Chapter 15: Long-term liabilities Flashcards
Effective Interest Amortization Method
(not studied)
Amortization model that calculates interest expense based on the current carrying amount of the bond and the market interest rate at issuance, and then amortizes the difference between the cash interest payment and calculated interest expense as a decrease to discount or premium.
Required by GAAP unless straight line amounts are similar
Present Value
Part of the Time Value of Money
Present value = the value of an investment today
vs
Future Value = the value of an investment at the end of a specific time frame
Use tables to determine factors
Market/ Sales price of bond = present value of the total interest payments bond holder receives + principal
Types of Bonds
(Also called “features” of a bond)
- Secured vs unsecured (Debentures): secured bonds have assets used as collateral. Debentures are only backed by the credit-worthyness of the user.
- Term vs Serial: Term all mature at a specified date. Serial mature in installments at regular intervals
- Registered and Bearer (coupon) bonds
- Convertable: can be converted into stock
vs Callable: issuer may call and pay off whenever issuer chooses (usually at a price point slightly above the face value)
Carrying Value of Bonds
Face Value of Bonds + unamortized bond premium at redemption date
or
Face Value of Bonds less unamoritzed bond discount at redemption date
Straight Line Amortization method
Amortization method that allocates an equal amount of bond discount or premium to each interest period over the life of the bond
Bond discount (or premium) / total interest period = amortization amount per period
Amortization Schedule
A schedule that details each loan payment allocation between principal and interest, plus beginning and ending loan balances.
Shows:
Date | Beginning Balance | Principal Payment | Interest Expense | Total Payment | End Balance
Disadvantages of Issuing Bonds
Interest must be paid PLUS principal repaid (vs stocks = paid-in-capital)
Bond interest payments are not optional (dividends are)
Financial Leverage
Occurs when a company ears more on income on borrowed money than the related interest expense
Advantages of Issuing Bonds
Debt is a less expense source of capital than stock (long term???)
Bonds do not affect the percentages of ownership of the corp (Stockholder control is not effected)
Tax savings
Earnings per share is higher
Bonds
A form of interest bearing notes payable
(the corporation issuing the bonds is borrowing money, buyer (bondholder) is investing in bonds)
Issued when capital required is too large for one lender to supply
Sold in small denominations (1,000s or multiples thereof)
Long-Term liabilities
Obligations expected to be paid after one year
When to capitalize a lease
Must meet one or more of the following criteria:
- lease eventually transfers ownership to lessee
- lease contains a bargain purchase option
- lease term is greater than or equal to 75% of the estimated economic life of the leased property
- Present value of minimum lease payment is greater than or equal to the fair value of the leased property (not including executory costs)
Long Term Notes Payable
Loan from a single lender
Typical terms require borrowers to make installment payments over the term of the loan.
Payments include: reduction of loan principal + interest on unpaid balance of the loan
- may be secured by a mortgage - pledges title to assets as security for loan
- initially record mortgage notes payable at face value
Converting Bonds into Common Stock
Until Conversion - bondholder continues to receive interest
Issuer sells bond at higher price and pays a lower interest rate than comparable debt securities without conversion option
Upon conversion the carrying value of the bond is transferred to paid-in-capital account. No gain or loss recognized.
Mortgages payable
Long term debts that are backed with a security interest in a specific property.
Include the borrower’s promise to transfer the legal title to specific assets if the mortgage isn’t paid on schedule.
Bonds sell at premium, face value or discount
Stated (coupon rate) > market interest rate = sold at a premium
- issue price is greater than the face value
- total cost of borrowing < interest paid
Stated Rate = Market Interest Rate = Sold at Face Value
State Rate < Market Rate = sold at a discount
- issue price is below face value
- Total cost of borrowing > interest paid
Stated interest rate of a bond
Interest rate that determines the amount of cash the borrowers pays and investor received each year
AKA face rate, coupon rate or nominal rate
Determining Market Value of Bond
Market Value: function of factors that determine present value
- dollar amount to be received
- length of time interest amounts are received
- Market rate of interest
Market Rate of Interest
The rate investors demand for loaning funds
Issuing Bonds
Bond Contract = Bond Indenture
- state laws grant corporations the right to issue bonds
- board and stockholders must approve issuing
- Board stipulates: Number of bonds authorized, total face value (usually $1k each), and contractual interest rate
- Bond = paper certificate = promise to pay sum of money at maturity date PLUS periodic interest at contractual (stated/face/coupon) rate on maturity amount. (periodic interest is usually semi-annually)
- sold for issuing company by an investment company
Debt Covenants
Protection for lenders
Specific financial measures that a company must maintain during the life of the loan.
- minimum retained earnings, cash flows, time interest earned rates etc…
(or loan agreement violated = creditors can demand repayment or renegotiation of terms)
Journaling Straight Line Amortization of Bond Premium
Amortization of bond premium DECREASES interest expense over the life of the bond.
Debit interest expense (interest paid less amortized premium)
Debit Premium on Bonds Payable (amortization amount)
Credit Cash (interest payment)
Journaling Redeeming Bonds at Maturity
Debit Bonds Payable
Credit Cash
Journaling Issuance of Premium Bonds
Debit Cash (cash received)
Credit Bonds Payable (face value)
Credit Premium on Bonds Payable (adjunct account)
Premium on Bonds payable then amortized over the life of the bond to reduce interest expense
Journaling Issuance of Discounted Bonds
Debit Cash Received
Debit Discount on Bonds Payable (adjunct account)
Credit Bonds Payable (face value)
Discount on Bonds Payable then amortized over years bond is outstanding
Bond Retirement Conversion to Stock
Debit Bonds Payable (face value)
Credit Common Stock (Par Value)
Credit paid-in-capital in excess of par
market price of stocks/ bonds not considered
Bond Retirement Before Maturity
Must:
- Eliminated carrying value of bonds at redemption date
- Recognize cash paid
- Recognize gain or loss on redemption (cash paid vs carrying value = gain or loss)
Debit Bonds Payable (face value)
(Debit Premium on Bonds Payable if applicable)
(Debit Loss on Bond Redemption if applicable)
(Credit Discount on Bonds Payable if applicable)
(Credit Gain on Bond Redemption if applicable)
Credit Cash received
Journaling Bonds Issued at Face Value
Issuing Bonds:
Debit Cash (face value)
Credit Bonds Payable
Interest Accrual:
Debit Interest Expense (FV x Rate)
Credit Interest Payable
Paying Accrued Interest:
Debit Interest Payable
Credit Cash
Paying NOT accrued interest:
Debit Interest Expense
Credit Cash
Journaling Bond Issuance
Journal Entries when:
- Corporation issues (sells) bonds
- Corporation retires (buys back) bonds
- Bonds are converted to common stock
If bonds are sold between investors no journal entry occurs because company receives no money
Journaling Operating vs capital lease
Operating:
Debit Rent Expense
Credit Cash
Capital:
Debit Leased Equipment (asset)
Credit Lease Liability
(records the lease as an asset)
Mortgage Payable
Issuance:
Debit Cash Received
Credit Mortgage Payable
Payment:
Debit Interest Expense
Debit Mortgage Payable
Credit Cash
Interest Entry for Bonds Purchased at Discounts
Debit Interest Expense (total)
Credit Discount on Bonds Payable (amortization amount)
Credit Cash
(face value of bond x interest rate x portion of the year)
Debit to total assets ratio
= Total Debt/ Total Assets
higher percentage of debt to assets= greater risk company is unable to meet its maturing obligations
Times Interest Earned
= Income Before Income Taxes and Interest Expenses / Interest Expense
Indicates company’s abilities to meet interest payments as they come due
Debt to Equity Ratio
= Total Liabilities / Total Equity
Measures the proportion of total liabilities to total equity
If higher than 1 the company is financing more assets with debt than equity (higher = greater risk)
Ratios for debt paying ability and long-run solvency
Debt to total assets ratio
Times Interest Earned Ratio
Cost of Borrowing for Bonds Issued at a Premium
Annual interest payments LESS: Bond Premium = Total Cost of borrowing or Principal at Maturity \+ Annual Interest Payments = Cash to be paid to bondholders Less: Cash received from borrowers = total cost of borrowing
Cost of borrowing for bonds issued at a discount
Annual Interest Payments PLUS Bond Discounts = total cost of borrowing or Principal at Maturity \+ Annual Interest Payments = Cash to be paid to bondholders Less: Cash Received from Borrowers = Total cost of borrowing
Market Value of Bonds
Present Value of all future cash payments
Present Value of a lump sum
= Future Value x PV Factor for (i, n)
i= interest rate
n= number of times interest will compound
Find Factor from table: Present Value of $1.00
Present Value of an Annuity
= amount of each cash inflow x Annuity PV Factor for (i, n)
i= interest rate
n= number of times interest will compound
Find Factor from table: Present Value of ordinary annuity of $1.00
Present Value of Bonds Payable
Preset Value of Principal paid back at maturity (present value of lump sum)
i = market interest rate at time bonds sold
PLUS
Present value of future interest payment (present value of an annuity)
i = stated interest rate of the bond
Simple Interest
Interest only calculated on principal amount
Compound interest
Interest calculated on principal plus all previously earned interest
Assumes interest will remain invested and earn interest at the same rate
Annuity
Stream of equal cash payments made at equal time intervals
Ordinary annuity = installments paid at the end of each period
Annuity Due = installments paid at beginning of each period
Future Value of a lump sum
= Present value x FV Factor for (i, n)
i= interest rate
n= number of times interest will compound
Find Factor from table: Future Value of $1.00
Future Value of an Annuity
=Amount of each cash inflow x annuity FV factor for (i,n)
i= interest rate
n= number of times interest will compound
Find Factor from table: Future Value of Ordinary Annuity of $1.00
Leases on Balance Sheet
Portion to be paid in next year = current liability
Remainder Outstanding = long term liability
Premium on Bonds Payable on Balance Sheet
Long Term Liabilities
Bonds Payable (face value)
Premium on Bonds Payable (premium amount)
Total carrying amount
Bond premium = reduction on the cost of borrowing
Discount on Bonds Payable on Balance Sheet
Long Term Liabilities
Bonds Payable
Less: Discount on Bonds Payable
Total = Carrying Value/ Book Value
Bond Discount = increase on cost of borrowing
Bonds on Earnings per share report
Because Income from bonds is reduced by interest paid taxes on bonds are lower and earnings per share to shareholder are higher.
Bond Indenture
A legal document which summarizes the rights and privileges of bondholders as well as the obligations and commitments of the issuing company is called
Valuation Account
AKA Contra Account
Bonds under IFRS
IFRS does not use discount or premium accounts. Carried at net
Net cost of borrowing considering income tax
Because company will not be paying income tax on the money paid out as interest? Net cost =
Interest payment x (1 - tax rate)
