1 Current and Long-Term Liabilities Chapter 8

2 Learning Objective 1 Account for current liabilities and contingent liabilities.

3 Current Liabilities  Obligations due within one year or within company’s normal operating cycle, whichever is longer  Liabilities can be: –Known amount, or –Estimated amounts

4  Examples of liabilities of known amount: –Accounts payable –Short-term notes payable –Sales tax payable –Currently maturing portion of long-term debt –Accrued expenses –Payroll liabilities –Unearned revenues [deferred revenues] Current Liabilities

Short-Term Notes Payable On January 30, a business purchased inventory for $8,000 by issuing a 1-year, 10% note payable. The fiscal year ends on April 30. Jan 30Inventory8,000 Notes Payable8,000 Purchased inventory by issuing a one-year, 10% note ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Short-Term Notes Payable Apr 30Interest Expense200 Interest Payable200 To accrue interest at year-end How much interest was accrued as of April 30? $8,000 × 10% × (3/12) = $200 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Short-Term Notes Payable $8,000 × 10% × (9/12) = $600 Jan 30Note Payable8,000 Interest Payable [April 30 accrual, last slide]200 Interest Expense600 Cash ($8,000 x 10%+$8,000)8,800 To record payment of loan when due ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Sales Tax Payable One day’s sales at a Home Depot Store totaled $200,000. The business collected an additional 5% in sales tax. Record the day’s sales. Cash ($200,000 X 1.05)210,000 Sales Revenue200,000 Sales Tax Payable10,000 To record cash sales and related sales tax ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

9 Current Installments of Long-Term Debt  Amount of the principal that is payable within one year  These currently maturing amounts must be shown as a current liability

10 Accrued Expenses  Expenses that have been incurred, but are not to be paid till after the accounting period: –Salaries –Taxes withheld –Interest expense –Utility expense

Payroll Liabilities Salary Expense10,000 Employee Income Tax Payable1,200 FICA Tax Payable800 Salary Payable8,000 To record salary expense ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

12 Unearned Revenues The Bradstreet Corporation provides credit evaluation services to subscribers. Bradstreet charges a client $750 for a three-year subscription. Prepare the entry.

Unearned Revenues Jan 1Cash750 Unearned Revenue750 To record receipt for a 3-year subscription Dec 31Unearned Revenue250 Subscription Revenue250 To record revenue earned at year-end for each of three years ($750 x 1/3) ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

14 Current Liabilities That Must Be Estimated Black & Decker made sales of $200,000 subject to product warranties. They estimate [typically based on previous experience] that 3% of the products it sells this year will require subsequent repair or replacement.  What is the estimated warranty expense?

Estimated Warranty Payable $200,000 ×.03 = $6,000 Warranty Expense6,000 Estimated Warranty Payable6,000 To accrue warranty expense: $200,000 x 3% ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Estimated Warranty Payable Estimated Warranty Payable5,800 Inventory5,800 To replace defective products sold under warranty Defective merchandise totals $5,800. Black & Decker will replace it and record the following: ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

17 Contingent Liabilities  Potential liability that depends on resolution in the future of a past event  For example, a lawsuit is filed against the entity  Record a liability if: – it is probable that the loss will occur and –the amount can be reasonably estimated

18 Contingent Liabilities  Disclose in the notes to the financial statement [i.e., no amounts are recorded] if it is reasonably possible that amounts will need to be paid based on ultimate resolution of the event  No need to report a contingent loss that is remote – unlikely to occur.

19 Bonds: An Introduction  Groups of long-term notes payable issued to multiple lenders (bondholders)

20 Types of Bonds  Term bonds  Serial bonds  Secured (mortgage) bonds  Unsecured (debenture) bonds

21 Bond Prices Quoted at a percent of their maturity value. A $1,000 bond quoted at 101½ sells for… $1,000 × = $1,015. A $1,000 bond quoted at 88-3/8 sells for… $1,000 × = $

22 Bond Prices  A bond is issued above face (par) value – premium if the interest on the bond is higher than the prevailing market rate of interest for similar debt securities at time of issue  A bond is issued at below face (par) value – discount if the interest on the bond is lower than the prevailing market rate of interest for similar debt securities at time of issue  As a bond nears maturity, its market price moves toward par value

23 Present Value The amount invested today receives a greater amount at a future date -present value of a future amount It depends on: –amount of the future receipt –length of time to future receipt –interest rate for the period

24 Bond Interest Rates  Bonds are sold at market price - amount that investors are willing to pay at any given time  Market price represents: –present value of periodic interest payments, plus –present value of principal to be received at maturity –Appendix C is used to determine above amounts

25 Bond Interest Rates  Contract rate (a.k.a. coupon rate) – stated rate on the face of the issue bond  Market rate – effective rate for similar obligations

26 Learning Objective 2 Accounting for bonds payable transactions.

Issuing Bonds at Par Value On January 1, Chrysler Corporation issued $50,000 of 9%, 5-year bonds at par. (Bond coupon rate is exactly the same as market rate of interest for similar bonds) Jan 1Cash50,000 Bonds Payable50,000 To issue 9%, 5-years bonds at par ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Issuing Bonds at Par Value Record semiannual interest payments. Jul 1Interest Expense2,250 Cash2,250 To pay semiannual interest $50,000 × 9% × 6/12 = $2,250 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Issuing Bonds Payable at Par Value Dec 31Interest Expense2,250 Interest Payable2,250 To accrue interest $50,000 × 9% × 6/12 = $2,250 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Issuing Bonds at a Discount Chrysler issues $100,000 of its 9% coupon, five-year bonds when the market interest rate is 10%. Chrysler receives $96,149 (the present value) at issuance. Why do the bonds sell at a discount? Jan 1Cash96,149 Discount on Bonds Payable3,851 Bonds Payable100,000 To issue 9%, 5-years bonds at a discount. ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

31 How Did We Determine the Present Value (P.V.) of the Bonds?  The bond consists of a lump sum payment at maturity ($100,000) of the principal plus the 10 equal interest payments over 5 years ($4,500 each)  Using Appendix C, the P.V. of the bond for 10 semi annual periods, to yield 5%: –$100,000 x = $61,400 –$4,500 x = 34,749 $96,149 $96,149

Issuing Bonds Payable at a Discount Chrysler’s balance sheet immediately after issuance of the bonds: Total current liabilities$ XXX Long-term liabilities: Bonds payable, 9%, due 2009$100,000 Discount on bonds payable ( 3,851)96,149 Discount on Bonds Payable - contra account to Bonds Payable ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

33 Learning Objective 3 Measure interest expense.

Amortization Table on Bonds Issued at a Discount ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Interest Expense on Bonds Issued at a Discount On July 1, 2004, Chrysler makes the first $4,500 semiannual interest payment and also amortizes (decreases) the bond discount Jul 1 Interest Expense4,807 Discount on Bonds Payable307 Cash4,500 To pay semiannual interest & amortize bond discount ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Interest Expense on Bonds Issued at a Discount At December 31, 2004, Chrysler accrues interest and amortizes the bond discount for July through December. Dec 31 Interest Expense4,823 Discount on Bonds Payable323 Interest Payable4,500 To accrue semiannual interest & amortize bond discount ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

37 Interest Expense on Bonds Issued at a Discount Bonds Payable Discount on Bonds Payable 100,0003, July Dec. 31 3,221 Bond carrying amount: $100,000 – $3,221 = $96,779 Chrysler’s bond accounts as of December 31, 2004.

Chrysler Corporation issues $100,000 of 9% coupon, five- year bonds when the market interest rate is 8%. Chrysler receives $104,100 at issuance. Why do the bonds sell at a premium? Issuing Bonds Payable at a Premium Cash104,100 Premium on Bonds Payable4,100 Bonds Payable100,000 To issue 9%, 5-years bonds at a premium. ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

39 How Did We Determine the Present Value (P.V.) of the Bonds?  The bond consists of a lump sum payment at maturity ($100,000) of the principal plus the 10 equal interest payments over 5 years ($4,500 each)  Using Appendix C, the P.V. of the bond for 10 semi annual periods, to yield 4%: –$100,000 x = $67,600 –$4,500 x = 34,749 $104,100 $104,100

Issuing Bonds Payable at a Premium Chrysler’s balance sheet immediately after issuance of the bonds: Total current liabilities$ XXX Long-term liabilities: Bonds payable$100,000 Premium on bonds payable 4,100 $104,100 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Amortization Table on Bonds Issued at a Premium ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Interest Expense on Bonds Issued at a Discount On July 1, 2004, Chrysler makes the first $4,500 semiannual interest payment and also amortizes (decreases) the bond premium Jul 1 Interest Expense4,164 Premium on Bonds Payable336 Cash4,500 To pay semiannual interest & amortize bond premium ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

43 Straight-Line Amortization Amortizes discount or premium by dividing it into equal amounts for each interest period GAAP allows this practice if S/L amounts are not materially different from interest calculated by the effective interest method Chrysler would amortize the $4,100 premium over 10 periods: $4,100 ÷ 10 = $410 per period

44 Early Retirement of Bonds Payable Air Products and Chemicals, Inc., has $70,000 of debenture bonds outstanding with unamortized discount of $350. The market price is 99¼.

Early Retirement of Bonds Payable Par value of bonds$70,000 Less: Unamortized discount( 350) Carrying amount of the bonds$69,650 Market price ($70,000 × ) 69,475 Other gain on retirement$ 175 Bonds Payable70,000 Discount on Bonds Payable350 Cash69,475 Gain on Retirement of Bonds175 To record bond retirement ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Convertible Bonds and Notes Texas Instruments has convertible notes payable (called “converts” among bond traders) of $250,000. Assume that noteholders convert half the notes into 4,000 shares, $1 par common stock. Notes Payable125,000 Common Stock4,000 Paid-in Capital121,000 To record conversion of notes payable ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

47 Convertible Bonds Typically Sell at a Lower Effective Interest Rate than Non-Convertible Bonds  Reasonably assured return of principal plus interest, and  If stock (underlying the conversion feature) rises in value, the bonds become more valuable in the market  Assume a $1,000 convertible bond can be redeemed for 50 shares of stock at $20: –If stock price rises to $30… –Bond holder can exercise the convert option getting the 50 shares worth $30 at only $20 each! –The shares could be immediately “flipped” for a $500 profit

48 Learning Objective 4 Understanding the advantages and disadvantages of borrowing.

49 Financing Operations With Bonds or Stocks Issuing Stock Issuing Notes or Bonds No liabilities No interest expense Less risky to corporation Does not dilute stock ownership or control Results in higher Earnings per share

50 Long-Term Liabilities: Leases Lease - rental agreement in which the tenant (lessee) agrees to make rent payments to the property owner (lessor). Leases can be: –Operating –Capital

51 Long-Term Liabilities: Leases  Capital lease, if: –transfers title at end of the term to lessee –contains bargain purchase option for lessee –lease terms cover 75% or more of estimated useful life of leased asset –present value of the minimum lease payments is 90% or more of the market value of leased asset at date of lease inception

52 Long-Term Liabilities: Pensions  Record pension and retirement benefit expenses while employees work for the company  At end of each period, compare the fair market value of the assets in the pension plan – cash and investments – with the plan’s accumulated benefit obligation

53 Long-Term Liabilities: Pensions  If p.v. of the accumulated benefit obligation exceeds plan assets, the plan is underfunded  Report excess liability amount as a long- term pension liability on the balance sheet  If pension is overfunded, asset and obligation (at p.v.) are disclosed only in foot notes to the financial statements

54 Learning Objective 5 Report liabilities on the balance sheet.

Reporting Liabilities Accounts payable$1,976 Accrued salaries and related expenses627 Sales tax payable298 Other accrued expenses1,402 Income taxes payable78 Current installments of long-term debt 4 Total current liabilities$4,385 Long-term debt1,545 Other long-term liabilities451 Amounts in millions ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

56 Reporting Fair Market Value of Long-Term Debt FASB Statement No. 107 requires companies to report fair market value of their financial instruments, which includes long-term debt AMR’s long debt (as stated in chapter) has a fair market value $1.3 billion less than the book carrying value: This means: * Interest rates have risen since the debt was sold; * AMR could retire that debt at a profit of $1.3 billion, pre- tax effect, if they had the cash to do so! * AMR could retire that debt at a profit of $1.3 billion, pre- tax effect, if they had the cash to do so!

Reporting Financing Activities on the Statement of Cash Flows Cash Flow from Financing Activities: Borrowing by issuing commercial paper$754 Proceeds from long-term borrowings32 Payment of long-term debt(29) Proceeds from issuance of common stock351 Payments of cash dividends(371) Other, net (4) Net cash provided by financing activities$733 Amounts in millions Year Ended December 31 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren