Accounting for Long-Term

Debt

Chapter Ten

McGraw-Hill/IrwinMcGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Long-term notes are liabilities that usuallyhave terms from two to five years.

Long-term notes are liabilities that usuallyhave terms from two to five years.

Each payment covers interest for the period and a portion of the principal.

Each payment covers interest for the period and a portion of the principal.

With each payment, the interest portion gets smaller and the principal portion gets larger.

With each payment, the interest portion gets smaller and the principal portion gets larger.

Principal

CompanyLender

Payments

Long-Term Notes Payable

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Applying payments to principal and interest Identify the unpaid principal balance.

Amount applied to interest = Unpaid principal balance × Interest rate.

Amount applied to principal = Cash payment – Amount applied to interest in .

Unpaid principal balance = Unpaid principal balance in – Amount applied to principalin .

Applying payments to principal and interest Identify the unpaid principal balance.

Amount applied to interest = Unpaid principal balance × Interest rate.

Amount applied to principal = Cash payment – Amount applied to interest in .

Unpaid principal balance = Unpaid principal balance in – Amount applied to principalin .

Long-Term Notes Payable

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$-

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

Year 1 Year 2 Year 3 Year 4 Year 5

Interest

Principal

The amount applied to the principal increases each year. The amount of interest decreases

each year.

The amount applied to the principal increases each year. The amount of interest decreases

each year.

Annual payments

are constant.

Long-Term Notes Payable

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Line of Credit

•Enable the company to borrow and repay funds.•Usually specify a maximum credit line.•Normally used for short-term borrowing to finance seasonal business needs.

•Enable the company to borrow and repay funds.•Usually specify a maximum credit line.•Normally used for short-term borrowing to finance seasonal business needs.

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Long-term borrowing of a large sum of money, called the principal.

Principal is usually paid back as a lump sum at maturity.

Individual bonds are often denominated with a face value of $1,000.

Long-term borrowing of a large sum of money, called the principal.

Principal is usually paid back as a lump sum at maturity.

Individual bonds are often denominated with a face value of $1,000.

Bond Liabilities

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Periodic interest payments based on a stated rate of interest.

Interest is paid semiannually. Interest paid is computed as:

Interest = Principal × Stated Interest Rate × Time

Bond prices are quoted as a percentage of the face amount.

For example, a $1,000 bond priced at 104 would sell for $1,040.

Periodic interest payments based on a stated rate of interest.

Interest is paid semiannually. Interest paid is computed as:

Interest = Principal × Stated Interest Rate × Time

Bond prices are quoted as a percentage of the face amount.

For example, a $1,000 bond priced at 104 would sell for $1,040.

Bond Liabilities

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Bond Issue Date

Bond Interest Payments

Bond Interest PaymentsCorporation Investors

Interest Payment = Principal × Interest Rate × Time

Interest Payment = Principal × Interest Rate × Time

Bond Liabilities

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Bond Liabilities

Advantages of bonds Longer term to maturity than notes payable issued to banks. Bond interest rates are usually lower than bank loan rates.

Advantages of bonds Longer term to maturity than notes payable issued to banks. Bond interest rates are usually lower than bank loan rates.

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Secured and Unsecured

Secured and Unsecured

Term and Serial

Term and Serial

Convertible and CallableConvertible and Callable

Characteristics of Bonds

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The Market Rate of Interest

The selling price of a bond is determined by the market rate of interest versus the stated

rate of interest.

=

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Gains or losses incurred as a result of early redemption of bonds should be reported as other income or other expense on the income statement.

Gains or losses incurred as a result of early redemption of bonds should be reported as other income or other expense on the income statement.

Bond Redemptions

Companies may redeem bonds with acall provision prior to the maturity date.Companies may redeem bonds with acall provision prior to the maturity date.

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Effective Interest Rate Method

Effective interest is a more accurate way to

amortize bond discounts and

premiums.

It correctly reflects the bond’s changing carrying value.

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Effective Interest Rate Method

Let’s assume Mason Company uses the effective interest method on its $100,000 bond.

Step 1:Determine the cash payment for interest.Step 1:Determine the cash payment for interest.

Face value of bondX Stated rate of interest

Cash payment

Face value of bondX Stated rate of interest

Cash payment

$ 100,000X .09$ 9,000

$ 100,000X .09$ 9,000

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Effective Interest Rate Method

Step 2:Determine the amount of interest expense.Step 2:Determine the amount of interest expense.

Carrying value of bond liabilityX Effective rate of interest

Interest expense

Carrying value of bond liabilityX Effective rate of interest

Interest expense

$ 95,000X .1033$ 9,814

$ 95,000X .1033$ 9,814

$100,000 face value - $5,000 discount = $95,000 carrying value$100,000 face value - $5,000 discount = $95,000 carrying value

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Effective Interest Rate Method

Step 3:Determine the amortization of the bond discount.Step 3:Determine the amortization of the bond discount.

Interest expense- Cash payment

Discount amortization

Interest expense- Cash payment

Discount amortization

$ 9,814- 9,000$ 814

$ 9,814- 9,000$ 814

Step 4:Update the carrying value of the bond liability.Step 4:Update the carrying value of the bond liability.

Discount amortization+ Beginning carrying value

Ending carrying value

Discount amortization+ Beginning carrying value

Ending carrying value

$ 814+ $ 95,000

$ 95,814

$ 814+ $ 95,000

$ 95,814

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Effective Interest Rate Method

* The decrease in the amount of the discount increases the amount of the bond liability.

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Effective Interest Rate Method (Appendix)

Notice that when using the effective interest method, interest expense

increases each year.

Notice that when using the effective interest method, interest expense

increases each year.

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Financial Leverage and Tax Advantage of Debt Financing

Financial leverage: Debt financing can increase return on equity when the borrower earns more on the borrowed funds than it pays in interest. As this example shows, the cost of

financing is the same, but debt financing has a tax advantage.

Financial leverage: Debt financing can increase return on equity when the borrower earns more on the borrowed funds than it pays in interest. As this example shows, the cost of

financing is the same, but debt financing has a tax advantage.

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Times Interest Earned Ratio

Times InterestEarned =

Net income + Interest expense + Income tax expense

Interest expense

The ratio shows the amount of resources generated for The ratio shows the amount of resources generated for each dollar of interest expense. In general, a high ratio each dollar of interest expense. In general, a high ratio

is viewed more favorable than a low ratio.is viewed more favorable than a low ratio.

The ratio shows the amount of resources generated for The ratio shows the amount of resources generated for each dollar of interest expense. In general, a high ratio each dollar of interest expense. In general, a high ratio

is viewed more favorable than a low ratio.is viewed more favorable than a low ratio.

Numerator is commonly called EBIT,Earnings before interest and taxes.Numerator is commonly called EBIT,Earnings before interest and taxes.

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End of Chapter Ten

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