and the purchasers of the bonds will pay) a selling price that is more than the face value of the bonds. In this case, a premium on the bonds results.

Bond selling prices are quoted as a percentage of face value. A bond selling at face value would be quoted at 100. When a bond premium arises, the bond sells at more than 100.

For example, a bond issue with a face value of $200,000 that sells at 102 (102% of face value), sells for $204,000 with a premium of $4,000.

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When a company sells a $200,000 bond

issue at 102, how is this recorded?

$200,000 X 1.02 = $204,000

Recording Bonds Issued at a Premium

+$204,000 (Cash)


(Bonds Payable)

The face value of the bonds $200,000 plus the $4,000 premium.

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A bond is a fixed rate instrument. This means that the interest paid on the bond is always the same.

Since the rate is fixed, the marketplace adjusts the value of the bond so that the fixed rate of interest paid is equal to the market rate, or yield. This is what creates premiums and discounts.

To illustrate, consider the issuance of a $10,000 bond with a 10% stated rate of interest when market interest rates are 10%, 8% and 12%. The bond pays $10,000 X 10%, or $1,000 of interest per year. What happens to the issue price at different yields?

Relationship Between Rates and Yields on Bonds

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10%

MarketInterestrates at

12%

MarketInterestRates at

8%

Bond issued at $10,000. Face rate

= market rate

Relationship Between Rates and Yields on Bonds

The bond is issued at a premium, for $12,500 because the $1,000 of

stated interest now equals a market yield of 8% ($12,500 X 8%)

The bond is issued at a discount for $8,333 because the $1,000 of stated interest now

equals a market yield of 12% ($8,333 X 12%)

The bond is issued at face value for $10,000 because the $1,000 of stated interest equals the market yield of

10% ($10,000 X 10%)

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Bond Interest Expense

When a company sells bonds at a premium or discount, the amount of money it receives (borrows) is more (premium) or less (discount) than the face amount of the bonds.

However, the total amount of cash the company pays (the interest and principal) is fixed by the bond certificate, and is the same amount as if the bonds had been sold at face value.

The excess of the total amount paid over the amount borrowed is the total (lifetime) interest paid by a company that issues the bonds.

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Bond Interest Expense Interest expense on bonds payable each period is


Yield (the market rate) Yield (the

market rate) XBook Value of

Bonds Payable at Beg. of Period

Book Value of Bonds Payable at

Beg. of Period=

Interest Expense for the Period

When a company sells bonds at a discount, its interest expense each period is higher than the cash interest paid to bondholders.

When a company sells bonds at a premium, its interest expense each period is lower than the cash interest paid to bondholders.

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Relationships Between Bond Selling Prices and Interest Expense

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Zero-Coupon Bonds The bonds we have discussed so far pay a fixed rate of interest each period.

Zero-coupon bonds are bonds that are issued at a discount and pay no interest each period. The face value of the bonds includes both the principal and the interest on the bonds and is only payable on maturity.

A company still reports interest expense each period because it has incurred interest on the amount borrowed. Because the selling price of zero-coupon bonds is usually much less than the face value, they are often referred to as “deep discount” bonds.

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If Unlimited Decadence issues 10-year zero-coupon bonds on January 1, 2004 with a face value of $1 million when the market yield is 10%, how is this recorded?

Selling price = $1,000,000 X 0.3855 (Table 20-1 – present value of a single sum for 10 periods at 10%) = $385,500

Recording the Issuance of Zero-Coupon Bonds

+$385,500 (Cash)


+$385,500(Bonds

Payable)

The face value of the bonds $1 million less the

$614,500 “deep” discount.

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Even though Unlimited Decadence does not pay any cash interest on the zero-coupon bonds until maturity, interest still accrues on the amount borrowed and must be recognized by the company each period.

This is done with the effective interest method, in which the company computes the interest expense as follows:

Recording the Interest Expense on Zero-Coupon Bonds

Yield (the market rate) Yield (the

market rate) XBook Value of



Beg. of Period=

Interest Expense for the Period

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The interest expense for the first year is then


XBook Value of



Beg. of Period=

Interest Expense

X $385,500$385,500 = $38,55010%10%

Yield (the market rate)

Yield (the market rate)


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By looking at a bond amortization schedule, it is easier to see how the pieces fit together:


Periodic Interest Discount BondDate payment expense amortized Book Value

1-Jan-04 Borrowed $ 385,500 385,500$ 1-Jan-05 -$ 38,550$ 38,550$ 424,050$ 1-Jan-06 -$ 42,405$ 42,405$ 466,455$ 1-Jan-07 -$ 46,646$ 46,646$ 513,101$ 1-Jan-08 -$ 51,310$ 51,310$ 564,411$ 1-Jan-09 -$ 56,441$ 56,441$ 620,852$ 1-Jan-10 -$ 62,085$ 62,085$ 682,937$ 1-Jan-11 -$ 68,294$ 68,294$ 751,230$ 1-Jan-12 -$ 75,123$ 75,123$ 826,353$ 1-Jan-13 -$ 82,635$ 82,635$ 908,989$ 1-Jan-14 -$ 91,011$ 91,011$ 1,000,000$ 1-Jan-14 1,000,000$ 0

Interest on each payment is

computed as 10% X the bond book value immediately

before the payment. This

represents discount which is then added to the

carrying value of the bond each

period. The total interest and

discount on the bond = $614,500.

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Retirement of Bonds When the bond is due at maturity, the company pays the face value of the bond to the

bondholders and eliminates the bond liability.

Sometimes a company may have the option to retire bonds prior to their maturity date. These bonds are called callable bonds.

A callable bond means that the company that issues the bonds has the right to recall (retire) the bonds before their maturity date at a call price specified when the bonds were issued. The call price is always higher than the original selling price. A loss on the bonds may result.

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Suppose a company pays $205,000 to retire bonds with a current book value of $198,000. In this situation, the company records a loss on the retirement of the bonds.

A $7,000 loss is recognized, the different between what the company pays and the current book value of the bonds.

Recording Retirement of Bonds

-$205,000 (Cash)


-$198,000(Bonds

Payable)

-$7,000 (+Loss on Retirement

of Debt)

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Using LT Debt and Interest Disclosures

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Leases A lease is an agreement giving the right to use property, plant, or equipment without transferring legal

ownership of the item.

The lessee is the company that acquires the right to use the item. The lessor is the company that gives up the use of the item.

For example, if Unlimited Decadence leases a computer from IBM, Unlimited Decadence is the lessee and IBM is the lessor.

In a lease, the lessee agrees to make periodic payments to the lessor for the right to use the leased item.

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Leases There are several reasons why a company might lease instead of buy.

First, a lease may not require a down payment to acquire the use of the asset, so a lessee with a cash shortage may be able to save cash.

Second, a lease may allow a lessee to avoid the risk of obsolescence, since the leased item may be returned to the lessor at the end of the lease.

Third, if the lessee is a corporation, it may obtain tax benefits (which saves cash) because it can take a tax deduction on its income tax return for the total lease payment.

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Leases There are similarities between leasing an asset and purchasing an asset on credit. Sometimes, a

lease is nothing more than a financing arrangement.

In these situations, the accounting rules treat leases as if they were purchases/sales. These leases are called capital leases and are a good example of where GAAP applies economic substance over legal form in determining the proper accounting treatment.

A capital lease transfers the risks and benefits of ownership from the lessor to the lessee.

An operating lease is a simple rental arrangement and does not transfer the risks and benefits of ownership from the lessor to the lessee.

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Capital Leases If a lease qualifies as a capital lease, the lessee records an operating

asset and a noncurrent liability as if the asset was being purchased over time.

The asset and related liability is recorded at the present value of the future lease payments. If the present value of the future lease payments ($4,000 per year for 5 years) equal $15,163, then the company records the following:

+$15,163 (Lease

Property)


+$15,163 (Capital Lease

Obligation)

The leased property is subject to depreciation since the economic substance of the transaction is a

purchase/sale.

The related liability is

amortized like a loan, with

amounts charged to

principal and interest each

period.

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Capital Leases Recording a lease as a capital lease has far greater implications than the accounting for

the transaction.

Managers have to be very careful to understand how particular lease arrangements will be treated under GAAP so that unexpected financial results don’t occur.

If a lease is a capital lease, the company must record an asset and a related liability on its books that would not have been there if the lease was an operating lease.

This has an impact on key ratios used to assess profitability, risk, and financial flexibility.

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Capital Leases Return on stockholder’s equity (Net income/average stockholders’ equity) is negatively

impacted in earlier years because the interest expense and depreciation on a capital lease is usually higher that the lease payments.

Recording the asset and liability also negatively affects a company’s debt ratio (Total liabilities/total assets) because the increase in liabilities is greater proportionately than the increase in assets.

Recording an asset and related liability provides more information about the company’s ability to use its assets to generate revenue, but it will negatively impact the ratio of net revenues to net property, plant,and equipment.

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Mortgages Payable

A mortgage payable is a noncurrent liability for which the lender has a specific claim against an asset of the borrower.

For example, most homeowners purchase their homes by issuing a mortgage – the lender has a specific claim on the house in the event of default.

A company can also issue a mortgage when purchasing property. In this instance, an asset and related liability is recorded.

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Deferred Income Taxes Deferred income taxes are future additional income tax liabilities not yet payable to

the government because of difference in financial/tax accounting rules.

Recall how depreciation, which we discussed in Chapter 21, is different for financial accounting and tax reporting purposes.

The total depreciation claims for financial accounting and tax reporting are the same, but the timing of the deductions differ significantly. These differences are called temporary differences and give rise to deferred income taxes.

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Accounting for Deferred Income Taxes

The concept of deferred income taxes can be simply illustrated. Assume Unlimited Decadence has $100,000 of net income but only $80,000 in taxable income for the same period.

The difference is the result of an additional $20,000 in MACRS depreciation (a timing difference) that can be claimed for taxes. The company’s tax rate is 40%.

+$32,000 (Income Tax

Liability)

+$8,000 (Deferred Tax

Liability)


+$40,000 (Income tax

Expense)

This is the amount of tax expense on the income statement

($100,000 X 40%)

This is the amount due currently to the Government ($80,000 X 40%)

This is the amount deferred until future years ($20,000 X 40%)

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Retirement Benefits Many companies have pension plans for their employees. The liabilities related to these

pension plans are recorded as long-term liabilities.

A pension plan is an agreement by a company to provide income to its employees after they retire.

A defined-contribution plan specifies the amount that a company must contribute to the plan each year while its employees work.

A defined-benefit plan specifies the amount that a company must pay to its employees each year during their retirement.

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Retirement Benefits

For example, a retired employee might receive an annual pension income under a defined-benefit plan based on the following formula:

XNumber of Years of Service

Number of Years of Service

=Annual Pension Income

Average of Last 5

Years’ Pay

Average of Last 5

Years’ PayX 0.020.02

An employee who worked for 40 years for this company with an average salary of $100,000 for the last 5 years of service receives $80,000 per year ($100,000 x 40 X 0.02) during retirement until death.

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Retirement Benefits

The agreement to pay future retirement benefits causes a company to incur a pension expense each year a covered employee works.

However, in some cases, a company pays less to the funding agency in a given year than it records as pension expense.

This is because GAAP defines the amount of the expense whereas federal law specifies the amount the company must pay.

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Retirement Benefits

For example, Crabtree Company has yearly

pension expense of $8,900 but pays only

$8,000 to its funding agency. A $900 pension

obligation (liability) must be recorded.

-$8,000 (Cash)

+$900 (Pension Obligation)


-$8,900 (+Pension Expense)

The difference between GAAP pension expense ($8,900) and what is paid ($8,000), or $900 must be recorded as a liability for the year.

1 chapter 22 long-term debt and other financing issues

Documents

loan payments

corporation account

corporation issue bonds

annuity payments

corporation issues bonds

typical loan

objective value

present value principles