Financial accounting 10th pratt peters chapter 11

Chapter 11: Long-Term Liabilities: Notes, Bonds and Leases Learning Objective List three major long-term liability categories and identify key financial ratios relied upon to assess the importance of these liabilities as a form of financing Long-Term Liabilities Many companies finance their operations and growth opportunities through the use of long term debt instruments: • Notes Payable – Formal borrowing agreement • Bonds Payable – Issued to bondholders, smaller dollar amounts and larger amount of notes • Leasehold Obligations – Future cash payments for use of an asset The Relative Size of Long-Term Liabilities Economic Consequences of Reporting Long-Term Liabilities • Improved credit ratings can lead to lower borrowing costs • Leverage and solvency measures have taken on increasing importance • Management has strong incentive to manage financial statement numbers by employing reporting strategies like “off-balance-sheet financing” Which of the following will result from receiving cash upon issuing long-term debt? a Increase in the company’s indebtedness b Decrease of the current ratio c Increase of retained earnings d Increase of total shareholders’ equity Learning Objective List three basic contractual forms that underlie long-term liabilities, and in each case show how the effective interest rate is computed Basic Definitions and Different Contractual Forms • Some contracts, called interest-bearing obligations, require periodic (annual or semiannual) cash payments (called interest) that are determined as a percentage of the face, principal, or maturity value, which must be paid at the end of the contract period • Non-interest-bearing obligations require no periodic payments, but only a single cash payment at the end of the contract period • Installment obligations require periodic payments covering both interest and principle throughout the life of the contract Basic Definitions and Different Contractual Forms Figure 11-2 Six possible kinds of notes • These contractual forms may contain additional terms that specify assets pledged as security or collateral in case the required cash payments are not met (default), as well as additional provisions (restrictive covenants) 10 Bond Redemptions • When bonds are redeemed at the maturity date, the issuing company simply pays cash to the bondholders in the amount of the face value and removes the bond payable from the balance sheet • To illustrate the redemption of a bond issuance prior to maturity at a loss, assume that bonds with a $100,000 face value and a $5,000 unamortized discount are redeemed for $102,000 The $7,000 loss on redemption would decrease net income 35 Concept Practice 36 Learning Objective Define and differentiate a capital lease from an operating lease 37 Leases A contract granting use of occupation of property during a specified period of time in exchange for rent payments • • • • Land Buildings Machinery Equipment • Avoid risks and associated costs of ownership • Operating Leases – pure rental agreement where the lessor maintains all ownership responsibilities • • Off-Balance-Sheet Financing Capital Leases – Risks and benefits of ownership have effectively transferred to the lessee 38 Leases (cont.) • Capital leases record the leased asset as a capital asset, and reflect the present value of the related payment contract as a liability • • • Risks and benefits of ownership have transferred to the lessee Present value of periodic leases approximate the fair market value of the property Property may revert to the lessor at the end of the lease or go to the lessee for a bargain price • Period of the lease may be equivalent to the asset’s useful life 39 Capital Lease Distinguishing capital from operating leases is important because of the financial statement impact FASB criteria for capital leases are listed below If any criteria are met, the lease should be accounted for as a capital lease 40 Capital Lease 41 International Perspective: The Importance of Debt Financing in Other Countries • The accounting disclosure requirements in non-U.S countries and IFRS are not as comprehensive as those in the United States, partially because the information needs of the major capital providers (i.e., banks) are satisfied in a relatively straightforward way—through personal contact and direct visits • A second way in which the heavy reliance on debt affects non-U.S accounting systems is that the required disclosures and regulations tend to be designed either to protect the creditor or to help in the assessment of solvency 42 Operating leases are treated as a increases in liabilities for both the lessor and the lessee b a sale is the leased asset has been transferred from the lessor to the lessee c capital leases by the lessee d rental expenses by the lessee 43 Learning Objective Appendices 11A and B Explain how investors decide whether to buy bonds and how the effective interest method is used to account for bond investments 44 Appendix 11A – The Determination of Bond Prices What will investors pay for the right to receive the interest payments and the face value of the bond at maturity? This is the amount investors will pay for the bond Determine the Effective (Actual) Rate of Return Determine the Required Rate of Return Compare the Effective Rate to the Required Rate 45 Appendix 11A – The Determination of Bond Prices • Determine the Effective (Actual) Rate of Return – when used to discount the bond’s future cash flows, results in a present value equal to the bond price • Determine the Required Rate of Return – what rate would you require with the terms offered by the company? Required Rate of Return = Risk-Free Return + Risk Premium • Determine the Risk-Free Return – what rate could be received on a riskless security (treasury notes and certificates of deposit may provide an estimate) 46 Appendix 11A – The Determination of Bond Prices (cont.) • Determine the Risk Premium – represents the probability that the company issuing the bonds will default on interest or premium payments, expressed as a percentage • Compare the Effective Rate to the Required Rate – if the effective rate is favorable in comparison to the required rate the bond will be purchased If the effective rate is not favorable to the required rate because of the risk free rate or judgement of risk premium, the bond should not be purchased 47 Appendix 11B – Investing in Bonds • Many companies invest in bonds as they are relatively low risk and provide periodic interest income • The accounting method is dependent on the intent of the management • Trading securities - are bought and held with the intent of being sold in the near future with the hope of generating profits in the short-term • Available-for-sale securities - are neither intended to be sold in the near future nor held until maturity • Held-to-maturity securities - management intends to hold until the final payment of principle 48 Appendix 11B – Investing in Bonds Figure 11B-1 Accounting for held-to-maturity bond investments 49 .. .Chapter 11: Long-Term Liabilities: Notes, Bonds and Leases Learning Objective List three major long-term liability categories and identify key financial ratios relied... received in exchange for notes Unsecured notes are not backed by an asset 19 Accounting for Long-Term Notes Payable Figure 11- 3 Accounting for non-interest-bearing note in exchange for equipment 20... Objective Define the effective interest method, and show how it is applied when accounting for bonds and notes payable 17 Accounting for Long-Term Obligations: The Effective Interest Method • The effective