Download Cash payment

Chapter
Ten
Accounting for
Long-Term
Debt
McGraw-Hill/Irwin
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Long-Term Notes Payable
Long-term notes are liabilities that usually
have terms from two to five years.
Principal
Payments
Company
Each payment covers interest
for the period and a portion of
the principal.
Lender
With each payment, the interest
portion gets smaller and the principal
portion gets larger.
10-1
Long-Term Notes Payable
Applying payments to principal and interest
 Identify the unpaid principal balance.
 Amount applied to interest = Unpaid principal
balance × Interest rate.
 Amount applied to principal = Cash payment
– Amount applied to interest in .
 Unpaid principal balance = Unpaid principal
balance in  – Amount applied to principal
in .
10-2
Long-Term Notes Payable
Annual
payments
are constant.
$30,000
$25,000
$20,000
Interest
Principal
$15,000
$10,000
$5,000
$Year 1
Year 2
Year 3
Year 4
Year 5
The amount applied to the principal increases each year.
The amount of interest decreases each year.
10-3
Line of Credit
•Enable the company to borrow and repay
funds.
•Usually specify a maximum credit line.
•Normally used for short-term borrowing to
finance seasonal business needs.
10-4
Bond Liabilities

Long-term borrowing of a large
sum of money, called the
principal.

Principal is usually paid back as
a lump sum at maturity.

Individual bonds are often
denominated with a face value of
$1,000.
10-5
Bond Liabilities

Periodic interest payments based on a
stated rate of interest.
 Interest is paid semiannually.
 Interest paid is computed as:
Interest = Principal × Stated Interest Rate × Time

Bond prices are quoted as a percentage of
the face amount.
For example, a $1,000 bond priced at 104 would
sell for $1,040.
10-6
Bond Liabilities
Bond Interest
Payments
Corporation
Investors
Bond Interest Payments
Bond Issue
Date
Interest Payment =
Principal × Interest Rate × Time
10-7
Bond Liabilities
Advantages of bonds
 Longer term to maturity than
notes payable issued to banks.
 Bond interest rates are usually
lower than bank loan rates.
10-8
Characteristics of Bonds
Term and
Serial
Secured and
Unsecured
Convertible
and Callable
10-9
The Market Rate of Interest
The selling price of a bond is determined by
the market rate of interest versus the stated
rate of interest.
Interest
Rates
Stated
Market Bond
Rate = Rate Price
Bond
Price
Face Value
= of the Bond
Accounting for
the Difference
There is no difference
to account for.
Stated
Market Bond
Face Value The difference is accounted
<
Rate < Rate Price
of the Bond
for as a bond discount.
Stated
Market Bond
Rate > Rate Price
Face Value The difference is accounted
> of the Bond for as a bond premium.
10-10
Bond Redemptions
Companies may redeem bonds with a
call provision prior to the maturity date.
Gains or losses incurred as a result of early
redemption of bonds should be reported as
other income or other expense on the
income statement.
10-11
Effective Interest Rate Method
Effective interest is a
more accurate way to
amortize bond
discounts and
premiums.
It correctly reflects the
bond’s changing
carrying value.
10-12
Effective Interest Rate Method
Let’s assume Mason Company uses the effective
interest method on its $100,000 bond.
Step 1:
Determine the cash payment for interest.
Face value of bond
X Stated rate of interest
Cash payment
$ 100,000
X
.09
$ 9,000
10-13
Effective Interest Rate Method
Step 2:
Determine the amount of interest expense.
$100,000 face value - $5,000 discount = $95,000 carrying value
Carrying value of bond liability
X
Effective rate of interest
Interest expense
$ 95,000
X .1033
$ 9,814
10-14
Effective Interest Rate Method
Step 3:
Determine the amortization of the bond discount.
Interest expense
Cash payment
Discount amortization
$ 9,814
- 9,000
$ 814
Step 4:
Update the carrying value of the bond liability.
Discount amortization
+ Beginning carrying value
Ending carrying value
$
814
+ $ 95,000
$ 95,814
10-15
Effective Interest Rate Method
* The decrease in the amount of the discount increases the
amount of the bond liability.
10-16
Effective Interest Rate Method
(Appendix)
Notice that when
using the effective
interest method,
interest expense
increases each year.
10-17
Financial Leverage and Tax
Advantage of Debt Financing
Financial leverage: Debt financing can increase return on equity when
the borrower earns more on the borrowed funds than it pays in interest.
As this example shows, the cost of financing is the same, but debt
financing has a tax advantage.
10-18
Times Interest Earned Ratio
Numerator is commonly called EBIT,
Earnings before interest and taxes.
Times Interest
Earned
Net income + Interest expense + Income
tax expense
=
Interest expense
The ratio shows the amount of resources generated for each
dollar of interest expense. In general, a high ratio is viewed
more favorable than a low ratio.
10-19
End of Chapter Ten
10-20