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Sources of Capital:
Debt
8-2
Legal Obligations That Are
Not Accounting Liabilities
Executory contracts.
Contracts in which neither party has yet
performed.
Contract to pay a baseball player $1 million per
year for five years.
A contract to provide legal services next year.
8-3
Are These Liabilities?
Receive $50,000 retainer for legal
services to be performed on an as-
needed basis next year.
Purchase contract for future delivery of
certain goods from the seller.
Seller of a house receives $10,000 as a
non-refundable deposit.
$1,000,000 product liability suit against
company. Is probable will lose suit. 8-4
Contingencies
Accounting
10 Treatment of Contingent Liabilities 11-5
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Accounting
Likelihood of Treatment
Occurring
Measurement Record and
Probable Estimable Disclose
Liability
Contingency Not Disclose
Estimable Liability
Disclose
Possible
Liability
6
No action70
Remote
required
Loss Contingency
• Record if:
– Probable an asset impaired or liability
incurred.
– Can be reasonably estimated.
• Disclose if:
– Only reasonably possible, and/or,
– Cannot be reasonably estimated.
• No disclosure if possibility is remote.
8-7
Sources of funds
8-8
Debt Capital
• Debt instruments.
• Term loans.
• Repayable according to a specified schedule.
• For major corporations, bonds more prevalent.
• Bonds.
• Certificate promising to pay its holder:
• Specified sum of money at a stated date, and
• Interest at a stated rate until maturity.
• Price usually quoted as % of face value (e.g., 98, 102).
8-9
10
Bond
BondsIndenture
Payable
10 15-2
11-5
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A corporation that issues bonds enters into a
contract or agreement (called a bond indenture or
trust indenture) with the bondholders.
8-11
Bonds
• Sinking fund bonds.
• Covenant that requires setting aside cash/investments
to be used to redeem bonds at maturity (or at regular
intervals).
• Serial bonds.
• Redeemed in installments (redemption date specified
on bond).
• Term bonds.
• When all bonds of an issue mature at the same time,
• Callable bonds.
• Option of issuing entity to redeem before maturity.
8-12
Bonds
Zero coupon bonds.
Issued at deep discount.
No interest is paid.
Convertible bonds.
Bondholder has the right to exchange bond for
specified number of common shares.
Subordinated.
Claims are inferior to claims of general or
secured creditors, but take precedence over
claims of shareholders.
8-13
Bond Terminology
• Par value.
• Also called face value, principal value, maturity
value.
• Coupon rate.
• Stated interest rate.
• Interest payments.
• Face value * Stated interest rate.
• Market rate.
• Prevailing interest rate for a given financial
instrument.
8-14
Bond Terminology
• Bond issuance costs.
• E.g., investment banking, accounting, legal,
printing.
• Recorded as a deferred charge.
• Amortized to expense over life of bond.
• Bond discount.
• Occurs when market rate is higher than coupon rate.
• Bond premium.
• Occurs when market rate is lower than coupon rate.
8-15
Bond Terminology
8-16
17
Pricing
PricingPayable
Bonds of
of
10Bond
BondsPayable
Payable 15-2
11-5
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When a corporation issues bonds, the price that
buyers are willing to pay depends upon three
factors:
1. The face amount of the bonds, which is the
amount due at the maturity date.
2. The periodic interest to be paid on the bonds.
This is called the contract rate or the coupon
rate.
3. The market or effective rate of interest.
17
18
Pricing
PricingPayable
Bonds of
of
10Bond
BondsPayable
Payable 15-2
11-5
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The market or effective rate of interest is
determined by transactions between buyers
and sellers of similar bonds. The market
rate of interest is affected by a variety of
factors, including:
1. investors assessment of current economic
conditions, and
2. future expectations.
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Pricing
PricingPayable
Bonds of
of
10Bond
BondsPayable
Payable 15-2
11-5
Click to edit Master title style
MARKET RATE = CONTRACT RATE
Selling price of bond = Rp1,000,000
Rp1,000,000
10% payable
annually
Pricing
PricingPayable
Bonds of
of
10Bond
BondsPayable
Payable 15-2
11-5
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MARKET RATE > CONTRACT RATE
Selling price of bond < Rp1,000,000
–
Rp1,000,000
10% payable
annually Discount
Pricing
PricingPayable
Bonds of
of
10Bond
BondsPayable
Payable 15-2
11-5
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MARKET < CONTRACT RATE
Selling price of bond > Rp1,000,000
Rp1,000,000
10% payable
+
annually Premium
Time
TimeValue
Pricing
Bonds Value
Payable
of
10Bonds
of
ofMoney
Money
Payable 15-2
11-5
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24
25
Rp1,000,000 x 0.82645 25
21
Rp826,450
26
15-2
Time
TimeValue
Pricing
Bonds Value
Payable
of
10Bonds
of
ofMoney
Money
Payable 15-2
11-5
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Example Exercise 15-2
Rp100,000
Rp100,000
Interest Interest
payment payment
Rp100,000 x
Rp82,64 0.82645
0
28
24
Present Value of 2-Year, 10% Bond
The Life of a Bond
1. IIssuance.
Record liability (i.e., Bonds Payable)
Record Bond Discount or Bond Premium.
Record Deferred Charges.
8-29
The Life of a Bond
2. BBond Interest Expense entries.
• Usually semi-annual.
• Consists of:
• Cash interest payments (i.e., Face value *
Stated interest rate), and
• ADD bond discount amortization, or
• SUBTRACT bond premium amortization.
• May need adjusting entry if bond interest
payment date does not match end of period.
8-30
The Life of a Bond
3. RRetirement.
• Before maturity (i.e., callable or purchased
in market).
• Gain (loss) = Reacquisition price – Net carrying
amount.
• At maturity.
• Zero ($0) balance in Deferred Charges, Bond
Discount (or Bond Premium) because of
amortization.
• Debit Bonds Payable, credit Cash.
8-31
Bond Interest Expense:
Additional Considerations
Effective interest method.
Required method to compute bond interest
expense (and discount/premium amortization).
Straight-line method allowed (if results not
materially different).
Bond interest expense = Book value * Market
rate.
Book value continuously changing (i.e., increasing with
discount, decreasing with premium).
Market rate at bond issuance (i.e., remains constant).
8-32
33
On January 1, 2007, a
corporation issues for cash
Rp100,000,000 of 12%, five-
year bonds; interest payable
semiannually. The market rate
of interest is 12%.
33
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34
29
*Because the present value tables are rounded to five decimal
places, minor rounding differences may appear in this illustration.
35
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Accounting for Bond Payable
Time Value
Pricing
Bonds Payable
of
10Bonds
of Money
Payable 15-3
15-2
11-5
Bonds Issued at a Discount
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Exercise
On the first day of the fiscal year, a company issues
a Rp1,000,000,000, 6%, 5-year bond that pays
semi-annual interest of Rp30,000,000
(Rp1,000,000,000 x 6% x ½), receiving cash of
Rp845,562,000. Journalize the entry to record the
issuance of the bonds.
Cash 845,562,000
Discount on Bonds Payable 154,438,000
Bonds Payable 1,000,000,000
36
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44
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45,226,000 45
41
Total present value of bonds Rp103,769,000
46
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Accounting for Bond Payable
Time Value
Pricing
Bonds Payable
of
10Bonds
of Money
Payable 15-3
15-2
11-5
15-3
Bonds Issued at a Premium
Cash 2,154,435,000
Premium on Bonds Payable 154,438,000
Bonds Payable 2,000,000,000
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50
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Capital Lease
Called “finance lease” by IFRS.
Meets certain criteria which requires it to be
recorded as a capital lease (rather than as an
operating lease).
Treated as a purchase of an asset and
creation of a liability.
Treated similar to an installment purchase.
Capital lease obligation (liability) is lower of fair
value or present value of minimum lease
payments.
Asset depreciated; interest paid on obligation.
8-56
Analysis of Capital Structure
8-57
Analysis of Capital Structure:
Measuring Leverage
Debt/equity ratio.
Debt ÷ Shareholders’ equity.
Debt can be total liabilities or just long-term
liabilities.
Debt/capitalization ratio.
Debt ÷ (Debt + Shareholders’ equity).
Times interest earned (i.e., interest coverage).
Pre-tax income before interest expense ÷
Interest expense.
8-58
Bond Ratings
8-60
61
Time Value
Pricing
Bonds
LeveragePayable
of Bonds
of Money
10Impact Payable
of Debt Instruments 15-2
11-5
15-1
15-4
15-3
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Plan 1 Plan 2 Plan 3
Issued 12% bonds -- -- Rp2 billion
Issued 9% preferred
stock, Rp50,000 par value -- Rp2 billion Rp1 billion
Issued common stock,
Rp10,000 par value Rp4 billion Rp2 billion Rp1 billion
Rp4 billion Rp4 billion Rp4 billion
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6
62
Leverage
Time Value
Pricing
Bonds Payable
of
10Impact
Bonds
of Money
of
Payable
Debt Instruments 15-2
11-5
15-1
15-4
15-3
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Effect of Alternative Financing Plans—Rp800,000,000 Earnings
62
7
63
Leverage
Time Value
Pricing
Bonds Payable
of
10Impact
Bonds
of Money
of
Payable
Debt Instruments 15-2
11-5
15-1
15-4
15-3
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Effect of Alternative Financing Plans—Rp440,000,000 Earnings
63
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64
Leverage
Time Value
Pricing
Bonds Payable
of 15-1
15-2
11-5
15-1
15-4
15-3
10Impact
Bonds
of Money
of
Payable
Debt Instruments
Click to edit(inMaster
‘000 Rp)
title style
(in ‘000 Rp)
Plan I Plan II
Earnings before bond interest
and income tax Rp750,000 Rp750,000
Bond interest 0 (2,000,000 x 10%) 200,000
Balance Rp750,000 Rp550,000
Income tax (750,000 x 30%) 225,000 (550,000 x 30%) 165,000
Net income Rp525,000 Rp385,000
Dividend on preferred stock 0 0
Earnings available for
common stock Rp525,000 Rp385,000
Number of common shares /300,000 /100,000
Earnings per share on
common stock Rp1,750 Rp3,850
65
10
For Practice: PE 15-1A, PE 15-1B
Thank You