Notes for the Week of April 18-22
Notes for the Week of April 18-22 ACCT 2110 - 002
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ACCT 2110 - 002
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This 14 page Class Notes was uploaded by Callisa Ruschmeyer on Friday April 22, 2016. The Class Notes belongs to ACCT 2110 - 002 at Auburn University taught by Elizabeth G Miller in Fall 2015. Since its upload, it has received 21 views. For similar materials see Principles of Financial Accounting in Accounting at Auburn University.
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Date Created: 04/22/16
th nd April 18 - 22 Chapter 9- Long Term Liabilities Long-Term Liabilities Any obligation of a business that is expected to be paid or satisfied in more than one year Type and size of long-term liabilities can vary across companies Most common and largest long-term liabilities often come from borrowing money Bonds Bond- financial instrument where the borrower promises to pay future interest and principal to a creditor in exchange for the creditor's cash today o Different than a note payable- with a note payable, you only pay interest at maturity o With bonds, you pay interest periodically over the life of the bond Borrower- "sells" or "issues" the bond and records a liability Creditor "buys" the bond and records an investment Bond Features Secured bonds- specific assets pledge as collateral o Unsecured bonds = debenture bonds --> usually are offered with a higher interest rate than secured bonds Convertible bonds- may be converted into common stock o Only if the bondholder gives that as an option Callable bonds- subject to retirement at a stated dollar amount o The borrower has the option to pay them off early o Investors do not like these bonds as much because they want to profit off as much interest as possible Junk bonds- unsecured bonds that pay high interest but are very risky Bond Vocabulary 1. Face Value: the amount that is repaid at maturity of a bond 2. Stated interest rate- the contractual rate at which interest is paid to the creditor 3. Maturity date- the date on which the face value must be repaid to the creditor 4. Market (or effective or yield) rate of interest- the rate of return that investors in the bond markets demand for a bond of similar risk Bond Rate Relationships Discount Bond Price = stated rate < market rate o Any amount paid below the face value of a bond is called a discount o Record discount as a debit- Discount on Bonds Payable o Increase the cost of borrowing Par Bond Price = stated rate = market rate o Par means face value o You always credit bonds at face value- face value is always the same at mature, no matter if you sell at a discount or premium rate Premium Bond Price = stated rate < market rate o Any amount paid above the face value of a bond is called a premium o Record premium as a credit- Premium on Bonds Payable o Decreases the cost of borrowing- they offset the costs of borrowing the money Interest Rate and Yield (Market Rate) Relationships Bonds Sold at Yield vs. Stated Interest over the Life of the Rate Bonds Discount (below Yield > Stated Rate Interest Expense > Interest Paid Par) Par Yield = Stated Rate Interest Expense = Interest Paid Premium (above Yield < Stated Rate Interest Expense < Interest Paid Par) Accounting for Long-Term Debt Three journal entries are needed for recording the giving of bonds 1. Issuance- the cash received when the bonds are issued (the issue or selling price) 2. Interest- the interest payments 3. Repayment- the repayment of the principal (or face value) at maturity Recognizing Interest Expense and Repayment of Principle If an obligation spans over several interest periods, the amount of interest associated with each period must be determined Interest Amortization - process used to determine the amount of interest to be recorded in each of the periods the liability is outstanding Two parts to interest amortization 1. The actual interest payment made to the lender during the period 2. Amortizing any premium or discount on the bond T- accounts for discounts and premiums will be zero when the bond reaches maturity Two Methods of Amortization of Discounts or Premiums 1. Straight-line method o Equal amount of interest expense and amortization of the discount or premium is recorded each time interest is paid o Easy to compute o Amount = (discount or premium) / number of interest periods o Specifics- if the bond is issued at… Par- or 100% of face value- no premium or discount is recorded Total interest expense = total interest payments Discount- less than 100% of face value- the total interest expense = totally interest payments + the discount Period interest expense = periodic interest payment + a portion of the discount Premium- or more than 100% of face value- the total interest expense = total interest payments - the premium Period interest expense = periodic interest payment - the portion of the premium o Cost of borrowing = period interest expense X number of interest periods 2. Effective Interest Rate o Amortizes the bond discount or premium so that interest expense each period is a constant percentage of the bond's carrying value Carrying Value of Bond When bonds are issued at a discount, o Carrying value = face value -namortized discount When bonds are issued at a premium, o Carrying value = face value + unamortized premium At maturity, carrying value= face value o You pay face value at the time of maturity Carrying value is basically what amount of debt you are carrying- carrying value = face value The day you sell bonds, the face value = carrying value Important journal entries o Discount Day issued Debit: Cash (minus amortized discount) and the Bonds on BP Credit: Bonds Payable (at face value) Interest entry Debit: Interest Expense (interest amount plus amortized discount) Credit: Cash (interest amount) and Discount at BP o Premium Day issued Debit: Cash (plus amortized premium) Credit: Bonds Payable (at face value) and Premium Interest entry Debit: Interest Expense (interest amount minus amortized premium) and Premium amount Credit: Cash for entire interest amount o At maturity, the journal entry is always Debit: Bonds Payable (for face value) Credit: Cash Useful formulas when discussing carrying value o Total cost of borrowing = interest expense X number of interest periods o Amortized amount of discount per period = discount / number of interest periods o Amount of payable interest = face value X interest rate X length of period Length of period = when are payments due In-class example, the length of the period was every 6 months- therefore, we multiplied: face value X interest rate X (6/12) o Discount Interest expense = interest payment + amortization of discount o Premium interest expense = interest payment - amortization of discount Redeeming a Bond Before Maturity Bonds can be retired (or redeemed) for many reasons: o A company wants to reduce future interest expense o A company may want to take advantage of falling interest rates and replace existing bonds with less costly bonds Three steps when accounting for the early retirement of a bond o Update the carrying value of bonds o Calculate gain or loss on retirement o Record the retirement Things to remember o Callable- you can pay off the bond at some point earlier than the true maturity o Not all bonds are callable o When retiring bonds, you compare the carrying value to the call price Gain or Loss on the Redemption o Gain on redemption = carrying value > call price The company is paying less than the value of the liability o Loss on redemption = carrying price < call price The company is paying more than the value of the liability The Effective Interest Rate Method Issuance of bond journal entry is the same for the effective interest rate method as it is for the straight-line method The total interest expense is also the same for both of these methods The cost of borrowing is also the same for both of these methods o The effective interest rate is just more accurate for each period o Cost of Borrowing = addition of all interest expenses Yield rate is the same things as market rate Effective interest rate distinguishes between interest payments o Amortized Interest = face value X stated rate X time Effective interest expense = carrying value X yield rate X time Discount: expense gets higher each year because carrying value gets higher each year o Interest expense increases each period; unamortized discount decrease; carrying value increases o Remember, with discounts, you have to make the low carrying value eventually become the higher face value Premium: expense gets lower each year because carrying value decreases each year o Interest is decreased every period; unamortized premium decreases; carrying vale decreases o Remember, with premiums, you have to make the higher carrying value eventually become the lower face value Leases Lessor- the legal owner of the asset Lessee- uses the asset during the term of the lease Operating lease- the lessor retains substantially all of the risks and obligations of ownership o Operating leases are NOT liabilities Capital lease- agreement that is in substance a purchase of the leased asset o Has conditions; therefore, the lease IS considered a liability o Three conditions for a capital lease 1. Transfer of the lease to the lessee at the end of a period of time for not cost or at a "bargain price" 2. Term for the lease is at least 75% of the economic life of the leased asset Basically, you’ve leased the asset for a least 75% of its useful life 3. The present value of the lease payments is a least 90% of the fair value of the leased asset As the lessee, you have made payments that equate to 90% of the value of the asset Ratio Analysis Ratios are used to analyze a company's solvency Solvency- the company is expected to operate in the long term You do not want liabilities to be over 50 percent of your assets You also want your liabilities to decrease over time Debt to Equity = Total Liabilities / Total Equity Debt to Total Assets = Total Liabilities / Total Assets Long-Term Debt to Equity = Long-Term Debt / Total Equity