Download Bond Interest Payments Mason Company Investors

Acct 2210
Chp 10 &
Appendix “F”
(pg 773-779)
Accounting for
Long-Term
Debt
McGraw-Hill/Irwin
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
LO 1
Show how an
installment note
affects financial
statements.
10-1
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.
10-2
Long-Term Notes Payable
Applying payments to principal and interest
 Identify the unpaid principal balance.
 Calculate the 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 .
10-3
Long-Term Notes Payable
On January 1, 2013, Blair Company issued a
$100,000 face value long-term note to National
Bank. The note had a 9% annual interest rate
and a five-year term. The loan agreement
called for five equal payments of $25,709 to be
made on December 31 of each year.
Prepare an amortization table for Blair’s note.
10-4
Long-Term Notes Payable
10-5
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.
10-6
Long-Term Notes Payable
Issuing the note has the following effect
on Blair’s 2013 financial statements:
Assets
=
Liab.
+
Equity
Rev.
–
Exp.
=
Net Inc.
100,000
=
100,000
+
NA
NA
–
NA
=
NA
Cash Flow
100,000
FA
The December 2013 cash payment has the following
effect on Blair’s 2013 financial statements:
Assets
=
Liab.
+
Equity
Rev.
–
Exp.
=
Net Inc.
(25,709)
=
(16,709)
+
(9,000)
NA
–
9,000
=
(9,000)
Cash Flow
(9,000)
OA
(16,709)
FA
10-7
Impact on Financial Statements
10-8
LO 2
Show how a line
of credit affects
financial
statements.
10-9
Line of Credit
•Enable the company to more easily
borrow and repay funds.
•Usually specify a maximum credit line.
•Normally used for short-term borrowing to
finance seasonal business needs.
10-10
LO 3
Describe bond
features and show
how bonds issued
at face value affect
financial
statements.
10-11
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.
10-12
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.
10-13
Bond Liabilities
Bond Selling Price
Corporation
Bond Certificate
at Face Value
Investors
Bond Issue
Date
10-14
Bond Liabilities
Bond Interest
Payments
Corporation
Investors
Bond Interest Payments
Bond Issue
Date
Interest Payment =
Principal × Interest Rate × Time
10-15
Bond Liabilities
Bond Principal
at Maturity Date
Corporation
Bond Issue
Date
Investors
Bond Maturity
Date
10-16
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.
10-17
Characteristics of Bonds
Term and
Serial
Secured and
Unsecured
Convertible
and Callable
10-18
Bonds Issued at Face Value
Mason Company issues bonds on January 1, 2013.
Principal = $100,000
Stated Interest Rate = 9%
Interest Paid Annually on 12/31
Maturity Date = December 31, 2017 (5 years)
Bond Selling Price
Mason Company
Bond Certificate
at Face Value
Investors
10-19
Bonds Issued at Face Value
Issuing the bonds has the following effect
on Mason’s 2013 financial statements:
Assets
=
Liab.
+
Equity
Rev.
–
Exp.
=
Net Inc.
Cash Flow
100,000
=
100,000
+
NA
NA
–
NA
=
NA
100,000 FA
To record the bond issue, Mason makes
the following entry on January 1, 2013:
Account Title
Cash
Bonds Payable
Debit
100,000
Credit
100,000
10-20
Bonds Issued at Face Value
On each interest payment date, Mason will pay
$9,000 in interest. The amount is computed
as follows:
$100,000 × 9% = $9,000
Bond Interest Payments
Mason Company
Investors
10-21
Bonds Issued at Face Value
The December 31, 2013, interest payment (and all other
annual interest
payments) has the following effect on Mason’s financial
statements:
Assets
=
(9,000) =
Liab.
+ Equity
Rev.
–
NA
+ (9,000)
NA
–
Exp.
9,000
= Net Inc.
=
Cash Flow
(9,000) (9,000) OA
To record an interest payment, Mason makes the following entry
on each December 31:
Account Title
Interest Expense
Cash
Debit
9,000
Credit
9,000
10-22
Bonds Issued at Face Value
On December 31, 2017, Mason will return the
$100,000 principal amount to the investors.
Bond Principal
at Maturity Date
Mason Company
Investors
10-23
Bonds Issued at Face Value
The principal repayment on December 31, 2017, will have the
following effect on Mason’s 2017 financial statements:
Assets
=
Liab.
+ Equity
(100,000) = (100,000) +
NA
Rev.
–
Exp.
NA
–
NA
= Net Inc.
=
NA
Cash Flow
(100,000) FA
To record an the principal repayment, Mason Company would
make
the following entry on December 31, 2017:
Account Title
Bonds Payable
Cash
Debit
100,000
Credit
100,000
10-24
Bonds Issued at Face Value
10-25
Bonds Issued at a Discount
If bonds of other companies are yielding more
than 9%, investors will be unwilling to pay the
full face amount for Mason’s 9% bonds. The
issue price of Mason’s 9% bonds will have to be
lower to entice investor interest. The difference
between the lower issue price and the principal
of $100,000 is called a discount.
Let’s continue the Mason Company example.
10-26
Bonds Issued at a Discount
Mason Company issues bonds on January 1, 2013.
Principal = $100,000
The only change from
Issue Price = $95,000
previous Mason example.
Stated Interest Rate = 9%
Interest Date = 12/31
Maturity Date = Dec. 31, 2017 (5 years)
Principal
$ 100,000
Cash
Proceeds
Discount
- $ 95,000 = $ 5,000
10-27
Bonds Issued at a Discount
Issuing the bonds at a discount has the following
effect on Mason’s 2013 financial statements:
Assets
=
Cash
95,000 =
Liabilities
Bonds Pay. –
100,000 –
+
Discount
Equity
Rev.
–
Exp.
NA
–
NA
= Net Inc.
Cash Flow
=
95,000 FA
+ Ret. Earn.
5,000 +
NA
NA
To record the bond issue, Mason Company would
make the following entry on January 1, 2013:
Account Title
Cash
Discount on Bonds Payable
Bonds Payable
Debit
95,000
5,000
Credit
100,000
10-28
Bonds Issued at a Discount
Partial Balance Sheet as of January 1, 2013
Long-term Liabilities:
Bonds Payable
Less: Discount on Bonds Payable
$
100,000
5,000
$ 95,000
Face Value
Carrying Value
10-29
Bonds Issued at a Discount
The principal repayment on December 31, 2017, will have the
following effect on Mason’s 2017 financial statements:
Assets
=
(100,000) =
Liab.
+
(100,000) +
Equity
Rev.
–
Exp.
=
Net Inc.
Cash Flow
NA
NA
–
NA
=
NA
(95,000) FA
(5,000) OA
To record an the principal repayment, Mason Company would make
the following entry on December 31, 2017:
Account Title
Bonds Payable
Cash
Debit
100,000
Credit
100,000
10-30
Bonds Issued at a Premium
If bonds of other companies are yielding less
than 9%, investors will be willing to pay more
than the face amount for Mason’s 9 percent
bonds. The issue price of Mason’s 9% bonds
will rise because of investor demand for the
9% bonds. The difference between the higher
issue price and the principal of $100,000 is
called a premium.
Let’s continue the Mason Company example.
10-31
Bonds Issued at a Premium
Mason Company issues bonds on January 1, 2013.
Principal = $100,000
The only change from the
Issue Price = $105,000
original Mason example.
Stated Interest Rate = 9%
Interest Date = 12/31
Maturity Date = Dec. 31, 2017 (5 years)
Cash
Proceeds
$ 105,000 - $
Bonds
Payable
Premium
100,000 = $ 5,000
10-32
Bonds Issued at a Premium
Issuing the bonds at a premium has the following
effect on Mason’s 2013 financial statements:
Assets
=
Cash
105,000 =
Liabilities
+
Equity
Bonds Pay. + Premium
+
Equity
100,000 +
5,000 +
NA
Rev.
–
Exp.
NA
–
NA
= Net Inc.
Cash Flow
=
105,000 FA
NA
To record the bond issue, Mason Company would
make the following entry on January 1, 2013:
Account Title
Cash
Premium on Bonds Payable
Bonds Payable
Debit
105,000
Credit
5,000
100,000
10-33
Bonds Issued at a Premium
Partial Balance Sheet as of January 1, 2013
Long-term Liabilities:
Bonds Payable
Add: Premium on Bonds Payable
$ 100,000
5,000
$
105,000
Face Value
Carrying Value
10-34
Bonds Issued at a Premium
The principal repayment on December 31, 2017, will have the
following effect on Mason’s 2017 financial statements:
Assets
=
(100,000) =
Liab.
+
(100,000) +
Equity
Rev.
–
Exp.
=
Net Inc.
Cash Flow
NA
NA
–
NA
=
NA
(100,000) FA
To record an the principal repayment, Mason Company would make
the following entry on December 31, 2017:
Account Title
Bonds Payable
Cash
Debit
100,000
Credit
100,000
10-35
L.O.5: Considering 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
Rate
Stated
Rate
Stated
Rate
=
Market Bond
Rate Price
<
Market Bond
Rate Price
>
Market Bond
Rate Price
Bond
Price
Accounting for
the Difference
=
Face Value
of the Bond
There is no difference
to account for.
<
Face Value The difference is accounted
of the Bond
for as a bond discount.
>
Face Value The difference is accounted
of the Bond
for as a bond premium.
10-36
LO 5: We will use this method for
our in-class case study
Use the “effective
interest rate”
method to
amortize bond
discounts and
premiums.
10-37
Effective Interest Rate Method:
See pg 553/554 example discussion
Effective interest is a
more accurate way to
amortize bond
discounts and
premiums.
It correctly reflects the
bond’s changing
carrying value.
10-38
Effective Interest Rate Method:
See pg 553/554 example discussion
Let’s assume Mason Company uses the effective
interest method on its $100,000 bond.
Step 1:
Determine the cash payment for interest. Note: the ONLY time the stated
(contract) rate is used is for this one calculation (to determine the actual
interest to be paid). ALL other calculations use the market rate because
we are “tailoring” the bond to the investor’s required rate of return.
Face value of bond
X Stated rate of interest
Cash payment
$ 100,000
X
.09
$ 9,000
10-39
Effective Interest Rate Method:
See pg 553/554 example discussion
Step 2: Determine the amount of interest expense, assuming
the investor requires a market (effective) rate of return of 10.33%.
Complete this example in conjunction with the pg 554 discussion
in our text as you work through these slides.
$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
10-40
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
10-41
Effective Interest Rate Method
* The decrease in the amount of the discount increases the
amount of the bond liability.
10-42
Effective Interest Rate Method
Notice that when using
the effective interest
method, interest expense
increases each year.
10-43
LO 6
Explain the
advantages and
disadvantages of
debt financing.
10-44
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.
10-45
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.
10-46
End of Chapter Ten
10-47