McGraw-Hill/Irwin Chapter Ten Accounting for LongTerm Debt The

McGraw-Hill/Irwin Chapter Ten Accounting for LongTerm Debt  The

McGraw-Hill/Irwin Chapter Ten Accounting for LongTerm Debt The McGraw-Hill Companies, Inc., 20 LO 1 LO 1 Show how the amortization of long-term notes affects financial statements. 10-2 Long-Term Notes Payable Long-term Long-term notes notes are are liabilities liabilities that that usually usually have have terms terms from from two two to to five five years. years. Principal Payments Company Each

Each payment payment covers covers interest interest for for the the period period and and aa portion portion of of the the principal. principal. Lender With With each each payment, payment, the the interest interest portion portion gets gets smaller smaller and and the the principal principal portion portion gets gets larger. larger. 10-3

Long-Term Notes Payable Applying Applying payments payments to to principal principal and and interest interest Identify Identify the the unpaid unpaid principal principal balance. balance. Amount Amount applied applied to to interest interest == Unpaid Unpaid principal principal balance balance Interest Interest rate. rate. Amount Amount applied applied to to principal principal == Cash Cash payment payment amount amount applied

applied to to interest interest in in . . Unpaid Unpaid principal principal balance balance == Unpaid Unpaid principal principal balance balance in in amount amount applied applied to to principal principal in in . . 10-4 Long-Term Notes Payable On On January January 1, 1, 2008, 2008, Blair Blair Company Company issued issued aa $100,000 $100,000 face face value

value long-term long-term note note to to National National Bank. Bank. The The note note had had aa 99 percent percent annual annual interest interest rate rate and and aa five five year year term. term. The The loan loan agreement agreement called called for for five five equal equal payments payments of of $25,709 $25,709 to to be be made made on on December December 31 31 of

of each each year. year. Prepare Prepare an an amortization amortization table table for for Blairs Blairs note. note. 10-5 Long-Term Notes Payable 10-6 Long-Term Notes Payable Annual payments are constant. $30,000 $25,000 $20,000 Interest Principal $15,000 $10,000 $5,000 $- Year 1

Year 2 Year 3 Year 4 Year 5 The The amount amount applied applied to to the the principal principal increases increases each each year. year. The The amount amount of of interest interest decreases decreases each each year. year. 10-7 Long-Term Notes Payable Issuing Issuing the the note note has has the the following

following effect effect on on Blairs Blairs 2008 2008 financial financial statements: statements: Assets = Liab. + Equity Rev. Exp. = Net Inc. 100,000 = 100,000 + NA

NA NA = NA Cash Flow 100,000 FA The The December December 2008 2008 cash cash payment payment has has the the following following effect effect on on Blairs Blairs 2008 2008 financial financial statements: statements: Assets = Liab. +

Equity Rev. Exp. = Net Inc. (25,709) = (16,709) + (9,000) NA 9,000 = (9,000) Cash Flow (9,000) OA

(16,709) FA 10-8 Impact on Financial Statements 10-9 Security for Bank Loan Agreements To To reduce reduce the the risk risk that that they they will will not not be be repaid, repaid, lenders lenders often: often: Require Require debtors debtors to to pledge pledge collateral collateral to to secure secure the the loan

loan Include Include covenants covenants in in the the loan loan agreement agreement restricting: restricting: Additional Additional borrowing borrowing Dividends Dividends Salary Salary increases. increases. 10-10 LO 2 LO 1 Show how a line of credit affects financial statements. 10-11 Line of Credit Enable Enable the the company company to to borrow

borrow and and repay repay funds funds Usually Usually specify specify aa maximum maximum credit credit line line Normally Normally used used for for short-term short-term borrowing borrowing to to finance finance seasonal seasonal business business needs. needs. 10-12 LO 3 LO 1 Explain how bond liabilities and their related interest costs affect financial statements. 10-13 Bond Liabilities

Significant Significant debt debt needs needs of of aa company company are are often often filled filled by by issuing issuing bonds. bonds. Bond s Cash 10-14 Bond Liabilities Long-term Long-term borrowing borrowing of of aa large large sum sum of of money, money, called called the the principal. principal.

Principal Principal is is usually usually paid paid back back as as aa lump lump sum sum at at maturity. maturity. Individual Individual bonds bonds are are often often denominated denominated with with aa face face value, value, of of $1,000. $1,000. 10-15 Bond Liabilities Periodic Periodic interest interest payments payments based based on on aa stated

stated rate rate of of interest. interest. Interest Interest is is paid paid semiannually. semiannually. Interest Interest paid paid is is computed computed as: as: Interest Interest == Principal Principal Stated Stated Interest Interest Rate Rate Time Time Bond Bond prices prices are are quoted quoted as as aa percentage percentage of of the the face face amount.

amount. For For example, example, aa $1,000 $1,000 bond bond priced priced at at 104 104 would would sell sell for for $1,040. $1,040. 10-16 Bond Liabilities Bond Selling Price Corporation Bond Certificate at Face Value Investors Bond Issue Date 10-17 Bond Liabilities Bond Interest Payments Corporation

Bond Issue Date Bond Interest Payments Investors Interest Payment = Principal Interest Rate Time 10-18 Bond Liabilities Bond Principal at Maturity Date Corporation Bond Issue Date Investors Bond Maturity Date 10-19 Bond Liabilities Advantages Advantages of of bonds bonds Longer

Longer term term to to maturity maturity than than notes notes payable payable issued issued to to banks. banks. Bond Bond interest interest rates rates are are usually usually lower lower than than bank bank loan loan rates. rates. 10-20 Characteristics of Bonds Term Term and and Serial Serial Secured

Secured and and Unsecured Unsecured Convertible Convertible and and Callable Callable 10-21 Bonds Issued at Face Value Mason Mason Company Company issues issues bonds bonds on on January January 1, 1, 2008. 2008. Principal Principal == $100,000 $100,000 Stated Stated Interest Interest Rate Rate == 9% 9% Interest Interest Paid Paid Annually Annually on on 12/31 12/31 Maturity

Maturity Date Date == Dec. Dec. 31, 31, 2012 2012 (5 (5 years) years) Bond Selling Price Mason Company Bond Certificate at Face Value Investors 10-22 Bonds Issued at Face Value Issuing Issuing the the bonds bonds has has the the following following effect effect on on Masons Masons 2008 2008 financial financial statements: statements: Assets = Liab.

+ Equity Rev. Exp. = Net Inc. Cash Flow 100,000 = 100,000 + NA NA NA = NA 100,000 FA

To To record record the the bond bond issue, issue, Mason Mason makes makes the the following following entry entry on on January January 1, 1, 2008: 2008: Account Title Cash Bonds Payable Debit 100,000 Credit 100,000 10-23 Bonds Issued at Face Value On On each each interest interest payment payment date, date, Mason Mason will will pay pay $9,000

$9,000 in in interest. interest. The The amount amount is is computed computed as as follows: follows: $100,000 9% = $9,000 Bond Interest Payments Mason Company Investors 10-24 Bonds Issued at Face Value ee December December 31, 31, 2008 2008 interest interest payment payment (and (and all all other other annual annual inter inter yments) yments) has has the the following following effect effect on

on Masons Masons financial financial statements: statements: Assets = (9,000) = Liab. + Equity Rev. NA + (9,000) NA Exp. 9,000 = Net Inc. = Cash Flow (9,000) (9,000) OA To To record

record an an interest interest payment, payment, Mason Mason makes makes the the following following entry entry on on each each December December 31: 31: Account Title Interest Expense Cash Debit 9,000 Credit 9,000 10-25 Bonds Issued at Face Value On On December December 31, 31, 2012, 2012, Mason Mason will will return return the the $100,000 $100,000 principal principal amount

amount to to the the investors. investors. Bond Principal at Maturity Date Mason Company Investors 10-26 Bonds Issued at Face Value The The principal principal repayment repayment on on December December 31, 31, 2012 2012 will will have have the the ollowing effect following effect on on Masons Masons 2012 2012 financial financial statements: statements: Assets =

Liab. + Equity (100,000) = (100,000) + NA Rev. Exp. NA NA = Net Inc. = NA Cash Flow (100,000) FA To To record record an an the the principal principal repayment, repayment, Mason Mason Company Company would

would mak mak he following the following entry entry on on December December 31, 31, 2012: 2012: Account Title Bonds Payable Cash Debit 100,000 Credit 100,000 10-27 Bonds Issued at Face Value 10-28 Bonds Issued at Face Value 10-29 LO 4 LO 1 Use the straightline method to amortize bond discounts and premiums. 10-30

Bonds Issued at a Discount If bonds of other companies are yielding more than 9 percent, investors will be unwilling to pay the full face amount for Masons 9 percent bonds. The issue price of Masons 9 percent 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. Lets continue the Mason Company 10-31 Bonds Issued at a Discount Mason Mason Company Company issues issues bonds bonds on on January January 1, 1, 2008. 2008. Principal Principal = = $100,000 $100,000 The only change Issue price = $95,000 Issue price = $95,000 from Stated Stated Interest

Interest Rate Rate = = 9% 9% previous Mason Interest Interest Date Date = = 12/31 12/31 example. Maturity Maturity Date Date = = Dec. Dec. 31, 31, 2012 2012 (5 (5 years) years) Principal $ 100,000 Cash Proceeds Discount - $ 95,000 = $ 5,000 10-32 Bonds Issued at a Discount Issuing Issuing the the bonds bonds at at aa discount discount has

has the the following following effect effect on on Masons Masons 2008 2008 financial financial statements: statements: Assets = Cash 95,000 = Liabilities Bonds Pay. 100,000 + Discount Equity Rev. Exp. NA NA

= Net Inc. Cash Flow = 95,000 FA + Ret. Earn. 5,000 + NA NA To To record record the the bond bond issue, issue, Mason Mason Company Company would would make make the the following following entry entry on on January January 1, 1, 2008: 2008: Account Title Cash Discount on Bonds Payable

Bonds Payable Debit 95,000 5,000 Credit 100,000 10-33 Bonds Issued at a Discount Partial Partial Balance Balance Sheet Sheet as as of of January January 1, 1, 2008 2008 Long-term Long-term Liabilities: Liabilities: Bonds Bonds Payable Payable Less: Less: Discount Discount on on Bonds Bonds Payable Payable $$ 100,000 100,000 5,000 5,000 $$ 95,000

95,000 Face Value Carrying Value 10-34 Bonds Issued at a Discount Amortizing Amortizing the the discount discount over over the the term term of of the the bond bond increases increases Interest Interest Expense Expense each each interest interest payment payment period. period. Using Using the the straight-line straight-line method, method, the the discount discount amortization amortization will will be

be $1,000 $1,000 every every year. year. $5,000 $5,000 55 years years == $1,000 $1,000 10-35 Bonds Issued at a Discount The The December December 31, 31, 2008 2008 interest interest payment payment (and (and all all other other annual annual interest interest payments) payments) has has the the following following effect effect on on Masons Masons financial financial statements: statements: Assets =

Cash (9,000) = Liabilities Bonds Pay. NA Discount + Equity + Equity (1,000) + (10,000) Rev. Exp. = Net Inc. NA 10,000 =

Cash Flow (10,000) (9,000) OA To To record record an an interest interest payment, payment, Mason Mason Company Company would would make make the the following following entry entry on on each each December December 31: 31: Account Title Interest Expense Liability Discount on Bonds Payable Contra decrease with a credit Cash Debit 10,000 Credit 1,000 9,000 10-36

Bonds Issued at a Discount $5,000 $1,000 = $4,000 Partial Partial Balance Balance Sheet Sheet as as of of December December 31, 31, 2008 2008 Long-term Long-term Liabilities: Liabilities: Bonds Bonds Payable Payable Less: Less: Discount Discount on on Bonds Bonds Payable Payable $$ 100,000 100,000 4,000 4,000 $$ 96,000 96,000 Face Value The carrying value will increase to exactly $100,000 on the maturity date. Carrying Value

10-37 Bonds Issued at a Discount The The principal principal repayment repayment on on December December 31, 31, 2012 2012 will will have have the the ollowing effect following effect on on Masons Masons 2012 2012 financial financial statements: statements: Assets = (100,000) = Liab. + (100,000) + Equity Rev.

Exp. = Net Inc. Cash Flow NA NA NA = NA (100,000) FA To To record record an an the the principal principal repayment, repayment, Mason Mason Company Company would would mak mak he following the following entry

entry on on December December 31, 31, 2012: 2012: Account Title Bonds Payable Cash Debit 100,000 Credit 100,000 10-38 Effect of Semiannual Interest Payments For semiannual interest payments, the company would make payments of $4,500 on June 30 and December 31 of each year. 10-39 LO 4 LO 1 Use the straightline method to amortize bond discounts and premiums. 10-40 Bonds Issued at a Premium If bonds of other companies are yielding less than 9 percent, investors will be

willing to pay more than the face amount for Masons 9 percent bonds. The issue price of Masons 9 percent bonds will rise because of investor demand for the 9 percent bonds. The difference between the higher issue price and the principal of $100,000 is called a premium. Lets continue the Mason Company 10-41 Bonds Issued at a Premium Mason Mason Company Company issues issues bonds bonds on on January January 1, 1, 2008. 2008. Principal Principal = = $100,000 $100,000 The only change from Issue Issue price price = = $105,000 $105,000 the Stated Stated Interest Interest Rate Rate = = 9% 9% original Mason

Interest Interest Date Date = = 12/31 12/31 example. Maturity Maturity Date Date = = Dec. Dec. 31, 31, 2012 2012 (5 (5 years) years) Cash Proceeds $ 105,000 - $ Principal Premium 100,000 = $ 5,000 10-42 Bonds Issued at a Premium Issuing Issuing the the bonds bonds at at aa premium premium has has the the following following effect effect on

on Masons Masons 2008 2008 financial financial statements: statements: Assets = Cash 105,000 = Liabilities Bonds Pay. + Premium 100,000 + + Equity + Equity 5,000 + NA Rev. Exp. NA

NA = Net Inc. Cash Flow = 105,000 FA NA To To record record the the bond bond issue, issue, Mason Mason Company Company would would make make the the following following entry entry on on January January 1, 1, 2008: 2008: Account Title Cash Premium on Bonds Payable Bonds Payable Debit 105,000

Credit 5,000 100,000 10-43 Bonds Issued at a Premium Partial Partial Balance Balance Sheet Sheet as as of of January January 1, 1, 2008 2008 Long-term Long-term Liabilities: Liabilities: Bonds Bonds Payable Payable Add: Add: Premium Premium on on Bonds Bonds Payable Payable $$ 100,000 100,000 5,000 5,000 $$ 105,000 105,000 Face Value Carrying Value 10-44

Bonds Issued at a Premium Amortizing Amortizing the the premium premium over over the the term term of of the the bond bond decreases decreases Interest Interest Expense Expense each each interest interest payment payment period. period. Using Using the the straight-line straight-line method, method, the the premium premium amortization amortization will will be be $1,000 $1,000 every every year. year. $5,000

$5,000 55 periods periods == $1,000 $1,000 10-45 Bonds Issued at a Premium The The December December 31, 31, 2008 2008 interest interest payment payment (and (and all all other other annual annual interest interest payments) payments) has has the the following following effect effect on on Masons Masons financial financial statements: Assets = Liabilities + Equity Rev. Exp. = Net Inc. Cash Flow statements: Cash (9,000) =

Bonds Pay. + Premium NA + + Ret. Earn. (1,000) + (8,000) NA 8,000 = (8,000) (9,000) OA To To record record an an interest interest payment, payment, Mason Mason Company Company would would make make the the following following entry entry on on each each December

December 31: 31: Account Title Interest Expense Premium on Bonds Payable Cash Debit 8,000 1,000 Credit 9,000 10-46 Bonds Issued at a Premium $5,000 $1,000 = $4,000 Partial Partial Balance Balance Sheet Sheet as as of of December December 31, 31, 2008 2008 Long-term Long-term Liabilities: Liabilities: Bonds Bonds Payable Payable Add: Add: Premium Premium on on Bonds Bonds Payable

Payable $$ 100,000 100,000 4,000 4,000 $$ 104,000 104,000 Face Value The carrying value will decrease to exactly $100,000 on the maturity date. Carrying Value 10-47 Bonds Issued at a Premium The The principal principal repayment repayment on on December December 31, 31, 2012 2012 will will have have the the ollowing effect following effect on on Masons Masons 2012 2012 financial financial statements: statements: Assets

= (100,000) = Liab. + (100,000) + Equity Rev. Exp. = Net Inc. Cash Flow NA NA NA = NA (100,000) FA

To To record record an an the the principal principal repayment, repayment, Mason Mason Company Company would would mak mak he following the following entry entry on on December December 31, 31, 2012: 2012: Account Title Bonds Payable Cash Debit 100,000 Credit 100,000 10-48 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. =

= < < > > 10-49 Bond Redemptions Companies Companies may may redeem redeem bonds bonds with with aa call call provision provision prior prior to to the the maturity maturity date. date. Gains Gains or or losses losses incurred incurred as as aa result result of of early early redemption redemption of

of bonds bonds should should be be reported reported as as other other income income or or other other expense expense on on the the income income statement. statement. 10-50 Bond Redemptions On January 1, 2011, 3 years after issue, Mason Company redeems its 9 percent bonds that were sold at a discount. The bonds have a call provision requiring Mason to pay a call price of $1,030 for each $1,000 bond. On the call date, the bonds have a carrying value of $98,000. 10-51 Bond Redemptions The The bond bond redemption

redemption on on January January 1, 1, 2011, 2011, will will have have the the following following effect effect on on Masons Masons 2011 2011 financial financial statements: statements: Assets = Cash 103,000 = Liabilities Bonds Pay. (100,000) + Discount Equity Rev. Exp.

= Net Inc. NA 5,000 = Cash Flow + Ret. Earn. (2,000) + (5,000) (5,000) (103,000) FA To To record record the the bond bond redemption, redemption, Mason Mason Company Company would would make make the the following following entry entry on on January January 1, 1, 2011

2011 Account Title Bonds Payable Loss on Bond Redemption Discount on Bonds Payable Cash Debit 100,000 5,000 Credit 2,000 103,000 10-52 LO 5 LO 1 Explain the advantages and disadvantages of debt financing. 10-53 Financial Leverage and Tax Advantage of Debt Financing Financial Financial leverage: leverage: Debt Debt financing financing can can increase increase return return on

on equity equity when when the the borrower borrower earns earns more more on on the the borrowed borrowed funds funds than than it it pays pays in in interest. interest. Consider Consider the the following following example example with with $100,000 $100,000 of of debt debt financing. financing. 10-54 Times Interest Earned Ratio Numerator is commonly called EBIT, Earnings before interest and taxes. Times Interest =

Earned Net income + Interest expense + Income tax expense Interest expense The The ratio ratio shows shows the the amount amount of of resources resources generated generated for for each each dollar dollar of of interest interest expense. expense. In In general, general, aa high high ratio ratio is is viewed viewed more more favorable favorable than than aa low low ratio. ratio. 10-55

LO 5 LO 1 Use the effective interest rate method to amortize bond discounts and premiums. (Appendix) 10-56 Effective Interest Rate Method (Appendix) Effective interest is a more accurate way to amortize bond discounts and premiums. It correctly reflects the bonds changing carrying value. 10-57 Effective Interest Rate Method (Appendix) Lets assume Mason Company uses the effective interest method on its $100,000 bond. Step 1: Determine the cash payment for interest. Face value of bond X Stated rate of interest Cash payment $ 100,000 X

.09 $ 9,000 10-58 Effective Interest Rate Method (Appendix) Step 2: Determine the amount of interest expense. $100,000 face value - $5,000 discount = $95,000 carrying value Carrying value of bond liability X Effective rate of interest Interest expense $ 95,000 X .1033 $ 9,814 10-59 Effective Interest Rate Method (Appendix) Step 3: Determine the amortization of the bond discount. Interest expense Cash payment Discount amortization $ 9,814 - 9,000 $ 814 10-60 Effective Interest Rate Method

(Appendix) Step 4: Update the carrying value of the bond liability. Discount amortization + Beginning carrying value Ending carrying value $ 814 + $ 95,000 $ 95,814 10-61 Effective Interest Rate Method (Appendix) * The decrease in the amount of the discount increases the amount of the bond liability. 10-62 Effective Interest Rate Method (Appendix) Notice that when using the effective interest method, interest expense increases each year. 10-63 End of Chapter Ten 10-64

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