Quiz 3 Review - Summary Principles of Accounting I PDF

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Long-Term Debt  Common types of debt o Bank loan: principal borrowed, periodic interest charged, principal paid at end of loan o Mortgage: principal borrowed, periodic interest charged, principal paid periodically over loan period o Corporate bond: bond issued by a corporation to raise financing money  Firm pays investors periodic cash flows (“coupons”) and a lump sum at maturity o Convertible debt: corporate bonds that allow investors an option to convert debt into a pre-specified number of shares of stock  Accounting for bank loans o Acquire loan:  Dr. Cash (+A)  Cr. Notes Payable (+L) o Interest at end of each year:  Dr. Interest Expense (+E)  Cr. Cash (-A) o Paying back principal at the end of loan:  Dr. Long-term debt (-L)  Cr. Cash (-A)  Accounting for par bonds o Initial accounting:  Dr. Cash (+A) amount raised by firm from selling bonds to investors  Cr. Bonds Payable (+L) same amount o Interest expense:  Dr. Interest Expense (+E) NBV of debt at beginning of period (same amount as in initial accounting) * market interest rate  Cr. Cash (-A) same amount o Coupon payments to be paid each period:  Dr. interest expense (+E)  Cr. Cash coupon (-A) number of bonds * coupon per bond o Repayment of bond  Entry for interest during last period  Dr. Bonds Payable (-L) amount from beginning  Cr. Cash (-A)  Bond value o The amount investors pay for the bond is the present value of cash flows offered  PV = present value  PR(n) = principal to be paid at the end of period n (AKA face value)  C = coupon amount to be paid by firm each period  Depends on whether it’s a par, discount, or premium bond  I = periodic interest rate demanded by investors

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 N = number of compounding periods o Investors pay present value of principal + present value of coupons  Present value of the bond principal: PV = principal/(1+i)^n  Present value of the coupons: PV = (C/i) – ((C/i)/(1+i)^n) Par, discount, and premium bonds o Par bonds  Coupon rate = market interest rate  Coupon payment = interest expense each period  NBV does not change over time o Discount bonds  Discount for investor  Coupon rate is below the market rate  The interest expense changes over time  NBV increases over time (because principal is greater than cash proceeds)  Accounting for interest expenses for discount bonds  Dr. Interest Expense (+E) o Cr. Bonds Payable (+L)  Interest expense change each period  Entry at maturity:  Account for last interest expense  Dr. Bonds Payable (-L) principal amount of the bonds issued o Cr. Cash (-A) o Premium bonds  Premium for investor  Coupon rate is greater than market rate  Coupon payment is greater than interest expense each period  So the NBV of bonds payable each period is reduced  NBV decreases over time (because cash proceeds are greater than principal)

o Early retirement of bonds o The firm buys bonds back from investors at a different rate from NBV of bonds o Firms must recognize a gain/loss when the purchase price is different from the NBV

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o o Book entry for a gain  Dr. Bonds Payable (-L) NBV of bonds  Cr. Cash (-A) purchase price  Cr. Gain on retirement of debt (plug) (+R) Reclassification of debt near maturity o Long-term debt must be reclassified as a current liability when it has only one year remaining o The current liability is called Current Maturity of Long Term Debt (CMLTD) o Book entry a year before maturity  Dr. Bonds Payable (-L)  Cr. CMLTD (+L) o Book entry at maturity  Dr. Interest Expense (+E)  Cr. CMLTD (+L)  Dr. CMLD (-L)  Cr. Cash (-A) Financial statement effects and disclosure of debt

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o Information in the footnotes and SCF allows us to reverse engineer bond-related events o Face value = amount we have to pay in the end The fair-value option in accounting for debt o Allows firms to adjust NBV each period to reflect the current market value o Fair value is the amount that people would be willing to pay for the bond

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This may be impacted by the current market interest rate and the credibility of the company  Lower interest rate  greater fair value o Book entry for adjustment  Dr. Long-term debt  Cr. Gain that affects SE  OR:  Dr. Loss that affects SE  Cr. Long-term debt o If fair value increases, firm recognizes a loss on SE o If fair value decreases, firm recognizes a gain on SE Net book value of debt o NBV is bonds payable, or what’s on the balance sheet o Coupon interest payment = face value (current NBV) * coupon rate o Interest expense = beginning NBV (principal) * market interest rate

Type of bonds)

Discount (investors buy for Discount (investors buy for Premium (investors less than principal) less than principal) buy for more than principal)

Par (investors buy for same amount as principal)

Principal 1000 (face value)

700

500

500

Proceeds 500 (cash)

500

700

500

Market rate

5%

5%

5%

5%

Coupon rate

0%

2%

8%

5%

NBV at 500 inception

500

700

500

NBV at year 1

Coupon: 700*.02=14.0 Int exp: 500*.05=25.0

Coupon: 500*.08=40.0 Int exp: 700*.05=35.0

Coupon: 500*.05=25.0 Int exp: 500*.05=25.0

Dr. Int Exp (+E) 35 Dr. Bonds Payable (L) 5 Cr. Cash (-A) 40

Dr. Int Exp (+E) 25 Cr. Cash (-A) 25 No bonds payable

Coupon: 1000*0=0 Int exp= 500*.05 = 25.0 Diff: 25 Dr. Int exp (+E) 25 Cr. Cash (-A) 0 Cr. Bonds Payable (+L) 25 Add L 500+25=525

Dr. Int Exp (+E) 25 Cr. Cash (-A) 14 Cr. Bonds Payable (+L) 25-14=11 Add L 500+11=511

Subtract L

700-5=695 500+0=500 NBV at year 2

Coupon: 1000*0=0 Int exp: 525*.05=26.25 Diff: 26.25 Dr. Int exp (+E) 26.25 Cr. Cash (-A) 0 Cr. Bonds Payable (+L) 26.25 Add L 525+26.25=551.25

Coupon: 700*.02=14.0 Int exp: 511*.05=25.55 Dr. Int exp (+E) 25.55 Cr. Cash (-A) 14 Cr. Bonds Payable (+L) 25.55-14=11.55 Add L 511+11.55=522.55

Coupon: 500*.08=40.0 Int exp: 695*.05=34.75

500

Dr. Int Exp (+E) 34.75 Dr. Bonds Payable (L) 40-34.75=5.25 Cr. Cash (-A) 40 Subtract L 695-5.25=689.75

NBV at year 3

Coupon: 1000*0=0 Coupon: 700*.02=14.0 Coupon: 500 Int exp: 500*.08=40.0 Int exp: 522.55*.05=26.1275 Int exp: 551.25*.05=27.5625 Dr. Int exp (+E) 27.5625 689.75*.05=34.4875 Dr. Int exp (+E) 26.1275 Cr. Cash (-A) 0 Cr. Cash (-A) 14 Dr. Int Exp (+E) Cr. Bonds Payable (+L) Cr. Bonds Payable (+L) 34.4875 27.5625 26.1275-14=12.1275 Dr. Bonds Payable (Add L L) 40551.25+27.5625=578.8125 Add L 522.55+12.1275=534.6775 34.4875=5.5125 Cr. Cash (-A) 40 Subtract L 689.755.5125=684.2375

… NBV at 1000 maturity NBV increases over time to accrue towards principal

700

500

500

NBV increases over time to accrue towards principal

NBV decreases over NBV stays the time to reach same over principal time

Leases  Off-balance sheet financing o Financial obligations that don’t have to be reported on the balance sheet o Rental contracts do not how up on balance sheets, so investors may not be aware of the risk and leverage  Leases o An agreement o The lessor (owner) transfers to the lessee (user) the right to use an asset over a period of time, in return for payments o Ex: airplanes, buildings, construction equipment o Can be viewed as a rental agreement o Short-term leases: allow use of an asset that would be inefficient to purchase o Long-term leases: financing arrangement to purchase a significant portion of a long-lived asset  Capital leases o Must meet at least 1 of the following criteria:  Lease term: the period of the lease encompasses at least 75% of the useful life of the asset  Present value: the present value of the minimum lease payments is at least 90% of the fair value of the asset at the beginning of the lease  Present value is discounting future cash flows and evaluating future cash flows based on what the present value is  Present value calculations allow you to compare different cash flows in the future  Present value discounts the cash flows based on the interest (or other income) that you could be earning to compare which set of cash flows work out better  Ex: I’d rather pay 100,000 every year than 950,000 upfront because of the present value of the 100,000 (you can earn interest on it)  There’s some number where it’s the same for either option, and present value can show you that  Ownership: the ownership is shifted from the lessor to the lessee at the end of the lease period  Bargain purchase option: the lessee can buy the asset from the lessor at the end of the lease term for a below-market price o Accounting  It’s a long-term liability, so it requires an interest expense  Long-term liability: present value of lease payments/principal (PV of lease payments at the end is 0 because they’ve all been paid)  Interest expense = implicit interest rate * NBV of the liability at the start of each period

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Interest expense for a particular year = implied interest rate on operating leases * present value of lease payments (all the future lease payments)  Implicit interest rate: market rate the firm would pay to borrow the funds in the capital markets  Principal payment = cash payment – interest expense  At the start of period, a long-term asset is recorded by the lessee  Long-term asset= present value of the lease payments  Depreciation expense/amortization is recorded for the long-term asset  Initial book entry  Dr. PPE (+A) present value of lease payments o Cr. Lease Obligation (+L) same number  Capital lease payment  Dr. Interest Expense (+E)  Dr. Lease obligation (+L) (plug) it’s a debit if cash > interest expense o Cr. Cash payment (-A) o Finding new capital leases entered into and equipment returned Leased Assets BB (don’t include amortization) Returned equipment New equipment (capital lease obligations incurred on SCF) EB (don’t include amortization) 

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Operating leases o If a lease is cancelable of doesn’t meet the criteria for a capital lease, it’s an operating lease o No asset or liability is recognized – just the rental expense that is equal to that year’s cash payment o Book entry each year  Dr. Rental/lease expense (+E) same amount  Cr. Cash payment (-A) cash paid o There is no balance sheet liability for operating leases, so there is no NBV (present value of future minimum capital lease payments) for operating leaess Operating leases vs. capital leases o There’s no difference in the total cash payments or total expenses o But the timing of the expenses differ, so there are differences if we look by year  Capital lease records more of the total expense in the early years and less in the later years  So a firm that uses capital leases will be more profitable in year 30, but a firm that uses operating leases will be more profitable in year 1

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SCF effects o Operating leases only affect CFO thru net income (lower because of rental expense) o Capital leases affect…  CFO thru net income (lower because of interest expense and depreciation expense) and adjustment for noncash expenses (depreciation)  CFF thru lease obligation o The total change in cash is the same, but it affects different parts

o “Capitalizing” Operating Leases o Adjusting the assets and liabilities on the B/S for operating leases o 1. Determine amount and timing of future cash flows related to operating leases o 2. Determine discount rate  Estimated interest rate if firm has capital leases outstanding: interest expense per year/ PV(future lease payments) o Use 1 and 2 to estimate the present value of operating lease payments Takeaways o Capital leases should be treated as purchasing an asset and taking out long-term debt to pay for the asset  Must depreciation the asset  Must pay interest on the lease o The lease determines the PV of the asset, which takes into account interest. The PV is split up into an annual cash payment over the life of the asset/lease  The cash payment is the same for operating and capital leases, but the expenses are different  For an operating lease, the expense is the same as the cash payment  For a capital lease, the expense is the interest expense plus the depreciation expense o Journal entry for operating lease  Dr. Lease Expense (+E)

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 Cr. Cash (-A) o Journal entry for capital lease  Dr. Interest expense (+E)  Dr. Lease obligation (-L) (plug, difference between the 2)  Cr. Cash (-A)  Dr. Depreciation Expense (+E)  Cr. Accumulated Depreciation (-A) o The beginning principal is the total lease obligation. It is reduced each year to reach 0 by the end of the lease. But the principal reduction/lease obligation each year is not the same as the annual cash payment because of the interest Future minimum lease payments = present value o Current portion of minimum lease payments = lease obligation o Implied interest rate:  Interest expense = interest rate * PV/future lease payments Leased Assets

BB (before amort.) New equipment (capital lease obligations incurred on supplement cash flow info)

EB (before amort.)

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