1. 9-1 ©2006 Prentice Hall, Inc.

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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. 9-9 ©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

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

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

12. 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?

13. 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

14. 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

15. 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

16. 9-16 ©2006 Prentice Hall, Inc. Warranty Example (3 of 4) TA Assets = Liab. + Cont. Cap. + R/E 1. 2. 3. 4. 5. 6. - - - - - - -

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

18. 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

19. 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

20. 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

21. 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

22. 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?

23. 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 45,046154,954 2 59,046 10,847 48,199106,756 3 59,046 7,473 51,573 55,183 4 59,046 3,863 55,183 0

24. 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

25. 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

26. 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

27. 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?

28. 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?

29. 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?

30. 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?

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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

47. 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

48. 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?

49. 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?

50. 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

51. 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

52. 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?

53. 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

54. 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?

55. 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

56. 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

57. 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?

58. 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)

59. 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 ]

60. 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 ]}

61. 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

62. 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?

63. 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 7.72173 = $463 2. Present value of the face value  10 periods, 5%, $1,000.  $1,000 x 0.61391 = $614  Bond price: $463 + $614 = $1,077

64. 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?

65. 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 7.721735 = $309 2. Present value of the face value  10 periods, 5%, $1,000.  $1,000 x 0.61391 = $614  Bond price: $309 + $614 = $923

66. 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

67. 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

68. 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

69. 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

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