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Chapter 14 Long term Liabilities

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Chapter 14 Long term Liabilities Powered By Docstoc
					   a way to borrow money

   a promise to pay
      a sum of money (par value) at a designated maturity date
     PLUS
      periodic interest payments (stated interest rate X par value
         X time factor)

   allows a borrower to divide a large amount
    borrowed into many smaller investing units (par
    value per bond usually $100, $1000, $5000, or
    $10,000) and enable more than one lender to
    participate in the loan
Bond Indenture – the legal contract between the bond issuer
  and the bondholders, identifies the parties and their rights
  and obligations, identifies the details of the bond – par
  value, interest payment dates, stated/coupon/nominal
  interest rate, settlement process

Three ways a company can issue bonds:
 firm underwriting – company sells all the bonds to one
  investment bank (the underwriter) for a negotiated price,
  then the underwriter sells the bond to others for what they
  can get
 best-efforts underwriting – company places bonds with
  investment bank (underwriter) who sells the bonds for
  what they can get and underwriter gets a commission
 private placement – company sells bonds directly to bond
  holders without underwriter
Students should spend some time on page 691
  defining the below types of bonds:
 secured bonds
 unsecured bonds
 term Bonds
 serial bonds
 callable bonds
 convertible bonds
 commodity-backed bonds
 deep-discount (zero-interest) bonds
 registered bonds
 bearer (coupon) bonds
 income bonds
 revenue bonds
   usually pays interest semiannually (twice a year)

   stated (nominal, coupon, contractual) interest
    rate usually expressed in annual terms

   the general interest rate environment
    (market/effective interest rate) has an inverse
    relationship with bond prices, if interest rate go
    up – the price of bonds goes down

   the price of a bond is lower when the bond
    carries a call feature (it is a callable bond), the
    bond holder must be rewarded for taking the risk
    the bond issuer may call the bond early
   Par value, face value, principal amount, or
    maturity value - the amount that the issuer
    will pay the bondholder on the maturity date

   Stated, coupon, nominal, or contractual
    interest rate - the annual interest rate used to
    compute the bond’s interest payments.
   Market interest rate or Effective interest rate – the
    rate that borrowers are willing to pay and lenders are
    willing to accept for a particular bond and its risk
    level
   Market interest rate or Effective interest rate – the
    actual rate of interest earned by the bond holder
   selling price of a bond is a function of the
    present value of the future cash flows from the
    bond

   future cash flows of a bond are generated in two
    streams:
    1. the payment of the par value at maturity date
    2. the payment of periodic interest

   present value of future cash flows of a bond is
    compute by discounting the cash flow streams by
    the effective (market) interest rate
    1. the payment of the par value at maturity date is a
       single payment discounted at the effective interest rate
    2. the payment of periodic interest is a series of
       payments (ordinary annuity) discounted at the
       effective interest rate
PL14-1 Question 1 (Textbook Exercise 14-11 on page 728)

Pawnee Inc. has issued three types of debt on January 1,
  2010, the start of the company's fiscal year.

(a) $10,000,000, 10-year, 13% unsecured bonds, interest
    payable quarterly. Bonds were priced to yield 12%.

(b) $25,000,000 par of 10-year, zero-coupon bonds at a
    price to yield 12% per year.

(c) $15,000,000, 10-year, 10% mortgage bonds, interest
    payable annually to yield 12%.

Prepare a schedule that identifies the following items for
  each bond:
  (1) maturity value
  (2) number of interest periods over life of bond
  (3) stated rate per each interest period.
  (4) effective interest rate per each interest period
  (5) payment amount per period
  (6) present value of bonds at date of issue.
If a bond issued between interest dates:
 the buyer of the bond will pay the seller of
  the bond, interest accrued from the last
  interest payment date to the date of issuance
AND
 on the next interest payment date after
  issuance, the holder of the bond will receive
  interest for the full interest period even
  though the bond was held for part of the
  interest period
PL14-1 Question 2, textbook brief exercise 14-5,
 page 725

Devers Corporation issued $400,000 of 6% bonds
 on May 1, 2011. The bonds were dated January 1,
 2011, and mature January 1, 2013, with interest
 payable July 1 and January 1. The bonds were
 issued at face value plus accrued interest.
 Prepare Devers's journal entries for (a) the May 1
 issuance, (b) the July 1 interest payment, and(c)
 the December 31 adjusting entry.
Bonds can be issued (sold):
 at face (par) value
 at a discount (for less than face/par value)
 at a premium (for more than face/par value)
   Discount on Bonds Payable is a contra
    account (an account that decreases or is
    subtracted from its related account)

   Premium on Bonds Payable is a adjunct
    account (an account that increases or adds to
    its related account)
   the bond issuer must amortize the bond discount
    or premium down to zero by the maturity date of
    the bond, because upon maturity all the issuer
    will have to pay is the par value

   bond discounts are charged to bond interest
    expense when amortized (bond discount will
    cause the bond interest expense to be higher
    than the bond interest payments)

   bond premiums are negative charges (reductions)
    to bond interest expense when amortized (bond
    premiums will cause the bond interest expense
    to be lower than the bond interest payments)
   Two methods to amortize bond discounts and premiums:
    ◦ straight-line method
      is acceptable as long as the amount of amortization is not
       materially different than amortization under the effective
       method
      amortizes an equal dollar amount of the bond discount or
       premium each period in the bond’s life
    ◦ effective-interest method (preferred method)
      aka present value method
      computes interest expense based on the carrying value (book
       value) of the bonds
      carrying value (book value) = par value – unamortized discount
       on bonds payable + unamortized premium on bonds payable
      yields varying amounts of discount or premium amortization
       each period
      provides a constant interest expense rate (the effective-interest
       rate)
Both methods yield the same interest expense over the life
  of the bond
PL14-2 Question 1, Textbook Brief Exercises
 14-6, page 725

On January 1, 2011, JWS Corporation issued
 $600,000 of 7% bonds, due in 10 years. The
 bonds were issued for $559,224, and pay
 interest each July 1 and January 1. JWS uses
 the effective interest method.

Prepare the company's journal entries for (a)
 the January 1 issuance, (b) the July 1 interest
 payment, and (c) the December 31 adjusting
 entry. Assume an effective interest rate of 8%.
PL14-2 Question 2, Textbook Brief Exercises 14-7,
 page 725

On January 1, 2011, JWS Corporation issued
 $600,000 of 7% bonds, due in 10 years. The
 bonds were issued for $644,636, and pay
 interest each July 1 and January 1. JWS uses the
 effective interest method.

Prepare the company's journal entries for (a) the
  January 1 issuance, (b) the July 1 interest
  payment, and (c) the December 31 adjusting
  entry. Assume an effective interest rate of 6%.
Amount of all interest payments
+ any discount on issuance
- any premium on issuance
Cost to Borrow the Funds (money)
   Cost of Issuing Bonds is capitalized into an
    asset account typically called “Unamortized
    Bond Issuance Cost”

   Cost of Issuing Bonds is then amortized to
    expense “Bond Issuance Expense” over the
    life of the bond
   payment of bonds (aka extinguishment of
    bonds)

   bonds extinguished at maturity are simple, at
    maturity the bond carrying value is equal to
    the par value, the issuer pays the par value to
    the bond holder and there is NO gain or loss
    on extinguishment of bonds

   bonds extinguished before maturity are not
    so simple
   reacquisition price represents the amounts paid to
    reacquire a bond before maturity, (includes the bond
    purchase price, any call premium, or other cost to execute
    the trade)

   net carrying value of the bond at reacquisition =
            +par value of the bond
            +unamortized premium on bond
            – unamortized discount on bond
            – unamortized bond issuance cost

   the difference between net carrying value of the bond on
    the reacquisition date AND the reacquisition price is a
    GAIN or LOSS from extinguishment of bonds
    (extinguishment of debt)
   refunding – the replacement of an existing
    debt issuance with a new debt issuance
PL14-3 Question 1 (Textbook Brief Exercise
 14-11, page 725)

On January 1, 2011, Henderson Corporation
 retired $500,000 of bonds at 99. At the time
 of retirement, the unamortized premium was
 $15,000 and unamortized bond issue costs
 were $5,250.

Prepare the corporation's journal entry to
 record the reacquisition of the bonds.
   one difference between current notes payable
    and long-term notes payable is the maturity
    date

    ◦ current notes payable are expected to be paid with
      current assets or creation of current liabilities
      within a year or the operating cycle, whichever is
      longer

    ◦ long-term notes payable are the notes that don’t
      meet the current note definition
   like a long-term bond, is reported on the balance
    sheet at its fair value, aka present value (future
    interest and principle cash flows)

   premium or discounts on notes payable are
    amortized to interest expense over the life of the
    note (straight-line or effective-interest method)

   on a zero-interest-bearing note, the discount
    represents the interest cost over the remaining life of
    the note

   implied interest rate is the rate of interest that
    equates the present value of an zero-interest-
    bearing note at issuance to the maturity (future) value
   at issuance a note is recorded at its present value (its fair
    value on the date of issuance)

   use the effective/market interest rate to determine the fair
    value of a long-term note (if not otherwise stated, assume
    the issuer’s borrowing rate is the effective interest rate)

   when there is no effective interest rate given and the
    stated interest rate is unreasonable, use the reasonable
    interest rate as the effective interest rate

   use the note’s stated interest rate to compute the interest
    payments

   if the entity’s effective interest rate is equal to the note’s
    stated interest rate, then the present value of the note is
    equal to the face value of the note.
PL14-3 Question 2 (Textbook Brief Exercises
 14-13, p 726)

Samson Corporation issued a 4-year, $75,000,
 zero-interest-bearing note to Brown
 Company on January 1, 2011, and received
 cash of $47,664. The implicit interest rate is
 12%.

Prepare Samson's journal entries for (a) the
 January 1 issuance and (b) the December 31
 recognition of interest.
PL14-3 Question 3 (Textbook Brief Exercises 14-
 14, p 726)

McCormick Corporation issued a 4-year, $40,000,
 5% note to Greenbush Company on January 1,
 2011, and received a computer that normally
 sells for $31,495. The note requires annual
 interest payments each December 31. The
 market rate of interest for a note of similar risk is
 12%.

Prepare McCormick's journal entries for (a) the
  January 1 issuance and (b) the December 31
  interest.
   mortgage payable –a promissory note
    secured by real estate, if the note maker
    defaults the note holder gets the real estate

   a point – one percent of the face of the note,
    lender often charges fees on loan origination
    by stating how many points charged

   installment note – a note where the periodic
    payments pay interest and repayment of part
    of the principle
A sample problem for installment notes:
(From Edmonds et. al. Fundamental Financial &
  Managerial Accounting, p527, Exercise 10-
  2A)

On January 1, 2007, Mooney Company
 borrowed $60,000 cash from First Bank by
 issuing a four-year, 6% note. Payments of
 $17,315 are to be made December 31 of each
 year beginning December 31, 2007.

Prepare an amortization schedule for the four
 year period.
   text says one of the most controversial areas
    in financial reporting

   Off-balance-sheet financing – an attempt to
    borrow monies in a particular manner as the
    debt does not have to be reported on the
    balance sheet
1.   Non-consolidated subsidiary
      entities that are less than 50% owned do not have to
      be consolidated into the parents financial statements,
      consolidated means the assets of the sub plus the
      assets of parent are added together and presented in
      the consolidated financial statement. Same is true for
      liabilities.
2.   Special Purpose Entity (SPE)
      another company is created to hold some of the assets
      and liabilities relating to particular functions and
      activities and these entities are structured so they are
      not consolidated into the parent’s financial statements
3.   Operating Leases
      under certain rules, a company can lease assets and
      not have to include the assets or liabilities in their
      balance sheet, they only have to record the leasing
      expense in their income statement
   less debt on the balance sheet makes a company
    look in better financial shape

   inclusion of the debt they are off-balance-sheet
    financing may cause their liabilities to exceed
    loan covenants

   some folks argue that assets are significantly
    understated (based on accounting rules and
    method selection) so it makes sense to
    understate the liability side of the balance sheet
   standards require that companies disclose all contractual
    obligations (contractual debt) in a tabular format in the
    notes

   standards require that companies disclose all contingent
    liabilities and commitments with either text or a table in
    the notes

   notes to the financial statements should disclose the
    nature of the liability, maturity dates, interest rates, call
    provisions, conversion privileges, restriction imposed by
    creditors, and assets designated or pledged as security

   companies must disclose in the notes future payments for
    sinking fund requirements and maturity amounts of long-
    term debt during each of the next five years

   standards require that if off-balance-sheet financing
    exists, extensive disclosure must be presented in the
    notes

				
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