MGTB06 Chapter 11 Notes.docx

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Financial Accounting
G.Quan Fun

MGTB06 Chapter 11—Reporting and Interpreting Non-Current Liabilities non-current liabilities are all of the entity’s obligations that are not classified as current liabilities, typically require payment more than one year in the future long-term debt reflects a contractual obligation whereby the borrower receives cash or other assets in exchange for a promise to pay the lender a fixed or determinable amount of money at a specific date in the future financial leverage is the use of borrowed funds to increase the rate of return on owners’ equity after-tax interest rate on debt is lower than the rate of return on total assets Characteristics of Long-Term Notes and Bonds Payable in cases where a company’s need for debt capital exceeds the financial capability of any single creditor, a company may issue publicly traded debt known as bonds 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 requires the payments of interest over its life, with the repayment of principle on the maturity date the bond principle is the amount payable at the maturity of the bond and is the basis for computing periodic cash interest payments; also called par value, face amount and maturity value the stated rate is the rate of interest per period specified in the bond contract types of bonds a debenture is an unsecured bond, no assets are specifically pledged to guarantee repayment in a secured bond specific assets are pledged as a guarantee of repayment at maturity callable bonds may be called for early retirement at the option of the issuer convertible bonds may be converted to other securities of the issuers (e.g. common shares) an indenture is a bond contract that specifies the legal provisions of a bond issue a prospectus is also prepared by the bond issuer and it describes the company, the bond and how the proceeds of the bond will be used Players in the Bond Market an underwriter either buys the entire issue of bonds and then resells them to individual creditors or simply sells the bonds or notes without any obligation to purchase them bond dealers sell bonds, typically to institutional investors such as banks, insurance companies and mutual and pension funds the higher the risk of default, the higher the interest rate required to successfully persuade investors to purchase the bond and the more restrictive will be the covenants protecting the bondholder bond prices change for two main reasons: change in creditworthiness of the bond issuer and changes in interest rates spread is the difference between the interest rate on debt instruments and the risk-free rate (rate at which the federal government can borrow money long-term), and the size of spread depends on the perceived additional risk that the company will default on either its interest or principle payments on the debt Reporting Bond Transactions the coupon rate is the stated rate of interest on bonds each bond indenture specifies two types of cash payments: the principle which is paid out when the bond matures and cash interest payments which are made based on when the bond contract specifies to determine the present value of the bond you must compute the present value of the principle (a single payment) and the present value of the interest payments (an annuity) and add the two amounts the market interest rate is the current rate of interest on a debt when incurred, also called the yield and effective interest rate if the stated and market interest rates are the same, a bond sells at par bond premium is the difference between the selling price and par when the bond pays a stated interest rate that the higher than market rate bond discount is the difference between the selling price and par when the bond pays a stated interest rate that is lower than the market rate corporations and creditors are indifferent to whether a bond is issued at par, discount or premium because bonds are always priced to provide the market rate of interest changes in daily bond prices do not affect the company’s financial statement, the company uses the interest rates that existed when the bonds were first sold to public Bonds Issued at Par bonds sell at their par value when buyers are willing to invest in them at the interest rate stated on the bond when the effective rate of interest equals the stated rate of interest the present value of the future cash flows associated with the bond equals the bond’s par value a bond’s selling price is determined by the present value of its future cash flows, not the par value Bonds Issued at a Discount bonds sell at a discount when the market rate of interest demanded by the buyers is higher than the stated interest rate offered by the issuer to calculate the present value of future cash flows in the case of a discount, we use the market rate of interest and the issue price comes out lower than the at par value the discount is recorded in a separate contra-liability account as a debit; balance sheet reports bonds payable at their carrying amount, which is their maturity amount less any unamortized discount to calculate interest expense, the borrow amortizes the bond discount to each interest period as an increase to the interest payment, amortization of bond discount is an increase to bond interest expense each period the amortization of the bond discount increases the bond’s carrying amount (or unpaid balance), the amortization of the bond discount is interest that was earned by the bondholders but not paid, it will be paid when the bond matures interest expense increases each year during the life of the bond because the amortized bond discount reflects unpaid interest on an increasing amount Bonds Issued at a Premium  bonds sell at a premium when the market rate of interest is l
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