ACCT Chapter 15: Long Term Liabilities

Bond underwriter

- "middleman", usually a banker or investment company that works with the bond issuer to market the bonds.

Convertible bonds

- Bond holder (lender) may exchange bond for shares of issuing company's stock

Companies that issue bonds must:

- account for interest expense over the life of the bond issue - report the appropriate liability on the balance sheet each year of the bond issue.

Term bonds

- all bonds in the bond issue mature at the same time

Debentures (unsecured bonds)

- backed only by general credit worthiness of issuing company

Bond trustee

- bank or trust company who represent the bondholders, ensuring that bond issuer fulfills provisions of the bond contract

Market Rate > Face rate

- bond sells at price less than face amount - discount

Serial bonds

- bonds in the bond issue have staggered maturity dates; since not all bonds mature at the same time it allows issuing company to spread out re payment

Market Rate < Face Rate

- bonds sells at price more than face amount - premium

Interest Expense Formula

- carrying value x market rate

Loan terms may require:

- constant payment to the principal plus interest on unpaid balance OR - may require constant total payment, with portion of total as payment to principal and remaining to interest.

Bond indenture

- contract that sets out details of the bond issue such as: interest rate, interest payment dates, and covenants

Bonds payable definition

- contract to borrow created by an entity then issued or sold to numerous lenders

Disadvantages of debt financing:

- debt might result in negative leverage - interest is not discretionary, you must pay it - eventually the principal must be be repaid.

What determines the selling price of the bond?

- depends on the face amount or principal, the contract or stated interest rate, and the market rate of interest on the issue date.

Advantages of debt financing:

- doesn't dilute ownership - reduces your taxable income (interest is a debt on the income statement) - debt might result in positive financial leverage

Secured bonds

- have specific assets of issuing company pledged as collateral

Stated rate (Coupon/Face)

- interest rate that determines the cash interest payments that the bond issuer must pay

Market/Effective Rate

- interest rate that is in effect at time of bond issue, determines the actual interest cost of issuing bonds.

Callable bonds

- issuer may "call" (repay) bonds before maturity

Notes Payable definition

- negotiated contract between two parties

Registered bonds

- owner's name is registered with issuing company or agent

Amortization definition

- process of allocating the cost of an intangible asset over a period of time

Bond Covenant

- promise; special provision in bond contract that is usually included as protection to the lender

Coupon (Bearer) Bonds

- property of bondholder; physical transfer of bond transfers ownership

Discount

- sell bond for a price lower than face value, because the coupon rate is less than the market rate.

Premium

- sell for a price higher than face value, because coupon rate is higher than the market rate.

zero coupon bond

- special type of bond in which there are no interest payments; the bond pays only the face amount at maturity.

Installment notes definition

- type of long term debt that requires the borrower to make equal, periodic payments to the lender - each payment consists of both interest on the outstanding debt and a portion of the principal

Aggie Company issued $2,000,000, 5%, 10-year bonds on January 1, 2014. Interest will be paid semi-annually on June 30 and December 31. At the time the bonds were issued, the market rate of interest was 6%. 1. Determine the selling price (issue price) of the bonds. 2. What was the total interest expense over the 10 year life of the bond issue?

1. 1,851,233 2. 1,148,767

Example #2 Installment loan (more people are familiar with) ITS AN ANNUITY On January 2, 20X3, Parker Company purchased a new warehouse. Parker paid $100,000 as a down payment and issued a long-term note to finance the balance. The note, which carries an interest rate of 6%, requires Parker to make annual payments of $150,000 for five years, with the first payment due on December 31, 20X3 1. What amount should Parker record as the cost of the new warehouse? 2. What amount should Parker record as interest expense for 20X3? 3. What amount should Parker record as the outstanding liability on the loan on December 31, 20X3 (after the first payment is made)? 4. What amount will Parker recognize as interest expense over the five-year life of this loan?

1. 731,854 2. 37,911 3. 519,765 4. 118,146

On January 1, Y1, Kyle Company purchased equipment costing $30,000 by issuing a 10% note. The note requires Kyle to make five annual payments, with the first payment due on December 31, Y1. What is the amount of the payment required? How much interest expense will Kyle Company report for Y1? For Y2? How will this liability appear on Kyle's 12/31/Y1 balance sheet? On the 12/31/Y2 balance sheet?

1. 7914 2. 3,000; 2509 3. 25086; 19,681

Somerville Company issued $200,000 bonds to finance the company's expansion. The bonds have a contract interest rate of 9%, will pay interest semi-annually on June 30 and December 31, and mature in five years. On the day the bonds were issued, the market rate of interest was 10%. Somerville's bond contract includes the provision that Somerville may buy back the bonds from the bondholders beginning two years from the date of the bond issue at a price of $204,000. 1. The stated rate of interest on the bonds is _____; bondholders will be paid $_____ every _______. 2. When Somerville decided to issue the bonds, they executed the bond contract or ____________, which spelled out the specific provisions of the bond issue. 3. The provision that allows Somerville to buy back the bonds from the bondholders before maturity makes these bonds

1. 9%, $9,000, six months 2. indenture 3. callable

What are the 2 promises of a bond contract?

1. A promise for the borrower (issuer) to make regular interest payments to the lenders. 2. A promise to repay the face amount of the bond at maturity.

On January 2, 2014, Longhorn Company issued 3-year, $100,000 bonds with a stated rate of 8%. The bonds pay interest annually on December 31. At the time of the issue, the market rate of interest was 10%. Longhorn Company uses the effective interest method to amortize any premium or discount. 1. What are the "two promises" of the bond contract? 2. what is the selling price of the bonds? 3. how much interest expense should Longhorn report over the life of the bond issue?

1. Promise to repay 100,000; and make 8000 regular payments 2. 95026 3. 28,974

A bond makes 2 promises to the bond holder which is:

1. Promise to repay the face value at maturity. 2. Promise to make regular interest payments every period based on the coupon rate.

On January 1, 2012, Aggie Company issues $20 million, 20-year, 5% bonds. The bonds pay interest semi-annually on June 30 and December 31. What are the two "promises" of this bond issue?

1. The interest payments will be 500,000 2. Repay the 20 million when the bond matures in 20 years.

On January 1, 2014, Benbrook Company issued bonds with a face value of $50,000. The bonds mature in five years, and pay interest annually at a stated rate of 10%. Since the market rate at the time of the issue was 12%, the bonds were sold at a discount; the actual issue price was $46,395. On January 1, 2015, Benbrook decides to redeem the bonds payable at the specified redemption price of 101. What is the carrying value of the bonds on the redemption date? How much gain or loss with the company recognize on the bond redemption?

46,963 3,537 loss

Aggie Construction Company issued $200,000 of 9.5%, 5-year bonds on January 1, 2012. Interest is to be paid semi-annually on June 30 and December 31. The market rate at the time of the bond issue was 10%; consequently the bonds were issued for $196,000. What is the total amount of interest expense that Aggie Construction will record over the five-year life of the bond issue? What amount will Aggie Company report as interest expense on the bonds for the first six months of 2012? What amount will Aggie Company report as interest expense on the bonds for the year ending December 31, 2012?

99,000 9800 19615

Formula to Determine the Cost of Borrowing

= Cash out - cash in = cash payments - premiums + discounts.

Cost of borrowing is _________________________

ALWAYS equal to the market rate.

Carrying value =

Bond payable - discounts + premiums

Loss/Gain =

Carrying value - cash paid

________________ the amount of discount increases the carrying value

Decreasing

Formula for finding the cash payment of a bond is

Face Value x adjusted coupon rate.

Westheimer Company's December 31, 2012 balance sheet included the following: Bonds payable, 8%, due in 2020, net of discount $165,045 $2,834,955 Determine if the following statements are true or false and then select the correct response. _____ When the bonds were issued, the market rate of interest was less than 8%. _____ Interest expense on the bonds was $240,000 in 2012. _____ Westheimer's cash payment for interest on these bonds is $240,000 each year

False, false, true.

What effect does selling the bonds at a discount have on the interest expense?

It increases the total expense, increasing the effective rate to the market rate

What effect does selling the bonds at a premium have on the interest expense?

It reduces the total expense, reducing the effective rate to the market rate

A corporation issues for cash $9,000,000 of 8%, 25-year bonds, interest payable semiannually. The amount received for the bonds will be a. present value of 50 semiannual interest payments of $360,000, plus present value of $9,000,000 to be repaid in 25 years. b. present value of 25 annual interest payments of $720,000. c. present value of 25 annual interest payments of $720,000 plus present value of $9,000,000 in 25 years. d. present value of $9,000,000 to be repaid in 25 years, less present value of 50 semiannual interest payments of $360,000. e. none of the above

a

Any unamortized bond discount should be reported on the balance sheet of the issuing corporation as a. a deduction from the face amount of the bonds. b. an asset. c. a deduction from retained earnings in the stockholders' equity section. d. an addition to the face amount of the bonds. e. none of the above

a

One promise, the interest payments is an _____________

annuity

How will bonds payable be reported on the balance sheet?

at the carrying value

Pearsall Company's bonds payable carry a stated rate of 7%; the market rate of interest at the time of the bond issue is 8%. The bonds will be sold at a. par value. b. a discount. c. maturity value. d. a premium. e. none of the above

b

How do corporations borrow money?

by issuing or selling bonds

One potential advantage of financing corporations through the use of bonds rather than common stock is a. the interest on bonds must be paid when due. b. the corporation must pay the bonds at maturity. c. the interest expense is deductible for tax purposes by the corporation. d. both a and b.

c

Snook Company issued $4,200,000, 20-year bonds payable on January 2, 2014. The bonds had a stated rate of 5%, with interest to be paid annually. The market rate at the time of the issue was 4%; consequently, the issue price of the bonds was $4,770,794. The firm uses the effective interest method to amortize any premium or discount on bonds payable. What is the amount of the cash payment required on these bonds each year? a. $168,000 b. $190,832 c. $210,000 d. $238,540

c

The stated/face rate is used to find the ____________________ and the market rate of interest determines the ____________________

cash interest payments; selling price of bond.

payment to principal =

cash payment - interest expense

The coupon rate is only used for

cash payments

1 out of 1 points Reveille Company issued $500,000 of 4%, 10-year bonds on January 1, 2010. Interest is to be paid semi-annually on December 31. The market rate at the time of the bond issue is 2%. Reveille uses the effective interest method of amortization. What is the selling price of bonds? a. $499,976 b. $500,000 c. $589,802 d. $590,226

d

Selling bonds at a premium has the effect of a. raising the effective interest rate above the stated interest rate. b. attracting investors that are willing to pay a lower rate of interest than on similar bonds. c. causing the interest expense to be higher than the bond interest paid. d. causing the interest expense to be lower than the bond interest paid. e. none of the above

d

A discount serves to _______________ bonds payable

decrease.

With premiums, carrying value should _______________ to face value, and interest expense should _________________ because of this

decrease; decrease

Losses = _________________ = ____________________

expenses;debits

At maturity carrying value =

face value

A premium serves to _____________ bonds payable.

increase

As carrying value _____________ the interest expense increased

increase

A discount _________________ your effective cost to borrow up to the market rate

increases

Bond prices and market rates are ___________________

inversely related

When you sell a bond at a premium, your interest expense should be ________________ than the payment because your bond is better

lower

The promise to repay the face amount is a single _____________________

lump sum payment

If a bond sold for a premium, but now sells for a discount, what happened to the market interest rates?

market rates are increasing

With a discount, the interest expense should be ____________ than the cash payments

more

The carrying value/outstanding loan balance is also the ________________________________; when the last of the payments are made the balance is _______________

present value of the remaining loan payments; zero

A premium _________________ your effective cost to borrow down to the market rate

reduces

Gains = _______________ = _________________

revenues; credits

Market rate = Face rate =

selling price is sold at face amount bond sells at par

Long term notes are generally issued to a ______________________; bonds payable are generally issued to a ________________________

single lender; large number of lenders