Accounting for Long-Term Debt 15.501/516 Accounting Spring 2004 Professor S. Roychowdhury Sloan School of Management Massachusetts Institute of Technology April 5, 2004 Agenda – Long-Term Debt  Extend our understanding of valuation methods beyond simple present value calculations.  Understand the terminology of long-term debt  Bonds – coupon and zero-coupon bonds  At Par vs. Discount vs. Premium  Market interest rate versus coupon rate  Mortgages – Interest plus Principal paid each period  Practice bookkeeping for debt issuance, interest accruals, periodic payments, and debt retirement.  Understand how long-term debt affects financial statements over time. Bonds  Bonds  Periodic interest payments and face value due at maturity  Face value (amount)  (Principal) Amount due at maturity  Interest payments  Coupon rate times the face value of debt  Coupon rate is the interest rate stated in the note. It’s used to calculate interest payments  Market rate of interest  The rate of interest demanded in the market place given the risk characteristics of a bond  Can be higher or lower than the coupon rate 1 2 3Bonds  Consider a loan with  principal of $10,000  initiated on 1/1/01  The market interest rate is 6%  Final payment is to be made at the end of the third year, i.e., on 12/31/03.  What annual payments are required under the following three alternatives?  Annual interest payment at the end of each year and repayment of principal at the end of the third year (typical bond terms).  A single payment (of principal and interest) at the end of year 3 (Zero-Coupon bond).  Three equal payments at the end of each year (mortgage / new car loan terms). Bonds - alternative payment streams Coupon Zero Mortgage End of Year 1 Int 0 Int + P End of Year 2 Int 0 Int + P End of Year 3 Int + P Int + P Int + P Accounting for a Bond issued at par Coupon Rate 6% = Market Rate 6%  At the time of the bond issue  Dr Cash 10,000  Cr Bond Payable 10,000  Periodically thereafter  Cash interest payments = Face Value x Coupon rate  Bond payable at the present value of cash flows, i.e., the present value of interest and principal  Interest expense = Bond payable x market interest rate  Difference between interest expense and cash interest payment is added to Bond Payable  At maturity  Pay interest and entire principal balance 6 4 5Accounting for a Bond issued at par Coupon Rate 6% = Market Rate 6%  What is the present value of the bond?  Payment stream  Three annual coupon payments of $600 each  Principal payment of $10,000 at the end of three years  Present value  PV of ordinary annuity, n = 3, r = 6%, Table 4  $600 x 2.67301 = $1603.81  PV of $10,000, n = 3, r = 6%, Table 2  $10,000 x 0.83962 = $8396.20  PV = $1603.81 + $8396.20 = $10,000 Accounting for a Bond issued at par Coupon Rate 6% = Market Rate 6%  End of year 1  Interest expense = $10,000 x 6%  Coupon payment = $100,000 x 6%  Dr Interest expense 600  Cr Cash 600  End of year 2  Dr Interest expense 600  Cr Cash 600  End of year 3  Dr Interest expense 600  Cr Cash 600  Dr Bond Payable 10,000  Cr Cash 10,000 Accounting for a Bond issued at par Coupon Rate 6% = Market Rate 6% Cash = Bond Payable Issuance 10,000 = 10,000 Cash = Bond Payable + Ret Erngs 2001 (600) = 2002 (600) = 2003 (600) = (10,000) (600) (600) (600) (10,000) 7 8 9Accounting for a Zero-Coupon Bond  The zero-coupon bond pays $10,000 at the end of three years.  How much will it sell for? That is, how much cash proceed will the firm receive at the time of issuing the zero-coupon bond?  What is the present value of such a bond at the time of issue?  PV of $10,000, n = 3, r = 6%, Table 2  $10,000 x 0.83962 = $8396.20  Accounting for a Zero-Coupon Bond At the time of the bond issue  Dr Cash 8,396.20  Dr Discount on bonds payable 1,603.80  Cr Bond Payable 10,000.00  Balance sheet presentation  Bond payable, gross $10,000.00  Less Discount ($1603.80)  Net Bond Payable $8396.20 11 Zero-Coupon Bond  Over time, the discount is reduced so that at maturity the net bond payable equals the face value of the bonds, $10,000  Periodically after issuance  Cash interest payments = 0  Interest expense = Bond payable x market interest rate  Difference between interest expense and cash interest payment reduces Discount Account  At maturity  Pay interest and entire principal balance  Remove Bonds Payable 10 12Zero-Coupon Bond  End of year 1  Interest expense = $8,396.2 x 6% = 503.77  No cash interest payment, so add the interest to Bond Payable  Dr Interest expense 503.77  Cr Discount 503.77  Balance in Discount Account = $(1603.80 – 503.77) = $ 1100.03  Net Bonds Payable = $8396.20 + 503.77 = $8899.97  OR  Net Bonds Payable = $10,000 – (1100.03) = $8899.97 Zero-Coupon Bond  End of year 2  Interest expense = $8,899.97 x 6% = 534.00  No cash interest payment, so add the interest to Bond Payable  Dr Interest expense 534.00  Cr Discount 534.00  Balance in Discount Account = $ (1100.03 – 534.00) = $ 566.03  Net Bonds Payable = $8899.97 + 534.00 = $9433.97  OR  Net Bonds Payable = $10,000 – 566.03 = $9433.97 Zero-Coupon Bond  End of year 3  Interest expense = $9433.97 x 6% = 566.03  No cash interest payment, so add the interest to Bond Payable  Dr Interest expense 566.03  Cr Discount 566.03  Balance in Discount Account = 0  Net Bonds Payable = $9433.97 + 566.04 = $10,000  OR  Net Bonds Payable = $10,000 – 0 = $10,000  Pay off the bond at maturity  Dr Bond Payable 10,000  Cr Cash 10,000 13 14 15Accounting for a Zero-Coupon Bond = [ ]Cash Bond Payable – Discount = NBP Issue 8,396.20 = [ 10,000 - 1,603.80 =]Cash = [Bond Payable - Discount = ] 2001 0 = 503.77 EB 10,000 - 1,100.03 2002 0 = 534 EB 10,000 - 566.032003 0 = 566.03 EB 10,000 0 Pay off the bond (10,000) 8,396.20 NBP + 8899.97 9433.97 10,000 (10,000) RE (503.77) (534) (566.03) Accounting for a Mortgage  In a mortgage, you make equal payments each period until