9-1 Definitely Determinable Liabilities Obligations that can be measured exactly E.g., bank loans, accounts payable, notes payable, salaries payable

9-1

Definitely Determinable Definitely Determinable LiabilitiesLiabilities

Obligations that can be measured exactlyE.g., bank loans, accounts payable,

notes payable, salaries payableAccounting for payroll

Firms must supply the government with information for each workerFederal, state, and Social Security taxes

9-2

Definitely Determinable Definitely Determinable LiabilitiesLiabilities

Accounting for payrollGross pay

Wages/salary before any deductionsDeductions

Federal income tax (FIT) withheldFIT Payable

FICA tax withheld (6.2% of salary)FICA Payable

Medicare tax withheld (1.45% of salary)Medicare Taxes Payable

Accounting for payrollEmployer must match employee

deduction for FICA and MedicareEmployer’s Payroll Tax Expense

9-3

Estimated LiabilitiesEstimated LiabilitiesAccounting for warranties

Obligation is not certain, so it is estimatedWarranty Payable and related Warranty

Expense recognized in year product is sold regardless of duration of the warranty

Accounting for warrantiesRepairs or replacement under warranty

Cash, parts inventory, and/or merchandise inventory decreases (credit)

Warranty Payable decreases (debit) because part of the warranty liability is satisfied

9-4

Warranty Example1. Electronics Universe (EU) sells $20,000 of

consumer electronics for cash during September with a 2-year warranty (ignore CoGS)

2. EU estimates that warranty work related to the sales will be 3% of sales.

3. During September, EU pays $100 cash and uses $80 of parts to satisfy warranty claims

9-5

Long-term Notes Payable and Long-term Notes Payable and MortgagesMortgages

Short-term notes Mature in < 1 yrInterest and principal usually paid at the

end of the term Long-term notes

Mature in > 1 yrOptions for repayment

Repay in one lump sum (principal + interest)Repay in equal annual payments

Payments combine principal and interestAs loan is repaid outstanding balance of loan

decreases, so the interest portion of the payment decreases and the principal portion increases

9-6


Present valueValue today of a given amount to be

paid or received in the futureBoth the principal and interest not paid

or received are earning interest at the discount rate

Discount rateInterest rate used to compute the present

value of the future cash flows

9-7


Present value (continued)If you deposited $100 in the bank at

5% interest, at the end of the year you would have $105The present value of receiving $105 one

year from now at a 5% discount rate is $100

Repaying a mortgage

9-8

Repaying a MortgageThe Universe borrows $200,000 on

1/1/08Discount rate: 7% Term of loan: 4 yearsPayments at end of each year:

$59,046Make journal entries for first two

yearsSee the amortization table on the

next slide?

9-9

Repaying a Mortgage

A B C D E

Yr Beg Prin

Mtg Pmt

Int ExpA x int %

Prin Paid B - C

End PrinA + D

1 200,000 59,046 14,000 45,046 154,954

2 154,954 59,046 10,847 48,199 106,756

3 106,756 59,046 7,473 51,573 55,183

4 55,183 59,046 3,863 55,183 0

9-10

Long-term Liabilities: Long-term Liabilities: Raising Money by Issuing Raising Money by Issuing

BondsBondsWhat is a bond?Types of bondsIssuing bonds payablePaying interest to bondholdersMarket for trading bonds

9-11

What Is A Bond?

An interest-bearing, long-term note payableInterest is usually paid to the

bondholder semi-annuallyPrincipal is repaid at maturityOnly corporations and governmental

agencies can issue bondsFace value (stated value) usually $1,000

9-12

Types of BondsSecured vs. unsecured

Do bondholders have a claim to specific assets if the corp defaults on the bonds?

Term vs. serialDo bonds mature all at once or do they mature

periodically over several years?Convertible

Bondholder has option to convert bond into specified # of shares of stock Callable

Corp has option to redeem bond before maturity, usually for more than the bond’s face value

Junk bondRated at below investment grade

9-13

Issuing Bonds PayableBond terminologyIssue priceIssuing bonds at parIssuing bonds at a discountIssuing bonds at a premium

9-14

Bond TerminologyMarket rate of interest

Interest rate based on the type of bond, the duration, and the risk that the issuer will default on the bond

Market interest rate fluctuates dailyUsed as the discount rate to determine

The issue priceInterest expense issuer recognizes

Stated rate of interestInterest rate on face of bondDetermines cash flow of interest

Face value x stated rate = interest paymentDoes not fluctuate over life of bond

9-15

Issue PriceStated Rate = Market Rate

Interest payments received = mkt rateBonds sell at a PAR

No difference between issue price and face value

Issuing corp’s interest payments equal to interest expense

9-16

Issue PriceStated Rate < Market Rate

Interest payments received < mkt rateBonds sell at a DISCOUNT

Difference between issue price and face value fairly compensates investor for accepting lower interest payments

Issuing corp’s interest expense is greater than the interest paid to investors

9-17

Issue PriceStated Rate > Market Rate

Interest payments received > mkt rateBonds sell at a PREMIUM.

Difference between issue price and face value reduces investor’s return to equal the market interest rate because interest payments are greater than the market rate

Issuing corp’s interest expense is less than the interest paid to investors

9-18

Issuing Bonds at Par

Start-up Corporation issues 100, $1,000 5-year bonds at 6% when the market rate = 6%

No discount or premium because stated rate = market rate

The bonds are issued at 100100% of par

9-19

Issuing Bonds at a Discount

Start-up Corporation issues 100, $1,000 5-year bonds at 6% when the market rate = 7%

The discount is $4,100What is the issue price?

Bond discount is a contra-liabilityCarrying value

Bond Payable - Discount on Bond Payable

9-20

Issuing Bonds at a Premium

Start-up Corporation issues 100, $1,000 5-year bonds at 6% when the market rate = 5.3%

The premium is $3,000What is the issue price?

Bond premium is an adjunct liabilityCarrying value

Bond Payable + Premium on Bond Payable

9-21

Paying Interest to Bondholders

Interest = principal x int rate x timeBonds issued at par

No discount or premium to amortizeStraight-line amortization per payment

Discount (or premium) / # of paymentsAs the bond matures, the carrying

value gets closer to the par valuePremium/discount account gets smaller

9-22


Bonds issued at a discountA portion of the discount is ADDED to

the interest payment to compute the interest expenseInterest pmt + discount amortized

5-year bond with a $4,100 discountCompute the discount amortized per

year

9-23


Bonds issued at a premiumA portion of the discount is SUBTRACTED

from the interest payment to compute the interest expenseInterest pmt - premium amortized

5-year bond with a $3,000 premiumCompute the premium amortized per yearMake the journal entry for the first year

9-24

Market for Trading BondsAfter bonds are issued, they are

traded in a secondary marketThe value of a bond fluctuates

daily depending on the market rate of interest

What happens to the value of a bond if the market interest rate increases? Decreases?

9-25

Capital StructureThe combination of debt and

equity a company uses as its source of capital

What other source of capital does a company have besides debt and contributed capital?

Generally, a company should only use debt financing when the return exceeds the cost of borrowing

9-26

Financial LeverageUsing borrowed funds to increase

earnings for the shareholders (owners)Increase return on equity

Positive financial leverageEarnings on borrowed money > cost of

borrowing moneyWhat is the cost of borrowing money?

9-27

Debt-to-equity RatioCompares value of creditors’ claims

to value of owners’ claimsMeasure of long-term risk

Which is riskier, financing with equity or financing with debt? Why?

Total liabilities _ Total shareholders’ equity

9-28

Times-interest-earned RatioMeasures a company’s ability to

make interest payments on its debtMeasure of short-term solvency

Income from operationsInterest Expense

Income from operations is used because it is more comparable across companies than net income. Why?

9-29

Business Risk, Control, and Business Risk, Control, and EthicsEthics

Risk associated with long-term debtNot being able to make debt

paymentsHow to minimize risk of defaulting

on debtSound business analysis accompanies

any decision to borrow moneyEvaluate types of debt for company’s

circumstances

9-30

Time Value of MoneyYou did some gardening for a

neighbor. The neighbor offers to pay you $100. Would you rather receive it when the job is finished or a year later?Receiving a dollar today is worth more

than receiving a dollar in the future. Why?

9-31

Simple vs. Compound Interest

Simple interestInterest is computed on principal

onlyShort-term loans use simple interest

Compound interestInterest computed on principal

PLUS interest accrued, but not paidInvestments grow much faster

when interest is compounded (Exhibit 9A.1)

9-32

Present Value of a Single Amount

FVn = PV (1 + i)n

where n = the number of yearsi = the interest ratePV = the present value of the future

sum of moneyFVn = the future value of the

investment at the end of n years

PV = FVn x [1/(1+i)n]

9-33

Present Value of an AnnuityAnnuity

A series of equal cash flows over equally spaced time intervals

Ordinary annuityPayments made at the end of the period

PV = (1/i) x {1-[1/(1+i)n]}

9-34

Appendix B: Bond Appendix B: Bond ProceedsProceeds

Proceeds from a bond is the sum of two cash flowsPresent of a single amount

Receiving the face value upon maturity of the bond

Present value of an annuityThe periodic interest payments

9-35


Bond issued at a premiumStated rate > market rate

Compute price on 10-year $1,000 bondStated rate is 6% and market rate is

5%How much interest is received each

period?

9-36


1.Present value of the annuity 10 periods, 5% per period, $60 per

pmt. $60 x 7.72173 = $463

2.Present value of the face value 10 periods, 5%, $1,000. $1,000 x 0.61391 = $614

Bond price: $463 + $614 = $1,077

9-37


Bonds issued at a discountStated rate < market rate

Compute price on 10-year $1,000 bondStated rate is 4% and market rate is

5%How much interest is received each

period?

9-38


1.Present value of the annuity 10 periods, 5% per period, $40 per

pmt. $40 x 7.721735 = $309

2.Present value of the face value 10 periods, 5%, $1,000. $1,000 x 0.61391 = $614

Bond price: $309 + $614 = $923

9-39

Appendix C: Bond Appendix C: Bond AmortizationAmortization

Effective interest methodActual interest expense on outstanding

principal balanceActual interest expense

[carrying value] x [mkt rate at issue] x [time]

Difference between interest payment and interest expense is the amount of premium/discount amortized for the period

9-40

Appendix C: Bond Appendix C: Bond AmortizationAmortization

Straight-line vs. effective interest methodStraight-line

Interest rate changes; interest expense is constantEffective interest method

Interest rate is constant; interest expense changesGAAP, but straight-line may be used if difference

between the two methods is not material

9-41

Appendix D: Leases and Appendix D: Leases and PensionsPensions

Capital leasesAccounted for as a purchase and a

loanAsset recorded on booksLiability recorded for future lease pmts

Obligations Under Capital LeasesDetails in notes to financial

statements

9-42

Appendix D: Leases and Appendix D: Leases and PensionsPensions

PensionsLiability increases for defined benefit

plans when cash payment to pension fund is less than the annual obligation

FASB requires disclosure of a great deal of information about pension plan and funding

9-43

Assign #3: pg. 477-478 - E9-6A, E9-9A; Assign #4: pg. 483-484 - P9-1A, P9-4A.

Documents

9-1 Definitely Determinable Liabilities Obligations that can be measured exactly E.g., bank loans, accounts payable, notes payable, salaries payable