chapter 14 financing with debt. financial statement items covered balance sheet income statement...

Chapter 14Financing

withDebt

Financial Statement Items Covered

Balance SheetIncome

StatementStatement of Cash Flows

Long-Term AssetsLeased assets

Current LiabilitiesAccounts payableAccrued operating

liabilitiesShort-term debtCurrent potion of

long-term debtLong-Term Liabilities

Mortgage payableBonds Payable (plus

premium or minus discount)

Capital lease liability

Interest expense OperatingCash paid for

interestFinancing

Cash received (paid) from issuance (repayment) of long-term debt

Debt Financing:Conceptual Issues

4

Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Liabilities

Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.Likelihood is high; liabilities impact the future

5


Liabilities

Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.Includes legal, moral, social, and implied obligations

6


Liabilities

Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.the obligation can involve either type of future event

7


Liabilities

Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.have already happened

8


Liabilities

Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

9


Classification of Liabilities

Monetary liabilities are obligations payable in a fixed sum of money

– Examples: accounts payable, accruals

Nonmonetary liabilities are obligations to provide fixed amounts of goods and services

– Example: revenues received in advance of providing a service

10


Classification of Liabilities

Current liabilities are obligations expected to be satisfied within one year of the balance sheet date

– Examples: accounts payable, accrued liabilities, current maturity of mortgage

Long-term liabilities are obligations expected to be satisfied after one year from the balance sheet date

– Examples: bonds payable, remainder of mortgage

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Measures the ability to repay debt in the short run

Current Ratio

Historically, less than 2:1 indicative of liquidity concerns

Now, due to advances in technology, frequently less than 1:1

Current AssetsCurrent Ratio =

Current Liabilities

12


Measurement of Liabilities

The existence of liabilities– Contingent liabilities are recognized if

• Probable and• Can be reasonably estimated

The amount of liabilities– Sometimes must be estimated

(example: warranty liability)– Current liabilities are shown at face

value– Long-term liabilities are shown at

present value (what it would cost to completely pay off the obligation today)

Short-Term Liabilities

14


Short-Term Operating Liabilities

Accounts payable represent a company’s obligation to pay

– for goods or services that have been provided

– usually within 10 to 60 days

Accrued liabilities include payables for operating activities

– Income taxes– Employee wages– Utilities

15


Short-Term Debt

Short-term debt refers to interest-bearing debt made to cover temporary shortages in cash

– May classify as long-term if (a) ability and (b) intent to refinance

Promissory notes (commercial paper) are formal loans that are issued by a company in exchange for cash

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Lines of Credit

A line of credit is a negotiated arrangement with a lender in which the terms are agreed to prior to the need for borrowingThe line of credit itself is not a liability

– A formal liability is created when the line of credit is used– Long-term or short-term depends on repayment

requirements

Present Value ofLong-Term Debt

18


Long-Term Debt Issues

Choose Issue Pay Account Retire

the method of financing

the debt interest for the specific

aspects of the type of

debt

the debt

19


The Importance of Present Value

Present value concepts must be used to properly value long-term loans where cash outflows extend far into the futureLoan amortization

– Each loan payment includes interest expense as well as a reduction in the principal of the loan

20


Mortgages

A loan backed by an asset whose title is pledged to the lender

– A mortgage is payable in equal installments (an annuity)

– Each payment is comprised of interest and principal

– Interest is charged on the declining principal balance

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Mortgages

The mortgage obligation is reported on the balance sheet at its present value

– Principle amounts due in the next twelve months are reported as a current liability

– The balance of the principle is reported as a long-term liability

A secured loan is backed by certain assets as collateral

– The interest cost is lower on this loan due to the reduced risk to the lender

23


Definition of a Bond

A bond is a written agreement between a borrower and a lender in which the borrower agrees to

– Repay a stated sum on a future date

– Make periodic interest payments at specified dates

After issuance, bonds may be publicly traded on a bond exchange

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Features of Bonds

The bond certificate details the particular features of a bond issue:

– Denomination– Maturity date– Stated interest rate– Interest payment dates– Other terms agreed to by the parties

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Bond Denomination

The denomination is also called the– Principal– Face value– Maturity value– Par value

The amount (usually $1,000) must be repaid to the lender

Interest payment calculations are based on this amount

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Bond Maturity Date

The principal of the bonds is repaid on the maturity date

Bond maturity may range from 5 to more than 30 years

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Bond Stated Interest Rate

Also referred to as face rate or coupon rate

Is specified on the bond at issuance

Is set as close as possible to the market rate – established by the money market– depends on the prevailing interest rates and

perceived risk of the company

Remains constant over the life of the bondIs applied to the face of the bond to calculate interest payments to bondholders

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Bond Interest Payment Dates

• Most bonds pay interest semiannually

• Stated interest rate is always an annual amount

– Example: 12% paid semiannually pays 6% every six months

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Zero-Coupon Bonds

• Do not pay interest periodically• Are issued at a deep discount

– The discount represents interest to be earned over the life of the bond

• Are a popular form of issue with governmental units

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Types of Bonds

Term Bonds

– all principle is due on a single date

Serial Bonds

– bonds are payable at specific intervals

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Types of Bonds

Unsecured bonds (debentures)– issued without any security to back

them

Secured bonds (mortgage bonds)– secured by the borrower’s collateral or

specified assets

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Types of Bonds

Convertible bonds– may at some future, specified date be

exchanged for, or converted into, the company’s common stock

Callable bonds– allow the borrower, or issuer, to call or

redeem the bonds prior to their maturity

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Bond Listingfrom the Wall Street Journal

Company (Ticker) Coupon Maturity Last PriceLast Yield

Est $ Vol. (000s)

General Motors (GM) 8.375 July 15, 2033 105.469 7.8920 75,139

Name of

Issuer

Stated Interest Rate

Maturity Date

Yield (Effective) Rate

Traded at a premium “Quote”

$75 million volume

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Determination of Bond Prices

Stated Interest Rate

Perceived Risk of

Investment

Length of Time

to Maturit

y

Prevailing Market

Rate

Bond Price

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Bond Price Quotations

QuotePercent of Face

Price Paid Per

$1,000 Bond

Bond Is Selling at

100 100% $1,000 Par

97½ 97.5% 975 Discount

104 104% 1,040 Premium

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Bond Issuance Scenarios

Face Rate 12%

Face Amount $100,000

Market Int Rate 10% 12% 14%

Rate Comparison

Face% > Mkt%

Face% = Mkt%

Face% < Mkt%

Effect on trading price

Raise price above face (premium)

Trade at face (par)

Lower price below face (discount)

Annual Cash Int

$12,000 $12,000 $12,000

Repay at maturity

$100,000 $100,000 $100,000

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Investing in Bonds

Assuming the risk and maturity date are equal among alternatives, investors want to invest an amount which will, over time, earn the prevailing market interest rate at the date of purchase

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Illustration: Investing in Bonds

Assume an investor is considering two investment alternatives when the market rate of interest is 14%:

– Investment A: $1,000, 5-year, 12% semiannual term bond

– Investment B: $1,000, 5-year, 14% semiannual term bond

Comparison ofInvestment Alternatives

Investor

“A”12% stated rate

earns 12%Invest $1,000?

“B”14% stated rate

earns 14%

Invest $1,000?Choose higher return

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Bond “A” Cash Flow Timeline

Present Value Calculation:Present value of principal

$1,000 × 0.50835 (present value of $1 factor for 10 periods at 7%) $508Present value of 10 semi-annual interest payments

$60 × 7.02358 (present value of an annuity factor for 10 periods at 7%) 421Present value = price of the 12% bond in the 14% market $930

$1,000 12% semiannual 5-year bond sold to yield 14%($1,000 × 12% × 6/12 = 60 semiannual interest)

60 60 60 60 60 60 60 60 60 60 semi-ann int

principal1,000

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Bond “B” Cash Flow Timeline


$1,000 × 0.50835 (present value of $1 factor for 10 periods at 7%) $508Present value of 10 semi-annual interest payments

$70 × 7.02358 (present value of an annuity factor for 10 periods at 7%) 492 Present value = price of the 14% bond in the 14% market $1,000

$1,000 14% semiannual 5-year bond sold to yield 14%($1,000 × 14% × 6/12 = 70 semiannual interest)

70 70 70 70 70 70 70 70 70 70 semi-ann int

principal1,000

Comparison ofInvestment Alternatives

Investor

“A”12% stated rate

earns 12%Invest $1,000?


earns 14%

Invest $1,000?

Investor


earns 14%

Invest $1,000?

Choose higher return

Returns are

equal

Invest $930?“A”

12% stated rate earns 14%

Present value

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Discount on Bond “A”

Face Value of Bond $1,000Present Value of Cash Inflows 930Discount on Bond $ 70

The investor is willing to pay (and the issuer willing to accept) $930 for the 12% bond so that it will yield 14%

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Illustration: Bond Issuedat a Premium


$100,000 × 0.61391 (present value of $1 factor for 10 periods at 5%) $61,391Present value of 10 semi-annual interest payments

$6,000 × 7.72173 (present value of an annuity factor for 10 periods at 5%) 46,330 Present value = price of the 12% bond in the 10% market $107,721

100 $1,000, 5-year 12% semiannual bonds sold when market is 10%

(100 × $1,000 × 12% × 6/12 = 6,000 semiannual interest)

6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000

100,000

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Illustration: Bond Premium

Present Value of Cash Inflows $107,721Face Value of Bond 100,000Premium on Bond $ 7,721

The investor is willing to pay (and the issuer willing to accept) $107,721 for the 12% bonds so that they will yield 10%

Accounting forthe Issuance of Bonds

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Bonds Issued at Par (Face) Value

On January 1, 2006, $100,000 of 5-year, 12%, term bonds with semiannual interest payments are issued at par

Assets Liabil Equity Revenue ExpenseCash

+100,000Bond Pay

+100,000

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Bonds Issued at Par (Face) Value

On June 30 the first semi-annual interest payment is due to bondholders. ($100,000 × 6%)

This is repeated every December 31 and June 30 for the five year term of the bond.


-6,000Int Exp

+6,000

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Bonds Issued at a Discount

On January 1, 2006, $100,000 of 5-year, 12%, term bonds with semiannual (Jan 1 & July 1) interest payments are issued when the market interest rate is 14%The effective rate of interest at issuance (14%) is used to determine the

– Discounted cash flows associated with the bond issue

– Interest expense associated with the bond issue

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Bonds Issued at a Discount


$100,000 × 0.50835 (present value of $1 factor for 10 periods at 7%) $ 50,835Present value of 10 semi-annual interest payments

$6,000 × 7.02358 (present value of an annuity factor for 10 periods at 7%) 42,141Present value = price of the 12% bonds in the 14% market $ 92,976Face Value 100,000Discount on Bond Payable $7,024

Assets Liabil Equity Revenue Expense

Cash

+92,976

Bond Pay+100,000

Disc on BP

- 7,024

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Balance Sheet Presentation:

Bonds Issued at a DiscountBonds Payable $100,000Less: Discount on Bonds Pay (7,024)Carrying Value $92,976Contra Liability

Account

52


Bonds Issued at a Premium

On January 1, 2006, $100,000 of 5-year, 12%, term bonds with semiannual (Jan 1 & July 1) interest payments are issued when the market interest rate is 10%The effective rate of interest at issuance (10%) is used to determine the

– Discounted cash flows associated with the bond issue

– Interest expense associated with the bond issue

53


Bonds Issued at a Premium


$100,000 × 0.61391 (present value of $1 factor for 10 periods at 5%) $ 61,391Present value of 10 semi-annual interest payments

$6,000 × 7.72173 (present value of an annuity factor for 10 periods at 5%) 46,330Present value = price of the 12% bonds in the 14% market $ 107,721Face Value 100,000Premium on Bond Payable $7,721

Assets Liabil Equity Revenue Expense

Cash

+107,721

Bond Pay+100,000

Prem on BP

+ 7,721

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Balance Sheet Presentation:

Bonds Issued at a PremiumBonds Payable $100,000Plus: Premium on Bonds Pay 7,721Carrying Value $107,721

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Bonds are recorded and recognized in the financial statements at the present value of future cash flows

– Interest annuity (face × stated rate × time)– Maturity value

Depending on the relationship between the stated interest rate and the yield rate, bonds are valued at

– par value– par value minus a discount– par value plus a premium

Bond Issuance Summary

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Bonds Subsequent to IssueNature of the Discount

AccountThe discount is additional interest

– Borrow less than face– Repay face– Amount not borrowed but repaid is

•Discount•Additional Interest

Discount is amortized over bond term

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Bond Discount and Bond Interest Expense

Interest expense paid to bondholders:Face value of bonds $100,000Semiannual stated interest rate × 6%Semiannual interest $ 6,000Number of interest periods × 10Total cash interest $ 60,000Discount on issuance + 7,024Total interest incurred $ 67,024

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Principal (at maturity) $100,000Cash interest over life + 60,000Total cash paid to bondholders 160,000Cash received at issuance - 92,976Total interest incurred $ 67,024

Bond Discount & Bond Interest Expense,

View 2

59


Interest Expense forBond with Discount

Interest Expense:Bond Carrying Value 92,976$ Effective Semiannual Rate 7%

6,508 Cash Interest 6,000 Reduction (amortization) of bond discount 508$

First 6-month period

At the end of the five-year life of the bonds:Face value 100,000Discount balance 0Carrying Value Equals Maturity Value 100,000

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Bonds Subsequent to IssueNature of the Premium

AccountThe premium reduces interest

– Borrow more than face– Repay face– Amount borrowed but not repaid is

•Premium•Reduction in iInterest

Premium is amortized over bond term

61


Bond Premium and Bond Interest Expense

Interest expense paid to bondholders:Face value of bonds $100,000Semiannual stated interest rate × 6%Semiannual interest $ 6,000Number of interest periods × 10Total cash interest $ 60,000Premium on issuance - 7,721Total interest incurred $ 52,279

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Principal (at maturity) $100,000Cash interest over life + 60,000Total cash paid to bondholders 160,000Cash received at issuance - 107,721Total interest incurred $ 52,279

Bond Premium & Bond Interest Expense,

View 2

63


Interest Expense forBond with Premium

Payment Number

Cash Interest Payment

Interest Expense

Reduction in

Premium

Bond Carrying

ValueBeginning Balance 107,721

1 6,000 5,386 614 107,107 2 6,000 5,355 645 106,462 3 6,000 5,323 677 105,786 4 6,000 5,289 711 105,075 5 6,000 5,254 746 104,329 6 6,000 5,216 784 103,545 7 6,000 5,177 823 102,722 8 6,000 5,136 864 101,858 9 6,000 5,093 907 100,951

10 6,000 5,049 951 100,000 (final interest expense adjusted for rounding)

64


Retiring Bonds

When bonds are repaid at maturity, Bonds Payable is decreased and Cash is decreased


-100,000Bond Pay

-100,000

65


Retiring Bonds

A bond sinking fund is a collection of cash and short-term securities that is set aside for repayment of the principal of the bondsThe sinking fund is an asset reported in the investment section of the balance sheet

66


Retiring Bonds

Early extinguishment of debt occurs when a firm’s long-term debt is retired before maturity

– A gain or loss occurs when there is a difference between the reacquisition price and the carrying value of the debt

– The gain or loss is reported as a component of income from continuing operations on the income statement

Leases

68


Definition of a Lease

A lease is a contractual agreement between the lessor (owner of the property) and the lessee (user of the property), giving the lessee the right to use the lessor’s property for a specific period in exchange for stipulated cash payments

69


Economic Advantages of Leasing

For the Lessee:• No (or low) down

payment• Avoid risks

associated with ownership–Technological obsolescence

–Physical deterioration–Changing economic conditions

• Flexibility

For the Lessor:•Increased sales•Ongoing business

relationship with the lessee

•Residual value retained

70


Lease Types

Capital leases are accounted for as if the lease agreement transfers ownership of the asset to the lessee

– The lease is equivalent to a financed purchase – An asset and liability must be recorded on

lessee’s books

Operating leases are accounted for as rental agreements, with no transfer of effective ownership associated with the lease

– Lease payments are recorded as rent expense by the lessee and rent revenue to the lessor

71


Lease Classification Criteria

1. The lease transfers ownership of the property to the lessee by the end of the lease term

2. The lease contains a bargain purchase option

3. The lease term is equal to 75% or more of the estimated economic life of the leased property

4. The present value of the minimum lease payments equals or exceeds 90% of the fair market value of the property

A lease is classified as a capital lease if any one of the following criteria are met:

72


Accounting for Leases

DATAOn January 1, 2006, Scully Corporation

(lessee) enters into a lease with Porter

Company (lessor) to lease a piece of

equipment for five equal annual year-end

installments of $13,870

• Accounting treatments comparedoperating leasecapital lease

• For illustration purposes only

• Classification is not elective

• Terms of the lease dictate classification

73


Accounting for Operating Lease

LesseeNothing is recorded on January 1, 2006Each December 31, record rent expenseNo asset; no liability

LessorContinues to carry as an assetContinues depreciation

74


Lessee Accountingfor Capital Leases

•Records the equipment as an asset and records an associated liability

– The asset and liability are recorded at the present value of the lease payments using an appropriate rate of interest

•Makes annual payments that are divided between interest and principal

•Depreciates the asset over a 5-year period

Lessee Accountingfor Capital Leases

DateAnnual

Payment

12% Interest

ExpensePrinciple

ReductionLease

Liability01-Jan-06 50,000 31-Dec-06 13,870 6,000 7,870 42,130 31-Dec-07 13,870 5,056 8,814 33,316 31-Dec-08 13,870 3,998 9,872 23,443 31-Dec-09 13,870 2,813 11,057 12,387 31-Dec-10 13,870 1,483 12,387 -

(final interest expense adjusted for rounding)

The interest amount for each year is based on 12% of the balance of the liability at the beginning of the year

Annual depreciation is $10,000 ($50,000 ÷ 5 years)

Off-Balance-SheetFinancing

77


Off-balance Sheet Financing

Obligations of a company that are not disclosed on the financial statements are termed off-balance sheet financingThree common types of off-balance sheet financing are

– Operating leases– Unconsolidated subsidiaries– Joint ventures

78


Operating Leases

• Operating leases agreements contain a promise to make future lease payments

• This promise (obligation) is not reported on the balance sheet

• Thus, off-balance-sheet financing of the asset used under an operating lease arrangement

79


Unconsolidated Subsidiaries

An unconsolidated subsidiary is a subsidiary that is accounted for using the equity method

– Companies that purchase less than 50% of an investee do not have to prepare consolidated financial statements

– The investee’s debt is kept off the balance sheet

80


Joint Ventures

Joint ventures occur when companies join forces to share the costs, risks, and benefits associated with specifically defined projects

– A joint venture is carefully structured to ensure that the liabilities of the venture are not disclosed in the balance sheets of the companies

– They are often just a special type of unconsolidated subsidiary

Debt-Related Ratiosand the Impact ofOperating Leases

82


Leverage

Using debt to finance asset purchases is called leverageThe benefits of leverage:

– Borrowing increases assets without any additional equity investment

– More assets means more sales can be generated– More sales means income should increase

83


Debt-Related Financial Ratios

Leverage ratios indicate the extent of financing used to purchase assets.Higher leverage increases return on equity

More borrowing More assets

More salesIncreased Net

Income

84


Debt-Related Financial Ratios

The debt ratio measures the amount of assets supplied by creditors

Rule of thumb: Most large U.S. companies borrow about half the funds they use to purchase assets

Total LiabilitiesDebt Ratio =

Total Assets

85


Leverage Ratios

The debt-to-equity ratio measures the number of dollars of borrowing for each dollar of equity investment

Total LiabilitiesDebt-to-Equity =Ratio Total Equity

86


Leverage Ratios

Times interest earned is the ratio of the income available for interest payments to the annual interest expense

Net Income beforeTimes Interest and Taxes

Interest =Interest ExpenseEarned

In Summary ...

• Liabilities are existing obligations for future economic sacrifice• Accounts payable and other short-term operating accruals are

generally non-interest-bearing• Long-term liabilities are reported at the present value of future

cash flows• Bonds are issued to borrow funds from multiple sources. Bonds

can be issued at par, at a discount, or at a premium.• Leases are either rental in nature (operating) or in essence,

purchases (capital). Four specific criteria exist for capital leases• Off-balance-sheet financing arises with operating leases,

unconsolidated subsidiaries, and joint ventures• Debt-related financial ratios indicate the degree of leverage and

the extent of a company to make period interest payments.

chapter 14 financing with debt. financial statement items covered balance sheet income statement...

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