Chapter 9 Long-term Liabilities PDF

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Warning: TT: undefined function: 32 Long-Term Liability ratios Long term debt is one of the first places decision makers should look when trying to get a handle on risk-Debt to equity ratio ○ = Total liabilities / stockholder's equity ○ Failure to pay debt might result in default or bankruptcy ○ ***...

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Chapter 9: Long-term Liabilities Tuesday, November 7, 2017

10:59 AM

Long-Term Liability ratios - Long term debt is one of the first places decision makers should look when trying to get a handle on risk - Debt to equity ratio ○ = Total liabilities / stockholder's equity ○ Failure to pay debt might result in default or bankruptcy ○ ***The higher this ratio is, the higher the rick of bankruptcy ○ Debit can be an advantage… it can enhance stockholder's equity ○ Measure of financial leverage § Leverage enables a company to earn a higher return using debt that without debt § Debt can be favorable OR not favorable - Returns on assets ○ = net income/average total assets ○ measures the amount of income generated for each dollar invested in assets ○ indicates a company's overall profitability, ignoring specific sources of financing - Times interest earned ratio ○ = (Net income + Interest expense + tax expense) / Interest expense ○ Compares interest expense with income available to pay those charges ○ Higher is stronger/better Balance sheet effects of operating and capital leases - Lease : a contractual arrangement by which the lessor, who is the owner of the asset, provides the lessee, who is the user, the right to use an asset for a specified period of time - Two types of leases 1. Operating leases i. Like rentals, no intention of owning the asset ii Only wants to use the asset temporarily

ii. iii. iv. v. vi.

2.

Only wants to use the asset temporarily Lessee records rent expense Lessor records rent revenue Most companies prefer this**** The expense isn't recorded on the balance sheet, is it only recorded as a rent expense as the payments are made 1) Doesn’t change accounting equation AT ALL 2) reports lower total liabilities in relation to stockholders’ equity, appearing less risky to investors and lenders from the standpoint of potential bankruptcy. Capital leases i. Occurs when the lessee essentially buys an asset and borrows the money through a lease to pay for the asset ii. Recorded the same way a loan would be recorded except "Notes payable" is "Lease Payable" iii. The amount is recorded as an asset AND a liability 1) Increases asset and liability on accounting equation

Financing activities -

Sources of financing ○ Internal financing § Profits generated by the company ○ External Financing § Funds coming from outside the company § Debt financing □ Borrowing money aka liabilities □ Tax deductible (this means its less costly) § Equity financing □ Obtaining additional investment from stockholders' □ Not tax deductible □ Paying dividends to stockholders DOES NOT REDUCE taxable income because dividends are an expense. § Capital structure □ The mixture of liabilities and SE a business uses ○ Three primary sources of long-term debt financing § Notes § Leases § Bonds

Installment Notes Payable - repayment in monthly installments - each installment payment includes both ○ an amount that represents interest ○ an amount that represents a reduction of the outstanding loan balance. - Amortization schedule for an installment note includes: ○ Date § Usually monthly ○ Cash paid § Usually a set number ○ Interest expense § Decreases over time § (carrying value*market rate) ○ Decrease in carrying value § Increases overtime § (Cash paid - Interest expense) ○ Carrying value § Decreases overtime § (Prior carrying value - decrease in carrying value) - First monthly installment payment: Debit: interest expense Loan amount*interest rate* (1/12) ○

Debit: Notes payable

The difference between cash-interest expense

Credit: Cash

Monthly payment

Retirement of bonds - when the issuing corporation buys back its bonds from the investors - Recorded bond retirements at maturity: ○ Bond issue Debit: Cash

Face amount

Cr: Bonds payable Face amount ○

Retirement of bond at maturity Debit: Bonds payable Face amount Cr: Cash

Face amount

(decreases assets and liabilities) **No matter if the bonds are issued at face amount, a discount, or a premium, their carrying value at maturity equals their face amount Recorded bond amounts before maturity: ○ Called Early extinguishment of debt ○ Two ways: 1. Callable (redeemable) 1) Call price > Face amount 2) Call price is stated in the bond contract and it usually higher than face value 2. Purchasing the bonds on the open market ○ Interest rates and bond pries have an inverse relationship § Example: ○ ○

-

§

Debit: Bonds payable (account balance)

100,000

Debit: Loss (Difference of cash and current carrying value)

13,772

Cr: Cash (Amount paid : new market interest rate * #of periods )

107,177

Cr: discount on bonds payable (if there was a discount)

6,595

Losses and gains on the early extinguishment of debt are reported as nonoperating items in the income statement Price of bond issue - Stated interest rate: the rate in the bond contract used to calculate the cash payments for interest - Most corporate bonds pay interest semiannually ○ Interest payments = face amount * interest rate * (1/2 year of semiannually) - Issue price of bonds: ○ = present value of the face amount + present value of the periodic interest payments ○ Four factors to calculate 1. Face amount 2. Interest payment per period 3. Market interest rate per period (the true interest rate used by investors to value the company's bond issue) ○

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□ Market rate / 2 for semiannually 4. Periods to maturity □ # of years to maturity * # of interest payments per year You can use these to determine the issue price of bonds § Financial calculator § Excel (video) § Or present value tables Annuity - series of equal amounts over equal time periods Market rate: § the interest rate investors determine for each bond issue through the forces of supply and demand § Change continuously § Increase can be caused by: □ Increase in the fed reserve □ Political unrest □ Increase in oil prices □ Growth in inflation § Not the same for all companies § Vary based on the default risk of the company issuing the bond □ Default risk refers to the possibility that a company will be unable to pay the bond's face amount or interest payments as they become due. □ Higher d. risk = higher market interest rate □ The higher the MIR is the lower the bond issue price is Discount § Makes it more attractive § When MIR is higher Premium § When MIR is lower § the issue price of a bond is above its face amount. § "Issued at 107.8" 107.8% of face value § In maturity…. The amount received is still face value Stated int. rate Market int. rate Bonds issued at

○

6%

7% (Higher)

Discount

6%

6% (Same)

Face amount

6%

5% (Lower)

Premium

Characteristics of bonds Bond - a 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. - Pays interest - Usually semiannual period (every 6 months) - Bonds are sold , or underwritten by investment houses ○ Costs/fees include § Legal § Accounting § Registration § Printing ○ Private placement: sells the debt securities directly to a single investor (large investment fund or insurance company) § To keep costs low ○ Why not borrow from a bank? § For loan under $20 million (borrow from bank) □ Bond issue cost > interest rate savings § For loan of $20 million or higher (issue bond) □ Bond issue cost < interest rate savings Secured bonds

Unsecured bonds

- supported by specific assets the issuer has pledged as collateral.

- not backed by a specific asset - are secured only by the "full faith and credit" of the borrower. - ***most loans

Term bonds

Serial bonds

- require payment of the full - require payments in installments over a series principal amount of the of years bond at the end of the loan - Easier to meet its bond obligations as they term become due. - A sinking fund is an investment fund to which an organization makes payments each year over the life of its outstanding debt. **m t l

- **most loans Callable Bonds

Convertible Bonds

- enables the borrower to repay the bonds before the scheduled maturity date at a specified call price - usually at an amount just above face value. - When MIR drops

- Enables you to convert each bond into a specified number of shares of common stock - You benefit if the stock price increases over your stock/bond price - the borrower also benefits - Usually sell at a higher price and lower interest rate

Recording accounts Issuance (if market=set IR) Debit: cash

Face amount

Cr: bonds payable Face amount First semiannual payment Debit: Interest expense Payment (100000*6%*1/2) Cr: cash

Payment

DISCOUNT BONDS Issuance Debit: Cash

Discount amount

Debit: discount on bonds payable (difference) Cr: Bonds payable

Face amount

monthly Debit: Interest expense

Payment (100000*7(MIR)%*1/2)

Cr: Discount on bonds payable (difference) Cr: cash Amortization Schedule: - Summarizes

Payment (100000*6%*1/2)

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Summarizes § Cash payments § Interest expense § Changes in carrying value § **Breakdown is above

PREMIUM Issuance Debit: Cash

Total amount paid

Cr: Bonds payable

Face amount

Cr: Premium on bonds payable (difference) monthly Debit: Interest expense

Payment (100000*5(MIR)%*1/2)

Debit: premium on bonds payable (difference) Cr: cash Carrying value decreases

Payment (100000*6%*1/2)...