In the previous chapter, we discussed current liabilities. In this chapter we focus on long-term liabilities, primarily bonds. Parts A, B, and C deal with various aspects of bonds. Part D discusses other important long-term liabilities such as installment notes and leases.
In this section, we will look at the various financing alternatives and the characteristics of bonds.
Some of the financing needed to fund a company’s growth can come from the profits generated by operations. Frequently, though, companies must find additional external financing to meet their needs for cash. Let’s look back at the basic accounting equation: Assets = Liabilities + Stockholders’ equity.Financing options available for a growing company include: Debt Financing: borrowing money (liabilities)Equity Financing: obtaining additional investment from stockholders (stockholders’ equity)Capital Structure is the mixture of liabilities and stockholders’ equity used by a business.Companies choose to borrow money rather than issue additional stock in the company because interest expense incurred when borrowing money is tax-deductible, whereas dividends paid to stockholders are not tax-deductible.Companies have three primary sources of long-term debt financing: bonds, notes, and leases. Bonds are the most common form of corporate debt.
A bond is a formal debt instrument that obligates the borrower to repay a stated amount, referred to as the principal or face amount, at a specified maturity date. In return for the use of the money borrowed, the borrower also agrees to pay interest over the life of the bond.Bonds usually are issued to many lenders, while notes most often are issued to a single lender such as a bank. Traditionally, interest on bonds is paid twice a year (semiannually) on designated interest dates, beginning six months after the original bond issue date.For most large corporations, bonds are sold, or underwritten, by investment houses. The three largest bond underwriters are JPMorgan Chase, Citigroup, and Bank of America. The issuing company—the borrower—pays a fee for these underwriting services. Other costs include legal, accounting, registration, and printing fees. To keep costs down, the issuing company may choose to sell the debt securities directly to a single investor, such as a large investment fund or an insurance company. This is referred to as a private placement.
Bonds may be secured or unsecured, term or serial, callable, or convertible. We’ll discuss each of these characteristics from the following slides.
Secured bonds are supported by specific assets the issuer has pledged as collateral. For instance, mortgage bonds are backed by specific real estate assets. If the borrower defaults on the payments, the lender is entitled to the real estate pledged as collateral.However, most bonds are unsecured. Unsecured bonds, also referred to as debentures, are not backed by a specific asset. These bonds are secured only by the “full faith and credit” of the borrower.Term bonds require payment of the full principal amount of the bond at the end of the loan term. Most bonds have this characteristic. Borrowers often plan ahead for the repayment by setting aside funds throughout the term to maturity. For example, let’s say a company borrows $20 million by issuing term bonds due in 10 years. To ensure that sufficient funds are available to pay the $20 million 10 years later, the borrower sets aside money in a “sinking fund.” A sinking fund is a designated fund to which an organization makes payments each year over the life of its outstanding debt. The company might put $2 million each year for 10 years into a sinking fund, so that $20 million is available to pay the bonds when they become due.Serial bonds require payments in installments over a series of years. Rather than issuing $20 million in bonds that will be due at the end of the 10th year, the company may issue $20 million in serial bonds, of which $2 million is due each year for the next 10 years. This makes it easier to meet its bond obligations as they become due. Since most bonds are term bonds, we focus on term bonds in this chapter.Most corporate bonds are callable, or redeemable. This feature allows the borrower to repay the bonds before their scheduled maturity date at a specifiedcall price, usually at an amount just above face value. Callable bonds protect the borrower against future decreases in interest rates. If interest rates decline, the borrower can buy back the high-interest-rate bonds at a fixed price and issue new bonds at the new, lower interest rate.A call feature is more common than a conversion feature. Another important distinction is that callable bonds benefit the borrower, whereas convertible bonds benefit both the borrower and the lender. Convertible bonds allow the lender (the investor) to convert each bond into a specified number of shares of common stock.Prior to conversion, the bondholder still receives interest on the convertible bond. The borrower also benefits. Convertible bonds sell at a higher price and require a lower interest rate than bonds without a conversion feature.
Assume that on January 1, 2015, California Coasters decides to raise money for development of its new roller coaster by issuing $100,000 of bonds paying a stated interest rate of 7%. The bonds are due in 10 years, with interest payable semiannually on June 30 and December 31 each year.In practice, most corporate bonds pay interest semiannually (every six months) rather than paying interest monthly, quarterly, or annually. Thus, investors inCalifornia Coasters’ bonds will receive (1) the face amount of $100,000 at the end of 10 years and (2) interest payments of $3,500 (= $100,000 × 7% × 1/2 year) every six months for 10 years. That’s a total of 20 interest payments of $3,500 each (= $70,000). This illustration provides a timeline of the cash flows related to the bond issue.Over the 10-year period, bondholders will receive a total of $170,000, which is the face amount of $100,000 due at maturity plus semiannual interest payments totaling $70,000. Investors will be willing to pay less than $170,000 today because the cash flows are in the future. In the next section we see how to determine that price.
In this section, we will be looking at how bonds are priced.
Assume that on January 1, 2015, California Coasters decides to raise money for development of its new roller coaster by issuing $100,000 of bonds paying a stated interest rate of 7%. The bonds are due in 10 years, with interest payable semiannually on June 30 and December 31 each year.The market interest rate is the same as the stated interest rate, 7%. This illustration shows the calculator inputs used to obtain an issue price at the face amount of $100,000.
An alternative to using a financial calculator is to calculate the price of bonds in Excel. This illustration demonstrates the inputs and the formula used to calculate the issue price.
A third alternative is to calculate the price of the bonds using present value tables. In this illustration, we calculate the price of the bonds using the present value tables provided at the back of the textbook.
California Coasters’ bonds are less attractive to investors, because investors can purchase bonds of similar risk that are paying the higher 8% rate. Because of this, to make the bonds more attractive, California Coasters will have to issue its 7% bonds below its $100,000 face amount. Bonds issued below face amount are said to be issued at a discount.In this illustration, we recalculate the issue price of the bonds, assuming the market rate of interest is now 8% per year (4% every semiannual period).
Investors will pay more than $100,000 for these 7% bonds since they look relatively attractive compared with bonds paying only 6%. These bonds will sell at a premium. A premium occurs when the issue price of a bond is above its face amount. In this case, the bonds will sell for more than $100,000. In this illustration, we recalculate the issue price using a market rate of 6% (3% semiannually).
If the bonds’ stated interest rate is less than the market interest rate, then the bonds will issue below face amount (discount). If the bonds’ stated interest rate equals the market interest rate, then the bonds will issue at face amount. Finally, if the bonds’ stated interest rate is more than the market interest rate, the bonds will issue above face amount (premium).Most bonds initially are issued at a slight discount. Because there is a delay between when the company determines the characteristics of the bonds and when the bonds actually are issued, the company must estimate the market rate of interest. Bond issuers usually adopt a stated interest rate that is close to, but just under, the expected market interest rate. However, in future periods, the bonds may trade at either a discount or a premium depending on changes in market interest rates.
In this section, we’ll see how transactions related to bonds payable are recorded.
To see how to record the issuance of bonds and the related interest, let’s return to our initial example. On January 1, 2015, California Coasters issues $100,000 of 7% bonds, due in 10 years, with interest payable semiannually on June 30 and December 31 each year.California Coasters reports bonds payable in the long-term liabilities section of the balance sheet. Nine years from now, when the bonds are within one year of maturity, the firm will reclassify the bonds as current liabilities.On June 30, 2015, the firm will record another semiannual interest payment on December 31, 2015. In fact, it will record semiannual interest payments at the end of every six-month period for the next 10 years.
When bonds issue at less than face value, we say they issue at a discount. The issue of bonds at discount is recorded using these journal entries.
An amortizationschedule provides a summary of the cash paid, interest expense, and changes in carrying value for each semiannual interest period. This illustration provides an amortization schedule for the bonds issued at a discount. Note that the amounts for the June 30, 2015, and the December 31, 2015, semiannual interest payments can be taken directly from the amortization schedule.
When bonds issue at more than face value, we say they issue at a premium. The issue of bonds at premium is recorded using these journal entries.
This illustration provides an amortization schedule for the bonds issued at a premium.
This illustration shows how carrying value changes as a bond approaches its maturity date.
When the issuing corporation buys back its bonds from the investors, we say the company has retired those bonds. The corporation can wait until the bonds mature to retire them, or frequently, the issuer will choose to buy the bonds back from the bondholders early.Regardless of whether bonds are issued at face amount, a discount, or a premium, their carrying value at maturity will equal their face amount. CaliforniaCoasters records the retirement of its bonds at maturity (December 31, 2024) as shown in this slide.
Earlier we noted that a call feature accompanies most bonds, allowing the issuer to buy back bonds at a fixed price. Even when bonds are not callable in this way, the issuing company can retire bonds early by purchasing them on the open market. Regardless of the method, when the issuer retires debt of any type before its scheduled maturity date, the transaction is an early extinguishment of debt.When interest rates go down, bond prices go up. If the market rate drops to 6%, it will now cost $106,877 to retire the bonds on December 31, 2015. The bonds have a carrying value on December 31, 2015, of only $93,670, but it will cost the issuing company $106,877 to retire them. California Coasters will record a loss for the difference. California Coasters records the retirement as shown in this slide. Gains and losses on the early extinguishment of debt are reported as non- operating items in the income statement.
Companies report many long-term liabilities other than bonds payable. In this section, we discuss two of them: installment notes and leases. The emphasis in this discussion is on the big picture, saving the details for more advanced accounting courses.
Installment notes usually call for payment in monthly installments rather than by a single amount at maturity. Each installment payment includes both an amount that represents interest and an amount that represents a reduction of the outstanding loan balance. The periodic reduction of the balance is enough that at maturity the note is completely paid.
Assume that California Coasters obtains a $25,000, 6%, four-year loan for a new car on January 1, 2015. The monthly payment of $587.13 is based on the following financial calculator inputs: future value, $0; present value, $25,000; market interest rate, 0.5% (6% ÷ 12 periods each year); periods to maturity, 48 (4 years × 12 periods each year)—and solving for the monthly payment (PMT).This illustration provides an amortization schedule for the loan. Notice that the carrying value begins at $25,000 and decreases each month to a final carrying value of $0 at the end of the four-year loan. Also, notice that interest expense decreases with each monthly payment. In each of the following months, the amount that goes to interest expense becomes less and the amount that goes to decreasing the carrying value (referred to as the principal) becomes more. Interest expense decreases over time because the carrying value decreases over time, and interest is a constant percentage of carrying value.
We record the note and the first two monthly installment payments as shown in the slide.
A lease is a contractual arrangement by which the lessor (owner) provides the lessee (user) the right to use an asset for a specified period of time. For accounting purposes, we have two basic types of leases: operating leases and capital leases.An operating lease is recorded just like a rental. The lessor owns the asset, and the lessee simply uses the asset temporarily. Over the lease term, the lessee records rent expense and the lessor records rent revenue. In a capital lease, the lessee essentially buys an asset and borrows the money through a lease to pay for the asset.
Business decisions include risk. Failure to properly consider risk in those decisions is one of the most costly, yet most common, mistakes investors and creditors make. Long-term debt is one of the first places decision makers should look when trying to get a handle on risk.Two ratios frequently used to measure financial risk related to long-term liabilities: (1) debt to equity and (2) times interest earned.
To measure a company’s risk, we often calculate the debt to equity ratio.The debt to equity ratio is a measure of financial leverage. Taking on more debt (higher leverage) can be good or bad depending on whether the company earns a return in excess of the cost of borrowed funds. Debt requires payment on specific dates. Failure to repay debt or the interest associated with the debt on a timely basis may result in default and perhapseven bankruptcy. Other things being equal, the higher the debt to equity ratio, the higher the risk of bankruptcy. When a company assumes more debt, risk increases. Debt also can be an advantage. It can enhance the return to stockholders. If a company earns a return in excess of the cost of borrowing the funds, shareholders are provided with a total return greater than what could have been earned with equity funds alone. Unfortunately, borrowing is not always favorable. Sometimes the cost of borrowing the funds exceeds the returns they generate. This illustrates the risk–reward trade-off faced byshareholders.
The times interest earned ratio measures a company’s ability to meet interest payments as they become due.Lenders require interest payments in return for the use of their money. Failure to pay interest when it is due may invoke penalties, possibly leading to bankruptcy. A ratio often used to measure this risk is the times interest earned ratio. This ratio compares interest expense with income available to pay those charges.Interest is one of the expenses subtracted in determining net income. So to measure the amount available to pay interest, we need to add interest back to net income. Similarly, because interest is deductible for income tax purposes, we need to add back tax expense as well.