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Accounting - Chapter 11&12 Notes.docx

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Department
Commerce
Course
COMMERCE 1BA3
Professor
Emad Mohammad
Semester
Fall

Description
CHAPTER ELEVEN: REPORTING AND INTERPRETING LONG-TERM LIABILITIES Capital Structure – Long-Term Debt  Long-term debt can be in the form of: o Notes payable o Bonds payable o Lease obligations o Mortgage payable  This chapter will focus on bonds payable Advantages and Disadvantages of Bonds Advantages of Bonds Disadvantages of Bonds - Bonds are debt not equity so do not - Risk of bankruptcy exists because lose ownership or control of company interest and principal are legal - Cash payments to debt holders are obligations (must be paid back as limited to scheduled payments of scheduled or creditors will for legal interest principal (do not have to pay action) dividends) - Huge lump sum of money due when - Interest expense is tax deductible bond expires (may not have enough cash - Positive financial leverage on hand at that time to pay it off) - Negative impact on cash flows exists because interest and principal must be repaid in future  Advantages of bonds are advantages of any debt financing over equity financing  Disadvantages are specific to bonds  Financial leverage: being able to increase Return on Equity  Ex. Which of the following is not an advantage of issuing debt? Bonds Payable  Form of interest-bearing notes payable issued by corporations, universities and government agencies  Sold in small denominations (makes them attractive to investors)  Any long-term liabilities affect long-term debt to equity ratio making company look more risky  Less lenders will want to lend money to risky company  Bonds are issued to stable companies  Secure bond: o Backed by collateral o Ex. mortgage bond (if do not pay can take house back)  Unsecure bond: o Not backed by collateral o Ex. a credit card (if do not pay back company cannot take anything from you)  Convertible bond: possible that company does not have money to pay off bonds so they convert them to shares of the company  Redeemable/retractable bond: allowed to buy bond back before it expires Characteristics of Bonds Payable  Issuer of bond is person paying  Bonds payable are long-term debt for issuing company  When bond is issued: o Company issuing bond gets money amounting to the bond issue price o Investor buying bond gets a bond certificate  Selling price of the bond is the present value of future cash flows (ex. $20M ten years from today) Ex. 10 years; $20M; 10% interest; Semi-annually Can borrow from one company: Can borrow from the market: - 10% for the year (not 6 months) - 11% on the $20M - Paying 5% every 6 months - For each of 20 payments market is - Will pay interest 20 times paying 0.5% more than the bond - Issuer of bond will calculate 0.5% x 20 payments and give that to investor as a discount - Have to sell bond at discount so it is equal with the market Terminology  Contractual interest rate: stated rate that determines amount of cash interest the borrower pays and the investor receives  Contractual rate also called: 1. Stated rate 2. Coupon rate 3. Face rate 4. Nominal rate 5. Bond rate  Market rate: interest rate investors demand for loaning funds  Market rate also called: 1. Effective rate 2. Yield rate  Face value: amount of principal due at maturity  Market value/issue price: o Quoted as a percentage of the face value of the bond o Present value (using the market rate) of: bond face value to be received at maturity and interest payments to be received periodically Bond Issue Price  Bonds may be issued at: o Face value (at par): Market rate = Coupon rate o Below face value (discount): Market rate > Coupon rate o Above face value (premium): Market rate < Coupon rate  Interest that the company is paying (what the certificate says): Interest payment = (Coupon rate) x (Bond value) x (Period)  Interest that the company should be paying (how much came out of their pocket for the bond): Interest expense = (Yield) x (Carrying value) x (Period)  Carrying value (what company gave up): o Carrying value = Face value + Unused premium o Carrying value = Face value – Unamortized discount  Amortization of bond discount/premium = (Interest payment) –(Interest expense) Ex. $20M, 10-year, 10%, semi-annual bonds were sold with a yield of 11%. Which one of the following could be the selling price? a) 100 b) 105 c) 110 d) 95 (because market rate > coupon rate  have to pay less than 100%) e) None of the above Issuing Bonds at Face Value (Par) Ex. On June 30, 2006, a corporation issues $100,000, 10%, 5-year bonds payable that pay interest semi-annually on June 30 and December 31 each year. Prepare the journal entries assuming a market rate of 10% and a fiscal year-end on December 31. Coupon rate = 10% Yield = 10% Face value = 100,000 Carrying value = 100,000 Period = 6/12 Period = 6/12 Interest payment = 10% x 100,000 x Interest expense = 10% x 100,000 x (6/12) (6/12) = 5,000 = 5,000 Journal Entries June 30, 2006 Cash 100,000 Bonds payable 100,000 December 31, 2006 (and every payment date until the maturity date – 10 interst payments of 5,000) Interest expense 5,000 Cash 5,000 June 30, 2011 (maturity date of the bonds) Interest expense 5,000 Cash 5,000 Bonds payable 100,000 Cash 100,000 How much will this bond sell for?  100,000 (issue price will be the same as the face value because you are paying the same rate as the market – no discount or premium) When a bond is issued at par, throughout the interest payments, the interest expense and the interest payments will be equal?  Yes Issuing Bonds at a Discount  Have to give a discount if market rate is above coupon rate  Discount represents an additional cost of borrowing and should be allocated to bond interest over the life of the bond  Amortizing the discount will cause interest expense to be greater than interst payment Ex. On June 30, 2006, a corporation issues $100,000, 10%, 5-year bonds payable that pays interest semi-annually on June 30 and December 31 each year. Prepare the journal entries assuming a market rate of 12% and a fiscal year-end on December 31.  Issue price = $92,640  Discount = 100,000 – 92,640 = $7,360  Interest payment = 10% x 100,000 x (6/12) = 5,000  Interest expense = 12% x 92,640 x (6/12) = 5,558.40 Journal Entries: June 30, 2006 Cash 92,640 Discount on bonds payable 7,360 Bonds payable 100,000 December 31, 2006 Interest expense 5,558 Cash 5,000 Discount on bonds payable 558 June 30, 2011 Interest expense 5,943 Cash 5,000 Discount on bonds payable 943 Bonds payable 100,000 Cash 100,000 Bond Amortization Schedule Dates Interest Interest Discount Discount Carrying payment expense amount value 30/06/06 5,000 7,760 92,640 31/12/06 5,000 5558.40 558 6,802 93,198 30/06/07 5,000 What will be the trend of interest expense for a discount on bonds payable?  Interest expense will keep increasing because the carrying value keeps increasing  Discount amount keeps increasing  Discount keeps decreasing to 0  Carrying value keeps going up to 100,000 (what is owed at maturity) True or false, for a discount on bonds payable, the interest expense keeps increasing at an increasing rate whereas the amortized discount keeps decreasing at an increasing rate?  True What type of account is discount on bonds payable?  Contra-liability Issuing Bonds at a Premium  Coupon rate is more than the market rate  Must return money up front as a premium to make them equal  Selling price will be higher Ex. On June 30, 2006 a corporation issues $100,000, 10%, 5-year bonds payable that pay interest semi-annually on June 30 and December 31 each year. Prepare the journal entries assuming a market rate of 8% and a fiscal year-end on December 31.  Sold for 108,111 (will always be given – do not need to calculate)  Premium = 108,111 – 100,000 = 8,111  Interest payment = 10% x 100,000 x (6/12) = 5,000  Interest expense = 8% x 108,111 x (6/12) = 4,324  Carrying value = 100,000 + 8,111 = 108,111 Amortizing the Premium  Issue price = $108,111  Premium = 108,111 – 100,000 = $8,111  Sales of bonds above face value causes total cost of borrowing to be less than interest paid because borrower is not required to pay bond premium at maturity date of bonds  Amortization of premium will be allocated to interest expense  Bond interest expense is reduced over the life of the bond Journal Entries: June 30, 2006 Cash 108,111 Bonds payable 100,000 Premium on bonds payable 8,111 December 31, 2006 Interest expense 4,324 Premium on bonds payable 676 Cash 5,000 June 30, 2007 Interest expense 4,297 Premium on bonds payable 703 Cash 5,000 June 30, 2011 Interest expense 4,038 Premium on bonds payable 962 Cash 5,000 Bonds payable 100,000 Cash 100,000 Trends  Interest payment is constant  Interest expense is decreasing because it is dependent on the carrying value and carrying value is decreasing  Premium amortization will keep increasing  Premium keeps decreasing to 0  Carrying value keeps decreasing to the face value True or false, when bonds are issued either at a premium or a discount, the amortization will keep increasing at an increasing rate?  True What type of account is a premium on bonds payable?  Adjunct liability (it is not possible for this liability to exist on its own – has to be tied to a bond) Redeeming Bonds Before Maturity  Company may decide to retire bonds before maturity in order to: o Reduce interest cost o Remove debt from its balance sheet  Company should retire debt early only if it has sufficient cash resources  Only able to buy back bond if have the ability to  Ability: have enough cash to buy back bond and have the permission to  Permission: bond must be redeemable (not all bonds are)  When bonds are retired before maturity: o Eliminate carrying value of bonds at redemption date o Record cash paid o Recognize gain/loss on redemption  Gain: Cost < Carrying value  Loss: Cost > Carrying value Ex. On June 30, 2006 a corporation issues $100,000, 10%, 5-year bonds payable that pay interest semi-annually on June 30 and December 31 each year. Prepare the journal entries assuming a market rate of 8% and a fiscal year-end on December 31. The issue price of these bonds is $108,111. Assume that the corporation retire
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