Chapter 10 - 12.docx - Page 446 10 ACCOUNTING FOR LONG-TERM...

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Unformatted text preview: Page 446 10 ACCOUNTING FOR LONG-TERM LIABILITIES CHAPTER PREVIEW BOND BASICS A1Bond financing Bond trading P1Par bonds NTK 10-1 DISCOUNT BONDS Discount or premium P2Bond payments Amortize discount Straight-line NTK 10-2 PREMIUM BONDS P3Bond payments Amortize premium Straight-line P4Bond retirement NTK 10-3 LONG-TERM NOTES C1Recording notes DEBT ANALYSIS A2Debt features A3Debt-to-equity NTK 10-4 LEARNING OBJECTIVES CONCEPTUAL C1Explain the types of notes and prepare entries to account for notes. C2Appendix 10A—Explain and compute bond pricing. C3Appendix 10C—Describe accounting for leases and pensions. ANALYTICAL A1Compare bond financing with stock financing. A2Assess debt features and their implications. A3Compute the debt-to-equity ratio and explain its use. PROCEDURAL P1Prepare entries to record bond issuance and interest expense. P2Compute and record amortization of a bond discount using the straight-line method. P3Compute and record amortization of a bond premium using the straight-line method. P4Record the retirement of bonds. P5 Appendix 10B—Compute and record amortization of a bond discount using the effective interest method. P6 Appendix 10B—Compute and record amortization of a bond premium using the effective interest method. Page 447 © David Paul Morris/Bloomberg via Getty Images “Push the limits” —Travis Kalanick Hitch a Ride SAN FRANCISCO—Garrett Camp and Travis Kalanick were in Paris and tried to hail a cab. “I would wait 30–40 minutes for a cab that never showed up,” explains Garrett. He recalls looking at his friend Travis and saying, “I just want to push a button and get a ride.” Travis perked up, “I’m like, ‘That’s pretty good.’” That’s how Uber (Uber.com) got started. Uber is an app that connects consumers with drivers through GPS location services. “Our mission is transportation as reliable as running water,” exclaims Travis, “everywhere for everyone!” To translate their idea into action, Garrett and Travis needed to finance the business. They decided on a mix of debt and equity financing. “Our strategy is to make sure that we are raising as much as our competitors are,” explains Travis, “that our balance sheet is as healthy as theirs is.” Debt financing is key for Garrett and Travis. Debt financing enables them to keep more control and reap more of the upside of Uber’s success. The two owners raised over a billion dollars in debt financing. Garrett and Travis explain that getting their accounting system in order was crucial in raising and tracking such large issuances of bonds and notes payable. This included bond issuance procedures, including how to account for and price bonds issued at a discount or premium. The owners discovered the usefulness of convertible bonds and issued them as one part of their financing efforts. They also had to deal with accounting rules for convertible bonds. “It takes a little time to get a system up and running,” explains Garrett, and he insists the reporting system is “very important” to their success. Creditors give Uber a thumbs-up for its management of debt and equity. Uber broke the U.S. record (previously held by Facebook) for most equity financing before offering stock to the public. Garrett and Travis successfully navigated the waters of debt and equity financing. Yet their greatest financing challenge might still lie ahead: an Uber IPO (initial public offering) of equity. “I’m going to make sure it happens,” proclaims Travis. “I want to build something that endures.” Sources: Uber website, January 2017; CNBC, March 2016; Wall Street Journal, January 2015; 99u, May 2014; Wall Street Journal, January 2013 Page 448 BASICS OF BONDS This section explains bonds and reasons for issuing them. Both for-profit and nonprofit companies, as well as governmental units, such as nations, states, cities, and schools, issue bonds. Bond Financing A1 Compare bond financing with stock financing. Projects that demand large amounts of money often are funded from bond issuances. A bond is its issuer’s written promise to pay an amount equaling the par value of the bond with interest.The par value of a bond, also called the face amount or face value, is paid at a stated future date known as the bond’smaturity date. Most bonds require the issuer to make semiannual interest payments. Interest paid each period is computed by multiplying the par value of the bond by the bond’s contract rate. Advantages of Bonds There are three main advantages of bond financing: 1. Bonds do not affect owner control. Equity financing reflects ownership in a company, but bond financing does not. A person who contributes $1,000 of a company’s $10,000 equity financing typically controls one-tenth of owner decisions. A person who owns a $1,000, 11%, 20-year bond has no ownership right. 2. Interest on bonds is tax deductible. Bond interest payments are tax deductible for the issuer, but distributions to owners are not. To illustrate, assume that a corporation with no bond financing earns $15,000 in income before paying taxes at a 40% tax rate, which amounts to $6,000 ($15,000 × 40%) in taxes. If a portion of its financing is in bonds, however, the resulting bond interest is deducted in computing taxable income. This means if bond interest expense is $10,000, then taxes owed would be $2,000 ([$15,000 − $10,000] × 40%), which is less than the $6,000 owed with no bond financing. 3. Bonds can increase return on equity. A company that earns a higher return with borrowed funds than it pays in interest on those funds increases its return on equity. This process is called financial leverageor trading on the equity. To illustrate the third point, consider Magnum Co., which has $1,000 million in equity and is planning a $500 million expansion to meet increasing demand for its product. Magnum predicts the $500 million expansion will yield $125 million in additional income before paying interest. It currently earns $100 million per year and has no interest expense. Magnum is considering three plans. Plan A is to not expand. Plan B is to expand and raise $500 million from equity financing. Plan C is to expand and issue $500 million of bonds that pay 10% annual interest ($50 mil.). Exhibit 10.1 shows how these three plans affect Magnum’s net income, equity, and return on equity (net income/equity). Magnum earns a higher return on equity under Plan C to issue bonds. Income under Plan C ($175 mil.) is smaller than under Plan B ($225 mil.), but the return on equity is larger because of less equity investment. Plan C has another advantage if income is taxable. This illustration reflects a general rule: Return on equity increases when the expected rate of return from the new assets is higher than the rate of interest expense on debt financing. Point: Financial leverage refers to issuance of bonds, notes, and preferred stock. EXHIBIT 10.1 Financing with Bonds versus Equity $ millions Plan A: Do Not Expand Plan B: Plan C: Equity Bond Financing Financing Income before interest expense $ 100 $ 225 Interest expense _— $ — 225 (50) Net income $ 100 $ 225 $ Equity $1,000 $1,500 $ 1,000 Return on equity 10.0% 15.0% 175 17.5% Example: Compute return on equity for all three plans if Magnum is subject to a 40% income tax. Answer ($ mil.): A = 6.0% ($100[1 − 0.4]/$1,000) B = 9.0% ($225[1 − 0.4]/$1,500) C = 10.5% ($175[1 − 0.4]/$1,000) Page 449 Disadvantages of Bonds The two main disadvantages of bond financing are: 1. Bonds can decrease return on equity. When a company earns a lower return with the borrowed funds than it pays in interest, it decreases return on equity. This downside of financial leverage is more likely when a company has periods of low income or net losses. 2. Bonds require payment of both periodic interest and the par value at maturity. Bond payments are a burden when income and cash flow are low. Equity financing does not require payments because withdrawals (dividends) are paid at the will of the owner (or board). Point: There are nearly 5 million individual U.S. bond issues, ranging from huge treasuries to tiny municipalities. This compares to about 12,000 individual U.S. stocks that are traded. Bond Trading Bonds can be bought and sold. A bond issue consists of a number of bonds, usually in denominations of $1,000 or $5,000, and is sold to many different lenders. After bonds are issued, they often are bought and sold among investors, meaning that a bond probably has a number of owners before it matures. When bonds are bought and sold in the market, they have a market value (price). Bond market values are expressed as a percent of par (face) value. For example, a bond trading at 103½ is bought or sold for 103.5% of par value. A bond trading at 95 is bought or sold at 95% of par value. Point: A bond with a par value of $1,000 trading at 103½ sells for $1,035 ($1,000 × 1.035). Point: Two of the largest bond issuances in history were: Verizon $49 billion Apple $17 billion DECISION INSIGHT Quotes The IBM bond quote here is interpreted (left to right) as Bonds, issuer name; Rate, contract interest rate (4%); Mat, matures in year 2042 when principal is paid; Yld, yield rate (3.81%) of bond at current price; Vol, dollar worth ($110,000) of trades (in 1,000s); Close, closing price (103.08) for the day as percentage of par value; Chg, change (+0.73%) in closing price from prior day’s close. ■ Bond s Rate Mat Yld Vol Close Chg IBM 4 42 3.81 110 103.0 8 +0.73% Bond-Issuing Procedures Authorization of bond issuances includes the number of bonds authorized, their par value, and the contract interest rate. The legal document describing the rights and obligations of both the bondholders and the issuer is called the bond indenture, which is the legal contract between the issuer and the bondholders (and specifies when interest is paid). A bondholder may also receive a bond certificate as evidence of the company’s debt. A bond certificate, such as in Exhibit 10.2, includes the issuer’s name, the par value, the contract interest rate, and the maturity date.1 EXHIBIT 10.2 Bond Certificate Courtesy of RBC Wealth Management Point: Indenture refers to a bond’s legal contract; debenture refers to an unsecured bond. Page 450 PAR BONDS P1 Prepare entries to record bond issuance and interest expense. Bonds issued at par value are called par bonds. To illustrate, suppose Nike issues $100,000 of 8%, 2-year bonds dated December 31, 2017, that mature on December 31, 2019, and pay interest semiannually each June 30 and December 31. If all bonds are sold at par value, Nike records the sale as follows—increasing Nike’s cash and long-term liabilities. 2017 Dec. 31 Cash Bonds Payable 100,000 100,000 Sold bonds at par. Assets+100,000=Liabilities+100,000+EquityAssets=Liabilities+Equity+100,000+100,000 Nike records the first semiannual interest payment as follows—the same entry is made every six months including the maturity date. 2018 June 30 Bond Interest Expense 4,000 Cash 4,000 Paid semiannual interest (8% × $100,000 × ½ year). Assets−4,000=Liabilities+Equity−4,000 Assets=Liabilities+Equity−4,000−4,000 When the bonds mature, Nike records its payment of principal as follows. 2019 Dec. 31 Bonds Payable 100,000 Cash 100,000 Paid bond principal at maturity. Assets−100,000=Liabilities−100,000+EquityAssets=Liabilities+Equity−100,000−100,000 NEED-TO-KNOW 10-1 Recording Par Value Bonds (P1) A company issues 8%, two-year bonds on December 31, 2017, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 8%, which implies a selling price of $7,000. Prepare journal entries to record (a) the issuance of bonds on December 31, 2017; (b) the first through fourth interest payments on each June 30 and December 31; and (c) the maturity of the bond on December 31, 2019. Solution a. 2017 Dec. 31 Cash Bonds Payable 7,000 7,000 Sold bonds at par. b. The following entry is made for each of the four interest payments of June 30 and December 31 for both 2018 and 2019. Bond Interest Expense 280 Cash 280 Pay semiannual interest ($7,000 × 8% × 1/2). c. 2019 Dec. 31 Bonds Payable Cash 7,000 7,000 Record maturity and payment of bonds. Do More: QS 10-16, E 10-1, E 10-16 Page 451 DISCOUNT BONDS This section explains accounting for bond issuances below par, called discount bonds. Bond Discount or Premium The bond issuer pays the interest rate specified in the indenture, the contract rate, also called thecoupon rate, stated rate, or nominal rate. The annual interest paid is computed by multiplying the bond par value by the contract rate. The contract rate is usually stated on an annual basis, even if interest is paid semiannually. For example, if a company issues a $1,000, 8% bond paying interest semiannually, it pays annual interest of $80 (8% × $1,000) in two semiannual payments of $40 each. The contract rate sets the interest the issuer pays in cash, which is not necessarily the bond interest expense for the issuer. Bond interest expense depends on the bond’s market value at issuance, which is determined by market expectations of the risk of lending to the issuer. The bond’s market rate of interest is the rate that borrowers are willing to pay and lenders are willing to accept for a bond and its risk level. As risk increases, the market rate increases to compensate purchasers for the bonds’ increased risk. Also, the market rate is usually higher when the time until the bond matures is longer due to the risk of bad events over a longer time period. When the contract rate and market rate are equal, a bond sells at par value. If they are not equal, it is sold at a premium above par value or at a discount below par value. Exhibit 10.3 shows the relation between the contract rate, the market rate, and a bond’s issue price. EXHIBIT 10.3 Relation between Bond Issue Price, Contract Rate, and Market Rate Issuing Bonds at a Discount P2 Compute and record amortization of a bond discount using the straight-line method. A discount on bonds payable occurs when a company issues bonds with a contract rate less than the market rate. This means the issue price is less than par value—the issuer gets less money at issuance than what the issuer must pay back at maturity. To illustrate, assume that Fila issues bonds with a $100,000 par value, an 8% annual contract rate (paid semiannually), and a two-year life. Also assume that the market rate for Fila bonds is 10%. These bonds sell at a discount because the contract rate is less than the market rate. The exact issue price is stated as 96.454 (implying 96.454% of par value, or $96,454); we show how to compute this issue price in Appendix 10A. Cash Payments with Discount Bonds These bonds require Fila to pay: 1. Par value of $100,000 cash at the end of the bonds’ two-year life. 2. Cash interest payments of $4,000 ($100,000 × 8% × 1/2 year) at the end of each semiannual period. Point: The difference between the contract rate and the market rate of interest on a new bond issue is usually a fraction of a percent. We use a difference of 2% to emphasize the effects. The pattern of cash receipts and payments for Fila bonds is shown in Exhibit 10.4. EXHIBIT 10.4 Discount Bond Cash Receipts and Payments Page 452 Recording Issuance of Discount Bonds When Fila accepts $96,454 cash for its bonds on the issue date of December 31, 2017, it records the sale as follows. Dec. 31 Cash 96,454 Discount on Bonds Payable 3,546 Bonds Payable 100,000 Sold bonds at a discount on their issue date. Assets+96,454=Liabilities+100,000 −3,546 −3,546+EquityAssets=Liabilities+Equity+96,454+100,000 Bonds payable are reported in the long-term liability section of Fila’s December 31, 2017, balance sheet as shown in Exhibit 10.5. A discount is deducted from par value to compute the carrying (book) value of bonds. Discount on Bonds Payable is a contra liability account. EXHIBIT 10.5 Balance Sheet Presentation of Bond Discount Point: Book value at issuance always equals the issuer’s cash borrowed. Amortizing Discount Bonds Fila receives $96,454 for its bonds; in return it must pay bondholders $100,000 when the bonds mature in two years (plus interest). The upper portion of panel A in Exhibit 10.6 shows that total bond interest expense of $19,546 is the sum of the four $4,000 interest payments and the $3,546 bond discount. EXHIBIT 10.6 Interest Computation and Entry for Discount Bonds Bonds Payable Discount on Bonds Payable 12/31/201 7 100,00 0 12/31/201 7 3,54 6 6/30/201 8 12/31/201 8 — 6/30/2018 88 7 — 12/31/201 8 88 7 6/30/2019 88 7 12/31/201 9 88 5 12/31/201 9 0 6/30/201 9 12/31/201 9 — 100,00 0 12/31/201 9 0 The total $19,546 bond interest expense is allocated over the four semiannual periods in the bonds’ life, and the bonds’ carrying value is updated at each balance sheet date. This is accomplished using the straight-line method (or the effective interest method in Appendix 10B). Both methods reduce the bond discount to zero over the bond life. This process is called amortizing a bond discount. The following section on discount amortization uses the straight-line method. Appendix 10B uses the effective interest method. An instructor can choose to cover either one or both methods. If the straight-line method is skipped, then move forward to the section titled “Premium Bonds.” Page 453 Straight-Line Method The straight-line bond amortization method allocates an equal portion of the total bond interest expense to each interest period. We divide the total bond interest expense of $19,546 by 4 (the number of semiannual periods in the bonds’ life). This gives a bond interest expense of $4,887 per period, which is $4,886.5 rounded to the nearest dollar per period—all computations, including those for assignments, are rounded to the nearest whole dollar. Panel B of Exhibit 10.6 shows how the issuer records bond interest expense and updates the balance of the bond liability account at the end of each of the four semiannual interest periods (June 30, 2018, through December 31, 2019). Point: Another way to compute bond interest expense: (1) Divide the $3,546 discount by 4 periods to get $887 amortized each period. (2) Add $887 to the $4,000 cash payment to get bond interest expense of $4,887 per period. EXHIBIT 10.7 Straight-Line Amortization of Bond Discount Exhibit 10.7 shows the pattern of decreases in the Discount on Bonds Payable account and the pattern of increases in the bonds’ carrying value. Three points summarize the discount bonds’ straight-line amortization: 1. At issuance, the $100,000 par value consists of the $96,454 cash received by the issuer plus the $3,546 discount. 2. During the bonds’ life, the (unamortized) discount decreases each period by the $887 amortization ($3,546/4), and carrying value (par value less unamortized discount) increases each period by $887. 3. At maturity, unamortized discount equals zero, and carrying value equals the $100,000 par value that the issuer pays the holder. DECISION INSIGHT Ratings Game Many bond buyers rely on rating services to assess bond risk. The best known are Standard & Poor’s, Moody’s, and Fitch. These services analyze the issuer’s financial statements and other factors in setting ratings. Standard & Poor’s ratings, from best quality to default, are AAA, AA, A, BBB, BB, B, CCC, CC, C, and D. Ratings can include a plus (+) or minus (−) to show relative standing within a category. Bonds rated in the A and B range are referred to as investment grade; lower-rated bonds are considered riskier. ■ Point: Amortization always results in the carrying value of a bond moving closer to its par value. NEED-TO-KNOW 10-2 Recording Discount Bonds (P1 P2) A company issues 8%, two-year bonds on December 31, 2017, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of 96.46 or $6,752. (a) Prepare an amortization table like Exhibit 10.7 for these bonds; use the straight-line method to am...
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