Liabilities in Perspective

1
Liabilities in Perspective

• Liabilities are one companys obligations to pay
  cash or to provide goods and services to other
  companies or individuals.
• Accrual accounting recognizes expense when they
  occur rather than when they are paid.
• When an expense is recognized before it is paid,
  a liability is created.

2
Liabilities in Perspective

• Liabilities are important to investors, financial
  analysts, management, and creditors.
• Excess liabilities often cause investors and
  creditors to stay away from the company.
• On the other hand, effective use of debt can make
  money for investors (financial leverage)

3
Liabilities in Perspective

• Liabilities are classified as either current or
  long term.
• Current liabilities - obligations that fall due
  within the coming year or within the companys
  normal operating cycle
• Long-term liabilities - obligations that fall due
  beyond one year from the balance sheet date
• If long-term liabilities are paid gradually, the
  portion that comes due within the year becomes a
  current liability.

4
Current Portion ofLong-Term Debt

• If long term liabilities are paid gradually, the
  portion that comes due within the year becomes a
  current liability.
• The journal entry to reclassify a liability is
• Long-term debt xxxx
• Current portion of long-term debt xxxx

5
Liabilities in Perspective

• Presentation of liabilities in the balance sheet
• Current liabilities
• Current maturities of long-term
  debt 19,500
• Accounts payable 26,250
• Wages payable 1,750
• Interest payable 2,500
• Total current liabilities 50,000

6
Contingent Liabilities

• Contingent liabilities - a potential liability
  that depends on a future event arising out of a
  past transaction
• Some contingent liabilities are certain in
  amount.
• Roberts Company may guarantee a loan for James
  Company. Roberts Company will pay if, and only
  if, James Company does not pay.
• This is a liability of James Company and a
  contingent liability of Roberts Company.

7
Contingent Liabilities

• More often, contingent liabilities are of an
  indefinite amount.
• Lawsuits are common examples. These are
  possible obligations of uncertain amounts.
• Taxes due are often another- IRS may challenge
  tax positions taken by the company
• Some companies show contingent liabilities on the
  balance sheet, but most disclose such items in
  the footnotes to the financial statements.
  Sometimes disclosures are not sufficient to
  assess the liability.

8
Contingent liabilities

• Contingent liability disclosure rules- FASB
  Statement 5
• Firm should recognize a contingent loss in the
  financial statements only if two criteria are met
• Information prior to the issuance of the
  financial statements indicates that it is
  probable that an asset has been impaired or a
  liability has been incurred.
• The amount of the liability can be reasonably
  estimated.

9
Notes Payable

• Promissory note (note payable) - a written
  promise to repay principal plus interest at
  specific future dates
• Notes payable can be classified as current or
  long term.

10
Notes Payable

• Rather than having to apply for many small loans
  at different times, companies obtain lines of
  credit with lenders.
• Line of credit - an agreement with a bank to
  automatically provide short-term loans up to some
  pre-established maximum
• The lender does not have to do extensive
  paperwork or credit checks every time a borrower
  needs money.
• The borrower has a preset amount of borrowing
  available.

11
Valuing Long-Term Liabilities

• Long-term liabilities are more difficult to value
  than short-term liabilities because of the long
  time frames involved.
• Long term liabilities are initially recorded at
  their present value.

12
Bonds and Notes

• Bond - formal certificate of indebtedness that is
  typically accompanied by (1) a promise to pay
  interest in cash at a specified annual rate plus
  (2) a promise to pay the principal at a specific
  maturity date
• The interest rate is often called the nominal
  interest rate, contractual rate, coupon rate, or
  stated rate.
• The principal amount is also known as the face
  amount or par value.

13
Bonds and Notes

• Interest rate - the percentage applied to a
  principal amount to calculate the amount of
  interest that must be paid on the loan
• Interest represents the return the lender can
  earn for loaning money.
• In general, riskier loans demand a higher
  interest rate.

14
Bonds and Present value

• When issued or acquired as an investment bonds
  are reported at their present value.
• The present value is the value of the stream of
  payments from the bond discounted at the market
  interest rate.
• The market rate may differ from the nominal rate
  used to determine cash amounts of interest paid.

15
Bond Accounting

• Suppose that on December 31, 1998, a company
  issued 1,000,000 in 5-year, 10 bonds at par
  value. Issuing the bonds at par value means that
  the nominal or coupon rate equals the market
  interest rate. Interest is to be paid
  semiannually on June 30 and December 31.
  Semi-annual interest payments are 5 every six
  months.

16
Bond accounting

• Assuming that the bonds are held to maturity, the
  journal entries are
• To record the issuance of the bonds
• Cash 1,000,000
• Bonds payable 1,000,000
• To record the payment of semiannual interest
  each six months the company records
• Interest expense 50,000
• Cash ((1,000,000 x 10) / 2)
  50,000
• To record the repayment of principal at maturity
• Bonds payable 1,000,000
• Cash 1,000,000

17
Present Value

• A city wants to issue 100,000 of
  non-interest-bearing bonds to be repaid in a lump
  sum in 5 years. How much should investors be
  willing to pay for the bonds if they require a
  10 return on their investment?
• 100,000 x .6209 62,090
• Investors should be willing to pay 62,090 for
  the bonds.

18
Present Value

• Remember to pay attention to the number of
  periods. Often interest is compounded
  semiannually instead of annually.
• If interest is compounded semiannually, the
  number of periods is twice the number of years,
  and the interest rate is one-half of the annual
  interest rate.
• In the previous example, if interest were
  compounded semiannually, the number of periods is
  10 instead of 5, and the interest rate is 5
  instead of 10.

19
Present Value of anOrdinary Annuity

• A city wants to issue 1,000,000 of
  non-interest-bearing bonds to be repaid 100,000
  per year for 10 years. How much should investors
  be willing to pay for the bonds if they require a
  10 return on their investment?
• 100,000 x 6.1446 614,460
• Investors should be willing to pay 61,446 for
  the bonds.

20
Accounting for Bond Transactions

• Bond - formal certificate of indebtedness that is
  typically accompanied by (1) a promise to pay
  interest in cash at a specified annual rate plus
  (2) a promise to pay the principal at a specific
  maturity date
• Bonds are often issued by corporations to finance
  operations or expansions.
• Bonds require periodic interest payments and
  repayment of principal at maturity.

21
Issuing and Trading Bonds

• The bond contract includes all terms of the
  bonds.
• Time to maturity
• Interest payment dates
• Interest amounts
• Size of the bond issue

22
Issuing and Trading Bonds

• The coupon rate on the bonds is initially set as
  close to the market rate as possible.
• Coupon rate is the interest to be paid on the
  bonds.
• Market rate is the rate available on investments
  in similar bonds at a moment in time.
• The market rate is affected by factors such as
  general economic conditions, industry conditions,
  risks of the use of the proceeds, and features of
  the bonds (callable, convertible, etc.).

23
Issuing and Trading Bonds

• Bonds may be sold at, above, or below par value
• If the bonds are sold for more than par, they are
  sold at a premium.
• If the bonds are sold for less than par, they are
  sold at a discount.
• Premiums and discounts do not reflect the credit
  record of the issuer they merely reflect the
  difference in interest rates.

24
Issuing and Trading Bonds

• When a bond sells at a premium or discount, the
  yield to maturity (effective interest rate)
  differs from the coupon rate.
• Yield to maturity (effective interest rate) - the
  interest rate that equates market price at issue
  to the present value of principal and interest
• The interest paid in cash is calculated by using
  the coupon rate, not the effective rate.

25
Issuing and Trading Bonds

• Bonds are usually issued in increments of 1,000,
  but they are usually expressed in terms of par.
• For example, a 1,000 bond quoted at 102 is
  selling for 1,020 (1,000 x 102).
• Current yield - annual interest payments
  divided by the current price of a bond

26
Assessing the Riskiness of Bonds

• Risk plays a large part in determining the coupon
  rate of interest on bonds.
• The riskier a bond, the higher the interest rate
  investors will require before making the
  investment.
• Rating companies, such as Moodys and Standard
  and Poors, rate the bonds for investors.
• Higher ratings are safer and have lower interest
  rates.
• Lower ratings are riskier and have higher
  interest rates.

27
Valuing Bonds

• Because bonds create cash flows in future
  periods, they are recorded at the present value
  of those future payments, discounted at the
  market interest rate in effect when the liability
  is created.
• Discount on bonds - The market interest rate is
  greater than the coupon rate.
• Premium on bonds - The market interest rate is
  less than the coupon rate.

28
Valuing Bonds

• When valuing bonds, the present value tables are
  used to determine the amount of proceeds that
  will be received.
• The present value of 1 table is used to
  determine the present value of the face amount of
  the bonds. B2
• The present value of an annuity in arrears of 1
  is used to determine the present value of the
  series of interest payments.B-3
• The amounts are added together to determine the
  amount of proceeds and premium or discount.

29
Valuing Bonds

• A company issues 20,000,000 of 5-year bonds
  with a coupon rate of 7. Interest is to be paid
  semiannually on June 30 and December 31 of each
  year. At the time of the issuance, the market
  rate is 10. What is the amount of the proceeds
  and any premium or discount on the bonds?

30
Valuing Bonds

• To determine the proceeds
• 20,000,000 x .6139 12,278,000
• 700,000 x 7.7217 5,405,190
• 17,683,190
• 
  
• (700,000 (20,000,000 x 7) / 2)
• PV factors for 10 years at 5
• The company will receive 17,683,190 upon
  issuance.
• The bonds are issued at a discount of 2,316,810.

31
Bonds Issued at a Discount

• When bonds are issued at at discount, the amount
  of proceeds received from the issuance is less
  than the actual liability.
• The difference must be recorded in a separate
  account on the books.
• Cash 17,683,190
• Discount on bonds payable 2,316,810
• Bonds payable 20,000,000

32
Bonds Issued at a Discount

• The discount on bonds payable is a contra
  account it is deducted from bonds payable.
• Balance sheet presentation
• Bonds payable, 7 20,000,000
• Deduct Discount on bonds payable 2,316,810
• Net liability 17,683,190

33
Bonds Issued at a Discount

• For bonds issued at a discount, the discount can
  be thought of as a second interest amount payable
  to the investors at the maturity date.
• Rather than recognizing the extra interest
  expense all at once upon maturity, the issuer
  should spread the extra interest over the life of
  the bonds.
• This is accomplished by discount amortization.
• The amortization of a discount increases the
  interest expense of the issuer.

34
Bonds Issued at a Discount

• Discount amortization can be calculated using
  two methods.
• Straight-line amortization
• The discount is an equal amount each period,
  but the effective interest rate is different each
  period.
• Effective interest amortization
• The effective interest rate is the same each
  period, but the discount is a different amount
  each period.

35
Bonds Issued at a Discount

• Amortization using the effective interest method
• Interest expense is equal to the carrying value
  of the debt multiplied by the market rate of
  interest in effect when the bond was issued.
• The cash interest payment is the coupon rate
  times the face amount of the bonds.
• The difference between the interest expense and
  the cash interest payment is the amount of
  discount amortization for the period.

36
Amortization Table
37
Bonds Issued at a Discount

• Journal entries
• To record the issuance of the bonds
• Cash xxxxxx
• Discount on bonds payable xxxx
• Bonds payable xxxxxx
• To record the payment of interest and discount
  amortization
• Interest expense (Carrying value x market
  interest) xxx
• Discount on bonds payable xx
• Cash (Face value x coupon rate)
  xx

38
Bonds Issued at a Premium

• Accounting for bonds issued at a premium is just
  the reverse as accounting for bonds issued at a
  discount.
• The cash proceeds exceed the face amount.
• The amount of the contra account Premium on Bonds
  Payable is added to the face amount to determine
  the net liability reported in the balance sheet.
• The amortization of bond premium decreases the
  interest expense to the issuer.

39
Early Extinguishment

• When a company redeems its own bonds before the
  maturity date, the transaction is called an early
  extinguishment.
• Early extinguishment usually results in a gain or
  loss on the extinguishment.
• The gain or loss is the difference between the
  cash paid and the net carrying amount (face
  amount less unamortized discount or plus
  unamortized premium) of the bonds.

40
Early Extinguishment

• Allen Company purchased all of its bonds on the
  open market at 98. The bonds have a face amount
  of 100,000 and a 12,000 unamortized discount.
  Determine any gain or loss on the early
  extinguishment, and prepare the journal entries
  to record the transaction.

41
Early Extiguishment

• Carrying amount
• Face value 100,000
• Deduct unamortized discount
  12,000 88,000
• Cash required (100,000 x 98) 98,000 Loss on
  early extinguishment 10,000
• Bonds payable 100,000
• Loss on early extinguishment 10,000
• Cash 98,000
• Discount on bonds payable 12,000

42
Non-Interest-BearingNotes and Bonds

• Some notes and bonds provide for the payment of a
  lump sum at a specified date instead of periodic
  interest payments.
• Zero coupon - a bond or note that pays no cash
  interest during its life
• These notes are sold for much less than the face
  or maturity value, which makes up for the lack of
  periodic interest payments.

43
Non-Interest-BearingNotes and Bonds

• On zero coupon notes, the market value is
  determined by calculating the present value of
  the maturity value, using the market rate of
  interest for similar notes.
• The discount is amortized over the life of the
  note.
• The discount is amortized as interest expense to
  the issuer.
• The discount is amortized as interest revenue to
  the investor.

44
Non-Interest-BearingNotes and Bonds

• Implicit interest - an interest expense that is
  not explicitly recognized in a loan agreement
• Imputed interest rate - the market interest rate
  that equates the proceeds from a loan with the
  present value of the loan payments
• The discount and interest are recorded in the
  same manner as with interest-bearing notes,
  except that no cash is exchanged.

45
Accounting for Leases

• Lease - a contract whereby an owner (lessor)
  grants the use of property to a second party
  (lessee) for rental payments
• Some leases are recorded simply as if one party
  is renting property from another.
• Other leases are recorded as liabilities and
  assets when the lease contract is signed.

46
Operating and Capital Leases

• Capital lease - a lease that transfers
  substantially all the risks and benefits of
  ownership to the lessee
• They are the same as installment sales which
  provide for the payment over time along with
  interest.
• The leased item must be recorded as if it were
  sold by the lessor and purchased by the lessee.

47
Operating and Capital Leases

• Operating lease - a lease that should be
  accounted for by the lessee as ordinary rent
  expenses - any lease other than a capital lease
• Examples include rental of an apartment or rental
  of a car on a daily basis.

48
Operating and Capital Leases

• Differences in accounting for operating and
  capital leases
• Operating - treat as rental expense
• Rent Expense xxx
• Cash xxx
• Capital - treat as if the lessee borrowed the
  money and purchased the leased asset
• Leased property xxxx
• Capital lease liability xxxx

49
Differences in Income Statements

• The major difference in the income statements for
  a capital lease and an operating lease is the
  timing of the expenses.
• A capital lease tends to bunch heavier charges in
  the early years. These charges are the
  amortization of the lease plus the interest
  factor.
• An operating lease records the payments directly
  as expenses, generally in a straight-line manner.
• For comparable leases, the total expense are the
  same.

50
Criteria for Capital Leases

• Before GAAP established criteria for leases to be
  classified as capital leases, many companies were
  keeping off balance sheet financing by treating
  noncancellable leases as monthly rentals.
• These leases created assets and liabilities
  that the companies were not recognizing.

51
Criteria for Capital Leases

• Under GAAP, a capital lease exists if one or more
  of the following conditions are met.
• Title to the leased property is transferred to
  the lessee by the end of the lease term.
• An inexpensive purchase option is available to
  the lessee at the end of the lease.
• The lease term equals or exceeds 75 of the
  estimated economic life of the property.
• At the start of the lease, the present value of
  minimum lease payments is at least 90 of the
  propertys fair value.

52
Constructive capitalization

• Used by analysts to examine the effect of
  operating leases as if they were capitalized.
• Use footnote disclosures to determine the present
  value of minimum lease payments
• Add this to liability and the same amount as a
  long term asset.