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Chapter 8: Long-Term Liabilities and Investments

2. I. Present Value Concepts. Two components determine the time value" of money:interest (discount) ratenumber of periods of discountingFor financial reporting, we are concerned primarily with present value concepts.. 3. Present Value Concepts Appendix A. To record activities in the general ledg

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Chapter 8: Long-Term Liabilities and Investments

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    1. 1 Chapter 8: Long-Term Liabilities and Investments I. Present Value Concepts (Appendix 8A) II. Bonds Payable III. Omit ‘Long Run Solvency’, ‘Investment in Debt and Equity Securities’, ‘Investment in Stock’, and ‘Consolidated Financial Statements’. These topics will not be tested.

    2. 2 I. Present Value Concepts Two components determine the “time value” of money: interest (discount) rate number of periods of discounting For financial reporting, we are concerned primarily with present value concepts.

    3. 3 Present Value Concepts Appendix A To record activities in the general ledger dealing with future cash flows, we should calculate the present value of the future cash flows using present value formulas or techniques. Examples of types of activities that require PV calculations: notes payable bonds payable and bond investments capital leases We will focus only on bonds payable, and use straight line amortization for the bonds

    4. 4 Types of Present Value Calculations To calculate the present value of bonds payable, we must consider 2 types of cash flows. PV of a single sum (PV1): discounting a future value of a single amount that is to be paid in the future (ex: face amount of bonds payable). PV of an annuity(PVA): discounting a set of payments, equal in amount over equal periods of time, where the first payment is made at the end of each period (ex: interest payments on bonds payable).

    5. 5 Present Value of a Single Sum All present value calculations presume a future value to be discounted (FV1), a discount rate (i), and a number of periods of discounting (n). There are 3 different ways you can calculate the PV1: 1. Formula: PV1 = FV1 [1/(1+i)n] 2. Tables: see pages 8-32 and 8-33, Table I PV1 Table PV1 = FV1( ) i, n 3. Calculator may be used for class problems. However, note that calculators with time value functions are not allowed in the exam. All problems are illustrated using the tables; you will be given excerpts from the tables for your calculations on the exam.

    6. 6 Present Value of an Annuity(PVA) PVA calculations presume a discount rate (i), where (A) = the amount of each equal annuity, and (n) = the number of annuities (or rents), which is the same as the number of periods of discounting. There are 3 different ways you can calculate PVA: 1. Formula: PVA = A [1-(1/(1+i)n)] / i 2. Tables: see pages 8-36 and 8-37, Table II PVA Table PVA = A( ) i, n 3. Calculator may be used for class problems. However, note that calculators with time value functions are not allowed in the exam. All problems are illustrated using the tables; you will be given excerpts from the tables for any calculations on the exam.

    7. 7 II.Bonds Payable Bonds payable are issued by a company (usually to the marketplace) to generate cash flow. The bonds represent a promise by the company to pay a stated interest (also called the coupon rate) each period (yearly, semiannually, quarterly), and pay the face amount of the bond at maturity. The marketplace values bonds by discounting the cash flows using the market rate of interest. This is also called the yield rate, discount rate, or effective rate. There are two types of cash flows with bonds: PVA (for the interest payments) and PV1 (for the payment of the maturity value).

    8. 8 Problem 1: Bonds Payable (Premium) On January 1, 2002, Mustang Corporation issues $100,000 of its 5 year bonds which have an annual stated rate of 7%, and pay interest annually each December 31, starting December 31, 2002. The bonds were issued to yield 6% annually. Calculate the issue price of the bond: (1) What are the cash flows and factors? Face value at maturity = $100,000 Stated Interest = Face value x stated rate x time period 100,000 x .07 per yr. x 1 year = $7,000 Number of periods = n = 5 yrs Discount rate = 6% per year

    9. 9 Present Value Calculations PV of interest annuity: PVA Table PVA Table PVA = A( ) = 7,000 (4.2124) = $29,487 i, n i = 6%, n = 5 PV of face value: PV1 Table PV1 Table PV =FV1( ) = 100,000(0.7473)=$74,730 i, n i=6%, n=5 Total issue price = $104,217 Issued at a premium of $4,217 because the company was offering an interest rate greater than the market rate, and investors were willing to pay more for the higher interest rate.

    10. 10 Journal Entry at Issue JE at 1/1/02 to issue the bonds: Cash 104,217 Premium on B/P 4,217 Bonds Payable 100,000 Premium on Bonds Payable is located in the liability section of the balance sheet, and adds to Bonds Payable. On the balance sheet at 1/1/02, the carrying value is defined as Face value + premium: Bonds Payable 100,000 Premium on B/P 4,217 104,217 (the carrying value is 104,217)

    11. 11 Amortization of Premiums and Discounts The carrying value must be equal to $100,000 at maturity, because that is all that the company will owe. Note that the premium must be amortized to zero by maturity, as the face amount of the bond will be its maturity value. The amortization will affect the calculation of interest expense. --Amortization of a premium will decrease interest expense below stated rate. --Amortization of a discount will increase interest expense above stated rate.

    12. 12 Amortization of Premiums We will be using the straight-line method to amortize premiums and discounts. An alternative method, effective interest method, is preferred, but more time consuming. (Omit discussion and tables related to the “interest method” in the text.) Using the straight-line method for this example, the premium of $4,217 must be amortized equally over 5 years. 4,217/5 = $843.40 per year Premiums are amortized with a debit. Note that, as the premium decreases, the carrying value is amortized down to face value by maturity.

    13. 13 Journal Entry to Pay Interest JE at 12/31/02 to pay interest: Interest Expense 6,156.60 Premium on B/P 843.40 Cash 7,000.00 Calculation: Cash paid = Face x Stated Rate x Time Premium amortization = 4,217/5 Interest expense is the “plug”: Interest expense is equal to: cash paid (or payable) - premium amortization

    14. 14 Bonds Payable at a Discount. If bonds are issued at a discount, the carrying value will be below face value at the date of issue. The Discount on B/P account has a normal debit balance and is a contra to B/P. The Discount account is amortized with a credit. Note that interest expense = cash paid (or payable) plus discount amortization Interest expense for bonds issued at a discount will be greater than cash paid. The amortization table will show the bonds amortized up to face value.

    15. 15 Problem 2: Bonds Payable (Discount) On January 1, 2002, Corvette Corporation issues $100,000 of its 5 year bonds which have an annual stated rate of 6%, and pay interest annually each December 31, starting December 31, 2002. The bonds were issued to yield 7% annually. Calculate the issue price of the bond: (1) What are the cash flows and factors? Face value at maturity = $100,000 Stated Interest = Face value x stated rate x time period 100,000 x .06 per yr x 1 yr. = $6,000 Number of periods = n = 5 yrs Discount rate = 7% per year

    16. 16 Present Value Calculations PV of interest annuity: PVA Table PVA Table PVA = A( ) = 6,000 (4.1002) = $24,601 i, n i = 7%, n = 5 PV of face value: PV1 Table PV1 Table PV =FV1( ) = 100,000(0.7130)=$71,300 i, n i=7%, n=5 Total issue price = $95,901 Issued at a discount of $4,099 because the company was offering an interest rate less than the market rate, and investors were not willing to pay as much for the lower interest rate.

    17. 17 Journal Entry at Issue JE at 1/1/02 to issue the bonds: Cash 95,901 Discount on B/P 4,099 Bonds Payable 100,000 Discount on Bonds Payable is located in the liability section of the balance sheet, as a contra, and offsets Bonds Payable. On the balance sheet at 1/1/02: Liabilities Bonds Payable 100,000 Discount on B/P (4,099) 95,901 (the carrying value is 95,901) Now work Ex. 8-12(a), Appendix A.

    18. 18 Journal Entry to Pay Interest JE at 12/31/02 to pay interest: Interest Expense 6,819.80 Discount on B/P 819.80 Cash 6,000.00 Calculation: Cash paid = Face x stated rate x time Discount amortization = 4,099/5 = $819.80 Interest expense is the “plug”. Interest expense = cash paid (or payable) + discount amortization Now work Ex. 8-21.

    19. 19 Accrued Interest on B/P If the end of the period falls between interest payments, the company must recognize interest payable and interest expense since the date of the last payment.

    20. 20 Retirement of Bonds Bonds are retired when the company pays the investors the amount owed. If bonds are held to maturity, the amount on the books is face value and the amount paid is face value. If bonds are retired before maturity, the amount on the books is the carrying value, and the amount paid is the market value at the point of retirement. Because these two amounts are seldom the same, a gain or loss must be recognized.

    21. 21 Retirement of Bonds The gain or loss is the difference between carrying value and cash paid. If cash paid is greater than CV, recognize loss (paid more than book liability). If cash paid is less than CV, recognize gain (paid less than book liability). When recording the early retirement, we must remove both Bonds Payable (face amount) and the related Premium or Discount (remaining unamortized amount).

    22. 22 Problem 3 - Retirement of Bonds Refer back to Problem 1. Assume that Mustang’s bonds were retired on December 31, 2003 (after the interest payment). Mustang Corporation paid $104,000 to retire the bonds from the marketplace. Record the entries on December 31, 2003. JE at 12/31/03 to pay the interest: Interest Expense 6,156.60 Premium on B/P 843.40 Cash 7,000.00 JE at 12/31/03 to retire the bonds: Bonds Payable 100,000.00 *Premium on B/P 2,530.20 Loss on Retirement 1,469.80 Cash 104,000.00 *Unamortized premium at 12/31/03= 4,217.00 - 843.40 - 843.40 = $2,530.20 Now work Ex. 8-24.

    23. 23 Other Related Bond Topics Some debt covenants require the establishment of a bond sinking fund. This requires a company to put aside a certain amount of cash each year so that it will accumulate towards the retirement of the bond. The bond sinking fund is an investment (a long-term asset account). Appropriation of retained earnings for bond debt is another possible requirement of the debt covenant. This simply restricts dividend payout to the unappropriated balance in retained earnings (discussed in Chapter 9).

    24. Ex. 8-8 (a), Appendix A Part (a) only: Cash flows? (Note: coupon rate same as stated rate) Annual interest annuity (for PVA): Face x Stated x Time 10,000 x .08 x 1 yr. = $800 per year Payment at maturity (for PV1): $10,000

    25. Ex. 8-8 (a), Appendix A Part (a) only: PV of interest annuity: PVA Table PVA = A( ) = i, n PVA Table ( ) = i = 10%, n = 5

    26. Ex. 8-8 (a), Appendix A Part (a) only: PV of face value: PV1 Table PV1 = FV1 ( ) = i, n PV1 Table ( )= i=10%, n=5

    27. Ex. 8-8(a), Appendix A Journal entry: Cash 9,241.64 Discount on B/P 758.36 Bonds Payable 10,000.00

    28. Ex. 8-21 (a) Premium or Discount? Premium (greater than face) (b) How much amortized this year? 2 ways: (1) reconstruct interest journal entry(ies): Cash paid = 100,000 x .06 x 1 year = 6,000 Interest expense 5,800 Premium on B/P 200 Cash 6,000 or (2) $3,800 = 19/20 of total 3,800(20/19) = total = $4,000 total so amortization this year = $200 (c) Issued at $4,000 premium, see (b.2), so total issue price = $104,000.

    29. Ex. 8-24 (a) Journal entry (Cash paid = 106% of face = 100,000 x 1.06)

    30. Ex. 8-24 (b) Journal entry (Cash paid = 51,000 for half) Bonds Payable 50,000 Premium on B/P 2,500 Cash 51,000 Gain on retirement 1,500

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