Transcript Accounting for Current and Long
Prof Johnson Acct 202 CHAPTER 8 & Appd B PowerPoint Lecture Slides
Ch8-- Accounting for Current and Long-Term Liabilities Appd B-- Time Value of Money
Opening Vignette - AMR Corporation
Alliances between companies in different industries Transportation = airlines Hospitality = hotels often create obligations for one party in the alliance.
Refer to the AMR Corporation situation described in the opening pages of the textbook
Opening Vignette - AMR Corporation
Opening Vignette - AMR Corporation
Holiday Inn and other partner companies pay AMR to credit air miles to customer frequent flyer accounts
These payments represent liabilities for AMR Corporation
Payments represent
obligation
to provide future transportation to frequent flyers
Chapter Learning Objectives
1. Account for current liabilities 2. Identify and report contingent liabilities 3. Account for basic bonds payable transactions 4. Measure interest expense, amortize bond discount and premium by the effective-interest method
Chapter Learning Objectives
5. Explain the advantages and disadvantages of borrowing 6. Account for lease transactions 7. Report liabilities on the balance sheet
Chapter Objective 1
Account for current liabilities
Liabilities
Obligation to transfer assets Or provide future services Resulting from past transactions
Liabilities
Obligation to transfer assets Or provide future services Resulting from past transactions
Can you think of examples?
Liabilities Incurred When a Business ...
Purchases inventory on account
Liabilities Incurred When a Business ...
Borrows money and makes (signs) a note payable
Liabilities Incurred When a Business ...
Accrues interest payable on a note or loan with the passage of time
Current Liabilities
Payable within one year Company’s operating cycle, if longer than one year Current liabilities classified in two ways (1)
Known
amount (2)
Estimated
amount
Current Liabilities of Known Amount
Accounts Payable Short-Term Notes Payable Short-Term Notes Issued at Discount Sales Tax Payable Current Portion of Long-Term Debt Accrued Expenses
Accounts Payable
Amounts owed to vendors (suppliers) for goods or services purchased on account
Journalize Asian Art, Inc.’s $350 purchase of office supplies on account
Accounts Payable
9/28/x6 Office Supplies $350 A/P $350
To record supplies purchased on account
Businesses often maintain
subsidiary A/P ledgers
vendors to track amounts owed to individual Task made easier by computers
Short-Term Notes Payable
Promissory note signed by the company payable within the year Company recognizes liability to repay principal amount borrowed Plus accrued interest expense/payable
EXAMPLE: The Valley Chamber Orchestra signs a $10,000, 60-day note payable in exchange for some remodeling done in its leased office space.
Short-Term Notes Payable
The 60-day note bears interest at 9% annually, and is made on November 15, 1998. 11/15/98 Leasehold Improvements $10,000 Note Payable, Short-Term $10,000
To record note issued for leasehold improvement
Short-Term Notes Payable
At fiscal year-end, December 31, the Orchestra must accrue interest payable on the note. 12/31/98 Interest Expense $115 Interest Payable $115
To accrue 1998 interest expense on note ($10,000 x .09 x 46*/360) * Nov. = 15 days Dec. = 31 days
Short-Term Notes Payable Issued at a Discount
Entity taking the note deducts interest from amount being borrowed Remits less than note’s
face value
to the borrower Borrower repays face value at note’s maturity
Short-Term Notes Payable Issued at a Discount $150 interest
Same $10,000, 60-day, 9% note as a “discounted” note payable ...
$9,850 proceeds remitted to borrower
Short-Term Notes Payable Issued at a Discount
$150 interest
Same $10,000, 60-day, 9% note as a “discounted” note payable ...
$10,000 x .09 x 60/360 = $150 total interest
Short-Term Notes Payable Issued at a Discount $150 interest
Same $10,000, 60-day, 9% note as a “discounted” note payable ...
$10,000 x .09 x 60/360 = $150 total interest $10,000 - $150 = $9,850 remitted to borrower
$9,850 proceeds remitted to borrower
Short-Term Notes Payable Issued at a Discount $150 interest
Same $10,000, 60-day, 9% note as a “discounted” note payable ...
$10,000 x .09 x 60/360 = $150 total interest $10,000 - $150 = $9,850 remitted to borrower Borrower repays $10,000 face value on January 15, 1999
$9,850 proceeds remitted to borrower
Short-Term Notes Payable Issued at a Discount
11/15/98 Cash $9,850 Discount on Note Payable 500 Notes Payable, Short-Term $10,000
To record discounted note payable
Accrued interest expense at year-end: 12/31/98 Interest Expense $150 Discount on Note Payable $150
To record 1998 interest expense
Sales Tax Payable DEPT. OF REVENUE
State and local taxes assessed on retail sales Sales tax collected by company along with sales revenue Sales tax periodically remitted to local/state government agencies
Sales Tax Payable
Ray’s Seafood Shack sold $3,475 of food and beverages (excluding tax) on a busy summer Friday evening Florida state sales tax is 6%, and Monroe County imposes a Tourist Development tax of .5%
What is the journal entry to recognize Ray’s sales tax payable?
Sales Tax Payable
7/9/x3 Cash $3,701 Sales Revenue $3,475 State Sales Tax Payable 209 County Sales Tax Payable 17
To record sales revenue for July 9
Retail POS systems easily capture sales revenue and related tax data
Current Portion of Long-Term Debt
Portion of long-term debt principal due within one year Adjusting entry reclassifies principal from long-term liability to current liability 12/31/x7 Cur. Portion of Long-Term Debt $5,000 Note Payable, Long-Term $5,000
To adjust current liabilities for current portion of long-term note payable
Current Portion of Long-Term Debt
Liability section of Asian Art, Inc.’s balance sheet Current Liabilities
Accounts Payable $20,000 Interest Payable 6,000
Current Portion of Long-Term Debt
Liability section of Asian Art, Inc.’s balance sheet Current Liabilities
Accounts Payable $20,000 Interest Payable 6,000 Current Portion of Long-Term Debt 21,000
Current Portion of Long-Term Debt
Liability section of Asian Art, Inc.’s balance sheet Current Liabilities
Accounts Payable $20,000 Interest Payable 6,000 Current Portion of Long-Term Debt 21,000 Total Current Liabilities $47,000
Current Portion of Long-Term Debt
Liability section of Asian Art, Inc.’s balance sheet Current Liabilities
Accounts Payable $20,000 Interest Payable 6,000 Current Portion of Long-Term Debt 21,000 Total Current Liabilities $47,000 Long-Term Notes Payable 190,000
Current Portion of Long-Term Debt
Liability section of Asian Art, Inc.’s balance sheet Current Liabilities
Accounts Payable $20,000 Interest Payable 6,000 Current Portion of Long-Term Debt 21,000 Total Current Liabilities $47,000 Long-Term Notes Payable 190,000
TOTAL LIABILITIES $237,000
Accrued Expenses
Result of adjusting entries accruing expenses incurred but not yet recognized
Wages/Salary Payable
Interest Payable
Taxes Payable AMR Corporation’s
Air Traffic Liability
Marriott International’s
Other Payables and Accruals
, including such frequent stay programs as
Marriott Miles, INNsiders’ Club, and Courtyard Club
Payroll Liabilities
Significant expense for many companies Total wages, salary, commissions, bonuses paid to company employees in exchange for their services
Refer to Textbook Exhibit 8-1 for adjusting entry prepared at end of accounting period to recognize payroll expense and related current liabilities
Payroll Liabilities Deductions from employee payroll include:
Federal income taxes
Social Security taxes
State/local income taxes
Group insurance (health/life) premiums
Union dues
Credit union savings or loan repayment
Contribution to 401(k) pension plans
Unearned Revenues
Cash received from customers prior to
earning revenue
Prior to delivering goods or providing services to customers
Unearned Revenues
When customer prepays for a product or service, company has
obligation
to: (1) Provide the product/service in the future (2) Refund the unearned revenue to customer
Unearned Revenues Customers of the Des Moines Register can prepay a 52-week newspaper subscription in advance. If the
subscription costs $108,
how does the Register
adjust its balance sheet for unearned revenues?
Unearned Revenues
A customer prepays her 52-week newspaper subscription beginning October 13, 19x4
10/13/x4 Cash $108 Unearned Subscription Rev. $108
To record prepaid 52-week subscription
The
Register’s
fiscal year ends on December 27, 19x4.
What adjusting entry must be made?
Unearned Revenues
12/27/x4 Unearned Subscript. Rev. $22.55 Subscription Revenue $22.55
To recognize revenue earned in 19x4*
*$108 / 52 weeks = $2.0769 / week $2.0769 / 7 days = $.2967 / day $.2967 x 76 days (October 13 through December 27)
Current Liabilities That Must Be Estimated
Estimated Warranty Payable Estimated Vacation Pay and Sick Pay Liability
Estimated Warranty Payable
Estimated Warranty Payable
Manufacturing and retailing companies often provide guarantees on products 30-60-90 days or one year in length
Matching principle
requires company to estimate expense of providing warranty and recognize it in same accounting period as revenue earned from product sale
Estimated Warranty Payable Suppose Cisco Systems -
a manufacturer of networking hubs and routers offers a 90-day warranty on equipment it sells Further, suppose Cisco’s recent actual warranty work amounts to .75% of all products sold.
Estimated Warranty Payable
If Cisco’s December 19x1 revenues are $3,500,000, what adjusting entry is necessary to estimate expense and current liability?
12/31/x1 Warranty Expense $26,250 Est. Warranty Payable $26,250
To record December warranty expense
Estimated Warranty Payable
When Cisco Systems actually replaces hubs or routers under warranty ...
Estimated Warranty Payable
When Cisco Systems actually replaces hubs or routers under warranty ...
2/2/x2 Est. Warranty Payable $2,000 Inventory $2,000
To record products replaced under warranty
Estimated Vacation and Sick Pay
Estimated Vacation and Sick Pay
Vacation and sick pay accrued in accounting period when earned
If Asian Art, Inc. employees earn one sick day and one vacation day per month, what adjusting entry is necessary at end of June to accrue these liabilities?
Estimated Vacation and Sick Pay
Use a 40-hour work week (160 hours per month) and total monthly payroll of $8,700 6/30/x6 Vacation Pay Expense Sick Pay Expense $435 435 Estimated Vacation Pay Liab. $435 Estimated Sick Pay Liab. 435
To record vacation and sick pay accruals for June
Chapter Objective 2
Identify and report contingent liabilities
Contingent Liabilities
Liability related to a past transaction
Dependent upon a future event
Guaranteeing debts of others
Awaiting outcome of pending lawsuit
Contingent Liabilities
Reporting guidelines rooted in several accounting principles: Full disclosure Conservatism Materiality Representational faithfulness
Contingent Liabilities
3 Ways to Classify Contingencies
Contingent Liabilities
Probable Possible Remote
Contingent Liabilities
Probable More likely than not that a loss will be incurred $ amount of loss can be reasonably estimated Possible Reasonably possible loss will be incurred Remote Not likely that loss will be incurred
Contingent Liabilities
Probable and reasonably estimable
Asian Art agrees to pay note payable of one of its suppliers if the supplier defaults on the note
At time supplier defaults, Asian Art knows the liability is probable (certain) and knows the amount of the loss LOAN PAYMENT
Contingent Liabilities
Probable and reasonably estimable
Asian Art will record
adjusting entry
to accrue expense and liability
Disclose additional information about liability in
footnotes
to financial statement LOAN PAYMENT
Contingent Liabilities
Possible
Ray’s Seafood Shack is defendant in negligence lawsuit
Customer slipped off sailboat during one of Ray’s sunset champagne cruises
At year-end, case has not been decided Ray’s lawyer does not believe the plaintiff will be successful in her claim against restaurant
Contingent Liabilities
Possible
Ray’s Seafood Shack would prepare a
brief disclosure
to be included in the financial statement
footnotes
only
Contingent Liabilities
Remote
A former member of the Valley Chamber Orchestra’s staff sues the organization for wrongful discharge after being fired The Orchestra’s labor attorney is confident the organization will be found innocent, especially in light of the former employee’s work record which includes warnings about sexual and discriminatory harassment of organization employees
Contingent Liabilities
Remote
The Orchestra
neither accrues
the estimated gain/loss
nor reports
details in footnotes to the financials
Begin Discussion of Appendix B: Time Value of Money
Appendix B: Accounting and the Time Value of Money After studying this chapter you should be able to:
Identify accounting topics where time value of money is relevant.
Distinguish between simple and compound interest.
Learn how to use appropriate compound interest tables.
Identify variables fundamental to solving interest problems.
Solve future and present value of 1 problems.
Solve future value of ordinary problems.
Solve present value of ordinary annuity problems.
Introduction
Concept of the
time value of money
is very important especially when interest rates are high and/or time periods are long.
Simply put--You are not indifferent as to when you receive or pay an identical sum of money. That is, a dollar received or paid today (the present) is not worth a dollar received or paid tomorrow (the future).
Someone owes you, a rational person, $100. They say to you--Which would you prefer: I pay you $100 today or I pay you $100 one year from now?
Introduction
Your response should be--Pay me $100 today (present). WHY? Assuming there is no inflation , would your answer change?
Again, your response should be to be paid today. You could take the funds today, invest them, earn a return and have more than $100 a year from now. How much more than $100 would depend on the return you could earn (interest).
Suppose, instead, someone offers you $100 one year from today. You wish the funds now (today), however. Will you accept less than $100 in settlement of the debt?
Introduction
Considering the interest rates, you will accept less than $100 today to settle the debt.
WHY?
If you had the settlement today you could invest it, earn a return and have $100 one year from now. If the interest rate is high you would accept less to settle the debt than if the interest rate was low.
Simply put,
at any interest rate: • A dollar received today is worth more than a dollar in the future. • A dollar in the future is worth less than a dollar today.
Introduction
The concept of the time value of money is pervasive. We see this concept in many topics including (to name a few): Leases Pensions Non-interest bearing notes Installment contracts Valuation of bonds Sinking fund provisions The FASB will simplify calculations by stating, at times, the time value of money is to be ignored. You must realize the import of that assumption as well!
Interest
Definitions of interest: A fee for the use of money Principle x Interest Rate x Time = Interest Principle: The amount borrowed or invested.
Interest rate: A percentage of the outstanding principle. Always expressed as an annual rate.
Time: The number of years or fraction thereof that the principle is outstanding.
Interest
Selection of appropriate interest rate is critical and, at times, very difficult. Would you be a wealthy person if you could accurately predict the interest rate?
The interest for us will be a given figure. In practice it can be the hardest figure to derive accurately.
Interest
Elements of the interest rate: The interest rate is the sum of Pure rate of interest (system risk) Initial rate charged assuming no possibility of default and no inflation.
Credit risk rate of interest (individual risk) Additional rate charged as a result of an individual entity’s risk of default.
Expected inflation rate of interest (inflation premium) Additional rate charged to compensate for the decrease in the purchasing power of the dollar over time.
Interest
Simple interest
is computed on the principle only. That is, interest is earned and removed. The interest does not earn interest.
–
Compound interest
is computed on the principle and any accumulated interest. Both the principal and interest then earn interest.
10
Types of Problems
For our calculations we will assume
compound interest
. The greater the number of periods and the higher the interest rate, the greater will be the effect of compounding interest.
Types of problems we will be working with:
Single Sum
. One sum ($1) will be received or paid either in the Present (Present Value of a Single Sum or
PV
) Future (Future Value of a Single Sum or
FV
) 11
Types of Problems
Types of annuity problems
:
Ordinary annuity
(
OA
) A series of
equal payments
(or rents) received or paid at the
end of a period
, assuming a
constant rate of interest
.
Value today of a series of equal, end-of period payments received in the future is the Present Value of an Ordinary Annuity or
PV-OA
.
Value in the future of a series of equal, end of-period payments received in the future is the Future Value of an Ordinary Annuity or
FV-OA.
12
Types of Problems Annuity Due
(
AD
) A series of
equal payments
(or rents) received or paid at the
beginning of a period
, assuming a
constant rate of interest.
Value today of a series of equal, beginning-of period payments received in the future is the Present Value of an annuity due or
PV AD
.
Value in the future of a series of equal, beginning-of-period payments received in the future is the Future Value of an annuity due or
FV-AD.
Types of Problems Note:
The difference between an ordinary annuity and an annuity due is that: Each rent or payment compounds (interest added) one more period in a annuity due, future value situation. Each rent or payment is discounted (interest removed) one less period under the annuity due situation. Given the same i, n and periodic rent, the annuity due will always yield a greater present value (less interest removed) and a greater future value (more interest added).
Calculation Variables
There will always be at least four variables in any present or future value problem. Three of the four will be known and you will solve for the fourth.
Single sum problems
: n = number of compounding periods i = interest rate PV = Value today of a single sum ($1) FV = Value in the future of a single sum ($1)
Calculation Variables
Annuity problems
: n = number of payments or rents i = interest rate R = Periodic rent received or paid And either: FV-OA or AD = Value in the future of a series of future payments (either ordinary or due). OR PV-OA or AD= Value today of a series of payments in the future (either ordinary or due).
• Note: The “n” and the “i” must match. That is, if the time period is semi-annual then so must the interest rate. Interest rates are assumed to be annual unless otherwise stated so you may have to adjust the rate to match the time period.
Single Sum Problems Let’s review the derivation of the single sum formula:
Suppose you have $100 today (present) and wish to deposit it at 10% for three periods, in this case years. What is the value of this single sum in the future?
At the end of the first year (n = 1): (Compound interest) $100 + $100(.1) = $110 At the end of the second year ( n = 2) $110 + $110(.1) = $121 At the end of third year (n = 3) $121 + $121(.1) = $133 (rounded) So the future value of $100 three years hence at 10% = $133
Single Sum Problems
I realize there is a simpler way to approach this: $100 (1 +.1)(1+.1)(1+.1) = $133 $100 (1+.1) 3 = $133 Generally for any “n” and “i” the single sum formula would be:
PV (1+ i) n = FV
$100 (1+.1) 3 = $133
Single Sum Problems
Not wishing to have to constantly raise the term to the required power I name the term (1+ i) n , the
Future Value Factor
then employ the table on page 320-321. The table is the result of the required multiplications at various “n” and “i” and is to be read vertically for the “n” and horizontally for the “i”. for a single term (
FVF n,i )
. I To solve my problem using the table:
PV(FVF n,i ) = FV
where n = 3 and i = 10% $100 (1.331) = $133
Single Sum Problems Note:
For single sum problems the “n” refers to
periods
not necessarily defined as years! The period may be annual, semi-annual, quarterly or another time frame.
In manual calculations the use of the table is strongly recommended. It enhances both speed and accuracy.
Single Sum Problems
Now suppose instead of $100 today I am to receive $133 three years from now. Again the interest rate is 10%. I don’t want to wait three years for my money. How much will I accept today in lieu of the future payment?
Going back to the general formula for a single sum:
PV(FVF n,i ) = FV
I realize I can isolate the term I wish to solve for on one side of the equation: PV = FV divided by (FVF n,i ) and rearranging terms: PV = FV ( 1/ FVF n,i )
Single Sum Problems
Not wishing to have to constantly raise the term to the required power and then divide it into 1, I name the term 1/ FVF n,i the single sum
(PVF n,i ) Present Value Factor
. I restate the formula for a
PV = FV (PVF n,i )
I then employ the table on page ???. The table is the result of the required multiplications and division at various “n” and “i” and is to be
read vertically for the “n”
and
horizontally for the “i”
Single Sum Problems
To solve my problem using the table:
Please look up the values on the tables as we go along!
n = 3, i = 10%, FV = $133
PV = FV (PVF n,i )
PV = $133 (.75132) PV = $100 23
Single Sum Problems Note:
Review the tables and note their characteristics.
They are very logical.
All sums in the future are worth less than themselves in the present. All factors on the present value of a single sum table are less than one. All factors on the future value of a single sum table are greater than one. All present sums are worth more than themselves in the future. Notice how the factors change dramatically as the “i” increases and the “n” lengthens!
24
Single Sum Problems
Single Sum problems, other unknowns.
Suppose you have $6,000 today (PV ) and you need $9,000 five years hence. What rate of annual interest must you earn to achieve your goal?
Note:
This can be solved as either a future or present value of a single sum problem. The formulas are reciprocals of each other.
25
Single Sum Problems
To solve as a future value of a single sum problem:
PV(FVF n,i ) = FV
where n = 5 and i = ? $6,000 (FVF n,i ) = $9,000 FVF n,i = $9,000/$6,000 = 1.500
Looking on the future of a single sum table (page ???) for n = 3 and a FVF of 1.500, I find the corresponding “i” to be between 8-9%.
26
Single Sum Problems
Alternatively, suppose I have $750 today. How long will I have to wait to have $1,200 when the interest rate is 10%? I will solve this as a PV problem.
PV = FV (PVF n,i )
$750 = $1,200 (PVF n,i ) PVF n,i where n = ? and i = 10% = $750/$1,200 = .625
Reading on the present value of a single sum table (page ???) for 10% the “n” for the factor .625 is between 4-5 periods.
A more precise answer may be derived through the use of the mathematical technique of interpolation.
27
Annuity Problems
Suppose I am to receive three equal $100 payments (R) each at the end of the period (in this case a period is a year) when the interest rate is a constant 15%. This is an ordinary annuity since payments are at the end of the period. What is the value to me at the end of the third year from receiving this annuity?
This is a future value of an ordinary annuity problem.
How do I go about solving it?
I realize an annuity is really a series of single sums.
If I take the FV for each single sum and add them I will have the value of the entire stream of payments.
I will use the FV formula which is:
PV(FVF n,i ) = FV
28
Annuity Problems Rent # Cmpd periods All at i = 15% Sum FVF FV
1 2 2 1 $100 1.322
$100 1.150
$132 $115 3 0 $100 1.000
$100
Totals
3.472
$347
This is tedious! I notice I am multiplying a constant rent ($100) by a changing interest factor. What if I added the three factors and multiplied the total by the rent? That would be less work! I’ll call the sum of the appropriate factors the
FVF-AO n,i
. I’ll derive the general formula where
R
equals the constant rent:
FV-OA = R (FVF-AO n,i
payments
)
when I = 15% and FV-OA = $100 (3.472) = $347 (rounded)
n = 3
29
Annuity Problems
Where do I get these summed factors? From the future value of an ordinary annuity table on pages ???. The addition for the appropriate “n” and “i” has already been done. The annuity tables are derived directly from the single sum tables. 30
Annuity Problems
Let’s take the case of the
present value of an ordinary annuity
. That is, what is a stream of future payments worth today? What sum do you need today to draw out a series of equal payments and have nothing left over? This situation is very common in retirement cases or the payment of debt.
Bonds Payable ABC Company 32
Annuity Problems
Suppose you are to pay three rents of $500, each at the end of the next three years. The interest rate is 8%. How much should I set aside today to have the required rents? Again I realize an annuity is simply a series of single sums. I take the same approach as before in that I discount (remove) interest from each of the rents. I take the present value of each, add, and I will have the required sum (total present value) that I will need.
I use the formula:
PV = FV (PVF n,i )
33
Annuity Problems Rent # Disc periods All at i = 8%
1 2 1 2 $500 .92593
$500 .85734
Sum PVF
$463 $429
PV
3 3 $500 .79383
$397
Totals
2.5771
$1,289
This is tedious! I notice I am multiplying a constant rent ($500) by a changing interest factor. What if I added the three factors and multiplied the total by the rent? That would be less work! I’ll call the sum of the appropriate factors the
PVF-AO n,i
. I’ll derive the general formula where
R
is the constant rent:
PV-OA = R (PVF-AO n,i )
for n = 3 payments and i = 8% PV-OA = $500 (2.5771) = $1,289 (rounded) 34
Annuity Problems
Where do I get these summed factors? From the present value of an ordinary annuity table on pages ???. The addition for the appropriate “n” and “i” has already been done. The annuity tables are derived directly from the single sum tables. 35
End Discussion of Appendix B: Time Value of Money and Start Discussion of Long Term Liabilities-- Bonds Payable
Chapter Objective 3
Account for basic bonds payable transactions
Financing Operations with Long-Term Debt
Large corporations borrow huge amounts of money by issuing
bonds
to lenders
Individuals
Corporate investors
Pension plans
Insurance
Financing Operations with Long-Term Debt
Bonds
are interest-bearing, long-term notes payable
Bond certificate
provides written evidence of borrowing company’s obligation to repay lender for principle borrowed plus accumulated interest
Refer to textbook Exhibit 8-2 for a picture of a bond certificate
Financing Operations with Long-Term Debt
Bond certificate states
Debenture Bonds
Financing Operations with Long-Term Debt
Debenture Bonds
MGM Grand, Inc.
$10,000.00
Bond certificate states
Principle (face or maturity value)
Financing Operations with Long-Term Debt
Debenture Bonds
MGM Grand, Inc.
$10,000.00
Eight percent
Bond certificate states
Principle (face or maturity value)
Contract interest rate (annual %)
Financing Operations with Long-Term Debt
Debenture Bonds
MGM Grand, Inc.
$10,000.00
Eight percent November 30, 2008
Bond certificate states
Principle (face or maturity value)
Contract interest rate (annual %)
Interest payment dates (usually semi-annually)
Types of Bonds
Secured (mortgage) bonds Entitle bondholders rights to specific assets in event company defaults on bond interest payments or maturity payment Unsecured (debenture) bonds Bondholders backed by reputation and integrity of the company More risky, therefore pay higher interest rate than secured bonds
Bond Prices
Initial bond issue prices determined by borrower and bond underwriter Prices of bonds traded on secondary market based on variety of factors
Bond Prices
Affected by: Time to maturity Credit rating of issuing company Contract interest rate compared to market interest rate
Bond Prices
Expressed in terms of percent of face value
Bond Prices
Expressed in terms of percent of face value $10,000 face value bond
Bond Prices
Expressed in terms of percent of face value Bond price might be: 98.75
$10,000 face value bond
Bond Prices
Expressed in terms of percent of face value Bond price might be: 98.75
$10,000 face value bond 98.75% of face value $9,875
BOND SOLD AT A “DISCOUNT”
Bond Prices
Expressed in terms of percent of face value Bond price might be: $10,000 face value bond 100
Bond Prices
Expressed in terms of percent of face value Bond price might be: $10,000 face value bond 100
BOND SOLD AT “PAR”
100% of face value $10,000
Bond Prices
Expressed in terms of percent of face value Bond price might be: $10,000 face value bond 104.5
Bond Prices
Expressed in terms of percent of face value Bond price might be: $10,000 face value bond 104.5
104.5% of face value $10,450
BOND SOLD AT A “PREMIUM”
Present Value
Money earns income (interest) with passage of time
Present Value
Amount of a dollar invested today is referred to as the
present value
of a future amount Amounts invested today accumulate interest and grow to a larger amount in the future
Present Value
$1,000 invested today is worth more than $1,000 to be received two years from now You can invest the $1,000 now It will be worth more in three years
Issuing Bonds Payable to Borrow Money
The City of Blacksburg, Virginia, issues $15,000,000 of 6% 10-year bonds on May 1, 19x3, to fund construction of a new water treatment plant
What is the City’s journal entry if the bonds are issued at par?
Issuing Bonds Payable to Borrow Money 5/1/x3 Cash $15,000,000 Bonds Payable $15,000,000
To record bonds issued at par
After initial bond issue, secondary market bond transactions do not involve the City of Blacksburg
City makes no journal entries
Keeps record of bond owners only for payment of periodic interest
Issuing Bonds Payable to Borrow Money
The City’s bonds pay interest each May 1 and November 1
What is the journal entry to record the first interest payment on Nov. 1, 19x3?
Issuing Bonds Payable to Borrow Money
11/1/x3 Interest Expense $450,000 Cash $450,000
To record interest expense Can you think of the adjusting entry necessary on November 30, 19x3, the City’s fiscal year-end?
Issuing Bonds Payable to Borrow Money 11/30/x3 Interest Expense $75,000 Interest Payable $75,000
To record interest accrual for 19x3
Issuing Bonds and Notes Payable Between Interest Dates
Bonds issued between interest payment dates are priced to include accrued interest
WHY?
Semiannual interest payments are paid in full to the current bondholder of record
Too time-consuming and impractical to track all bondholders during the semiannual period
Consider that some bondholders may hold bonds only for several days or weeks before selling them
Issuing Bonds and Notes Payable Between Interest Dates Suppose the City of Blacksburg issued its bonds (dated 5/1/x3) on July 1, 19x3 7/1/x3 Cash $15,150,000 Interest Payable $150,000 Bonds Payable 15,000,000
To record bonds issued between interest dates
Issuing Bonds and Notes Payable Between Interest Dates
How would the first interest payment on November 1 would be recorded?
11/1/x3 Interest Expense $300,000 Interest Payable 150,000 Cash $450,000
To record interest expense
Issuing Bonds and Notes Payable Between Interest Dates Interest Expense Interest Payable $150,000 7/1
Issuing Bonds and Notes Payable Between Interest Dates Interest Expense Interest Payable 11/1 $300,000 $150,000 7/1
Issuing Bonds and Notes Payable Between Interest Dates Interest Expense Interest Payable 11/1 $300,000 11/1 $150,000 $150,000 7/1
Issuing Bonds Payable at a Discount
When would bonds be issued at a discount?
When contractual rate of interest is
lower
than market rate
Bondholders will pay amount
less than face value
for investment yielding less than current market rate
Issuing Bonds Payable at a Discount
Suppose the City of Blacksburg, Virginia, issues the $15,000,000 of 6% 10-year bonds on May 1, 19x3, when similar bonds of comparable quality and risk pay 8% interest
What is the City’s journal entry if the bonds are issued at a discount?
Issuing Bonds Payable at a Discount 5/1/x3 Cash $12,955,500 Discount on Bonds Payable 2,044,500 Bonds Payable $15,000,000
To record bonds issued at discount
Discount on Bonds Payable is a
contra
account to Bonds Payable
Net amount of Discount and Bonds Payable accounts referred to as the bond’s
carrying value
Issuing Bonds Payable at a Discount
Discount represents additional interest expense to be allocated over life of bonds
Effect is to increase entity’s interest expense incurred on bond to equivalent of the market rate of interest
Issuing Bonds Payable at a Discount
City of Blacksburg would report its newly-issued bonds on the balance sheet:
Long-Term Liabilities
Bonds Payable (6%, due 5/1/20x3) $15,000,000 Less Bond Discount 2,044,500 Carrying Value $12,955,500
Issuing Bonds Payable at a Discount
City of Blacksburg would report its newly-issued bonds on the balance sheet:
Long-Term Liabilities
Bonds Payable (6%, due 5/1/20x3) $15,000,000 Less Bond Discount 2,044,500 Carrying Value $12,955,500 Carrying value is
Issuing Bonds Payable at a Discount
City of Blacksburg would report its newly-issued bonds on the balance sheet:
Long-Term Liabilities
Bonds Payable (6%, due 5/1/20x3) $15,000,000 Less Bond Discount 2,044,500 Carrying Value $12,955,500 Carrying value is face value
Issuing Bonds Payable at a Discount
City of Blacksburg would report its newly-issued bonds on the balance sheet:
Long-Term Liabilities
Bonds Payable (6%, due 5/1/20x3) $15,000,000 Less Bond Discount 2,044,500 Carrying Value $12,955,500 Carrying value is face value minus unamortized bond discount
Chapter Objective 4
Measure interest expense; amortize bond discount and premium by the effective-interest method
Effective-Interest Method of Debt Amortization
GAAP requires bond discount to be amortized (allocated) over life of bond to yield interest expense equivalent to market interest rate Known as
effective-interest method
Semiannual cash interest payment to bondholders remains same Interest expense recognized by entity grows slightly each period
Effective-Interest Method of Debt Amortization
Textbook Exhibit 8-6 shows an amortization schedule for a bond issued at a discount Notice ....
Effective-Interest Method of Debt Amortization
Interest payments to bondholders do not change over time
Interest expense recognized by company increases as bond carrying value increases
Unamortized bond discount decreases as bonds get closer to maturity
Bond carrying value rises to face value as it nears maturity
Interest Expense on Bonds Issued at a Discount - Amortizing Discount on Bonds Payable
Bond discount represents additional interest expense to entity “Unstated” cost of issuing bonds when contractual interest rate is lower than market rate of interest on similar bonds Refer to textbook Exhibit 8-7 to see relationship between interest payments and interest expense
Interest Expense on Bonds Issued at a Discount - Amortizing Discount on Bonds Payable
Let’s amortize the first semiannual interest payment for the City of Blacksburg’s bonds
11/1/x3 Interest Expense $518,220 Discount on Bonds Payable $68,220 Cash 450,000
To record bond interest payment
Interest Expense on Bonds Issued at a Discount - Amortizing Discount on Bonds Payable After recording interest expense, related account balances look like this: Discount on Interest Bonds Payable Expense
Interest Expense on Bonds Issued at a Discount - Amortizing Discount on Bonds Payable After recording interest expense, related account balances look like this: Discount on Interest Bonds Payable Expense 5/1 $2,044,500
Interest Expense on Bonds Issued at a Discount - Amortizing Discount on Bonds Payable After recording interest expense, related account balances look like this: Discount on Interest Bonds Payable Expense 5/1 $2,044,500 $68,220 11/1
Interest Expense on Bonds Issued at a Discount - Amortizing Discount on Bonds Payable After recording interest expense, related account balances look like this: Discount on Interest Bonds Payable Expense 5/1 $2,044,500 $68,220 11/1 11/1 $518,220
Interest Expense on Bonds Issued at a Discount - Amortizing Discount on Bonds Payable After recording interest expense, related account balances look like this: Discount on Interest Bonds Payable Expense 5/1 $2,044,500 $68,220 11/1 11/1 $518,220 Bal $1,976,280
Issuing Bonds Payable at a Premium
Suppose the City of Blacksburg had issued its water treatment plant bonds at an interest rate higher than market rates
How would the May 1, 19x3, journal entry change if the contract rate of the bonds was 10% and the market rate of interest at 8%?
Issuing Bonds Payable at a Premium 5/1/x3 Cash $17,032,500 Premium on Bonds Payable $2,032,500 Bonds Payable 15,000,000
To record bonds issued at premium
Net amount of Premium and Bonds Payable accounts equal bond’s
carrying value
Issuing Bonds Payable at a Premium
Premium, like a discount, is amortized over life of bond Premium represents a
reduction
interest expense in total Created by bondholders’ willingness to pay
more
than face value for the bond issue Effect of premium is to expense
reduce
bond interest
Issuing Bonds Payable at a Premium
City of Blacksburg would report its bonds on the balance sheet:
Long-Term Liabilities
Bonds Payable (10%, due 5/1/20x3) $15,000,000 Plus Bond Premium 2,032,500 Carrying Value $17,032,500
Issuing Bonds Payable at a Premium
City of Blacksburg would report its bonds on the balance sheet:
Long-Term Liabilities
Bonds Payable (10%, due 5/1/20x3) $15,000,000 Plus Bond Premium 2,032,500 Carrying Value $17,032,500 Carrying value is
Issuing Bonds Payable at a Premium
City of Blacksburg would report its bonds on the balance sheet:
Long-Term Liabilities
Bonds Payable (10%, due 5/1/20x3) $15,000,000 Plus Bond Premium 2,032,500 Carrying Value $17,032,500 Carrying value is face value
Issuing Bonds Payable at a Premium
City of Blacksburg would report its bonds on the balance sheet:
Long-Term Liabilities
Bonds Payable (10%, due 5/1/20x3) $15,000,000 Plus Bond Premium 2,032,500 Carrying Value $17,032,500 Carrying value is face value plus unamortized bond premium
Issuing Bonds Payable at a Premium
How would the City’s first semi-annual interest payment on the bonds be recorded?
11/1/x3 Interest Expense $681,300 Premium on Bonds Payable 68,700 Cash $750,000
To record bond interest payment
Interest Expense on Bonds Issued at a Premium - Amortizing Premium on Bonds Payable
Textbook Exhibit 8-9 shows a bond premium amortization schedule
Observe the differences between it and Exhibit 8-6
Interest Expense on Bonds Issued at a Premium - Amortizing Premium on Bonds Payable
Interest payments to bondholders do not change over time
Interest expense recognized by company decreases as bond carrying value decreases toward maturity
Unamortized bond premium decreases as bonds get closer to maturity, similar to unamortized bond discount
Bond carrying value falls to its face value as it nears maturity
Interest Expense on Bonds Issued at a Premium - Amortizing Premium on Bonds Payable
Bond premium represents a
reduction
interest expense to entity of Reduction in cost of issuing bonds when contractual interest rate is
higher
than market rate of interest on similar bonds Refer to textbook Exhibit 8-10 to see relationship between interest payments and interest expense
Straight-Line Amortization of Bond Discount and Bond Premium
GAAP requires bond discounts and premiums to be amortized using effective-interest method
Companies permitted to use straight-line method provided it yields similar results
That is, differences are not material
Straight-Line Amortization of Bond Discount and Bond Premium
Consider the difference for the City of Blacksburg bonds issued at a premium: Effective-interest method Bond premium - $2,032,500 First period amortization - $68,700
Straight-Line Amortization of Bond Discount and Bond Premium
Straight-line method Bond premium - $2,032,500 First period amortization $101,625
Straight-line amortization understates period interest expense by almost 5% $681,300 - effective rate $648,375 - straight-line rate
Straight-Line Amortization of Bond Discount and Bond Premium Amt. Amortized $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $ Total Interest
Straight-line method Bond premium - $2,032,500 First period amortization $101,625
Straight-line amortization understates period interest expense by almost 5% $681,300 - effective rate $648,375 - straight-line rate
Early Retirement of Bonds Payable
Bonds typically retired (paid off) at maturity date
Some bonds retired prior to maturity date
Why?
Early Retirement of Bonds Payable
Early retirement allows entity to reduce bond interest payments By paying off debt early Eliminating interest expense and cash outflow associated with bond interest payments Or by reissuing bonds at a lower interest rate Reducing interest expense and cash outflow related to interest payments
Early Retirement of Bonds Payable Issuer can retire bonds before maturity by:
Purchasing bonds on the secondary market (buying up all bonds currently held by bondholders)
Exercising
call
option
Clause allowing issuer to redeem bonds at specified price as of specific date
Early Retirement of Bonds Payable
After 6 years, the City of Blacksburg decides to call its 10% bonds Perhaps interest rates have fallen, and the City believes it can reissue the debt at lower rate Suppose the bonds came with a call provision, allowing the City to call bonds at 101
Early Retirement of Bonds Payable
What journal entry should the City make to retire these bonds?
5/1/x9 Bonds Payable $15,000,000 Premium on Bonds Payable 1,000,229 Gain on Bond Retirement $850,229 Cash 15,150,000
To record early bond retirement
Early Retirement of Bonds Payable
GAAP requires gain or loss on bond retirement to be shown as an
extraordinary item
on entity’s income statement
Reported on separate section of income statement, net of income tax effect
Convertible Bonds and Notes
Convertible bonds
allow bondholder to exchange bonds for specified number of shares of common stock in the company
Bonds issued with conversion feature generally carry
lower
interest rate
Bondholder willing to accept lower rate due to benefits of stock ownership
When bonds converted into common stock, company increases stockholders’ equity for carrying value of bonds
Chapter Objective 5
Explain the advantages and disadvantages of borrowing
Advantage of Financing Operations with Bonds v. Stock
Businesses can acquire assets through debt or equity
Debt:
can issue bonds, take mortgages, borrow funds to purchase assets
Equity:
can issue stock in the company, use proceeds to purchase assets
Advantage of Financing Operations with Bonds v. Stock
Financing with debt
Doesn’t dilute ownership in company
Usually results in higher earnings per share
Refer to textbook Exhibit 8-12
Reduces total net income
Increases debt ratios and may impose financial restrictions on company
Advantage of Financing Operations with Bonds v. Stock
Financing with equity
No liabilities = no increase in debt ratios No fixed interest payments Generally higher total net income Will dilute ownership interest and earnings per share of current stockholders
Chapter Objective 6
Account for lease transactions
Lease Liabilities
Rental agreement permitting lessee (user) to possess and use asset without long-term commitments or large cash down payment
Lease Liabilities
Operating leases
2 types of leases
Lease Liabilities
Operating leases
2 types of leases
Capital leases
Operating Leases
Short-term in nature Generally cancelable Right to undisturbed use of asset during lease period 6/1/98 Prepaid Rent $12,000 Cash $12,000
To record 12-month rent prepayment
Capital Leases
Long-term, non cancelable method of financing asset purchases
Airlines, railways, large retailers enter into long term leases for many of their plant assets
Lease must meet 1 of 4 criteria to be classified as a capital lease
Capital Leases
1. Leased asset becomes property of lessee at end of lease period 2. Lease includes
“bargain purchase”
option - for example, can buy asset for $100 at conclusion of lease 3.
Lease term is 75% or more of asset’s estimated useful life 4. Present value of lease payments is greater than 90% of asset’s market value
Accounting for Capital Leases
Accounting similar to purchased assets Lessee records leased asset and related lease liability Lessor removes asset from its records Record depreciation on lease cost Recognize interest expense as part of “cost” of acquiring leased asset (financing the asset acquisition over time)
Off-Balance-Sheet Financing
Some business financing activities use debt that is not required to be reported on the balance sheet
Operating leases are an example
Operating lease disclosures in footnotes are important to understanding company’s future obligations
Pension Liabilities
A
pension
is money employees receive after their retirement from an organization
Companies match (accrue) pension expense in the accounting period employees worked to generate revenues If company doesn’t accrue sufficient funds, excess liability is recognized as long-term pension liability
Detailed footnotes explain the current and future pension liabilities of the company
Chapter Objective 7
Report liabilities on the balance sheet
Reporting Current and Long-Term Liabilities on the Balance Sheet
Balance sheets of actual companies have wide variety of account titles and situations for which liabilities are recorded
Reported on face of balance sheet
Disclosed in footnotes to statements
Reporting Financing Activities on the Statement of Cash Flows
Financing activities on the statement of cash flows include: Cash received from issuing debt Cash paid to retire debt Cash received upon sale of stock Cash dividends paid to stockholders
World Wide Web Sites to Visit
AMR Corporation http://www.amrcorp.com/amr/amr_home.htm
Chrysler Corporation http://www.chrysler.com/
THE END Of Ch 8 Presentation Slides
Ch 8 Teaching Slides are Next
Categories of Current Liabilities
Amount of Liability Known When Recorded
Trade accounts payable Short-term notes payable Sales taxes payable Current portion of long-term debt Accrued expenses: Interest payable Payroll liabilities such as: Salaries and wages payable FICA tax payable Employee income tax payable Unearned revenues (collected in advance)
Amount of Liability Must Be Estimated When Recorded
Estimated warranty payable Income tax payable Estimated vacation pay liability Contingent liabilities © 1998 by Prentice Hall, Inc.
Contingent Liabilities
Potential liability dependent upon a future event arising out of a past transaction Accounting treatment
° Record a liability if probable and the amount of loss can be reasonably estimated ° Report in a note only if reasonably possible ° No need to report if remote (unlikely to occur) © 1998 by Prentice Hall, Inc.
Nature and Types of Bonds
Nature of Bonds
• In effect, a long-term note payable that bears interest.
• States that the issuer will repay the principal and specific interest payments.
• Usually in units of $1,000 called face value, maturity value, or par value.
• Interest is paid annually or semi-annually.
Types of Bonds
$1,000 Bond
Term bonds
- mature at the same time
Serial bonds
- mature in installments over time
Secured (mortgage) bonds
- give the bond holder the right to claim of assets if the issuer defaults
Debenture bonds
- unsecured bonds © 1998 by Prentice Hall, Inc.
Interest Payments and Interest Expense on Bonds Payable
Bonds Issued at a Discount $5,000 $4,900 $4,800 $4,700 $4,600 $4,500 $4,400 $4,300 $4,200 Interest Expense Interest Payments 1 2 3 4 5 6 7 8 9 Bonds Issued at a Premium $4,500 $4,400 $4,300 $4,200 $4,100 $4,000 $3,900 $3,800 $3,700 Interest Payments Interest Expense 1 2 3 4 5 6 7 8 9 10 10
© 1998 by Prentice Hall, Inc.
Financing with Debt Versus Stock
Investment Risk Corporate Obligation to Repay Long-term Debt
Low Yes
Dividends or Interest Obligation to Pay Dividends or Interest Market Value Fluctuations under Normal Conditions
Tax deductible Interest At Fixed Dates Low
Common Stock
High No Dividends Only After Declaration High © 1998 by Prentice Hall, Inc.
Other Types of Liabilities
Current Portion of Long-term Debt
The amount of long-term notes or bonds payable within the current period
Mortgage Notes
Borrowing agreement with assets pledged as collateral
Leases
• Capital leases long-term non-cancelable financing obligation reported as a liability • Operating lease short-term cancelable rental agreements
Off-balance-sheet Financing
Acquisition of assets or services with debt that is not reported on the balance sheet
Pensions and Post-retirement Benefits
Employee compensation and health benefits that will be received during retirement
Deferred Income Taxes
© 1998 by Prentice Hall, Inc.
Income tax liabilities that the company can defer and pay later
Financing Activities on the Statement of Cash Flows
Cash Flows From Financing Activities
Proceeds from issuance of long-term debt Other short-term borrowings Payments on long-term debt Payments on capital leases Payment of cash dividends $12,000 10,000 (4,000) (11,000) (8,000) Net Cash used for Financing Activities $( 1,000) © 1998 by Prentice Hall, Inc.
App D: Accounting for Partnership Slides Should be Inserted Here!