Chapter 10: Highlights
1.
Firms need cash for long-term purposes, such as acquiring buildings, land, or equipment,
may have to do one of two things: borrow from commercial banks or other financial
institutions or issue bonds in the capital markets.
2.
Loans from commercial banks or other financial institutions would often require
collateral to secure the loan. Long-term notes usually have a maturity of less than ten
years and are signed with a single lender. This Note Payable would appear as a Longterm Liability on the Balance Sheet.
3.
When a firm needs large amounts of funds, a firm may borrow from the general investing
public through the use of a bond issue. Bonds usually have maturity of longer than ten
years and are issued to many lenders instead of an individual lender. A bond is a
financial contract in which the borrower and the lender agree to certain conditions about
the repayment of the bonds, the operating policies, and other borrowing activities while
the bond is outstanding.
4.
The distinctive features of a bond issue are: (a) the parties draw up a bond indenture, or
agreement, which states the terms of the loan; (b) bond certificates evidence the bond
issue, each certificate representing a portion of the total loan; (c) any property serving as
collateral for the loan.
5.
Characteristics of bonds include:
debenture bonds: the most common type of corporate bond which carries no special
collateral; instead, it is issued on the general credit of the business. This type of bond
pays interest periodically, usually semiannually, during the life of the bond and repays
the principal at maturity.
serial bonds: requires periodic payments of interest and a portion of the principal
throughout the life of the bond.
zero coupon bond: provides no periodic payment of interest while the bond is
outstanding but the bond pays the principal and all interest at maturity.
convertible bonds: these bonds are debentures that the holder can exchange, after some
specified period of time has elapsed, for a specific number of shares of common or,
perhaps, preferred stock.
callable bonds: bonds in which the issuer (borrower) can repurchase the bonds prior to
the maturity date at a specified price.
6.
Bonds can carry either fixed interest rates or variable interest rates. Bonds with fixed
interest rates pay the same interest throughout the life of the bond. Bonds with variable
interest rates pay interest that may change over the life of the bond. The bond indenture
specifies the formula for the periodic calculations of the variable interest rate.
7.
The accounting measurement of notes and bonds payable follows two principles:
(a) the amount borrowed initially and the market value of the note or bond at any
subsequent point in time is the present value of the remaining cash flows discounted
at the market rate of interest.
(b) market interest rate (yield to maturity or internal rate of return): the discount rate that
that equated the future cash flows to the market value at any date.
8.
Amortized cost refers to the carrying value of notes or bonds while these obligations are
outstanding. The historical market rate of interest is used to compute the amortized cost.
9.
The current market rate of interest (instead of the historical market rate) is used to
compute the fair value of notes or bonds.
10.
Long-term borrowings appear on the balance sheet at the present value of all payments
the borrower will make in the future, using the historical market interest rate at the time
the firm incurred the liability to discount the cash payments.
11.
For most long-term liabilities, the borrower knows the amount of cash received as well as
the amounts and due dates of cash repayments. The borrower uses the historical market
rate, either specified or computed at the time the borrower receives the loan, throughout
the life of the loan to compute interest expense. When the borrower makes a cash
payment, a portion (perhaps all) of the payment represents interest. Any excess of cash
payment over interest expense reduces the borrower's liability for the principal amount.
If a given payment is too small to cover all the interest expense accrued since the last
payment date, then the liability principal increases by the excess of interest expense over
cash payment.
12.
The amount of funds received by the borrower may be more or less than the par (face)
value of the bonds issued. The price at which a firm issues bonds depends on (a) the
future cash payments that the bond indenture requires the firm to make, and (b) the
discount rate that the market deems appropriate given the risk of the borrower and the
general level of interest rates in the economy. If the coupon (or stated) rate is less than
the market interest rate, the bond will sell at a discount (the bond will sell for less than its
face amount). If the coupon rate is higher than the market interest rate, the bond will sell
at a premium (the bond will sell for more than its face amount). If the coupon rate equals
the market interest rate, the bond will sell at its face amount.
13.
When a firm issues bonds for less than par, the difference between the face value and the
amount of the proceeds, referred to as a discount, represents additional interest, which the
borrower will pay as a part of the face value at maturity. This borrower recognizes this
additional interest as an expense over the life of the bonds using the effective interest
method. Therefore, the periodic interest expense includes the interest payment plus a
portion of the discount.
14.
When a firm issues bond for more than par, the difference between the amount of the
proceeds and the face value, referred to as a premium, represents a reduction in future
interest. The borrower recognizes this reduction in interest expense over the life of the
bonds using the effective interest method of amortization.
15.
Generally accepted accounting principles require the effective-interest method of
recognizing interest expense. Under the effective-interest method (a) interest expense
each period equals the market interest rate at the time the firm issued the bonds (the
historical interest rate) multiplied by the book value of the liability at the beginning of the
interest period; (b) the interest expense on the income statement will equal a constant
percentage (historical interest rate) of the recorded liability at the beginning of each
interest period (for a bond issued at a discount, interest expense on the income statement
will be an increasing amount each period because the book value amount of the liability
increases each period and for a bond issued at a premium, interest expense on the income
statement will be a decreasing amount each period because the book value amount of the
liability decreases each period); and (c) the bonds will appear on the balance sheet at the
present value of the remaining cash outflows discounted at the market rate of interest
when the bonds were issued (historical interest rate).
16.
Bonds may remain outstanding until their stated maturity date or a firm may enter the
marketplace and purchase its own bonds before they mature. As market interest rates
change, the market price of a bond issue will change. For example, assume that a
company issues a 6 percent bond at par (that is, the market rate of interest is also 6
percent). The issuing company records the bonds at par, using the historical cost
convention. If market interest rates rise, the market price of the bond issue will decrease.
If market interest rates drop, the market price of the bond issue will increase. There is
therefore an inverse relation between the market interest rate and the market price of the
bond. If market interest rates rise and the market price of the bond issue decreases, the
issuing company can go into the marketplace and repurchase its bonds and record a gain
from the retirement of the bonds. The gain actually occurred as interest rates increased.
Under historical cost accounting, the firm recognizes the gain in the period when it retires
the bond.
17.
Firms report gains and losses on bond retirements in the income statement. Such gains
and losses result because firms record bond issues using historical interest rates and do
not record changes in the bond's market price as they occur.
18.
Both U.S. GAAP and IFRS allow firms to account for certain financial liabilities (notes
payable and bonds payable) using either amortized cost, with measurements based on the
historical market interest rate or fair value with measurements based on current market
conditions, including the current market rate of interest.
19.
Authoritative guidance believes that fair value provides more relevant and reliable
information of financial liabilities. Fair value measurement in not yet required for all
financial assets and liabilities. Firms can choose between fair value and amortized cost
based on historical market interest rates.
20.
There are two approaches to accounting for leases: the operating lease method and the
capital lease method. In an operating lease, the lessor transfers only the rights to use the
property to the lessee for specified periods of time. At the end of the lease period, the
lessee returns the property to the lessor. The lessee merely records annual rent expense
when it makes a lease payment. Under the capital lease method, the lease is judged to be
a form of borrowing to purchase the property. This treatment recognizes the signing of
the lease as the acquisition of a long-term asset, called a leasehold, and the incurring of a
long-term liability for lease payments. The lessee must amortize the leased asset over its
useful life and must recognize each lease payment as part payment of interest on the
liability and part reduction of the liability itself.
21.
For the lessee, one difference between the operating lease method and the capital lease
method is the timing of the expense recognition. Another difference is that the capital
lease method recognizes both the asset (leasehold) and the liability on the balance sheet.
Most lessees prefer to use the operating lease method because the reported income is
higher in the earlier years of the lease than it would be under the capital lease method.
Also, with an operating lease, the asset and related liability do not appear on the lessee's
balance sheet. When a journal entry debits an asset account and credits a liability
account, the debt-equity ratio increases and makes the company appear more risky.
Therefore, most managers prefer not to show an asset and a related liability on the
balance sheet. However, most analysts think that the capital lease method provides
higher quality measures of financial position.
22.
A firm must account for a lease as a capital lease if the lease meets any one of four
conditions. A lease is a capital lease (a) if it transfers ownership to the lessee at the end
of the lease term, (b) if transfer of ownership at the end of the lease term seems likely
because the lessee has a "bargain purchase" option, (c) if it extends for at least 75 percent
of the asset's life, or (d) if the present value of the contractual minimum lease payments
equals or exceeds 90 percent of the fair market value of the asset at the time the lessee
signs the lease.
23.
The four criteria attempt to identify whether the lessor or lessee enjoys the economic
benefit and bears the economic risk of the leased asset. For example, if the leased asset
becomes the property of the lessee at the end of the lease period, then the lessee enjoys all
of the economic benefits of the asset and incurs all risks of ownership.
24.
A bargain purchase option gives the lessee the right to purchase the asset for a price less
than the predicted fair market value of the asset when the option is exercised.
25.
Generally, the lessor uses the same criteria as the lessee for classifying a lease as a capital
lease or an operating lease. When the lessor and lessee sign a capital lease, the lessor
recognizes revenue in an amount equal to the present value of all future lease payments
and recognizes expenses in an amount equal to the book value of the leased asset. The
lessor records the lease receivable at the present value of the future cash flows. Lessors
tend to prefer the capital lease method because it enables them to recognize income on
the "sale" of the asset on the date the lease is signed.