Chapter 9

1. Chapter 9 Valuing and Accounting for Bonds and Leases

2. Learning Objectives After studying this chapter, you should be able to: • Compute and interpret present and future values. • Value bonds using present value techniques. • Account for bond issues over their entire life. • Value and account for long-term lease transactions. • Evaluate pensions and other postretirement benefits.

3. Valuing Long-Term Liabilities • Long-term liabilities are more difficult to value than short-term liabilities because of the long time frames involved. • Accountants use the time value of money to value long-term liabilities. • The time value of money refers to the fact that a dollar you expect to pay or receive in the future is not worth as much as a dollar you have today.

4. Compound Interest, Future Value, and Present Value • When money is borrowed, the amount borrowed is known as the loan principal. • For the borrower, interest is the cost of using the principal. • Investing money is the same as making a loan. • The interest received is the return on the investment.

5. Compound Interest, Future Value, and Present Value • Calculating the amount of interest depends on the interest rate and the interest period. • Types of interest: • Simple interest - the interest rate multiplied by an unchanging principal amount • Compound interest - the interest rate multiplied by a changing principal amount • The unpaid interest is added to the principal balance and becomes part of the new principal balance for the next interest period.

6. Future Value • Future value - the amount accumulated over time, including principal and interest • For example, if a person lets $10,000 sit in a bank account that pays 10% interest per year for 3 years, the future value of the $10,000 is $13,310 and is determined as follows: Year 1: $10,000 x 1.10 = $11,000 Year 2: $11,000 x 1.10 = $12,100 Year 3: $12,100 x 1.10 = $13,310

7. Future Value • The general formula for computing the future value (FV) of S dollars in n years at interest rate i is: n refers to the number of periods the funds are invested. The interest rate must be stated consistently with the time period.

8. Future Value • The calculations for future values can be very tedious. Most people use future value tables to determine future values. • In the table, each number is the solution to the expression (1 + i)n. • The value of i is given in the column heading. • The value of n is given in the row label for the number of periods.

9. Future Value To how much will $25,000 grow if left in the bank for 20 years at 6% interest? The answer is determined as follows: $25,000 x 3.2071* = $80,177.50 *3.2071 is the future value factor for 20 periods at 6% interest.

10. Present Value • Present value - the value today of a future cash inflow or outflow • Present value calculations are the reverse of future value calculations. • In future value calculations, you determine how much money you will have at a date in the future given a certain interest rate. • In present value calculations, you determine how much must be invested today given a certain interest rate to get to how much money you want in the future.

11. Present Value • For example, if $1.00 is to be received in one year and the interest rate is 6%, you will have to invest $0.9434 ($1.00 / 1.06). • Thus, $0.9434 is the present value of $1.00 to be received in one year at 6% interest.

12. Present Value • The general formula for the present value (PV) of a future value (FV) to be received or paid in n periods at an interest rate of i per period is:

13. Present Value • Just as with future values, tables can be helpful in determining the present value of amounts. • In the table, each number is the solution to the expression 1/(1 + i)n. • The value of i is given in the column heading. • The value of n is given in the row label for the number of periods.

14. Present Value • Interest rates are sometimes called discount rates in calculations involving present values. • Present values are also called discounted values, and the process of finding the present value is discounting. • Present values can be thought of as decreasing the value of a future cash inflow or outflow because the cash is to be received or paid in the future, not today.

15. Present Value A city wants to issue $100,000 of non-interest-bearing bonds to be repaid in a lump sum in 5 years. How much should investors be willing to pay for the bonds if they require a 10% return on their investment? $100,000 x .6209* = $62,090 *.6209 is the present value of $1 factor for 5 years at 10% interest.

16. Present Value • Remember to pay attention to the number of periods. Interest is often compounded semiannually instead of annually. • If interest is compounded semiannually, the number of periods is twice the number of years, and the interest rate is one-half of the annual interest rate. • In the previous example, if interest were compounded semiannually, the number of periods is 10 instead of 5, and the interest rate is 5% instead of 10%.

17. Present Value of anOrdinary Annuity • Annuity - a series of equal cash flows to take place during successive periods of equal length • The present value of an annuity is the sum of the present values of each cash receipt or payment. • If a note has a series of payments, its present value can be determined by finding the present value of each payment and adding those present values together.

18. Present Value of anOrdinary Annuity • Again, tables can be helpful in determining the present value of an ordinary annuity. • The factors in a present value of an annuity table are merely the cumulative sum of the present value of $1 factors in the present value of $1 table for the number of annuity periods. • The present value of an ordinary annuity tables are especially helpful if the cash payments or receipts extend into the future over many periods.

19. Present Value of anOrdinary Annuity A city wants to issue $1,000,000 of non-interest-bearing bonds to be repaid $100,000 per year for 10 years. How much should investors be willing to pay for the bonds if they require a 10% return on their investment? $100,000 x 6.1446* = $614,460 *6.1446 is the present value of an annuity of $1 for 10 periods at 10% interest.

20. Present Value of anOrdinary Annuity • Notice that the higher the interest rate, the lower the present value factor. • This occurs because at higher interest rates, less must be invested to obtain the same stream of future annuity payments or a certain amount in the future.

21. Valuing Bonds • Because bonds create cash flows in future periods, they are recorded at the present value of those future payments, discounted at the market interest rate in effect when the liability is created. • Bond - formal certificate of indebtedness that is typically accompanied by: • A promise to pay interest in cash at a specified annual rate plus • A promise to pay the principal at a specific maturity date

22. Valuing Bonds • When valuing bonds, the present value tables are used to determine the amount of proceeds that will be received. • The present value of $1 table is used to determine the present value of the face amount of the bonds. • The present value of an annuity of $1 is used to determine the present value of the series of interest payments. • The amounts are added together to determine the amount of proceeds and any premium or discount.

23. Valuing Bonds • Discount on bonds - occurs when the market interest rate is greater than the coupon rate. • Premium on bonds - occurs when the market interest rate is less than the coupon rate. < = >

24. Valuing Bonds A company issues $20,000,000 of 5-year bonds with a coupon rate of 7%. Interest is to be paid semiannually on June 30 and December 31 of each year. At the time of the issuance, the market rate is 10%. What is the amount of the proceeds and any premium or discount on the bonds?

25. Valuing Bonds • To determine the proceeds: $20,000,000 x .6139* = $12,278,000 $700,000‡ x 7.7217* = 5,405,190 $17,683,190 =============================== ‡($700,000 = ($20,000,000 x 7%) / 2) *PV factors are for 10 periods at 5% The company will receive $17,683,190 upon issuance. The bonds are issued at a discount of $2,316,810.

26. Issuing and Trading Bonds • Bonds are usually sold through underwriters. • Underwriters - a group of investment bankers that buys an entire bond or stock issue from a corporation and then sells the bonds to the general public • By using underwriters, corporations are guaranteed that they will receive the entire amount of the issue.

27. Issuing and Trading Bonds • The bond contract includes all terms of the bonds such as: • Time to maturity • Interest payment dates • Interest amounts • Size of the bond issue

28. Issuing and Trading Bonds • The coupon rate on the bonds is set as close to the market rate as possible. • The coupon rate is the interest to be paid (in cash) on the bonds. • The market rate is the rate available on investments in similar bonds at a moment in time. • The market rate is affected by factors such as general economic conditions, industry conditions, risks of the use of the proceeds, and features of the bonds (callable, convertible, etc.).

29. Issuing and Trading Bonds • Bonds may be sold at, above, or below par value. • If the bonds are sold for more than par, they are sold at a premium. • If the bonds are sold for less than par, they are sold at a discount. • Premiums and discounts do not reflect the credit record of the issuer; they merely reflect the difference in interest rates.

30. Issuing and Trading Bonds • When a bond sells at a premium or discount, the yield to maturity (effective interest rate) differs from the coupon rate. • Yield to maturity (effective interest rate) - the interest rate that equates market price at issue to the present value of principal and interest • The interest paid in cash is calculated by using the coupon rate, not the effective rate.

31. Issuing and Trading Bonds • Bonds are usually issued in increments of $1,000, but they are usually expressed in terms of par. • For example, a $1,000 bond quoted at 102 is selling for $1,020 ($1,000 x 102%). • Current yield - annual interest payments divided by the current price of a bond

32. Assessing the Riskiness of Bonds • Risk plays a large part in determining the coupon rate of interest on bonds. • The riskier a bond, the higher the interest rate investors will require before making the investment. • Rating companies, such as Moody’s and Standard and Poor’s, rate the bonds for investors. • Higher ratings are safer and have lower interest rates. • Lower ratings are riskier and have higher interest rates.

33. Assessing the Riskiness of Bonds • Analysts rely on the debt level of a company in assessing the riskiness of a bond. • If a company has lots of debt, the ability of that company to repay the bonds might be in doubt. • The credit worthiness of the company issuing bonds is a key in determining the riskiness of bonds issued by the company.

34. Interest Rates • Interest rates have three components. • Real interest rate - the return that investors demand because they are delaying their consumption • Inflation premium - the extra interest that investors require because they worry that the general price level will change between now and the time they will receive their money • Firm specific risk - the risk that a firm will not repay the loan or will not pay the interest on time

35. Bonds Issued at a Discount • When bonds are issued at at discount, the amount of proceeds received from the issuance is less than the actual liability. • The difference must be recorded in a separate account on the books. Cash 17,683,190 Discount on bonds payable 2,316,810 Bonds payable 20,000,000

36. Bonds Issued at a Discount • The discount on bonds payable is a contra account; it is deducted from bonds payable. • Balance sheet presentation: Bonds payable, 7% $ 20,000,000 Deduct: Discount on bonds payable 2,316,810 Net liability $ 17,683,190 ============================

37. Bonds Issued at a Discount • For bonds issued at a discount, the discount can be thought of as a second interest amount payable to the investors at the maturity date. • Rather than recognizing the extra interest expense all at once upon maturity, the issuer should spread the extra interest over the life of the bonds. • This is accomplished by discount amortization. • The amortization of a discount increases the interest expense of the issuer at each cash interest payment date, but it has no effect on cash paid.

38. Bonds Issued at a Discount • Discount amortization can be calculated using two methods. • Straight-line amortization • The amortization of the discount is an equal amount each period, but the effective interest rate is different each period. • Effective-interest amortization • The effective interest rate is the same each period, but the amortization of the discount is a different amount each period.

39. Bonds Issued at a Discount • Amortization using the effective-interest method: • For each period, interest expense is equal to the carrying value of the debt multiplied by the market rate of interest in effect when the bond was issued. • The cash interest payment is the coupon rate times the face amount of the bonds. • The difference between the interest expense and the cash interest payment is the amount of discount amortization for the period.

40. Bonds Issued at a Discount • Journal entries: To record the issuance of the bonds: Cash xxxxxx Discount on bonds payable xxxx Bonds payable xxxxxx To record the payment of interest and discount amortization: Interest expense (Carrying value x Market rate) xxx Discount on bonds payable xx Cash (Face value x Coupon rate) xxx

41. Bonds Issued at a Premium • Accounting for bonds issued at a premium is just the opposite of accounting for bonds issued at a discount. • The cash proceeds exceed the face amount. • The amount of the contra account Premium on Bonds Payable is added to the face amount to determine the net liability reported in the balance sheet. • The amortization of bond premium decreases the interest expense to the issuer.

42. Bonds Issued at a Premium A company issues $20,000,000 of 5-year bonds with a coupon rate of 7%. Interest is to be paid semiannually on June 30 and December 31 of each year. At the time of the issuance, the market rate is 6%. What is the amount of the proceeds and any premium or discount on the bonds?

43. Bonds Issued at a Premium To determine the proceeds: $20,000,000 x .7441* = $14,882,000 $700,000‡ x 8.5302* = 5,971,140 $20,853,140 =========================== ‡($700,000 = ($20,000,000 x 7%) / 2) *PV factors are for 10 periods at 3% The company will receive $20,853,140 upon issuance. The bonds are issued at a premium of $853,140.

44. Early Extinguishment • When a company redeems its own bonds before the maturity date, the transaction is called an early extinguishment. • Early extinguishment usually results in a gain or loss to the company redeeming the bonds. • The gain or loss is the difference between the cash paid and the net carrying amount (face amount less unamortized discount or plus unamortized premium) of the bonds.

45. Early Extinguishment Allen Company purchased all of its bonds on the open market at 98. The bonds have a face amount of $100,000 and a $12,000 unamortized discount. Determine any gain or loss on the early extinguishment, and prepare the journal entries to record the transaction.

46. Early Extinguishment Carrying amount: Face value $100,000 Deduct: Unamortized discount 12,000 $88,000 Cash required ($100,000 x 98%) 98,000Loss on early extinguishment $10,000 ================== Bonds payable 100,000 Loss on early extinguishment 10,000 Cash 98,000 Discount on bonds payable 12,000

47. Bonds Sold BetweenInterest Dates • Sometimes bonds are issued or sold between interest dates or after the date when the issuance was supposed to take place. • This difference has an effect on both the investor and the issuer.

48. Bonds Sold BetweenInterest Dates • For the investor: • If bonds are issued between interest dates, the investor will earn only a portion of that interest (the investor did not own the bond for the full interest period). • The investor must pay an extra amount for any unearned interest to be received at the next interest payment date. • The investor has earned only a part of the interest for the period but will receive cash for the entire amount, so he must pay extra. • The extra payment is recovered when the interest payment is received at the regular interest date.

49. Bonds Sold BetweenInterest Dates • For the issuer: • The issuer should record interest expense only for the period that the bonds were actually issued and outstanding. • However, at the interest date, interest expense will equal the amount of interest paid, which is incorrect. • The extra payment made by the investor reduces the amount of interest expense recorded by the issuer to the proper amount, just as it reduces the interest income to the investor.

50. Non-Interest-BearingNotes and Bonds • Some bonds and notes provide for the payment of a lump sum at a specified date instead of periodic interest payments. • Zero coupon - a bond or note that pays no cash interest during its life • These bonds or notes are sold for much less than the face or maturity value, which makes up for the lack of periodic interest payments.