Before Class starts.(make sure your name is on all submissions)

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Madison Mosley
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1 Before Class starts.(make sure your name is on all submissions) Last Homework due Thursday 4/17 before class. Final Exam is Saturday May 3 9:00-Noon; Conflicts? Contact me ASAP! What questions do you have for me? TA Office Hours 6-7 T&R in GBS401 & Accounting Lab Hours on File cabinet downstairs contains your mail folder. Your homework and exams returned there.

2 P11-10 Callable Bond Redemptions account balances are: Bond payable $500,000 Premium on bond payable $ 12,600 The bonds have an annual stated rate of 8% and an effective rate of 6%. Interest is paid 6.30 and a. Compute the gain or loss if the bonds are called for 104 on ?

3 Bond Conversion Basics

4 Bond Conversions The Jolly Corporation has $400,000 of 6 percent bonds outstanding. There is $20,000 of unamortized discount remaining on these bonds after the July 1, 2011, semiannual interest payment. The bonds are convertible at the rate of 20 shares of $5 par value common stock for each $1,000 bond. On July 1, 2011, bondholders presented $300,000 of the bonds for conversion. 1. Is there a gain or loss on conversion, and if so, how much is it? 2. How many shares of common stock are issued in exchange for the bonds? 3. In dollar amounts, how does this transaction affect the total liabilities and the total stockholders' equity of the company? In your answer, show the effects on four accounts.

5 International Perspective The accounting disclosure requirements in non-u.s. countries and IFRS are not as comprehensive as those in the United States, partially because the information needs of the major capital providers (i.e., banks) are satisfied in a relatively straightforward way through personal contact and direct visits. A second way in which the heavy reliance on debt affects non- U.S. accounting systems is that the required disclosures and regulations tend to be designed either to protect the creditor or to help in the assessment of solvency.

6 Economic Consequences of Reporting Long-Term Liabilities Improved credit ratings can lead to lower borrowing costs Management has strong incentive to manage the balance sheet by using off-balance-sheet financing i.e., operating leases

7 Leases: operating or capital FASB issued SFAS No. 13, which requires certain leases to be recorded as capital leases. Capital leases record the leased asset as a capital asset, and reflect the present value of the related payment contract as a liability. Requirements of SFAS No record as capital lease for the lessee if any one of the following is present in the lease: Title transfers at the end of the lease period, The lease contains a bargain purchase option, The lease life is at least 75% of the useful life of the asset, or The lessee pays for at least 90% of the fair market value of the lease.

8 P11-14 Capital and Operating Leases Company leased equipment on for an annual lease payment of $30,000. a. Compute rent expense for if lease is treated as an operating lease. Assume the lease term is 5 years and the life of the equipment is also 5 years. If the lease is treated as a capital lease, the FMV of the equipment is $119,781. The straight line depreciation method is used to depreciate fixed assets. The effective interest rate on the lease is 8%. b. Compute the amounts that would complete the table: Date BS Value Leasehold Obligation Interest Expense Depreciation Expense Total Expense c. Compare total expense over 5 years for the two methods and comment.

9 Capital Lease

10 P11-14 Capital and Operating Leases Company leased equipment on for an annual lease payment of $30,000. Assume the lease term is 5 years and the life of the equipment is also 5 years. If the lease is treated as a capital lease, the FMV of the equipment is $119,781. The straight line depreciation method is used to depreciate fixed assets. The effective interest rate on the lease is 8%. a. Compute rent expense for if lease is treated as an operating lease. b. Compute the amounts that would complete the table: Date BS Value Leasehold Obligation Interest Expense Depreciation Expense Total Expense c. Compare total expense over 5 years for the two methods and comment.

14 BUS210 Introduction to Liabilities: Economic Consequences, Current Liabilities and Contingencies Problems: E10-2, E10-4, E10-7, E10-10, P10-1, P10-4

15 Liabilities What is a liability? Probable future sacrifice of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. My definition: Responsibilities to others Classification: Current or Long-term Criteria: Definitely determinable date, amount, & who to; Accrual-estimated amount & matching principle; Contingency

16 Classification Current Liabilities expected to require the use of current assets (or the creation of other current liabilities) to settle the obligation. Valuing current liabilities on the balance sheet Report at face value (Ignore present value) Reporting current liabilities Primary problem is ensuring that all existing current liabilities are reported on the balance sheet.

17 P10-1 Current Liabilities and Long-term Liabilities 1. Accounts payable of $170,000 owed to suppliers for inventory. 2. $60,000 note payable due in 3 months. Company plans to acquire a 5 year loan to pay off note. Bank has agreed to grant loan. 3. $500,000 mortgage: $75,000 payable within 12 months, and the remainder payable over the next six years. 4. $8,000 owed to phone company for December services. 5. Advances of $25,000 received from customer. If services not performed within 6 months the, $25,000 will be returned to the customer. 6. $15,000 due federal government for income taxes withheld from employees during last quarter, must be submitted by end of next quarter. 7. $125,000 note: $30,000 is payable with 12 months and the remainder over the next two years. Current payment will be made by issuing common stock. 8. Company declares a cash dividend of $50,000 on Dividend will be paid next year on Classify 1-8 as current or long-term as of the end of the year. Compute to total CL and LTL amounts.

18 Review: Definitely Determinable, Estimated, Commitment, Contingent

19 Current Liabilities Determinable (how much, when, & who) 1. Accounts payable (Ch 7) 2. Short-term notes 3. Current maturities of long-term debts 4. Dividends payable 5. Unearned revenues (Ch 5) 6. Sales tax payable 7. Income taxes payable (App 10B) 8. Payroll taxes payable

20 Current Liabilities Estimated Amount & Matching Principle Accrued liabilities - accrue expense and liability at the end of the current period, and usually paid sometime during the next year. For each item, debit expense and credit liability. Examples include: Wages payable Salary payable Interest payable Rent payable Insurance payable Property taxes payable Employee bonuses

21 Reporting Liabilities on the Balance Sheet: Perspectives Shareholders and investors Debt: interest expense is tax deductible, but more debt means more risk to shareholders equity ownership is subordinated to creditors Creditors Debt: restrictive covenants regarding debt limits Management wants to minimize debt on the balance sheet often looks for off-balance sheet financing less debt now improves ability to borrow in the future Current & long-term liability mix

22 Liabilities Disclosures: Coca Cola 2012 & 2011

24 E10-7 T accounts and inferring payments The following information was taken from the 2008 annual report of Bed Bath & Beyond (dollars in thousands). a. Assume the accounts payable reflects only inventory suppliers, and compute the cash payments made to suppliers during Cost of Goods Sold $4,335,104 $4,123,711 Inventory 1,642,339 1,616,981 Accounts Payable 514, ,605

25 Liabilities and Current Ratio E10-2 Company borrowed $100,000 to finance the purchase of fixed assets. The loan contract provided of a 12% interest rate and that the principal must be paid in full in ten years. The contract also states that current ratio be maintained at 1.5:1. Before the company borrowed the $100,000, the current assets and current liabilities were $130,000 and $80,000 respectively. a. Compute current ratio if invest $50,000 in fixed assets and remainder in short-term investments. To what dollar amount can current liabilities grow before company violates the debt contract? b. Compute current ratio if invest $80,000 in fixed assets and remainder in cash or short-term investments. To what dollar amount can current liabilities grow before company violates the debt contract? c. Compute current ratio if invest $100,000 in fixed assets. To what dollar amount can current liabilities grow before company violates the debt contract?

28 E10-4 Notes Payable and Actual Interest Rate On 12.1 company borrowed $19,250 from bank signing a 90 day note with a face amount of $20,000. the stated interest rate is 15%. a. Provide journal entry by borrower on b. Provide adjusting journal entry on before FS are prepared. Show how the note payable would be disclosed on the BS. c. Compute the actual annual interest rate on the note. d. Why is the actual interest rate different from the stated rate?

29 Contingent Liabilities Contingent on some future event or activity in order to know the exact amount. Examples: warranties, coupons, and lawsuits Changes in estimate may be made in subsequent periods, when future event is concluded. Under IFRS, much of these transactions are reported in a balance sheet account called provisions. Provisions are more readily booked than contingent liabilities because IFRS provisions are accrued when the obligation is more likely than not, while under US GAAP contingent liabilities are accrued when highly probable, which is a much higher threshold.

30 Figure 10-5

31 Contingencies & Off Balance Sheet Arrangements: Coca Cola

32 Warranty A promise by a manufacturer or seller to ensure the quality or performance of the product for a specific period of time Almost Honest JOHN S I ll stand behind it for 50 miles or 50 minutes whichever comes first Used Cars

33 Contingent Liabilities Warranties Uncertain future costs Adjusting Entry: Record estimated expense and liability when products are sold (matching concept): Warranty Expense [on IS] xx Estimated Warranty Liability[on BS] xx Actual warranty work: As costs are incurred (usually in subsequent periods), charge expenditure to warranty liability: Estimated Warranty Liability[on BS] xx Cash, etc.[on BS] xx

34 Warranties: Exercise: E10-10(a) (1) JE to record sale in 2011 $250 each): Cash 50,000 Sales revenue 50,000 (2) AJE in 2011 to record estimated warranty for the sales $20): Warranty expense 4,000 Estimated Warr. Liability 4,000 (3) JE to record payment in 2011 for repairs: Est. Warr. Liability 1,400 Cash 1,400 JE to record payment in 2012 for repairs: Est. Warr. Liability 2,600 Cash 2,600

35 Class Exercise: E10-10(b) Income effects for the revenue and warranty expense under the two alternative for recognition of expense (expressed in thousands): Accrue Expense Expense as Paid Revenues 50, , Warr. Expense (4,000) --- (1,400) (2,600) Note that the accrual method recognizes the expense in the same period as the revenues generated by the sale. MATCHING CONCEPT

36 P10-4 Contingent Liability Recognition While shopping, a customer slipped and seriously injured his back. The customer believes the store should have warned him that the floors were slippery, thus he sues the store for damages. At yearend, the suit is still in progress. According to the company s lawyers, it was probable that the company would lose and the loss could be between $250,000 and $1.5 million, with a best guess of the loss at $742,000. The lawsuit was eventually settled the following year in favor of customer for $690,000. a. Discuss the issues in deciding how to report the lawsuit on this year s F/S, store perspective, customer perspective. b. If you were auditing the company, how would you recommend this lawsuit be reported on this year s F/S? c. If a contingent liability of $742,000 was accrued at yearend, what s the entry? What s the entry on the date of settlement?

37 Potential Lawsuit: P10-4, Parts a & b: Issues and recommendations: - Likelihood? Probable - Disclose? Yes - Disclosure? Can you estimate? Indicate range and level of probability (250, million) - Accrue? Since probable (or greater) and estimable, accrual is required, based on best estimate.

38 Class Problem: P10-4, Part c: Adjusting journal entry for 2011: Estimated loss[on IS] 742,000 Estimated liability[onbs] 742,000 (Best guess in the range) Journal entry at settlement (8/12/12): Estimated liability[onbs] 742,000 Recovery of estimated loss[on IS] 52,000 Cash[on BS] 690,000

39 Deferred Income Tax Liability

40 Deferred Income Tax Liability Entries

41 NIKE Deferred Taxes Liabilities Disclosures

43 Deferred Taxes (App 10B) Generated by the discrepancy between income and expenses for taxation (specified by IRS) and financial reporting (specified by GAAP). Timing Difference Example: Equipment purchased on 1/1/09 for $9,000 3-year useful life no salvage value DDB for income tax purposes SL for financial reporting purposes Income tax rate of 30%

44 Depreciation Schedules Year DDB-TI Exp SL-IS Exp Diff Rate Tax Benefit (Disbenefit) 2009 $ = $3000 X 30% = $ = (1000) X 30% = (300) = (2000) X 30% = (600) Total $9000 $9000 $0 $ Deferred income tax liability $ Deferred income tax benefit $ Deferred income tax benefit $600

45 Leases FASB issued SFAS No. 13, which requires certain leases to be recorded as capital leases. Capital leases record the leased asset as a capital asset, and reflect the present value of the related payment contract as a liability. Requirements of SFAS No record as capital lease for the lessee if any one of the following is present in the lease: Title transfers at the end of the lease period, The lease contains a bargain purchase option, The lease life is at least 75% of the useful life of the asset, or The lessee pays for at least 90% of the fair market value of the lease.

46 Economic Consequences of Operating Leases Improved credit ratings can lead to lower borrowing costs Management has strong incentive to manage the balance sheet by using off-balance-sheet financing

47 Retirement Costs (App 10A) Defined Contribution Plans Less expensive than Defined Benefit Plans 401(k), 403(b), 457 The entry to record period contributions is very simple: Dr. Pension Expense Cr. Cash Defined Benefit Plans Benefits must be predicted, therefore several assumptions and estimates are required Social Security is form of Defined Benefit Plan The entry to record the estimated liability is simple, but the calculations can be quite complicated: Dr. Pension Expense Cr. Pension Liability

48 Coca Cola:

Before Class starts.(make sure your name is on all submissions)

Before Class starts.(make sure your name is on all submissions) Last Homework due TODAY before class. LAST class review Final Exam is Saturday December 13 9:00-Noon; Conflicts? Contact me ASAP! What questions