ACCT5001 Semester 1, 2010 Week 10

0verview Week 10
Text: Chapter 9 LO 1 - 4, pp. 498 - 515; LO 10, pp. 523 - 527. Demo Questions: BE9.2, E9.2, PSA9.5, Additional Demonstration Question Self-Study Questions: Q3, Q8, Q9,; E9.3; E9.5; PSA9.1; PSA9.2; PSA9.4, 5; * BSB9.5 NB. Additional Self Study Questions on Debenture (Bond) Issues Explain the difference between current and non-current liabilities. Identify types of current liabilities and explain how to account for them. Identify types of non-current liabilities, such as debentures and unsecured notes, and explain how to account for them Calculate the issue price, and record the debentures (bonds) issues at: a) par, b) at a discount, c) at a a premium Calculate and record the relevant interest expense and payment entries required under the effective interest method Prepare journal entries for loans payable by instalment and distinguish between current and non-current components of long term debt.
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Reporting and Analysing Liabilities

Developed by Dr Anne Abraham Adapted by Ron Day 2009 John Wiley & Sons Australia, Ltd

CURRENT LIABILITIES Current liabilities

Def: are obligations that can reasonably be expected to be paid within one year or within the operating cycle, whichever is the longer Eg. - accounts payable, (Chp 2 & 5) - accrued liabilities and revenue received in advance (Chp 3 & 4) - other payables (e.g. payroll deductions payable etc.), - notes payable (due < 1 year ) - Short term provisions (due < 1 year) Liabilities that dont meet this definition are non-current liabilities - Eg - Loans payable and Mortgages (loans secured by property) - Unsecured notes and Debentures (Bonds) - Long-term provisions (due > 1 year) - Finance leases
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Other Payables Other Payables amounts owing to other than suppliers of inventory
E.g. Wages and other payroll deductions payable Employers deduct amounts from employees wages and salaries if they are required to be paid to other parties: See E9.2 Mar 31 Dr Cr Cr Cr Cr Wages Expense Cr ABC Health Fund payable Pay-as-you-go withheld tax payable Superannuation fund payable Union Fees payable Wages payable 70 000 4 500 7 500 2 200 500 55 300

(To record payroll and other payables withheld on March 31)

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Notes Payable Notes Payable

Formal contract to record obligations in the form of a legal document - Usually require borrower to pay interest or borrowing costs as well - Frequently issued to meet short-term financing needs - Issued for varying medium periods of time (say 3 mths, 6 mths or 1 year) Eg. BE 9.2 Borrowed $60 000 from XXX Bank 0n July 1 by issuing a one year 10% note (interest payable on settlement at maturity date) Journal entry when note issued July 1 Dr Cash 60 000 Cr Notes Payable 60 000 (To record issue of 10%, one year note payable to XXX Bank)
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Notes Payable (Continued)

Journal entry to record accrued interest at balance-day December 31 Dec 31 Dr Interest expense Cr Interest payable 3 000 3 000

(Entry to record accrual of interest owing to XXX Bank at end of period 10% x $60,000 x 6/12) Journal entry to settle the liability June 1 Dr Notes payable Dr Interest expense Dr Interest payable Cr Cash 60 000 3 000 3 000 66 000

(To record payment of note and interest to XXX Bank at maturity)

NON-CURRENT LIABILITIES
are obligations where the future sacrifice of economic benefits is not expected to be paid until after 1 year Referred to as debt financing/borrowing from single or multiple lenders Common forms of single lender borrowing are: - Bank loans - Long-term notes payable Common forms of multiple lender borrowing direct from the public - Unsecured notes no security over assets (therefore higher risk and interest) - Debentures (Bonds) subject to a secured charge on the issuers assets Why would a company raise money direct from the public from multiple lenders?

Why issue long-term debt? Advantages of Debt Financing

Shareholder control is not affected Why? Debt is often cheaper Why?

Financial leverage can benefit shareholders by increasing EPS How?

Disadvantage of Debt Financing

Increases financial risk How? - Debt creates contractual obligations that must be paid in good or bad times - Interest must be paid periodically (unlike dividends that can be varied) and the - Principal must be paid at maturity (unlike shares that are not usually repaid)
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Loans payable by Instalments Instalment Loans

money is borrowed from a single lender in the form of repayable loan If the loan is secured by a charge over property it is called a mortgage.
- if the borrower defaults the lender may sell the property to repay the loan

Loans Payable by Instalments (Continued)

A mortgage schedule can be prepared to outline the amount of each instalment to apportion between interest and principal reduction, which provides the details for the journal entry for each mortgage payment
- See Example in Fig 9.6 p.512 for a $106 220 two year loan at 12% p.a Note: - Each instalment of cash is the same amount each time - Interest expense (interest rate x balance of principal decreases over time as the principal reduces - Loan payable reduction (instalment - interest expense) increases over time as the interest portion of the instalment decreases. - The schedule (calculated on present value principles discussed later) continues these trends until the last instalment at end of loan pays the final interest and the remaining portion of the loan payable

the total loan repayments - the amount originally borrowed = interest Equal periodic loan instalments consist of part interest, part principal - (i) interest expense (fixed percentage by principal balance) - (ii) remainder of instalment is a reduction of the principal of the loan Jan 31 Dr Interest Expense Dr Mortgage Loan Payable Cr Cash at Bank 1 062 3 938 5 000

(To record loan repayment for January)

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Do PSA9.5 - Partial completion of schedule and entries for 1 yr loan at 24% pa

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Presentation of long-term debt in the financial statements

In presenting long term debt in the Statement of Financial Position - Reduction of principal within a one year from balance-date is classified as a current liability, with the remainder as a non-current liability. The mortgage schedule can be used to calculate the amount of principal to be reduced in the next year (CL) , and the remainder then is a NCL.
- Refer to Fig. 9.6, p.512 and calculate the current and non-current portion of mortgage payable as at reporting date of 31 March 2012

Present Value Concepts

Most long-term debts are required to be measured at present value, but before proceeding, we need to understand time value of money. Q. Would you rather receive $1 000 now or $1 000 in a years time?
- If now, you recognise that money received/paid in the future (FV) is worth less than the same amount in present value (PV) dollars received/paid today. Why? - The PV of $1 000 in a years time, is equivalent to the present amount you would need to invest at the current interest rate, to give you $1,000 in a years time.

- NCL - CL

= = = = =

Mortgage balance at 31/03/2013 (1 yr after balance date) $42 833 Mortgage bal at 31//3/2012 - Mortgage bal at 31/3/2013 $94 288 - $42 833 $51 455

PV of $1 formula/tables provides a discount factor to convert FV to PV. The PV of $1 000 in a years time, if interest rate is 10% PV = FV / (1 + r) n = $1 000/(1 + 0.1)1 = $909.09

- Fig 9.8, p.515 calculates this by summing the reduction in principal amounts for next 12 months for the CL, and summing the remaining amounts for the NCL.
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Present Value of a Single Sum

(PV of $1 Table)

Present Value of an Annuity

(PV of an annuity of $1) Assume that you have also received an option to choose to receive $70 000 now or $30 000 each year for 3 yrs (current int rate = 10%) To answer this, you could calculate the PV of $30 000 in each period by discounting it at the current interest rate and period, then sum the amounts
Future amount $30 000 (1 year away) $30 000 (2 years away) $30 000 (3 years away) PV factor of 10% 0.909 0.826 0.751 2.486 PV $ 27 270 24 780 22 530 $74 580

Example 1: You have won a lottery, and must choose to receive

$90 000 in 3 years time (current interest rate = 10%), or $70 000 now
- To answer, you need to calculate the PV of the $90,000 in 3 yrs by discounting it at the current int rate, so that you can compare the PVs on an equivalent basis

Present Value of a single sum of $1 table helps us to calculate this by providing the relevant discount rate for each interest rate and period .
- Refer to the PV of $1 table and find the discount factor at 10% int for 3 periods - Calculate the PV by multiply the FV by the discount factor - Compare to the amounts in present value terms PV [i=10%, n=3] of $90 000 0.751 (see Table 1) = $67 590 Amount to be received immediately 70 000 *Choose Difference - 2 410
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Alternatively, you can look up discount factors for a PV of an annuity $1 (Table 2 bottom half of PV tables page) PV of an annuity of $30 000 per yr for 3yrs [i=10%, n=3] = $30 000 x 2.487 (see Table 2) = $74 610 *Choose Amount to be received immediately 70 000 Difference + 4 610
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Measurement of long-term debt - Debentures (bonds)

Most long-term debt is measured at present value (PV) to report the fair value of the long-term liability The present value of a debenture (bond) consists of: - (i) PV of the principal to be repaid on maturity - (ii) PV of the annuity of periodic interest payments: Calculation of present value is affected by the: - cash amounts to be paid (face value + face or contract interest rate), - time period over which the payments are made - relevant market interest rates at the issue date Terminology

Measurement of long-term debt

Debentures (Bonds)

Debenture (Bond) Certificate provides details of the contract (name of issuer, face value due on maturity, maturity date, face rate of interest) Face Value (FV) is the principal amount due at maturity Book Value (BV) is the carrying amount of the note/debenture/bond in the companys ledger and statement of financial position Face Rate (FR) is the coupon rate on the face of the note/debenture/bond that determines the amount of interest paid to the holder each period Market Rate (MR) - the rate of interest on similar securities at date of issue, It is used in discounting the PV of the Principal and PV of interest annuity when determining issue price, and used to calculate interest exp (FR x FV) Issue Price- the amount paid by the borrower to the lender at time of issue. It may be > or < the face value, if the MR differs from FR at time of issue
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Calculation of Present Value of Debentures (Bonds)

Example 2
Illustrate the calculation of the issue price of 100 $1 000 10% Bonds with 5 years to maturity if the market rate of interest at issue date is 10%, Refer to PV Tables [i = 10%, n = 5] PV of a single sum of $100 000 PV annuity of $ 10 000 Present value (issue price) x x PV factor Present Value

Example 3- Solution
PV of principal (i = 5%, n = 10) = $100 000 x 0.614 = $ 61 400 PV of interest payments (MR = 5% , n = 10) = $5 000 x 7.722 = $ 36 110
= $ 100 000 rounded

0.621 (Table 1) $ 62 100 3.791 (Table 2) $ 37 910 $ 100 000 rounded

PV calculations where interest is paid semi-annually (twice a yr) In this case: i) adjust the interest rate (i) to that rate per period ii) adjust number of periods (n) to number of interest periods .

Example 3
Calculate issue price of a 10% semi annual 5 yr, $100 000 bond issued at par (market rate of interest also is 10%), with interest paid semi annually interest rate becomes 10/2 = 5% and No. of periods becomes 5 2 = 10
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Discount and Premium on Debentures (Bonds)

Market Rates 8% Issued at: Premium

Discount and Premium on Debentures (Bonds)

Where MR > FR the debentures (Bonds) will be issued at a discount - Investors are compensated for a lower face rate of interest (FR) that they will receive, compared to the market rate (MR) on similar investments. - The discount result in an effective rate = the market rate at date of issue - Present value calculations using the market rate will = the issue price

Bond Issued when: Face Rate (FR) Of interest rate 10%

10%

Face Value
Where MR < FR the debentures (Bonds) will be issued at a premium - Investors will pay more for a higher face rate of interest (FR) that they will receive, compared to the market rate (MR) on similar investments.

12%

Discount

- The premium results in an effective rate = the market rate at issue date - Present value calculations using the market rate will = the issue price

See interactive spreadsheet that illustrates the effects when market interest rate of similar securities differs from the face rate at date of issue
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Debentures (Bonds) issued at par Refer to Additional Demonstration Question

Debentures (bonds) issued on 1/1/2020: Face value $500 000; face rate of 8%, maturing in 10 years with semi annual interest paid.

Debentures (Bonds) issued at par

(iii) Record interest at semi annual interest dates: 2010 30/06/10 Dr Interest expense Cr Cash Interest expense Cr Cash 20 000 20 000 20 000 20 000

(a) Debentures (Bonds) issued at par

(i) Calculate issue price if the market rate is also 8% at issue date [I = 4%, n = 20] PV of face value 500 000 x (.456) PV of interest 20 000 x (13.590) (ii) Record the issue of the debentures: 1/1/2010 Dr Cash 500 000 Cr Debentures payable (to record issue of debentures at par) 500 000 = = 228 000 271 800 500 000* (rounding)

31/12/10 Dr

(NB. Above entries would normally be recoded in cash payment journal) (iv) Record the Balance Sheet presentation: Non-current Liabilities: Debentures Payable 500 000

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Debentures (Bonds) issued at a Discount

Debentures (bonds) issued on 1/1/2010: Face value $500 000; face rate of 8%, maturing in 10 yrs with semi annual interest paid

Debentures (Bonds) issued at a Discount

(iii) Calculate and record the Semi-annual interest Yr 1
Date 01/01/10 30/06/10 31/12/10 21 887 21 981 20 000 20 000 + 1,887 + 1,891 Interest expense 5% x BV Interest paid 4% x FV Increase in Bond Payable Book value 437 740 439 627 441 608

(b) Debentures (Bonds) issued at a discount

(i) Calculate the Issue price if the market rate =10% [I = 5% n = 20]: PV of face value PV of interest 500 000 x (.377) = = 188 500 249 240 437 740 20 000 x (12.462)

Journal entries to record interest expense and interest payments

30/06/10 Dr Interest expense (5% x 437 740) Cr Debenture Payable Cr Cash (4% x 500 000) 31/12/10 Dr Interest expense (5% x 439 627) Cr Debenture Payable Cr Cash (4% x 500 000) 21 887 1 887 20 000 21 981 1 981 20 000

(ii) Record the Journal entry at issue date: 1/1/10 Dr Cash Cr Debentures payable 437 740 437 740

(to record issue of debentures at a discount)

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(iv) Prepare an extract of the Balance Sheet (at end of year)

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Debentures (Bonds) issued at a Premium

Debentures (bonds) issued on 1/1/2010: Face value $500 000; face rate of 8%, maturing in 10 yrs with semi annual interest paid

Debentures (Bonds) issued at a Premium

(iii) Calculate and record the Semi-annual interest Yr 1
Date 01/01/10 Interest expense 3% x BV 17 236 17 153 Interest paid 4% x FV 20 000 20 000 Increase in Bond Payable - 2 764 -2 847 Book value 574 540 571 776 568 929

(c) Debentures (Bonds) issued at a premium

(i) Calculate the Issue price if the market rate = 6% (ii) Record the Journal entry at issue date: 1/1/10 Dr Cash Cr Debentures payable 574 540 574 540 PV of face value PV of interest 500 000 x 0.544 = = 20 000 x 14.877 [i = 3 n =2 0]:
30/06/10 31/12/10

277 000 297 540 574 540

Journal entries to record interest expense and interest payments

30/06/10 Dr Interest expense (3% x 574 540) Dr Debenture Payable Cr Cash (4% x 500,000) 31/12/10 Dr Interest expense (5% x 571 776) Dr Debenture Payable Cr Cash (4% x 500 000) 17 236 2 764 20 000 17 153 2 847 20 000

(to record issue of debentures at a discount)

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(iv) Prepare an extract of the Balance Sheet (at end of year)

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Summary of calculation of effective interest

(1) Calculate debenture (bond) interest expense (BV x MR)

Redeeming debentures (bonds) at maturity date Redeeming at Maturity

Debentures (bonds) are redeemed at the end of their maturity date by being repurchased (repaid) by the issuing company The Carrying amount of the notes will always equal their face value
- If issued at a discount, debentures payable was increased towards par each interest period by the difference between interest expense and interest paid - If issued at a premium debentures payable was decreased towards par each interest period by the difference between interest expense and interest paid

(2) Calculate debenture (bond) interest paid (FV x FR) (3) Calculate the increase or decrease to debentures (Bonds) payable by finding the difference between (1) and (2)

Bond interest expense Book value (carrying Market amt) at beg of period x rate (BV) (MR)

Bond interest paid Face value (FV)

x of interest
(FR)

Face Rate

Entry to record redemption at maturity 30/6/2030 Dr Debentures Payable 1 000 000 Cr Cash 1 000 000 (To record redemption of debentures at maturity)
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Redeeming debentures (bonds) before maturity Redeeming before maturity

- A company may decide to redeem notes early
- to reduce interest cost or remove debt from its statement of financial position

Financial Statement Analysis - Liquidity ratios 1. Liquidity Ratios

These measure the short-term ability of an entity to pay its maturing obligations and to meet unexpected needs for cash. 3 useful measures: (a) Working capital
= Current assets Current liabilities

To account for this, the company must

- eliminate carrying amount of debentures (bonds) at redemption date - record cash paid - recognise the difference as a gain or loss on redemption

Eg. Entry to record redemption before maturity at 103% of face value Dr Debentures Payable Dr Loss on Redemption of Debentures Cr Cash (To record redemption of debentures at 103) 1 000 000 30 000 1 030 000

Example:

($ in millions) Telstra Corporation

2008 $5513 $8123 = $2610

2007 $5353 $9434 = $4081

More working capital indicates more current assets available to meet current liabilities.
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Financial Statement Analysis Liquidity ratios (continued)

(b) Current ratio
= Current assets Current liabilities

Financial Statement Analysis Liquidity ratios (continued)

(c) Quick ratio = Cash + Marketable securities + Net receivables Current liabilities - Provides a measure of immediate short-term liquidity

Example:

($ in millions) Telstra Corporation

2008 $5513 = 0.68:1 $8123

2007 $5353 = 0.57:1 $9434

Example:

($ in millions) Telstra Corporation

2008 $899 + $3952 = 0.60:1 $8123

2007 $823 + $3891 = 0.50:1 $9434

A higher ratio indicates better liquidity. A higher ratio indicates better liquidity.

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Financial Statement Analysis Solvency ratios 2. Solvency Ratios

These measure the ability of an entity to survive over a long period of time 2 useful measures: (a) Debt to total assets ratio Example: = Total liabilities Total assets (b) Times interest earned

Financial Statement Analysis Solvency ratios (Continued)

= Profit before income tax + Interest expense Interest expense - Provides an indication of an entitys ability to meet interest payments as they become due Example:

($ in millions) Telstra Corporation

2008 $25 676 = 0.68:1 $37 921

2007 $25 295 = 0.67:1 $37 875

($ in millions) Telstra Corporation

2008 $5140 + $1158 = 5.4 times $1158

2007 $4692 + $1144 = 5.1 times $1144

The ratio indicates the extent to which the entitys assets are financed by creditors.
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A higher interest coverage is interpreted as indicating a greater ability to meet interest payments.
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Before next week 1. Do Week 10 Self-Study Questions. 2. Check solutions on Blackboard after doing the questions yourself. 3. You may want to complete reflective, self-evaluation and learning strategies exercise. 4. Skim read chapter 10; LO 1-9, pp.552-585 Start with Summary of Learning objectives on pp. 587-588 5. Obtain a copy of Week 11 lecture material from Blackboard to bring to class Feedback from Mid semester Test available on blackboard this week Part B of Assignment due Friday May 14 at 2pm
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