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OU ACCT 2113 - Chapter 9 Notes

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ACCT 2113 1st Edition Lecture 9 Outline of Last Lecture II. Current LiabilitiesA. Current vs. long-term liabilitiesB. Account for notes payable and interest expenseC. ExampleIII. Measuring InterestA. ExampleIV. Line of CreditA. Employee/employer payroll liabilitiesB. Employee/employer costsV. Current portion of long-term debtA. Deferred taxesVI. ContingenciesA. Litigations and other causesB. Contingent liabilitiesC. Accounting treatmentD. WarrantiesE. Contingent gainsVII. Assessing liquidityOutline of Current Lecture II. Financing alternativesA. Debt financingB. Equity financingIII. BondA. Definition of private placementB. CharacteristicsC. Secured & unsecured, term & serial, callable & convertibleIV. Pricing and recording a bondA. Face amount, discount, premiumV. Amortization schedules for bondsVI. Retirement of bondsVII. Other long-term liabilitiesA. Installment notesThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.B. LeasesVIII. Long-term liability ratiosA. Debt to equity ratioB. Times interest earned ratioCurrent Lecture Chapter 9: Long-term LiabilitiesFinancing alternativesFinancing options: 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 businessAccounting EquationWhat is a bond?Bonds are very similar to notes. Bonds, though, 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 (semi-annually) on designated interest dates, beginning six months after the original bond issue date.Bonds provide a way to borrow the money needed from many community members, each willing to lend a small amount. In return, those investing in the bonds receive interest over the life of the bonds, say 20 years, and repayment of the principal amount at the end of the bonds’ life.o A formal debt instrument that obligates the borrower to repay a stated amount, referredto as the principal or face amount, at a specified maturity date. o In return, the borrower agrees to pay interest over the life of the bond.o Similar to notes payable, except bonds are usually issued to many lenders at the same time.o Traditionally, interest on bonds is paid twice a year (semi-annually).o Bonds are sold or underwritten by investment houses like JPMorgan, Citibank and Bank of America. o The borrower pays a fee for underwriting services. Other costs include legal, accounting, registration, and printing fees. o To keep costs lower, the issuing company may choose to sell the debt securities directly to a single investor. This is referred to as a Private placement. o Issue costs are lower because privately placed securities are not subject to the costly and lengthy process of registering with the SEC that is required of all publicofferings. A company that borrows by issuing bonds is effectively by-passing the bank and borrowing directly from the investing public, usually at a lower interest rate than it would in a bank loan. However, issuing bonds entails significant bond issue costs that can exceed 5% of the amount borrowed. For smaller loans, the additional bond issuance costs exceed the savings from a lower interest rate, making it more economical to borrow from a bank. For loans of $20 million or more, the interest rate savings often exceed the additional bond issuance costs, making a bond issue more attractive.A bond issue, in effect, breaks down a large debt into manageable parts—usually $1,000 units. This avoids the necessity of finding a single investor who is both willing and able to loan a large amount of money at a reasonable interest rate.Characteristics of bonds:A bond indenture is a contract between a firm issuing bonds to borrow money (the issuer) and the corporations or individuals who purchase the bonds as investments (the investors). For any particular bond, the bond may be secured or unsecured, term or serial, callable, or convertible.Secured and Unsecured Bondso Secured Bonds - supported by specific assets the issuer has pledged as collateral.o Mortgage bonds are backed by specific real estate assets. o If the borrower defaults on the payments, the lender is entitled to the real estatepledged as collateral.o Unsecured bonds - referred to as debentures, are not backed by a specific asset.o Secured only by the “full faith and credit” of the borrower.When you buy a house and finance your purchase with a bank loan, you sign a mortgage agreement assigning your house as collateral. If later you are unable to make the payments, the bank is entitled to take your house. Secured bonds are similar. They 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 and Serial Bondso Term bonds require payment of the full principal amount of the bond at a single maturity date.o Most bonds have this characteristic.o To ensure that sufficient funds are available to repay the amount at maturity, the borrower sets aside money in a “sinking fund.” o A sinking fund is an investment fund used to set aside money to pay the outstanding debt as it comes due. o Serial bonds require payments in instalments over a series of years.o It makes it easier for the borrower to meet its bond obligations as they become due. Term bonds require payment of the full principal amount of the bond at a single maturity date. 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 city borrows $20 million tobuild a new sports park by issuing 7% term bonds due in 12 years. To ensure that sufficient funds are available to pay the $20 million 12 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 city might save $2


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