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