AFM 101 - Chapter 11 Notes.docx

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Accounting & Financial Management
AFM 101
Donna Psutka

Chapter 11: Reporting and Interpreting Non-Current Liabilities November 10, 2013 4:28 PM Non- Current Liabilities: Are all of the entity's obligations not classified as current liabilities Financial Leverage: is the use of borrowed funds to increase the rate of return on owners' equity; it occurs when the after-tax interest rate on debt is lower than the rate of return on total assets Characteristics of Long-Term Notes and Bonds Payable  Raising debt from financial service organizations, is known as Private Placement o Often called a Note Payable: a written promise to pay a stated sum of money at one or more specified future dates, called the Maturity Date  A company may issue bonds to raise more money than a creditor can provide o Bonds can be traded in established markets that provide bondholders with liquidity  Lenders often want their loans to be secured as opposed to unsecured o Personal Credit is usually unsecured o Whereas when you purchase a vehicle its secured  Secured debt provides the creditor with the right to foreclose on the debt and repossess the assets, or collateral, pledged by the company as security should the company violate the terms of its debt contract  A bond usually requires the payment of interest over its life, with the repayment of principal on the maturity date  The bond principal: is the amount payable at the maturity of the bond. It is also the basis for computing periodic cash interest payments o The principal is also called the Par Value/ Face Amount o Stated Rate: is the rate of interest per period specified in the bond contract  Companies design bond features that are attractive to different groups of creditors  Different types of bonds:  Unsecured Bonds (Debenture Bonds): is an unsecured bond; no assets are specifically pledged to guarantee repayment  Secured Bonds: Specific assets are pledged as a guarantee of repayment at maturity Callable Bond: may be called for early retirement at the option of the issuer   Convertible Bonds: may be converted to other securities of the issuer (usually common shares)  When a company decides to issue new bonds, it prepares a bond indenture  Indenture: is a bond contract that specifies the legal provisions of a bond issue  Provisions include: maturity date, rate of interest to be paid, date of each interest payment, and any conversion privileges  Also includes covenants designed to protect the creditor  They are usually included in the notes of the financial statements  Bond issuer also prepares a prospectus - a legal document given to potential bond investors  When a bond is issued, the investors receive a bond certificate  Bond Certificate: is the bond document that each bondholder receives  Trustee: is an independent party appointed to represent bondholders Players in the Bond Market  Most companies work with an underwriter - an individual who buys the entire issue of bonds and then resells them to individual creditors or simply sells them without any obligation to purchase them  Bond dealers sell bonds to institutional investors such as banks, insurance companies, and mutual pension funds  Almost all trades occur over the telephone or over the counter, not through a formal bond exchange  There are many agencies to measure the risk that a company may not be able to repay the bond value and the interest  Risk is called default risk -the higher the risk the higher the interest rate  Bond Prices change for two main reasons:  Change in creditworthiness of the bond issuer  Change in interest rates  Depends on the rate at which the government can borrow money for the long term  This is the risk-free rate of return on bonds because purchasers believe that the federal government will never fail to repay or default on its debt  All other rates are established relative to the risk-free rate  The difference between the two rates is called the Spread Reporting Bond Transactions  Each bond indenture specifies two types of cash payments: Principal (Par/Face Value) - the single payment made on the maturity date Cash Interest Payments: Computed by multiplying the principal times the interest rate, called the contract, stated or coupon rate in the bond contract  The contract specifies whether it is paid quarterly, semi-annually, or annually,  Market determines the current cash equivalent of future interest and principal payments by using the present value concepts o Creditors demand the Market Interest Rate: the current rate of interest on a debt when incurred; also called the yield, or effective interest rate o The present value of a bond may be the same as par, above par (bond premium) or below par (bond discount)  Bond Premium: is the difference between the selling price and par when the bond is sold for more than par  Bond Discount: is the difference between the selling price and par when the bond is sold for less than par Bonds Issued at Par  When buyers are willing to invest in them at the interest rate stated on the bond  To calculate the present value of the bond you will have to use a table (it can be found in appendix 5B)  When the effective rate of interest equals the stated rate of interest, the present value of the future cash flows associated with a bond always equals the bonds par value  The journal entry for issuing bonds: Cash Bond Payable  The Journal Entry for paying the expense: Bond Interest Expense Cash  Interest expense incurred but not paid must be accrued with an adjusting entry. Bonds Issued at Discount  When the market rate of interest demanded by the buyers is higher then the stated interest rate offered by the issuer  Journal Entry: Cash Discount on bonds payable Bonds Payable  Reporting Interest Expense on Bonds issued at a Discount:  Effective Interest Method: amortizes a bond discount or premium on the basis of the effective interest rate Step 1 : Compute Interest Expense Unpaid balance x Effective interest x n/12 = n (number of months In each interest period) Step 2: Compute Amortization Amount Amortization of bond discount = Interest Expense - Interest paid (or accrued)  Journal Entry to record the periodic interest expense: Bond Interest Expense Discount on Bonds Payable Cash Bonds Issued at a Premium  When the market rate of interest is lower than the stated interest rate  Journal Entry: Cash Premium on Bonds Payable Bonds Payable  Reporting Interest Expense on Bonds issued at a Premium:  You would have to use the same method as the
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