long-term debt financing long-term debt financing c h a p t e r 10

Long-TermDebt FinancingLong-TermDebt Financing

C H A P T E R 10

Learning Objective 1

Use present value concepts to measure long-term liabilities.

Define Long-Term Liabilities

Notes payable Bonds payable Mortgages payable Lease payments Pension obligations

Debts and other obligations that will not be paid in cash or satisfied with other assets or services within one year.

Accounting forLong-Term Liabilities

Measurement and recording of long-term liabilities are based on the time value of money concept.

If money can earn 10% per year, $100 to be received 1 year from now is approximately equal to $90.91 received today.

Present value of $1 is the value today of $1 to be received or paid in

the future, given a specific interest rate.

Present and FutureValue Tables

Present Value Table Locate the number of

periods in the left column and the interest rate in the row at the top of the table.

This intersection is the factor representing the present value of $1.

Discounting—present value amount is the amount that could be paid today to satisfy the obligation.

Future Value Table Locate the number of

periods in the left column and the interest rate in the row at the top of the table.

This intersection is the factor representing the future value of $1.

Compounding—the frequency with which interest is added to the principal.

Present value of $100 paid in 5 years discounted at 10 percent.

PV = $62.09PV = $62.09

TodayToday 11 22 33 44 FutureFuture

$100$100

Discount at 10%Discount at 10%

Present Value

Future value of $100 today compounded for 5 years at 10 percent.

FV = $161.05FV = $161.05

TodayToday 11 22 33 44 FutureFuture

$100$100

Future Value

Compound at 10%Compound at 10%

Value Table — Future ValueJoan invested $2,000 for 3 years at 12 percent, compounded annually. Using the table below, what is the future value of the $2,000?

Periods 6% 8% 10% 12% 3 1.1910 1.2597 1.3310 1.4049 4 1.2625 1.3605 1.4641 1.5735 5 1.3382 1.4693 1.6105 1.7623 6 1.4185 1.5869 1.7716 1.9738

Future value = Amount x FV Factor

Future value = $2,000 x 1.4049

Future value = $2,809.80

Joan invested $2,000 for 3 years at 12 percent, compounded semiannually. Using the table below, what is the future value of the $2,000?

Periods 6% 8% 10% 12% 3 1.1910 1.2597 1.3310 1.4049 4 1.2625 1.3605 1.4641 1.5735 5 1.3382 1.4693 1.6105 1.7623 6 1.4185 1.5869 1.7716 1.9738

Value Table — Future Value

Future value = Amount x FV Factor

Future value = $2,000 x 1.4185

Future value = $2,837

Computing the Interest RateProvide the Appropriate Formula.

Yearly interest rate

Compounding periods per year

Interest rate per compounding period =

Number of interest periods =

Compoundingperiods per year

Number of

years

x

Define Annuities

Annuity

A series of equal amounts to be received or paid at the end of equal time intervals.

Present Value of an Annuity

The value today of a series of equally spaced, equal-amount payments to be made or received in the future given a specified interest rate.

Value Tables — Annuity

Joan is paid $8,000 a year for 8 years at 10 percent interest per year. Using the table below, what is the present value of the annuity?

Periods 6% 8% 10% 12% 7 5.5824 5.2064 4.8684 4.5683 8 6.2098 5.7466 5.3349 4.9676 9 6.8017 6.2469 5.7590 5.3282 10 7.3601 6.7101 6.1446 5.6502

Present value = Amount x PV Factor

Present value = $8,000 x 5.3349

Present value = $42,679.20


Account for long-term liabilities, including notes payable and mortgages payable.

Time Line ofBusiness Issues

Choose Issue Pay Amortize Retire

NotePayable

MortgagePayable

Bond

Bond ++––

Bond

Jan. 1 Cash. . . . . . . . . . . . . . . . . 20,000Note Payable . . . . . . . 20,000

Borrowed $20,000 for 3 years at 12%.

Example: Interest-Bearing Notes

Dec. 31Interest Expense . . . . 2,400Cash. . . . . . . . . . . . . . 2,400

Made interest payment ($20,000 x 0.12).

On January 1, 2003, Silver Eagle Co. borrowed $20,000 for 3 years at 12 percent interest. The interest is payable on December 31 of each year. What entries are necessary for 2003?

Example: Interest-Bearing Notes

Dec. 31Interest Expense . . . . . . . 2,400Note Payable. . . . . . . . . . 20,000

Cash. . . . . . . . . . . . . . 22,400Interest payment and repayment of loan.

What entry is needed when Silver Eagle Co. repays the loan on December 31, 2002?

What is a Mortgage Payable? A written promise to pay a stated amount of

money at one or more specified future dates. Secured by the pledging of certain assets,

usually real estate, as collateral. Generally requires periodic (usually

monthly) payments of principal plus interest.

Jan. 1 Cash. . . . . . . . . . . . . . . 500,000 Mortgage Payable. . 500,000

Borrowed $500,000 to purchase building.

Example: Mortgages Payable

Jan. 31 Mortgage Payable . . . . 409.84 Interest Expense . . . . . 2,916.67

Cash. . . . . . . . . . . . 3,326.51Made first month’s mortgage payment.

On January 1, 2003, Blue Bird Corp. borrowed $500,000 to acquire a new building. The building was signed as collateral for the 30-year, 7 percent loan. Payments of $3,326.51 are to be made monthly. What are the January 2003 entries?

A mortgage amortization schedule shows the breakdown between interest and principal for each payment over the life of a mortgage.

Monthly Principal Interest MortgageMonth Payment Paid Paid Balance 1 3,326.51 409.84 2,916.67 499,590.16 2 3,326.51 412.23 2,914.28 499,177.93 3 3,326.51 414.64 2,911.87 498,763.29 4 3,326.51 417.06 2,909.45 498,346.23 5 3,326.51 419.49 2,907.02 497,926.74 6 3,326.51 421.94 2,904.57 497,504.80

Mortgages Payable


Account for capital lease obligations and

understand the significance of

operating leases being excluded from

the balance sheet.

Lease ObligationsMatch the Following Terms.

1.1. The party that is granted the right to use property under the terms of a lease.

2.2. The owner of property that is rented (leased) to another party.

3. A simple short-term rental agreement.

4.4. A leasing transaction that is recorded as a purchase by the lessee.

5. A contract that specifies the terms under which the owner of an asset agrees to transfer the right to use the asset to another party.

Lessor

Operating Lease

Lease

Lessee

Capital Lease

Classifying LeasesIf the lease is cancelable or does not meet any of the four requirements, is it an operating lease?

Yes

Yes

Yes

Yes

No

No

No

No

Transfer of Ownership?

Bargain PurchaseOption?

Term 75% ofUseful Life?

PV Payment 90%of FMV?

CapitalLease

OperatingLease

YES

Example: Lease Obligations

Jan. 1 Leased Computer . . . . . . .24,838Lease Liability . . . . . . . 24,838

Leased a computer for company use.

On January 1, 2003, The Cockatoo Company leased a computer. The lease requires annual payments of $5,000 for 8 years. The applicable interest rate is 12 percent. How is the lease recorded? What is the December 31, 2003 entry for interest expense?

Dec. 31 Lease Liability . . . . . . . . . . 2,019Interest Expense . . . . . . . . 2,981

Cash. . . . . . . . . . . . . . . 5,000 Paid annual lease payment for computer.


Account for bonds, including the original issuance, the payment of interest, and the retirement of bonds.

BondA contract between a borrower (issuer) and a lender (investor). The borrower promises to pay a specified amount of interest for each period the bond is outstanding and to repay the principal at the maturity date.

Unsecured Bonds (Debentures)Bonds for which no collateral has been pledged.

Secured BondsBonds for which assets have been pledged in order to guarantee repayment.

Coupon (Bearer) BondsUnregistered bonds for which owners receive periodic interest payments by clipping a coupon from the bond and sending it to the issuer as evidence of ownership.

Define These Types of Bonds

1. Bonds that mature in one lump sum on a specified future date.

2. Bonds that mature in a series of installments at specified future dates.

3. Bonds for which the issuer reserves the right to pay the obligation before its maturity date.

4. Bonds that can be traded for, or converted to, other securities after a specified period of time.

5. The names and addresses of the bondholders are kept on file by the issuing company.

Types of Bonds

MatchingSerial Bonds

Convertible Bonds

Term Bonds

Callable Bonds

Registered Bonds

2.

4.

1.

3.

5.

Zero-Coupon Bonds

Bonds issued with no promise of interest payments; only a lump sum payment will be made.

Junk Bonds

Bonds issued by companies in weak financial condition with large amounts of debt already outstanding; these bonds yield high rates of return because of high risk.

Types of Bonds

A contract between a bond issuer and a bond purchaser that specifies the terms of a bond.

The amount that will be paid on a bond at the maturity date.

The date at which a bond principal or face amount becomes payable.

Characteristics of BondsMatch Correctly.

Principal (face value or market value)

Bond Indenture

Bond Maturity Date

A contract between a bond issuer and a bond purchaser that specifies the terms of a bond.


The date at which a bond principal or face amount becomes payable.

Price should equal:

present value of the interest payments +present value of the bond’s lump-sum face value at maturity

Market rate (effective rate or yield rate) of interestThe interest rate investors expect to earn on their investment.

Stated rate of interestThe rate of interest printed on the bond.

Determining Issuance Price

Determining Issuance PriceCorrectly Define Each Term.

Face Value


Bond Discount

The difference between the face value and the sales price when bonds are sold below their face value.

Bond Premium

The difference between the face value and the sales price when bonds are sold above their face value.

BondStatedInterest

Rate10%

Market Rate Bond Sold at

Characteristics of Bonds

8% Premium

10% Face Value

12% Discount

Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective and stated rates are equal. Calculate the issue price.

Example: Bond Issued at Face Value

1. Semiannual interest payments $ 25,000Present value of interest annuity $193,043

2. Maturity value of bonds $500,000Present value of bonds 306,957

3. Issuance price of bonds $500,000

Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 12 percent. Calculate the issue price of the bonds.

Example: Bond Issuedat a Discount




Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 8 percent. Calculate the issue price of the bonds.

Example: Bond Issuedat a Premium




Example: Accounting for Bonds Payable

Jan. 1 Cash . . . . . . . . . . . . . . . . 500,000Bonds Payable. . . . . . . 500,000

Issued $500,000, 10%, 5-year bonds.

On January 1, 2003, Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 10 percent. What entry is needed to record the liability?

Example: Accounting for Bonds Payable

Jun. 30Bond Interest Expense . . 25,000Cash. . . . . . . . . . . . . . 25,000

Paid interest ($500,000 x 0.10 x 0.5).

On January 1, 2003, Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 10 percent. What entry is needed to record the first interest payment?

Example: Bond Retirements at Maturity

Jan. 1 Bond Interest Expense. . . . . 25,000Bonds Payable. . . . . . . . . . . . 500,000

Cash. . . . . . . . . . . . . . 525,000Retired 5-year, $500,000, 10% bonds; paid interest ($500,000 x 0.10 x 0.5).

On January 1, 2003, Falcon Company agreed to issue 5-year, $500,000 bonds and pay 10 percent interest, compounded semiannually. Assume the effective rate is 10 percent. What entry is needed to record the retirement of the bond on January 1, 2008?

Example: Bond Retirements Before Maturity

Jan. 1 Bonds Payable. . . . . . . . .200,000Loss on Bond Retirement.20,000

Cash (200,000 x 1.10) . 220,000

Retired a callable bond at 110.

The Great Owl Company issued $200,000, 14 percent bonds, which are now selling for 107 and are callable at 110. The bonds were issued at face value. If the company decides to call the bonds, what entry is needed?


Use debt-related ratios to determine the degree of a

company’s financial leverage and its ability to repay loans

Debt Ratio

Measures the amount of assets supplied by lenders.

Total Liabilities Total Assets

Debt-to-Equity Ratio

Measures the balance of funds being provided by creditors and

stockholders

Total Liabilities Total stockholders’ equity

Times Interest Earned Ratio

The ratio of income that is available for

interest payments to the annual

interest expense.

Income before interest and taxes (operating profit) Annual interest expense

Expanded MaterialLearning Objective 6

Amortize bond discounts and bond premiums using either the straight-line method or the effective-interest method.

Define the Two Bond Premium/Discount Amortization

MethodsStraight-line Method

A method of systematically writing off a bond premium or discount, resulting in equal amounts being amortized each period.

Effective-interest Method

A method of systematically writing off a bond premium or discount, taking into consideration the time value of money.

GAAP prefers the effective-

interest method.

GAAP prefers the effective-

interest method.

Which method is preferred by GAAP?

On January 1, 2003, The Ostrich Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. The company received $196,000 for the bonds. Make the entry to record the issuance of the bonds.


Jan. 1 Cash. . . . . . . . . . . . . . . . .196,000Discount on Bonds. . . . . . 4,000

Bonds Payable . . . . . . . 200,000Issued $200,000 at a discount.

On January 1, 2003, The Ostrich Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. Using straight-line amortization, what entry is made for the interest payment on June 30, 2003?


Jun. 30Bond Interest Expense . . .10,200Discount on Bonds. . . . 200Cash. . . . . . . . . . . . . . . 10,000

Paid interest ($200,000 x 0.10 x 0.5).

On January 1, 2003, The Ostrich Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. Using straight-line amortization, what adjusting entry is needed on December 31, 2003?


Dec. 31Bond Interest Expense . . .10,200Discount on Bonds. . . . 200Bond Interest Payable . 10,000

To recognize interest expense for 6 months.

On January 1, 2003, The Ostrich Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. What entry is necessary to retire the debt after 10 years?


Jan. 1 Bonds Payable. . . . . . . . . . 200,000Cash . . . . . . . . . . . . . . . 200,000

Retired a $200,000, 10-year, 10% bond.


Jan. 1 Cash. . . . . . . . . . . . . . . . .210,000Premium on Bonds. . . 10,000Bonds Payable . . . . . . . 200,000

Issued $200,000 at a premium.

On January 1, 2003, The Parrot Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. The company received $210,000 for the bonds. Make the entry to record the issuance of the bonds.


Jun. 30Bond Interest Expense. . . 9,500Premium on Bonds. . . . . . 500

Cash . . . . . . . . . . . . . . 10,000

Paid interest ($200,000 x 0.10 x 0.5).

On January 1, 2003, The Parrot Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. The company received $210,000 for the bonds. Using straight-line amortization, what entry is made for the interest payment on June 30, 2003?


Dec. 31 Bond Interest Expense. . . .9,500Premium on Bonds. . . . . . .500

Bond Interest Expense . 10,000

To recognize interest expense for 6 months.

On January 1, 2000, The Parrot Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. The company received $210,000 for the bonds. Using straight-line amortization, what entry is needed on December 31, 2000?


Jan. 1 Bonds Payable. . . . . . . . . .200,000Cash . . . . . . . . . . . . . . 200,000

Retired a $200,000, 10-year, 10% bond.

On January 1, 2003, The Parrot Company agreed to issue 10-year, $200,000 bonds and pay 10 percent interest, compounded semiannually. The company received $210,000 for the bonds. What entry is necessary to retire the debt after 10 years?

Example: Effective-Interest MethodThe Woodpecker Company issued a $1,000, 8 percent bond. The market rate was 7 percent at the time of issuance. Create an effective-interest table.

A B C D E(A-B) (D-C) (1,000+D)(1,000 x 0.04) (E x 0.035)

Premium Amortization # Payment

Interest Expense

Unamortized Premium

Bond Book

$71.00 $1,071.00

1 $40.00 $37.49 $2.51 68.49 1,068.49

2 40.00 37.40 2.60 65.89 1,065.89

3 40.00 37.31 2.69 63.20 1,063.20

long-term debt financing long-term debt financing c h a p t e r 10

Documents

value table future value

present value slide

future value compound

discountingpresent value

x fv factor future value

use present value concepts

value tables annuity

time value of money