9-1 ©2006 Prentice Hall, Inc.

9-2 ©2006 Prentice Hall, Inc. REPORTING & UNDERSTANDING LIABILITIES (1 of 2)  Learning objectives Learning objectives  Definitely determinable liabilities Definitely determinable liabilities  Estimated liabilities Estimated liabilities  Long-term notes payable and mortgages Long-term notes payable and mortgages  Long-term liabilities: Raising money by issuing bonds Long-term liabilities: Raising money by issuing bonds

9-3 ©2006 Prentice Hall, Inc. REPORTING & UNDERSTANDING LIABILITIES (2 of 2)  Financial statement analysis Financial statement analysis  Business risk, control, and ethics Business risk, control, and ethics  Appendix A: Time value of money Appendix A: Time value of money  Appendix B: Bond proceeds Appendix B: Bond proceeds  Appendix C: Bond amortization Appendix C: Bond amortization  Appendix D: Leases and pensions Appendix D: Leases and pensions

9-4 ©2006 Prentice Hall, Inc. Learning Objectives (1 of 2)  Define a definitely determinable liability and explain how payroll is recorded  Define an estimated liability and explain how to account for warranties  Explain how long-term notes and mortgages work

9-5 ©2006 Prentice Hall, Inc. Learning Objectives (2 of 2)  Record the issue of bonds and payment of interest to bondholders  Explain capital structure and compute the debt-to-equity and the times- interest-earned ratios  Identify the major risk associated with long-term debt and the related controls

9-6 ©2006 Prentice Hall, Inc. Definitely Determinable Liabilities (1 of 3)  Obligations that can be measured exactly  E.g., bank loans, accounts payable, notes payable, salaries payable  Accounting for payroll  Firms must supply the government with information for each worker  Federal, state, and Social Security taxes

9-7 ©2006 Prentice Hall, Inc. Definitely Determinable Liabilities (2 of 3)  Accounting for payroll (continued)  Gross pay  Wages/salary before any deductions  Deductions  Federal income tax (FIT) withheld  FIT Payable  FICA tax withheld (6.2% of salary)  FICA Payable  Medicare tax withheld (1.45% of salary)  Medicare Taxes Payable

9-8 ©2006 Prentice Hall, Inc. Definitely Determinable Liabilities (3 of 3)  Accounting for payroll (continued)  Employer must match employee deduction for FICA and Medicare  Employer’s Payroll Tax Expense  What is take-home pay? How is it calculated?  Where do you find FICA Payable on the financial statements?  Payroll example Payroll example

9-9 ©2006 Prentice Hall, Inc. Payroll Example (1 of 3)  In 2006, accounting graduates’ starting salary was around $875/week ($45,500/yr)  Assume that Federal income taxes are withheld at a 20% rate

9-10 ©2006 Prentice Hall, Inc. Payroll Example (2 of 3)  Record payment of the weekly payroll Assets = Liab. + Cont. Cap. + R/E DateTransactionDebitCredit

9-11 ©2006 Prentice Hall, Inc. Payroll Example (3 of 3)  Record payment of weekly payroll taxes Assets = Liab. + Cont. Cap. + R/E DateTransactionDebitCredit

9-12 ©2006 Prentice Hall, Inc. Estimated Liabilities (1 of 2)  Accounting for warranties  Obligation is not certain, so it is estimated  Why do companies provide warranties on their products and services?  Warranty Payable and related Warranty Expense recognized in year product is sold regardless of duration of the warranty  What accounting principle (ch 2)requires this?

9-13 ©2006 Prentice Hall, Inc. Estimated Liabilities (2 of 2)  Accounting for warranties (continued)  Repairs or replacement under warranty  Cash, parts inventory, and/or merchandise inventory decreases (credit)  Warranty Payable decreases (debit) because part of the warranty liability is satisfied  Is Warranty Payable current or long-term?  Warranty example Warranty example

9-14 ©2006 Prentice Hall, Inc. Warranty Example (1 of 4) 1. Electronics Universe (EU) sells $20,000 of consumer electronics for cash during September with a 2-year warranty (ignore CoGS) 2. EU estimates that warranty work related to the sales will be 3% of sales. 3. During September, EU pays $100 cash and uses $80 of parts to satisfy warranty claims

9-15 ©2006 Prentice Hall, Inc. Warranty Example (2 of 4) 4. In October, EU changes name to The Universe  Nobody knows what they sell so they only had $1,500 of cash sales with a two-year warranty (ignore CoGS)  See the importance of marketing?  What happened to the value of its trade name? 5. EU estimates that warranty work related to the sales will be 3% of sales. 6. During September, EU pays $50 cash and uses $110 of parts to satisfy warranty claims

9-16 ©2006 Prentice Hall, Inc. Warranty Example (3 of 4) TA Assets = Liab. + Cont. Cap. + R/E

9-17 ©2006 Prentice Hall, Inc. Warranty Example (4 of 4) Dr. Cr.

9-18 ©2006 Prentice Hall, Inc. Long-term Notes Payable and Mortgages (1 of 4)  Short-term notes  Mature in < 1 yr  Interest and principal usually paid at the end of the term

9-19 ©2006 Prentice Hall, Inc. Long-term Notes Payable and Mortgages (2 of 4)  Long-term notes  Mature in > 1 yr  Options for repayment  Repay in one lump sum (principal + interest)  Repay in equal annual payments  Payments combine principal and interest  As loan is repaid outstanding balance of loan decreases, so the interest portion of the payment decreases and the principal portion increases

9-20 ©2006 Prentice Hall, Inc. Long-term Notes Payable and Mortgages (3 of 4)  Present value  Value today of a given amount to be paid or received in the future  Both the principal and interest not paid or received are earning interest at the discount rate  Discount rate  Interest rate used to compute the present value of the future cash flows

9-21 ©2006 Prentice Hall, Inc. Long-term Notes Payable and Mortgages (4 of 4)  Present value (continued)  If you deposited $100 in the bank at 5% interest, at the end of the year you would have $105  The present value of receiving $105 one year from now at a 5% discount rate is $100  Repaying a mortgage Repaying a mortgage

9-22 ©2006 Prentice Hall, Inc. Repaying a Mortgage (1 of 3)  The Universe borrows $200,000 on 1/1/08  Discount rate: 7%  Term of loan: 4 years  Payments at end of each year: $59,046  Make journal entries for first two years  See the amortization table on the next slide?

9-23 ©2006 Prentice Hall, Inc. Repaying a Mortgage (2 of 3) ABCDE YrBeg Prin Mtg Pmt Int Exp A x int % Prin Paid B - C End Prin A + D 1200,00059,046 14,000 45,046154, ,046 10,847 48,199106, ,046 7,473 51,573 55, ,046 3,863 55,183 0

9-24 ©2006 Prentice Hall, Inc. Repaying a Mortgage (3 of 3) DateTransactionDebitCredit 12/31/08 12/31/09 Assets = Liab. + Cont. Cap. + R/E

9-25 ©2006 Prentice Hall, Inc. Long-term Liabilities: Raising Money by Issuing Bonds  What is a bond? What is a bond?  Types of bonds Types of bonds  Issuing bonds payable Issuing bonds payable  Paying interest to bondholders Paying interest to bondholders  Market for trading bonds Market for trading bonds

9-26 ©2006 Prentice Hall, Inc. What Is A Bond? (1 of 2)  An interest-bearing, long-term note payable  Interest is usually paid to the bondholder semi-annually  Principal is repaid at maturity  Only corporations and governmental agencies can issue bonds  Face value (stated value) usually $1,000

9-27 ©2006 Prentice Hall, Inc. What Is a Bond? (2 of 2)  List three reasons why a corporation may prefer to borrow money by issuing bonds than by borrowing money from a bank?  What are bond covenants?  Why are they a disadvantage of issuing bonds?

9-28 ©2006 Prentice Hall, Inc. Types of Bonds (1 of 3)  Secured vs. unsecured  Do bondholders have a claim to specific assets if the corp defaults on the bonds?  Term vs. serial  Do bonds mature all at once or do they mature periodically over several years?

9-29 ©2006 Prentice Hall, Inc. Types of Bonds (2 of 3)  Convertible  Bondholder has option to convert bond into specified # of shares of stock  If a $1,000 convertible bond is converted into 25 shares of stock, what is the minimum stock price in which it would make sense to convert the bond?

9-30 ©2006 Prentice Hall, Inc. Types of Bonds (3 of 3)  Callable  Corp has option to redeem bond before maturity, usually for more than the bond’s face value  Junk bond  Rated at below investment grade  Why would a corp issue each type of bond? Why would someone buy each type of bond?

9-31 ©2006 Prentice Hall, Inc. Issuing Bonds Payable  Bond terminology Bond terminology  Issue price Issue price  Issuing bonds at par Issuing bonds at par  Issuing bonds at a discount Issuing bonds at a discount  Issuing bonds at a premium Issuing bonds at a premium

9-32 ©2006 Prentice Hall, Inc. Bond Terminology (1 of 2)  Market rate of interest  Interest rate based on the type of bond, the duration, and the risk that the issuer will default on the bond  Market interest rate fluctuates daily  Used as the discount rate to determine  The issue price  Interest expense issuer recognizes

9-33 ©2006 Prentice Hall, Inc. Bond Terminology (2 of 2)  Stated rate of interest  Interest rate on face of bond  Determines cash flow of interest  Face value x stated rate = interest payment  Does not fluctuate over life of bond

9-34 ©2006 Prentice Hall, Inc. Issue Price (1 of 3)  Stated Rate = Market Rate  Interest payments received = mkt rate  Bonds sell at a PAR  No difference between issue price and face value  Issuing corp’s interest payments equal to interest expense

9-35 ©2006 Prentice Hall, Inc. Issue Price (2 of 3)  Stated Rate < Market Rate  Interest payments received < mkt rate  Bonds sell at a DISCOUNT  Difference between issue price and face value fairly compensates investor for accepting lower interest payments  Issuing corp’s interest expense is greater than the interest paid to investors

9-36 ©2006 Prentice Hall, Inc. Issue Price (3 of 3)  Stated Rate > Market Rate  Interest payments received > mkt rate  Bonds sell at a PREMIUM.  Difference between issue price and face value reduces investor’s return to equal the market interest rate because interest payments are greater than the market rate  Issuing corp’s interest expense is less than the interest paid to investors

9-37 ©2006 Prentice Hall, Inc. Issuing Bonds at Par (1 of 2)  Start-up Corporation issues 100, $1,000 5-year bonds at 6% when the market rate = 6%  No discount or premium because stated rate = market rate  The bonds are issued at 100  100% of par

9-38 ©2006 Prentice Hall, Inc. Issuing Bonds at Par (2 of 2)  Record the bond issue DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

9-39 ©2006 Prentice Hall, Inc. Issuing Bonds at a Discount (1 of 2)  Start-up Corporation issues 100, $1,000 5-year bonds at 6% when the market rate = 7%  The discount is $4,100  What is the issue price?  Bond discount is a contra-liability  Carrying value  Bond Payable - Discount on Bond Payable

9-40 ©2006 Prentice Hall, Inc. Issuing Bonds at a Discount (2 of 2)  Record the bond issue DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

9-41 ©2006 Prentice Hall, Inc. Issuing Bonds at a Premium (1 of 2)  Start-up Corporation issues 100, $1,000 5-year bonds at 6% when the market rate = 5.3%  The premium is $3,000  What is the issue price?  Bond premium is an adjunct liability  Carrying value  Bond Payable + Premium on Bond Payable

9-42 ©2006 Prentice Hall, Inc. Issuing Bonds at a Premium (2 of 2)  Record the bond issue DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

9-43 ©2006 Prentice Hall, Inc. Paying Interest to Bondholders (1 of 5)  Interest = principal x int rate x time  Bonds issued at par  No discount or premium to amortize  Straight-line amortization per payment  Discount (or premium) / # of payments  As the bond matures, the carrying value gets closer to the par value  Premium/discount account gets smaller

9-44 ©2006 Prentice Hall, Inc. Paying Interest to Bondholders (2 of 5)  Bonds issued at a discount  A portion of the discount is ADDED to the interest payment to compute the interest expense  Interest pmt + discount amortized  5-year bond with a $4,100 discount  Compute the discount amortized per year

9-45 ©2006 Prentice Hall, Inc. Paying Interest to Bondholders (3 of 5)  Record the interest expense for 2008 DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

9-46 ©2006 Prentice Hall, Inc. Paying Interest to Bondholders (4 of 5)  Bonds issued at a premium  A portion of the discount is SUBTRACTED from the interest payment to compute the interest expense  Interest pmt - premium amortized  5-year bond with a $3,000 premium  Compute the premium amortized per year  Make the journal entry for the first year

9-47 ©2006 Prentice Hall, Inc. Paying Interest to Bondholders (5 of 5)  Record the interest expense for 2008 DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

9-48 ©2006 Prentice Hall, Inc. Market for Trading Bonds (1 of 2)  After bonds are issued, they are traded in a secondary market  The value of a bond fluctuates daily depending on the market rate of interest  What happens to the value of a bond if the market interest rate increases? Decreases?

9-49 ©2006 Prentice Hall, Inc. Market for Trading Bonds (2 of 2)  What corporation-specific factors can cause the market interest rate to change?  What factors external to the corporation can cause the market interest rate to change?

9-50 ©2006 Prentice Hall, Inc. Financial Statement Analysis  Capital structure Capital structure  Financial leverage Financial leverage  Debt-to-equity-ratio Debt-to-equity-ratio  Times-interest-earned ratio Times-interest-earned ratio

9-51 ©2006 Prentice Hall, Inc. Capital Structure  The combination of debt and equity a company uses as its source of capital  What other source of capital does a company have besides debt and contributed capital?  Generally, a company should only use debt financing when the return exceeds the cost of borrowing

9-52 ©2006 Prentice Hall, Inc. Financial Leverage  Using borrowed funds to increase earnings for the shareholders (owners)  Increase return on equity  Positive financial leverage  Earnings on borrowed money > cost of borrowing money  What is the cost of borrowing money?

9-53 ©2006 Prentice Hall, Inc. Debt-to-equity Ratio  Compares value of creditors’ claims to value of owners’ claims  Measure of long-term risk  Which is riskier, financing with equity or financing with debt? Why? Total liabilities _ Total shareholders’ equity

9-54 ©2006 Prentice Hall, Inc. Times-interest-earned Ratio  Measures a company’s ability to make interest payments on its debt  Measure of short-term solvency Income from operations Interest Expense  Income from operations is used because it is more comparable across companies than net income. Why?

9-55 ©2006 Prentice Hall, Inc. Business Risk, Control, and Ethics  Risk associated with long-term debt  Not being able to make debt payments  How to minimize risk of defaulting on debt  Sound business analysis accompanies any decision to borrow money  Evaluate types of debt for company’s circumstances

9-56 ©2006 Prentice Hall, Inc. Appendix A: Time Value of Money  Time value of money Time value of money  Simple vs. compound interest Simple vs. compound interest  Present value of a single amount Present value of a single amount  Present value of an annuity Present value of an annuity

9-57 ©2006 Prentice Hall, Inc. Time Value of Money  You did some gardening for a neighbor. The neighbor offers to pay you $100. Would you rather receive it when the job is finished or a year later?  Receiving a dollar today is worth more than receiving a dollar in the future. Why?

9-58 ©2006 Prentice Hall, Inc. Simple vs. Compound Interest  Simple interest  Interest is computed on principal only  Short-term loans use simple interest  Compound interest  Interest computed on principal PLUS interest accrued, but not paid  Investments grow much faster when interest is compounded (Exhibit 9A.1)

9-59 ©2006 Prentice Hall, Inc. Present Value of a Single Amount  FV n = PV (1 + i) n  where n = the number of years  i = the interest rate  PV = the present value of the future sum of money  FV n = the future value of the investment at the end of n years  PV = FV n x [1/(1+i) n ]

9-60 ©2006 Prentice Hall, Inc. Present Value of an Annuity  Annuity  A series of equal cash flows over equally spaced time intervals  Ordinary annuity  Payments made at the end of the period  PV = (1/i) x {1-[1/(1+i) n ]}

9-61 ©2006 Prentice Hall, Inc. Appendix B: Bond Proceeds (1 of 5)  Proceeds from a bond is the sum of two cash flows  Present of a single amount  Receiving the face value upon maturity of the bond  Present value of an annuity  The periodic interest payments

9-62 ©2006 Prentice Hall, Inc. Appendix B: Bond Proceeds (2 of 5)  Bond issued at a premium  Stated rate > market rate  Compute price on 10-year $1,000 bond  Stated rate is 6% and market rate is 5%  How much interest is received each period?

9-63 ©2006 Prentice Hall, Inc. Appendix B: Bond Proceeds (3 of 5) 1. Present value of the annuity  10 periods, 5% per period, $60 per pmt.  $60 x = $ Present value of the face value  10 periods, 5%, $1,000.  $1,000 x = $614  Bond price: $463 + $614 = $1,077

9-64 ©2006 Prentice Hall, Inc. Appendix B: Bond Proceeds (4 of 5)  Bonds issued at a discount  Stated rate < market rate  Compute price on 10-year $1,000 bond  Stated rate is 4% and market rate is 5%  How much interest is received each period?

9-65 ©2006 Prentice Hall, Inc. Appendix B: Bond Proceeds (5 of 5) 1. Present value of the annuity  10 periods, 5% per period, $40 per pmt.  $40 x = $ Present value of the face value  10 periods, 5%, $1,000.  $1,000 x = $614  Bond price: $309 + $614 = $923

9-66 ©2006 Prentice Hall, Inc. Appendix C: Bond Amortization (1 of 2)  Effective interest method  Actual interest expense on outstanding principal balance  Actual interest expense  [carrying value] x [mkt rate at issue] x [time]  Difference between interest payment and interest expense is the amount of premium/discount amortized for the period

9-67 ©2006 Prentice Hall, Inc. Appendix C: Bond Amortization (2 of 2)  Straight-line vs. effective interest method  Straight-line  Interest rate changes; interest expense is constant  Effective interest method  Interest rate is constant; interest expense changes  GAAP, but straight-line may be used if difference between the two methods is not material

9-68 ©2006 Prentice Hall, Inc. Appendix D: Leases and Pensions (1 of 2)  Capital leases  Accounted for as a purchase and a loan  Asset recorded on books  Liability recorded for future lease pmts  Obligations Under Capital Leases  Details in notes to financial statements

9-69 ©2006 Prentice Hall, Inc. Appendix D: Leases and Pensions (2 of 2)  Pensions  Liability increases for defined benefit plans when cash payment to pension fund is less than the annual obligation  FASB requires disclosure of a great deal of information about pension plan and funding

Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business 9-70 ©2006 Prentice Hall, Inc.