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Chapter 10 Long-Term Liabilities

Bonds Payable and other long-term debt are issued by a company to generate cash flow. Bonds Payable represent a promise by the company to pay a stated interest each period (yearly, semiannually, quarterly), and pay the face amount of the bond at maturity.

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Chapter 10 Long-Term Liabilities

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  1. Bonds Payable and other long-term debt are issued by a company to generate cash flow. Bonds Payable represent a promise by the company to pay a stated interest each period (yearly, semiannually, quarterly), and pay the face amount of the bond at maturity. The marketplace values bonds by discounting the cash flows using the market rate of interest. This is also called the yield rate, discount rate, or effective rate. The present value of the cash flows is the amount at which the bonds will issue. Chapter 10Long-Term Liabilities

  2. Issued for financing purposes. Advantages compared to issuing equity (ex: common stock) do not affect ownership control. interest on bonds is tax deductible (dividends are not deductible). Disadvantages compared to issuing equity Increases debt to equity ratio. interest payments are required to prevent default (where dividends are not required). Bonds Payable

  3. Bonds may be issued at face value, or at an amount greater than face value (premium), or an amount less than face value (discount). The amount of the stated interest rate offered by the company affects the price of the bond issue: Higher than market rate: issue at a premium Lower than market rate: issue at a discount Premium on B/P: (adjunct account) adds to bonds payable (normal credit balance) Discount on B/P: (contra account) reduces bonds payable (normal debit balance Carrying value of bonds = Face value + premium or Face value - discount Journal Entries for Bonds Payable

  4. If bonds are issued at a discount, the carrying value will be below face value at the date of issue. The Discount on B/P account has a normal debit balance and is a contra to B/P. The Discount account is amortized with a credit. Note that interest expense now equals the sum of the Cash Paid and the amount of the amortization. Int. expense = cash paid + discount amort. The company incurs additional interest expense because the discount is a cost to the company (must still pay back face value). Bonds Payable at a Discount.

  5. On January 1, 2006, Corvette Corporation issues $100,000 of its 5 year bonds which have an annual stated rate of 5%, and pay interest annually each December 31, starting December 31, 2006. The bonds were issued to yield 6% annually. Calculate the issue price of the bond: What are the cash flows and factors? (1) Face value at maturity = (2) Stated Interest = Face value x stated rate x time period Number of periods = n = 5yrs Discount rate = 6% per year Illustration 1: Bonds Payable (Discount)

  6. PV of interest annuity: PVA Table PVA Table PVA = A( ) = i, ni = 6%, n=5 PV of face value: PV1 Table PV1 Table PV =FV1( ) = i, n I = 6%, n=5 Total issue price = Issued at a discountof $4,212 because the company was offering an interest rate less than the market rate, and investors were not willing to pay as much for the lower interest rate. Illustration 1 : Present Value Calculations

  7. JE at 1/1/06 to issue the bonds: Discount on Bonds Payable is located in the liability section of the balance sheet, as a contra, and offsets Bonds Payable. On the balance sheet at 1/1/06: Liabilities Bonds Payable Discount on B/P (the carrying value is 95,788) Illustration 1 : Journal Entry at Issue

  8. JE at 12/31/06 to pay interest: Calculations first: Cash paid=Face x stated rate x time = = 100,000 x .05 x 1 yr. = $5,000 Interest expense = CV x market rate x time = = 95,788 x .06 x 1 yr = $5,747 (rounded) Amortization of discount = difference (plug) = 5,747 – 5,000 = 747 (credit) Now journal entry: Illustration 1 : Journal Entry to Pay Interest

  9. Cash Interest Carrying Date Paid ExpenseDifference Value 1/01/06 95,788 12/31/06 5,000 5,747 747 96,535 12/31/07 5,000 5,792 792 97,327 12/31/08 5,000 5,840 840 98,167 12/31/09 5,000 5,890 890 99,057 12/31/10 5,000 5,943 943 100,000 Cash paid = Face Value x Stated Rate x Time Int. expense = Carrying Value x Mkt. Rate x Time Illustration 1 - Amortization Schedule

  10. On July 1, 2005, Camero Corporation issues $50,000 of its 5 year bonds which have an annual stated rate of 7%, and pay interest semiannually each June 30 and December 31, starting December 31, 2005. The bonds were issued to yield 6% annually. Calculate the issue price of the bond: What are the cash flows and factors? (1) Face value at maturity = $100,000 (2) Stated Interest = Face value x stated rate x time period 100,000 x .07 x 1/2 = $3,500 Number of periods = n = 5 yrs x 2 = 10 Discount rate = 6% / 2 = 3% per period Illustration 2: Premium

  11. PV of interest annuity: PVA Table PVA Table PVA = A( ) = 3,500 (8.530) = $29,855 i, ni = 3%, n = 10 PV of face value: PV1 Table PV1 Table PV =FV1( ) = 100,000(0.744)=$74,400 i, n i=3%, n=10 Total issue price = $104,255 Issued at a premium of $4,255 because the company was offering an interest rate greater than the market rate, and investors were willing to pay more for the higher interest rate. Illustration 2 - Solution

  12. Cash Interest Carrying Date Paid ExpenseDifference Value 7/01/05 104,255 12/31/05 3,500 3,128 372 103,883 6/30/06 3,500 3,117 383 103,500 12/31/06 3,500 3,105 395 103,105 6/30/07 3,500 3,093 407 102,698 12/31/07 3,500 3,081 419 102,279 6/30/08 3,500 3,069 431 101,848 12/31/08 3,500 3,056 444 101,404 6/30/09 3,500 3,042 458 100,946 12/31/09 3,500 3,029 471 100,475 6/30/10 3,500 3,014 475* 100,000 *rounding difference Illustration 2 - Amortization Schedule

  13. JE at 12/31/05 to pay interest: Note that the numbers for interest change each period because the carrying value changes, but the cash payment is the same each period. JE at 6/30/2010 to retire the bonds: Illustration 2 - Journal Entries

  14. Bonds are retired when the company pays the investors the amount owed. If bonds are held to maturity, the amount on the books is face value and the amount paid is face value. If bonds are retired before maturity, the amount on the books is the carrying value, and the amount paid is the market value at the point of retirement. Because these two amounts are seldom the same, a gain or loss must be recognized. Retirement of Bonds

  15. The gain or loss is the difference between carrying value and cash paid. If cash paid is greater than CV, recognize loss (paid more than book liability). If cash paid is less than CV, recognize gain (paid less than book liability). When recording the early retirement, we must remove both Bonds Payable (face amount) and the related Premium or Discount (remaining unamortized amount). The gain or loss is recognized as part of Income from Continuing Operations (Other Revenues and Gains or Other Expenses and Losses). Retirement of Bonds

  16. Assume that Camaro’s bonds were retired on June 30, 2006 (after the interest payment). Camaro Corporation paid $103,000 to retire the bonds from the marketplace. Record the entries on June 30, 2006. JE at 6/30/06 to pay the interest (see Slide 12): JE at 6/30/06 to retire the bonds (CV = 103,500; see Slide 12): Back to Illustration 2 – Bond Retirement

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