1 Long-Term Liabilities: Notes, Bonds, and Leases

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Long-Term Liabilities:Long-Term Liabilities:

Notes, Bonds, and LeasesNotes, Bonds, and Leases

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Long-Term Liabilities: Long-Term Liabilities: Notes, Bonds, and LeasesNotes, Bonds, and Leases

Long-term liabilities are recorded at the present value of the future cash flows.

The subject of calculation of present value is covered in Appendix A.

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Present Value ConceptsPresent Value ConceptsAppendix A (Pages 654-676)Appendix A (Pages 654-676)

The value of a dollar today will decrease over time. Why?

Two components determine the “time value” of money:– interest (discount) rate– number of periods of discounting

For financial reporting, we are concerned primarily with present value concepts.

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Present Value ConceptsPresent Value Concepts

To record activities in the general ledger dealing with future cash flows, we should calculate the present value of the future cash flows using present value formulas or techniques.

Types of activities that require PV calculations:– notes payable– bonds payable and bond investments– capital leases

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Types of Present Value CalculationsTypes of Present Value Calculations PV of a single sum (PV1): Discounting a future

value of a single amount that is to be paid in the future (ex: notes payable, bonds payable).

PV of an ordinary annuity (PVOA): Discounting a set of payments, equal in amount over equal periods of time, where the first payment is made at the end of each period (ex: interest on bonds payable).

PV of an annuity due (PVAD): Discounting a set of payments, equal in amount over equal periods of time, where the first payment is made at the beginning of each period (ex: lease payments).

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1.Present Value of a Single Sum1.Present Value of a Single Sum

All present value calculations presume a discount rate (i) and a number of periods of discounting (n).There are 3 different ways you can calculate the PV1:

1. Formula: PV1 = FV1 [1/(1+i)n]

2. Tables: See Page 674, Table 4

3.Calculator if it has time value of money functions.

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Long-term Notes PayableLong-term Notes Payable Usually issued to financial institutions. May be interest bearing or non-interest bearing (we

will look at non-interest bearing). May be serial notes (periodic payments) or term

notes (balloon payments). We will look at balloon payments here.

Problem 1: On January 2, 2005, Pearson Company purchases a section of land for its new plant site. Pearson issues a 5 year non-interest bearing note, and promises to pay $50,000 at the end of the 5 year period. What is the cash equivalent price of the land, if a 6 percent discount rate is assumed?

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Problem 1 SolutionProblem 1 SolutionSee Page 674, Table 4

PV1 Table

PV1 = FV1( )

i, n

PV1 Table

PV1 = 50,000 ( 0.74726) = $37,363

i=6%, n=5

Journal entry Jan. 2, 2005:

Land 37,363Discount on N/P12,637

Notes Payable 50,000

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Problem 1 Solution, continuedProblem 1 Solution, continued

What amount would be recognized for interest expense at December 31, 2005?

In this chapter we will use the effective interest method to calculate interest expense. The formula for interest is:

Interest Expense = Carrying value x Interest rate x Time period (CV) (Per year) (Portion of year)

Where carrying value = face - discount.For Example 1, CV= 50,000 - 12,637 = 37,363 Interest expense = 37,363 x 6% per year x 1year

= $2,242

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Journal entry, December 31, 2005:

Carrying value on B/S at 12/31/2005?

(Discount = $12,637 - 2,242 = $10,395)

Interest expense 2,242Discount on N/P 2,242

Notes Payable $50,000Discount on N/P (10,395) $39,605

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$50,000

Interest expense at Dec. 31, 2006: 39,605 x 6% x 1 = $2,376Journal entry, December 31, 2006:

Carrying value on B/S at 12/31/2006?

(Discount = 10,395 - 2,376)Carrying value on 12/31/2009 (before

retirement)?

Interest expense 2,376Discount on N/P 2,376

Notes Payable $50,000Discount on N/P (8,019) $41,981

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2. Present Value of an 2. Present Value of an Ordinary Annuity(PVOA) Ordinary Annuity(PVOA)

PVOA calculations presume a discount rate (i), where (A) = the amount of each annuity, and (n) = the number of annuities (or rents), which is the same as the number of periods of discounting. There are 3 different ways you can calculate PVOA:

1. Formula: PVOA = A [1-(1/(1+i)n)] / i

2. Tables: see page 675, Table 5

PVOA Table

PVOA = A( ) i, n


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Bonds PayableBonds PayableBonds payable are issued by a company

(usually to the marketplace) to generate cash flow.

The bonds represent a promise by the company to pay a stated interest each period (yearly, semiannually, quarterly), and pay the face amount of the bond at maturity.

The marketplace values bonds by discounting the cash flows using the market rate of interest. This is also called the yield rate, discount rate, or effective rate.

There are two types of cash flows with bonds: PVOA and PV1.

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Problem 2: Bonds PayableProblem 2: Bonds Payable On July 1, 2005, Mustang Corporation issues

$100,000 of its 5-year bonds which have an annual stated rate of 7%, and pay interest semiannually each June 30 and December 31, starting December 31, 2005. The bonds were issued to yield 6% annually.

Calculate the issue price of the bond:(1) What are the cash flows and factors?

Face value at maturity = $100,000Stated Interest = Face value x stated rate x time period

100,000 x 7% x (1/2) = $3,500Number of periods = n = 5 years x 2 = 10Discount rate = 6% / 2 = 3% per period

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Problem 2 - calculationsProblem 2 - calculationsPV of interest annuity:

PVOA Table PVOA Table

PVOA = A( ) = 3,500 (8.53020) = $29,856 i, n i = 3%, n = 10

PV of face value:

PV1 Table PV1 Table

PV =FV1( ) = 100,000 (0.74409)=$74,409 i, n i=3%, n=10

Total issue price = $104,265Issued at a premium of $4,265 because the company was offering an interest rate greater than the market rate, and investors were willing to pay more for the higher interest rate.

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Problem 2 - Amortization ScheduleProblem 2 - Amortization ScheduleTo recognize interest expense using the effective

interest method, an amortization schedule must be constructed. (This expands the text discussion.)

To calculate the columns (see next slide):Cash paid = Face x Stated Rate x Time

= 100,000 x 7% x 1/2 year = $3,500(this is the same amount every period)

Int. Expense = CV x Market Rate x Time at 12/31/05 = 104,265 x 6% x 1/2 year = 3,128 at 6/30/06 = 103,893 x 6% x 1/2 year = 3,117The difference between cash paid and interest expense

is the periodic amortization of premium.Note that the carrying value is amortized down to face

value by maturity.

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Problem 2 - Amortization ScheduleProblem 2 - Amortization Schedule

Cash Interest Carrying Date Paid Expense Difference Value 7/01/05 104,26512/31/05 3,500 3,128 372 103,893 6/30/06 3,500 3,117 383 103,51012/31/06 3,500 3,105 395 103,115 6/30/07 3,500 3,093 407 102,70812/31/07 3,500 3,081 419 102,289 6/30/08 3,500 3,069 431 101,85812/31/08 3,500 3,056 444 101,414 6/30/09 3,500 3,042 458 100,95612/31/09 3,500 3,029 471 100,485 6/30/10 3,500 3,015 485 100,000

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Problem 2 - Journal EntriesProblem 2 - Journal EntriesJE at 7/1/05 to issue the bonds:

JE at 12/31/05 to pay interest:

Note that the numbers for each interest payment come from the lines on the amortization schedule.

Cash 104,265Premium on B/P 4,265Bonds Payable 100,000

Interest Expense 3,128Premium on B/P 372

Cash 3,500

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Bonds Payable at a Discount.Bonds Payable at a Discount. If bonds are issued at a discount, the carrying

value will be below face value at the date of issue.

The Discount on B/P account has a normal debit balance and is a contra to B/P (similar to the Discount on N/P).

The Discount account is amortized with a credit. Note that the difference between Cash Paid and Interest Expense is still the amount of amortization.

Interest expense for bonds issued at a discount will be greater than cash paid.

The amortization table will show the bonds amortized up to face value.

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Retirement of BondsRetirement of BondsBonds are retired when the company pays the

investors the amount owed. If bonds are held to maturity, the amount on the

books is face value and the amount paid is face value.

If bonds are retired before maturity, the amount on the books is the carrying value, and the amount paid is the market value at the point of retirement. Because these two amounts are seldom the same, a gain or loss must be recognized.

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Retirement of BondsRetirement of Bonds The gain or loss is the difference between

carrying value and cash paid.– If cash paid is greater than CV, recognize loss

(paid more than book liability).– If cash paid is less than CV, recognize gain

(paid less than book liability). When recording the early retirement, we must

remove both Bonds Payable (face amount) and the related Premium or Discount (remaining unamortized amount).

The gain or loss is recognized as part of Income from Continuing Operations (Other Revenues and Gains or Other Expenses and Losses).

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Problem 2 - Retirement of BondsProblem 2 - Retirement of BondsAssume that Mustang’s bonds were retired on June 30,

2006 (after the interest payment). Mustang Corporation paid $104,000 to retire the bonds from the marketplace. Record the entries on June 30, 2006.

JE at 6/30/06 to pay the interest:

JE at 6/30/06 to retire the bonds:

Interest Expense 3,117Premium on B/P 383

Cash 3,500

Bonds Payable 100,000Premium on B/P 3,510Loss on Retirement 490

Cash 104,000

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3.PV of an Annuity Due (PVAD)3.PV of an Annuity Due (PVAD) The difference between an ordinary annuity and an annuity due is

the timing of the periodic payments: an annuity due has payments (rents, annuities) at the beginning of each period.

The result is that there is one less period of discounting. There are 3 different ways you can calculate PVAD:

1. Formula: PVAD = A [((1-(1/(1+i)n-1)) / i) + 1]

2. Tables: see page 708, Table 6

PVAD Table

PVAD = A( ) i, n where n = number of payments (not periods)


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LeasesLeasesOperating leases

– Lessee assumes no risk of ownership.– Recognize rent expense as each payment

made.– At end of lease term, right to use the

property reverts to the owner.Capital leases

– Effectively an installment purchase.– Lessee assumes rights and risks of

ownership.– Treated as asset purchased with related

liability and depreciation.

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LeasesLeasesOff-balance-sheet financing

– Companies historically liked to contract for leases rather than asset purchases, to keep the liability off the books.

– FASB issued SFAS No. 13, which requires certain leases to be recorded as capital leases.

– Capital leases record the leased asset as a capital asset, and reflect the present value of the related payment contract as a liability.

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LeasesLeasesRequirements of SFAS No. 13 - record as

capital lease for the lessee if any one of the following is present in the lease:– Title transfers at the end of the lease

period,– The lease contains a bargain purchase

option,– The lease life is at least 75% of the useful

life of the asset, or– The lessee pays for at least 90% of the

fair market value of the lease.

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LeasesLeases

Payments under a lease agreement may include:– Periodic rental payments (an annuity)

and:– Bargain purchase option (BPO): An end of

lease payment to purchase the asset at significantly below market OR

– Guaranteed residual value (GRV): A minimum amount (of cash and asset) required by the lessor if the asset is returned to the lessor.

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LeasesLeasesThe amount to capitalize (record for asset and

related liability) is the present value of the minimum lease payments:

PVMLP = PV RENTS + PVBPO or GRV

If lease contains both BPO and GRV, include only BPO. The assumption is that a rational lessee would exercise the BPO and not have to pay an GRV.

If the rents occur at the beginning of each period, like most leases, the PV RENTS is an annuity due.

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Problem 3 - LeasesProblem 3 - LeasesLee Company (the lessee) signed a contract to lease equipment

from Lawrence Company (the lessor). The terms of the lease were as follows:

1. Four year lease starting January 1, 2005.

2. Annual lease payments of $6,000. The first payment is due at lease inception (January 1, 2005), with subsequent payments on December 31, 2005, 2006, and 2007.

3. Bargain purchase option of $1,000 at end of lease (December 31, 2008).

Other information:

Lee’s borrowing rate: 8%

Useful life of equipment: 6 years with no salvage value.

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Problem 3 - LeasesProblem 3 - LeasesRequirement 1: Calculate the PVMLP

(Note that the lease payments are an annuity due.)

PVMLP = PV RENTS + PVBPO

PVAD Table PVAD Table

PV RENTS =PVAD= A( ) = 6,000(3.5771) = $21,463 i, n i =8%, n=4

PV1 Table PV1 Table

PVBPO = PV1 = FV1( ) = 1,000(0.73503) = $ 735 i, n i = 8%, n = 4

The present value of the minimum lease pmts = $22,198

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Problem 3 - LeasesProblem 3 - LeasesRequirement 2: Prepare the amortization schedule (effective interest method) to recognize the interest payments and principal payments over the life of the lease. This is similar to the amortization schedule for the bonds payable (cash paid is constant, and interest expense =

CV x MR x T), except that the lease payment includes both an interest payment and a principal payment. The “difference” in this case is the principal reduction each period.

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Problem 3 - LeasesProblem 3 - Leases Cash Interest Carrying

Date Paid Expense Difference Value 1/01/05 22,198 1/01/05 6,000 -0- 1 6,000 16,19812/31/05 6,000 1,2962 4,704 11,49412/31/06 6,000 920 5,080 6,41412/31/07 6,000 513 5,487 92712/31/08 1,000 733 927 -0-

1No interest at 1/1/05, because no time has passed. This is equivalent to a “down payment” which immediately reduces the total liability.

2Int. Expense = CV x MR x T = 16,198 x 8% x 1 year 3Rounding difference of $1 absorbed in calculation.

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Problem 3 - LeasesProblem 3 - LeasesRequirement 3: Prepare the following journal

entries for the year 2005:Initial lease at 1/1/05:

First payment at 1/1/05:

Second payment at 12/31/05:

Equipment 22,198Lease Liability 22,198

Lease Liability 6,000Cash 6,000

Interest Expense 1,296Lease Liability 4,704

Cash 6,000

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Problem 3 - LeasesProblem 3 - LeasesFor the last entry, we must calculate straight-

line depreciation on leased asset at 12/31/05. Since we are recording an asset, we must depreciate the asset.

Note that the calculation here is based on the length of time that the lessee will actually use the asset (6 years here because of the BPO).

(Cost-SV)/Est. life =(22,198 - 0)/6 = $3,700JE for Depreciation at 12/31/05:

Depreciation expense 3,700Accumulated Depr. 3,700

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Comments on LeasesComments on LeasesMany companies still have many leases that

qualify as operating leases for financial reporting.

Comparison to companies with capital leases is difficult (different asset and liability structures).

Disclosure information regarding operating lease components makes it possible for analysts to “capitalize” the operating leases for financial statement comparison.

Documents

1 Long-Term Liabilities: Notes, Bonds, and Leases