Definitely Determinable Liabilities

1
Definitely Determinable Liabilities

• Obligations that can be measured exactly
• E.g., bank loans, accounts payable, notes
  payable, salaries payable
• Accounting for payroll
• Firms must supply the government with information
  for each worker
• Federal, state, and Social Security taxes

2
Definitely Determinable Liabilities

• Accounting for payroll
• Gross pay
• Wages/salary before any deductions
• Deductions
• Federal income tax (FIT) withheld
• FIT Payable
• FICA tax withheld (6.2 of salary)
• FICA Payable
• Medicare tax withheld (1.45 of salary)
• Medicare Taxes Payable
• Accounting for payroll
• Employer must match employee deduction for FICA
  and Medicare
• Employers Payroll Tax Expense

3
Estimated Liabilities

• Accounting for warranties
• Obligation is not certain, so it is estimated
• Warranty Payable and related Warranty Expense
  recognized in year product is sold regardless of
  duration of the warranty
• Accounting for warranties
• Repairs 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

4
Warranty Example

1. 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

5
Long-term Notes Payable and Mortgages

• Short-term notes
• Mature in lt 1 yr
• Interest and principal usually paid at the end of
  the term
• Long-term notes
• Mature in gt 1 yr
• Options for repayment
• Repay in one lump sum (principal interest)
• Repay in equal annual payments
• Payments combine principal and interest
• As loan is repaid outstanding balance of loan
  decreases, so the interest portion of the payment
  decreases and the principal portion increases

6
Long-term Notes Payable and Mortgages

• Present value
• Value today of a given amount to be paid or
  received in the future
• Both the principal and interest not paid or
  received are earning interest at the discount
  rate
• Discount rate
• Interest rate used to compute the present value
  of the future cash flows

7
Long-term Notes Payable and Mortgages

• Present value (continued)
• If you deposited 100 in the bank at 5 interest,
  at the end of the year you would have 105
• The present value of receiving 105 one year from
  now at a 5 discount rate is 100
• Repaying a mortgage

8
Repaying a Mortgage

• The Universe borrows 200,000 on 1/1/08
• Discount rate 7
• Term of loan 4 years
• Payments at end of each year 59,046
• Make journal entries for first two years
• See the amortization table on the next slide?

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Repaying a Mortgage
A B C D E
Yr Beg Prin Mtg Pmt Int Exp A x int Prin Paid B - C End Prin A 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
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Long-term Liabilities Raising Money by Issuing
Bonds

• What is a bond?
• Types of bonds
• Issuing bonds payable
• Paying interest to bondholders
• Market for trading bonds

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What Is A Bond?

• An interest-bearing, long-term note payable
• Interest is usually paid to the bondholder
  semi-annually
• Principal is repaid at maturity
• Only corporations and governmental agencies can
  issue bonds
• Face value (stated value) usually 1,000

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Types of Bonds

• Secured vs. unsecured
• Do bondholders have a claim to specific assets if
  the corp defaults on the bonds?
• Term vs. serial
• Do 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 bonds face value
• Junk bond
• Rated at below investment grade

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Issuing Bonds Payable

• Bond terminology
• Issue price
• Issuing bonds at par
• Issuing bonds at a discount
• Issuing bonds at a premium

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Bond Terminology

• Market 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 daily
• Used as the discount rate to determine
• The issue price
• Interest expense issuer recognizes
• Stated rate of interest
• Interest rate on face of bond
• Determines cash flow of interest
• Face value x stated rate interest payment
• Does not fluctuate over life of bond

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Issue Price

• Stated Rate Market Rate
• Interest payments received mkt rate
• Bonds sell at a PAR
• No difference between issue price and face value
• Issuing corps interest payments equal to
  interest expense

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Issue Price

• Stated Rate lt Market Rate
• Interest payments received lt mkt rate
• Bonds sell at a DISCOUNT
• Difference between issue price and face value
  fairly compensates investor for accepting lower
  interest payments
• Issuing corps interest expense is greater than
  the interest paid to investors

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Issue Price

• Stated Rate gt Market Rate
• Interest payments received gt mkt rate
• Bonds sell at a PREMIUM.
• Difference between issue price and face value
  reduces investors return to equal the market
  interest rate because interest payments are
  greater than the market rate
• Issuing corps interest expense is less than the
  interest paid to investors

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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 100
• 100 of par

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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 4,100
• What is the issue price?
• Bond discount is a contra-liability
• Carrying value
• Bond Payable - Discount on Bond Payable

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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 3,000
• What is the issue price?
• Bond premium is an adjunct liability
• Carrying value
• Bond Payable Premium on Bond Payable

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Paying Interest to Bondholders

• Interest principal x int rate x time
• Bonds issued at par
• No discount or premium to amortize
• Straight-line amortization per payment
• Discount (or premium) / of payments
• As the bond matures, the carrying value gets
  closer to the par value
• Premium/discount account gets smaller

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Paying Interest to Bondholders

• Bonds issued at a discount
• A portion of the discount is ADDED to the
  interest payment to compute the interest expense
• Interest pmt discount amortized
• 5-year bond with a 4,100 discount
• Compute the discount amortized per year

23
Paying Interest to Bondholders

• Bonds issued at a premium
• A portion of the discount is SUBTRACTED from the
  interest payment to compute the interest expense
• Interest pmt - premium amortized
• 5-year bond with a 3,000 premium
• Compute the premium amortized per year
• Make the journal entry for the first year

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Market for Trading Bonds

• After bonds are issued, they are traded in a
  secondary market
• The 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?

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Capital Structure

• The 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

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Financial Leverage

• Using borrowed funds to increase earnings for the
  shareholders (owners)
• Increase return on equity
• Positive financial leverage
• Earnings on borrowed money gt cost of borrowing
  money
• What is the cost of borrowing money?

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Debt-to-equity Ratio

• Compares value of creditors claims to value of
  owners claims
• Measure of long-term risk
• Which is riskier, financing with equity or
  financing with debt? Why?
• Total liabilities _
• Total shareholders equity

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Times-interest-earned Ratio

• Measures a companys ability to make interest
  payments on its debt
• Measure of short-term solvency
• Income from operations
• Interest Expense
• Income from operations is used because it is more
  comparable across companies than net income. Why?

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Business Risk, Control, and Ethics

• Risk associated with long-term debt
• Not being able to make debt payments
• How to minimize risk of defaulting on debt
• Sound business analysis accompanies any decision
  to borrow money
• Evaluate types of debt for companys circumstances

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Time Value of Money

• You 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?

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Simple vs. Compound Interest

• Simple interest
• Interest is computed on principal only
• Short-term loans use simple interest
• Compound interest
• Interest computed on principal PLUS interest
  accrued, but not paid
• Investments grow much faster when interest is
  compounded (Exhibit 9A.1)

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Present Value of a Single Amount

• FVn PV (1 i)n
• where n the number of years
• i the interest rate
• PV the present value of the future sum of money
• FVn the future value of the investment at the
  end of n years
• PV FVn x 1/(1i)n

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Present Value of an Annuity

• Annuity
• A series of equal cash flows over equally spaced
  time intervals
• Ordinary annuity
• Payments made at the end of the period
• PV (1/i) x 1-1/(1i)n

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Appendix B Bond Proceeds

• Proceeds from a bond is the sum of two cash flows
• Present of a single amount
• Receiving the face value upon maturity of the
  bond
• Present value of an annuity
• The periodic interest payments

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Appendix B Bond Proceeds

• Bond issued at a premium
• Stated rate gt market rate
• Compute price on 10-year 1,000 bond
• Stated rate is 6 and market rate is 5
• How much interest is received each period?

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Appendix B Bond Proceeds

• Present value of the annuity
• 10 periods, 5 per period, 60 per pmt.
• 60 x 7.72173 463
• Present value of the face value
• 10 periods, 5, 1,000.
• 1,000 x 0.61391 614
• Bond price 463 614 1,077

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Appendix B Bond Proceeds

• Bonds issued at a discount
• Stated rate lt market rate
• Compute price on 10-year 1,000 bond
• Stated rate is 4 and market rate is 5
• How much interest is received each period?

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Appendix B Bond Proceeds

• Present value of the annuity
• 10 periods, 5 per period, 40 per pmt.
• 40 x 7.721735 309
• Present value of the face value
• 10 periods, 5, 1,000.
• 1,000 x 0.61391 614
• Bond price 309 614 923

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Appendix C Bond Amortization

• Effective interest method
• Actual interest expense on outstanding principal
  balance
• Actual 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

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Appendix C Bond Amortization

• Straight-line vs. effective interest method
• Straight-line
• Interest rate changes interest expense is
  constant
• Effective interest method
• Interest rate is constant interest expense
  changes
• GAAP, but straight-line may be used if difference
  between the two methods is not material

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Appendix D Leases and Pensions

• Capital leases
• Accounted for as a purchase and a loan
• Asset recorded on books
• Liability recorded for future lease pmts
• Obligations Under Capital Leases
• Details in notes to financial statements

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Appendix D Leases and Pensions

• Pensions
• Liability 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

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