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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