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Notes for the Week of April 18-22

by: Callisa Ruschmeyer

Notes for the Week of April 18-22 ACCT 2110 - 002

Marketplace > Auburn University > Accounting > ACCT 2110 - 002 > Notes for the Week of April 18 22
Callisa Ruschmeyer
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About this Document

Chapter 9 Long Term Liabilities Straight-line Amortization Effective Interest Rate Amortization Leases Liability/Equity Ratios
Principles of Financial Accounting
Elizabeth G Miller
Class Notes
Miller, financial accounting, Chapter, 9, Long-Term Liabilities
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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


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