FINANCIAL ACCOUNTING
A USER PERSPECTIVE
Hoskin • Fizzell • Davidson
Second Canadian Edition
Long-term Liabilities
Chapter Ten
Bonds
• Companies may raise long-term
funds through:
– Equity (stock) market
– Debt market
• Borrow money from a commercial
bank
• Sell bonds to investors
Bond Characteristics
• Formal agreement
• Specifies
– How the money is to be paid back
– Conditions that must be met during
the period of the loan
• Stated in the indenture agreement
• May include restrictions (bond
covenants)
Bond Characteristics
• Bonds traded in public markets
are standardized, stating
– Face value: $1,000
• Specifies the cash payment to be
made at maturity
– Semi-annual interest payments
– Bond interest rate
• Stated as an annual percentage
Bond Characteristics
• Mortgage bond
– Has real property as collateral
• Collateral trust bond
– Provides shares and bonds of other
companies as collateral
• Debenture bond
– Carries no specific collateral
Bond Characteristics
• Some bonds have special
provisions
– Convertible bonds
• Convertible to a specified number of
common shares
Public Bond Issues
• Investment banker
– Helps design the bond issue
– Responsible for the initial sale of
the issue to its investor clients
• Underwriters
– Investment bankers jointly
responsible for selling the issue
Bond Pricing
• Market price of bonds is
determined by discounting future
cash flows
• Example:
– A company issues a $1,000 bond
with two years to maturity
– Interest is 10% paid semi-annually
Bond Pricing
• The company expects the
investor to demand a return of
8% compounded semi-annually
from this type of investment
• What price can the company
expect to get from this offering?
Bond Pricing
• The cash flows must be
discounted using the yield rate of
8%.
• (Often called the discount rate or
market rate)
Bond Pricing
• Assumptions
Face value
Bond interest rate
Time to maturity
Yield rate
$1,000
10%
2 years
8%
Bond Pricing
• Calculation
Number of periods
= Time to maturity x 2
= 2 years x 2 = 4
Yield rate per period = Yield rate / 2
= 8% / 2 = 4%
Interest payments
= Face amount x bond
interest rate x 1/2
= $1,000 x 10% x 1/2
= $50
Bond Pricing
Cash flows
End of period
(semi-annual
periods)
$1,000
$ 50 $ 50 $ 50 $ 50
0
1
2
3
4
Bond Pricing
Calculate present value of future cash flows
Cash flows
1, 2, 3, 4
$ 50
$ 50
$ 50
4%
4%
4%
$1,000
$ 50
4%
Present
0.9616 0.9246 0.8890
0.8548
value of $1
Present
48.08 46.23 44.45
42.74 +
value of
54.80=
cash flows
$1,036.30
Bond Pricing
• Alternative calculation:
Interest payments (treated as an annuity)
$50 x 3.6299 (present value for 4 periods at
4%)
+ ($1,000 x 0.8548)
= $181.50 + $854.80
= $1,036.30
Bond Pricing
• If the buyers demand a 12% return
on their investment:
PV of bond = PV of interest payments + PV of
maturity payment
= PV of annuity of $50 for 4 periods at 6%
(Table 4)
+ PV of $1,000 for 4 periods at 6% (Table 2)
= ($50 x 3.4651) + ($1,000 x 0.7921) = $965.35
Bond Pricing
• Selling price:
– Higher than
face value
– Lower than
face value
– Equals face
value
• Bond issued at:
Premium
Discount
At Par
Bonds Issued at Par
• Bond issued at par are said to be
issued at 100.
A-Cash
L-Bond Payable
1,000
1,000
• No interest is recognized on the
date of issuance, because interest
accrues as time passes
Bonds Issued at Par
• Recognition of interest:
– Accrue the interest expense and the
amount payable to the bondholders
Interest expense
= Carrying value x Yield rate x Time
= $1,000 x 10% x 6/12 = $50
Interest payable
= Face Amount x Bond interest rate x
Time = $1,000 x 10% x 6/12 = $50
Bonds Issued at Par
• Recognition of interest:
SE-Interest Expense
L-Interest Payable
50
50
– Record the cash payment made
L-Interest payable
A-Cash
50
50
Bonds Issued at Par
• Calculations:
– Interest payable amount will be the
same in all our interest periods over the
life of the bond
– Interest expense in each period will
depend on the carrying value of the
bond at the beginning of each period.
Bonds Issued at Par
• Calculations:
Carrying value (ending)
= Carrying value )beginning)
+ Interest expense
- Interest payments
= $1,000 + 50 - 50 = $1,000
• Final payment
L-Bond Payable
A-Cash
1,000
1,000
Bonds Issued at Par
Book Value
Carrying Value of a Bond Issued at a Premium
1,060
1,040
1,020
1,000
980
960
940
920
At Par
At a Discount
At a Premium
0
1
2
Period
3
4
Bonds Issued at Par
Period Beginning Interest Payment Ending
Carrying
Carrying
Value
Value
$1,000
$50
$50
$1,000
1
2
$1,000
$50
$50
$1,000
3
$1,000
$50
$50
$1,000
4
$1,000
$50
$1,050
$
-0-
Bonds Issued at a Discount
• Assume investors demanded a
12 % return
• The bond would be issued at a
price of $965.35
• The bond sold at 96.535
A-Cash
965.35
XL-Discount on Bond Payable
34.65
L-Bond Payable
1,000.00
Bonds Issued at a Discount
• Interest entries:
Interest expense
= Carrying value x Yield rate x Time
= $965.35 x 12% x 6/12 = $57.92
Interest payable
= Face Amount x Bond interest rate x Time =
$1,000 x 10% x 6/12 = $50.00
Bonds Issued at a Discount
• Effective interest method
– Difference between interest
expense and interest payable
decreases (amortizes) the balance
of the discount
Bonds Issued at a Discount
• Interest entries:
SE-Interest Expense
57.92
XL-Discount on Bond Payable
7.92
L-Interest Payable
50.00
L-Interest payable
A-Cash
50.00
50.00
Bonds Issued at a Discount
• Calculations:
– Interest payable amount will be the
same in all our interest periods over the
life of the bond
– Interest expense in each period will
depend on the carrying value of the
bond at the beginning of each period.
Bonds Issued at a Discount
• Calculations:
Carrying value (ending)
= Carrying value (beginning)
+ Interest expense
- Interest payments
= $965.35 + 57.92 - 50.00 = $973.27
• Final payment
L-Bond Payable
A-Cash
1,000.00
1,000.00
Bonds Issued at a Discount
Book Value
Carrying Value of a Bond Issued at a Discount
1,060
1,040
1,020
1,000
980
960
940
920
At Par
At a Discount
At a Premium
0
1
2
Period
3
4
Bonds Issued at a Discount
Beginning Interest Payment Ending Beginning
Carrying
Carrying Discount
Value
Value
1 $965.35 $57.92 $50.00 $973.27 ($34.65)
2
$973.27
$58.40
$50.00 $981.67
($26.73)
3
$981.67
$58.90
$50.00 $990.57
($18.33)
4
$990.57
$59.43 1,050.00 $
-0-
($9.43)
Bonds Issued at a Premium
• Assume investors demanded 8 %
return
• The bond would be issued at a
price of $1,036.30
• The bond sold at 103.63
A-Cash
1,036.30
XL-Premium on Bond Payable
36.30
L-Bond Payable
1,000.00
Bonds Issued at a Premium
• Interest entries:
Interest expense
= Carrying value x Yield rate x Time
= $1,036.30 x 8% x 6/12 = $41.45
Interest payable
= Face Amount x Bond interest rate x Time =
$1,000 x 10% x 6/12 = $50.00
Bonds Issued at a Premium
• Effective interest method
– Difference between interest
expense and interest payable
decreases (amortizes) the balance
of the premium
Bonds Issued at a Premium
• Interest entries:
SE-Interest Expense
41.45
XL-Premium on Bond Payable 8.55
L-Interest Payable
50.00
L-Interest payable
A-Cash
50.00
50.00
Bonds Issued at a Premium
• Calculations:
– Interest payable amount will be the
same in all our interest periods over the
life of the bond
– Interest expense in each period will
depend on the carrying value of the
bond at the beginning of each period.
Bonds Issued at a Premium
• Calculations:
Carrying value (ending)
= Carrying value (beginning)
+ Interest expense
- Interest payments
= $1,036.30 + 41.45 - 50.00 = $1,027.75
• Final payment
L-Bond Payable
A-Cash
1,000.00
1,000.00
Bonds Issued at a Premium
Book Value
Carrying Value of a Bond Issued at a Premium
1,060
1,040
1,020
1,000
980
960
940
920
At Par
At a Discount
At a Premium
0
1
2
Period
3
4
Bonds Issued at a Premium
Beginning Interest Payment Ending
Beginning
Carrying
Carrying Premium
Value
Value
1 $1,036.30 $41.45 $50.00 $1,027.75 $36.30
2 $1,027.75 $41.11
$50.00 $1,018.86
$27.75
3 $1,018.86 $40.75
$50.00 $1,009.62
$18.86
4 $1,009.62 $40.38 1,050.00 $
-0-
$9.62
Early Retirement of Debt
• Retire by buying the bonds on the
bond market or by calling the
bonds
L-Bond Payable
1,000.00
L-Premium on Bond Payable 18.86
A-Cash
981.67
SE-Gain on Early Retirement of Bond 37.19
Leasing
• Lease agreement for an asset
– A lessor buys the asset and the
lessee makes periodic payments in
exchange for the use of the asset
over the lease term
Capital Lease
• A lease qualifies as a capital
lease if one of the following
criteria is met:
– Title passes at the end of the term
– Term = or > useful life of the asset
– PV of payments > 90% of the fair
value of the asset
Operating Lease
• If none of the capital lease
criteria is met, the lease is an
operating lease
Leases
• Example:
– Asset is leased for 5 years
– Quarterly lease payments of
$2,000, payable in advance
– Title does not pass
– No purchase option
– Interest rate is 12%
Operating Lease
• If the lease qualifies as an
operating lease:
SE-Rent expense (Lease expense) 2,000
A-Cash
2,000
Capital Lease
• If the lease qualifies as a capital
lease,
• Both the asset and the obligation
would be recorded at the present
value of the lease payments
• The asset is accounted for as if it
had been purchased
Capital Lease
• Present value of the lease
payments:
= First payment + PV of 19 payments at 3%
(quarterly rate based on the 12% annual rate)
= $2,000 + ($2,000 x 14.32380)
= $2,000 = $28,647.60
= $30,647.60
Capital Lease
• At date of signing, record the
purchase of the asset
A-Asset under capital lease 30,647.60
L-Obligation under capital lease 30,647.60
Capital Lease
• On the first day of each quarter,
record the payment entry:
L-Obligation under capital lease 2,000.00
A-Cash
2,000.00
• On the last day of the quarter,
record the expense entry:
SE-Interest expense
859.43
L-Obligation under capital lease
859.43
Capital Lease
• On the last day of the quarter,
record the amortization expense
for the asset:
SE-Amortization expense
1,532.38
XA-Accumulated amortization
(on lease assets)
1,532.38
(Assumes straight-line amortization over 20
quarters)
Lease Disclosure
• In Canada, companies are
required to disclose significant
future lease payments to be made
in total and for each of the next
five years
Pensions
• Agreements between employers
and employees that provide
employees with specified benefits
(income) upon retirement
• Represent an estimated future
obligation
Pensions
• Defined contribution plans
– Employer agrees to make a set
(defined) contribution to a
retirement fund for the employee
• Defined benefit plans
– Employee is guaranteed a certain
amount of money during each year
of retirement
Debt/Equity Ratio
Debt/Equity
Ratio
=
Total liabilities
Total liabilities +
Shareholders’ equity
Times Interest Earned Ratio
Times
interest
earned
=
=
Income before interest and taxes
Interest
Net income + taxes + interest
Interest