Accounting 201 Chpt 9 Long Term Liabilities

Table 3

Used to calculate the future value of interest payment made at the end of each compounding period (1 + i )^n - 1 / i

Table 4

Used to calculate the present value of the interest payments since they are a series of equal payments (annuity)

Carrying Value

Balance in the bonds payable account

Serial Bonds

Bond issue matures in installments (uncommon)

Interest Expense Equation

Calculate the carrying value (amount actually owed during that period) times the market rate (semiannually)

Bond

Formal debt instrument that obligates the borrower to repay a stated amount, face amount, at a specific maturity date with interest over the life of the debt

Lease Advantages

Improves cash flows through up to 100% financing, improves the balance sheet by reducing long term debt, and can lower income tax.

Interest Expense Recording Entry- Premium

Interest Expense (" 6% x 1/2 x 107,439 ") Bonds Payable (difference) --------Cash (" 7% x 1/2 x 100,000 ")

Stated Interest Rate

Rate quoted in the bond contract to calculate cash payments for interest. Used to find interest payment each period.

Equity Financing

Refers to borrow equity (stockholder's equity)

Debt Financing

Refers to borrowing money (liabilities)

Market Interest Rate

Represents true interest rate used by investors to value a bond issue. Determines the interest rate per period, determined by forces of supply and demand.

Term Bonds

Require payment of the full principal amount of the bond at a single maturity date (end of loan term). This bond accounts for most type of bonds.

Matured Bonds

Retired, issuing corporation buys back its bonds from investors. Regardless of whether the bonds were issued at face value, a discount, or premium, their carrying value at maturity will equal their face amount.

Market Rate of Return

The higher the market interest rate, the lower the bond issue price will be.

Default Risk

The possibility that a company will be unable to pay the bond's face amount or interest payments as they become due. As a company's risk increases, investors demand a higher market interest rate on their bond investments.

Company's Capital Structure- Debt

This capital structure would have a higher portion of liabilities relative to stockholder's equity.

Company's Capital Structure- Equity

This capital structure would have fewer liabilities than stockholder's equity.

Debt to Equity Ratio

Total Liabilities / Stockholders' Equity (measure of financial risk related to long term liabilities; companies with more debt will have a higher ratio, more likely to hit bankruptcy)

Why Companies Issue Bonds

A company that borrows by issuing bonds is effectively bypassing the bank and borrowing directly from the investing public, usually at a lower interest rate than it would in a bank loan. A bond issue breaks down a large debt into manageable parts, usually $1,000 units.

Callable Bonds

Allows a borrow to pay off bonds early (before scheduled maturity date) at a specified call price stated in the bond contract. This feature helps protect borrower against future decreases in interest rates.

Times Interest Earned Ratio

(Net Income + Interest Expense + Tax Expense) / Interest Expense Measures a company's ability to pay interest payments as they become due.

Bonds Issued at Discount

Bonds issued below face amount. (Ex. If face amount is $100,000 we know the bonds will issue for less than that value, the carrying value and interest rate will increase over the life of the bond)

Bonds Issued at Premium

Bonds issued price is above face amount. (Over the life of the bond, the carrying value and interest expense will increase)

Unsecured Bonds

Bonds not backed by specific assets, also called debentures. Only secured by faith and full credit of the borrower. (Most bonds)

Secured Bonds

Bonds supported by specific assets the issuer has pledged as collateral. (Ex. Mortgage bonds are backed by real estate assets)

Convertible Bonds

Bonds that allow the lender (investor) to convert each bond into a specified number of shares of common stock. These bonds sell at a higher price and require lower interest rates than bonds without this conversion feature.

Primary Sources of Long-Term Debt Financing

Bonds, notes, and leases. However, bonds are the most common form of corporate debt.

Issue Bond Price

Calculated as the present value of the face amount plus the present value of the periodic interest payments.

Bond Indenture

Contract between a firm issuing bonds to borrow money (the issuer) and the corporations or individuals who purchase the bonds as investments (the investors). Held by a trustee, usually a commercial bank appointed by issuing firm.

Capital Leases

Contract in which the lessee essentially buys an asset and borrows the money through a lease to pay for the asset.

Operating Leases

Contract in which the lessor owns the asset and the lessee simply uses the asset temporarily (ex: rental houses)

Lease

Contractual arrangement by which the lessor (owner) provides the lessee (user) the right to use an asset for a specific period of time.

Amortization Schedule

Convenient summary of the cash interest payments, interest expense, and changes in carrying value for each semiannual interest period.

Sinking Fund

Designated fund to which an organization makes payments each year over the life of its outstanding debt (Ex. City puts away 2 million each year for 10 years, so that 20 million is available to pay bonds when they become due)

Interest Expense Variations

Discount: interest expense is more than cash paid for interest Premium: interest expense is less than cash paid for interest

Cash Paid for Interest

Face Amount x Stated Interest Rate (Remains the same throughout amortization schedule)

Where are bonds payable recorded at?

In the long-term liabilities section of the balance sheet up until the last year, then they move to current liabilities.

Installment Payment

Includes both an amount that represents interest and an amount that represents a reduction of the outstanding loan balance. (Ex. Car loan, house loan). Interest expense decreases with each monthly payment.

Interest Expense Recording Entry- Discount

Interest Expense (" 8% x 1/2 x 93,205 ") --------Bonds Payable (difference) --------Cash (" 7% x 1/2 x 100,000 ")

Advantage of Debt Financing

Interest on borrow funds is tax-deductible, whereas dividends paid to stockholder's are not.

Market Value of Bonds

Market interest rate is constantly changing because the market value of bonds moves in the opposite direction of interest rates: when market interest rates go up, the market value of bonds decreases.

Capital Structure

Mixture of liabilities and stockholder's equity a business uses

Return on Equity

Net Income / Average Stockholders' Equity (indicates company's ability to generate earnings from resources the owners provide)

Return on Assets

Net Income / Average Total Assets (indicates a company's overall profitability, ignoring specific sources of financing)

Table 2

One time only calculation of the present value of the face amount (150,000 x 0.67556 = $162,166 if.. i=4 and n=10)