objectives: contingent liabilities present value concepts types of long term liabilities notes...

OBJECTIVES:

•Contingent Liabilities •Present Value Concepts•Types of Long Term Liabilities

•Notes Payable•Bonds Payable

•Shareholders Equity ??

Commitmentssignificant agreements that can affect the

future operations of the companyrequire disclosure in the notes to the

financial statementsbut are not recorded in the financial

statements until the agreement is executed (in whole or in part)

For Example: A Note appearing in the financial statement.‘The company has entered into agreements with certain well-known celebrities to endorse the Company's products. The agreements, among other things, require the Company to make certain guaranteed payments in the future.’

Contingencies defined as something of uncertain occurrence an event has occurred which will result in a gain or loss in

the future, but will not be known for sure until another event occurs or fails to occur in the future

Accounting Rules for Contingencies

gains:

losses:

never anticipate the gain; only disclose the possible gain in the notes to the financial statements until the outcome is known

record the event (i.e., the liability & loss) if the loss outcome is likely and the amount of the loss can be reasonably estimated

Present Value Concepts you are responsible for understanding the concept and its application to accounting but not the underlying methods of calculating present values

money received today can be invested to earn interest $10 invested today at 10% = $11 next year $11 next year is the same as $10 today the present value of $11 to be received next year = $10

the present value of $11 to be paid next year = $10

The Concept:

the present value (pv) of $11 to be paid next year = $10

$11$10

$1

principal

interest

B/S(liability)

CashPayment

record only the principal (pv) when the liability is incurred interest is incurred (and recorded) as time passes

Present Value Concepts

On January 1, Air Canada purchased parts from American Airlines by issuing a note payable of $12,000, due in two years. At 7% interest rates, the note is equivalent to $10,481 now.Required:

Prepare the journal entries that are required during the first and second year.

(to record the purchase of parts)

Dr. Aircraft Parts $10,481 Cr. Note Payable $10,481

(to record the interest on the note in year 1 = 7% x 10,481)

Dr. Interest Expense $734 Cr. Note Payable $734

Dr. Interest Expense $785 Cr. Note Payable $785

(to record the interest on the note in year 2 = 7% x 11,215)

Note Payable

10,481

734

11,215

785

12,000

Notes Payable

A note payable is is a written promise to pay a stated sum at one or more specified future dates. A note payable may require a single-sum repayment at the due date or maturity date or it may call for installment payments. If it requires regular payments in installments it is called an annuity.

Notes payable require the payment of interest and the recording of interest expense. Interest expense is incurred on liabilities because of the time value of money.

To calculate interest three important variables must be considered. (1) the principal; (2) the rate ; and (3) duration or time period

Interest = Principal x Rate x Time

Accounting for an Interest-Bearing Note

The accounting entry to record $10,000 cash borrowed on a five-year 10% interest bearing note payable, with interest being payable at maturity would be:

Dr. Cash 10,000Cr. Note Payable 10,000

Interest is an expense of the period when the money is used, therefore it is measured, recorded and reported on a time basis rather than when the cash is actually paid.

Important Considerations – Interest Expense

Accounting for a ‘Noninterest’-Bearing Note

A no interest-bearing note includes the interest amount in the face value of the note. This causes a difference in the accounting entries.

Assume in the previous example that the note was non-interest bearing, the accounting entries will be as follows:

Dr. Cash 10,000Dr. Discount on note payable 600

Cr. Note Payable 10,600

At the end of the first period, your accounting entries as it relates to interest will be as follows:

Dr. Interest Expense XXCr. Discount on note payable XX

Future income taxes(a.k.a. deferred income taxes)

3 types of income taxes ...

(i) income taxes withheld from employees' pay

(ii) income taxes as calculated on the company's tax return

(iii) income taxes that will arise in the future but haven't yet become payable based on the company's tax return

Dr. Wages & salaries expense Cr. Employee income tax payable Cr. Wages & salaries payable

Dr. Income tax expense Cr. Income taxes payable (CL)

Future income taxes

Future income taxes

CCRA (Canada Customs & Revenue Agency) allows some reporting policies for tax purposes that aren't allowed by GAAP

Income Statement

Sales Revenues

COGS

Operating Expenses

Amortization Expense

Interest Expense

Etc.

GAAP

Tax Return

Sales Revenues

COGS

Operating Expenses

Amortization Expense (CCA)

Interest Expense

Etc.

Tax Rules

Future income taxes

CCRA (Canada Customs & Revenue Agency) allows some reporting policies for tax purposes that aren't allowed by GAAP

- report as "taxes payable" the amount of taxes owed according to the tax return (i.e., using "income tax policies")- report as "future income taxes" any liabilities (or assets) that are likely to arise in the future when the temporary differences reverse

thus, taxes owed using "income tax policies" may differ from taxes based on "financial statement policies"

for example, CCRA sometimes allows very high deductions for amortization on tax returns in the early years of a capital asset's life, but GAAP may not

these tax vs. accounting differences are called "temporary differences" (because eventually they will reverse)

Long Term Liabilities - Bonds

Bond Liabilities: What is a bond?

a formal, legal debt agreement it sets-out how the borrower will repay the lender it’s like a long-term note payable, except that bonds can be owed to

multiple entities (called bondholders) the bond describes the conditions of the debt agreement

maturity date (i.e., when it has to be repaid) amount to be repaid at maturity (i.e., face value) interest to be paid periodically until maturity (i.e.,bond

interest rate / a.k.a. “coupon rate”)

Some Terms

Finance Terms Related to Bonds amount to be repaid at maturity

interest to be paid periodically until maturity

FACE VALUE

BOND RATE

Finance Terms Related to Bonds

$1,000 FACE VALUE

8% per year

8% per year

8% per year

8% per year

8% per year

BO

ND

RA

TE

?bond price

interest

Cash Received(Liability)

CashPayment


face value

CashPayment

CashPayment

CashPayment

CashPayment

CashPayment

CashPayment

$1,000$40 $40$40$40$40$40

bond price = p.v. of face value + p.v. of bond interest payments

$1,000bond price

interest

Cash Received (liability)

CashPayment


face value

CashPayment

CashPayment

CashPayment

CashPayment

CashPayment

CashPayment

$1,000$40 $40$40$40$40$40

Bonds Issued At Par simply means that bond price = face value means bond interest rate (8%) = market rate (8%) in other words, interest paid by bond = interest demanded


Accounting for Bonds Issued at Par

?bond price

interest

face value

$1,000$40 $40$40$40$40$40

record the bond liability at the p.v. of future paymentsDr. Cash $1,000 Cr. Bond Payable $1,000

record interest expense = effective interest rate x liabilityDr. Interest Expense $ 40 Cr. Interest Payable $ 40

record the bond interest payment

Dr. Interest Payable $ 40 Cr. Cash $ 40

= 1000 x 8% x 6/12

$ 949

bond price

interest


CashPayment


face value

CashPayment

CashPayment

CashPayment

CashPayment

CashPayment

CashPayment

$1,000$40 $40$40$40$40$40

Bonds Issued At a Discount discount means that bond price < face value means bond interest rate (8%) < market rate (10%) in other words, interest paid by bond < interest demanded


Accounting for Bonds Issued at a Discount

?bond price

interest

face value

$1,000$40 $40$40$40$40$40

record the bond liability at the p.v. of future paymentsDr. Cash (A) $ 949Dr. Bond Discount (xL) $ 51 Cr. Bond Payable (L) $1,000

effective liability

at is

sue

Balance Sheet

Liabilities

Bond Payable $1,000Bond Discount (51)Effective Liab. $ 949

Accounting for Bonds Issued at a Discount

?bond price

interest

face value

$1,000$40 $40$40$40$40$40

record the bond liability at the p.v. of future payments

Dr. Cash $ 949Dr. Bond Discount $ 51 Cr. Bond Payable $1,000

record interest expense = market interest rate x liability

Dr. Interest Expense Cr. Bond Discount Cr. Interest Payable

record the bond interest payment Dr. Interest Payable $ 40 Cr. Cash $ 40

effective liability

= (1000-51) x 10% x 6/12

at i

ssu

eA

fter

6

mo

nth

s

$ 7.45 $ 40.00

$ 47.45

Balance Sheet Income Statement

Liabilities

Bond Payable $1,000Bond Discount (51) $ 949

Expenses

$ 47.82

record interest expense = market interest rate x liabilityDr. Interest Expense $ 47.82 Cr. Bond Discount $ 7.82 Cr. Interest Payable $ 40.00

= 10% x 6/12 x (1000-43.55)


$1,000 (35.73) 964.27

at issue

$ 1,000 (43.55) 956.45

6 months 6 months 6 months

Interest $ 47.456 months

another 6 months later ...

= 949 x 10% x 6/12

$1,054

bond price

interest


CashPayment


face value

CashPayment

CashPayment

CashPayment

CashPayment

CashPayment

CashPayment

$1,000$40 $40$40$40$40$40

Bonds Issued At a Premium premium means that bond price > face value means bond interest rate (8%) > market rate (6%) in other words, interest paid by bond > interest demanded


Accounting for Bonds Issued at a Premium

?bond price

interest

face value

$1,000$40 $40$40$40$40$40

record the bond liability at the p.v. of future paymentsDr. Cash $ 1,054 Cr. Bond Premium (L) $ 54 Cr. Bond Payable (L) $1,000

effective liability

at is

sue

Balance Sheet

Liabilities

Bond Payable $1,000Bond Premium 54 $1,054

at issue

Accounting for Bonds Issued at a Premium

?bond price

interest

face value

$1,000$40 $40$40$40$40$40

record the bond liability at the p.v. of future payments

Dr. Cash $ 1,054 Cr. Bond Premium $ 54 Cr. Bond Payable $1,000

record interest expense = effective interest rate x liabilityDr. Interest Expense $ 31.62Dr. Bond Premium $ 8.38 Cr. Interest Payable $ 40.00


effective liability

= 6% x 6/12 x (1000+54)

at i

ssu

e6

mo

nth

s

Balance Sheet Income Statement

Liabilities

Bond Payable $1,000Premium 54 $ 1,054

Expenses

$ 31.37

record interest expense = effective interest rate x liabilityDr. Interest Expense $ 31.37 Cr. Bond Premium $ 8.63 Cr. Interest Payable $ 40.00

= 6% x 6/12 x (1000-45.62)


$1,000 36.99 1,036.99

at issue

$ 1,000 45.62 1,045.62

6 months 6 months 6 months

Interest $ 31.626 months

another 6 months later ...

Early Retirement of Bonds

remove the bonds payable (& any premium/discount)

record the cash given up to retire the bonds

record the gain/loss = amount by which liability >/< cash

Dr. Bond Payable $1,000 (given)

Dr. Bond Premium $ 37 (as per acctg records)

Cr. Cash $ 964 (assumed)

Cr. Gain on Bond Retirement $ 73 (plug)

Assume the $1,000 bond issued at 105.4 (the previous example) is retired after only 1 year. The cash payment made to bondholders to retire the bond was $964. What’s the journal entry?

Practice

Rose Corporation sold 10-year, 8 percent bonds with a $100,000 par value on January 1, 2001. Interest is paid on June 30 and December 31. If the bonds were sold at 104 for a return of 7.42%, give the journal entries for 2001.

Relevant facts:

bonds were sold at 104 (i.e., $104,000) 8% is bond interest rate 7.42% is market discount rate

face value of bonds is $100,000 bonds were issued at a premium

$104bond price

interest

Liability

face value

DecemberPayment

JunePayment

Final CashPayments

$100$4 $4$4$4$4 ...

...

DecemberPayment

JunePayment

Accounting for Bonds Issued at a Premium record the bond liability at the p.v. of future payments

Dr. Cash $ 104,000 Cr. Bond Premium $ 4,000 Cr. Bond Payable $100,000Ja

n. 1

/01

record interest expense = effective interest rate x liability

Dr. Interest Expense $ 3858Dr. Bond Premium $ 142 Cr. Interest Payable $ 4000



= 7.42% x 6/12 x (100+4)

Jun

e 3

0/0

1Ju

ne

30

/01

Accounting for Bonds Issued at a Premium record interest expense = effective interest rate x liability

Dr. Interest Expense $ 3853Dr. Bond Premium $ 147 Cr. Interest Payable $ 4000



= 7.42% x 6/12 x (100,000+4,000-142)= 3,853

Dec

. 31

/01

Dec

. 31

/01

Ratios for Long-term Liabilitiesdebt/equity ratio

shows the proportion of financing from debt suggests corporate financing strategy

Total Liabilities Total Liabilities + Shareholders' Equity

=

Ratios for Long-term Liabilitiestimes interest earned ratio

shows whether sufficient income is generated to cover interest costs

suggests the likelihood of interest payment

Net Income + Tax Expense + Interest Interest

=

Leases an agreement that allows one entity to obtain (from another entity) the use of assets

two types of leases exist:

1) "OPERATING LEASES"these are simple rental agreements that allow one company the right to use another company's property in exchange for a rental payment

the company providing the rented property is called the "lessor" and the company obtaining the use of the property is called the "lessee"

Leases an agreement that allows one entity to obtain (from another entity) the use of assets

two types of leases exist:

2) "CAPITAL LEASES""rental" agreements whereby the lessor transfers substantially all of the risks & rewards of property ownership to the lessee

in substance, this is just like the lessee going out and buying the property from the lessor with a long-term promissory noteif a lease meets any one of three criteria, it is a capital lease (otherwise, it's an operating lease)

Accounting for the 2 Types of Leases1) "OPERATING LEASES" this is what we have been doing all along so far

Lessee LessorDr. Rent Expense Cr. Rent Payable

Dr. Rent Receivable Cr. Rental Revenue

note that the lessee does not record the leased asset on the balance sheet

Accounting for the 2 Types of Leases

1) "OPERATING LEASES" this is what we have been doing all along so far



2) "CAPITAL LEASES" because substantially all the risks and rewards of ownership pass

from the lessor to the lessee, the lessee records a purchase & loan and the lessor records a sale

Dr. Capital Asset under Lease Cr. Obligation under Capital Lease

Lessee

$ (pv of lease pmts)$ (pv of lease pmts)

both an asset & liability appear on the balance sheet

Accounting for the 2 Types of Leases1) "OPERATING LEASES" this is what we have been doing all along so far



2) "CAPITAL LEASES" because substantially all the risks and rewards of ownership pass

from the lessor to the lessee, the lessee records a purchase & the lessor records a sale

Lessor don't worry about the journal entry details essentially, the lessor records a "lease sale" and related "cost of lease sales"

Criteria for Identifying Capital Leases

1) ownership transfers sometime during the lease

a guide for determining whether substantially all of the risks & rewards have been transferred

2) the lease covers substantially all ( ) of the asset's life

3) the lease payments are substantially all of the asset value ( )

75%

pvmlp > 90% fmv

IF...

IT'S A CAPITAL LEASE

or


Lessee

More on Accounting for Capital Leases

first capitalize ... then amortize

records a capital asset

(just like any other capital asset)usually use straight-line amortization methodamortization period often = lease term


Lessee

More on Accounting for Capital Leases

lease payments include principal & interest

a long-term liability

(just like any other long-term debt payments) principal portion reduces the liabilityinterest portion recorded as an expense

OPERATING LEASE

CAPITAL LEASE

make periodic pmts make periodic pmts

liability for lease payments only as they come due

liability for present value of all lease payments before they come due

no asset appears on the balance sheet

capital asset appears with long-term assets on the balance sheet

full payment shown as rent expense on I/S

interest portion of lease payment & amortization shown as expenses

Similar

Asset?

Liability?

Expense?

Lessee’s Point of View

objectives: contingent liabilities present value concepts types of long term liabilities notes...

Documents

note payable

notes payable

present value pv

estimated slide

principal x rate x time

time value of money

present values

liability loss