Chapter 10

Accounting for Debt Accounting for Debt TransactionsTransactions

LOANS & BONDSLOANS & BONDS

Business Background

Capital structure is the mix of debt and equity used to finance a company.

LoansLoans from banks, insurance companies, or pension funds are often used when borrowing small amounts of capital.

BondsBonds are debt securities issued when borrowing large amounts of money. Can be issued by either corporations or

governmental units.

Characteristics of Bonds Payable

Bonds usually involve the borrowing of a large sum of money, called principalprincipal, for a fairly long time period.

The principal is usually paid back as a lump sumlump sum at the end of the bond period.

Individual bonds are often denominated with a par valuepar value, or face face valuevalue, of $1,000.

Characteristics of Bonds Payable

Bonds usually carry a stated rate of stated rate of interestinterest.

Interest is normally paid semiannually. Interest is computed as:

Interest = Principal × Stated Rate × Time Interest = Principal × Stated Rate × Time

Assume that all three bonds are issued Assume that all three bonds are issued today in equal quantities & that each today in equal quantities & that each

carries identical risk. How much extra will carries identical risk. How much extra will you get in exchange for paying the highest you get in exchange for paying the highest

possible interest? And, how much possible interest? And, how much discount will get in exchange for paying discount will get in exchange for paying

the lowest possible interest?the lowest possible interest?

Bond A pays 10%

Bond B pays 12%

Bond C pays 14%

10 year, $1,000 Bonds10 year, $1,000 Bondsoffered to raise cashoffered to raise cash

(annual interest)(annual interest)

Bonds Payable Journal Entries:Bonds Payable Journal Entries:

Issuance:Issuance:Dr CashDr Cash AmntRec’dAmntRec’dDr Discount on Bonds PayableDr Discount on Bonds Payable DifDif

Cr Premium on Bonds PayableCr Premium on Bonds Payable DifDifCr Bonds PayableCr Bonds Payable FaceFace

Interest Date:Interest Date: Dr Interest ExpenseDr Interest Expense EffRateEffRate

Dr Premium on Bonds Payable Dr Premium on Bonds Payable DifDifCr Discount on Bonds Payable Cr Discount on Bonds Payable DifDifCr CashCr Cash

AmntPd.AmntPd.

Bond A raises: $ 887 Bond A raises: $ 887 (discount = $113)(discount = $113)Bond B raises: $1,000 Bond B raises: $1,000 (sells at its face value)(sells at its face value)Bond C raises: $1,113 Bond C raises: $1,113 (premium = $113)(premium = $113)

(A) Record the Issuance of Bonds A, B & C.(A) Record the Issuance of Bonds A, B & C.(B) Record each interest payment & amortize the(B) Record each interest payment & amortize the discount or premium discount or premium (assume interest is paid at year-end)(assume interest is paid at year-end)

using the Effective Interest Method using the Effective Interest Method

Bond A pays 10%

Bond B pays 12%

Bond C pays 14%

The time value of money...

Selling price of a bond =

present value of future cash flows promised by the bonds, discounted using the market rate of interest

Measuring Bonds Payable and Interest Expense

The interest rate used to compute the present value is the market interest ratemarket interest rate. Also called yield, effective rate, or true rate.

Creditors demand a certain rate of interest to compensate them for the risks related to bonds.

The stated ratestated rate, or coupon ratecoupon rate, is only used to compute the periodic cash interest payments.

Determining the Selling Price

Selling price = Present value of future cash flows promised by the bonds, using market rate for present-value calculations. (The Appendix demonstrates these calculations.)

Therefore, if market % > stated %: Discount market % < stated %: Premium market % = stated %: Face or par

Measuring and Recording Interest on Bonds Issued at a Discount

The discount must be amortizedamortized over the outstanding life of the bonds.

The discount amortization increases the periodic interest expenseinterest expense for the issuer.

Two methods are commonly used: Straight-line amortization Effective-interest amortization (in Appendix)

Straight-Line Amortization of Bond Discount

Identify the amount of the bond discount.

Divide the bond discount by the number of interest periods.

Include the discount amortization amount as part of the periodic interest expense entry.

The discount will be reduced to zero by the maturity date.

Carrying value of BONDS Carrying value of BONDS PAYABLEPAYABLE

While the specific long-term liability, Bonds Payable, is always recorded (and kept) at face value, the remaining balance (called the Unamortized balance) of the Discount or Premium will be either subtracted (if discount) or added (if premium) to the B/P-face amount to get the carrying value [also called “book” value] of the bonds at any given date.

Measuring and Recording Interest on Bonds Issued at a Premium

The premium must be amortizedamortized over the term of the bonds.

The premium amortization decreases the periodic interest expenseinterest expense for the issuer.

Two methods are commonly used: Straight-line amortization Effective-interest amortization

Straight-Line Amortization of Bond Premium

Identify the amount of the bond premium.

Divide the bond premium by the number of interest periods.

Include the premium amortization amount as part of the periodic interest expense entry.

The premium will be reduced to zero by the maturity date.

Understanding Notes to Financial Statements

Effective-interest method of amortization is required by GAAP. (This method is in the Appendix.)

Straight-line amortization may be used if it is not materially different from effective interest amortization.

Most companies do not disclose the method used for bond interest amortization.

Loans: Long-term Mortgages

A mortgage is a special kind of “note” payable--one issued for property.

It is repaid in equal installments, part of which are repayment of principal and part of which are interest.

How buying an asset using a mortgage is reflected in the financial statements:

Journal entry when the mortgage is issued: Debit LAND or BLDG. Credit Mortgage Payable

Journal entry to make a payment: Debit Interest expense Debit Mortgage Payable Credit Cash.

Debt vs. Equity Debt vs. Equity FinancingFinancing

Financing with debtFinancing with debt

Interest payments are tax deductible.Interest payments are tax deductible.

Financing with EquityFinancing with Equity (additional (additional owners’ capital investment)owners’ capital investment)

Distributions to owners (Dividends) Distributions to owners (Dividends) are NOT tax deductible. are NOT tax deductible.

Debt vs. Equity Debt vs. Equity FinancingFinancing

Financing with debtFinancing with debt Interest payments Interest payments MUST BE PAIDMUST BE PAID

even if the company is losing money.even if the company is losing money.

Financing with EquityFinancing with Equity (additional (additional owners’ capital investment)owners’ capital investment) Distributions to owners (Dividends) Distributions to owners (Dividends) couldcould be reduced be reduced or eliminatedor eliminated in in “bad times.”“bad times.”

Debt–to–Asset Ratio Debt–to–Asset Ratio

Total Liabilities Total Liabilities Total AssetsTotal Assets

==

This ratio measures the percentage of assets being provided by creditors. It indicates the margin of safety to creditors

Times Interest Earned RatioTimes Interest Earned Ratio

Earnings before Interest Expense and Income TaxesEarnings before Interest Expense and Income TaxesInterest ExpenseInterest Expense==

Measures the ease inMeasures the ease inpaying interest on debtpaying interest on debt