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Accounting for Long-Term
Debt
Chapter Ten
McGraw-Hill/IrwinMcGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Long-term notes are liabilities that usuallyhave terms from two to five years.
Long-term notes are liabilities that usuallyhave terms from two to five years.
Each payment covers interest for the period and a portion of the principal.
Each payment covers interest for the period and a portion of the principal.
With each payment, the interest portion gets smaller and the principal portion gets larger.
With each payment, the interest portion gets smaller and the principal portion gets larger.
Principal
CompanyLender
Payments
Long-Term Notes Payable
10-2
Applying payments to principal and interest Identify the unpaid principal balance.
Amount applied to interest = Unpaid principal balance × Interest rate.
Amount applied to principal = Cash payment – Amount applied to interest in .
Unpaid principal balance = Unpaid principal balance in – Amount applied to principalin .
Applying payments to principal and interest Identify the unpaid principal balance.
Amount applied to interest = Unpaid principal balance × Interest rate.
Amount applied to principal = Cash payment – Amount applied to interest in .
Unpaid principal balance = Unpaid principal balance in – Amount applied to principalin .
Long-Term Notes Payable
10-3
$-
$5,000
$10,000
$15,000
$20,000
$25,000
$30,000
Year 1 Year 2 Year 3 Year 4 Year 5
Interest
Principal
The amount applied to the principal increases each year. The amount of interest decreases
each year.
The amount applied to the principal increases each year. The amount of interest decreases
each year.
Annual payments
are constant.
Long-Term Notes Payable
10-4
Line of Credit
•Enable the company to borrow and repay funds.•Usually specify a maximum credit line.•Normally used for short-term borrowing to finance seasonal business needs.
•Enable the company to borrow and repay funds.•Usually specify a maximum credit line.•Normally used for short-term borrowing to finance seasonal business needs.
10-5
Long-term borrowing of a large sum of money, called the principal.
Principal is usually paid back as a lump sum at maturity.
Individual bonds are often denominated with a face value of $1,000.
Long-term borrowing of a large sum of money, called the principal.
Principal is usually paid back as a lump sum at maturity.
Individual bonds are often denominated with a face value of $1,000.
Bond Liabilities
10-6
Periodic interest payments based on a stated rate of interest.
Interest is paid semiannually. Interest paid is computed as:
Interest = Principal × Stated Interest Rate × Time
Bond prices are quoted as a percentage of the face amount.
For example, a $1,000 bond priced at 104 would sell for $1,040.
Periodic interest payments based on a stated rate of interest.
Interest is paid semiannually. Interest paid is computed as:
Interest = Principal × Stated Interest Rate × Time
Bond prices are quoted as a percentage of the face amount.
For example, a $1,000 bond priced at 104 would sell for $1,040.
Bond Liabilities
10-7
Bond Issue Date
Bond Interest Payments
Bond Interest PaymentsCorporation Investors
Interest Payment = Principal × Interest Rate × Time
Interest Payment = Principal × Interest Rate × Time
Bond Liabilities
10-8
Bond Liabilities
Advantages of bonds Longer term to maturity than notes payable issued to banks. Bond interest rates are usually lower than bank loan rates.
Advantages of bonds Longer term to maturity than notes payable issued to banks. Bond interest rates are usually lower than bank loan rates.
10-9
Secured and Unsecured
Secured and Unsecured
Term and Serial
Term and Serial
Convertible and CallableConvertible and Callable
Characteristics of Bonds
10-10
The Market Rate of Interest
The selling price of a bond is determined by the market rate of interest versus the stated
rate of interest.
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10-11
Gains or losses incurred as a result of early redemption of bonds should be reported as other income or other expense on the income statement.
Gains or losses incurred as a result of early redemption of bonds should be reported as other income or other expense on the income statement.
Bond Redemptions
Companies may redeem bonds with acall provision prior to the maturity date.Companies may redeem bonds with acall provision prior to the maturity date.
10-12
Effective Interest Rate Method
Effective interest is a more accurate way to
amortize bond discounts and
premiums.
It correctly reflects the bond’s changing carrying value.
10-13
Effective Interest Rate Method
Let’s assume Mason Company uses the effective interest method on its $100,000 bond.
Step 1:Determine the cash payment for interest.Step 1:Determine the cash payment for interest.
Face value of bondX Stated rate of interest
Cash payment
Face value of bondX Stated rate of interest
Cash payment
$ 100,000X .09$ 9,000
$ 100,000X .09$ 9,000
10-14
Effective Interest Rate Method
Step 2:Determine the amount of interest expense.Step 2:Determine the amount of interest expense.
Carrying value of bond liabilityX Effective rate of interest
Interest expense
Carrying value of bond liabilityX Effective rate of interest
Interest expense
$ 95,000X .1033$ 9,814
$ 95,000X .1033$ 9,814
$100,000 face value - $5,000 discount = $95,000 carrying value$100,000 face value - $5,000 discount = $95,000 carrying value
10-15
Effective Interest Rate Method
Step 3:Determine the amortization of the bond discount.Step 3:Determine the amortization of the bond discount.
Interest expense- Cash payment
Discount amortization
Interest expense- Cash payment
Discount amortization
$ 9,814- 9,000$ 814
$ 9,814- 9,000$ 814
Step 4:Update the carrying value of the bond liability.Step 4:Update the carrying value of the bond liability.
Discount amortization+ Beginning carrying value
Ending carrying value
Discount amortization+ Beginning carrying value
Ending carrying value
$ 814+ $ 95,000
$ 95,814
$ 814+ $ 95,000
$ 95,814
10-16
Effective Interest Rate Method
* The decrease in the amount of the discount increases the amount of the bond liability.
10-17
Effective Interest Rate Method (Appendix)
Notice that when using the effective interest method, interest expense
increases each year.
Notice that when using the effective interest method, interest expense
increases each year.
10-18
Financial Leverage and Tax Advantage of Debt Financing
Financial leverage: Debt financing can increase return on equity when the borrower earns more on the borrowed funds than it pays in interest. As this example shows, the cost of
financing is the same, but debt financing has a tax advantage.
Financial leverage: Debt financing can increase return on equity when the borrower earns more on the borrowed funds than it pays in interest. As this example shows, the cost of
financing is the same, but debt financing has a tax advantage.
10-19
Times Interest Earned Ratio
Times InterestEarned =
Net income + Interest expense + Income tax expense
Interest expense
The ratio shows the amount of resources generated for The ratio shows the amount of resources generated for each dollar of interest expense. In general, a high ratio each dollar of interest expense. In general, a high ratio
is viewed more favorable than a low ratio.is viewed more favorable than a low ratio.
The ratio shows the amount of resources generated for The ratio shows the amount of resources generated for each dollar of interest expense. In general, a high ratio each dollar of interest expense. In general, a high ratio
is viewed more favorable than a low ratio.is viewed more favorable than a low ratio.
Numerator is commonly called EBIT,Earnings before interest and taxes.Numerator is commonly called EBIT,Earnings before interest and taxes.
10-20
End of Chapter Ten
10-21