1. 9-1 Definitely Determinable Liabilities  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

2. 9-2 Definitely Determinable Liabilities  Accounting for payroll  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  Accounting for payroll  Employer must match employee deduction for FICA and Medicare  Employer’s Payroll Tax Expense

3. 9-3 Estimated Liabilities  Accounting for warranties  Obligation is not certain, so it is estimated  Warranty Payable and related Warranty Expense recognized in year product is sold regardless of duration of the warranty  Accounting for warranties  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

4. 9-4 Warranty Example 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

5. 9-5 Long-term Notes Payable and Mortgages  Short-term notes  Mature in < 1 yr  Interest and principal usually paid at the end of the term  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

6. 9-6 Long-term Notes Payable and Mortgages  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

7. 9-7 Long-term Notes Payable and Mortgages  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

8. 9-8 Repaying a Mortgage  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. 9-9 Repaying a Mortgage ABCDE YrBeg Prin Mtg PmtInt 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

10. 9-10 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

11. 9-11 What Is A Bond?  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

12. 9-12 Types of Bonds  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?  Convertible  Bondholder has option to convert bond into specified # of shares of stock 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

13. 9-13 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

14. 9-14 Bond Terminology  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  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

15. 9-15 Issue Price  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

16. 9-16 Issue Price  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

17. 9-17 Issue Price  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

18. 9-18 Issuing Bonds at Par  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

19. 9-19 Issuing Bonds at a Discount  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

20. 9-20 Issuing Bonds at a Premium  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

21. 9-21 Paying Interest to Bondholders  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

22. 9-22 Paying Interest to Bondholders  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

23. 9-23 Paying Interest to Bondholders  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

24. 9-24 Market for Trading Bonds  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?

25. 9-25 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

26. 9-26 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?

27. 9-27 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

28. 9-28 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?

29. 9-29 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

30. 9-30 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?

31. 9-31 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)

32. 9-32 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 ]

33. 9-33 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 ]}

34. 9-34 Appendix B: Bond Proceeds  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

35. 9-35 Appendix B: Bond Proceeds  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?

36. 9-36 Appendix B: Bond Proceeds 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

37. 9-37 Appendix B: Bond Proceeds  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?

38. 9-38 Appendix B: Bond Proceeds 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

39. 9-39 Appendix C: Bond Amortization  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

40. 9-40 Appendix C: Bond Amortization  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

41. 9-41 Appendix D: Leases and Pensions  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

42. 9-42 Appendix D: Leases and Pensions  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

43. 9-43  Assign #3: pg. 477-478 - E9-6A, E9-9A; Assign #4: pg. 483-484 - P9-1A, P9-4A.