AFM101 Textbook and Lecture notes on Chapter 11:Reporting and Interpreting Non-current liabilities AND ARTICLES

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Accounting & Financial Management
AFM 101
Donna Psutka

Chapter 11 notes – Reporting and Interpreting Non-current liabilities Characteristics of Long-term notes and bonds payable - Raising long-term debt from financial service organizations is called private placement - This type of debt is called a note payable, written promise to pay a stated sum of money at one or more specified future dates called maturity dates - Company’s need for debt capital exceeds capability of any single creditor, issue bonds - Secured or unsecured loans -> secured means can repossess lender’s items - A bond principal is called the par value, face amount, and maturity value, amount that will be paid when bond matures. Most Canadian par value bonds are $1000 - Stated rate is rate of interest per period specified in bond contract - A debenture is an unsecured bond; no assets are specifically pledged to guarantee repayment - Callable bonds 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 - An indenture is a bond contract that specifies the legal provisions of a bond issue - A bond certificate is the bond document that each bondholder receives - A trustee is an independent party appointed to represent the bondholders Players in the Bond Market - Firm commitment underwriter is an underwriter that buys the entire issue of bonds and then resells them to individual creditors - Best efforts underwriter sells the bonds or notes without any obligation to purchase them - Almost all trades occur by telephone (over the counter), not through formal bond exchange - Default risk is the probability the bond issuer will default on the indenture bond - bond prices change for two reasons: changes in creditworthiness of bond inssuer, and changes in interest rates - Rate at which federal government can borrow money is the risk-free rate - Spread is the difference between interest rate on a specific bond and the risk-free rate, depends on perceived additional risk of the company defaulting on interest or principal payments Reporting Bond Transactions - Each bond indenture specifies: o Principal which is payment made when bond matures, aka par or face value o Cash interest payments aka contract, stated, or coupon rate - To determine the present value of the bond, you compute the present value of the principal and the present value of the interest payments and add the two amounts - Market interest rate is the current rate of interest on a debt when incurred, aka yield or effective interest rate - The present value of a bond may be par, above par (bond premium), or below par (bond discount) - Corporations and creditors are indifferent to whether a bond is issued at par, at discount, or premium because same return Bonds issued at Par Cash (A) 400,000 Bonds Payable (L) 400,000 Date of Issue of bond issued at par Bond Interest Expense (E) 20,000 Cash (A) 20,000 Interest on bonds issued at par Bonds Issued at a Discount - Only use stated interest to calculate the individual interest payments - Number of total periods is years x periods in each year (10 years semi-annually is 20 periods) - Use the market rate/number of periods in a year as the interest rate to determine present value of the principal and the present value of the annuity, and add them together to find issue (sale) price Cash (A) 354,118 Discount on bonds payable (XL) 45,882 Bonds payable (L) 400,000 Issue of bond on discount - Effective interest method: o Interest expense is computed by multiplying the amount that was actually borrowed times the market rate of interest that existed on date bonds were sold o Periodic amortization of bond discount or premium is then calculated as difference between interest expense and amount of cash paid (the stated rate x principal) $354,118 x 12% x 6/12 = $21,247 Amount of discount that has been amortized: (21,247 – 20,000 = 1,247) Bond interest expense (E) 21,247 Discount on bonds payable (XL) 1,247 Cash (A) 20,000 First interest payment 355,365 x 12% x 6/12 = 21,322 Amount of discount amortized: (21,322 – 20,000 = 1,322) Bond interest expense (E) 21,322 Discount on bonds payable (XL) 1,322 Cash 20,000 Second interest payment - Interest expense increases when a bond is issued at discount Bonds Issued at a Premium - Like bonds issued at discount, but opposite - Initial issue of bond causes a credit to premium on bonds payable - Amortization of the premium is a debit to premium on bonds payable at every interest payment - Amortization of a discount increases the carrying amount of the bond - Amortization of a premium reduces the carrying amount of the bond - So interest expense decreases as each interest payment goes on for a bond issued at premium Times Interest Earned ratio - Times interest earned ratio = Profit before interest and taxes / interest expense - High ratio is better - Ratio shows amount of profit before interest and income tax that is generated relative to interest expense - Analysts interested because company’s inability to meet required interest payments could result in bankruptcy - Can be misleading for new or rapidly growing companies that tend to invest considerable resources to build capacity - Consider long-term strategy when using this ratio Early Retirement of Debt - Callable bonds can be called for early retirement at the option of the issuer - Retractable bonds may be turned in for early retirement at the option of the bondholder - Convertible bonds may be converted to other securities of the issuer, usually common shares, at the option
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