Chapter 10 - Long Term Liabilities

bond

issuer’s written promise to pay the par value of the bond with interest

3 advantages of bonds

(1) bonds don’t affect owner control or dilute equity

(2) bonds can increase return on equity

(3) interest on bonds is tax deductible

disadvantages of bonds

(1) bonds can decrease ROE

(2) require repayment of principal and interest at maturity

bond indenture

legal contract between the issuer and the bondholders

par bonds

bonds issued at par value

contract rate

bond interest rate

computed by multiplying bond par value by contract rate

**sets the interest rate paid in cash, which isn’t necessarily the bond interest expense for the issuer

what does bond interest expense depend on?

the bond’s market value at issuance

market rate

rate that borrowers are willing to pay and lenders are willing to accept for a bond and its risk level

what happens to the market rate as the bond risk increases?

the market rate increases as well to compensate bond purchasers

relationships between market rate and contract rate

(1) contract = market —> sold at par value

(2) contract < market —> sold at a discount bc it’s risky

(3) contract > market —> sold at a premium

when does a discount on bonds payable happen

when a company issues bonds with a contract rate less than the market rate

what kind of account is discount on bonds payable

contra liability account w/ a normal debit balance

straight line bond amortization

allocates equal bond interest expense to each interest period

what kind of an account is premium on bonds payable

an adjunct liability account w/ a normal credit balance

when do issuers retire some/all of the bonds before maturity?

if interest rates decline, they may want to replace high-interest paying bonds w/ new, low interest bonds

what re two common ways to retire bonds before maturity

(1) exercise a call option —> issuer can reserve the right to retire bonds early by issuing callable bonds which gives the issuer an option to call the bonds before they mature by paying the par value plus a call premium

(2) open market purchase —> issuer can repurchase them from bondholders at current market price

**regardless of if they’re called or purchased, bondholders will likely pay a different amount than their carrying value

installment note

liability requiring a series of payments to the lender

common for franchises and other businesses when lenders and borrowers agree to spread payments over time

how is interest calculated for notes?

you do it by each period

mortgage

legal agreement that helps protect a lender if a borrower doesn’t make required payments on notes or bonds

gives lender the right to be paid from the cash proceeds of the sale of a borrower’s assets identified in the mortgage

typically sued for homes and plant assets

features of bonds and notes

secured and unsecured

convertible and callable

term and serial

registered and bearer

debt to equity ratio

helps investors assess the risk of a company’s financing structure

= total liabilities / total equity

what’s considered hig for a debt to equity ratio is very different depending on the industry —> start ups tend to have much higher ones bc theyre doing so much R&D

if a D2E ratio = 1.68, that means debtholders contributd $1.68 for each $1 contributed by equity holders

higher ratio = more risk

secured or unsecured (bond characteritsics)

secured —> have specific assets of the issuer pledged or mortgaged as collateral and unsecured bonds are backed by the issuer’s general credit standing and are riskier than secured debt

term or serial

term bonds and notes mature on one specified date

serial bonds matrue at more than one date and are usually repaid over a number ofp periods

registered or bearer

registered —> bonds issued in the names and addresses of their holders, issuer makes bond payments by sending checks to registered holders

bearer bonds —> paid out to whoever currently holds them, they might have bought them from someone else

convertible and/or callable

convertible bonds can be exchanged for a fixed number of shares of the issuing corporation’s stock, offers hodlers potential to profit from increases in stock price, still recieve interest while the debt is held and the par value if they hold the debt to maturity

callable bonds give the issuer the option to retire them at a state dollar amount before maturity

leases

financial agreement between the lessor (owner) and the lessee (asset renter or tenant) that gives the lessee the right to use the asset for a period of time in return for cash (rent) payments

finance lease

long-term leases where the lessee receives substantially all remaining benefits of the asset, must meet one or more of 5 criteria:

(1) transfers ownership of leas asset to lessee

(2) has a purchase option that lessee is reasonably certain to exercise

(3) lease term is for major part of lease assets remaining econoic life

(4) present value of lease payments equal or exceed substantially all of the lease asset’s fair value

(5) lease asset is specialized and expected to have no alternative use to lessor at lease end

Ex: leases of airplanes and department store buidlings

operating leases

long-term leases that don’t meet any of the 5 criteria for finance leases

ex: most car and apartment rental agreements

pension

an agreement for the employer to provide benefits (payments) to employees after they retire

defined benefit plans

the employer’s contributions vary, depending on assumptions about future pension assets and liabilities

a pension liability is reported when the accumulated benefit obligation is more than the plan assets, a so-called underfunded plan