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Sources of Capital: Debt

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8Part One: Financial Accounting

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Loss Contingency Slide 8-1

1. Information available prior to issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has incurred.

2. The amount of loss can be reasonable estimated.

A loss contingency is recorded as a liability if both of the following conditions are met:

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• a specified sum of money at a stated date, a specified sum of money at a stated date, called the called the maturity datematurity date

• interest at a stated rate until the maturity interest at a stated rate until the maturity datedate

• a specified sum of money at a stated date, a specified sum of money at a stated date, called the called the maturity datematurity date

• interest at a stated rate until the maturity interest at a stated rate until the maturity datedate

Bonds Slide 8-2

A bond is a certificate promising to pay its holder--

Bond

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Mortgage bondSecured bondDebenture bondSinking fund bondSerial bondsCallable bondsZero-coupon bondsConvertible bondsSubordinated bonds

Types and Features of Bonds Slide 8-3

A bond can have a combination of these features.

A bond can have a combination of these features.

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Recording a Bond Issue Slide 8-4

Mason Corporation’s 10% bonds, for which investors paid $851 each, also had issue costs to Mason averaging $21 per bond,

resulting in a net cash inflow to Mason of $830 per bond.

Mason Corporation’s 10% bonds, for which investors paid $851 each, also had issue costs to Mason averaging $21 per bond,

resulting in a net cash inflow to Mason of $830 per bond.

Cash 83,000Bond Discount 14,900Deferred Charges 2,100

Bonds Payable 100,000

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Recording a Bond Issue Slide 8-5

By contrast, if prevailing rates for similar bonds had been 9 percent, the bonds would have been

issued at a premium of $91 per bond.

By contrast, if prevailing rates for similar bonds had been 9 percent, the bonds would have been

issued at a premium of $91 per bond.

Cash 107,000Deferred Charges 2,100

Bond Premium 9,100Bonds Payable 100,000

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Balance Sheet Presentation Slide 8-6

If a Discount:Bonds payable:

Face value $100,000Less: Unamortized discount 14,900

$ 85,100

If a PremiumBonds payable:

Face value $100,000Plus: Unamortized premium 9,100

$109,100

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Slide 8-7Bond Interest Expense

The first year’s interest expense for the 10 percent Mason Corporation bonds (issued at a

discount; effective rate is 12 percent).

The first year’s interest expense for the 10 percent Mason Corporation bonds (issued at a

discount; effective rate is 12 percent).

Bond Interest Expense 10,212Bond Discount 212Cash 10,000

$85,100 x .12

$100,000 x .10

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Adjusting Entries Slide 8-8

The bonds were issued on October 1. The interest date is September 30, and the fiscal year ends on December 31. The

adjusting entry at December 31 would be--

The bonds were issued on October 1. The interest date is September 30, and the fiscal year ends on December 31. The

adjusting entry at December 31 would be--

Bond Interest Expense 2,553Bond Discount 53Accrued Interest Payable 2,500

$85,100 x .12 x 3/12

$100,000 x .10 x 3/12

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Interest Payment Entry Slide 8-9

Payment of interest is made to bondholders on September 30.Payment of interest is made to bondholders on September 30.

Bond Interest Expense 7,659Accrued Interest Payable 2,500

Bond Discount 159Cash 10,000

$85,100 x .12 x 9/12

$100,000 x .10

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Refunding a Bond Issue Slide 8-10

One hundred Mason Corporation bonds are called at the end of five years at a price of $1,050 per bond.

Miscellaneous refunding costs amount to $1,000.

One hundred Mason Corporation bonds are called at the end of five years at a price of $1,050 per bond.

Miscellaneous refunding costs amount to $1,000.

Reacquisition price ($105,000 + $1,000) $106,000Net carrying amount:

Face value $100,000 Less: Unamortized discount (13,553)Less: Unamortized issuance cost (1,575) 84,872

Loss on retirement of bond $ 21,128

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Refunding a Bond Issue Slide 8-10

One hundred Mason Corporation bonds are called at the end of five years at a price of $1,050 per bond.

Miscellaneous refunding costs amount to $1,000.

One hundred Mason Corporation bonds are called at the end of five years at a price of $1,050 per bond.

Miscellaneous refunding costs amount to $1,000.

Bonds Payable 100,000Loss on Retirement of Bonds 21,128

Cash 106,000Bond Discount 13,553Deferred Charges (Issuance Costs) 1,575

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• Ownership is transferred to the the lessee at the end of the term of the lease

• The lessee has an option to purchase the asset at a “bargain” price

• The term of the lease is 75 percent or more of the economic life of the asset

• The present value of the lease payments is 90 percent or more of the fair value of the property

Capital Leases Slide 8-11

The Financial Accounting Standards Board has ruled that a lease is a capital lease if one or more of the following criteria are met:

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Slide 8-12

A company leases equipment whose useful life is 10 years. Lease payments are $1,558 per year payable at the end of each of the next 10 years. The fair value of

the equipment is $10,000.

A company leases equipment whose useful life is 10 years. Lease payments are $1,558 per year payable at the end of each of the next 10 years. The fair value of

the equipment is $10,000.

Capital Leases

Equipment 10,000Capital Lease Obligations 10,000

What is the journal entry to record acquiring the equipment?.

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Slide 8-13

The first annual lease payment consists of $900 of interest expense and $658 to reduce the liability.

The first annual lease payment consists of $900 of interest expense and $658 to reduce the liability.

Capital Leases

Interest Expense 900Capita Lease Obligations 658

Cash 1,558

Assuming straight-line depreciation, the following adjusting entry is made to record annual depreciation.

Assuming straight-line depreciation, the following adjusting entry is made to record annual depreciation.

Depreciation Expense 1,000Accumulated Depreciation 1,000

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Debt/Equity Ratio

Total liabilities

Shareholders’ equityDebt/Equity

Ratio=

$3,400

$3,600Debt/Equity

Ratio=

Debt/Equity Ratio

= 94 percent

Excluding current liabilities, the ratio changes to 50 percent

Excluding current liabilities, the ratio changes to 50 percent

Slide 8-14

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Times Interest Earned Slide 8-15

Pre-tax income before interest

Interest expenseTimes Interest Earned =

$1,000

$200Times Interest Earned =

5.0 timesTimes Interest Earned =

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Future Value--Compound Interest Slide 8-16

FV = p(1 + i)n

where:

p = Principal (initial investment)

i = Interest rate

n = Number of periods

The future value of $1,000 invested at 5 percent for 10 years is given by:

FV = $1,000(1 + 0.05) = $1,628.8910

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Present Value of a Future Amount Slide 8-17

PV =p

(1 + i)n

What is the present value of $400 to be received 10 years hence, discounted at a rate of 8 percent?

What is the present value of $400 to be received 10 years hence, discounted at a rate of 8 percent?

PV =p

(1 + i)n

Amount to bereceived in future

Amount to bereceived in future

From Table A, wefind the 10 year/8% factor to be 0.463.

From Table A, wefind the 10 year/8% factor to be 0.463.

$185.20 = $400 x 0.463

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1 $1,750 0.909 $1,591

2 1,750 0.826 1,446

3 1,750 0.751 1,314

4 1,750 0.683 1,195

Present value of series $5,546

Present Value of a Series of Payments Slide 8-18

What would be the present value of a series of equal payments of $1,750 for 10 years (assume 10 percent)?

What would be the present value of a series of equal payments of $1,750 for 10 years (assume 10 percent)?

Year Payment (Table A) Value Present

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Present Values and Liabilities Slide 8-19

Kinnear Company borrowed $25,000, with interest at 10 percent to be paid annually and the principal to be repaid in one lump sum at the end of ten years. What

balance sheet liability would be reported at the inception of the debt?

Kinnear Company borrowed $25,000, with interest at 10 percent to be paid annually and the principal to be repaid in one lump sum at the end of ten years. What

balance sheet liability would be reported at the inception of the debt?

Interest, $2,500*3.791 (Table B) $ 9,478 Principal, $25,000*0.621 (Table A) 15,575 Total present value $25,003* *Does not add exactly to $25,000 due to rounding

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Present Values and Liabilities Slide 8-20

Kinnear Company borrowed $25,000, with interest at 10 percent to be repaid in equal annual amounts at the end of each of the next five years. How much is each

equal annual payment?

Kinnear Company borrowed $25,000, with interest at 10 percent to be repaid in equal annual amounts at the end of each of the next five years. How much is each

equal annual payment?

PV of the annuity = Table B Value x Annual for 10 percent/5 payment year factor

$25,000 = 3.791 x ?

$25,000 = 3.791 x $6,595

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Chapter 8

The End