4/10/2012. Liabilities and Interest. Learning Objectives (LO) LO 1 Current Liabilities. LO 1 Current Liabilities. LO 1 Current Liabilities

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1 Learning Objectives (LO) Liabilities and Interest CHAPTER 9 After studying this chapter, you should be able to 1. Account for current liabilities 2. Measure and account for long-term liabilities 3. Account for bond issues over their entire life 4. Value and account for long-term lease obligations 5. Evaluate pensions and other postretirement benefits 6. Interpret deferred tax liabilities 7. Use ratio analysis to assess a company s debt levels 8. Compute and interpret present and future values Pearson Prentice Education Hall Business Inc. Publishing as Prentice Introduction Hall Introduction to Financial to Financial Accounting, Introduction Accounting, to 9/e Financial 9/e Accounting, Horngren/Sundem/Elliott/Philbrick 10/e 2of 66 Liabilities = current obligations to pay cash or to provide goods and services in the future as a result of past transactions or events Long-term liabilities are those that fall due more than 1 year beyond the balance sheet date Reclassify portion due next year as a current liability Current liabilities are obligations that fall due within 1 year or the normal operating cycle, if longer Use many specific ledger accounts in the records Combined into accrued liabilities when reported Accrue to build up over time Accounts payable Buying goods/services from suppliers on credit Large outflow of money justifies comprehensive documentation and strong internal controls over the entire process Purchase order - specifies the quantities and prices of items ordered Receiving report - indicates that the company received the goods Invoice - the bill from the seller The above are matched and authorization to pay should precede disbursement of cash 3of 66 4of 66 Notes Payable Promissory note - written promise to pay a loan s principal and interest when due Commercial paper - a debt contract issued by prominent companies that t borrows funds directly from investors (shorter than 9 month payback period) Line of credit a predetermined maximum amount a company can borrow without additional credit checking May or may not be used Accounts Payable - example Supply Expense 100 Merchandise Inventory 200 Accounts Payable 300 Accounts Payable 300 Cash 300 Notes Payable - example Cash 400 Notes Payable 400 Notes Payable 400 Interest expense 10 Cash 410 5of 66 6of 66 1

2 Compensation - Assume 1) a $100,000 monthly payroll, 2) company withholds $15,000 for income taxes and $7,000 for Social Security taxes the employee is expected to pay from his/her salary. Compensation expense 100,000 Salaries and wages payable 78,000 Income tax withholding payable 15,000 Social Security withholding payable 7,000 Payroll taxes - amounts paid to the government by the employer for their portion of Social Security, Federal and state unemployment taxes, workers compensation taxes, etc. Fringe benefits - amounts voluntarily paid by the employer for employee pensions, life and health insurance, vacation pay, etc. Employee benefit expense 24,000 Employer Social Security payable 7,000 Pension liability payable 10,000 Workers compensation/unemployment taxes 2,000 Life and health insurance payable 5,000 7of 66 8of 66 Income Tax Liability Periodic installment payments based on the company s estimated income tax liability for the year Income tax expense 2,000 Cash 2,000 At year end, must determine final taxable income then pay unpaid balance owed or seek refund Owe Income Tax Expense 500 Income Tax Payable 500 Refund Income Tax Receivable 30 Income Tax Expense 30 Current Portion of Long-term Debt If a portion of long-term debt is due next year, it should be reported as a current liability Long-term debt 239,000 Current maturities of long-term debt 239,000 Sales Tax - $10,000 7% sales tax rate Cash 10,700 Sales revenue 10,000 Sales tax payable 700 Sales tax payable 700 Cash 700 9of of 66 Unearned revenue cash collections from customers ($2,000) before 1) it delivers the goods or services ($1,200) or 2) determines it cannot ($800). Until goods/services are delivered or funds are returned, it is a liability. Cash 2,000 Unearned Revenue 2000 Unearned Revenue 2,000 Sales Revenue 1,200 Cash 800 Unearned revenue continued Lease rentals Magazine subscriptions Insurance premiums Advance airline or theater ticket sales Advance repair service contracts 11 of of 66 2

3 Product Warranties seller s post-sale commitment to fix it for X years at no cost to the customer Need to record the expense in the same period as the sale (proper matching) Do not know what the expense will be since it will happen in the future Estimate future expenses based on past experience Warranty Expense 600,000 Warranty Payable 600,000 Warranty Payable 1,000 Cash (or another liability) 1,000 Refundable Deposits Deposit Cash 300 Deposits (payable) 300 Deposit Deposits (payable) 300 returned Cash of of 66 Long-term liabilities are Obligations that are not due for at least 1 year or beyond an operating cycle Measured at their present value, adjusting for the Time Value of Money (Appendix 9) Examples of long-term liabilities are: Corporate notes and bonds Lease liabilities Pension liabilities Deferred tax liabilities Contingent liabilities Bonds - formal certificates of debt that include promises to pay Face value is often $1000 Interest paid in cash at an annual rate known as the Nominal interest t rate Contractual rate Often every 6 months Coupon rate Stated rate The principal (face amount or par value) of the loan Interest and principal are payable on time (specific dates set forth in the contract) 15 of of 66 Negotiable bonds are transferrable Private Placement sold directly to specific investors rather than the general public Specific Characteristics Bondholders have a preference in liquidation over equity holders (Liquidation means converting assets to cash and paying off outside claims) Mortgage bond - secured by the pledge of specific property. In default, holders get proceeds from the sale of that property. Higher claim than debentures Specific characteristics - continued Debenture - a debt secured by a general claim against the company s total assets Shares the available assets with other general creditors, i.e. lower claim than mortgage bonds Subordinated bondholders - have claims against the assets that remain after satisfying the claims of other general creditors Bond covenants - restrict the ability of the borrower to take certain actions or give the lender the ability to force early payment, i.e., protect the investor 17 of of 66 3

4 Specific characteristics - continued Callable bonds - allow the issuer the option to redeem (call) them before maturity Call premium - the amount the redemption price exceeds the face value of the bond Sinking fund bonds - require the issuer to make annual payments into a fund that can be used to redeem the bonds at maturity Convertible bonds - bonds that lenders may exchange for a preset number of shares of the issuing company s common stock Market characteristics All of the above affect the Market rate of interest - amount investors require to purchase bonds which is determined in reference to Real interest rate the return investors want for use of their money with out risk (riskless rate) Risk Premium Inflation premium Protection between now and when they get their money against inflation Firm-specific risk Risk the firm will not repay 1) the loan, 2) interest, 3) on time 19 of of 66 Market characteristics - continued Market rate of interest (continued) - Three possibilities Market rate equals the stated rate Market rate exceeds the stated rate Market rate is less than the stated rate Yield to Maturity - after issuance, the market interest rate that equates cash flows to the bond s current price Time value of money principals (Appendix 9) techniques used to account for bond-related events Market characteristics - continued Underwriters - a syndicate of investment bankers who buy the entire bond offering then sell bonds to their clients, keeping a small percentage as compensation for their efforts (primary capital market) Secondary capital market Subsequent to the initial sale, bondholders resell bonds to other investors Face value - Often in $1,000 dominations Market value is expressed in percentage terms, e.g., selling for $985 with a face value of $1,000, 98.5 or 98.5% would describe this situation 21 of of 66 Preliminary to accounting Company issues debt instruments Underwriters inform investors of investment opportunity Investors assess offering and current/future market conditions, eventually offering to buy the bonds at an interest rate that adequately compensates them for their risks. Three possibilities (rates shown are hypothetical) Required (market) rate Coupon rate Sold at 10% 10% Par 12% 10% Discount 8% 10% Premium Example - On December 31, 20X0, Bill Co. Issued 10,000 $1,000 face value debentures Coupon (stated) interest rate = 10% Interest is payable semiannually Bonds principal is due in 2 years (Present value examples show calculations for one bond; to reflect the full offering, all amounts should be multiplied by 10,000) 23 of of 66 4

5 0 Mo 6 Mo 12 Mo 18 Mo 24 Mo $177.3 = $ (n=4; i = 5%) (Present Value of Ordinary Annuity Table 9A-3) $822.7 = 1, (Present Value of $1 Table 9A-2) 1,000 Investors bought each bond for $1,000 because the coupon rate (10% annual) equaled their required interest rate, i.e., the bonds were issued at Par value Cash 10,000,000 Bonds payable 10,000,000 To record proceeds upon issuance Interest expense 500,000 Cash 500,000 To record four payments of interest, one each 6-month period Bonds payable 10,000,000 Cash 10,000,000 To record payment of maturity value of bonds and their retirement 25 of of 66 0 Mo 6 Mo 12 Mo 18 Mo 24 Mo $173.3 = $ (n=4; i = 6%) (Present Value of Ordinary Annuity Table 9A-3) $792.1 = 1, (Present Value of $1 Table 9A-2) 1,000 Investors bought each bond for $965.4 because the coupon rate (10% annual) was below the 12% they wanted, justifying a lower (discounted) purchase price. Cash 9,653,489 Discount on bonds payable 346,511 Bonds payable 10,000,000 Discount on bonds payable is a contra account, which is deducted from the debt s face amount to show the balance sheet carrying amount (book value) Bonds Payable 10,000,000 Less Discount on bonds payable (346,511) Net Liability (book value) 9,653, of of 66 Effective interest method Interest expense - calculated as the book (carrying) value of the debt at the beginning of the period times the market interest rate at the time the debt was issued Amount of discount amortized - the difference between the interest expense and the cash interest payment (face value times the coupon rate) Over the life of the debt, the discount will be fully amortized, i.e., the account will end with a zero balance Debit Credit Credit Payment Interest Expense Discount Cash ,210 79, , ,963 83, , ,000 89, , ,340 94, , ,346, ,503 2,000,000 The complete last payment would be Interest Expense 594,340 Bonds Payable 10,000,000 Discount 94,340 Cash 10, 500, of of 66 5

6 0 Mo 6 Mo 12 Mo 18 Mo 24 Mo $181.5 = $ (n=4; i = 4%) (Present Value of Ordinary Annuity Table 9A-3 $854.8 = 1, (Present Value of $1 Table 9A-2 Investors bought each bond for $ because the coupon rate (10% annual) was above the 8% they would accept, justifying a premium purchase price. 1,000 Cash 10,362,989 Premium on bonds payable 362,989 Bonds payable 10,000,000 Premium on bonds payable is an adjunct account, which is added to the debt s face amount to show the balance sheet carrying amount (book value) Bonds Payable 10,000,000 Plus Premium on bonds payable 362,989 Net Liability 10,362, of of 66 Debit Debit Credit Payment Interest Expense Premium Cash ,517 85, , ,098 88, , ,542 92, , ,843 96, , ,637, ,000 2,000,000 The complete last payment would be Interest Expense 403,843 Bonds Payable 10,000,000 Premium 96,157 Cash 10, 500,000 Cash flows from financing activities Receipts from proceeds of the bond issue Repayment of the borrowed amounts Cash flows from operating activities Direct method Interest expense is an operating cash outflow Indirect method Interest expense is included in net income so no action needed unless Premium subtract change from net income Discount add change to net income 33 of of 66 Early extinguishment - when a company redeems its own bonds before maturity Par Loss on early extinguishment (could be gain) Bonds Payable Cash Discount Loss on early extinguishment (could be gain) Bonds Payable Discount Cash Premium Bonds Payable Premium Gain on early extinguishment (could be loss) Cash Zero coupon bonds No interest during the time the bonds are open Pay all interest due at maturity But interest is amortized over the life of the bond Example 2-year, zero coupon bond, $10,000 face-value note issued December 20X3, when market interest rates were 10% (5% semiannually) Cash 8,227 Discount 1, 773 Bonds Payable 10,000 N = 4, I = 5; Present value of a $1 Table 9A-2 PV of $1 from Table 9A-2, 5% column, 4-period row = of 66 PV of $10,000 note = $10,000 x.8227 = $8, of 66 6

7 12/31/X3 Cash 8,227 Discount on note payable 1,773 Note payable 10,000 6/30/X4 Interest expense (8,227.06) 411 Discount on note payable /31/X4 Interest expense 432 Discount on note payable 432 6/30/X5 Interest expense 454 Discount on note payable /31/X5 Interest expense 476 Discount on note payable 476 6/30/X6 Note payable 10,000 Cash 10,000 Book value = 10, = 8,227 Lease is a contract whereby Lessor (owner) grants the use of property to a Lessee in exchange for regular payments Legal title to the property remains with the lessor, but the lessee uses the property as if it had ownership Accountants categorize leases into two categories: Operating Capital 37 of of 66 Operating leases If it is not a capital lease, it is an operating lease Rent Expense xx Cash xx Lessee does not Record an asset or depreciate it Record a liability for future lease payments Lessor keeps the asset on his/her books and depreciates it Both cash flows are operating Capital lease most risks and benefits are passed to the lessee. It is a capital lease if it meets at least one of the following Lessor transfers ownership of the asset to the lessee by the end of the lease term Lease contains a bargain purchase option - can purchase the asset at the end of the lease for a price substantially lower than the market value Lease term equals or exceeds 75% of the estimated economic life of the property Present value of minimum lease payments is at least 90% of the property s fair value (like buying on time) 39 of of 66 Capital Lease example Bestick can acquire a truck with useful life of 4 years and no residual value under the following conditions: Rental cost per year - $16,462 payable at year-end (most lease payments occur at the beginning of the year) Ownership transfers at the end of the lease Purchase can be financed at 12% annual interest Accounted for as a capital lease due to the title transfer What is the interest rate inherent in this lease? Capital Lease example - continued What is the interest rate inherent in this lease? $16,462 some table factor = $50,000 Table factor = $50,000 / 16,462 = Table = Present Value of an Ordinary Annuity (Table 9A-3) Reading along the n=4 line till is found, then read up implies a 12% interest rate is inherent in this deal How much depreciation expense will be recorded? $50,000 / 4 years = $12,500 per year (straight line) 41 of of 66 7

8 Capital Lease example - continued Lease signing Truck leasehold 50,000 Capital lease liability, current 10,462 * Capital lease liability, long-term 39,538 ** * First interest and principal payment $16,462 Less interest (12% 50,000) in first payment 6,000 Present value of first payment on the liability $10,462 ** $39,538 is the present value of the remaining three payments against the loan s principal 43 of 66 Capital Lease example continued Interest expense = book value of the debt at the beginning of the period times the required (market) interest rate at the time the deal was cut Year 1 2 Interest expense ($50,000 12%) 6,000 Lease liability (difference) 10,462 Cash 16,462 Interest expense ($39,538 12%) 4,745 Lease liability (difference) 11,717 Cash 16, of 66 Capital Lease example continued Interest expense = book value of the debt at the beginning of the period times the required (market) interest rate at the time the deal was cut Year 3 4 Interest expense ($27,825 12%) 3,339 Lease liability (difference) 13,123 Cash 16,462 Interest expense ($14,700 12%) 1,764 Lease liability (difference) 14,698 Cash 16,462 Income statement: Capital leases tend to produce heavier expenses and lower income than operating leases in the early years Balance sheet: Capital leases create an asset and liability Operating leases do not Statement of cash flows: Cash payments for operating leases are operating activities Capital leases affect both operating (for interest) and financing sections (for payments against the liability) 45 of of 66 LO 5 Pensions/Postretirement Benefits Pensions - post-retirement payments to employees Defined contribution plans Employer contributions belong to the employees Payments depend on how well the fund performs Risk rewards belong to the employee Defined benefit plans Retirement pay is guaranteed or fixed The pension liability obligation is the present value of the expected future benefits to employees Pension obligation and assets available are calculated and disclosed yearly in the footnotes LO 5 Pensions/Postretirement Benefits Defined benefit pension plans - continued Pension expense is roughly the total expected pension obligation at the end of the year less what existed at the beginning of the year, e.g., $108M If the value of the fund assets is < the present value of the total pension obligation, cash should be contributed ($84M) and the total net liability increased by the difference ($24M) Pension expense 108,000,000 Cash 84,000,000 Pension liability 24,000, of of 66 8

9 LO 5 Pensions/Postretirement Benefits Other postretirement benefits health care and other benefits Total obligation at year end less total obligation at the beginning of the year = this year s expense Assets generally not set aside as is done with pensions creating huge unfunded liabilities Further, those assets that are set aside are usually invested, meaning they are subject to market fluctuations Applies to governments as well as businesses 49 of 66 Rules and procedures are written by to FASB/SEC - provide useful information to investors IRS - generate revenues/provide incentives If both sets were identical (as in other countries) then one set of rules and procedures works Since they aren t identical in the U.S., differences exist Permanent differences one set recognizes a revenue or expense, the other does not Temporary differences while both sets recognize a revenue (income) or expense (deduction), they permit such at different times 50 of 66 Permanent difference Municipal bond interest FASB/SEC include it on the income statement as revenue IRS exclude it as it is not taxable income $100 pretax income less $20 municipal bond interest = $80 on which taxes will be based. At 40% tax rate Tax Expense 32 Taxes Payable 32 Note: a Deferred Tax Liability is not created Note: Corporations pay taxes on taxable income (tax (rate X (taxable income less allowable deductions)) Temporary difference revenues/expenses must be recognized but at different times E.g., accelerated depreciation for tax purposes and straight-line depreciation for financial reporting purposes (40% tax rate) Year 1 Year 2 Income before depreciation and taxes 40,000 40,000 $10,000 asset with 2 year life Depreciation straight line 5,000 5,000 Depreciation accelerated 10, of of 66 Temporary difference - continued Straight line Year 1 ($40,000 $5,000) x 40% = $14,000 Year 2 ($40, $5,000) x 40% = $14,000 $28,000 Double declining balance Year 1 Year 1 ($40,000 10,000) x 40% = $12,000 Year 2 ($40,000 0) x 40% = $16,000 $28,000 Same Income tax expense 14,000 Deferred tax liability 2,000 Taxes payable 12,000 Year 2 Income tax expense 14,000 Deferred tax liability 2,000 Taxes payable 16,000 Over the 2 year period, the same amount ($28,000) was paid to the IRS and reported as income tax expense on the income statements 53 of of 66 9

10 Contingent situation - uncertainty as to possible gain or loss that arose from a past transaction or event that will be resolved when future event(s) occur or fail to occur Contingent gains - not recorded Contingent losses If the probability of the event occurring is Probable and reasonably estimated record it Possible, whether or not it is reasonably estimable disclose it in the footnotes Remote Disclosure is not required Restructuring closing a plant, downsizing the workforce, and/or terminating or relocating various activities For this year, restructuring costs are recognized as an expense on the income statement and a cash outflow or accrued liability on the balance For future years, such costs are shown as a current or long-term liability but still recorded on this year s income statement sheet if they meet the probable and estimable criteria of a contingent situation 55 of of 66 LO 7 Ratio Analysis LO 7 Ratio Analysis The ratios below are alternate ways of expressing debt burden of a company The higher the ratio, the riskier the firm and thus the higher the interest rate it must pay when borrowing Debt-to-equity ratio = Total liabilities Total shareholders equity Long-term-debt- = Total long-term debt to-total-capital ratio Total shareholders equity + long-term debt Debt-to-total = Total liabilities assets ratio Total assets This ratio measures the firm s ability to meet its interest obligation The lower the ratio, the more likely the company will have difficulty making payments Interest-coverage ratio = Pretax income + Interest expense Interest expense Debt burdens and interest coverage ratios vary across firms and industries 57 of of 66 Key terms Principal the amount borrowed/loaned Interest - the cost the borrower pays the lender to use the principal Interest rate Stated rate the rate printed in the contract Market rate the rate investors seek when loaning their funds (see earlier slide) Interest/loan period the length of time between the loan s inception and when it is paid back Key terms - continued Simple interest = interest rate principal (which remains unchanged) Compound interest = interest rate principal (which h increases each time interest t is earned but not withdrawn, i.e., it is added to the principal amount) Time perspectives Future value the value in the future of one or more cash flows that occur today or tomorrow Present value the value today of one or more cash flows that will occur in the future 59 of of 66 10

11 Future value (FV) Single amount Year $ i $ $ $ 1 10,000 10% = 1,000 interest + 10,000 = 11, ,000 10% = 1,100 interest + 11,000 = 12, ,100 10% = 1,210 interest + 12,100 = 13,310 Simplified $10,000 (1+i)(1+i)(1+i) = $10,000 (1+i) 3 = $13,310 Formula Future Value = Present Value (PV) x (1+i) n Table 9A-1 Future Value of $1 (n=3; i = 10%) = $10,000 = $13,310 Future value (FV) recurring amounts Unequal flows each period solve individually Equal flows the same amount over the same time period are called an annuity Annuity due - first payment/receipt Not covered In text but starts immediately occur often, Ordinary annuity - first payment/receipt e.g., regular savings starts at the end of the first period deposits 61 of of 66 Present value (PV) Single amount Formula If FV = PV (1+i) n then PV = FV = FV 1 (1+i) n (1+i) n Table 9A-2 Present Value of $1 (n=3; i = 10%) =.7513 $13, = $10,000 Table 9A-1 and 9A-2 are the reciprocal of each other On 9A-1 select any number and divide it into 1.0 On Table 9A-2, look in the same row and column and you will find the number selected on Table 9A-1 Repeat the process starting with Table 9A-2 Present value (PV) recurring amounts Unequal flows each period solve individually Equal flows the same amount over the same time period are called an annuity Annuity due - first payment/ receipt starts immediately Not covered in text but occur often, e.g., leases Ordinary annuity - first payment/receipt starts at the end of the first period covered in the text Discounting - the process of finding the present value of future cash flows using a discount interest rate (often the current market interest rate) 63 of of 66 Present value (PV) Ordinary Annuity $1,000 will be paid/received at the end of each year for the next 3 years. What is the present value of those cash flows using a 6% discount rate Time 0 Yr 1 Yr 2 Yr 3 $ =.8396 x 1,000 $ =.8900 x 1,000 $ =.9434 x 1,000 $ Look at Table 9A-3 (Present Value of an Ordinary Annuity) (n=3; I = 6%) Present value (PV) Ordinary Annuity - continued Example: The PV of an annuity of $1,000 received at the end of each year for 20 years discounted at 6% interest is ($1, ) or $11, of of 66 11

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