Session 9 - Class Notes - Financial liabilities (2)

Session 9 - Class Notes - Financial liabilities (2) -...

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Unformatted text preview: Session 9: Financial Liabilities Hye Sun Chang ACCY 303 Learning Objectives Learning Objectives 1. Identify the underlying characteristics of debt instruments and describe the basic approach to account for debt. 1. Account for bonds issued at par, at a discount, or at a premium. Balance Sheet Balance Sheet Current Assets Cash and cash equivalents Short­term investments: Trading or AFS securities Accounts receivable Inventory Current Liabilities Accounts payable Notes payable Interest payable Long­term investments Non­current Assets Property, plant and equipment Intangible assets: goodwill, patents Other assets : bond issue cost, deferred tax asset Capital stock: preferred stock, common stock Stockholders Equity Additional paid­in capital Retained earnings Accumulated other comprehensive income Treasury stock Non­current liabilities Bonds payable Lease payable Deferred tax liability Liabilities Liabilities 1. Current liabilities ­ Obligations due within a year or within the company’s operating cycle, whichever is longer ­ Rarely discounted because their short maturity makes immaterial the difference between the amount due at maturity and the present value of that maturity amount 2. Noncurrent liabilities ­ Initially recorded at their present value when incurred Long­term Liability Long­term Liability • Long­term Liability: – Obligations that extend beyond one year or the operating cycle, whichever is longer • Long­term Note: – Long­term debt that firms borrowed from a bank or other financial institutions • Bond: – Financial instrument that represents a formal promise to repay both the amount borrowed as well as the interest on the amount borrowed • The accounting treatments for Notes and Bonds are similar. Bonds Bonds • Secured Bonds ­ backed by either real estate property (mortgage bonds) or personal property (collateral trust bonds) • Unsecured Bonds ­ also called debentures • Term Bonds ­ bonds that mature on a single date • Serial Bonds ­ bonds that mature in installment • Convertible Bonds ­ bonds that can be converted into common stock at the holder’s option • Callable Bonds ­ bonds that are subject to retirement at a stated amount prior to maturity at the option of the issuer Bonds Bonds Interest 10% 6/30 & 12/31 Face Value $1,000 BOND PAYABLE Bond Date 1/1/06 1. 1. 2. 2. 3. 3. 4. 4. 5. Face value Face Maturity Date Maturity Stated Interest Rate Stated Interest Payment Dates Interest Bond Date Maturity Date 12/31/15 Other Factors: 6. Market Interest Rate 7. Issue Date Bonds Bonds Terminology 1.Principle amount ­ also called the par value, maturity value, and face value 2. Stated interest rate ­ also called the coupon rate, and nominal rate 3. Market interest rate ­ also called the effective interest rate Bonds Bonds At Bond Issuance Date Company Company Company Company IIssuing ssuing Bonds Bonds Bonds Bonds Bond Selling Price Bond Certificate IInvestor Investor nvestor Investor Buying Buying Bonds Bonds Bonds Bonds Subsequent Periods Company Company Company Company IIssuing ssuing Bonds Bonds Bonds Bonds Interest Payments Face Value Payment at Face End of Bond Term End IInvestor Investor nvestor Investor Buying Buying Bonds Bonds Bonds Bonds Learning Objectives Learning Objectives Account for bonds issued at par, at a discount, or at a premium, recording interest at the effective rate. Recording Bonds at Issuance Recording Bonds at Issuance On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to Apex, Inc. The market interest rate is 10%. The bonds Apex, Inc. The market interest rate is 10%. The bonds have the following terms: have the following terms: Face Value = $1,000 Face Value = $1,000 Maturity Date = 12/31/10 (5 years) Maturity Date = 12/31/10 (5 years) Stated Interest Rate = 10% Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Interest Dates = 6/30 & 12/31 Bond Date = 1/1/06 Bond Date = 1/1/06 Record the issuance of the bonds on 1/1/06. Recording Bonds at Issuance Recording Bonds at Issuance Matrix, Inc. - Issuer Matrix, Date Description Jan. 1 Cash Bonds payable Debit 1,000,000 Credit 1,000,000 Apex, Inc. - Investor Apex, Date Description Jan. 1 Investment in bonds Cash Debit 1,000,000 Credit 1,000,000 Recording Interest Recording Interest Matrix - Issuer Matrix Date Jun. 30 Description Interst Expense Cash Debit 50,000 Credit 50,000 Apex - Investor Date Jun. 30 Description Cash Interest Revenue Debit 50,000 Credit 50,000 Bonds Sold at Discount Bonds Sold at Discount On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to Apex, Inc. The market interest rate is 12%. The bonds Apex, Inc. The market interest rate is 12%. The bonds have the following terms: have the following terms: Face Value = $1,000 Face Value = $1,000 Maturity Date = 12/31/10 (5 years) Maturity Date = 12/31/10 (5 years) Stated Interest Rate = 10% Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Interest Dates = 6/30 & 12/31 Bond Date = 1/1/06 Bond Date = 1/1/06 What is the selling price of these bonds? Determining the Selling Price Determining the Selling Price • Use the face value and the stated interest rate to compute the interest payment. rate • The interest rate used to compute the present value is the market interest rate. market Determining the Selling Price Determining the Selling Price n = 5 years × 2 payments per year = 10 years 10 i = 12% ÷ 2 payments per year = 6% 12% 6% Interest annuity = $1,000,000 × 10% ÷ 2 = $50,000 Interest $50,000 Principal $ 1,000,000 PV $1* 0.55839 I nterest $ PV annuity $1* 50,000 7.36009 Bond issue price $ 558,390 368,005 $ 926,395 Bonds issued at a discount. Bonds discount *n = 10, i = 6% Determining the Selling Price Determining the Selling Price Stated interest rate is Above market rate Equal to market rate Below market rate The bonds sells: At a premium (Cash received is greater than face amount) At face amount (Cash received is equal to face amount) At a discount (Cash received is less than face amount) Journal Entry at Issuance Journal Entry at Issuance Matrix, Inc. - Issuer Matrix, Date Description Jan. 1 Cash D iscount on bonds payable Bonds payable Debit 926,395 73,605 Credit 1,000,000 Apex, Inc. - Investor Apex, Date Description Jan. 1 Investment in bonds Discount on bond investment Cash Debit 1,000,000 Credit 73,605 926,395 Determining Interest Determining Interest Effective Interest Method (Effective rate multiplied by the outstanding balance of the debt) Cash Interest Period 1/1/06 6/30/06 $ 50,000 Effective Interest 55,584 Increase in Balance 5,584 Outstanding Balance $ 926,395 931,979 $926,395 × 6% $926,395 $55,584 - $50,000 $55,584 $926,395 + $5,584 Determining Interest Determining Interest Effective Interest Method (Effective rate multiplied by the outstanding balance of the debt) Period 1/1/06 6/30/06 12/31/06 6/30/07 12/31/07 6/30/08 12/31/08 6/30/09 12/31/09 6/30/10 12/31/10 Cash Interest $ * 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 rounded Effective Interest 55,584 55,919 56,274 56,650 57,049 57,472 57,921 58,396 58,900 59,440 * Increase in Balance 5,584 5,919 6,274 6,650 7,049 7,472 7,921 8,396 8,900 9,440 Outstanding Balance $ 926,395 931,979 937,898 944,171 950,821 957,871 965,343 973,263 981,660 990,560 1,000,000 Journal Entry for Periodic Journal Entry for Periodic Interest Matrix, Inc. - Issuer Matrix, Date Description Jun. 30 Interest expense D iscount on bonds payable C ash Debit 55,584 Credit 5,584 50,000 Apex, Inc. - Investor Apex, Date Description Jun. 30 Cash Discount on bond investment Interest revenue Debit 50,000 5,584 Credit 55,584 Bonds Sold at a Premium Bonds Sold at a Premium On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to Apex, On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to Apex, Inc. The market interest rate is 8%. The bonds have the Inc. The market interest rate is 8%. The bonds have the following terms: following terms: Face Value = $1,000 Face Value = $1,000 Maturity Date = 12/31/10 (5 years) Maturity Date = 12/31/10 (5 years) Stated Interest Rate = 10% Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Interest Dates = 6/30 & 12/31 Bond Date = 1/1/06 Bond Date = 1/1/06 What are the journal entries for Matrix on: • 1/1/06 and 6/30/06 1/1/06 • 9/30/06 ( Matrix’s fiscal year end)? 9/30/06 Bonds Sold at a Premium Bonds Sold at a Premium n = 5 years × 2 payments per year = 10 years 10 i = 8% ÷ 2 payments per year = 4% 8% 4% Interest annuity = $1,000,000 × 10% ÷ 2 = $50,000 Interest $50,000 Principal $ 1,000,000 PV $1* I nterest PV annuity $1* Bond issue price 0.67556 $ $ 675,560 50,000 8.11090 405,545 $ 1,081,105 Bonds issued at a premium. Bonds premium *n = 10, i = 4% Bonds Sold at a Premium Bonds Sold at a Premium Matrix, Inc. - Issuer Matrix, Date Description Jan. 1 Cash Premium on bonds payable Bonds payable Debit 1,081,105 Credit 81,105 1,000,000 Bonds Sold at a Premium Bonds Sold at a Premium Cash I nterest Period 1/1/06 6/30/06 $ Effective I nterest Decrease in Balance Outstanding Balance $ 1,081,105 50,000 43,244 6,756 1,074,349 12/31/06 50,000 42,974 7,026 1,067,323 6/30/07 50,000 42,693 7,307 1,060,016 12/31/07 50,000 42,401 7,599 1,052,417 6/30/08 50,000 42,097 7,903 1,044,514 12/31/08 50,000 41,781 8,219 1,036,295 6/30/09 50,000 41,452 8,548 1,027,747 12/31/09 6/30/10 50,000 50,000 41,110 40,754 8,890 9,246 1,018,857 1,009,611 12/31/10 50,000 40,389 * 9,611 1,000,000 * rounded Periodic Interest Expense Periodic Interest Expense Let’s look at the June 30 entry: Matrix, Inc. - Issuer Matrix, Date Description Jun. 30 Interest expense Premium on bonds payable Cash Debit 43,244 6,756 Credit 50,000 Financial Statements Prepared Between Interest Dates Assume that in our previous example, Matrix, Inc. and Apex, Inc. both have fiscal years that end on September 30. that Year­end is on September 30, 2006, before the second interest date of December 31. $42,974 × ½ = $21,487 (3 months interest) $42,974 $21,487 $ 7,026 × ½ = $ 3,513 (3 months amortization) Matrix, Inc. - Issuer Matrix, Date Description Sep. 30 Interest expense Premium on bonds payable Interest payable Debit 21,487 3,513 Credit 25,000 Financial Statements Prepared Between Financial Statements Prepared Between Interest Dates The entries at December 31, 2006. Matrix, Inc. - Issuer Matrix, Date Description Dec. 31 Interest expense Interest payable Premium on bonds payable Cash Debit 21,487 25,000 3,513 Credit 50,000 Apex, Inc. - Investor Apex, Date Description Dec. 31 Cash Interest receivable Interest revenue Premium on bond investment Debit 50,000 Credit 25,000 21,487 3,513 Carrying Value of Bonds over time Carrying Value of Bonds over time Carrying value Premium T=M, Maturity Par value T=0, Issuance Discount Zero­Coupon Bonds Zero­Coupon Bonds These bonds do not pay interest. T do IInstead, they offer a return in the nstead, they offer a return in the form of a “deep discount” from the of a “deep fface amount. ace Debt Issue Costs Debt Issue Costs Legal Accounting Underwriting Commission Engraving Printing Registration Promotion These costs should be These costs should be recorded separately recorded separately and amortized over the and amortized over the term of the related term of the related debt. debt. Straight­line Straight­line amortization is often amortization is often used. used. Next class Next class • Read reading set 6, RCJM chapter 6 (pp. 323­333), and chapter 11 (pp. 601­620) • HW 1 due this Thu ...
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This note was uploaded on 11/08/2011 for the course ACCY 303 taught by Professor Staff during the Spring '08 term at University of Illinois, Urbana Champaign.

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