ACCTG 230: Chapter 9
Example of Calculating Issue Price:
• In our earlier example for California Coasters, the face amount equals $100,000. • The interest payment every six months is $3,500 (= $100,000 × 7% × 1/2 year) based on the bond's stated interest rate of 7%. • The number of periods to maturity is 20 because the bonds pay interest semiannually (twice per year) for 10 years.
Recording Lease Payable:
DEBIT: Lease Asset 15,000 CREDIT: Lease Payable 15,000
Times Interest Earned Ratio formula:
return on assets= net income / average total assets
Recording Lease Payable:
• At the beginning of the lease, record: ❑ Lease asset - right to use the asset over lease period ❑ Lease payable- present value of obligation to make payments
Installment Notes:
• Most car loans and home loans call for payment in monthly installments rather than by a single amount at maturity • Companies, too, often borrow cash using installment notes.
Which of the following are methods of long-term financing with debt?
Bonds Leases Notes payablelbie
Key Point:
Companies obtain external funds through debt financing (liabilities) and equity financing (stockholders' equity). One advantage of debt financing is that interest on borrowed funds is tax-deductible.
What is the difference between interest expense and dividends?
Interest expense incurred when borrowing money is TAX-DEDUCTIBLE Dividends paid to stockholders are NOT tax deductible.
Key Point:
Most notes payable require periodic installment payments. Each installment payment includes an amount that represents interest expense and an amount that represents a reduction of the carrying value (remaining loan balance).
Installment Loan Transactions: First two monthly payments
NOV 30, 2021 DEBIT: DEBIT: CREDIT: DEC 31, 2021 DEBIT: DEBIT: CREDIT:
KEY POINT:
No gain or loss is recorded on bonds retired at maturity. For bonds retired before maturity, we record a gain or loss on early extinguishment equal to the difference between the price paid to repurchase the bonds and the bonds' carrying value.
- Capital structure:
mixture of liabilities and stockholders' equity a business uses ❑ Debit financing: borrowing money ❑ Equity financing: obtaining investment from stockholders
On December 31, Leann Corp. paid $5,120 on an installment note that requires annual payments. The outstanding loan balance on January 1 was $50,000; the effective interest rate is 8%. The journal entry to recognize the payment should include debits to
notes payable for $1,120. interest expense for $4,000.
XYZ Company has a 10 year installment note requiring $5,000 to be paid within the current year and $45,000 to be paid over the remaining 9 years. How is this installment note reported in the balance sheet of XYZ Company?
$5,000 current note payable; $45,000 long-term note payable
Financing Alternatives:
- debt financing - equity financing
Installment Loan Transactions: Establishment of the Note Payable
DEBIT: CREDIT:
Smith Company enters into a lease agreement with Rent-All Corp. At the beginning of the lease period, Smith Company records:
a lease asset a lease payable
Debt to Equity Ratio formula:
debit to equity ratio= total liabilities / stockholders equity
Retirement of Bonds:
• Company buys back its bonds from investors. • If bonds are retired at maturity, the carrying value will equal the face amount. The bond payable is debited and cash is credited. • Bonds can be retired before maturity by ❑ Exercising the call feature included in the bond contract or buying the bonds in the open market ❑ Retirement before maturity is called early extinguishment of debt, and may result in a gain or loss equal to the difference between the book value of the bond and the price paid to retire the bond.
Calculating the Issue Price of a Bond:
• The issue price of a bond equals the present value of the bond's face amount plus the present value of its periodic interest payments.
Walker Inc. signs a $24,000 installment note, which requires equal monthly payments of $1,100 over the next two years. The journal entry to recognize the note includes a:
credit to Notes Payable for $24,000
Periodic payments on installment notes typically include (Select all that apply.)
a portion that reduces the outstanding loan balance. a portion that reflects interest.
Why Buy Back Debt Early?
• When interest rates decrease, companies with a call feature are more likely to repurchase higher-cost debt and then reissue debt at new, lower interest rates. This type of buyback and reissue lowers future interest expense. • Another reason to repay debt early is to improve the company's debt ratios (discussed later in the chapter). • Early extinguishment of debt can also be timed to manage reported earnings. Since bonds payable are reported at carrying values and not market values, firms can time their repurchase of bonds to help meet earnings expectations. For instance, when interest rates go up, bond prices go down. In this case, a company will record a gain rather than a loss on early extinguishment.
To calculate these present values, we need to know
❑ The face amount of the bond. ❑ The interest payment each period based on the stated interest rate of the bond. ❑ The number of periods until the bond matures. ❑ The market interest rate per period. • Except for the market interest rate, these items are found in the bond contract.
Debt Analysis: Two ratios used to measure financial risk related to long-term liabilities:
❑ debit to equity ❑ times interest earned
At the beginning of the year, Petra owes $10,000 on an installment notes payable, which has an interest rate of 6%. At the end of the year, Petra makes a payment of $2,000. After the payment, the carrying value of the installment notes payable will be:
8,600
Which of the following are possible benefits of leasing an asset rather than purchasing an asset?
Improvement in cash flows Lower periodic payments on the asset Protection against declining asset value
Summary of Bond Characteristics: 1. Secured 2. Unsecured 3. Term 4. Serial 5. Callable 6. Convertible
1. Bonds are backed by collateral. 2. Bonds are not backed by collateral. 3. Bond issue matures on a single date. 4. Bond issue matures in installments. 5. Issuing company can pay off bonds early. 6. Investor can convert bonds to common stock.
Installment Notes: • Each installment Payment includes both:
1. Interest on borrowed amount 2. Reduction of outstanding loan balance
Decision Maker's Perspective: Why Do Many Companies Lease Rather Than Buy?
1. Leasing reduces the upfront cash needed to use an asset. 2. Lease payments often are lower than installment payments. 3. Leasing offers flexibility and lower costs when disposing of an asset. 4. Leasing may offer protection against the risk of declining asset values.
On December 31, Katie Corp. records a journal entry related to an installment note that includes a debit to interest expense for $4,000, and a debit to notes payable for $9,000. Katie's journal entry should also include a credit to cash for:
13000
Bond Retirements before Maturity: California Coasters issued bonds on January 1, 2021, above face amount (at a premium) at $107,439. The carrying value of the bonds one year later on December 31, 2021, is $106,877. Record the bond retirement before maturity on December 31, 2021, for $114,353.
DEBIT: DEBIT: DEBIT: CREDIT: California Coasters records a loss for the difference between the price paid to repurchase the bonds ($114,353) and the bonds' carrying value ($106,877).
Bonds Issued at Face Amount (1 of 2): • California Coasters issues $100,000 of bonds paying 7% interest for $100,000 (face amount).
DEBIT: Cash 100,000 CREDIT: Bonds Payable 100,000
Bonds Issued at a Discount: • Issue $100,000 of bonds paying 7% interest for $93,205 (discount), assuming an 8% market interest rate
DEBIT: Cash 93,205 DEBIT: Discount on Bonds Payable 6,795 CREDIT: Bonds Payable 100,000
Bonds Issued at Face Amount (1 of 2): • First semiannual interest payment:
DEBIT: Interest Expense 3,500 CREDIT: Cash 3,500
Interest Expense and Interest Payment— Bonds Issued at a Discount JUNE 30, 2021 • first semiannual interest payment:
DEBIT: Interest Expense 3,728 CREDIT: Discount on Bonds Payable (difference) 228 CREDIT: Cash 3,500
Interest Expense and Interest Payment— Bonds Issued at a Discount DEC 31, 2021 • second semiannual interest payment:
DEBIT: Interest Expense 3,737 CREDIT: Discount on Bonds Payable (difference) 237 CREDIT: Cash 3,500
Bonds Issued at a Premium: • Issue $100,000 of bonds, paying 7% interest for $107,439 (premium), assuming a 6% market interest rate
DEBIT: Interest Expense 3,737 CREDIT: Discount on Bonds Payable 237 CREDIT: Cash 3,500
Bond Retirements at Maturity: • Assume $100,000 in bonds are retired at maturity (December 31, 2030)
DEBIT: Interest Expense 3,737 CREDIT: Discount on Bonds Payable 237 CREDIT: Cash 3,500 No gain or loss is recorded on bonds retired at maturity.
COMMON MISTAKE:
Students sometimes incorrectly record interest expense using the stated rate rather than the market rate. Remember that interest expense is the carrying value times the market rate, while the cash paid for interest is the face amount times the stated rate.
Which of the following are typically shown in an amortization schedule related to an installment notes payable? (Select all that apply.)
The carrying value of the note at the beginning of the period The cash paid each payment period The carrying value of the note at the end of the period
Key Point:
The debt to equity ratio is a measure of financial leverage. Taking on more debt (higher leverage) can be good or bad depending on whether the company earns a return in excess of the cost of borrowed funds. The times interest earned ratio measures a company's ability to meet interest payments as they become due.
Which of the following are typically shown in an amortization schedule related to an installment notes payable requiring period payment of interest and principal? (Select all that apply.)
The decrease in the carrying value of the note The cash paid each payment period The carrying value of the note at the end of the period Interest expense based on the beginning period carrying value and the effective rate of the loan
Key point:
The distinguishing characteristics of bonds include whether they are backed by collateral (secured or unsecured), become due at a single specified date or over a series of years (term or serial), can be redeemed prior to maturity (callable), or can be converted into common stock (convertible).
Bonds Issued at a Discount or Premium
The following three slides demonstrate the calculation of the issue price when there is a discount. Then, the next three demonstrate the calculation of the issue price when there is a premium.
Common Mistake:
The interest rate we use to calculate the bond issue price is always the market rate, never the stated rate. Some students get confused and incorrectly use the stated rate to calculate present value. Use the stated rate to calculate the interest payment each period, but use the market rate to calculate the present value of the cash flows.
Key Point:
The issue price of a bond is equal to the present value of the face amount (principal) payable at maturity, plus the present value of the periodic interest payments. Bonds can be issued at face amount, below face amount (at a discount), or above face amount (at a premium).
Key Point:
When bonds issue at face amount, the carrying value and the corresponding interest expense remain constant over time. When bonds issue at a discount (below face amount), the carrying value and the corresponding interest expense increase over time. When bonds issue at a premium (above face amount), the carrying value and the corresponding interest expense decrease over time.
Key Point:
While not transferring ownership as in a purchase, a lease gives the lessee (user) the right to use the asset over the lease period. This right is recorded as an asset, and the obligation to make lease payments is recorded as a liability.
Debt to Equity Ratio:
• A measure of risk. • Other things being equal, the higher the debt to equity ratio, the higher the risk of bankruptcy. When a company assumes more debt, risk increases.
Times Interest Earned Ratio:
• An indication to creditors of how many "times" greater earnings are than interest expense
Bond Retirements at Maturity:
• Bond retirements occur when the issuing corporation buys back its bonds from the investors
Leases:
• Contractual arrangement by which the lessor (owner) provides the lessee (user) the right to use an asset for a specified period of time • Leases are recorded by the lessee as a debit to lease asset and a credit to lease payable ❑ for the present value of the lease payments ❑ at the beginning of the lease term
What Are Bonds?
• Formal debt instrument that obligates the borrower to repay a stated amount, referred to as the principal or face amount, at a specified maturity date • The borrower also agrees to pay interest over the life of the bond • Traditionally, interest on bonds is paid twice a year (semiannually) on designated interest dates, beginning six months after the original bond issue date
Debt Analysis:
• Long-term debt is one of the first places decision makers look when trying to get a handle on risk
Calculating the Present Value of Lease Payments (Annuity):
• Table 4 at the back of the book provides present values of annuities of $1 (ordinary annuity). • These values are multiplied by the monthly lease payment to get the present value of the total lease payments. • To use the table, you need to know n (time periods) and I (interest rate.) • For combinations of n and I not shown, you can calculate the present value of the lease payments using a financial calculator or Excel.
Stated Interest Rate versus Market Interest Rate:
• The stated interest rate is specified in the bond contract. • The market interest rate is not specified in the bond contract. • Investors demand a higher market rate for bonds that have a higher default risk. • Bonds may be issued at the face amount, or at a discount or premium.
Bonds Issued at Face Amount (2 of 2)
• There are three ways to determine the issue price of a bond. We will apply those three methods to bonds issued at their face amount. The three methods are listed here, and are demonstrated on the next three slides. ❑ Use a financial calculator (Illustration 9-9) ❑ Use Excel (Illustration 9-10) ❑ Use present value table factors (Illustration 9-11)
- Examples of debt:
❑ Notes, leases, and bonds
