Chapter 14: Long Term Liabilities

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Chapter 14 Long Term Liabilities
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Long Term Debt General

• Consists of probable future sacrifices
• Has various covenants or restrictions
• Protect both lenders borrowers
• Indenture agreement
• Terms of issue
• Restrictions

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Long Term Debt General

• Examples
• Bonds payable
• LT notes payable
• Mortgages
• Pensions
• Leases

4
Issuing Bonds

• Bonds are a very common type LTD
• Publicly traded companies /or LTD form
• Usually issued in 1,000 denominations
• Bond indenture
• Promise (by the lender to the borrower) to pay
• Sum of money at the designated date AND
• Periodic interest at stipulated rate on the face
  value

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Selected Types of Bonds

• Secured unsecured bonds
• Term or serial bonds
• Callable bonds
• Convertible bonds
• Bearer bonds
• Deep discount
• Commodity-backed (asset linked bonds)

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Bond Issues Parties to the Contract
Bond Issuer
Bondholders
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Valuation of Bonds Determining Bond Prices

• Bond price determined by
• PV of interest payments AND
• PV of face value
• Both discounted
• At market (effective) rate of interest
• At date of issue.
• Interest payments calculated as
• Face value of bond issue x Stated (face) rate
  of interest

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Bond Issue Pricing Concept
Relationship Relationship between betwee
n Stated rate Issue Price and market rate
and face value
S.R. Mkt Rate Issue Price F.V.
S.R. lt Mkt Rate Issue Price lt F.V.
S.R. gt Mkt Rate Issue Price gt F.V.
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Determining Bond Prices Example

• Given
• Face value of bond issue 100,000
• Term of issue 5 years
• Stated interest rate 9 annually at end of
  the year
• Market rate of interest 11
• What is the issue price of the bonds?

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Determining Bond Prices Example Cash Flows
Interest 100,000 x 9 per year stated rate
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Determining Bond Prices Example Present Value
of Cash Flows
92,608 is the issue price
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Discount on Bonds Payable

• Discount amortization
• Straight line method
• Effective interest method
• Preferred GAAP
• Interest expense
• Cash paid for interest XXX
• Add Discount amortized XXX
• Interest expense recognized XXX

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Classification of Discount on Bonds Payable

• Discount on bonds payable is a contra liability
  account
• Bonds Payable (face value) XXX
• Less Unamortized Discount ( XX)
• Bonds Payable (carrying value) XXX

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Premium on Bonds Payable

• Premium amortization
• Straight line method
• Effective interest method
• Preferred GAAP
• Interest expense
• Cash paid for interest XXX
• Less Premium amortized XXX
• Interest expense recognized XXX

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Classification of Premium on Bonds Payable

• Premium on bonds payable is an adjunct account
• Bonds Payable (face value) XXX
• Add Unamortized Premium XX
• Bonds Payable (carrying value) XXX

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A Note on Amortization Methods

• Straight-line method
• Allocates same amount of discount (or premium) to
  each interest period
• Effective-interest method
• Allocates discount or premium in increasing
  amounts over bond term
• Total discount or premium amortized is the same
  under both methods

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Straight-Line Method

• Equal amount of interest expense and
  discount/premium amortization each period
• Amount to amortize each period
• Total Discount/Premium
• Total Number of Periods

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Effective-Interest Method

• Method results in a different interest expense
  amortization each period
• Bond interest expense
• BOP Carrying Value x Effective Rate at Time of
  Issuance
• Discount/premium amortized
• Interest expense less interest to be paid

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Bond Discount and Premium Amortization Computation
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Bonds Issued on Interest Date

• Issued at par
• Cash
• Bonds Payable
• Issued at a discount
• Cash
• Discount on Bonds Payable
• Bonds Payable
• Issued at a premium
• Cash
• Premium on Bonds Payable
• Bonds Payable

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Bonds Issued Between Interest Dates

• May be issued between interest dates
• Interest for period between the issue date last
  interest date is collected with issue price of
  the bonds
• Accrued interest
• At specified interest date interest is paid for
  the entire interest period
• Semi-annual or annual
• Premium or discount are also amortized from issue
  date to end of interest period

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Accounting for the Costs of Issuing Bonds

• Must be amortized over the life of the bond issue
• Even though both straight-line and
  effective-interest methods are acceptable,
  straight-line method used in most cases

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Extinguishment of Debt

• Extinguished at maturity
• No gain or loss
• Premium, discount, BIC all amortized
• Extinguished early
• Adjust CV for unamortized discount, premium,
  BIC
• Calculate amortization through date of
  extinguishment
• CV gt reacquisition price GAIN
• CV lt reacquisition price LOSS

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LT Notes Payable and Bonds Payable A Comparison

• Similarities in notes and bonds payable
• Both have fixed maturity dates
• Both have either stated or implicit rates
• Notes payable valued at PV of its future interest
  payments face value (at maturity date)

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Zero-Interest Bearing Notes

• Zero-interest bearing note issued for cash
• PV measured by cash received
• Implicit interest rate
• Rate that equates cash received with future
  payment amount(s)
• Discount/premium amortized over term of note
  (effective interest method)
• Effective rate gt stated rate discount
• Effective rate lt stated rate premium

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Interest Bearing Notes

• Interest bearing note issued for cash
• Accounting similar to bonds payable
• Discount/premium amortized over term of note
  (effective interest method)
• Effective rate gt stated rate discount
• Effective rate lt stated rate premium
• NP credited in lieu of bonds payable

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Notes Issued for Property, Goods, or Services

• Note may be issued for items other than cash
• Stated interest rate presumed fair unless
• No interest is stated OR
• Stated interest rate is unreasonable OR
• Face amount is materially different from current
  fair value

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Notes Issued for Property, Goods, or Services

• Stated rate presumed fair
• Record note at face value
• Stated interest rate is not fair
• PV of note equals FV of items received
• Interest element (over and above any stated rate)
• Difference between face amount of note and FV of
  the property

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Interest Rate

• Imputed interest rate
• Affected by
• Prevailing rates similar issuers with similar
  credit ratings
• Specifically restrictive covenants, collateral,
  terms
• Existing prime rate
• Made when note issued
• Subsequent changes in prevailing rates ignored

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Mortgage Notes Payable

• Most common form LT NP
• Pledge title to property
• Face liability amount
• Points (1 of FV of NP)
• Raise effective rate
• Fixed vs. variable rate
• Variable changes as stated in NP

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Off-Balance Sheet Financing

• Represents borrowing arrangements that are not
  recorded
• Amount of debt reported in BS does not include
  such financing arrangements
• Objective of off BS debt
• Improve certain financial ratios (i.e.
  debt-equity ratio, etc.)
• Types
• Non-consolidated subsidiaries
• Special purpose entities (SPEs)
• Operating leases

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Analysis

• Debt to total assets ratio measures of assets
  provided by creditors
• Total debt
• Total assets
• Times interest earned ratio ability to meet
  interest payments when due
• Income before taxes interest expense
• Interest expense

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Ethics Issues

• Effective interest rate
• Imputed rate considerations
• Off balance sheet financing
• Note disclosures

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Problems

• E14-1 E14-4
• E14-5 E14-20
• E14-25 E14-27
• E14-11 E14-14 do bring to class