Chapter 9

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© 2002 Prentice Hall Business Publications Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott

Chapter 9

Valuing and Accountingfor Bonds and Leases

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Learning ObjectivesAfter studying this chapter, you should be able to: Compute and interpret present and future values. Value bonds using present value techniques. Account for bond issues over their entire life. Value and account for long-term lease transactions. Evaluate pensions and other postretirement benefits.

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Valuing Long-Term Liabilities Long-term liabilities are more difficult to value

than short-term liabilities because of the long time frames involved.

Accountants use the time value of money to value long-term liabilities.• The time value of money refers to the fact that a

dollar you expect to pay or receive in the future is not worth as much as a dollar you have today.

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Compound Interest, Future Value, and Present Value

When money is borrowed, the amount borrowed is known as the loan principal. • For the borrower, interest is the cost of using the

principal.

Investing money is the same as making a loan.• The interest received is the return

on the investment.

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Compound Interest, Future Value, and Present Value

Calculating the amount of interest depends on the interest rate and the interest period.

Types of interest:• Simple interest - the interest rate multiplied by an

unchanging principal amount• Compound interest - the interest rate multiplied by a

changing principal amount– The unpaid interest is added to the principal balance and

becomes part of the new principal balance for the next interest period.

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Future Value Future value - the amount accumulated over time,

including principal and interest• For example, if a person lets $10,000 sit in a bank

account that pays 10% interest per year for 3 years, the future value of the $10,000 is $13,310 and is determined as follows:

Year 1: $10,000 x 1.10 = $11,000

Year 2: $11,000 x 1.10 = $12,100

Year 3: $12,100 x 1.10 = $13,310

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Future Value The general formula for computing the future

value (FV) of S dollars in n years at interest rate i is:

niSFV )1(

n refers to the number of periods the funds are invested. Theinterest rate must be stated consistently with the time period.

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Future Value The calculations for future values can be very

tedious. Most people use future value tables to determine future values.• In the table, each number is the solution to the

expression (1 + i)n.• The value of i is given in the column heading.• The value of n is given in the row label for the

number of periods.

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Future ValueTo how much will $25,000 grow if left in the bank for 20 years at 6% interest?

The answer is determined as follows:

$25,000 x 3.2071* = $80,177.50

*3.2071 is the future value factor for 20 periods at 6% interest.

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Present Value Present value - the value today of a future cash

inflow or outflow

Present value calculations are the reverse of future value calculations.• In future value calculations, you determine how much

money you will have at a date in the future given a certain interest rate.

• In present value calculations, you determine how much must be invested today given a certain interest rate to get to how much money you want in the future.

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Present Value For example, if $1.00 is to be received in one

year and the interest rate is 6%, you will have to invest $0.9434 ($1.00 / 1.06). • Thus, $0.9434 is the present value of $1.00 to be

received in one year at 6% interest.

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Present Value The general formula for the present value (PV) of

a future value (FV) to be received or paid in n periods at an interest rate of i per period is:

ni

FVPV

)1(

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Present Value Just as with future values, tables can be helpful in

determining the present value of amounts.• In the table, each number is the solution to the

expression 1/(1 + i)n.• The value of i is given in the column heading.• The value of n is given in the row label for the

number of periods.

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Present Value Interest rates are sometimes called discount rates

in calculations involving present values.

Present values are also called discounted values, and the process of finding the present value is discounting.• Present values can be thought of

as decreasing the value of a future cash inflow or outflow because the cash is to be received or paid

in the future, not today.

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Present ValueA city wants to issue $100,000 of non-interest-bearing bonds to be repaid in a lump sum in 5 years. How much should investors be willing to pay for the bonds if they require a 10% return on their investment?

$100,000 x .6209* = $62,090

*.6209 is the present value of $1 factor for 5 years at 10% interest.

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Present Value Remember to pay attention to the number

of periods. Interest is often compounded semiannually instead of annually.• If interest is compounded semiannually, the number

of periods is twice the number of years, and the interest rate is one-half of the annual interest rate.

• In the previous example, if interest were compounded semiannually, the number of periods is 10 instead of 5, and the interest rate is 5% instead of 10%.

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Present Value of anOrdinary Annuity

Annuity - a series of equal cash flows to take place during successive periods of equal length

The present value of an annuity is the sum of the present values of each cash receipt or payment.• If a note has a series of payments, its present value

can be determined by finding the present value of each payment and adding those present values together.

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Again, tables can be helpful in determining the present value of an ordinary annuity.

The factors in a present value of an annuity table are merely the cumulative sum of the present value of $1 factors in the present value of $1 table for the number of annuity periods.• The present value of an ordinary annuity tables are

especially helpful if the cash payments or receipts extend into the future over many periods.

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A city wants to issue $1,000,000 of non-interest-bearing bonds to be repaid $100,000 per year for 10 years. How much should investors be willing to pay for the bonds if they require a 10% return on their investment?

$100,000 x 6.1446* = $614,460

*6.1446 is the present value of an annuity of $1 for 10 periods at 10% interest.

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Notice that the higher the interest rate, the lower the present value factor.

This occurs because at higher interest rates, less must be invested to obtain the same stream of future annuity payments or a certain amount in the future.

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Valuing Bonds Because bonds create cash flows in future periods,

they are recorded at the present value of those future payments, discounted at the market interest rate in effect when the liability is created.

Bond - formal certificate of indebtedness that is typically accompanied by:• A promise to pay interest in cash at a specified annual

rate plus• A promise to pay the principal at a specific maturity

date

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Valuing Bonds When valuing bonds, the present value tables are

used to determine the amount of proceeds that will be received.• The present value of $1 table is used to determine the

present value of the face amount of the bonds.• The present value of an annuity of $1 is used to

determine the present value of the series of interest payments.

• The amounts are added together to determine the amount of proceeds and any premium or discount.

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Valuing Bonds Discount on bonds - occurs when the market

interest rate is greater than the coupon rate.

Premium on bonds - occurs when the market interest rate is less than the coupon rate.

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Valuing BondsA company issues $20,000,000 of 5-year bonds with a coupon rate of 7%. Interest is to be paid semiannually on June 30 and December 31 of each year. At the time of the issuance, the market rate is 10%. What is the amount of the proceeds and any premium or discount on the bonds?

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Valuing Bonds To determine the proceeds:

$20,000,000 x .6139* = $12,278,000

$700,000‡ x 7.7217* = 5,405,190

$17,683,190 ===============================

‡($700,000 = ($20,000,000 x 7%) / 2)

*PV factors are for 10 periods at 5%

The company will receive $17,683,190 upon issuance.The bonds are issued at a discount of $2,316,810.

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Issuing and Trading Bonds Bonds are usually sold through underwriters.

• Underwriters - a group of investment bankers that buys an entire bond or stock issue from a corporation and then sells the bonds to the general public

• By using underwriters, corporations are guaranteed that they will receive the entire amount of the issue.

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Issuing and Trading Bonds The bond contract includes all terms of the bonds

such as:• Time to maturity• Interest payment dates• Interest amounts• Size of the bond issue

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Issuing and Trading Bonds The coupon rate on the bonds is set as close to

the market rate as possible.• The coupon rate is the interest to be paid (in cash) on

the bonds.• The market rate is the rate available on investments in

similar bonds at a moment in time.– The market rate is affected by factors such as general

economic conditions, industry conditions, risks of the use of the proceeds, and features of the bonds (callable, convertible, etc.).

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Issuing and Trading Bonds Bonds may be sold at, above, or below par value.

• If the bonds are sold for more than par, they are sold at a premium.

• If the bonds are sold for less than par, they are sold at a discount.

Premiums and discounts do not reflect the credit record of the issuer; they merely reflect the difference in interest rates.

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Issuing and Trading Bonds When a bond sells at a premium or discount, the

yield to maturity (effective interest rate) differs from the coupon rate.• Yield to maturity (effective interest rate) - the interest

rate that equates market price at issue to the present value of principal and interest

The interest paid in cash is calculated by using the coupon rate, not the effective rate.

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Issuing and Trading Bonds Bonds are usually issued in increments of $1,000,

but they are usually expressed in terms of par.• For example, a $1,000 bond quoted at 102 is selling

for $1,020 ($1,000 x 102%).

Current yield - annual interest payments divided by the current price of a bond

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Assessing the Riskiness of Bonds Risk plays a large part in determining the coupon

rate of interest on bonds.• The riskier a bond, the higher the interest rate

investors will require before making the investment.• Rating companies, such as Moody’s and Standard and

Poor’s, rate the bonds for investors.– Higher ratings are safer and have lower interest rates.

– Lower ratings are riskier and have higher interest rates.

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Assessing the Riskiness of Bonds Analysts rely on the debt level of a company in

assessing the riskiness of a bond.• If a company has lots of debt, the ability of that

company to repay the bonds might be in doubt.• The credit worthiness of the company

issuing bonds is a key in determining the riskiness of bonds issued by the company.

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Interest Rates Interest rates have three components.

• Real interest rate - the return that investors demand because they are delaying their consumption

• Inflation premium - the extra interest that investors require because they worry that the general price level will change between now and the time they will receive their money

• Firm specific risk - the risk that a firm will not repay the loan or will not pay the interest on time

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Bonds Issued at a Discount When bonds are issued at at discount, the amount

of proceeds received from the issuance is less than the actual liability.

The difference must be recorded in a separate account on the books.

Cash 17,683,190

Discount on bonds payable 2,316,810

Bonds payable 20,000,000

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Bonds Issued at a Discount The discount on bonds payable is a contra

account; it is deducted from bonds payable.

Balance sheet presentation:

Bonds payable, 7% $ 20,000,000

Deduct: Discount on bonds payable 2,316,810

Net liability $ 17,683,190============================

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Bonds Issued at a Discount For bonds issued at a discount, the discount can

be thought of as a second interest amount payable to the investors at the maturity date.• Rather than recognizing the extra interest expense all

at once upon maturity, the issuer should spread the extra interest over the life of the bonds.

• This is accomplished by discount amortization.

The amortization of a discount increases the interest expense of the issuer at each cash interest payment date, but it has no effect on cash paid.

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Bonds Issued at a Discount Discount amortization can be calculated using

two methods.• Straight-line amortization

– The amortization of the discount is an equal amount each period, but the effective interest rate is different each period.

• Effective-interest amortization– The effective interest rate is the same each period, but the

amortization of the discount is a different amount each period.

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Bonds Issued at a Discount Amortization using the effective-interest method:

• For each period, interest expense is equal to the carrying value of the debt multiplied by the market rate of interest in effect when the bond was issued.

• The cash interest payment is the coupon rate times the face amount of the bonds.

• The difference between the interest expense and the cash interest payment is the amount of discount amortization for the period.

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Bonds Issued at a Discount Journal entries:

To record the issuance of the bonds:Cash xxxxxx

Discount on bonds payable xxxx

Bonds payable xxxxxx

To record the payment of interest and discount amortization:Interest expense (Carrying value x Market rate) xxx

Discount on bonds payable xx

Cash (Face value x Coupon rate) xxx

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Bonds Issued at a Premium Accounting for bonds issued at a premium is just

the opposite of accounting for bonds issued at a discount.• The cash proceeds exceed the face amount.• The amount of the contra account Premium on Bonds

Payable is added to the face amount to determine the net liability reported in the balance sheet.

• The amortization of bond premium decreases the interest expense to the issuer.

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Bonds Issued at a PremiumA company issues $20,000,000 of 5-year bonds with a coupon rate of 7%. Interest is to be paid semiannually on June 30 and December 31 of each year. At the time of the issuance, the market rate is 6%. What is the amount of the proceeds and any premium or discount on the bonds?

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Bonds Issued at a PremiumTo determine the proceeds:

$20,000,000 x .7441* = $14,882,000

$700,000‡ x 8.5302* = 5,971,140

$20,853,140 ===========================

‡($700,000 = ($20,000,000 x 7%) / 2)

*PV factors are for 10 periods at 3%

The company will receive $20,853,140 upon issuance.The bonds are issued at a premium of $853,140.

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Early Extinguishment When a company redeems its own bonds before

the maturity date, the transaction is called an early extinguishment.• Early extinguishment usually results in a gain or loss

to the company redeeming the bonds.• The gain or loss is the difference between the cash

paid and the net carrying amount (face amount less unamortized discount or plus unamortized premium) of the bonds.

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Early ExtinguishmentAllen Company purchased all of its bonds on the open market at 98. The bonds have a face amount of $100,000 and a $12,000 unamortized discount. Determine any gain or loss on the early extinguishment, and prepare the journal entries to record the transaction.

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Early ExtinguishmentCarrying amount:

Face value $100,000

Deduct: Unamortized discount 12,000$88,000

Cash required ($100,000 x 98%) 98,000 Loss on early extinguishment$10,000==================

Bonds payable 100,000

Loss on early extinguishment 10,000

Cash 98,000

Discount on bonds payable 12,000

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Bonds Sold BetweenInterest Dates

Sometimes bonds are issued or sold between interest dates or after the date when the issuance was supposed to take place.• This difference has an effect on

both the investor and the issuer.

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For the investor:• If bonds are issued between interest dates, the investor

will earn only a portion of that interest (the investor did not own the bond for the full interest period).

• The investor must pay an extra amount for any unearned interest to be received at the next interest payment date.

– The investor has earned only a part of the interest for the period but will receive cash for the entire amount, so he must pay extra.

– The extra payment is recovered when the interest payment is received at the regular interest date.

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For the issuer:• The issuer should record interest expense only for the

period that the bonds were actually issued and outstanding.

• However, at the interest date, interest expense will equal the amount of interest paid, which is incorrect.

• The extra payment made by the investor reduces the amount of interest expense recorded by the issuer to the proper amount, just as it reduces the interest income to the investor.

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Non-Interest-BearingNotes and Bonds

Some bonds and notes provide for the payment of a lump sum at a specified date instead of periodic interest payments.

Zero coupon - a bond or note that pays no cash interest during its life• These bonds or notes are sold for much less than the

face or maturity value, which makes up for the lack of periodic interest payments.

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On zero coupon bonds or notes, the market value is determined by calculating the present value of the maturity value, using the market rate of interest for similar notes.

The discount is amortized over the life of the note.• The discount is amortized as interest expense to the

issuer.• The discount is amortized as interest revenue to the

investor.

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Implicit interest - an interest expense that is not explicitly recognized in a loan agreement

Imputed interest rate - the market interest rate that equates the proceeds from a loan with the present value of the loan payments

The discount, amortization of the discount, and interest are recorded in the same manner as with interest-bearing notes, except that no cash interest is exchanged on a periodic basis.

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Accounting for Leases Lease - a contract whereby an owner (lessor)

grants the use of property to a second party (lessee) for rental payments• Some leases are recorded simply as if one party is

renting property from another.• Other leases are recorded as liabilities and

assets when the lease contract is signed.

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Operating and Capital Leases Capital lease - a lease that transfers substantially

all the risks and benefits of ownership to the lessee• They are the same as installment sales which provide

for payments over time along with interest.• The leased item must be

recorded as if it were sold by the lessor and purchased by the lessee.

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Operating and Capital Leases Operating lease - a lease that should be accounted

for by the lessee as ordinary rental expenses; any lease other than a capital lease• Examples include rental of an apartment or rental of a

car on a daily basis.

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Operating and Capital Leases Differences in accounting for operating and

capital leases:• Operating - treat as rental expense

Rent expense xxx

Cash xxx

• Capital - treat as if the lessee borrowed the money and purchased the leased assetLeased property xxxx

Capital lease liability xxxx

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Differences in Income Statements The major difference in the income statements

for a capital lease and an operating lease is the timing of the expenses.• A capital lease tends to bunch heavier charges in the

early years. These charges are the amortization of the lease plus the interest factor.

• An operating lease records the payments directly as expenses, generally in a straight-line manner.

• For comparable leases, the total expenses are the same.

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Criteria for Capital Leases Before GAAP established criteria for leases to be

classified as capital leases, many companies were keeping “off balance sheet financing” by treating noncancellable leases as monthly rentals.• These leases created assets and

liabilities that the companies were not recognizing.

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Criteria for Capital Leases Under GAAP, a capital lease exists if one or more

of the following conditions are met:• Title to the leased property is transferred to the lessee

by the end of the lease term.• An inexpensive purchase option is available to the

lessee at the end of the lease.• The lease term equals or exceeds 75% of the estimated

economic life of the property.• At the start of the lease, the present value of minimum

lease payments is at least 90% of the property’s fair value.

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Pensions and OtherPostretirement Benefits

Pension - payments to former employees after they retire, usually in the form of a portion of former wages

Other postretirement benefits - benefits provided to retired workers in addition to a pension, such as life and health insurance

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Pensions and other postretirement benefits are considered to be liabilities because accrual accounting requires that expenses are to be matched with associated revenues.• These benefits must be recognized when they are

earned by the employees, usually many years before they are disbursed.

• The obligations are reported as unpaid liabilities on the balance sheet.

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Because of the long time frame involved, present value techniques must be used to measure the obligations.• To calculate the present values, firms must estimate

employee life expectancy, future work lives, ages at retirement, and levels of future pension payments to retirees.

• The firm must also choose an interest rate to be used in the present value computations.

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Companies do not just accrue huge pension liabilities each year.

Money must be set aside each year to fund the liabilities.• This ensures that cash will be available to meet

pension obligations upon retirement of employees.• Congress provides tax incentives to companies that

contribute cash to pension funds that are separate from the firms’ assets and controlled by third-party trustees.

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Jones Corporation’s pension expense for the year is $100,000. Jones pays $90,000 of the pension expense into a pension fund. How is this transaction recorded?

Pension expense 100,000

Cash 90,000

Accrued pension liability 10,000

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Accounting for other postretirement benefits is essentially the same as accounting for pensions.• However, Congress does not allow tax

incentives for payments for these benefits.• Most companies do not fund other postretirement

benefits, so the entire amount is usually recorded as a liability.

– Analysts and accountants treat the present value of the expected future payments as a liability.

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