Chapter 10 Long-Term Liabilities Management Issues Related to Issuing Long-Term Debt © Royalty Free PhotoDisc/ Getty Images Copyright © Cengage Learning. All rights reserved. 10–1 Funding Growth Growth usually requires investment in longterm assets and research and development How do companies raise long-term funds? Issuance of capital stock Issuance of long-term debt Take on long-term debt? How much debt to carry? What types of debt to incur? Copyright © Cengage Learning. All rights reserved. 10–2 Deciding to Issue Long-Term Debt Advantages to consider Disadvantages to consider No loss of stockholder control A high level of debt exposes a as when issuing stock company to financial risk The interest on debt is taxdeductible If earnings on funds borrowed do not exceed interest on debt, If earnings on funds borrowed negative financial leverage is experienced exceed interest on debt, financial leverage is gained Copyright © Cengage Learning. All rights reserved. 10–3 Average Debt to Equity for Selected Industries Copyright © Cengage Learning. All rights reserved. 10–4 Evaluating Long-Term Debt Many companies use the debt to equity ratio when assessing how much debt to carry Total Liabilitie s Debt to Equity Ratio Total Stockholde rs’ Equity $4,498.5 $9,613.4 McDonald’ s Debt to Equity Ratio 0.9 $15,279.8 McDonald’s also has long-term leases that do not appear on the balance sheet, called off-balance sheet financing. Copyright © Cengage Learning. All rights reserved. 10–5 Off-Balance Sheet Financing A legal way of structuring a lease commitment so that it does not have to be included on the balance sheet as a liability Financial statement users should review the notes to the financial statements for information about any leases that may have the effect of long-term liabilities © Royalty Free/ Corbis Copyright © Cengage Learning. All rights reserved. 10–6 Interest Coverage Ratio Measures how much risk a company is undertaking with its long-term debt Income Before Income Taxes Interest Expense Interest Coverage Ratio Interest Expense Measures the degree of protection a company has from default on interest payments Copyright © Cengage Learning. All rights reserved. 10–7 Interest Coverage Ratio Illustrated (hwk E 3) McDonald’s 2007 annual report shows that the company had income before income taxes of $3,572.1 million and interest expense of $410.1 million. Income Before Taxes Interest Expense Interest Coverage Ratio Interest Expense $3,572.1 $410.1 $410.1 9.7 times McDonald’s interest expense was covered 9.7 times in 2007. However, management will add the company’s off-the-balance sheet rent expense of $1,053.8 to its interest expense. This procedure decreases the coverage ratio to less than 3.0 times, still adequate to cover interest payments. Copyright © Cengage Learning. All rights reserved. 10–8 Types of Long-Term Debt Bonds payable Notes payable Mortgages payable Long-term leases Pensions Other postretirement benefits Deferred income taxes © Royalty Free PhotoDisc/ Getty Images Copyright © Cengage Learning. All rights reserved. 10–9 Long-Term Debt Bonds Payable Most common type of long-term debt May be convertible to common stock Involves a debt to many creditors Copyright © Cengage Learning. All rights reserved. Notes Payable Represents a loan from a bank or other creditor Deutsche Telekom International Finance recently raised $14.6 billion by issuing a series of long-term notes denominated in dollars, Euros, pounds, and yen. 10–10 Mortgages Payable Long-term debt secured by real property. Usually repaid in equal monthly installments that include interest on the debt and a reduction in the initial debt. Illustration: Monthly Payment Schedule on a $100,000, 12% mortgage Payment Date 6/1 7/1 8/1 9/1 Unpaid Bal. At Beg. of Period $100,000 99,400 98,794 M onthly Payment $1,600 1,600 1,600 Copyright © Cengage Learning. All rights reserved. Interest for 1 M onth at 1% on Unpaid Bal. $1,000 994 988 Reduction in Debt Unpaid Bal. At End of Period $600 606 612 $100,000 99,400 98,794 98,182 10–11 Leases • Companies may obtain an operating asset in three ways: Borrow the money and buy the asset Rent the asset on a short-term lease (operating lease; payments are treated as rent expense) Obtain the asset on a long-term lease (may be structured as a capital lease or an operating lease) Copyright © Cengage Learning. All rights reserved. 10–12 Capital Leases Accounting standards require that a lease be treated as a capital lease if the lease: Cannot be cancelled Has about the same duration as the useful life of the asset Stipulates that the lessee has the option to buy the asset at a nominal price at the end of the lease Copyright © Cengage Learning. All rights reserved. Accounting for a Capital Lease The lessee should: 1) Record the asset 2) Record depreciation on the asset 3) Record a liability equal to the present value of the total lease payments during the lease term 10–13 Capital Lease Illustrated Polany’s Manufacturing Company enters into a long-term lease for a machine. The lease terms call for an annual payment of $8,000 for six years, which approximates the useful life of the machine. At the end of the lease period, the title to the machine passes to Polany. Use present value techniques to place a value on the asset and on the corresponding liability. Assume that the interest cost on the unpaid part of the obligation is 16 percent. $8,000 x 3.685 = $29,480 Capital Lease Equipment Capital Lease Obligations To record capital lease on machinery Copyright © Cengage Learning. All rights reserved. 29,480 29,480 10–14 Capital Lease Illustrated (hwk E5) Each year, Polany must record depreciation on the leased asset. Assume the company uses the straight-line method and no salvage value. Depreciation Expense, Capital Lease Equipment Accum. Depreciation, Capital Lease Equip. To record depr. expense on capital lease machinery 4,914 4,914 Polany must also record interest expense for the lease. The interest expense for each year is computed by multiplying the interest rate by the amount of remaining lease obligation. Interest Expense Capital Lease Obligations Cash Made payment on capital lease $29,480 x 16% = $4,717 Copyright © Cengage Learning. All rights reserved. 4,717 3,283 8,000 10–15 Pension Liabilities Pension plans Require a company to pay Employer Employee benefits to employees contributions contributions after they retire Some companies pay full cost of pension plan Pension Fund Employees often share the cost of pension plans Pension benefits paid to retired employees Copyright © Cengage Learning. All rights reserved. 10–16 Pension Plans Defined Contribution Plan Defined Benefit Plan Employer makes fixed, agreed- Employer makes upon, annual contribution variable payments Retirement payments vary required to fund the depending on how much the estimated future pension fund earns liability arising from Employees usually control their current employment own accounts and can transfer Retirement benefits are funds if they leave the firm fixed More complex Examples: 401(K) plans, profitaccounting required sharing plans, and ESOPs Copyright © Cengage Learning. All rights reserved. 10–17 Other Postretirement Benefits Retired employees may also be provided health care benefits and other postretirement benefits Recent accounting Estimates should account standards hold for retirement age, mortality, postretirement benefits future trends in health care should be estimated and Future benefits should be expensed during the time discounted to the current that employees are period working in accordance with the matching rule. Copyright © Cengage Learning. All rights reserved. 10–18 Deferred Income Taxes Results from using different accounting methods to calculate income taxes on the income statement and income tax liability on the income tax return © Royalty Free C Squared Studios/ Getty Images Copyright © Cengage Learning. All rights reserved. A company might use straight-line depreciation for financial reporting and an accelerated method for income tax purposes. The difference in taxes resulting from the two methods is listed as a long-term liability. 10–19 Bonds A security, usually long term, representing money that a corporation borrows from the investing public Governments and foreign countries also issue bonds to raise money Must be repaid at a specified time and require periodic payments of interest at a specified rate at specified times © Royalty Free PhotoDisc/ Getty Images Copyright © Cengage Learning. All rights reserved. 10–20 What Is a Bond Issue? A bond issue is the total value of bonds issued at one time Prices of Bonds • Stated in terms of a percentage of face value • Bonds selling at 100 • Sell at face or par value For example, a $1,000,000 bond issue could consist of one thousand, $1,000 bonds Copyright © Cengage Learning. All rights reserved. • Bonds selling above 100 • Sell at a premium • Bonds selling below 100 • Sell at a discount 10–21 Selling Price of Bond Illustrated A bond issue is quoted at 103 ½ What is the selling price of a $1,000 bond? A bond issue quoted at 103 ½ means that the bond sells at 103.5 percent of its face value Bond Selling Price Face Value Quoted Percentage of Face Value $1,000 1.035 $1,035 This bond sells at a premium and would cost the buyer $1,035 Copyright © Cengage Learning. All rights reserved. 10–22 Interest Rates Face Interest Rate Market Interest Rate Fixed rate of interest paid to bondholders based on the face value of the bonds Rate of interest paid in the market on bonds of similar risk, also called the effective interest rate Copyright © Cengage Learning. All rights reserved. 10–23 Discounts and Premiums Discount • Equals the excess of the face value over the issue price. • The issue price will be less than the face value when the market interest rate is higher than the face interest rate. Copyright © Cengage Learning. All rights reserved. Premium • Equals the excess of the issue price over the face value. • The issue price will be more than the face value when the market interest rate is lower than the face interest rate. 10–24 Bond Characteristics (hwk P 2) Issued on the basis of a firm’s general credit Carry a pledge of certain corporate assets as a Secured guarantee of repayment Term All bonds of an issue mature at the same time Bonds of an issue mature on different dates Serial Gives issuer the right to buy back and retire the Callable bonds before maturity at a specified call price Allows bondholder to exchange a bond for a Convertible specified number of shares of common stock Registered Issued to a specific bondholder Not registered with the organization Coupon Unsecured Copyright © Cengage Learning. All rights reserved. 10–25 Issuing Bonds Payable The board of directors must submit the appropriate legal documents to the Securities and Exchange Commission (SEC) for approval to issue bonds No journal entry is required for the authorization of the bond issue (most companies disclose in the notes to the financial statements) © Royalty Free/ Corbis Copyright © Cengage Learning. All rights reserved. 10–26 Bonds Issued at Face Value Bharath Corporation issues $200,000 of 9 percent, 5-year bonds on January 1, 2010 and sells them on the same date for their face value. The bond indenture states that interest is to be paid on January 1 and July 1 of each year. Jan. 1 Cash 200,000 Bonds Payable Sold $200,000 of 9%, 5-year bonds at face value 200,000 Record a semiannual interest payment: Bond Interest Expense Cash (Interest Payable) Paid (or accrued) semiannual interest to bondholders of 9%, 5year bonds 9,000 9,000 Interest Principal Rate Time Copyright © Cengage Learning. All rights reserved. $200,000 .09 6/12 year $9,000 10–27 Bonds Issued at a Discount Bharath Corporation issues $200,000 of 9 percent, 5-year bonds at 96.149 on January 1, 2010, when the market rate is 10 percent. Record the issuance of the bonds at a discount: 2010 Jan. 1 Cash Unamortized Bond Discount Bonds Payable Sold $200,000 of 9%, 5-year bonds at 96.149 Face amount of bonds Less purchase price of bonds ($200,000 x .96149) Unamortized bond discount 192,298 7,702 200,000 $200,000 192,298 $ 7,702 Unamortized Bond Discount is a contra-liability account Carrying Value of Bonds = Face Value – Unamortized Bond Discount Copyright © Cengage Learning. All rights reserved. 10–28 Bonds Issued at a Premium Bharath Corporation issues $200,000 of 9 percent, 5-year bonds for $208,200 on January 1, 2010, when the market rate is 8 percent. Record the issuance of the bonds at a premium: 2010 Jan. 1 Cash Unamortized Bond Premium Bonds Payable Sold $200,000 of 9%, 5-year bonds at 104.1 ($200,000 x 1.041) 208,200 8,200 200,000 Carrying Value of Bonds = Face Value + Unamortized Bond Premium = $200,000 + $8,200 = $208,200 Copyright © Cengage Learning. All rights reserved. 10–29 Bond Issue Costs Can amount to as much as 5 percent of a bond issue © Royalty Free PhotoDisc/ Getty Images Establish an account for these costs and amortize over life of bonds Copyright © Cengage Learning. All rights reserved. 10–30 Using Present Value to Value a Bond © Royalty Free PhotoDisc/ Getty Images Copyright © Cengage Learning. All rights reserved. 10–31 Influence of the Market Interest Rate on Bonds The market interest rate varies from day to day and therefore what investors are willing to pay changes as well If current market interest rate > bond’s interest rate, investors are willing to pay less If current market interest rate < bond’s interest rate, investors are willing to pay more Copyright © Cengage Learning. All rights reserved. 10–32 Case 1: Present Value Market interest rate > Face interest rate A bond has a face value of $20,000 and pays fixed interest of $900 every six months (a 9 percent annual rate). The bond is due in 5 years and the market interest rate is 12 percent. What is the present value of the bond? Determine the interest rate and number of periods to use in the present value tables • Divide the annual interest rate by the number of periods in the year 12% ÷ 2 = 6% • Multiply the number of periods in one year by the number of years 2 x 5 = 10 periods Present value of 10 periodic payments @ 6% Present value of a single payment at the end of 10 periods @ 6% Present value of $20,000 bond Copyright © Cengage Learning. All rights reserved. Table 2 $900 x 7.360 $6,624.00 Table 1 $20,000 x .558 11,160.00 $17,784.00 10–33 Case 2: Present Value (hwk E 7) Market interest rate < Face interest rate A bond has a face value of $20,000 and pays fixed interest of $900 every six months (a 9 percent annual rate). The bond is due in 5 years and the market interest rate is 8 percent. What is the present value of the bond? Present value of 10 periodic payments @ 4% Table 2 $900 x 8.111 $7,299.90 Present value of a single payment at the end of 10 periods @ 4% Table 1 $20,000 x .676 13,520.00 Present value of $20,000 bond Copyright © Cengage Learning. All rights reserved. $20,819.90 10–34 Amortization of Bond Discounts and Premiums © Royalty Free/ Corbis Copyright © Cengage Learning. All rights reserved. 10–35 Bond Discounts or Premiums Amount by which the total interest cost is higher or lower than the total interest payments Amortized over the life of the bonds Use straight-line or effective interest method © Royalty Free C Squared Studios/ Getty Images Copyright © Cengage Learning. All rights reserved. 10–36 Total Interest Cost Illustrated Bharath Corporation issues $200,000 of 9 percent, 5-year bonds at 96.149 when the market rate is 10 percent. The bonds sold for $192,298 resulting in an unamortized bond discount of $7,702. The bonds were issued at a discount: The interest rate paid by the company is greater than the face interest rate on the bonds Although the company does not receive the full face value of the bonds on issue, it still must pay back the full face value at maturity Interest Cost to Company Stated Interest Payments Amount of Bond Discount Copyright © Cengage Learning. All rights reserved. 10–37 Calculating Total Interest Cost Bharath Corporation issues $200,000 of 9 %, 5-year bonds at 96.149 when the market rate is 10 percent. The bonds sold for $192,298, resulting in an unamortized bond discount of $7,702. Cash to be paid to bondholders Face value at maturity Interest payments ($200,000 x .09 x 5 years) Total cash paid to bondholders Less cash received from bondholders Total interest cost $200,000 90,000 $290,000 192,298 $ 97,702 Or, alternately Interest payments ($200,000 x .09 x 5 years) Bond discount Total interest cost $90,000 7,702 $97,702 The bond discount increases the interest paid on the bonds from the stated interest rate to the effective interest rate. Copyright © Cengage Learning. All rights reserved. 10–38 Accounting for Total Interest Cost Effective Interest Rate = Stated Rate + Discount Amortization of the bond discount Must be allocated over the remaining life of the bonds as an increase in the interest expense each period Interest expense for each period will exceed the actual payment of interest by the amount of the bond discount amortized over the period Zero coupon bonds are issued by some companies and governmental units Do not require periodic interest payments Represent a promise to pay a fixed amount at the maturity date Copyright © Cengage Learning. All rights reserved. 10–39 Effective Interest Method Applies a constant interest rate to the carrying value of bonds at the beginning of the interest period Rate equals the market, or effective, rate at the time the bonds were issued. Amount amortized is the difference between interest computed and actual interest paid to bondholders © Royalty Free PhotoDisc/ Getty Images Copyright © Cengage Learning. All rights reserved. 10–40 Interest and Amortization of a Bond Discount: Effective Interest Method Copyright © Cengage Learning. All rights reserved. 10–41 Bond Amortization – Effective Interest Method Face value = $200,000 Face Interest rate = 9% Life of bond = 5 years Column A Carrying value = Face value – Unamortized bond discount A Semiannual Interest Period 0 1 Carrying Value at Beginning of Period $192,298 Interest payments = Semiannual Bond discount = $7,702 Column B – Use market interest rate ($192,298 x .10 x 6/12 = $9,615) Column C – Use face interest rate on bond ($200,00 x .09 x 6/12 = $9,000) B Semiannual Interest Expense at 10% to be Recorded (5% x A) C Semiannual Interest to be Paid to Bondholders (4.5% x $100,000) $9,615 $9,000 Copyright © Cengage Learning. All rights reserved. D E F Amortization of Bond Discount (B – C) Unamortized Bond Discount at End of Period (E – D) $7,702 Carrying Value at End of Period (A + D) $192,298 10–42 Bond Amortization – Effective Interest Method (cont’d) Column D Discount amortized = Effective interest expense – Actual interest payment to bondholders ($9,615 – $9,000 = $615) A Semiannual Interest Period 0 1 Carrying Value at Beginning of Period $192,298 Column F Carrying value at beg. of period + Amort. during the period ($192,298 + $615 = $192,913) B Semiannual Interest Expense at 10% to be Recorded (5% x A) C Semiannual Interest to be Paid to Bondholders (4.5% x $100,000) $9,646 $9,000 Notice that the sum of the carrying value and the unamortized discount always equals the face value of the bonds Copyright © Cengage Learning. All rights reserved. D Amortization of Bond Discount (B – C) $615 E F Unamortized Bond Discount at End of Period (E – D) $7,702 7,087 Carrying Value at End of Period (A + D) $192,298 192,913 Column E Bond discount at beg. of period – Current pd amort. ($7,702 – $615 = $7,087) 10–43 Bond Amortization – Effective Interest Method (cont’d) Record first semiannual interest payment and amortization of bond discount: 2010 July 1 Bond Interest Expense 9,615 Unamortized Bond Discount Cash (or Interest Payable) Paid (or accrued) semiannual interest to bondholders and amortized discount on 9%, 5-year bonds 615 9,000 It is not necessary to prepare an interest and amortization table to determine amortization of a discount for the period Amount of Interest t o Amortize (Carrying Value Effective Interest Rate) – Interest Payment ($192,298 .05) – $9,000 $615 Copyright © Cengage Learning. All rights reserved. 10–44 Carrying Value and Interest Expense – Bonds Issued at a Discount (hwk E 12) Copyright © Cengage Learning. All rights reserved. 10–45 Bond Premiums Bondholders pay more than face value for bonds Premium is an amount that bondholders will receive over the life of the bond issue (it is a reduction, in advance, of the total interest paid on the bonds over life of the issue) Copyright © Cengage Learning. All rights reserved. © Royalty Free PhotoDisc/ Getty Images 10–46 Total Interest Cost Bharath Corporation issues $200,000 of 9 percent, 5-year bonds at 104.1 on January 1, 2010, when the market rate is 8 percent. The bonds sold for $208,200 resulting in an unamortized bond premium of $8,200. Cash to be paid to bondholders Face value at maturity Interest payments ($200,000 x .09 x 5 years) Total cash paid to bondholders Less cash received from bondholders Total interest cost $200,000 90,000 $290,000 208,200 $ 81,800 Or, alternately Interest payments ($200,000 x .09 x 5 years) Less bond premium Total interest cost $90,000 8,200 $ 81,800 The bond premium decreases the interest paid on the bonds from the stated interest rate to the effective interest rate. Copyright © Cengage Learning. All rights reserved. 10–47 Interest and Amortization of a Bond Premium: Effective Interest Method Copyright © Cengage Learning. All rights reserved. 10–48 Bond Amortization – Effective Interest Method (cont’d) Record first semiannual interest payment and amortization of bond premium: 2010 July 1 Bond Interest Expense 8,328 Unamortized Bond Premium 672 Cash (or Interest Payable) Paid (or accrued) semiannual interest to bondholders and amortized premium on 9%, 5-year bonds 9,000 It is not necessary to prepare an interest and amortization table to determine amortization of a premium for the period Amount of Interest t o Amortize Interest Payment - (Carrying Value Effective Interest Rate) $9,000 – ($208,200 .04) $672 Copyright © Cengage Learning. All rights reserved. 10–49 Carrying Value and Interest Expense – Bonds Issued at a Premium (hwk E 11) Copyright © Cengage Learning. All rights reserved. 10–50 Retirement of Bonds © Royalty Free PhotoDisc/ Getty Images Copyright © Cengage Learning. All rights reserved. 10–51 Calling Bonds Why call bonds before their maturity date? If bond interest rates drop, the company can call the bonds and reissue debt at a lower interest rate. Company has earned enough to pay off the debt. The reason for having the debt no longer exists. The company wants to restructure its debt to equity ratio. Copyright © Cengage Learning. All rights reserved. 10–52 Callable Bonds Illustrated The issuer has the right to buy back and retire bonds at a specified call price Bharath Corporation can call or retire at 105 the $200,000 of bonds it issued at a premium (104.1). It decides to do so on July 1, 2013. The entry for the required interest payment and amortization of the premium has already been made. Record the retirement of the bonds: 2013 July 1 Bonds Payable Unamortized Bond Premium Loss on Retirement of Bonds Cash Retired 9% bonds at 105 200,000 2,892 7,108 210,000 The loss occurs because the call price of the bonds is greater than the carrying value Copyright © Cengage Learning. All rights reserved. 10–53 Callable Bonds (Purchase) (hwk E13) Bharath Corporation can call or retire at 105 the $200,000 of bonds it issued at a premium (104.1). Because of a rise in interest rates, Bharath is able to purchase the $200,000 bond issue on the open market for 85. The entry for the required interest payment and amortization of the premium has already been made. Record the purchase of the bonds: 2013 July 1 Bonds Payable Unamortized Bond Premium Cash Gain on Retirement of Bonds Purchased and retired 9% bonds at 85 200,000 2,892 170,000 32,892 The gain occurs because the call price of the bonds is less than than the carrying value Copyright © Cengage Learning. All rights reserved. 10–54 Convertible Bonds Illustrated (hwk E14) Bharath Corporation issued $200,000 of convertible bonds on January 1, 2010, that can be converted to 40 shares of common stock for each $1,000 bond. The bondholders decide to convert all the bonds to $8 par value common stock on July 1, 2013. Record the bond conversion: 2013 July 1 Bonds Payable 200,000 Unamortized Bond Premium 2,892 Common Stock Additional Paid-in Capital Converted 9% bonds payable into $8 par value common stock at a rate of 40 shares for each $1,000 bond 64,000 138,892 No loss or gain is recorded because the bond liability and the associated unamortized discount or premium are written off the books. Copyright © Cengage Learning. All rights reserved. 10–55