OBJECTIVES: ontingent Liabilities resent Value Concepts ypes of Long Term Liabilities Notes Payable Bonds Payable hareholders Equity ??
Dec 27, 2015
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
Finance Terms Related to Bonds
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
Finance Terms Related to Bonds
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
bond price = p.v. of face value + p.v. of bond interest payments
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
Cash Received (liability)
CashPayment
Finance Terms Related to Bonds
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
bond price = p.v. of face value + p.v. of bond interest payments
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)
record the bond interest payment Dr. Interest Payable $ 40 Cr. Cash $ 40
$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
Cash Received (liability)
CashPayment
Finance Terms Related to Bonds
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
bond price = p.v. of face value + p.v. of bond interest payments
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
record the bond interest payment Dr. Interest Payable $ 40 Cr. Cash $ 40
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)
record the bond interest payment Dr. Interest Payable $ 40 Cr. Cash $ 40
$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?
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
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
record the bond interest payment
Dr. Interest Payable $ 4000 Cr. Cash $ 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
record the bond interest payment
Dr. Interest Payable $ 4000 Cr. Cash $ 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
Lessee LessorDr. Rent Expense Cr. Rent Payable
Dr. Rent Receivable Cr. Rental Revenue
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
Lessee LessorDr. Rent Expense Cr. Rent Payable
Dr. Rent Receivable Cr. Rental Revenue
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
Dr. Capital Asset under Lease Cr. Obligation under Capital Lease
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
Dr. Capital Asset under Lease Cr. Obligation under Capital Lease
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