OBJECTIVES: Contingent Liabilities Present Value Concepts Types of Long Term Liabilities Notes Payable Bonds Payable Shareholders Equity ??

Commitments H significant agreements that can affect the future operations of the company H require disclosure in the notes to the financial statements H but are not recorded in the financial statements until the agreement is executed (in whole or in part) For Example: A Note appearing in the financial statement. ‘The company has entered into agreements with certain well- known celebrities to endorse the Company's products. The agreements, among other things, require the Company to make certain guaranteed payments in the future.’

Contingencies l defined as something of uncertain occurrence l an event has occurred which will result in a gain or loss in the future, but will not be known for sure until another event occurs or fails to occur in the future Accounting Rules for Contingencies gains: losses: never anticipate the gain; only disclose the possible gain in the notes to the financial statements until the outcome is known record the event (i.e., the liability & loss) if the loss outcome is likely and the amount of the loss can be reasonably estimated

Present Value Concepts l you are responsible for understanding the concept l and its application to accounting l but not the underlying methods of calculating present values l money received today can be invested to earn interest l $10 invested today at 10% = $11 next year l $11 next year is the same as $10 today l the present value of $11 to be received next year = $10 l the present value of $11 to be paid next year = $10 The Concept:

l the present value (pv) of $11 to be paid next year = $10 $11$10 $1 principal interest B/S (liability) Cash Payment l record only the principal (pv) when the liability is incurred l interest is incurred (and recorded) as time passes Present Value Concepts

On January 1, Air Canada purchased parts from American Airlines by issuing a note payable of $12,000, due in two years. At 7% interest rates, the note is equivalent to $10,481 now. Required: Prepare the journal entries that are required during the first and second year. (to record the purchase of parts) Dr. Aircraft Parts $10,481 Cr. Note Payable $10,481 (to record the interest on the note in year 1 = 7% x 10,481) Dr. Interest Expense $734 Cr. Note Payable $734 Dr. Interest Expense $785 Cr. Note Payable $785 (to record the interest on the note in year 2 = 7% x 11,215) Note Payable 10, , ,000

Notes Payable A note payable is is a written promise to pay a stated sum at one or more specified future dates. A note payable may require a single- sum repayment at the due date or maturity date or it may call for installment payments. If it requires regular payments in installments it is called an annuity. Notes payable require the payment of interest and the recording of interest expense. Interest expense is incurred on liabilities because of the time value of money. To calculate interest three important variables must be considered. (1) the principal; (2) the rate ; and (3) duration or time period Interest = Principal x Rate x Time

Accounting for an Interest-Bearing Note The accounting entry to record $10,000 cash borrowed on a five- year 10% interest bearing note payable, with interest being payable at maturity would be: Dr. Cash10,000 Cr. Note Payable 10,000 Interest is an expense of the period when the money is used, therefore it is measured, recorded and reported on a time basis rather than when the cash is actually paid. Important Considerations – Interest Expense

Accounting for a ‘Noninterest’-Bearing Note A no interest-bearing note includes the interest amount in the face value of the note. This causes a difference in the accounting entries. Assume in the previous example that the note was non-interest bearing, the accounting entries will be as follows: Dr. Cash10,000 Dr. Discount on note payable 600 Cr.Note Payable10,600 At the end of the first period, your accounting entries as it relates to interest will be as follows: Dr. Interest Expense XX Cr. Discount on note payableXX

Future income taxes (a.k.a. deferred income taxes) 3 types of income taxes... (i) income taxes withheld from employees' pay (ii) income taxes as calculated on the company's tax return (iii) income taxes that will arise in the future but haven't yet become payable based on the company's tax return Dr. Wages & salaries expense Cr. Employee income tax payable Cr. Wages & salaries payable Dr. Income tax expense Cr. Income taxes payable (CL) Future income taxes

CCRA (Canada Customs & Revenue Agency) allows some reporting policies for tax purposes that aren't allowed by GAAP Income Statement Sales Revenues COGS Operating Expenses Amortization Expense Interest Expense Etc. GAAP Tax Return Sales Revenues COGS Operating Expenses Amortization Expense (CCA) Interest Expense Etc. Tax Rules

Future income taxes CCRA (Canada Customs & Revenue Agency) allows some reporting policies for tax purposes that aren't allowed by GAAP - report as "taxes payable" the amount of taxes owed according to the tax return (i.e., using "income tax policies") - report as "future income taxes" any liabilities (or assets) that are likely to arise in the future when the temporary differences reverse thus, taxes owed using "income tax policies" may differ from taxes based on "financial statement policies" l for example, CCRA sometimes allows very high deductions for amortization on tax returns in the early years of a capital asset's life, but GAAP may not l these tax vs. accounting differences are called "temporary differences" (because eventually they will reverse)

Long Term Liabilities - Bonds Bond Liabilities: What is a bond? l a formal, legal debt agreement l it sets-out how the borrower will repay the lender l it’s like a long-term note payable, except that bonds can be owed to multiple entities (called bondholders) l the bond describes the conditions of the debt agreement l maturity date (i.e., when it has to be repaid) l amount to be repaid at maturity (i.e., face value) l interest to be paid periodically until maturity (i.e.,bond interest rate / a.k.a. “coupon rate”) Some Terms

Finance Terms Related to Bonds l amount to be repaid at maturity l interest to be paid periodically until maturity FACE VALUE BOND RATE Finance Terms Related to Bonds $1,000 FACE VALUE 8% per year BOND RATE

? bond price interest Cash Received (Liability) Cash Payment Finance Terms Related to Bonds face value Cash Payment Cash Payment Cash Payment Cash Payment Cash Payment Cash Payment $1,000 $40 bond price = p.v. of face value + p.v. of bond interest payments

$1,000 bond price interest Cash Received (liability) Cash Payment Finance Terms Related to Bonds face value Cash Payment Cash Payment Cash Payment Cash Payment Cash Payment Cash Payment $1,000 $40 Bonds Issued At Par u simply means that bond price = face value u means bond interest rate ( 8% ) = market rate ( 8% ) u in other words, interest paid by bond = interest demanded bond price = p.v. of face value + p.v. of bond interest payments

Accounting for Bonds Issued at Par ? bond price interest face value $1,000 $40 u record the bond liability at the p.v. of future payments Dr. Cash $1,000 Cr. Bond Payable $1,000 u record interest expense = effective interest rate x liability Dr. Interest Expense $ 40 Cr. Interest Payable $ 40 u record the bond interest payment Dr. Interest Payable $ 40 Cr. Cash $ 40 = 1000 x 8% x 6/12

$ 949 bond price interest Cash Received (liability) Cash Payment Finance Terms Related to Bonds face value Cash Payment Cash Payment Cash Payment Cash Payment Cash Payment Cash Payment $1,000 $40 Bonds Issued At a Discount u discount means that bond price < face value u means bond interest rate ( 8% ) < market rate ( 10% ) u in other words, interest paid by bond < interest demanded bond price = p.v. of face value + p.v. of bond interest payments

Accounting for Bonds Issued at a Discount ? bond price interest face value $1,000 $40 u record the bond liability at the p.v. of future payments Dr. Cash (A) $ 949 Dr. Bond Discount (xL) $ 51 Cr. Bond Payable (L) $1,000 effective liability at issue Balance Sheet Liabilities Bond Payable $1,000 Bond Discount (51) Effective Liab. $ 949

Accounting for Bonds Issued at a Discount ? bond price interest face value $1,000 $40 u record the bond liability at the p.v. of future payments Dr. Cash $ 949 Dr. Bond Discount $ 51 Cr. Bond Payable $1,000 u record interest expense = market interest rate x liability Dr. Interest Expense Cr. Bond Discount Cr. Interest Payable u record the bond interest payment Dr. Interest Payable $ 40 Cr. Cash $ 40 effective liability = ( ) x 10% x 6/12 at issue After 6 months $ 7.45 $ $ 47.45

Balance Sheet Income Statement Liabilities Bond Payable $1,000 Bond Discount (51) $ 949 Expenses $ u record interest expense = market interest rate x liability Dr. Interest Expense $ Cr. Bond Discount $ 7.82 Cr. Interest Payable $ = 10% x 6/12 x ( ) u record the bond interest payment Dr. Interest Payable $ 40 Cr. Cash $ 40 $1,000 (35.73) at issue $ 1,000 (43.55) months Interest $ months another 6 months later... = 949 x 10% x 6/12

$1,054 bond price interest Cash Received (liability) Cash Payment Finance Terms Related to Bonds face value Cash Payment Cash Payment Cash Payment Cash Payment Cash Payment Cash Payment $1,000 $40 Bonds Issued At a Premium u premium means that bond price > face value u means bond interest rate ( 8% ) > market rate ( 6% ) u in other words, interest paid by bond > interest demanded bond price = p.v. of face value + p.v. of bond interest payments

Accounting for Bonds Issued at a Premium ? bond price interest face value $1,000 $40 u record the bond liability at the p.v. of future payments Dr. Cash $ 1,054 Cr. Bond Premium (L) $ 54 Cr. Bond Payable (L) $1,000 effective liability at issue Balance Sheet Liabilities Bond Payable $1,000 Bond Premium 54 $1,054 at issue

Accounting for Bonds Issued at a Premium ? bond price interest face value $1,000 $40 u record the bond liability at the p.v. of future payments Dr. Cash $ 1,054 Cr. Bond Premium $ 54 Cr. Bond Payable $1,000 u record interest expense = effective interest rate x liability Dr. Interest Expense $ Dr. Bond Premium $ 8.38 Cr. Interest Payable $ u record the bond interest payment Dr. Interest Payable $ 40 Cr. Cash $ 40 effective liability = 6% x 6/12 x ( ) at issue 6 months

Balance Sheet Income Statement Liabilities Bond Payable $1,000 Premium 54 $ 1,054 Expenses $ u record interest expense = effective interest rate x liability Dr. Interest Expense $ Cr. Bond Premium $ 8.63 Cr. Interest Payable $ = 6% x 6/12 x ( ) u record the bond interest payment Dr. Interest Payable $ 40 Cr. Cash $ 40 $1, , at issue $ 1, , months Interest $ months another 6 months later...

Early Retirement of Bonds u remove the bonds payable (& any premium/discount) u record the cash given up to retire the bonds u record the gain/loss = amount by which liability >/< cash Dr. Bond Payable $1,000 (given) Dr. Bond Premium $ 37 (as per acctg records) Cr. Cash $ 964 (assumed) Cr. Gain on Bond Retirement $ 73 (plug) Assume the $1,000 bond issued at (the previous example) is retired after only 1 year. The cash payment made to bondholders to retire the bond was $964. What’s the journal entry?

Practice

l Rose Corporation sold 10-year, 8 percent bonds with a $100,000 par value on January 1, Interest is paid on June 30 and December 31. If the bonds were sold at 104 for a return of 7.42%, give the journal entries for Relevant facts: l bonds were sold at 104 (i.e., $104,000) l 8% is bond interest rate l 7.42% is market discount rate l face value of bonds is $100,000 bonds were issued at a premium $104 bond price interest Liability face value December Payment June Payment Final Cash Payments $100 $4... December Payment June Payment

l Rose Corporation sold 10-year, 8 percent bonds with a $100,000 par value on January 1, Interest is paid on June 30 and December 31. If the bonds were sold at 104 for a return of 7.42%, give the journal entries for Relevant facts: l bonds were sold at 104 (i.e., $104,000) l 8% is bond interest rate l 7.42% is market discount rate l face value of bonds is $100,000 bonds were issued at a premium $104 bond price interest Liability face value December Payment June Payment Final Cash Payments $100 $4... December Payment June Payment

Accounting for Bonds Issued at a Premium u record the bond liability at the p.v. of future payments Dr. Cash $ 104,000 Cr. Bond Premium $ 4,000 Cr. Bond Payable $100,000 Jan. 1/01 u record interest expense = effective interest rate x liability Dr. Interest Expense $ 3858 Dr. Bond Premium $ 142 Cr. Interest Payable $ 4000 u record the bond interest payment Dr. Interest Payable $ 4000 Cr. Cash $ 4000 = 7.42% x 6/12 x (100+4) June 30/01

Accounting for Bonds Issued at a Premium u record interest expense = effective interest rate x liability Dr. Interest Expense $ 3853 Dr. Bond Premium $ 147 Cr. Interest Payable $ 4000 u record the bond interest payment Dr. Interest Payable $ 4000 Cr. Cash $ 4000 = 7.42% x 6/12 x (100,000+4, ) = 3,853 Dec. 31/01

Ratios for Long-term Liabilities l debt/equity ratio l shows the proportion of financing from debt l suggests corporate financing strategy Total Liabilities Total Liabilities + Shareholders' Equity =

Ratios for Long-term Liabilities l times interest earned ratio l shows whether sufficient income is generated to cover interest costs l suggests the likelihood of interest payment Net Income + Tax Expense + Interest Interest =

Leases u an agreement that allows one entity to obtain (from another entity) the use of assets u two types of leases exist: 1) "OPERATING LEASES" Ù these are simple rental agreements that allow one company the right to use another company's property in exchange for a rental payment Ù the company providing the rented property is called the "lessor" and the company obtaining the use of the property is called the "lessee"

Leases u an agreement that allows one entity to obtain (from another entity) the use of assets u two types of leases exist: 2) "CAPITAL LEASES" Ù "rental" agreements whereby the lessor transfers substantially all of the risks & rewards of property ownership to the lessee Ù in substance, this is just like the lessee going out and buying the property from the lessor with a long-term promissory note Ù if a lease meets any one of three criteria, it is a capital lease (otherwise, it's an operating lease)

Accounting for the 2 Types of Leases 1) "OPERATING LEASES" u this is what we have been doing all along so far Lessee Lessor Dr. Rent Expense Cr. Rent Payable Dr. Rent Receivable Cr. Rental Revenue Ù note that the lessee does not record the leased asset on the balance sheet

Accounting for the 2 Types of Leases 1) "OPERATING LEASES" u this is what we have been doing all along so far Lessee Lessor Dr. Rent Expense Cr. Rent Payable Dr. Rent Receivable Cr. Rental Revenue 2) "CAPITAL LEASES" u because substantially all the risks and rewards of ownership pass from the lessor to the lessee, the lessee records a purchase & loan and the lessor records a sale Dr. Capital Asset under Lease Cr. Obligation under Capital Lease Lessee $ (pv of lease pmts) Ù both an asset & liability appear on the balance sheet

Accounting for the 2 Types of Leases 1) "OPERATING LEASES" u this is what we have been doing all along so far Lessee Lessor Dr. Rent Expense Cr. Rent Payable Dr. Rent Receivable Cr. Rental Revenue 2) "CAPITAL LEASES" u because substantially all the risks and rewards of ownership pass from the lessor to the lessee, the lessee records a purchase & the lessor records a sale Lessor u don't worry about the journal entry details u essentially, the lessor records a "lease sale" and related "cost of lease sales"

Criteria for Identifying Capital Leases 1) ownership transfers sometime during the lease Ù a guide for determining whether substantially all of the risks & rewards have been transferred 2) the lease covers substantially all ( ) of the asset's life 3) the lease payments are substantially all of the asset value ( ) 75% pvmlp > 90% fmv IF... IT'S A CAPITAL LEASE or

Dr. Capital Asset under Lease Cr. Obligation under Capital Lease Lessee More on Accounting for Capital Leases è first capitalize... then amortize records a capital asset (just like any other capital asset) ä usually use straight-line amortization method ä amortization period often = lease term

Dr. Capital Asset under Lease Cr. Obligation under Capital Lease Lessee More on Accounting for Capital Leases è lease payments include principal & interest a long-term liability (just like any other long-term debt payments) ä principal portion reduces the liability ä interest portion recorded as an expense

OPERATING LEASE CAPITAL LEASE l make periodic pmts l liability for lease payments only as they come due l liability for present value of all lease payments before they come due l no asset appears on the balance sheet l capital asset appears with long-term assets on the balance sheet l full payment shown as rent expense on I/S l interest portion of lease payment & amortization shown as expenses Similar Asset? Liability? Expense? Lessee’s Point of View