Kế toán tài chính 2 - Chapter 16: Long - Term liabilities

Long-TermLiabilitiesMultimedia Slides by: Gail A. Mestas, MAcc, New Mexico State UniversityChapter 16Learning ObjectivesIdentify the management issues related to issuing long-term debt.Identify and contrast the major characteristics of bonds.Record the issuance of bonds at face value and at a discount or premium.2Copyright © Houghton Mifflin Company. All rights reserved.Learning Objectives (cont’d)Use present values to determine the value of bonds.Amortize bond discounts and bond premiums using the straight-line and effective interest methods.Record bonds issued between interest dates and year-end adjustments.3Copyright © Houghton Mifflin Company. All rights reserved.Supplemental ObjectivesAccount for retirement of bonds and the conversion of bonds into stock.Explain the basic features of mortgages payable, long-term leases, and pensions and other postretirement benefits as long-term liabilities.4Copyright © Houghton Mifflin Company. All rights reserved.Management Issues Related to Issuing Long-Term DebtObjective 1Identify the management issues related to issuing long-term debt5Copyright © Houghton Mifflin Company. All rights reserved.Long-Term Liabilities are obligations of the business that are due to be paid after one year or beyond the normal operating cycle, whichever is longer6Copyright © Houghton Mifflin Company. All rights reserved.Long-Term Liabilities (cont’d)How a company finances its operations is the most important factor in the company’s long-term viabilityThe amount and the type of debt a company incurs depend onThe nature of the businessIts competitive environmentThe state of the financial marketsThe predictability of its earnings7Copyright © Houghton Mifflin Company. All rights reserved.Reasons and Resources for Long-Term DebtGrowing businesses frequently need long-term financing to invest in R&D activities and long-term assetsKey sources of long-term fundsIssuance of capital stockIssuance of long-term debt such as bonds, notes, mortgages, and leases8Copyright © Houghton Mifflin Company. All rights reserved.Management Issues Related to Issuing Long-Term DebtWhether to take in long-term debtHow much long-term debt to carryWhat types of long-term debt to carryHow to handle debt repayment9Copyright © Houghton Mifflin Company. All rights reserved.The Decision to Issue Long-Term Debt A key management decision regarding long-term funding for the company is Stockholders’ equity versus long-term debt10Copyright © Houghton Mifflin Company. All rights reserved.The Decision to Issue Long-Term DebtAdvantages of common stock over debtIt does not have to be paid backDividends are paid only if the company earns sufficient income11Copyright © Houghton Mifflin Company. All rights reserved.The Decision to Issue Long-Term DebtAdvantages of long-term debt over common stockStockholder controlCreditors do not elect directorsTax effectsInterest is tax-deductibleFinancial leverageAfter interest is paid, all excess earnings accrue to stockholders12Copyright © Houghton Mifflin Company. All rights reserved.Disadvantages of Debt FinancingCash is requiredFor periodic interest payments and to pay back the principal amountCompany can become overcommittedFinancial leverage can work against a companyIf the earnings from its investments do not exceed its interest payments13Copyright © Houghton Mifflin Company. All rights reserved.How Much Debt to CarryThe use of debt financing varies widely across industriesMany companies carry less than 100% of their stockholders’ equityLong-term debt Stockholders’ equityCommon measure of how much risk a company is undertaking with its debt is the interest coverage ratio14Copyright © Houghton Mifflin Company. All rights reserved.Average Debt to Equity for Selected IndustriesThe average debt to equity for these selected industries exceeds 100 percent of stockholders’ equity15Copyright © Houghton Mifflin Company. All rights reserved.Measures the degree of protection a company has from default on interest paymentsInterest Coverage Ratio measures how much risk a company is undertaking with its debt16Copyright © Houghton Mifflin Company. All rights reserved.AT&T had income before taxes and special items of $2,836 million and interest expense of $1,448 million in 2002This means that AT&T’s interest expense was covered 3.0 times in 2002Example of Interest Coverage Ratio17Copyright © Houghton Mifflin Company. All rights reserved.Long-term financing must be structured to the best advantage of the companyTypes of Long-Term DebtLong-term bonds (debentures) Can have many different characteristicsTime until repaymentAmount of interestAbility to repay earlyConversion into other securitiesLong-term notesMortgagesLong-term leases18Copyright © Houghton Mifflin Company. All rights reserved.Timing of Long-Term DebtCash flows must be carefully planned to ensure there will be sufficient funds to repay long-term debt when it becomes dueWhen done well and consistently, a company canAchieve the best debt ratingBenefit from lower interest ratesSchedule of debt repayment included in notes to financial statements19Copyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat are the advantages and disadvantages of issuing long-term debt?AdvantagesCommon stockholders do not relinquish controlInterest on debt is tax-deductibleFinancial leverage may increase a company’s earnings DisadvantagesInterest and principal must be repaid on scheduleFinancial leverage can work against a company if a project is not successful20Copyright © Houghton Mifflin Company. All rights reserved.The Nature of BondsObjective 2Identify and contrast the major characteristics of bonds21Copyright © Houghton Mifflin Company. All rights reserved.Bondsare securities, usually long-term, representing money borrowed from the investing public by a corporation or some other entityAre promises to repay the amount borrowed (principal) and interest at a specified rate on specified future datesMust be repaid at a specified time and require periodic (usually semiannual) payments of interest22Copyright © Houghton Mifflin Company. All rights reserved.The Nature of BondsBondholdersAre creditorsReceive a bond certificate or registration number as evidence of the organization's debtBond IssueTotal number of bonds issued at one timeFace value usually $1,000 or some multiple of $1,000Bond indenture Defines the rights, privileges, and limitations of the bondholdersDescribes the maturity date, interest payment dates, interest rate, and other characteristics of the bonds23Copyright © Houghton Mifflin Company. All rights reserved.Prices of Bonds are stated in terms of a percentage of face valueBonds selling at 100Sell at face or par valueBonds selling above 100Sell at a premiumBonds selling below 100Sell at a discount24Copyright © Houghton Mifflin Company. All rights reserved.Example of Selling Price of BondsA bond issue is quoted at 103 ½ What is the selling price of a $1,000 bond?A bond issue quoted at 103 ½ means that the bond sells at 103.5 percent of its face valueThis bond sells at a premium and would cost the buyer $1,03525Copyright © Houghton Mifflin Company. All rights reserved.Secured or Unsecured BondsUnsecured bondsIssued on the general credit of the organizationAlso called debenture bondsSecured bondsAssets are pledged as guarantee of repaymentSpecific asset(s)General category of property, plant, or equipment26Copyright © Houghton Mifflin Company. All rights reserved.Term or Serial BondsTerm bonds All mature at the same timeExampleIssue $1,000,000 all due 20 years from the date of issueSerial bonds Mature on several different datesCan help ease the task of retiring debtExampleIssue $1,000,000 with $20,000 of principal retired every 5 years27Copyright © Houghton Mifflin Company. All rights reserved.Registered or Coupon BondsRegistered bondsOrganization keeps a register of owners’ names and addressesPays interest by check to bondholders of record on interest payment dateMost common bonds issued todayCoupon bondsGenerally not registered with the organizationBear interest coupons State amount of interest due and payment dateBondholder presents coupon at bank for collection28Copyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat are a bond certificate, a bond issue, and a bond indenture?Bond certificateThe document that gives evidence of a company’s debt to a bondholder Bond issueThe total amount of bonds made available at one time Bond indentureThe supplementary agreement that specifies the characteristics of the bond issue29Copyright © Houghton Mifflin Company. All rights reserved.Accounting for Bonds PayableObjective 3Record the issuance of bonds at face value and at a discount or premium30Copyright © Houghton Mifflin Company. All rights reserved.Issuing Bonds PayableThe board of directors must submit the appropriate legal documents to the Securities and Exchange Commission (SEC) for approval to issue bondsA limited time for issue exists once bonds are authorizedNo journal entry requiredCan prepare a memorandum in the Bonds Payable account describing the issueStates particulars of the bond issueOnce bonds are issued, the company must payInterest over the life of the bondsThe principal of the bonds at maturity31Copyright © Houghton Mifflin Company. All rights reserved.Balance Sheet Disclosure of BondsBonds are disclosed on the balance sheet Usually as long-term liabilitiesAs current liabilities if maturity date is within one year32Copyright © Houghton Mifflin Company. All rights reserved.Balance Sheet Disclosure of BondsProvisions of bond indentures are reported in notes to the financial statementsIncludeList of bond issuesKinds of bondsInterest ratesInterest payment datesSecurities connected with bondsMaturity datesEffective interest rates33Copyright © Houghton Mifflin Company. All rights reserved.Vason Corporation has authorized the issuance of $100,000 of 9 percent, 5-year bonds on January 1, 20x4. Interest is to be paid on January 1 and July 1 of each year. The bonds are sold for their face value on January 1, 20x4Record the issuance of the bondsRecord a semiannual interest paymentBonds Issued at Face Value34Copyright © Houghton Mifflin Company. All rights reserved.Face Interest Rate and Market Interest RateFace interest rateThe rate of interest paid to bondholders based on the face value, or principal, of the bondsRate and amount are fixed over the life of the bondMarket interest rateThe rate of interest paid in the market on bonds of similar riskRate fluctuates dailyAlso called effective interest rate35Copyright © Houghton Mifflin Company. All rights reserved.Discounts and Premiums result from a difference between the market interest rate on the date of issue and the face interest rate, established by the bond issuer prior to the date of issueDiscountMarket interest rate > face interest rateBonds sell for less than face valuePremiumFace interest rate > market interest rateBonds sell for more than face value36Copyright © Houghton Mifflin Company. All rights reserved.Vason Corporation issues $100,000 of 9 percent, 5-year bonds at 96.149 on January 1, 20x4, when the market rate is 10 percentRecord the issuance of the bonds at a discountUnamortized Bond Discount is a contra-liability accountCarrying Value of Bonds = Face Value – Unamortized Bond DiscountBonds Issued at a Discount= $100,000 – $3,851 = $96,14937Copyright © Houghton Mifflin Company. All rights reserved.Vason Corporation issues $100,000 of 9 percent, 5-year bonds for $104,100 on January 1, 20x4, when the market rate is 8 percentRecord the issuance of the bonds at a premiumCarrying Value of Bonds = Face Value + Unamortized Bond PremiumBonds Issued at a Premium= $100,000 + $4,100 = $104,10038Copyright © Houghton Mifflin Company. All rights reserved.Bond Issue Costs are fees to underwriters for taking care of the details of marketing the issue or for taking a chance on receiving the selling priceCan be spread over the life of the bonds through the amortization of a discount or premium Decrease the amount of cash receivedIncrease bond discount or decrease bond premium39Copyright © Houghton Mifflin Company. All rights reserved.DiscussionUnder what circumstance does a bond sell at face value?When the face interest rate of the bond is identical to the market interest for similar bonds on the date of issue40Copyright © Houghton Mifflin Company. All rights reserved.Using Present Value to Value a BondObjective 4Use present values to determine the value of bonds41Copyright © Houghton Mifflin Company. All rights reserved.Using Present Value to Value a BondPresent value is relevant to the study of bonds The value of a bond is based on the present value of two components of cash flowA series of fixed interest paymentsA single payment at maturityThe amount of interest a bond pays is fixed over its life42Copyright © Houghton Mifflin Company. All rights reserved.Influence of the Market Interest RateThe market interest rate varies from day to day and therefore what investors are willing to pay changes as wellIf current market interest rate > bond’s interest rate, investors are willing to pay lessIf current market interest rate Face interest rateDetermining Present Value of a Bond44Copyright © Houghton Mifflin Company. All rights reserved.A bond has a face value of $10,000 and pays fixed interest of $450 every six months (a 9 percent annual rate). The bond is due in 5 years and the market interest rate is 8 percentWhat is the present value of the bond?Determine the interest rate and number of periods to use in the present value tablesDivide the annual interest rate by the number of periods in the year8% ÷ 2 = 4%Multiply the number of periods in one year by the number of years2 x 5 = 10 periodsMarket interest rate < Face interest rateDetermining Present Value of a Bond45Copyright © Houghton Mifflin Company. All rights reserved.DiscussionA corporation sold $500,000 of 5%, $1,000 bonds on the interest payment date. What would the proceeds from the sale be if the bonds were issued at 95, at 100, and at 102?The proceeds from the sale at 95 would be $475,000; at 100, $500,000; and at 102, $510,00046Copyright © Houghton Mifflin Company. All rights reserved.Amortization of Bond Discounts and PremiumsObjective 5Amortize bond discounts and bond premiums using the straight-line and effective interest methods47Copyright © Houghton Mifflin Company. All rights reserved.Bond Discount or Premium represents the amount by which the total interest cost is higher or lower than the total interest paymentsThe discount or premium is amortized over the life of the bondsProperly records interest costEnsures that the carrying value of bonds payable equals its face value at maturityUse straight-line or effective interest method48Copyright © Houghton Mifflin Company. All rights reserved.Amortizing a Bond DiscountWhen bonds are sold at a discountThe bond discount is unamortized Should be amortized (reduced gradually) over timeThis increases the carrying value of the bond (Stated value - Remains constant)(↓ as discount is amortized) (↑ as discount is amortized) 49Copyright © Houghton Mifflin Company. All rights reserved.Amortizing a Bond Discount (Stated value - Remains constant)(↓ as discount is amortized) (↑ as discount is amortized) By the bond maturity dateThe carrying value of the issue will equal its face valueThe unamortized bond discount will be zero50Copyright © Houghton Mifflin Company. All rights reserved.Vason Corporation issues $100,000 of 9 percent, 5-year bonds at 96.149 on January 1, 20x4, when the market rate is 10 percent. The bonds sold for $96,149, resulting in an unamortized bond discount of $3,851Calculation of Total Interest CostThe bonds were issued at a discountThe interest rate paid by the company is greater than the face interest rate on the bondsAlthough the company does not receive the full face value of the bonds on issue, it still must pay back the full face value at maturity51Copyright © Houghton Mifflin Company. All rights reserved.Vason Corporation issues $100,000 of 9 percent, 5-year bonds at 96.149 on January 1, 20x4, when the market rate is 10 percent. The bonds sold for $96,149, resulting in an unamortized bond discount of $3,851Or, alternativelyThe bond discount increases the interest paid on the bonds from the stated interest rate to the market interest rateCalculation of Total Interest Cost52Copyright © Houghton Mifflin Company. All rights reserved.Amortization of the Bond Discount Market Interest Rate = Stated Rate + DiscountFor each year’s interest expense to reflect the market interest rateThe discount must be allocated over the remaining life of the bond as an increase in the interest expense each periodThe interest expense for each period is then greater than the actual payment of interest By the amount of the bond discount amortized over the periodThe market interest rate is also called the effective interest rate53Copyright © Houghton Mifflin Company. All rights reserved.Zero Coupon BondsDo not require periodic interest paymentsRepresent a promise to pay a fixed amount at the maturity dateAre issued by some companies and governmental units54Copyright © Houghton Mifflin Company. All rights reserved.Step 1: Determine the total number of interest paymentsStep 2: Determine the amount of bond discount to amortize each interest periodStraight-Line Method assumes equal amortization of the bond discount for each interest period55Copyright © Houghton Mifflin Company. All rights reserved.Straight-Line Method (cont’d) assumes equal amortization of the bond discount for each interest periodStep 3: Determine the cash interest payment amountStep 4: Determine the total interest expense per interest period56Copyright © Houghton Mifflin Company. All rights reserved.Straight-Line Method (cont’d) assumes equal amortization of the bond discount for each interest periodRecord first semiannual interest payment and amortization of bond discount57Copyright © Houghton Mifflin Company. All rights reserved. Bond Amortization – Straight-Line MethodBonds Payable100,0003,581Jan 1, 20x4: Bonds issued$100,000 at 96.149, 9%, 5-year, semiannual interest paymentsUnamortized Bond DiscountNotice that the carrying value is equal to the amount of cash received for the bond issue58Copyright © Houghton Mifflin Company. All rights reserved. 358.10The amount of unamortized bond discount is declining while the carrying value of the bond is increasingBond Amortization – Straight-Line MethodBonds Payable100,0003,581Unamortized Bond DiscountJuly 1, 20x4: First semiannual interest date. Bond discount is amortized59Copyright © Houghton Mifflin Company. All rights reserved. Jan. 1, 20x5 through January 1, 20x9: Second through tenth semiannual interest dates358.10Bond Amortization – Straight-Line MethodBonds Payable100,0003,581Unamortized Bond DiscountNotice that the carrying value is now equal to the face amount of the bond issue358.10358.10358.10358.10358.10358.10358.10358.10Bal. -0-358.1060Copyright © Houghton Mifflin Company. All rights reserved. 358.10Bond Amortization – Straight-Line MethodBonds Payable100,0003,581Unamortized Bond Discount358.10358.10358.10358.10358.10358.10358.10358.10Bal. -0-358.10The company will pay the bondholder $100,000 (the face value of the bond), which is equal to the cash received when the bond was issued plus the bond discountJan. 1, 20x9: Bond dueBal. -0-100,00061Copyright © Houghton Mifflin Company. All rights reserved.Weaknesses of Straight-Line MethodBecause carrying value goes up each period and the bond interest expense says the sameWhen amortizing a discount, the rate of interest falls over timeWhen amortizing a premium, the rate of interest rises over timeStraight-line method can be used only when it does not lead to a material difference from the effective interest methodPer Accounting Principles Board62Copyright © Houghton Mifflin Company. All rights reserved.Effective Interest Method applies a constant interest rate to the carrying value of bonds at the beginning of the interest periodRate equals the market, or effective, rate at the time the bonds were issuedAmount amortized is difference between interest computed and actual interest paid to bondholders 63Copyright © Houghton Mifflin Company. All rights reserved.64Copyright © Houghton Mifflin Company. All rights reserved. First interest period Column A – Carrying value = Face value – Unamortized bond discount Column B – Use effective interest rate ($96,149 x .10 x 6/12 = $4,807) Column C – Use face interest rate on bond ($100,00 x .09 x 6/12 = $4,500) Is a constant amountBond issuedBond Amortization – Effective Interest Method65Copyright © Houghton Mifflin Company. All rights reserved. Bond Amortization – Effective Interest MethodFirst interest period (cont.) Column D – Discount amortized = Effective interest expense – Actual interest payment to bondholders ($4,807 - $4,500 = $307) Column E – Bond discount at beginning of period – Current period amortization ($3,851 - $307 = $3,544) Column F – Carrying value at beginning of period + Amortization during the period ($96,149 + $307 = $96,456)66Copyright © Houghton Mifflin Company. All rights reserved. Bond Amortization – Effective Interest MethodNotice that the sum of the carrying value and the unamortized discount always equals the face value of the bonds67Copyright © Houghton Mifflin Company. All rights reserved.Record first semiannual interest payment and amortization of bond discountIt is not necessary to prepare an interest and amortization table to determine amortization of a discount for the periodBond Amortization – Effective Interest Method (cont’d)68Copyright © Houghton Mifflin Company. All rights reserved.Carrying Value and Interest Expense – Bonds Issued at a Discount69Copyright © Houghton Mifflin Company. All rights reserved.Amortizing a Bond Premium is similar to amortizing a bond discountExcept bondholders pay more than face value for the bondsPremium represents an amount that bondholders will not receive at maturityIs a reduction, in advance, of the total interest paid on the bonds over the life of the issue70Copyright © Houghton Mifflin Company. All rights reserved.Vason Corporation issues $100,000 of 9 percent, 5-year bonds at 104.1 on January 1, 20x4, when the market rate is 8 percent. The bonds sold for $104,100 resulting in an unamortized bond premium of $4,100Or, alternativelyThe bond premium decreases the interest paid on the bonds from the stated interest rate to the market interest rateCalculation of Total Interest Cost71Copyright © Houghton Mifflin Company. All rights reserved.Step 1: Determine the total number of interest paymentsStep 2: Determine the amount of bond discount to amortize each interest periodStraight-Line Method assumes equal amortization of the bond premium for each interest period72Copyright © Houghton Mifflin Company. All rights reserved.Straight-Line Method (cont’d) assumes equal amortization of the bond premium for each interest periodStep 3: Determine the cash interest payment amountStep 4: Determine the total interest expense per interest period73Copyright © Houghton Mifflin Company. All rights reserved.Straight-Line Method (cont’d) assumes equal amortization of the bond premium for each interest periodRecord first semiannual interest payment and amortization of bond discount74Copyright © Houghton Mifflin Company. All rights reserved.75Copyright © Houghton Mifflin Company. All rights reserved.Record first semiannual interest payment and amortization of bond premiumIt is not necessary to prepare an interest and amortization table to determine amortization of a discount for the periodBond Amortization – Effective Interest Method (cont’d)76Copyright © Houghton Mifflin Company. All rights reserved.Carrying Value and Interest Expense – Bonds Issued at a Premium77Copyright © Houghton Mifflin Company. All rights reserved.DiscussionWhy is a bond discount considered a component of total interest cost?A bond discount represents the amount by which the face value of the bond exceeds the issue price. This amount must be paid by the corporation at the time of maturity78Copyright © Houghton Mifflin Company. All rights reserved.Other Bonds Payable IssuesObjective 6Record bonds issued between interest dates and year-end adjustments79Copyright © Houghton Mifflin Company. All rights reserved.Sale of Bonds Between Interest DatesGenerally accepted method Collect from investors the interest that would have accrued for the partial period preceding the issue dateWhen the first interest period is completed, the corporation pays investors the interest for the entire periodThis procedure is followed for two reasons:Decreases bookkeeping for sales at various datesWhen the accrued amount is netted against the full interest paid on the interest payment date, the result is the interest expense for the time the money was borrowed80Copyright © Houghton Mifflin Company. All rights reserved.Vason Corporation sold $100,000 of 9 percent, 5-year bonds on May 1, 20x4 (after the January 1, 20x4 issue date)Record the sale of the bondsBond Interest ExpenseBal. 0May 1 3,000Bondholder pays interest that would have accrued for the partial period from the issue date to the sale date Example of Sale of Bonds Between Interest Dates81Copyright © Houghton Mifflin Company. All rights reserved.Vason Corporation sold $100,000 of 9 percent, 5-year bonds on May 1, 20x4 (after the January 1, 20x4 issue date)Record the first semiannual interest paymentBond Interest ExpenseBal. 0May 1 3,000Example of Sale of Bonds Between Interest DatesJuly 1 4,500Bal. 1,500Corporation pays the bondholder interest for the entire period The bondholder is reimbursed for the partial interest payment made at time of sale ($3,000) plus paid interest for the partial period the bond was held ($1,500)82Copyright © Houghton Mifflin Company. All rights reserved.Effect of Bond Interest Expense When Bonds Are Issued Between Interest Dates83Copyright © Houghton Mifflin Company. All rights reserved.Year-End Accrual of Bond Interest ExpenseBond interest dates rarely correspond with a company’s fiscal yearMake an adjustment at end of accounting periodAccrue interest expense on bonds from last payment date to end of fiscal yearAmortize any discount or premium84Copyright © Houghton Mifflin Company. All rights reserved.Record the year-end accrual of bond interest expenseVason Corporation issues $100,000 of 9 percent, 5-year bonds at 104.1 on January 1, 20x4. The company’s fiscal year ends September 30, 20x4Interest and amortization were recorded on July 1, 20x4Three months of interest has accrued since thenYear-End Accrual of Bond Interest Expense (cont’d)85Copyright © Houghton Mifflin Company. All rights reserved.Record second semiannual interest payment and amortization of bond premiumVason Corporation issues $100,000 of 9 percent, 5-year bonds at 104.1 on January 1, 20x4. The company’s fiscal year ends September 30, 20x4Year-End Accrual of Bond Interest Expense (cont’d)86Copyright © Houghton Mifflin Company. All rights reserved.DiscussionWhen bonds are issued between interest dates, why is it necessary for the issuer to collect an amount equal to accrued interest from the buyer?Interest must be allocated between the buyer and the seller when a sale takes place between interest dates because the full period’s interest is paid on interest dates to the holders on those dates The buyer pays the seller the accrued interest for the period since the last interest date The seller is then reimbursed for that amount on the following interest payment date when the full amount of interest for the period is paid87Copyright © Houghton Mifflin Company. All rights reserved.Retirement of BondsSupplemental Objective 7Account for retirement of bonds and the conversion of bonds into stock88Copyright © Houghton Mifflin Company. All rights reserved.Retirement of Bonds occurs when a corporation buys back bonds before the maturity dateCallable BondsThe issuer has the right to buy back and retire bonds at a specified call priceConvertible bondsCan be exchanged for common stock or other securities of the corporation89Copyright © Houghton Mifflin Company. All rights reserved.Callable Bonds can be bought back by the issuer and retired at a specific call price before maturityCall priceUsually above face value90Copyright © Houghton Mifflin Company. All rights reserved.Callable Bonds (cont’d) Reasons to call bondsIf bond interest rates dropCall bonds, then reissue debt at a lower interest rateCompany has earned enough to pay back debt before maturity dateReason for debt no longer existsTo restructure the company’s debt to equity ratioEarly retirement of bonds is called early extinguishment of debt91Copyright © Houghton Mifflin Company. All rights reserved. Record the retirement of the bondsVason Corporation can call or retire at 105 the $100,000 of bonds it issued at a premium (104.1). It decides to do so on July 1, 20x7. The entry for the required interest payment and amortization of the premium has already been madeThe loss occurs because the call price of the bonds is greater than the carrying value Example of Callable Bonds92Copyright © Houghton Mifflin Company. All rights reserved. Vason Corporation can call or retire at 105 the $100,000 of bonds it issued at a premium (104.1). Because of a rise in interest rates, Vason is able to purchase the $100,000 bond issue on the open market for 85. It decides to do so on July 1, 20x7. The entry for the required interest payment and amortization of the premium has already been madeRecord the purchase of the bondsThe gain occurs because the call price of the bonds is less than the carrying value Example of Callable Bonds (cont’d)93Copyright © Houghton Mifflin Company. All rights reserved.Convertible Bondscan be exchanged for common stock or other securities of the corporationEnables an investor to make more money If the market price of the common stock rises, the value of the bonds risesIf the market price does not rise, the investor holds the bonds and receives both interest payments and principal at the maturity date94Copyright © Houghton Mifflin Company. All rights reserved.Reasons to Issue Convertible BondsDesirability to investors enables companies to issue at lower interest ratesLower costManagement does not give up any controlBondholders have no voting rightsBond interest expense is tax-deductibleTax savings 95Copyright © Houghton Mifflin Company. All rights reserved.Reasons to Issue Convertible Bonds (cont’d)If the company earns a return higher than the interest expense, income will increase Financial flexibilityIf stock price increases and convertible bond price exceeds face value, management can avoid repaying bonds because bondholders will want to convert into common stock96Copyright © Houghton Mifflin Company. All rights reserved.Possible Disadvantages of Convertible BondsBond interest payments must be made on stated dates (usually semiannually) Failure to do so can lead to bankruptcyWhen bonds are converted, bondholders become stockholders with additional rights, e.g., voting rightsConversion to common stock dilutes existing stockholders’ ownership97Copyright © Houghton Mifflin Company. All rights reserved.Vason Corporation issued $100,000 of convertible bonds on January 1, 20x4, that can be converted to 40 shares of common stock for each $1,000 bond. The bondholders decide to convert all the bonds to $8 par value common stock on July 1, 20x7Record the bond conversionNo loss or gain is recorded because the bond liability and the associated unamortized discount or premium are written off the booksExample of Convertible Bonds98Copyright © Houghton Mifflin Company. All rights reserved.DiscussionWhy would a company want to exercise the callable provision of a bond when it can wait to pay off the debt?A company may have earned enough money to pay off the debt The reason for the debt may no longer exist Market conditions may have changed, making it cost-effective to call the debt The company may want to restructure its debt to equity ratio99Copyright © Houghton Mifflin Company. All rights reserved.Other Long-Term LiabilitiesSupplemental Objective 8Explain the basic features of mortgages payable, long-term leases, and pensions and other postretirement benefits as long-term liabilities100Copyright © Houghton Mifflin Company. All rights reserved.Other Common Long-Term LiabilitiesMortgages payableLong-term leasesPensionsOther post-retirement benefits101Copyright © Houghton Mifflin Company. All rights reserved.Mortgages PayableA mortgage is a long-term debt secured by real property, usually paid in equal monthly installments102Copyright © Houghton Mifflin Company. All rights reserved.Obtaining New Operating AssetsThere are several ways for a company to obtain new operating assetsBorrow money to purchase the assetAsset and liability are recorded at the amount paidAsset is subject to periodic depreciationRent the asset on a short-term leaseCalled an operating leaseRisks of ownership remain with the lessorObtain the asset on a long-term leaseRequires no immediate cash paymentCost is less than a short-term lease103Copyright © Houghton Mifflin Company. All rights reserved.Long-Term LeasesOften the lease cannot be canceledDuration of the lease may be about the same as the useful life of the assetThere may be a provision for the lessee to buy the asset at the end of the lease termSimilar to an installment purchase If a lease meets the above conditions, the FASB rules that it should be accounted for as a capital lease104Copyright © Houghton Mifflin Company. All rights reserved.Capital Leases are more like purchases or sales on installmentUnder a capital leaseEquipment is classified as a long-term assetObligations are classified as long-term liabilities Both are equal to the present value of the lease payments over the lease termEach lease payment consists of interest and repayment of debtDepreciation is computed on the asset105Copyright © Houghton Mifflin Company. All rights reserved.Record the lease contractIsaacs Company enters into a long-term lease for a machine used in its operations. The lease terms call for an annual payment of $4,000 for six years, which approximates the useful life of the machine. Title to the machine passes to Isaacs at the end of the lease periodCompute the present value of the lease payments, if Isaacs’s interest cost is 16%Use Table 4 of the future and present value tablesLong-term assetLong-term liabilityExample of Capital Lease106Copyright © Houghton Mifflin Company. All rights reserved.Isaacs Company enters into a long-term lease for a machine used in its operations. The lease terms call for an annual payment of $4,000 for six years, which approximates the useful life of the machine. Title to the machine passes to Isaacs at the end of the lease periodRecord periodic depreciationCompute periodic depreciation using the straight-line method (assume no salvage value)Example of Capital Lease107Copyright © Houghton Mifflin Company. All rights reserved. Example of Capital LeaseIsaacs Company enters into a long-term lease for a machine used in its operations. The lease terms call for an annual payment of $4,000 for six years, which approximates the useful life of the machine. Title to the machine passes to Isaacs at the end of the lease periodRecord interest expenseCompute interest expense for the yearThe lease obligation is reduced by the difference between the amount of the cash payment and interest expense108Copyright © Houghton Mifflin Company. All rights reserved.Pension Plansare contracts between a company and its employees in which the company agrees to pay benefits to the employees after they retireContributions from the employee and the company are paid into a pension fundPensions are accounted for by a debit to Pension Expense and a credit to Cash or a liability109Copyright © Houghton Mifflin Company. All rights reserved.Types of Pension PlansDefined contribution plan Amount of annual contribution is fixedRequires that the employer contribute a specified annual amount Amount of future retirement benefits based on amount of pension payments the accumulated contributions can supportDefined benefit plan Amount of annual contribution variesEmployer required to contribute the amount needed to fund pension liabilities arising from employment in current yearAmount of future retirement benefits is fixed110Copyright © Houghton Mifflin Company. All rights reserved.Other Postretirement BenefitsInclude health care and other benefitsIn addition to pension benefitsThe FASB has concluded that they should be estimated and accrued while the employee is working, in order to follow the matching principleIn the past, were accounted for on a cash basis111Copyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat is the difference between an operating lease and a capital lease?Operating leaseShort-term, cancelable leaseRisk of ownership lies with lessorPayments recorded as an expense Capital leaseLong-term, often cannot be canceledRisk of ownership lies with lesseePresent value recorded as an asset and depreciated112Copyright © Houghton Mifflin Company. All rights reserved.Time for ReviewIdentify the management issues related to issuing long-term debtIdentify and contrast the major characteristics of bondsRecord the issuance of bonds at face value and at a discount or premium113Copyright © Houghton Mifflin Company. All rights reserved.More ReviewUse present values to determine the value of bondsAmortize bond discounts and bond premiums using the straight-line and effective interest methodsRecord bonds issued between interest dates and year-end adjustments114Copyright © Houghton Mifflin Company. All rights reserved. And FinallyAccount for retirement of bonds and the conversion of bonds into stockExplain the basic features of mortgages payable, long-term leases, and pensions and other postretirement benefits as long-term liabilities115Copyright © Houghton Mifflin Company. All rights reserved.