1. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-1 CHAPTER 8 Accounting for Current and Long-term Liabilities Debt

2. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-2 The liability section of The Home Depot balance sheet is presented below: 1. LIABILITIES: 2. Current Liabilities: 3. Accounts Payable$1,586 4. Accrued Salaries and Related Expenses 395 5. Sales Taxes Payable 176 6. Other Accrued Liabilities (Accrued Expenses Payable) 586 7. Income Taxes Payable 100 8. Current Installments of Long-Term Debt (notes 2 and 5) 14 9. Total Current Liabilities 2,857 10. Long-Term Debt, excluding current installments 1,566 11. Other Long-Term Liabilities 208 12. Deferred Income Taxes 85 13. Minority Interest 9 1. LIABILITIES: 2. Current Liabilities: 3. Accounts Payable$1,586 4. Accrued Salaries and Related Expenses 395 5. Sales Taxes Payable 176 6. Other Accrued Liabilities (Accrued Expenses Payable) 586 7. Income Taxes Payable 100 8. Current Installments of Long-Term Debt (notes 2 and 5) 14 9. Total Current Liabilities 2,857 10. Long-Term Debt, excluding current installments 1,566 11. Other Long-Term Liabilities 208 12. Deferred Income Taxes 85 13. Minority Interest 9

3. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-3 CURRENT LIABILITIES Current liabilities –Are obligations due within one year or within the company’s normal operating cycle if it is longer than one year –Fall into one of two categories: Liabilities of known amount Liabilities whose amount must be estimated Accounts payable are amounts owed for products or services purchased on account

4. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-4 Short-term notes payable are notes payable due within one year CURRENT LIABILITIES The following entry records a note payable: 20X1 Sep. 30 Inventory8,000 Note payable, short-term 8,000 Purchase of inventory by issuing a one-year 10% note 20X1 Sep. 30 Inventory8,000 Note payable, short-term 8,000 Purchase of inventory by issuing a one-year 10% note

5. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-5 CURRENT LIABILITIES At year end, the company must accrue interest expense: Dec. 31 Interest Expense (8,000 x.10 x 3/12)200 Interest Payable200 Adjusting entry to accrue interest expense at year end Dec. 31 Interest Expense (8,000 x.10 x 3/12)200 Interest Payable200 Adjusting entry to accrue interest expense at year end

6. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-6 CURRENT LIABILITIES The following entry records the note’s payment at maturity 20X2 Sep. 30 Note Payable, Short-term8,000 Interest Payable 200 Interest Expense ($8,000 x.10 x 9/12) 600 Cash [$8,000 + ($8,000 x.10)] 8,800 20X2 Sep. 30 Note Payable, Short-term8,000 Interest Payable 200 Interest Expense ($8,000 x.10 x 9/12) 600 Cash [$8,000 + ($8,000 x.10)] 8,800 The cash payment entry must separate the total interest on the note between –The interest expense accrued at the end of the previous period ($200) –The current period’s interest expense ($600) The cash payment entry must separate the total interest on the note between –The interest expense accrued at the end of the previous period ($200) –The current period’s interest expense ($600)

7. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-7 Sales tax payable is a current liability as shown on line 5 CURRENT LIABILITIES Suppose a day’s sales at a Home Depot store totals $200,000. The business collects 5% in sales tax. The store records the day’s sales as follows: Cash ($200,000 x 1.05)210,000 Sales Revenue200,000 Sales Tax Payable ($200,000 x.05) 10,000 To record cash sales and the related sales tax Cash ($200,000 x 1.05)210,000 Sales Revenue200,000 Sales Tax Payable ($200,000 x.05) 10,000 To record cash sales and the related sales tax

8. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-8 The current installment of long-term debt is –The amount of the principal that is payable within one year At the end of the year, a company reclassifies the amount of its long-term debt that must be paid during the upcoming year –Reported as a current liability CURRENT LIABILITIES

9. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-9 An accrued expense (accrued liability) is –An expense that the business has incurred but has not yet paid –A liability, thus the term accrued liability CURRENT LIABILITIES

10. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-10 Home Depot reports several categories of accrued expenses on its balance sheet –Accrued Salaries and Related Expenses (line 4) Includes liabilities for salaries, wages, and related payroll expenses at the end of the period –Other Accrued Liabilities (line 6) Includes such items as interest payable –Income Taxes Payable (line 7) is the amount of taxes still owed at year end CURRENT LIABILITIES

11. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-11 Payroll (employee compensation) is –A major expense of most businesses –Includes Salaries - pay stated at a yearly or monthly rate Wages - pay stated at hourly rates Commissions - a percentage of the sales the employee has made Bonuses - rewards for excellent performance CURRENT LIABILITIES

12. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-12 Salary expense represents employees’ gross pay and includes several payroll liabilities –Salary payable to employees - net (take- home) pay –Employee Income Tax Payable - the employees’ income tax that has been withheld from their paychecks CURRENT LIABILITIES

13. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-13 –FICA Tax Payable - the employees’ Social Security tax that has been withheld Includes a liability for Medicare tax –Other withholdings authorized by the employee, e.g., union dues CURRENT LIABILITIES

14. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-14 CURRENT LIABILITIES Accounting for Payroll Expenses and Liabilities Salary Expense (Wage Expense, Commission Expense) 10,000 Employee Income Tax Payable 1,200 FICA Tax Payable 800 Employee Union Dues Payable 140 Salary Payable to Employees (take home pay) 7,860 To record salary expense Salary Expense (Wage Expense, Commission Expense) 10,000 Employee Income Tax Payable 1,200 FICA Tax Payable 800 Employee Union Dues Payable 140 Salary Payable to Employees (take home pay) 7,860 To record salary expense

15. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-15 Unearned revenues indicate that the business has received cash from its customers before it has earned the revenue CURRENT LIABILITIES

16. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-16 CURRENT LIABILITIES The Dun & Bradstreet (D&B) Corporation provides credit evaluation services to businesses that subscribe to the D&B reports. The liability account is called Unearned Subscription Revenue. Assume that D&B charges a client $150 for a three-year subscription. D&B’s entries would be: 20X1 Jan. 1 Cash150 Unearned Subscription Revenue150 To receive cash for a three-year subscription 20X1 Jan. 1 Cash150 Unearned Subscription Revenue150 To receive cash for a three-year subscription 20X1, 20X2, 20X3 Dec. 31Unearned Subscription Revenue 50 Subscription Revenue ($150/3) 50 To record revenue earned at the end of each year 20X1, 20X2, 20X3 Dec. 31Unearned Subscription Revenue 50 Subscription Revenue ($150/3) 50 To record revenue earned at the end of each year

17. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-17 CURRENT LIABILITIES December 31, Balance Sheet Year 1 Year 2 Year 3 Current liabilities: Unearned subscription revenue $50$50-0- Long-term liabilities: Unearned subscription revenue$50 -0--0- Income Statement Revenues: Subscription revenue$50$50$50 December 31, Balance Sheet Year 1 Year 2 Year 3 Current liabilities: Unearned subscription revenue $50$50-0- Long-term liabilities: Unearned subscription revenue$50 -0--0- Income Statement Revenues: Subscription revenue$50$50$50

18. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-18 CURRENT LIABILITIES THAT MUST BE ESTIMATED Estimated warranty payable –Arises when a company warranties its product –Is recorded in the same period that the business recognizes sales revenue –Is estimated because the exact amount of warranty expense cannot be known with certainty Warranty

19. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-19 CURRENT LIABILITIES THAT MUST BE ESTIMATED Assume that Black & Decker made sales of $200,000,000 subject to product warranties. If Black & Decker estimates that 3% of the products it sells this year will require repair or replacement, the company would estimate warranty expense of $6,000,000 ($200,000,000 x.03) for the period and make the following entry: Warranty Expense 6,000,000 Estimated Warranty Payable6,000,000 To accrue warranty expense Warranty Expense 6,000,000 Estimated Warranty Payable6,000,000 To accrue warranty expense

20. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-20 CURRENT LIABILITIES THAT MUST BE ESTIMATED Assume that defective merchandise totals $5,800,000. Black & Decker will replace it and record the following: Estimated Warranty Payable5,800,000 Inventory5,800,000 To replace defective products sold under warranty Estimated Warranty Payable5,800,000 Inventory5,800,000 To replace defective products sold under warranty The company reports Estimated Warranty Payable on the balance sheet under the current-liability caption Accrued liabilities or Accrued expenses payable

21. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-21 Estimated vacation pay liability is –Accrued as an employee works –Reduced when cash is paid CURRENT LIABILITIES THAT MUST BE ESTIMATED

22. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-22 CONTINGENT LIABILITIES A contingent liability is –A potential liability that depends on a future event arising out of past events –Subject to the following FASB guidelines for accounting for contingent losses (or expenses) and their related liabilities Record an actual liability if it is probable that the loss (or expense) will occur and the amount can be reasonably estimated

23. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-23 Report the contingency in a financial statement note if it is reasonably possible that a loss (or expense) will occur There is no need to report a contingent loss that is remote (unlikely to occur) –May be reported in a short presentation, after liabilities on the balance sheet, but with no amounts given Usually accompanied by an explanatory note CONTINGENT LIABILITIES

24. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-24 Financing Operations With Long-Term Debt

25. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-25 BONDS: AN INTRODUCTION Bonds payable –Are groups of notes payable issued to multiple lenders, called bondholders –State the principal The amount that the company has borrowed on the bond certificates –Typically are stated in units of $1,000 called face value, maturity value, or par value Bond

26. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-26 –Obligate the issuing company to pay the holder the principal amount at a specific future date called the maturity date Bondholders loan their money to companies for a price: interest on the principal The bond certificate states –The interest rate the issuer will pay –The dates the interest payments are due BONDS: AN INTRODUCTION

27. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-27 When the company pays back the principal –The holder returns the certificate –The company retires (or cancels) the bond BONDS: AN INTRODUCTION

28. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-28 TYPES OF BONDS Term bonds mature at a specified time Serial bonds mature in installments over a period of time Secured (mortgage) bonds give the bondholder the right to take specified assets of the issuer if the company defaults (fails to pay principal or interest) Debentures are unsecured bonds and are backed only by the good faith of the borrower

29. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-29 BOND PRICES Bond prices are quoted at a percentage of their maturity value –A $1,000 bond quoted at 100 is bought or sold for $1,000, which is 100% of its face value –A bond quoted at 101½ has a market price of $1,015 (101.5% of face value, or $1,000 x 1.015) –A $1,000 bond quoted at 88 3/8 is priced at $883.75 ($1,000 x 0.83375)

30. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-30 BOND PRICES The exhibit below contains actual price information for the bonds of Ohio Edison Company, taken from The Wall Street Journal. On this particular day, 12 of Ohio Edison’s 9 1/2%, $1,000 face value bonds maturing in the year 2006 (indicated by 06) were traded. The bonds’ highest price on this day was $795 ($1,000 x 0.795). The lowest price of the day was $785 ($1,000 x 0.785). The closing price (last sale price of the day) was $795, 2 points higher than the closing price of the preceding day. Bonds Volume High Low Close Net Change OhEd 9 1/2 06 12 79 1/2 78 1/2 79 1/2 +2 Bonds Volume High Low Close Net Change OhEd 9 1/2 06 12 79 1/2 78 1/2 79 1/2 +2

31. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-31 A bond issued at a price above its face (par) value is said to be issued at a premium, and a bond issued at a price below face (par) value has a discount As a bond nears maturity, its market price moves toward par value On the maturity date, a bond’s market value exactly equals its par value BOND PRICES

32. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-32 PRESENT VALUE Money earns income over time, a fact called the time value of money The amount that a person would invest at the present time to receive a greater amount at a future date is called the present value of a future amount

33. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-33 The exact present value of any future amount depends on –The amount of the future payment (or receipt) –The length of time from the investment to the date when the future amount is to be paid (or received) –The interest rate during the period Present value is always less than the future amount PRESENT VALUE

34. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-34 BOND INTEREST RATES Bonds are sold at market price Market price is –The amount that investors are willing to pay at any given time –The bond’s present value equals the present value of two obligations: Principal payment Cash interest payments

35. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-35 The contract (stated) interest rate is –The interest rate that determines the amount of cash interest the borrower pays each year The market (effective) interest rate is –The rate that investors demand for loaning their money BOND INTEREST RATES

36. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-36 Contract (stated) interest rate on a bond payable Example: (9%) Contract (stated) interest rate on a bond payable Example: (9%) Contract (stated) interest rate on a bond payable Example: (9%) Market interest rate 9% Market interest rate 10% Market interest rate 8% Premium: $1,000 bond issued above $1,000 Par: $1,000 bond issued for $1,000 equals greater than impliesPar (face, or maturity) value Discount (price below par) Discount: $1,000 bond issued below $1,000 Premium (price above par) = less than   How the Contract Interest Rate and the Market Interest Rate Interact to Determine the Price of a Bond Payable Issuance Price of Bonds Payable

37. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-37 Issuing Bonds Payable to Borrow Money

38. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-38 ISSUANCE AT PAR Suppose Chrysler Corporation has $50 million in 9% bonds that mature in five years. Chrysler issued these bonds at par on January 1, 2000. The issuance entry is 2000 Jan. 1 Cash 50,000,000 Bonds Payable 50,000,000 To issue 9%, 5-year bonds at par 2000 Jan. 1 Cash 50,000,000 Bonds Payable 50,000,000 To issue 9%, 5-year bonds at par

39. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-39 ISSUANCE AT PAR Interest payments occur each January 1 and July 1. Chrysler’s entry to record the first semiannual interest payment is 2000 July 1 Interest Expense ($50,000,000 x.09 x 6/12) 2,250,000 Cash 2,250,000 To pay semiannual interest 2000 July 1 Interest Expense ($50,000,000 x.09 x 6/12) 2,250,000 Cash 2,250,000 To pay semiannual interest

40. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-40 ISSUANCE AT PAR At year end, Chrysler must accrue interest expense and interest payable for six months (July through December), as follows: 2000 Dec. 31 Interest Expense ($50,000,000 x.09 x 6/12) 2,250,000 Interest Payable 2,250,000 To accrue interest 2000 Dec. 31 Interest Expense ($50,000,000 x.09 x 6/12) 2,250,000 Interest Payable 2,250,000 To accrue interest

41. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-41 ISSUANCE AT PAR At maturity, Chrysler will record payment of the bonds as follows: 2005 Jan. 1 Bonds Payable 50,000,000 Cash 50,000,000 To pay bonds payable at maturity 2005 Jan. 1 Bonds Payable 50,000,000 Cash 50,000,000 To pay bonds payable at maturity

42. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-42 ISSUING BONDS PAYABLE BETWEEN INTEREST DATES Assume that Chrysler issued its 9% bonds payable on February 28, 2000-- two months after the bonds were dated (January 1, 2000). At issuance, Chrysler Corporation will collect two months of interest from the bondholder and record issuance of the bonds as follows: 2000 Feb. 29 Cash 50,750,000 Bonds Payable50,000,000 Interest Payable ($50,000,000 x.09 x 2/12) 750,000 To issue 9%, 5-year bonds at par two months after original issue date 2000 Feb. 29 Cash 50,750,000 Bonds Payable50,000,000 Interest Payable ($50,000,000 x.09 x 2/12) 750,000 To issue 9%, 5-year bonds at par two months after original issue date On June 30, Chrysler will make a semiannual interest payment. Chrysler has interest expense for the four months that the bonds have been outstanding.

43. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-43 ISSUING BONDS PAYABLE AT A DISCOUNT Suppose Chrysler Corporation issues $100,000 of its 9%, five-year bonds when the market interest rate is 10 percent. Chrysler receives $96,149 at issuance. The entry is 2000 Jan. 1Cash96,149 Discount of Bonds Payable 3,851 Bonds Payable 100,000 To issue 9%, 5-year bonds at a discount 2000 Jan. 1Cash96,149 Discount of Bonds Payable 3,851 Bonds Payable 100,000 To issue 9%, 5-year bonds at a discount

44. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-44 ISSUING BONDS PAYABLE AT A DISCOUNT Bonds PayableDiscount on Bonds Payable After posting, the bond accounts have the following balances: 100,0003,851 The $3,851 discount represents extra interest expense that Chrysler will recognize little by little over the life of the bond issue

45. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-45 ISSUING BONDS PAYABLE AT A DISCOUNT Chrysler’s balance sheet immediately after issuance of the bonds would report the following: Total current liabilities$ XXX Long-term liabilities: Bonds payable, 9%, due 2003$100,000 Less: Discount on bonds payable (3,851)96,149 Total current liabilities$ XXX Long-term liabilities: Bonds payable, 9%, due 2003$100,000 Less: Discount on bonds payable (3,851)96,149 Discount on Bonds Payable is a contra account to Bonds Payable. Subtracting its balance from Bonds Payable yields the carrying amount of the bonds

46. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-46 EFFECTIVE-INTEREST METHOD OF DEBT AMORTIZATION Chrysler Corporation pays interest on its bonds semiannually. Each semiannual interest payment is fixed by the bond contract and remains the same amount over the life of the bonds: Semiannual interest payment = $100,000 x.09 x 6/12 = $4,500 Semiannual interest payment = $100,000 x.09 x 6/12 = $4,500

47. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-47 The following table uses the effective- interest method of amortization to determine the periodic interest expense and bond carrying amounts For bonds issued at a discount, the interest expense increases as the bonds’ carrying amount increases EFFECTIVE-INTEREST METHOD OF DEBT AMORTIZATION

48. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-48 Jan. 1, 2000 July 1 Jan. 1, 2001 July 1 Jan. 1, 2002 July 1 Jan. 1, 2003 July 1 Jan. 1, 2004 July 1 Jan. 1, 2005 Semiannual Interest Date Interest Payment (4 1/2% of Maturity Value) Interest Expense (5% of Preceding Bond Carrying Amount) Discount Amortization (B - A) Discount Account Balance (Preceding D-C) Bond Carrying Amount ($100,000 -D) $4,500 4,500 $4,807 4,823 4,839 4,856 4,874 4,892 4,912 4,933 4,954 4,961 $307 323 339 356 374 392 412 433 454 461 $3,851 3,544 3,221 2,882 2,526 2,152 1,760 1,348 915 416 -0- $ 96,149 96,456 96,779 97,118 97,474 97,848 98,240 98,652 99,085 99,539 100,000 A B C D E

49. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-49 INTEREST EXPENSE ON BONDS ISSUED AT A DISCOUNT The following exhibit graphs the data from the amortization table –The interest expense (Column B) –The interest payment (Column A) –The amortization of bond discount (Column C)

50. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-50 1 2 3 4 5 6 7 8 9 10 $5,000 4,950 4,900 4,850 4,800 4,500 4,400 Interest expense Interest payment Amortization of bond discount, $461 $4,961 $4,500 $4,807 $4,500 Interest Expense Semiannual Interest Periods $307

51. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-51 The following graph illustrates the amortization of the bond discount from its beginning balance of $3,851 to its ending balance of $0 These amounts come from column D of the amortization table INTEREST EXPENSE ON BONDS ISSUED AT A DISCOUNT

52. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-52 1 2 3 4 5 6 7 8 9 10 Semiannual Interest Periods $101,000 100,000 99,000 98,000 97,000 96,000 95,000 Bond Carrying Amount Bond’s maturity value = $100,000 Bond discount = 0 Bond carrying amount increases to maturity $3,851 Discount on bonds payable is amortized to $0

53. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-53 INTEREST EXPENSE ON BONDS ISSUED AT A DISCOUNT On July, Chrysler makes the first $4,500 semiannual interest payment and also amortizes (decreases) the bond discount. Chrysler's journal entry is 2000 July 1 Interest Expense4,807 Discount on Bonds Payable 307 Cash 4,500 To pay semiannual interest and amortize bond discount 2000 July 1 Interest Expense4,807 Discount on Bonds Payable 307 Cash 4,500 To pay semiannual interest and amortize bond discount

54. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-54 INTEREST EXPENSE ON BONDS ISSUED AT A DISCOUNT At December 31, 2000, Chrysler accrues interest and amortizes the bond discount for July through December with this entry (amounts from amortization table): 2000 Dec. 31 Interest Expense 4,823 Discount on Bonds Payable 323 Interest Payable 4,500 To accrue semiannual interest and amortize bond discount 2000 Dec. 31 Interest Expense 4,823 Discount on Bonds Payable 323 Interest Payable 4,500 To accrue semiannual interest and amortize bond discount

55. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-55 INTEREST EXPENSE ON BONDS ISSUED AT A DISCOUNT At December 31, 2000, Chrysler's bond accounts appear as follows: Bonds PayableDiscount on Bonds Payable 100,0003,851307 323 Bal. 3,221 Bond carrying amount, $96,779 = ($100,000 - $3,221)

56. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-56 ISSUING BONDS PAYABLE AT A PREMIUM Assume that Chrysler Corporation issues $100,000 of five-year, 9% bonds that pay interest semiannually The market interest rate is 8% and issue price is $104,100 The premium on these bonds is $4,100 The following table shows how to amortize the premium by the effective- interest method

57. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-57 Jan. 1, 2000 July 1 Jan. 1, 2001 July 1 Jan. 1, 2002 July 1 Jan. 1, 2003 July 1 Jan. 1, 2004 July 1 Jan. 1, 2005 Semiannual Interest Date Interest Payment (4 1/2% of Maturity Value) Interest Expense (4% of Preceding Bond Carrying Amount) Premium Amortization (A - B) Premium Account Balance (Preceding D-C) Bond Carrying Amount ($100,000 +D) $4,500 4,500 $4,164 4,151 4,137 4,122 4,107 4,091 4,075 4,058 4,040 3,955 $336 349 363 378 393 409 425 442 460 545 $4,100 3,764 3,415 3,052 2,674 2,281 1,872 1,447 1.005 545 -0- $104,100 103,764 103,415 103,052 102,674 102,281 101,872 101,447 101,005 100,545 100,000 A B C D E

58. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-58 ISSUING BONDS PAYABLE AT A PREMIUM The entries to record issuance of the bonds and make the first interest payment and amortize the related premium are as follows: 2000 Jan. 1 Cash 104,100 Bonds Payable 100,000 Premium on Bonds Payable 4,100 To issue 9% bonds at a premium 2000 Jan. 1 Cash 104,100 Bonds Payable 100,000 Premium on Bonds Payable 4,100 To issue 9% bonds at a premium 2000 July 1 Interest Expense4,164 Premium on Bonds Payable 336 Cash 4,500 To pay semiannual interest and amortize bond premium 2000 July 1 Interest Expense4,164 Premium on Bonds Payable 336 Cash 4,500 To pay semiannual interest and amortize bond premium

59. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-59 ISSUING BONDS PAYABLE AT A PREMIUM Immediately after issuing the bonds, Chrysler would report the bonds payable on the balance sheet as follows: Total current liabilities $ XXX Long-term liabilities: Bonds payable$100,000 Premium on bonds payable 4,100104,100 Total current liabilities $ XXX Long-term liabilities: Bonds payable$100,000 Premium on bonds payable 4,100104,100

60. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-60 INTEREST EXPENSE ON BONDS ISSUED AT A PREMIUM The $4,100 premium on the bonds is a reduction in Chrysler's interest expense over the term of the bond The amount of interest expense each period decreases as the bond carrying amount is amortized downward toward maturity value

61. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-61 1 2 3 4 5 6 7 8 9 10 $4,500 4,400 4,300 4,200 4,100 4,000 3,900 Interest expense Interest payment Amortization of bond premium, $545 $4,500 $3,955 $4,164 $4,500 Interest Expense Semiannual Interest Periods $336

62. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-62 1 2 3 4 5 6 7 8 9 10 Semiannual Interest Periods $105,000 104,000 103,000 102,000 101,000 100,000 Bond Carrying Amount Bond’s maturity value = $100,000 Bond premium = 0 Bond carrying amount decreases to maturity $4,100 Premium on bonds payable is amortized to $0

63. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-63 STRAIGHT-LINE AMORTIZATION OF BOND DISCOUNT AND BOND PREMIUM The straight-line amortization method –Divides a bond discount (or premium) into equal periodic amounts over the bond’s term The amount of interest expense is the same for each interest period –Is allowed by GAAP only when its amounts differ insignificantly from the amounts determined by the effective-interest method

64. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-64 EARLY RETIREMENT OF BONDS PAYABLE The main reason for retiring bonds early is to eliminate interest payments Some bonds are callable –The bonds issuer may call, or pay off, the bonds at a specified price whenever the issuer chooses The alternative to calling the bonds is to purchase them in the open market at their current market price

65. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-65 EARLY RETIREMENT OF BONDS PAYABLE Air Products and Chemicals, Inc., has $70 million of debenture bonds outstanding with an unamortized discount of $350,000. If the market price of the bonds is 99¼, retiring the bonds results in a gain of $175,000: Par value of bonds being retired$70,000,000 Less: Unamortized discount 350,000 Carrying amount of the bonds 69,650,000 Market price ($70,000,000 x 0.9925) 69,475,000 Gain on retirement$ 175,000 Par value of bonds being retired$70,000,000 Less: Unamortized discount 350,000 Carrying amount of the bonds 69,650,000 Market price ($70,000,000 x 0.9925) 69,475,000 Gain on retirement$ 175,000

66. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-66 EARLY RETIREMENT OF BONDS PAYABLE The following entry records retirement of the bonds immediately after an interest date: June 30 Bonds Payable 70,000,000 Discount on Bonds Payable 350,000 Cash ($70,000,000 x 0.9925) 69,475,000 Extraordinary Gain on Retirement of Bonds Payable 175,000 To retire bonds payable before maturity June 30 Bonds Payable 70,000,000 Discount on Bonds Payable 350,000 Cash ($70,000,000 x 0.9925) 69,475,000 Extraordinary Gain on Retirement of Bonds Payable 175,000 To retire bonds payable before maturity

67. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-67 The entry removes the bonds payable and the related discount from the accounts and records a gain on retirement GAAP identifies gains and losses on early retirement of debts as extraordinary, and they are reported separately on the income statement, net of tax EARLY RETIREMENT OF BONDS PAYABLE

68. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-68 CONVERTIBLE BONDS AND NOTES Convertible bonds (or notes) may be converted into the issuing company’s common stock at the investor’s option Bond Stock

69. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-69 CONVERTIBLE BONDS AND NOTES Prime Western, Inc., has convertible notes outstanding carried on the books at $12.5 million. The maturity value of the notes is $13 million. If the noteholders convert the notes into 400,000 shares of the company’s $1 par common stock, the entry for this conversion is: May 14Notes Payable 13,000,000 Discount on Notes Payable 500,000 Common Stock (400,000 x $1 par) 400,000 Paid-in Capital in Excess of Par - Common 12,100,000 To record conversion of notes payable May 14Notes Payable 13,000,000 Discount on Notes Payable 500,000 Common Stock (400,000 x $1 par) 400,000 Paid-in Capital in Excess of Par - Common 12,100,000 To record conversion of notes payable

70. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-70 The carrying amount of the notes ($13,000,000 - $500,000) becomes stockholders’ equity ($400,000 + $12,100,000) The Notes Payable account and its related discount account are zeroed out Common Stock is recorded at its par value Any extra carrying amount of the Notes Payable is credited to Paid-in Capital in Excess of Par - Common CONVERTIBLE BONDS AND NOTES

71. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-71 ADVANTAGES OF FINANCING OPERATION WITH BONDS VS. STOCKS The money to acquire assets may be financed by the business’s –Retained earnings –A stock issue –A bond issue Each financing strategy has its advantages

72. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-72 Creates no liabilities or interest expense Less risky to the issuing corporation Does not dilute stock ownership or control of the corporation Results in higher earnings per share because interest expense is tax deductible Advantages of Financing Operations By Issuing Stock Issuing Notes or Bonds Payable

73. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-73 Earnings per share (EPS) is the amount of a company’s net income for each share of its common stock It is a standard measure of operating performance for comparing companies of different sizes and from different industries ADVANTAGES OF FINANCING OPERATION WITH BONDS VS. STOCKS

74. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-74 ADVANTAGES OF FINANCING OPERATION WITH BONDS VS. STOCKS Suppose a corporation needs $500,000 for expansion. The company has net income of $300,000 and 100,000 shares of common stock outstanding. Management is considering two financing plans: –Plan 1 is to issue $500,000 of 10% bonds payable –Plan 2 is to issue 50,000 additional shares of common stock for $500,000

75. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-75 The new cash can be invested in operations to earn income of $200,000 before interest and taxes Earning more income on borrowed money than the related interest expense increases the earnings for common stockholders and is called trading on the equity ADVANTAGES OF FINANCING OPERATION WITH BONDS VS. STOCKS

76. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-76 The next slide shows the earnings-per- share advantage of borrowing The company’s EPS amount is higher if the company borrows by issuing bonds ADVANTAGES OF FINANCING OPERATION WITH BONDS VS. STOCKS EPS

77. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-77 Net income before expansion $300,000 $300,000 Project income before interest and income tax $200,000$200,000 Less interest expense ($500,000 x 0.10) (50,000) -0- Project income before income tax 150,000 200,000 Less income tax expense (40%) 60,000 (80,000) Project net income 90,000 120,000 Total company net income $390,000 $420,000 Earnings per share after expansion: Plan 1 ($390,000/100,000 shares) $ 3.90 Plan 2 ($420,000/150,000 shares) $ 2.80 Plan 1 Borrow $500,000 at 10% Plan 2 Issue $500,000 of Common Stock

78. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-78 LEASE LIABILITIES

79. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-79 LEASE LIABILITIES A lease is a rental agreement in which the tenant (lessee) agrees to make rent payments to the property owner (lessor) in exchange for the use of the asset The two types of leases are –Operating leases –Capital leases

80. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-80 OPERATING LEASES Operating leases –Give the lessee the right to use the asset but provide the lessee with no continuing rights to the asset –Are accounted for by debiting Rent Expense (or Lease Expense) and crediting Cash for the amount of the lease payment The lessee’s books do not report the leased asset or any lease liability

81. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-81 CAPITAL LEASES A capital lease is a noncancelable long- term financing obligation that is a form of debt To be classified as a capital lease, a lease agreement must meet any one of the following four criteria: ÀThe lease transfers title of the leased asset to the lessee at the end of the lease term

82. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-82 ÁThe lease contains a bargain purchase option The lessee can be expected to purchase the leased asset and become its legal owner ÂThe lease term is 75% of the estimated useful life of the leased asset The lessee uses up most of the leased asset’s service potential CAPITAL LEASES

83. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-83 ÃThe present value of the lease payments is 90% or more of the market value of the leased asset The lease payments operate as installment payments for the leased asset CAPITAL LEASES

84. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-84 ACCOUNTING FOR A CAPITAL LEASE The lessee enters the asset into its own accounts and records a lease liability at the beginning of the lease term The lessee capitalizes the asset even though the lessee may never take legal title to the property

85. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-85 REPORTING LIABILITIES ON THE BALANCE SHEET The Home Depot liability section of the balance sheet is presented again on the next slide

86. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-86 The liability section of The Home Depot balance sheet is presented below: 1. LIABILITIES: 2. Current Liabilities: 3. Accounts Payable$1,586 4. Accrued Salaries and Related Expenses 395 5. Sales Taxes Payable 176 6. Other Accrued Liabilities (Accrued Expenses Payable) 586 7. Income Taxes Payable 100 8. Current Installments of Long-Term Debt (notes 2 and 5) 14 9. Total Current Liabilities 2,857 10. Long-Term Debt, excluding current installments 1,566 11. Other Long-Term Liabilities 208 12. Deferred Income Taxes 85 13. Minority Interest 9 1. LIABILITIES: 2. Current Liabilities: 3. Accounts Payable$1,586 4. Accrued Salaries and Related Expenses 395 5. Sales Taxes Payable 176 6. Other Accrued Liabilities (Accrued Expenses Payable) 586 7. Income Taxes Payable 100 8. Current Installments of Long-Term Debt (notes 2 and 5) 14 9. Total Current Liabilities 2,857 10. Long-Term Debt, excluding current installments 1,566 11. Other Long-Term Liabilities 208 12. Deferred Income Taxes 85 13. Minority Interest 9

87. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-87 REPORTING LIABILITIES ON THE BALANCE SHEET Additional categories of long-term liabilities include –Deferred income taxes Income taxes that the company can defer and pay later –Minority interest Outside stockholders’ interest –Other long-term liabilities Includes long-term unearned revenue (deferred credits)

88. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-88 REPORTING THE FAIR MARKET VALUE OF LONG-TERM DEBT FASB Statement No. 107 requires companies to report the fair market value of their financial instruments Long-term debts, including notes and bonds payable, are financial instruments

89. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-89 PENSION AND POSTRETIREMENT LIABILITIES A pension is employee compensation that will be received during retirement Companies also provide postretirement benefits, such as medical insurance Companies record pension and retirement benefit expense while employees work for the company

90. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-90 At the end of each period, the company compares –The fair market value of the assets in the pension plan--cash and investments--with –The plan’s accumulated benefit obligation The present value of promised future pension payment to retirees PENSION AND POSTRETIREMENT LIABILITIES

91. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-91 If the accumulated benefit obligation exceeds plan assets, the plan is underfunded, and the company must report the excess liability amount as a long-term pension liability on the balance sheet PENSION AND POSTRETIREMENT LIABILITIES

92. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-92 REPORTING ON THE STATEMENT OF CASH FLOWS The next slide is an excerpt from The Home Depot’s statement of cash flows The Home Depot finances most of its operations with equity However, it borrowed $246 million by issuing commercial paper (line 3) and paid $8 million on its long-term debt (line 5) Home Depot is able to finance most of its asset purchases with cash generated by operations (line 1)

93. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-93 Cash Flow from Operating Activities: 1. Net Cash provided by operating activities $ 1,917 Cash Flow from Investing Activities: 2. Net Cash used in investing activities $(2,271) Cash Flow from Financing Activities: 3. Borrowing by issuing commercial paper $ 246 4. Proceeds from long-term borrowing -0- 5. Payments of long-term debt (8) 6. Proceeds from issuance of common stock 167 7. Payments of cash dividends (168) 8. Other, net 7 9. Net cash provided by (used in) financing activities $ 244 10. Increase (decrease) in cash (110) 11. Cash at beginning of year 172 12. Cash at end of year $ 62 The Home Depot Statement of Cash Flows For the year ended January 31, 1999 In millions

94. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 8-94 END OF CHAPTER 8