Accounting for Long-Term

Debt

Acct 2210 Chp 10 &

Appendix “F” (pg 773-779)

McGraw-Hill/IrwinMcGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Show how an installment note affects financial

statements.

LO 1

10-2

Long-term “notes” are liabilities that usually

have terms from two to five years.

Long-term “notes” are liabilities that usually

have terms from two to five years.

Each payment covers interest for the period and a

portion of the principal.

Each payment covers interest for the period and a

portion of the principal.

With each payment, the interest portion gets smaller and the principal portion gets larger.

With each payment, the interest portion gets smaller and the principal portion gets larger.

Principal

CompanyLender

Payments

Long-Term Notes Payable

10-3

Applying payments to principal and interest Identify the unpaid principal balance. Calculate the interest = Unpaid principal

balance × Interest rate. Amount applied to principal = Cash payment

– Amount applied to interest in . Unpaid principal balance = Unpaid principal

balance in – Amount applied to principalin .

Applying payments to principal and interest Identify the unpaid principal balance. Calculate the interest = Unpaid principal

balance × Interest rate. Amount applied to principal = Cash payment

– Amount applied to interest in . Unpaid principal balance = Unpaid principal

balance in – Amount applied to principalin .

Long-Term Notes Payable

10-4

On January 1, 2013, Blair Company issued a $100,000 face value long-term note to National Bank. The note had a 9% annual interest rate and a five-year term. The loan agreement called for five equal payments of $25,709 to be made on December 31 of each year.

Prepare an amortization table for Blair’s note.

On January 1, 2013, Blair Company issued a $100,000 face value long-term note to National Bank. The note had a 9% annual interest rate and a five-year term. The loan agreement called for five equal payments of $25,709 to be made on December 31 of each year.

Prepare an amortization table for Blair’s note.

Long-Term Notes Payable

10-5

Long-Term Notes Payable

10-6

$-

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

Year 1 Year 2 Year 3 Year 4 Year 5

Interest

Principal

The amount applied to the principal increases each year. The amount of interest

decreases each year.

The amount applied to the principal increases each year. The amount of interest

decreases each year.

Annual payments

are constant.

Long-Term Notes Payable

10-7

Long-Term Notes Payable

Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

100,000 = 100,000 + NA NA – NA = NA 100,000 FA

Issuing the note has the following effecton Blair’s 2013 financial statements:Issuing the note has the following effecton Blair’s 2013 financial statements:

Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

(25,709) = (16,709) + (9,000) NA – 9,000 = (9,000) (9,000) OA

(16,709) FA

The December 2013 cash payment has the followingeffect on Blair’s 2013 financial statements:The December 2013 cash payment has the followingeffect on Blair’s 2013 financial statements:

10-8

Impact on Financial Statements

10-9

Show how a line of credit

affects financial

statements.

LO 2

10-10

Line of Credit

•Enable the company to more easily borrow and repay funds.

•Usually specify a maximum credit line.•Normally used for short-term borrowing

to finance seasonal business needs.

•Enable the company to more easily borrow and repay funds.

•Usually specify a maximum credit line.•Normally used for short-term borrowing

to finance seasonal business needs.

10-11

Describe bond features and

show how bonds issued at face value affect

financial statements.

LO 3

10-12

Long-term borrowing of a large sum of money, called the principal.

Principal is usually paid back as a lump sum at maturity.

Individual bonds are often denominated with a face value of $1,000.

Long-term borrowing of a large sum of money, called the principal.

Principal is usually paid back as a lump sum at maturity.

Individual bonds are often denominated with a face value of $1,000.

Bond Liabilities

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Periodic interest payments based on a stated rate of interest.

Interest is paid semiannually. Interest paid is computed as:

Interest = Principal × Stated Interest Rate × Time Bond prices are quoted as a percentage of

the face amount.For example, a $1,000 bond priced at 104 would sell for $1,040.

Periodic interest payments based on a stated rate of interest.

Interest is paid semiannually. Interest paid is computed as:

Interest = Principal × Stated Interest Rate × Time Bond prices are quoted as a percentage of

the face amount.For example, a $1,000 bond priced at 104 would sell for $1,040.

Bond Liabilities

10-14

Bond Certificateat Face Value

Bond Certificateat Face Value

Bond Issue Date

Bond Selling Price

Corporation Investors

Bond Liabilities

10-15

Bond Issue Date

Bond Interest Payments

Bond Interest Payments

Corporation Investors

Interest Payment = Principal × Interest Rate × Time

Interest Payment = Principal × Interest Rate × Time

Bond Liabilities

10-16

Bond Issue Date

Bond Principalat Maturity Date

Bond Maturity

Date

Corporation Investors

Bond Liabilities

10-17

Bond Liabilities

Advantages of bonds Longer term to maturity than notes payable issued to banks.

Bond interest rates are usually lower than bank loan rates.

Advantages of bonds Longer term to maturity than notes payable issued to banks.

Bond interest rates are usually lower than bank loan rates.

10-18

Secured and Unsecured

Secured and Unsecured

Term and Serial

Term and Serial

Convertible and CallableConvertible and Callable

Characteristics of Bonds

10-19

Mason Company issues bonds on January 1, 2013.Principal = $100,000Stated Interest Rate = 9%Interest Paid Annually on 12/31Maturity Date = December 31, 2017 (5 years)

Mason Company issues bonds on January 1, 2013.Principal = $100,000Stated Interest Rate = 9%Interest Paid Annually on 12/31Maturity Date = December 31, 2017 (5 years)

Bond Certificateat Face Value

Bond Certificateat Face Value

Bond Selling Price

Mason Company Investors

Bonds Issued at Face Value

10-20

Bonds Issued at Face Value

Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

100,000 = 100,000 + NA NA – NA = NA 100,000 FA

Issuing the bonds has the following effecton Mason’s 2013 financial statements:Issuing the bonds has the following effecton Mason’s 2013 financial statements:

To record the bond issue, Mason makes the following entry on January 1, 2013:To record the bond issue, Mason makes the following entry on January 1, 2013:

Account Title Debit CreditCash 100,000 Bonds Payable 100,000

10-21

Bonds Issued at Face Value

Bond Interest Payments

Mason Company Investors

On each interest payment date, Mason will pay $9,000 in interest. The amount is computed as follows:

On each interest payment date, Mason will pay $9,000 in interest. The amount is computed as follows:

$100,000 × 9% = $9,000 $100,000 × 9% = $9,000

10-22

Bonds Issued at Face Value

Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

(9,000) = NA + (9,000) NA – 9,000 = (9,000) (9,000) OA

The December 31, 2013, interest payment (and all other annual interestpayments) has the following effect on Mason’s financial statements:

The December 31, 2013, interest payment (and all other annual interestpayments) has the following effect on Mason’s financial statements:

To record an interest payment, Mason makes the following entry on each December 31:To record an interest payment, Mason makes the following entry on each December 31:

Account Title Debit CreditInterest Expense 9,000 Cash 9,000

10-23

Bonds Issued at Face Value

Bond Principalat Maturity Date

Mason Company

Investors

On December 31, 2017, Mason will return the $100,000 principal amount to the

investors.

On December 31, 2017, Mason will return the $100,000 principal amount to the

investors.

10-24

Bonds Issued at Face Value

Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

(100,000) = (100,000) + NA NA – NA = NA (100,000) FA

The principal repayment on December 31, 2017, will have thefollowing effect on Mason’s 2017 financial statements:

The principal repayment on December 31, 2017, will have thefollowing effect on Mason’s 2017 financial statements:

To record an the principal repayment, Mason Company would makethe following entry on December 31, 2017:

To record an the principal repayment, Mason Company would makethe following entry on December 31, 2017:

Account Title Debit CreditBonds Payable 100,000 Cash 100,000

10-25

Bonds Issued at Face Value

10-26

Bonds Issued at a Discount

If bonds of other companies are yielding more than 9%, investors will be unwilling to pay the full face amount for Mason’s 9% bonds. The issue price of Mason’s 9% bonds will have to be lower to entice investor interest. The difference between the lower issue price and the principal of $100,000 is called a discount.

Let’s continue the Mason Company example.

If bonds of other companies are yielding more than 9%, investors will be unwilling to pay the full face amount for Mason’s 9% bonds. The issue price of Mason’s 9% bonds will have to be lower to entice investor interest. The difference between the lower issue price and the principal of $100,000 is called a discount.

Let’s continue the Mason Company example. 10-27

Principal

Cash Proceeds Discount

100,000$ - 95,000$ = 5,000$

Bonds Issued at a Discount

Mason Company issues bonds on January 1, 2013.Principal = $100,000Issue Price = $95,000Stated Interest Rate = 9%Interest Date = 12/31Maturity Date = Dec. 31, 2017 (5 years)

Mason Company issues bonds on January 1, 2013.Principal = $100,000Issue Price = $95,000Stated Interest Rate = 9%Interest Date = 12/31Maturity Date = Dec. 31, 2017 (5 years)

The only change fromprevious Mason example.

10-28

Bonds Issued at a Discount

Assets = + Equity Rev. – Exp. = Net Inc. Cash Flow

Cash Bonds Pay. – Discount + Ret. Earn.

95,000 = 100,000 – 5,000 + NA NA – NA = NA 95,000 FA

Liabilities

Issuing the bonds at a discount has the followingeffect on Mason’s 2013 financial statements:Issuing the bonds at a discount has the followingeffect on Mason’s 2013 financial statements:

To record the bond issue, Mason Company wouldmake the following entry on January 1, 2013:To record the bond issue, Mason Company wouldmake the following entry on January 1, 2013:

Account Title Debit CreditCash 95,000 Discount on Bonds Payable 5,000 Bonds Payable 100,000

10-29

Partial Balance Sheet as of January 1, 2013

Long-term Liabilities: Bonds Payable 100,000$ Less: Discount on Bonds Payable 5,000 95,000$

Face ValueFace Value

Carrying ValueCarrying Value

Bonds Issued at a Discount

10-30

Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

(100,000) = (100,000) + NA NA – NA = NA (95,000) FA (5,000) OA

The principal repayment on December 31, 2017, will have thefollowing effect on Mason’s 2017 financial statements:The principal repayment on December 31, 2017, will have thefollowing effect on Mason’s 2017 financial statements:

To record an the principal repayment, Mason Company would makethe following entry on December 31, 2017:To record an the principal repayment, Mason Company would makethe following entry on December 31, 2017:

Account Title Debit CreditBonds Payable 100,000 Cash 100,000

Bonds Issued at a Discount

10-31

Bonds Issued at a Premium

If bonds of other companies are yielding less than 9%, investors will be willing to pay more than the face amount for Mason’s 9 percent bonds. The issue price of Mason’s 9% bonds will rise because of investor demand for the 9% bonds. The difference between the higher issue price and the principal of $100,000 is called a premium.

Let’s continue the Mason Company example.

If bonds of other companies are yielding less than 9%, investors will be willing to pay more than the face amount for Mason’s 9 percent bonds. The issue price of Mason’s 9% bonds will rise because of investor demand for the 9% bonds. The difference between the higher issue price and the principal of $100,000 is called a premium.

Let’s continue the Mason Company example.

10-32

Cash Proceeds

Bonds Payable Premium

105,000$ - 100,000$ = 5,000$

Mason Company issues bonds on January 1, 2013.Principal = $100,000Issue Price = $105,000Stated Interest Rate = 9%Interest Date = 12/31Maturity Date = Dec. 31, 2017 (5 years)

Mason Company issues bonds on January 1, 2013.Principal = $100,000Issue Price = $105,000Stated Interest Rate = 9%Interest Date = 12/31Maturity Date = Dec. 31, 2017 (5 years)

The only change from theoriginal Mason example.

Bonds Issued at a Premium

10-33

Assets = + Equity Rev. – Exp. = Net Inc. Cash Flow

Cash Bonds Pay. + Premium + Equity

105,000 = 100,000 + 5,000 + NA NA – NA = NA 105,000 FA

Liabilities

Issuing the bonds at a premium has the followingeffect on Mason’s 2013 financial statements:Issuing the bonds at a premium has the followingeffect on Mason’s 2013 financial statements:

To record the bond issue, Mason Company wouldmake the following entry on January 1, 2013:To record the bond issue, Mason Company wouldmake the following entry on January 1, 2013:

Account Title Debit CreditCash 105,000 Premium on Bonds Payable 5,000 Bonds Payable 100,000

Bonds Issued at a Premium

10-34

Partial Balance Sheet as of January 1, 2013

Long-term Liabilities: Bonds Payable 100,000$ Add: Premium on Bonds Payable 5,000 105,000$

Face ValueFace Value

Carrying ValueCarrying Value

Bonds Issued at a Premium

10-35

Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

(100,000) = (100,000) + NA NA – NA = NA (100,000) FA

The principal repayment on December 31, 2017, will have thefollowing effect on Mason’s 2017 financial statements:The principal repayment on December 31, 2017, will have thefollowing effect on Mason’s 2017 financial statements:

To record an the principal repayment, Mason Company would makethe following entry on December 31, 2017:To record an the principal repayment, Mason Company would makethe following entry on December 31, 2017:

Account Title Debit CreditBonds Payable 100,000 Cash 100,000

Bonds Issued at a Premium

10-36

L.O.5: Considering the Market Rate of Interest

The selling price of a bond is determined by the market rate of interest versus the stated

rate of interest.

Interest Bond Accounting forRates Price the Difference

Stated Market Bond Face Value There is no differenceRate Rate Price of the Bond to account for.

Stated Market Bond Face Value The difference is accountedRate Rate Price of the Bond for as a bond discount.

Stated Market Bond Face Value The difference is accountedRate Rate Price of the Bond for as a bond premium.

=

>

<

>

<

=

10-37

Use the “effective

interest rate” method to

amortize bond discounts and

premiums.

LO 5: We will use this method for our in-class case study

10-38

Effective Interest Rate Method:See pg 553/554 example discussion

Effective interest is a more accurate way to

amortize bond discounts and

premiums.

It correctly reflects the bond’s changing carrying value.

10-39

Effective Interest Rate Method: See pg 553/554 example discussion

Let’s assume Mason Company uses the effective interest method on its $100,000 bond.

Step 1:Determine the cash payment for interest. Note: the ONLY time the stated (contract) rate is used is for this one calculation (to determine the actual interest to be paid). ALL other calculations use the market rate because we are “tailoring” the bond to the investor’s required rate of return.

Step 1:Determine the cash payment for interest. Note: the ONLY time the stated (contract) rate is used is for this one calculation (to determine the actual interest to be paid). ALL other calculations use the market rate because we are “tailoring” the bond to the investor’s required rate of return.

Face value of bondX Stated rate of interest

Cash payment

Face value of bondX Stated rate of interest

Cash payment

$ 100,000X .09$ 9,000

$ 100,000X .09$ 9,000

10-40

Effective Interest Rate Method: See pg 553/554 example discussion

Step 2: Determine the amount of interest expense, assumingthe investor requires a market (effective) rate of return of 10.33%.Complete this example in conjunction with the pg 554 discussionin our text as you work through these slides.

Step 2: Determine the amount of interest expense, assumingthe investor requires a market (effective) rate of return of 10.33%.Complete this example in conjunction with the pg 554 discussionin our text as you work through these slides.

Carrying value of bond liabilityX Effective rate of interest

Interest expense

Carrying value of bond liabilityX Effective rate of interest

Interest expense

$ 95,000X .1033$ 9,814

$ 95,000X .1033$ 9,814

$100,000 face value - $5,000 discount = $95,000 carrying value$100,000 face value - $5,000 discount = $95,000 carrying value

10-41

Effective Interest Rate Method

Step 3:Determine the amortization of the bond discount.Step 3:Determine the amortization of the bond discount.

Interest expense- Cash payment

Discount amortization

Interest expense- Cash payment

Discount amortization

$ 9,814- 9,000$ 814

$ 9,814- 9,000$ 814

Step 4:Update the carrying value of the bond liability.Step 4:Update the carrying value of the bond liability.

Discount amortization+ Beginning carrying value

Ending carrying value

Discount amortization+ Beginning carrying value

Ending carrying value

$ 814+ $ 95,000

$ 95,814

$ 814+ $ 95,000

$ 95,814

10-42

Effective Interest Rate Method

* The decrease in the amount of the discount increases the amount of the bond liability.

10-43

Effective Interest Rate Method

Notice that when using the effective interest

method, interest expense increases each year.

Notice that when using the effective interest

method, interest expense increases each year.

10-44

Explain the advantages

and disadvantages

of debt financing.

LO 6

10-45

Financial Leverage and Tax Advantage of Debt Financing

Financial leverage: Debt financing can increase return on equity when the borrower earns more on the borrowed funds than it

pays in interest. As this example shows, the cost of financing is the same, but debt financing has a tax advantage.

Financial leverage: Debt financing can increase return on equity when the borrower earns more on the borrowed funds than it

pays in interest. As this example shows, the cost of financing is the same, but debt financing has a tax advantage.

10-46

Times Interest Earned Ratio

Times InterestEarned =

Net income + Interest expense + Income tax expense

Interest expense

The ratio shows the amount of resources generated for each dollar of interest expense. In general, a high ratio

is viewed more favorable than a low ratio.

The ratio shows the amount of resources generated for each dollar of interest expense. In general, a high ratio

is viewed more favorable than a low ratio.

Numerator is commonly called EBIT,Earnings before interest and taxes.Numerator is commonly called EBIT,Earnings before interest and taxes.

10-47

End of Chapter Ten

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