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Prof Johnson Acct 202 CHAPTER 8 & Appd B PowerPoint Lecture Slides Ch8-- Accounting for Current and Long-Term Liabilities Appd B-- Time Value of Money

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Opening Vignette - AMR Corporation Alliances between companies in different industries s Transportation = airlines s Hospitality = hotels often create obligations for one party in the alliance. t Refer to the AMR Corporation situation described in the opening pages of the textbook

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Opening Vignette - AMR Corporation

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t Holiday Inn and other partner companies pay AMR to credit air miles to customer frequent flyer accounts t These payments represent liabilities for AMR Corporation t Payments represent obligation to provide future transportation to frequent flyers Opening Vignette - AMR Corporation

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Chapter Learning Objectives 1.Account for current liabilities 2.Identify and report contingent liabilities 3.Account for basic bonds payable transactions 4.Measure interest expense, amortize bond discount and premium by the effective-interest method

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Chapter Learning Objectives 5.Explain the advantages and disadvantages of borrowing 6.Account for lease transactions 7.Report liabilities on the balance sheet

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Chapter Objective 1 Account for current liabilities

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Liabilities t Obligation to transfer assets t Or provide future services t Resulting from past transactions

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Liabilities t Obligation to transfer assets t Or provide future services t Resulting from past transactions t Can you think of examples?

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Liabilities Incurred When a Business... t Purchases inventory on account SANTA’S ORDERS

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t Borrows money and makes (signs) a note payable Liabilities Incurred When a Business...

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t Accrues interest payable on a note or loan with the passage of time Liabilities Incurred When a Business...

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Current Liabilities t Payable within one year t Company’s operating cycle, if longer than one year t Current liabilities classified in two ways (1) Known amount (2) Estimated amount

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Current Liabilities of Known Amount t Accounts Payable t Short-Term Notes Payable t Short-Term Notes Issued at Discount t Sales Tax Payable t Current Portion of Long-Term Debt t Accrued Expenses

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Accounts Payable t Amounts owed to vendors (suppliers) for goods or services purchased on account t Journalize Asian Art, Inc.’s $350 purchase of office supplies on account

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Accounts Payable 9/28/x6 Office Supplies $350 A/P $350 To record supplies purchased on account t Businesses often maintain subsidiary A/P ledgers to track amounts owed to individual vendors t Task made easier by computers

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Short-Term Notes Payable t Promissory note signed by the company payable within the year t Company recognizes liability to repay principal amount borrowed s Plus accrued interest expense/payable EXAMPLE: The Valley Chamber Orchestra signs a $10,000, 60-day note payable in exchange for some remodeling done in its leased office space.

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Short-Term Notes Payable t The 60-day note bears interest at 9% annually, and is made on November 15, /15/98 Leasehold Improvements $10,000 Note Payable, Short-Term $10,000 To record note issued for leasehold improvement

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Short-Term Notes Payable t At fiscal year-end, December 31, the Orchestra must accrue interest payable on the note. 12/31/98 Interest Expense $115 Interest Payable $115 To accrue 1998 interest expense on note ($10,000 x.09 x 46*/360) * Nov. = 15 days Dec. = 31 days

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Short-Term Notes Payable Issued at a Discount t Entity taking the note deducts interest from amount being borrowed t Remits less than note’s face value to the borrower t Borrower repays face value at note’s maturity

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t Same $10,000, 60-day, 9% note as a “discounted” note payable... Short-Term Notes Payable Issued at a Discount $150 interest $9,850 proceeds remitted to borrower

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t Same $10,000, 60-day, 9% note as a “discounted” note payable... t $10,000 x.09 x 60/360 = $150 total interest FACE VALUE = $10,000 Short-Term Notes Payable Issued at a Discount $150 interest

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t Same $10,000, 60-day, 9% note as a “discounted” note payable... t $10,000 x.09 x 60/360 = $150 total interest t $10,000 - $150 = $9,850 remitted to borrower FACE VALUE = $10,000 Short-Term Notes Payable Issued at a Discount $150 interest $9,850 proceeds remitted to borrower

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t Same $10,000, 60-day, 9% note as a “discounted” note payable... t $10,000 x.09 x 60/360 = $150 total interest t $10,000 - $150 = $9,850 remitted to borrower t Borrower repays $10,000 face value on January 15, 1999 FACE VALUE = $10,000 Short-Term Notes Payable Issued at a Discount $150 interest $9,850 proceeds remitted to borrower

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11/15/98 Cash $9,850 Discount on Note Payable 500 Notes Payable, Short-Term $10,000 To record discounted note payable t Accrued interest expense at year-end: 12/31/98 Interest Expense $150 Discount on Note Payable $150 To record 1998 interest expense Short-Term Notes Payable Issued at a Discount

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Sales Tax Payable t State and local taxes assessed on retail sales t Sales tax collected by company along with sales revenue t Sales tax periodically remitted to local/state government agencies DEPT. OF REVENUE

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Sales Tax Payable t Ray’s Seafood Shack sold $3,475 of food and beverages (excluding tax) on a busy summer Friday evening t Florida state sales tax is 6%, and Monroe County imposes a Tourist Development tax of.5% t What is the journal entry to recognize Ray’s sales tax payable?

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Sales Tax Payable 7/9/x3 Cash $3,701 Sales Revenue $3,475 State Sales Tax Payable 209 County Sales Tax Payable 17 To record sales revenue for July 9 t Retail POS systems easily capture sales revenue and related tax data

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Current Portion of Long-Term Debt t Portion of long-term debt principal due within one year t Adjusting entry reclassifies principal from long-term liability to current liability 12/31/x7 Cur. Portion of Long-Term Debt $5,000 Note Payable, Long-Term $5,000 To adjust current liabilities for current portion of long-term note payable

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Liability section of Asian Art, Inc.’s balance sheet Current Liabilities Accounts Payable $20,000 Interest Payable 6,000 Current Portion of Long-Term Debt

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Liability section of Asian Art, Inc.’s balance sheet Current Liabilities Accounts Payable $20,000 Interest Payable 6,000 Current Portion of Long-Term Debt 21,000 Current Portion of Long-Term Debt

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Liability section of Asian Art, Inc.’s balance sheet Current Liabilities Accounts Payable $20,000 Interest Payable 6,000 Current Portion of Long-Term Debt 21,000 Total Current Liabilities $47,000 Current Portion of Long-Term Debt

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Liability section of Asian Art, Inc.’s balance sheet Current Liabilities Accounts Payable $20,000 Interest Payable 6,000 Current Portion of Long-Term Debt 21,000 Total Current Liabilities $47,000 Long-Term Notes Payable 190,000 Current Portion of Long-Term Debt

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Liability section of Asian Art, Inc.’s balance sheet Current Liabilities Accounts Payable $20,000 Interest Payable 6,000 Current Portion of Long-Term Debt 21,000 Total Current Liabilities $47,000 Long-Term Notes Payable 190,000 TOTAL LIABILITIES $237,000 Current Portion of Long-Term Debt

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Accrued Expenses t Result of adjusting entries accruing expenses incurred but not yet recognized t Wages/Salary Payable t Interest Payable t Taxes Payable t AMR Corporation’s Air Traffic Liability t Marriott International’s Other Payables and Accruals, including such frequent stay programs as Marriott Miles, INNsiders’ Club, and Courtyard Club

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Payroll Liabilities t Significant expense for many companies t Total wages, salary, commissions, bonuses paid to company employees in exchange for their services t Refer to Textbook Exhibit 8-1 for adjusting entry prepared at end of accounting period to recognize payroll expense and related current liabilities

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Payroll Liabilities Deductions from employee payroll include: t Federal income taxes t Social Security taxes t State/local income taxes t Group insurance (health/life) premiums t Union dues t Credit union savings or loan repayment t Contribution to 401(k) pension plans

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Unearned Revenues t Cash received from customers prior to earning revenue t Prior to delivering goods or providing services to customers

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When customer prepays for a product or service, company has obligation to: (1) Provide the product/service in the future (2) Refund the unearned revenue to customer Unearned Revenues

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Customers of the Des Moines Register can prepay a 52-week newspaper subscription in advance. If the subscription costs $108, how does the Register adjust its balance sheet for unearned revenues?

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Unearned Revenues t A customer prepays her 52-week newspaper subscription beginning October 13, 19x4 10/13/x4 Cash $108 Unearned Subscription Rev. $108 To record prepaid 52-week subscription t The Register’s fiscal year ends on December 27, 19x4. What adjusting entry must be made?

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Unearned Revenues 12/27/x4 Unearned Subscript. Rev. $22.55 Subscription Revenue $22.55 To recognize revenue earned in 19x4* *$108 / 52 weeks = $ / week $ / 7 days = $.2967 / day $.2967 x 76 days (October 13 through December 27)

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Current Liabilities That Must Be Estimated t Estimated Warranty Payable t Estimated Vacation Pay and Sick Pay Liability

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Estimated Warranty Payable

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t Manufacturing and retailing companies often provide guarantees on products t days or one year in length t Matching principle requires company to estimate expense of providing warranty and recognize it in same accounting period as revenue earned from product sale

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Estimated Warranty Payable Suppose Cisco Systems - s a manufacturer of networking hubs and routers offers a 90-day warranty on equipment it sells Further, suppose Cisco’s recent actual warranty work amounts to.75% of all products sold.

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Estimated Warranty Payable t If Cisco’s December 19x1 revenues are $3,500,000, what adjusting entry is necessary to estimate expense and current liability? 12/31/x1 Warranty Expense $26,250 Est. Warranty Payable $26,250 To record December warranty expense

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Estimated Warranty Payable t When Cisco Systems actually replaces hubs or routers under warranty...

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Estimated Warranty Payable 2/2/x2 Est. Warranty Payable $2,000 Inventory $2,000 To record products replaced under warranty t When Cisco Systems actually replaces hubs or routers under warranty...

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Estimated Vacation and Sick Pay

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t Vacation and sick pay accrued in accounting period when earned t If Asian Art, Inc. employees earn one sick day and one vacation day per month, what adjusting entry is necessary at end of June to accrue these liabilities? Estimated Vacation and Sick Pay

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t Use a 40-hour work week (160 hours per month) and total monthly payroll of $8,700 6/30/x6 Vacation Pay Expense $435 Sick Pay Expense 435 Estimated Vacation Pay Liab. $435 Estimated Sick Pay Liab. 435 To record vacation and sick pay accruals for June

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Chapter Objective 2 Identify and report contingent liabilities

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Contingent Liabilities t Liability related to a past transaction t Dependent upon a future event t Guaranteeing debts of others t Awaiting outcome of pending lawsuit

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Contingent Liabilities Reporting guidelines rooted in several accounting principles: t Full disclosure t Conservatism t Materiality t Representational faithfulness

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Contingent Liabilities 3 Ways to Classify Contingencies

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Contingent Liabilities t Probable t Possible t Remote

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Contingent Liabilities t Probable s More likely than not that a loss will be incurred s $ amount of loss can be reasonably estimated t Possible s Reasonably possible loss will be incurred t Remote s Not likely that loss will be incurred

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Contingent Liabilities Probable and reasonably estimable t Asian Art agrees to pay note payable of one of its suppliers if the supplier defaults on the note t At time supplier defaults, Asian Art knows the liability is probable (certain) and knows the amount of the loss LOAN PAYMENT

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Contingent Liabilities Probable and reasonably estimable t Asian Art will record adjusting entry to accrue expense and liability t Disclose additional information about liability in footnotes to financial statement LOAN PAYMENT

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Contingent Liabilities Possible t Ray’s Seafood Shack is defendant in negligence lawsuit s Customer slipped off sailboat during one of Ray’s sunset champagne cruises t At year-end, case has not been decided t Ray’s lawyer does not believe the plaintiff will be successful in her claim against restaurant

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Contingent Liabilities Possible t Ray’s Seafood Shack would prepare a brief disclosure to be included in the financial statement footnotes only

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Contingent Liabilities Remote t A former member of the Valley Chamber Orchestra’s staff sues the organization for wrongful discharge after being fired t The Orchestra’s labor attorney is confident the organization will be found innocent, especially in light of the former employee’s work record which includes warnings about sexual and discriminatory harassment of organization employees

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Contingent Liabilities Remote t The Orchestra neither accrues the estimated gain/loss nor reports details in footnotes to the financials

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Begin Discussion of Appendix B: Time Value of Money

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Appendix B: Accounting and the Time Value of Money After studying this chapter you should be able to: t Identify accounting topics where time value of money is relevant. t Distinguish between simple and compound interest. t Learn how to use appropriate compound interest tables. t Identify variables fundamental to solving interest problems. t Solve future and present value of 1 problems. t Solve future value of ordinary problems. t Solve present value of ordinary annuity problems.

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33333 Introduction t Concept of the time value of money is very important especially when interest rates are high and/or time periods are long. t Simply put--You are not indifferent as to when you receive or pay an identical sum of money. That is, a dollar received or paid today (the present) is not worth a dollar received or paid tomorrow (the future). t Someone owes you, a rational person, $100. They say to you--Which would you prefer: I pay you $100 today or I pay you $100 one year from now?

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44444 Introduction t Your response should be--Pay me $100 today (present). WHY? Assuming there is no inflation, would your answer change? t Again, your response should be to be paid today. You could take the funds today, invest them, earn a return and have more than $100 a year from now. How much more than $100 would depend on the return you could earn (interest). t Suppose, instead, someone offers you $100 one year from today. You wish the funds now (today), however. Will you accept less than $100 in settlement of the debt?

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55555 Introduction t Considering the interest rates, you will accept less than $100 today to settle the debt. WHY? t If you had the settlement today you could invest it, earn a return and have $100 one year from now. If the interest rate is high you would accept less to settle the debt than if the interest rate was low. Simply put, at any interest rate: A dollar received today is worth more than a dollar in the future. A dollar in the future is worth less than a dollar today.

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66666 Introduction t The concept of the time value of money is pervasive. We see this concept in many topics including (to name a few): s Leases s Pensions s Non-interest bearing notes s Installment contracts s Valuation of bonds s Sinking fund provisions t The FASB will simplify calculations by stating, at times, the time value of money is to be ignored. You must realize the import of that assumption as well!

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77777 Interest t Definitions of interest: s A fee for the use of money s Principle x Interest Rate x Time = Interest Principle: The amount borrowed or invested. Interest rate: A percentage of the outstanding principle. Always expressed as an annual rate. Time: The number of years or fraction thereof that the principle is outstanding.

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88 Interest s Selection of appropriate interest rate is critical and, at times, very difficult. Would you be a wealthy person if you could accurately predict the interest rate? s The interest for us will be a given figure. In practice it can be the hardest figure to derive accurately.

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99 Interest s Elements of the interest rate: The interest rate is the sum of Pure rate of interest (system risk) Initial rate charged assuming no possibility of default and no inflation. Credit risk rate of interest (individual risk) Additional rate charged as a result of an individual entity’s risk of default. Expected inflation rate of interest (inflation premium) Additional rate charged to compensate for the decrease in the purchasing power of the dollar over time.

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10 Interest s Simple interest s Simple interest is computed on the principle only. That is, interest is earned and removed. The interest does not earn interest. –Compound interest –Compound interest is computed on the principle and any accumulated interest. Both the principal and interest then earn interest.

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11 Types of Problems t For our calculations we will assume compound interest. The greater the number of periods and the higher the interest rate, the greater will be the effect of compounding interest. t Types of problems we will be working with: s Single Sum s Single Sum. One sum ($1) will be received or paid either in the PV Present (Present Value of a Single Sum or PV) FV Future (Future Value of a Single Sum or FV)

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12 Types of Problems s Types of annuity problems s Types of annuity problems: OA Ordinary annuity (OA) A series of equal payments (or rents) received or paid at the end of a period, assuming a constant rate of interest. PV-OA Value today of a series of equal, end-of- period payments received in the future is the Present Value of an Ordinary Annuity or PV-OA. FV-OA. Value in the future of a series of equal, end- of-period payments received in the future is the Future Value of an Ordinary Annuity or FV-OA.

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13 Types of Problems AD Annuity Due (AD) A series of equal payments (or rents) received or paid at the beginning of a period, assuming a constant rate of interest. PV- AD Value today of a series of equal, beginning- of-period payments received in the future is the Present Value of an annuity due or PV- AD. FV-AD. Value in the future of a series of equal, beginning-of-period payments received in the future is the Future Value of an annuity due or FV-AD.

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14 Types of Problems Note: Note: The difference between an ordinary annuity and an annuity due is that: Each rent or payment compounds (interest added) one more period in a annuity due, future value situation. Each rent or payment is discounted (interest removed) one less period under the annuity due situation. Given the same i, n and periodic rent, the annuity due will always yield a greater present value (less interest removed) and a greater future value (more interest added).

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15 Calculation Variables t There will always be at least four variables in any present or future value problem. Three of the four will be known and you will solve for the fourth. s Single sum problems s Single sum problems: n = number of compounding periods i = interest rate PV = Value today of a single sum ($1) FV = Value in the future of a single sum ($1)

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16 Calculation Variables s Annuity problems s Annuity problems: n = number of payments or rents i = interest rate R = Periodic rent received or paid And either: FV-OA or AD = Value in the future of a series of future payments (either ordinary or due). OR PV-OA or AD= Value today of a series of payments in the future (either ordinary or due). Note: The “n” and the “i” must match. That is, if the time period is semi-annual then so must the interest rate. Interest rates are assumed to be annual unless otherwise stated so you may have to adjust the rate to match the time period.

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17 Single Sum Problems Let’s review the derivation of the single sum formula: t Suppose you have $100 today (present) and wish to deposit it at 10% for three periods, in this case years. What is the value of this single sum in the future? s At the end of the first year (n = 1): (Compound interest) $100 + $100(.1) = $110 s At the end of the second year ( n = 2) $110 + $110(.1) = $121 s At the end of third year (n = 3) $121 + $121(.1) = $133 (rounded) s So the future value of $100 three years hence at 10% = $133

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18 Single Sum Problems t I realize there is a simpler way to approach this: $100 (1 +.1)(1+.1)(1+.1) = $133 $100 (1+.1) 3 = $133 Generally for any “n” and “i” the single sum formula would be: PV (1+ i) n = FV $100 (1+.1) 3 = $133

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19 Single Sum Problems FVF n,i ) t Not wishing to have to constantly raise the term to the required power I name the term (1+ i) n, the Future Value Factor for a single term (FVF n,i ). I then employ the table on page The table is the result of the required multiplications at various “n” and “i” and is to be read vertically for the “n” and horizontally for the “i”. t To solve my problem using the table: PV(FVF n,i ) = FV PV(FVF n,i ) = FV where n = 3 and i = 10% $100 (1.331) = $133

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20 Note: “n” periods For single sum problems the “n” refers to periods not necessarily defined as years! The period may be annual, semi-annual, quarterly or another time frame. In manual calculations the use of the table is strongly recommended. It enhances both speed and accuracy. Single Sum Problems

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21 Single Sum Problems t Now suppose instead of $100 today I am to receive $133 three years from now. Again the interest rate is 10%. I don’t want to wait three years for my money. How much will I accept today in lieu of the future payment? Going back to the general formula for a single sum: PV(FVF n,i ) = FV t I realize I can isolate the term I wish to solve for on one side of the equation: PV = FV divided by (FVF n,i ) and rearranging terms: PV = FV ( 1/ FVF n,i )

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22 Single Sum Problems (PVF n,i ) t Not wishing to have to constantly raise the term to the required power and then divide it into 1, I name the term 1/ FVF n,i the Present Value Factor for a single sum (PVF n,i ). I restate the formula PV = FV (PVF n,i ) read vertically for the “n” t I then employ the table on page ???. The table is the result of the required multiplications and division at various “n” and “i” and is to be read vertically for the “n” horizontally for the “i” and horizontally for the “i”

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23 Single Sum Problems t To solve my problem using the table: Please look up the values on the tables as we go along! n = 3, i = 10%, FV = $133 PV = FV (PVF n,i ) PV = $133 (.75132) PV = $100

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24 Single Sum Problems Note: Review the tables and note their characteristics. They are very logical. All sums in the future are worth less than themselves in the present. All factors on the present value of a single sum table are less than one. All factors on the future value of a single sum table are greater than one. All present sums are worth more than themselves in the future. Notice how the factors change dramatically as the “i” increases and the “n” lengthens!

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25 Single Sum Problems Single Sum problems, other unknowns. s Suppose you have $6,000 today (PV ) and you need $9,000 five years hence. What rate of annual interest must you earn to achieve your goal? Note: This can be solved as either a future or present value of a single sum problem. The formulas are reciprocals of each other.

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26 Single Sum Problems t To solve as a future value of a single sum problem: PV(FVF n,i ) = FV PV(FVF n,i ) = FV where n = 5 and i = ? $6,000 (FVF n,i ) = $9,000 FVF n,i = $9,000/$6,000 = Looking on the future of a single sum table (page ???) for n = 3 and a FVF of 1.500, I find the corresponding “i” to be between 8-9%.

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27 Single Sum Problems t Alternatively, suppose I have $750 today. How long will I have to wait to have $1,200 when the interest rate is 10%? I will solve this as a PV problem. PV = FV (PVF n,i ) $750 = $1,200 (PVF n,i ) where n = ? and i = 10% PVF n,i = $750/$1,200 =.625 Reading on the present value of a single sum table (page ???) for 10% the “n” for the factor.625 is between 4-5 periods. A more precise answer may be derived through the use of the mathematical technique of interpolation.

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28 Annuity Problems t Suppose I am to receive three equal $100 payments (R) each at the end of the period (in this case a period is a year) when the interest rate is a constant 15%. This is an ordinary annuity since payments are at the end of the period. What is the value to me at the end of the third year from receiving this annuity? This is a future value of an ordinary annuity problem. How do I go about solving it? s I realize an annuity is really a series of single sums. s If I take the FV for each single sum and add them I will have the value of the entire stream of payments. s I will use the FV formula which is: PV(FVF n,i ) = FV

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29 Annuity Problems Rent #Cmpd periodsSumFVFFV All at i = 15% 12$ $132 21$ $115 30$ $100 Totals3.472$347 FVF-AO n,i t This is tedious! I notice I am multiplying a constant rent ($100) by a changing interest factor. What if I added the three factors and multiplied the total by the rent? That would be less work! I’ll call the sum of the appropriate factors the FVF-AO n,i. I’ll derive the general formula where R equals the constant rent: FV-OA = R (FVF-AO n,i ) FV-OA = R (FVF-AO n,i ) when I = 15% and n = 3 payments FV-OA = $100 (3.472) = $347 (rounded)

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30 Annuity Problems t Where do I get these summed factors? From the future value of an ordinary annuity table on pages ???. The addition for the appropriate “n” and “i” has already been done. The annuity tables are derived directly from the single sum tables.

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32 Annuity Problems t Let’s take the case of the present value of an ordinary annuity. That is, what is a stream of future payments worth today? What sum do you need today to draw out a series of equal payments and have nothing left over? This situation is very common in retirement cases or the payment of debt. Bonds Payable ABC Company

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33 Annuity Problems t Suppose you are to pay three rents of $500, each at the end of the next three years. The interest rate is 8%. How much should I set aside today to have the required rents? s Again I realize an annuity is simply a series of single sums. I take the same approach as before in that I discount (remove) interest from each of the rents. s I take the present value of each, add, and I will have the required sum (total present value) that I will need. PV = FV (PVF n,i ) I use the formula: PV = FV (PVF n,i )

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34 Annuity Problems Rent # Disc periodsSumPVFPV All at i = 8% 11$ $463 22$ $429 33$ $397 Totals2.5771$1,289 PVF-AO n,i t This is tedious! I notice I am multiplying a constant rent ($500) by a changing interest factor. What if I added the three factors and multiplied the total by the rent? That would be less work! I’ll call the sum of the appropriate factors the PVF-AO n,i. I’ll derive the general formula where R is the constant rent: PV-OA = R (PVF-AO n,i ) PV-OA = R (PVF-AO n,i ) for n = 3 payments and i = 8% PV-OA = $500 (2.5771) = $1,289 (rounded)

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35 Annuity Problems t Where do I get these summed factors? From the present value of an ordinary annuity table on pages ???. The addition for the appropriate “n” and “i” has already been done. The annuity tables are derived directly from the single sum tables.

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End Discussion of Appendix B: Time Value of Money and Start Discussion of Long Term Liabilities-- Bonds Payable

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Chapter Objective 3 Account for basic bonds payable transactions

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Financing Operations with Long-Term Debt t Large corporations borrow huge amounts of money by issuing bonds to lenders t Individuals t Corporate investors t Pension plans t Insurance

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t Bonds are interest-bearing, long-term notes payable t Bond certificate provides written evidence of borrowing company’s obligation to repay lender for principle borrowed plus accumulated interest t Refer to textbook Exhibit 8-2 for a picture of a bond certificate Financing Operations with Long-Term Debt

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t Bond certificate states Financing Operations with Long-Term Debt Debenture Bonds

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t Bond certificate states t Principle (face or maturity value) Financing Operations with Long-Term Debt Debenture Bonds MGM Grand, Inc. $10,000.00

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t Bond certificate states t Principle (face or maturity value) t Contract interest rate (annual %) Financing Operations with Long-Term Debt Debenture Bonds MGM Grand, Inc. $10, Eight percent

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t Bond certificate states t Principle (face or maturity value) t Contract interest rate (annual %) t Interest payment dates (usually semi-annually) Financing Operations with Long-Term Debt Debenture Bonds MGM Grand, Inc. $10, Eight percent November 30, 2008

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Types of Bonds t Secured (mortgage) bonds s Entitle bondholders rights to specific assets in event company defaults on bond interest payments or maturity payment t Unsecured (debenture) bonds s Bondholders backed by reputation and integrity of the company s More risky, therefore pay higher interest rate than secured bonds

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Bond Prices t Initial bond issue prices determined by borrower and bond underwriter t Prices of bonds traded on secondary market based on variety of factors

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Bond Prices Affected by: t Time to maturity t Credit rating of issuing company t Contract interest rate compared to market interest rate

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Bond Prices t Expressed in terms of percent of face value

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Bond Prices t Expressed in terms of percent of face value $10,000 face value bond

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Bond Prices t Expressed in terms of percent of face value t Bond price might be: s $10,000 face value bond

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Bond Prices t Expressed in terms of percent of face value t Bond price might be: s $10,000 face value bond 98.75% of face value $9,875 BOND SOLD AT A “DISCOUNT”

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Bond Prices t Expressed in terms of percent of face value t Bond price might be: s 100 $10,000 face value bond

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Bond Prices t Expressed in terms of percent of face value t Bond price might be: s 100 $10,000 face value bond 100% of face value $10,000 BOND SOLD AT “PAR”

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Bond Prices t Expressed in terms of percent of face value t Bond price might be: s $10,000 face value bond

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Bond Prices t Expressed in terms of percent of face value t Bond price might be: s $10,000 face value bond 104.5% of face value $10,450 BOND SOLD AT A “PREMIUM”

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Present Value Money earns income (interest) with passage of time

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Present Value t Amount of a dollar invested today is referred to as the present value of a future amount t Amounts invested today accumulate interest and grow to a larger amount in the future

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Present Value t $1,000 invested today is worth more than $1,000 to be received two years from now t You can invest the $1,000 now t It will be worth more in three years

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Issuing Bonds Payable to Borrow Money t The City of Blacksburg, Virginia, issues $15,000,000 of 6% 10-year bonds on May 1, 19x3, to fund construction of a new water treatment plant t What is the City’s journal entry if the bonds are issued at par?

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5/1/x3 Cash $15,000,000 Bonds Payable $15,000,000 To record bonds issued at par t After initial bond issue, secondary market bond transactions do not involve the City of Blacksburg t City makes no journal entries t Keeps record of bond owners only for payment of periodic interest Issuing Bonds Payable to Borrow Money

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t The City’s bonds pay interest each May 1 and November 1 t What is the journal entry to record the first interest payment on Nov. 1, 19x3? Issuing Bonds Payable to Borrow Money

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11/1/x3 Interest Expense $450,000 Cash $450,000 To record interest expense Can you think of the adjusting entry necessary on November 30, 19x3, the City’s fiscal year-end? Issuing Bonds Payable to Borrow Money

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11/30/x3 Interest Expense $75,000 Interest Payable $75,000 To record interest accrual for 19x3 Issuing Bonds Payable to Borrow Money

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Issuing Bonds and Notes Payable Between Interest Dates t Bonds issued between interest payment dates are priced to include accrued interest WHY? t Semiannual interest payments are paid in full to the current bondholder of record t Too time-consuming and impractical to track all bondholders during the semiannual period s Consider that some bondholders may hold bonds only for several days or weeks before selling them

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Suppose the City of Blacksburg issued its bonds (dated 5/1/x3) on July 1, 19x3 7/1/x3 Cash $15,150,000 Interest Payable $150,000 Bonds Payable 15,000,000 To record bonds issued between interest dates Issuing Bonds and Notes Payable Between Interest Dates

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How would the first interest payment on November 1 would be recorded? 11/1/x3 Interest Expense $300,000 Interest Payable 150,000 Cash $450,000 To record interest expense Issuing Bonds and Notes Payable Between Interest Dates

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Interest Expense Interest Payable $150,000 7/1 Issuing Bonds and Notes Payable Between Interest Dates

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Interest Expense Interest Payable 11/1 $300,000 $150,000 7/1 Issuing Bonds and Notes Payable Between Interest Dates

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Interest Expense Interest Payable 11/1 $300,000 11/1 $150,000 $150,000 7/1 Issuing Bonds and Notes Payable Between Interest Dates

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Issuing Bonds Payable at a Discount t When would bonds be issued at a discount? t When contractual rate of interest is lower than market rate t Bondholders will pay amount less than face value for investment yielding less than current market rate

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t Suppose the City of Blacksburg, Virginia, issues the $15,000,000 of 6% 10-year bonds on May 1, 19x3, when similar bonds of comparable quality and risk pay 8% interest t What is the City’s journal entry if the bonds are issued at a discount? Issuing Bonds Payable at a Discount

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5/1/x3 Cash $12,955,500 Discount on Bonds Payable 2,044,500 Bonds Payable $15,000,000 To record bonds issued at discount t Discount on Bonds Payable is a contra account to Bonds Payable t Net amount of Discount and Bonds Payable accounts referred to as the bond’s carrying value

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t Discount represents additional interest expense to be allocated over life of bonds t Effect is to increase entity’s interest expense incurred on bond to equivalent of the market rate of interest Issuing Bonds Payable at a Discount

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City of Blacksburg would report its newly-issued bonds on the balance sheet: Long-Term Liabilities Bonds Payable (6%, due 5/1/20x3) $15,000,000 Less Bond Discount 2,044,500 Carrying Value $12,955,500 Issuing Bonds Payable at a Discount

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City of Blacksburg would report its newly-issued bonds on the balance sheet: Long-Term Liabilities Bonds Payable (6%, due 5/1/20x3) $15,000,000 Less Bond Discount 2,044,500 Carrying Value $12,955,500 Carrying value is Issuing Bonds Payable at a Discount

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City of Blacksburg would report its newly-issued bonds on the balance sheet: Long-Term Liabilities Bonds Payable (6%, due 5/1/20x3) $15,000,000 Less Bond Discount 2,044,500 Carrying Value $12,955,500 Carrying value is face value Issuing Bonds Payable at a Discount

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City of Blacksburg would report its newly-issued bonds on the balance sheet: Long-Term Liabilities Bonds Payable (6%, due 5/1/20x3) $15,000,000 Less Bond Discount 2,044,500 Carrying Value $12,955,500 Carrying value is face value minus unamortized bond discount Issuing Bonds Payable at a Discount

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Chapter Objective 4 Measure interest expense; amortize bond discount and premium by the effective-interest method

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Effective-Interest Method of Debt Amortization t GAAP requires bond discount to be amortized (allocated) over life of bond to yield interest expense equivalent to market interest rate s Known as effective-interest method t Semiannual cash interest payment to bondholders remains same t Interest expense recognized by entity grows slightly each period

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t Textbook Exhibit 8-6 shows an amortization schedule for a bond issued at a discount t Notice.... Effective-Interest Method of Debt Amortization

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t Interest payments to bondholders do not change over time t Interest expense recognized by company increases as bond carrying value increases t Unamortized bond discount decreases as bonds get closer to maturity t Bond carrying value rises to face value as it nears maturity Effective-Interest Method of Debt Amortization

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Interest Expense on Bonds Issued at a Discount - Amortizing Discount on Bonds Payable t Bond discount represents additional interest expense to entity t “Unstated” cost of issuing bonds when contractual interest rate is lower than market rate of interest on similar bonds t Refer to textbook Exhibit 8-7 to see relationship between interest payments and interest expense

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Interest Expense on Bonds Issued at a Discount - Amortizing Discount on Bonds Payable t Let’s amortize the first semiannual interest payment for the City of Blacksburg’s bonds 11/1/x3 Interest Expense $518,220 Discount on Bonds Payable $68,220 Cash 450,000 To record bond interest payment

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After recording interest expense, related account balances look like this: Discount on Interest Bonds Payable Expense Interest Expense on Bonds Issued at a Discount - Amortizing Discount on Bonds Payable

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After recording interest expense, related account balances look like this: Discount on Interest Bonds Payable Expense 5/1 $2,044,500 Interest Expense on Bonds Issued at a Discount - Amortizing Discount on Bonds Payable

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After recording interest expense, related account balances look like this: Discount on Interest Bonds Payable Expense 5/1 $2,044,500 $68,220 11/1 Interest Expense on Bonds Issued at a Discount - Amortizing Discount on Bonds Payable

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After recording interest expense, related account balances look like this: Discount on Interest Bonds Payable Expense 5/1 $2,044,500 $68,220 11/1 11/1 $518,220 Interest Expense on Bonds Issued at a Discount - Amortizing Discount on Bonds Payable

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After recording interest expense, related account balances look like this: Discount on Interest Bonds Payable Expense 5/1 $2,044,500 $68,220 11/1 11/1 $518,220 Bal $1,976,280 Interest Expense on Bonds Issued at a Discount - Amortizing Discount on Bonds Payable

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Issuing Bonds Payable at a Premium t Suppose the City of Blacksburg had issued its water treatment plant bonds at an interest rate higher than market rates t How would the May 1, 19x3, journal entry change if the contract rate of the bonds was 10% and the market rate of interest at 8%?

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5/1/x3 Cash $17,032,500 Premium on Bonds Payable $2,032,500 Bonds Payable 15,000,000 To record bonds issued at premium t Net amount of Premium and Bonds Payable accounts equal bond’s carrying value Issuing Bonds Payable at a Premium

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t Premium, like a discount, is amortized over life of bond t Premium represents a reduction in total interest expense s Created by bondholders’ willingness to pay more than face value for the bond issue t Effect of premium is to reduce bond interest expense

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City of Blacksburg would report its bonds on the balance sheet: Long-Term Liabilities Bonds Payable (10%, due 5/1/20x3) $15,000,000 Plus Bond Premium 2,032,500 Carrying Value $17,032,500 Issuing Bonds Payable at a Premium

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City of Blacksburg would report its bonds on the balance sheet: Long-Term Liabilities Bonds Payable (10%, due 5/1/20x3) $15,000,000 Plus Bond Premium 2,032,500 Carrying Value $17,032,500 Carrying value is Issuing Bonds Payable at a Premium

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City of Blacksburg would report its bonds on the balance sheet: Long-Term Liabilities Bonds Payable (10%, due 5/1/20x3) $15,000,000 Plus Bond Premium 2,032,500 Carrying Value $17,032,500 Carrying value is face value Issuing Bonds Payable at a Premium

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City of Blacksburg would report its bonds on the balance sheet: Long-Term Liabilities Bonds Payable (10%, due 5/1/20x3) $15,000,000 Plus Bond Premium 2,032,500 Carrying Value $17,032,500 Carrying value is face value plus unamortized bond premium Issuing Bonds Payable at a Premium

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t How would the City’s first semi-annual interest payment on the bonds be recorded? 11/1/x3 Interest Expense $681,300 Premium on Bonds Payable 68,700 Cash $750,000 To record bond interest payment Issuing Bonds Payable at a Premium

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t Textbook Exhibit 8-9 shows a bond premium amortization schedule t Observe the differences between it and Exhibit 8-6 Interest Expense on Bonds Issued at a Premium - Amortizing Premium on Bonds Payable

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t Interest payments to bondholders do not change over time t Interest expense recognized by company decreases as bond carrying value decreases toward maturity t Unamortized bond premium decreases as bonds get closer to maturity, similar to unamortized bond discount t Bond carrying value falls to its face value as it nears maturity Interest Expense on Bonds Issued at a Premium - Amortizing Premium on Bonds Payable

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t Bond premium represents a reduction of interest expense to entity t Reduction in cost of issuing bonds when contractual interest rate is higher than market rate of interest on similar bonds t Refer to textbook Exhibit 8-10 to see relationship between interest payments and interest expense

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Straight-Line Amortization of Bond Discount and Bond Premium t GAAP requires bond discounts and premiums to be amortized using effective-interest method t Companies permitted to use straight-line method provided it yields similar results t That is, differences are not material

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Consider the difference for the City of Blacksburg bonds issued at a premium: t Effective-interest method Bond premium - $2,032,500 First period amortization - $68,700 Straight-Line Amortization of Bond Discount and Bond Premium

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t Straight-line method Bond premium - $2,032,500 First period amortization - $101,625 t Straight-line amortization understates period interest expense by almost 5% $681,300 - effective rate $648,375 - straight-line rate Straight-Line Amortization of Bond Discount and Bond Premium

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t Straight-line method Bond premium - $2,032,500 First period amortization - $101,625 t Straight-line amortization understates period interest expense by almost 5% $681,300 - effective rate $648,375 - straight-line rate Straight-Line Amortization of Bond Discount and Bond Premium

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Early Retirement of Bonds Payable t Bonds typically retired (paid off) at maturity date t Some bonds retired prior to maturity date t Why?

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t Early retirement allows entity to reduce bond interest payments t By paying off debt early s Eliminating interest expense and cash outflow associated with bond interest payments t Or by reissuing bonds at a lower interest rate s Reducing interest expense and cash outflow related to interest payments Early Retirement of Bonds Payable

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Issuer can retire bonds before maturity by: t Purchasing bonds on the secondary market (buying up all bonds currently held by bondholders) t Exercising call option s Clause allowing issuer to redeem bonds at specified price as of specific date Early Retirement of Bonds Payable

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t After 6 years, the City of Blacksburg decides to call its 10% bonds t Perhaps interest rates have fallen, and the City believes it can reissue the debt at lower rate t Suppose the bonds came with a call provision, allowing the City to call bonds at 101 Early Retirement of Bonds Payable

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t What journal entry should the City make to retire these bonds? 5/1/x9 Bonds Payable $15,000,000 Premium on Bonds Payable 1,000,229 Gain on Bond Retirement $850,229 Cash 15,150,000 To record early bond retirement Early Retirement of Bonds Payable

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t GAAP requires gain or loss on bond retirement to be shown as an extraordinary item on entity’s income statement t Reported on separate section of income statement, net of income tax effect Early Retirement of Bonds Payable

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Convertible Bonds and Notes t Convertible bonds allow bondholder to exchange bonds for specified number of shares of common stock in the company t Bonds issued with conversion feature generally carry lower interest rate s Bondholder willing to accept lower rate due to benefits of stock ownership t When bonds converted into common stock, company increases stockholders’ equity for carrying value of bonds

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Chapter Objective 5 Explain the advantages and disadvantages of borrowing

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Advantage of Financing Operations with Bonds v. Stock t Businesses can acquire assets through debt or equity t Debt: can issue bonds, take mortgages, borrow funds to purchase assets t Equity: can issue stock in the company, use proceeds to purchase assets

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t Financing with debt t Doesn’t dilute ownership in company t Usually results in higher earnings per share s Refer to textbook Exhibit 8-12 t Reduces total net income t Increases debt ratios and may impose financial restrictions on company Advantage of Financing Operations with Bonds v. Stock

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t Financing with equity t No liabilities = no increase in debt ratios t No fixed interest payments t Generally higher total net income t Will dilute ownership interest and earnings per share of current stockholders Advantage of Financing Operations with Bonds v. Stock

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Chapter Objective 6 Account for lease transactions

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Lease Liabilities t Rental agreement permitting lessee (user) to possess and use asset without long-term commitments or large cash down- payment

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Lease Liabilities Operating leases 2 types of leases

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Lease Liabilities Operating leases Capital leases 2 types of leases

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Operating Leases t Short-term in nature t Generally cancelable t Right to undisturbed use of asset during lease period 6/1/98 Prepaid Rent $12,000 Cash $12,000 To record 12-month rent prepayment

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Capital Leases t Long-term, non- cancelable method of financing asset purchases t Airlines, railways, large retailers enter into long- term leases for many of their plant assets t Lease must meet 1 of 4 criteria to be classified as a capital lease

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Capital Leases 1.Leased asset becomes property of lessee at end of lease period 2.Lease includes “bargain purchase” option - for example, can buy asset for $100 at conclusion of lease 3.Lease term is 75% or more of asset’s estimated useful life 4.Present value of lease payments is greater than 90% of asset’s market value

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Accounting for Capital Leases t Accounting similar to purchased assets t Lessee records leased asset and related lease liability t Lessor removes asset from its records t Record depreciation on lease cost t Recognize interest expense as part of “cost” of acquiring leased asset (financing the asset acquisition over time)

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Off-Balance-Sheet Financing t Some business financing activities use debt that is not required to be reported on the balance sheet t Operating leases are an example t Operating lease disclosures in footnotes are important to understanding company’s future obligations STATEMENTS AND FOOTNOTES

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Pension Liabilities t A pension is money employees receive after their retirement from an organization t Companies match (accrue) pension expense in the accounting period employees worked to generate revenues t If company doesn’t accrue sufficient funds, excess liability is recognized as long-term pension liability t Detailed footnotes explain the current and future pension liabilities of the company

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Chapter Objective 7 Report liabilities on the balance sheet

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t Balance sheets of actual companies have wide variety of account titles and situations for which liabilities are recorded t Reported on face of balance sheet t Disclosed in footnotes to statements Reporting Current and Long-Term Liabilities on the Balance Sheet

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Reporting Financing Activities on the Statement of Cash Flows Financing activities on the statement of cash flows include: t Cash received from issuing debt t Cash paid to retire debt t Cash received upon sale of stock t Cash dividends paid to stockholders

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World Wide Web Sites to Visit AMR Corporation t Chrysler Corporation t

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THE END Of Ch 8 Presentation Slides

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Ch 8 Teaching Slides are Next

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© 1998 by Prentice Hall, Inc. Categories of Current Liabilities Amount of Liability Known When Recorded Trade accounts payable Short-term notes payable Sales taxes payable Current portion of long-term debt Accrued expenses: Interest payable Payroll liabilities such as: Salaries and wages payable FICA tax payable Employee income tax payable Unearned revenues (collected in advance) Amount of Liability Must Be Estimated When Recorded Estimated warranty payable Income tax payable Estimated vacation pay liability Contingent liabilities

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© 1998 by Prentice Hall, Inc. Contingent Liabilities Potential liability dependent upon a future event arising out of a past transaction Accounting treatment °Record a liability if probable and the amount of loss can be reasonably estimated °Report in a note only if reasonably possible °No need to report if remote (unlikely to occur)

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© 1998 by Prentice Hall, Inc. Nature and Types of Bonds Nature of Bonds In effect, a long-term note payable that bears interest. States that the issuer will repay the principal and specific interest payments. Usually in units of $1,000 called face value, maturity value, or par value. Interest is paid annually or semi-annually. $1,000 Bond Types of Bonds Term bonds - mature at the same time Serial bonds - mature in installments over time Secured (mortgage) bonds - give the bond holder the right to claim of assets if the issuer defaults Debenture bonds - unsecured bonds

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© 1998 by Prentice Hall, Inc. Interest Payments and Interest Expense on Bonds Payable Bonds Issued at a Discount Bonds Issued at a Premium

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© 1998 by Prentice Hall, Inc. Financing with Debt Versus Stock

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© 1998 by Prentice Hall, Inc. Other Types of Liabilities Current Portion of Long-term Debt The amount of long-term notes or bonds payable within the current period Mortgage Notes Borrowing agreement with assets pledged as collateral Leases Capital leases long-term non-cancelable financing obligation reported as a liability Operating lease short-term cancelable rental agreements Off-balance-sheet Financing Acquisition of assets or services with debt that is not reported on the balance sheet Pensions and Post-retirement Benefits Employee compensation and health benefits that will be received during retirement Deferred Income Taxes Income tax liabilities that the company can defer and pay later

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© 1998 by Prentice Hall, Inc. Financing Activities on the Statement of Cash Flows Cash Flows From Financing Activities Proceeds from issuance of long-term debt $12,000 Other short-term borrowings 10,000 Payments on long-term debt (4,000) Payments on capital leases (11,000) Payment of cash dividends (8,000) Net Cash used for Financing Activities $( 1,000)

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App D: Accounting for Partnership Slides Should be Inserted Here!

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