Chapter 9 Reporting and Understanding Liabilities

Chapter 9

Reporting and Understanding Liabilities

In Chapter 8

You learned:

o How to account for the purchase and use of long-term assets

o How to calculate depreciation using various methods

In Chapter 9 and Appendix A

You will learn:

o How firms account for current and non-current liabilities

o Types of Liabilities (definite, estimated, contingent)

o Notes, mortgages

o BONDS!

Appendix A

Time Value of $$$$$$$$$$Present ValueFuture Value

Reporting Current and Non-Current Liabilities

Current Liabilities are debts that will be

settled within the next year

Long-term Liabilities are debts that will NOT be settled

within the next year

Payroll related liabilities

I worked 40 hours this week. My hourly rate

is $12.50.

I’ll take your time sheet and you’ll get your

check on Friday

I wonder how much my

check will be

Gross Pay

Where does your paycheck go?

Payday!

Think about your pay stub….

Gross Pay

FIT FICA-SS

FICA – Med

Other Net Pay

Gross Pay = # of hours worked at hourly rate

40 hours @ $12.50$500.00

FIT = Federal Income Tax Withholding The amount is determined based on the employee’s wages,

marital status and number of dependents

Assume 20%

20% of $500 =$100.00

FICA (SS) = Social Security Taxes withheld. This amount is 6.2% of gross wages

$500 * 6.2%$31.00

FICA (Med) = Medicare Taxes withheld. This amount is 1.45% of gross wages

$500 * 1.45%$7.25

As authorized

Other Employee-Authorized deductions to include: Health Insurance, Union Dues, 401k contributions,

gifts to charity

Gross Pay – FIT – FICA – Medicare = Net Pay

$500.00 - $100.00 - $31.00 - $7.25 = $361.75

$361.75

Journal Entry for Salaries Expense

Gross Pay

FIT FICA-SS

FICA – Med

Other Net Pay

Debit Salaries Expense$500.00

Credit FIT Payable$100.00

Credit FICA

Payable$31.00

Credit Medicare Payable$7.25

Credit Other

Payables

Credit Cash$361.75

Employer Payroll Tax Expense

In addition to the Gross Pay, the employer is responsible for:

o Matching amounts for Social Security and Medicare

o State and Federal Unemployment Taxes

o Other State and Local taxes

$7.25

Employer’s Payroll Tax Expense

Gross Pay

FIT FICA-SS

FICA – Med

Other Net Pay

Debit Salaries Expense$500.00

Credit FIT Payable$100.00

Credit Other

Payables

Credit Cash$361.75$31.00

Amounts withheld from Employees

$7.25Matched by Employer$31.00

Matched by Employer$7.25

Paid to the Governmental Agency

Total Withheld .Total Withheld plus Employer’s Tax is paid to Governmental Agency

+ Employer Match

Accounting for Warranties

When products are sold with warranties, a liability is estimated and recorded.

This records the expense in the same time period as the resulting revenue (Matching Principle)

Warranty ???

How do companies know how much to put in the Warranty accrual?? (Where did the $1,400 come from)???

Satisfying Warranty Obligations

When a warranty claim is made, the cost is written off against the liability

This transaction has no affect on net income, even if the claim is made in a subsequent accounting period.

Disclosing Warranty Information

Details of Warranty obligations are disclosed in the notes to the financial statements

Contingent Liabilities – must be:

ProbableReasonably estimated

Long-Term Notes Payable and Mortgages

Company has borrowed funds for more than one year

Principal payments may be made periodically (e.g. a car payment) or as a lump-sum at the maturity date.

“Discounting” is the process of eliminating the interest portion of each payment.

Formula for Interest:

Repaying principal and interest

Payment amounts are calculated using present value charts, found in the appendix of your text

Each payment is allocated to partly to principal and partly to interest.

A schedule of principal versus interest is called an amortization schedule

Payment = $38,803.35Interest = $8,000

Principal = $30,803.35

Let’s assume that you borrow $100,000 at 8% for three years. And that your payment has been calculated at $38,803.35

Beginning Balance

Interest Rate

Interest Expense

Payments Ending Balance

Beginning Debt Balance = $100,000 Principal

$100,000 $8,000

$38,803.35 $69,196.65

X 8% =

Since payments will be made annually, the annual interest rate is used.

$8,000 Interest is added to the amount owed. $108,000 is owed before the payment is applied

Using Present Value Factors, Annual Payments are determined to be $38,803.35

Total Payment = $38,803.35 ($8,000 Interest + $30,803.35 Principal)

Let’s follow this for the remaining two years…..

Beginning Balance

Interest Rate

Interest Expense

Payments Ending Balance

Amount Owed$100,000

8% annual rate $8,000.00

Annual Payment

$38,803.35

$69,196.65X 8% =

$69,196.65 X 8% =$5,535.7

3

Since the Balance owed has decreased, so has the interest amount.

$38,803.35 $35,929.03

Total Payment = $38,803.35 ($5,535.73 Interest + $33,267.62 Principal)

$35,929.03 X 8% =$2,874.3

2$38,803.3

5

Total Payment = $38,803.35 = ($2,874.32 Interest + $35,929.03 Principal)

$0

$100,000$108,000

$69,197$74,732

$35,929 $38,803

$-$-

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

Change in Debt Balance

+ 8% Interest - $38,803 payment+ 8% Interest - $38,803 payment+ 8% Interest - $38,803 payment

____________

________________________

____________

The carrying value of the debt changes based on the relationship between the interest expense and the

payments on the debt

Long-term bonds

Bonds are long-term debt agreements

The contractual agreement specifies a fixed series of repayments to include

A series of either annual or semi-annual interest payments

A lump sum payment (face value)

Bonds – Contractual Agreements

Bonds - Terminology

Example:

On January 1, 2006, Hewlett-Packard issues a 5-year, 4.5%, $1,000 bond with interest payable annually.

Face Value – Lump Sum payment at the end of the bond

Term – Number of years until the Face Value is Repaid

Stated “Interest” Rate – Cash Repayment Rate used to calculate the annual or semi-annual payments. This amount may be

more or less than the actual interest rateCompounding Mode – # of payments per year

Types of Bonds

Bonds – Calculating the Cash Flows

Example:

On January 1, 2006, Hewlett-Packard issues a 5-year, 4.5%, $1,000 bond with interest payable annually.

Calculating the periodic interest payments

1. Multiply the Face Value by the Stated %

2. Divide by the number of payments per year (1 for annual, 2 for semi-annual)

$1,000

X 4.5%

= $45

÷ 1 pay/year

= $45

Bonds – Promise to repay fixed amounts

Example:

On January 1, 2006, Hewlett-Packard issues a 5-year, 4.5%, $1,000 bond with interest payable annually.

2007

$45

2008

$45

2009

$45

2010

$45

2011

$45

Face Value$1,000Total Repayments = $1,225 (5 payments of $45 + 1

payment of $1,000)

Bond prices fluctuate inversely with market rates

I have read the bond several

times, but I don’t know how much I

will be able to borrow!

That’s true! The amount you will be able to raise

from the bonds

Is dependent on the Market

Rate of Interest

This promise is evaluated by the market

Example:

On January 1, 2006, Hewlett-Packard issues a 5-year, 4.5%, $1,000 bond with interest payable annually.

2007

$45

2008

$45

2009

$45

2010

$45

2011

$45

Face Value$1,000The market rate of interest is used to calculate the selling

price of the bond

2006

Amount Borrowed = Present

Value

So the More I Repay, the More I Can

Borrow!The Stated Rate is the Payment

Rate

The Higher the Stated Rate,

The Higher the Selling Price

Stated Rate is Lower

Amount Borrowed is

Lower

Stated Rate is Higher

Amount Borrowed is Higher

Journal Entries for Bonds Issued at Par

Interest is the Difference between the amount borrowed and the amount repaid

Hewlett-Packard issues a 5-year, 4.5%, $1,000 bond with interest payable annually.

Amount Repaid

- Amount Borrowed

= Interest

$1,225

- $1,000

= $ 225

If the Stated Rate = Market Rate

If the Stated Rate <

Market Rate

$1,225

- $1,000

= $ 225

If the Stated Rate >

Market Rate

$1,225

- $1,000

= $ 225LowerHigher

HigherLower

$245

$ 980 $1,020

$205

Journal Entries for Bonds Issued at a Discount

◄ A contra-liability account

Balance Sheet Presentation

◄ Selling Price is 98% of Face Value

Journal Entries for Interest on Bonds issued at a Discount Amount Repaid

- Amount Borrowed

= Interest

$1,225

- $1,000

= $ 225$245

$ 980

$245 Total ÷ 5 years =

$20 Discount ÷ 5 years =

Amortization Schedule – Bonds Issued at a Discount

The Carrying Value always moves toward the Face Value

Journal Entries for Bonds Issued at a Premium

◄ An adjunct liability account

Balance Sheet Presentation

◄ Selling Price is 102% of Face Value

Journal Entries for Interest on Bonds issued at a Discount Amount Repaid

- Amount Borrowed

= Interest

$1,225

- $1,000

= $ 225$205

$ 1,020

$205 Total ÷ 5 years =

$20 premium ÷ 5 years =

Amortization Schedule – Bonds Issued at a Premium

The Carrying Value always moves toward the Face Value

Financial Statement Ratios

Risk/Controls

Risk – can’t pay back debt when DUEReview before borrowingPick the BEST loan around for your

needs:Best interest rate?Quickest funding source?

Be WARY of “Off Balance Sheet financing” schemes……Enron….

Appendix A….

Appendix A

Do compound interest calculations! Future Value

Present Value

Time Value of Money. . . .

What is Simple Interest?

You borrow $5,000

For 2 years

At 12%

$5000 * 12% = 600

$5000 * 12% = 600

$1,200 __________

Time Value of Money. . . .

What is Compound Interest?You put $7,938 in a bankFor 3 yearsAt 8%$7938 * 8% = 635$8574 * 8% = 686$9259 * 8% = 741

$2,062 __________

What about Annuities?

If I put $3000 in an account each December, what will it be worth in 3 years?“

We know Present Value: $3,000 Interest Rate: 8% Table ____ Factor: ____ Future Value? _____

Present Value: what’s it worth now?

Single Amount Example: What do I have to put into the bank NOW, to have $10,000 in 3 years?“ assume 8%

We know Present Value: _____ Interest Rate: 8% Table ____ Factor: ____ Future Value? $10,000

Present Value: what’s it worth now?

Annuity Example: "I'm making payments of $3,000 for the next 3 years. If I chose NOT to pay on time, but pay in CASH, what would they charge me?"

We know Present Value: _____ Interest Rate: 8% Table ____ Factor: ____ Payments: $3,000

Appendix A – applications -3

I’m promised $100 in one year. How much is it worth TODAY (assume 10%)

We know Present Value: _____ Interest Rate: 10% Table ____ Factor: ____ Future Value $100 Payment: ________

Appendix A – applications -4

You sell your motorcycle and the person will pay you $500 for four years. Assume interest = 5%)

We know: Present Value: _____ Interest Rate: 5% Table ____ Factor: ____ Future Value ______ Payment: $500

Appendix A – applications –other

Installment notes Valuing a bond Recording leases Pension obligations Debt Depreciation of PPE Capital expenditure decisions Anywhere TIME is involved. . . . .

Summary

AP TurnoverDefinitely determinable liabilitiesContingent LiabilitiesKnow SIMPLE & COMPOUND interestUse Appendix D and solve time value

problems

End – Chapter 9

What would happen to your credit card balance…..

Beginning Balance

Interest Rate

Finance Charge

Payments Ending Balance

If each month, your payment was equal to the finance charges

Amount Owed

$2,500.00

12% annual rate

1% per month $25.00

Payments equal 1%$25.00 $2,500.00x 1% =

Your debt balance would stay constant throughout the term of the debt.

When the Interest Rate is equal to the payment rate, the debt balance is unchanged.

What would happen to your credit card balance…..

Beginning Balance

Interest Rate

Finance Charge

Payments Received

Ending Balance

If each month, your payment was less than the finance charges

Amount Owed$2,500.00

24% annual rate

2% per month $50.00

Payments equal 1.5%$37.50 $2,512.50X 2% =

Your debt balance increases throughout the term of the debt.

When the Interest Rate is greater than the payment rate, the debt balance increases.

What would happen to your credit card balance…..

Beginning Balance

Interest Rate

Finance Charge

Payments Received

Ending Balance

If each month, your payment was more than the finance charges

Amount Owed$2,500.00

12% annual rate

1% per month $25.00

Payments equal 1.5%$37.50 $2,487.50X 1% =

Your debt balance decreases throughout the term of the debt.

When the Interest Rate is less than the payment rate, the debt balance decreases.

Appendix A – applications -1

Investing IDLE CASH. . . .Let’s invest $10,000,000 for half a year at 12%,

compounded monthly. We know

Present Value: _____ Interest Rate: 12% Table ____ Factor: ____ Future Value? ______ Payment ______

Appendix A – applications - 2

We need to pay off a loan, worth $100,000 in five years, by making annual deposits into a bank account.

We know Present Value: _____ Interest Rate: 12% Table ____ Factor: ____ Future Value ______ Payment: ________

If Stated Rate

$980

$1,031

$986

$1,038

$993

$1,045

$1,000

$970

$980

$990

$1,000

$1,010

$1,020

$1,030

$1,040

$1,050

When we apply this logic to bonds, we see that the carrying value will increase to the face value

+ Inter

est @

5.0%

MR

- Paym

ents @

4.5%

SR +

Inte

rest

@

5.0

% M

R

- Paym

ents @

4.5%

SR + In

teres

t @

5.0%

MR

-Paym

ents

@ 4.5%

SR

____

____________ ____________

____________

Selling Price

< Market Rate

< Face Value

SR = Stated Rate < MR = Market Rate

If Market Rate

$1,000

$1,045

$1,000

$1,045

$1,000

$1,045

$1,000

$995

$1,000

$1,005

$1,010

$1,015

$1,020

$1,025

$1,030

$1,035

$1,040

$1,045

$1,050

When Market Rate = Stated Rate Bonds Sell at Face Value

+ In

tere

st @

4.5

%

Mar

ket R

ate

- Paym

ents @

4.5%

Stated

Rate

+ In

tere

st @

4.5

%

Mar

ket R

ate

- Paym

ents @

4.5%

Stated

Rate

+ In

tere

st @

4.5

%

Mar

ket R

ate

- Paym

ents @

4.5%

Stated

Rate____________

____________ ____________

____________

Interest Expense

= Stated Rate

= Payments .

Selling Price

Face Value

=

If Stated Rate

$1,020

$1,059

$1,014

$1,052

$1,007

$1,045

$1,000

$990

$1,000

$1,010

$1,020

$1,030

$1,040

$1,050

$1,060

$1,070

When we apply this logic to bonds, we see that the carrying value will decrease to the face value

+ Inter

est @

4.0% M

R

- Paym

ents @

4.5%

SR

+ Inter

est @

4.0 % M

R

- Paym

ents

@ 4.5%

SR + In

terest

@

4.0% M

R

-Paym

ents

@ 4.5%

SR

____

__

__

_

Selling Price > Market Rate

> Face Value

SR = Stated Rate > MR = Market Rate