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ADMS 3595 (10)
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Chapter 14.rtf

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Department
Administrative Studies
Course
ADMS 3595
Professor
All Professors
Semester
Summer

Description
Chapter 14: Long-Term Financial Liabilities NATURE OF LONG-TERM DEBT: Long-term debt: obligations not payable within one year, or one business operating cycle - whichever is longer. Examples include: • Bonds payable • Long-term notes • Mortgages • Pension liabilities • Lease liabilities → Often with restrictive covenants (terms) are attached. → Yield, Effective and Market rate are the same. → Stated, Coupon and Nominal rate are the same. Bonds: Most common type of long-term debt that companies report on their balance sheet. • A bond indenture is a promise (by the lender to the borrower) to pay a sum of money at the designated date, and periodic interest (usually paid semi- annually) at a stipulated rate on the face value. • Abond issue may be sold either through an investment banker, or by private placement. Notes Payable: Similar in nature to bonds as it requires repayment of principal at a future date and requires periodic interest payments. • The difference is that notes do not normally trade on public markets • Accounting for bonds and notes is the same in many respects, like a bond, a note is recorded at the PV of future interest and principal, and any premium/discount is amortized over the life of the note. Types of Bonds/Notes Registered and Bearer (coupon) bonds: are freely transferable by current owner. Secured and unsecured debt: secured by collateral (real estate, stocks). Collateral trust bonds or notes are secured by shares and bonds of other corporations. Debt instruments that are not backed by collateral are unsecured e.g., debenture bonds. Junk bonds are unsecured and also very risky and pay a high interest rate. Serial bonds: Matures in installments. Callable bonds: Give issuer right to call and retire debt prior to maturity. The issuer may want to money want if the interest rate is dropping. Income and revenue bonds: Interest payments tied to some form of performance. Deep-discount bonds: Little or no interest payments; sold at substantial discount. Convertible bonds: Can be converted into other corporate securities ex. common shares for a specified time after issue. Bond Ratings • Companies such as Moody’s Investors Service and Standard & Poor’s Corporation assess credit ratings of company bonds and preferred shares. • Bonds ratings range from a quality of “Prime” to “Very speculative.” • AAA rating indicates a rating of “Prime”, while bonds rated below BBB are considered below investment grade ("junk bonds"), experience default rates ranging from 20% -50%. • The issue price of the bond is determined by the market, based on the time value of money. MEASUREMENT AND VALUATION: Bond Valuation by determining Bond Prices • Price of a bond issue is determined by finding the present value (PV) of future cash flows: - The PV of the interest payments (at the stated or coupon rate of interest), plus - The PV of the redemption (face, par) value, - Both discounted at the market (yield) rate of interest in effect at issue date. • When market rate > stated rate the bond sells at discount. • When market rate < stated rate the bond sells at premium. Given: - The face value of the bond issue $100,000 FV = -100,000 - Term of the bond is 5 years. N = 5 - Stated Interest Rate is 9% per year. PMT = -9,000 (0.09x100,000) - Market Interest Rate is 11% I/Y = 11 - Determine the issue price of the bonds. PV => 92,608 Amortizing the Bond Premium/Discount • A premium effectively decreases the annual interest expense for the corporation. • A discount effectively increases the annual interest expense for the issuing corporation. Two methods available for amortization: 1) Straight line: Allocates the same amount of discount (or premium) to each interest period which is acceptable under PE GAAP. • Identify the amount of the bond discount.. • Divide the bond discount by the number of interest periods. • Include the discount amortization amount as part of the periodic interest expense entry. • The discount will be reduced to zero by the maturity date. Given: Face Value = $800,000 Discount/Premium = $24,000 Coupon Rate = 10% Bond Maturity = 10 years The annual discount/premium amortization: $24,000 /10 years = $2,400 The entry to record the annual discount/premium amortization would be: Bond Payable 2,400 Bond Interest Payable 2,400 2) Effective interest: Allocates the discount or premium over the bond term (i.e. amortizes the discount or premium) which is required under IFRS. • Compute interest expense by multiplying the current unpaid balance times the market rate of the interest. • The discount amortization is the difference between interest expense and the cash paid (or accured) for interest. • Produces a periodic interest expense equal to a constant percentage (using market rate) of the carrying value of the bond. • The amortization of the discount or premium is determined by comparing the interest expense with the interest paid. • Total interest expense over the life of the bond is the same as that using the straight-line method. Given: Face Value = 100,000 Market Rate = 10% Bond Maturity = 5 years Coupon Rate = 8% Compute the Bond- Discount Amortization table using effective interest methond semi annual interest payments. Cash/Intere Interest Discount Carrying Amount of Date st Paid Expense Amortized Bonds 01/01/11 $92,278 07/01/11 $4,000 $4,614 $614 $92,892 01/01/12 $4,000 $4,645 $645 $93,537 07/01/12 $4,000 $4,677 $677 $94,214 01/01/13 $4,000 $4,711 $711 $94,925 07/01/13 $4,000 $4,746 $746 $95,671 01/01/14 $4,000 $4,783 $783 $96,454 07/01/14 $4,000 $4,823 $823 $97,277 01/01/15 $4,000 $4,864 $864 $98,141 07/01/15 $4,000 $4,907 $907 $99,048 01/01/16 $4,000 $4,952 $952 $100,000 $40,000 $47,722 $7,722 Carrying Value: PV=> 92,278 N=10, I/Y = 5, PMT= -4,000 [(.08 x 100,000) /2], FV=-100,000 Cash/Interest Paid: 4,000 = $100,000 x .08 / 2 Interest Expense: 4,614 = $92,278 x 0.10 / 2 Discount Amortized: $614 = $4,614 - $4,000 Carrying Amount of Bonds: $92,898 = $92,278 + $614 Journal entry to record the bond issuance is Cash 92,278 Bonds Payable 92,278 Journal entry for first semi-annual payment is: Bond Interest Expense 4,614 Bond Payable 614 Cash 4,000 Given: Face Value = 100,000 Market Rate = 6% Bond Maturity = 5 years Coupon Rate = 8% Compute the Bond-Premium Amortization table using effective interest methond semi annual interest payments. Cash/Interest Carrying Amount Date Paid Interest Expense Premium Amortized of Bonds 01/01/11 07/01/11 $4,000 $3,256 $744 $107,786 01/01/12 $4,000 $3,234 $966 $107,019 07/01/12 $4,000 $3,211 $789 $106,230 01/01/13 $4,000 $3,187 $813 $105,417 07/01/13 $4,000 $3,162 $837 $104,579 01/01/14 $4,000 $3,137 $863 $103,717 07/01/14 $4,000 $3,112 $888 $102,828 01/01/15 $4,000 $3,085 $915 $101,913 07/01/15 $4,000 $3,257 $943 $100,971 01/01/16 $4,000 $3,029 $971 $100,000 $40,000 $31,470 $8,530 Carrying Value: PV=> 108,530 N=10, I/Y = 3, PMT= -4,000 [(.08 x 100,000) /2], FV=-100,000 Cash/Interest Paid: $4,000 = $100,000 x .08 / 2 Interest Expense: $3,256 = $108,530 x 0.06 / 2 Discount Amortized: $744 = $4,000 - $3,256 Carrying Amount of Bonds: $107,786 = $108,530 - $744 Journal entry to record the bond issuance is Cash 108,350 Bonds Payable
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