Fall 2010 Class 2

Fall 2010 Class 2 - CHAPTER 14 Long­Term Financial...

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Unformatted text preview: CHAPTER 14 Long­Term Financial Liabilities Questions We Need to Answer 1. What is a long-term liability? 1. 2. What are the major types of long-term What financial liabilities? financial 3. How to record and disclose long-term How financial liabilities? financial 4. How to analyze a company’s long-term How liabilities? liabilities? 5. What is off-balance sheet financing What arrangements? arrangements? Long­Term Debt Long­Term Debt • Obligations not payable within one year, or one Obligations business operating cycle—whichever is longer business • Major types of long-term liabilities include: – – – – – Bonds payable Long-term notes Mortgages Pension liabilities Lease liabilities • Often with restrictive covenants (terms) attached Often restrictive Bonds Bonds • Most common type of long-term debt • A bond indenture is a promise (by the lender to bond the borrower) to pay: the • a sum of money at the designated maturity date • periodic interest at a stipulated rate on the face periodic value value • A bond issue may be sold: • either through an investment banker, or • by private placement Source: www.pomexport.com Bond Valuation • Price of a bond issue is determined by finding the Price present value (PV) of future cash flows: present • the PV of the interest payment annuity (at the stated the or coupon rate of interest), plus or • the PV of the redemption (face, par) value, • both discounted at the market (yield) rate of interest both market in effect at issue date in • When stated rate < market rate When ∀ ⇒ bond sells at discount discount • When stated rate > market rate When • ⇒ bond sells at premium premium Bond Valuation: Bond Price Calculation Given: Given: Face value of bond issue: $100,000 Term of issue: 5 years Stated interest rate: 9% per year, payable at the Stated end of the year end Market rate of interest: 11% Determine the issue price of the bonds. issue Bond Valuation: Bond Price Calculation Year 1 Year Year 2 $9,000 Year 3 $9,000 Year 4 $9,000 Interest annuity Year 5 $9,000 $9,000 Face Value $100,000 Discount the future cash flows using the market (yield) rate of interest Bond Valuation: Bond Price Calculation Year 1 Year Year 2 $9,000 $33,263 plus $ 59,345 Year 3 $9,000 Year 4 $9,000 Year 5 $9,000 $9,000 Discount at market rate, 11% $9,000 x 3.69590 Discount at market rate, 11% $100,000 x 0.59345 =$92,608 is the issue price $100,000 Entries for the Issuance of Bonds at Entries for the Issuance of Bonds at Discount Sold at a Discount Cash 92,608 Bonds Payable 92,608 Using a financial calculator: $? PV 11% I 5 N (9,000) PMT FV $ (100,000) Yields $92,608 Bond issued at Premium Given: Given: Face value of bond issue: $100,000 Term of issue: 5 years Stated interest rate: 12% per year, payable end Stated of the year of Market rate of interest: 10% Determine the issue price of the bonds. issue What if the stated rate is 12%, and the market rate is 10% Year 1 Year Year 2 Year 3 $12,000 $12,000 $45,489 plus $ 62,092 Year 4 $12,000 Year 5 $12,000 $12,000 Discount at market rate, 10% $12,000 x 3.79079 Discount at market rate, 10% $100,000 x 0.62092 =$107,581 is the issue price $100,000 Entries for the Issuance of Bonds at Entries for the Issuance of Bonds at Premium Sold at a Premium Cash 107,581 Bonds Payable 107,581 Using a financial calculator: $? PV 10% I 5 N (12,000) PMT FV $ (100,000) Yields $107,581 Amortization of Discount or Premium – Amortization of Discount or Premium Effective Interest • Effective interest method – Interest expense=The carrying value of the Interest bond at the beginning of the period * the effective interest rate. effective – Amount of amortized discount=Interest Amount discount=Interest expense - Face value of the bond * Stated interest rate – Amount of amortized premium= Face value of Amount premium Face the bond * Stated interest rate - Interest Stated expense expense Effective Interest Method—Discount Effective Interest Method Given: Face Value = $100,000 Coupon Rate = 9% Coupon Discount = $7,392 Discount Market /Effective Rate = 11% Market The annual discount amortization = Interests expensesThe discount Interests payable= $92,608* 11% -$100,000*9%=$1,187 Interests $92,608 11% The entry to record the annual accrued interests and The discount amortization would be: discount Bond Interest Expense (2) 10,187 Bond (2) Bonds Payable (3) Bonds (3) 1,187 1,187 Bond Interest payable (1) 9,000 Bond (1) Amortization Schedule­Discount Amortization Schedule­Discount Face Value = $100,000 Discount = $7,392 Market Rate = 11% Coupon Rate = 9% Bond Maturity = 5 years A C D Interest Paid Interest Expense Discount Amortization Carrying Value Face Value * 9% Year B D* 11% B­A D+C 0 92,608 1 9,000 10,187 1,187 93,795 2 9,000 10,317 1,317 95,112 3 9,000 10,462 1,462 96,575 4 9,000 10,623 1,623 98,198 5 9,000 10,802 1,802 100,000 Effective Interest Method—Premium Effective Interest Method Given: Face Value = $100,000 Coupon Rate = 12% Coupon Premium = $7,581 Premium Market /Effective Rate = 10% Market /Effective Rate = 10% The annual premium amortization = Interests PayableThe premium Interest expense = $100,000* 12% -$107,581 *10%=$1,242 Interest 12% The entry to record the annual premium amortization and The accrued interests would be: accrued Bond Interest Expense (2) 10,758 Bond (2) Bonds Payable (3) 1,242 Bonds (3) Bond Interest Payable (1) 12,000 Bond (1) Amortization Schedule­Premium Amortization Schedule­Premium Face Value = $100,000 Premium = $7,581 Market Rate = 10% Coupon Rate = 12% Bond Maturity = 5 years A C D Interest Paid Interest Expense Premium Amortization Carrying Value Face Value * 12% Year B D* 10% A­B D­C 0 107,581 1 12,000 10,758 1,242 106,339 2 12,000 10,634 1,366 104,973 3 12,000 10,497 1,503 103,470 4 12,000 10,347 1,653 101,817 5 12,000 10,182 1,818 99,999 Note Disclosure Note Disclosure • Include: – – – – – – – Nature of the liability Maturity date Interest rate Call provision Conversion privileges Any restrictions imposed Assets designated or pledged as security Situations that make accountants’ job Situations that make accountants difficult • Bonds Issued Between Interest Dates • The interest payment date different from The financial statement date financial • Issuance costs Issuance • Early retirement of the bond Bonds Issued Between Interest Bonds Issued Between Interest Dates Example: – – – – – 800,000 par value, 10-year bonds Dated January 1,2004 Stated rate of 10%, market rate of 9.68% Interests payable semiannually on Jan. 1, and July 1 Interests on Issued on March 1, 2004 at 102 plus accrued interest at plus January 1, 2014 Solution: bond holders pay the interests for the pre-issuance period, Solution: and get the full amount of interests at the next interest payment date. date. Bonds Issued Between Interest Dates Entries to record issuance: Entries Cash 829,333 Bonds Payable Bond Interest Expense 816,000 13,333 Accrued interest=$13,333=$800,000*10%*2/12 Premium=$16,000=$800,000*2% What about the amortization of the premium and interests payment? Bonds Issued Between Interest Dates To record interests expenses and amortization on June 30 (effective interests method): June Interest Expense 39,663 Bonds Payable 337 Bonds Interests Payable 40,000 Interest payable=$800,000*10%*6/12=$40,000 Interest Expense=$816,000*9.68%*4/12+$13,333 =$39,663 Premium amortized=$40,000-$39,663 =$337 Different interest payment date and financial statement date January 1 June 1 July 1 January 1 Dec. 1 • Don’t forget to record bond interest accrued from Don’t record the last interest payment date. the • Also amortize the discount or premium for the Also amortize period between last interest payment date and financial statement date financial Bond Issue Costs Bond Issue Costs • Those costs directly related to issuing the bonds – e.g., costs paid to the broker, legal costs, printing e.g., costs. • Not part of any premium or discount • Canadian GAAP allow two choices: – Recognize as expenses in current period (Not Recognize IFRS) IFRS) – Increase the discount or reduce the premium on Increase bonds payable, and amortize over the life of the bond using effective interest method. (consistent with IFRS) with Bond Issuance Costs Given: Given: Face value of bond issue: $100,000 Term of issue: 5 years Stated interest rate: 12% per year, payable end Stated of the year of Market rate of interest: 10% Issue at premium for $107,581 Issuance costs were $20,000 Issuance Costs Issuance Costs Entries to record issuance costs of 120,000: Option 1, To expense issuance costs: Cash 87,581 Bond Issue Expense 20,000 Bonds Payable 107,581 Option 2, To amortize the costs: Cash Bonds Payable 87,581 87,581 (the bonds were in fact issued at a discount) (the Extinguishment of Debt Extinguishment of Debt • When debt is paid out prior to maturity, – Write off all related accounts, and – Recognize gain or loss, if any Recognize gain loss • May be full or partial acquisition May partial • Complete amortization up to the acquisition date before writing off the balance before Extinguishment of Debt: Example Extinguishment of Debt: Example Given: • Existing debt-Face value: • Called and canceled at: • Unamortized discount: $800,000 $808,000 $ 14,400 Note: Discount has been amortized up to the date Discount of cancellation of debt. of Prepare the journal entries for the extinguishment. Extinguishment of Debt: Example Bonds Payable Bonds Loss on Redemption of Bonds Loss Cash Cash 785,600 22,400 808,000 Long­Term Debt Analysis Long­Term Debt Analysis Debt to Total Assets: Total debt Total assets Total • Level or percentage of assets that is financed Level through debt through Times Interest Earned: Income before income taxes and interest Interest Expense • Measures ability to meet interest payments Off­Balance­Sheet Financing Off­Balance­Sheet Financing • Off-balance-sheet financing represents borrowing arrangements that are not recorded at borrowing the B/S. the • The objective is to improve certain financial ratios The (such as debt-equity ratio) (such • In project financing arrangements, companies project companies form a new entity and borrow through that entity form • The debt appears on the books of the new entity, The and not on those of the parent companies Off­Balance­Sheet Financing Off­Balance­Sheet Financing • Different forms of off-balance-sheet financing off-balance-sheet 1. Non-consolidated subsidiaries (NCS) 2. Special Purpose Entities (SPE) or Variable Interest Entities (VIE) 3. Operating Leases Exercise: P14­5 Exercise: P14­5 Assume the firm uses effective interest rate method, and the market rate is 11%. Prepare the journal entries for the transactions above. Summary Summary • • Long-term liabilities are debts not payable within Long-term one year one Major bond transactions include: – – – – • • Issuance Interests payment Discount / premium amortization Extinguishment Analysis of long-term liabilities helps to assess longterm liquidity Off-balance sheet financing includes: NCS, SPE, Off-balance and operating lease and Case Discussion CA13­1, ABC Case Discussion CA13­1, ABC Airlines (page 901) Case for next week Case for next week • CA14-1, in page 953 of the textbook • Question of the case change to: “If you were the controller of Pitt, what is your analysis of If the situation described, how would you handle financial reporting issues related to the agreements between Pitt and ACC and why?” and ...
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