BA102A

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BA102A

• All the other liabilities in the world
• BOND LIABILITIES

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Current Liabilities

• You intend to pay within a year
• Must be reported at amount to be paid
• Examples
• Accounts Payable
• Short term notes payable
• Interest payable
• Taxes payable (income, sales, employee, etc)
• Wage and salary payable
• Current portion of long term debt
• Unearned revenues (deferred revenues)

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Estimated and Contingent Liabilities

• Contingent liabilites are based on a transaction
  that has not yet occurred. They are only
  reported if BOTH probable AND reasonably
  estimable. If only one or the other, they are
  reported in footnotes. If neither, they are not
  reported. Example Lawsuit
• Estimated liabilities are contingent liabilities
  that are recorded. They are estimated because of
  Conservatism.
• They always incur an EXPENSE.
• They are adjusting entries.
• Example Warranty

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Long term liabilities

• Intent is to pay in more than a year.
• Also must be reported at amount due.
• Examples
• Bonds, bonds, bonds and bonds
• Long term notes payable (treated the same as
  bonds, but usually issued at par, so rarely have
  premium or discount. Also usually NOT sold to
  third party.)
• Mortgage payable (serial note payable)
• Leases (similar to bonds but more complex because
  of payment stream.)
• Pensions (complex because of two or three
  unrelated cash streams.)

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In order to understand the valuation of long term
liabilities, you need to understand

• Present Values !

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The Time Value of Money

• Refers to the fact that money has the ability to
  earn interest.
• Can be calculated if you know the interest rate
  and number of periods over which interest will be
  paid.
• Depends on either the PRESENT VALUE or FUTURE
  VALUE.
• Can be calculated for single amounts (lump sums)
  or annuities (equal payments over equal
  intervals.)

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Simple Example Compounding
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Simple Example Discounting
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Learn to use the PV tables (pp 746-748 in your
book) or a financial calculator that can
calculate present values for you.

• Most accounting applications of the time value of
  money are discounting, not compounding, problems
• Discounting is used to find the value of a bond
  payable, a long term note payable, and a capital
  lease, since the obligation must be reported
  separately from the interest.

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BONDS

• Not James Bond, but almost as much fun

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What are Bonds?

• Bonds represent a long term borrowing of large
  amounts of money, usually for a specific project.
  The money is borrowed from many sources, and the
  bond itself is the contract for that borrowing.
• The firm or entity borrowing the money is the
  ISSUER of the bond. The issuer must pay interest
  on specific dates (usually twice a year) and must
  pay back the loan on a specific date, called the
  maturity date.
• The person, firm or entity buying the bond
  (lending the money) is the INVESTOR. Investors
  may sell their bonds to other investors before
  the maturity date. Investors receive interest on
  specific dates, and receive the principal of the
  loan on the maturity date.

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To Find the Value or Price of a Bond Obligation

• The value of the bond is the amount at which it
  is recorded in your books. It is also called the
  carrying value. When you issue a bond, the
  carrying value equals the amount for which you
  sell (issue) the bond. This is called its Price.
  To find the value or the price
• You need the principal (or face value) of the
  bond. Bonds usually sell in increments of
  1,000.
• You need the stated rate of the bond.
• You need the number of interest payment periods
  until maturity.
• You need the market rate of interest on the date
  the bond was issued or sold.
• For example, you may have a 100,000 bond that
  matures in three years, so it has six interest
  payment periods left. Lets say it has a stated
  rate of interest of 10, which means it pays
  5,000 every six months.

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Bonds Issued At Par

• When the market rate of interest is the same as
  the stated rate of the bond, the bond is issued
  at par.
• This means that the price and the carrying value
  of the bond equals its face value.
• Accounting for bonds issued at par is pretty
  easy. You simply record the issue of the bond,
  the interest payments, and the repayment on the
  maturity date.

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Example of Bond Issued at Par
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Calculating the Price (or Value) of a Bond not
Issued at Par
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How Do We Account for This?

• When you issue the bond, you are only receiving
  95,100, though you must repay the full 100,000
• Thus the bond obligation will be reported at
  100,000.
• But to show that there was a discount, you report
  the discount in a CONTRA LIABILITY account called
  Discount on Bond Payable
• The net of the Bond and the Discount accounts
  will give you the 95,100 carrying value of the
  bond.

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Here are the journal entries

• For the issue of the bond
• Cash 95,100
• Discount on Bond 4,900
• Bond Payable 100,000
• For the interest payments
• Interest Expense 5,706
• Discount on Bond 706
• Cash 5,000
• To repay the loan on the maturity date
• Bond Payable 100,000
• Cash 100,000

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Whoa there what was that interest expense???

• When a bond is issued at a discount, the discount
  account is a contra liability. This represents
  the difference between the stated interest rate
  and the interest the investor wants to earn.
• This difference must be spread over the life of
  the bond, just like the rest of the interest is
  earned over the life of the bond.
• Moreover, by the maturity date, the carrying
  value of the bond itself must reflect the actual
  amount owed.
• Thus, the discount will decrease every period,
  and this decrease is called amortization.
• Further, the amortization of the discount will
  increase the interest EXPENSE, but of course it
  will not affect the cash interest payment.

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What if you issue the bond when the market rate
is BELOW the stated rate?

• Then investors will find your bond very
  attractive.
• They will be willing to pay more than face value
  for your bond.
• This extra amount is called a PREMIUM.
• The premium will be recorded in a separate
  account that is added to (rather than subtracted
  from) the bond obligation.
• This kind of account is called an ADJUNCT
  account.
• Just like the discount, the premium will amortize
  over the life of the bond. However, it reduces
  rather than increases interest expense.

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How do you find the premium on the bond?

• The premium is calculated the same way as the
  discount.
• You find the present values of both cash flows
  (face value and interest payments) at the MARKET
  rate of interest.
• The price of the bond, less the face value, will
  be the premium.

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Heres the calculation
So the premium will be 10,800, and this will
Amortize over the life of the bond.
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Journal Entry for Issue of Bond with Premium

• Cash 110,800
• Bond Payable 100,000
• Premium on Bond 10,800

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How does the discount or premium amortize?

• There are two methods straight line is simple
  but nobody uses it so it is useless.
• Effective interest is more complicated, but
  widely used and more sensible.
• To find the interest EXPENSE you multiply the
  carrying value of the bond by the market rate of
  interest for six months.
• The cash payment for interest will be, as one
  would expect, the face value of the bond times
  the stated rate of interest for six months.
• The difference between the interest expense and
  the cash payment will be the amortization of the
  premium or discount.
• Note that this amount will be different each
  interest payment period because the carrying
  value of the bond will change as the discount or
  premium amortizes.

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When you issue a bond and the stated rate is not
equal to the market rate, you can create a Bond
Amortization Schedule. Using the same example
from the issuers point of view, we would have
the following bond amortization schedules.
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The following slides are more advanced bond
journal entries

• You will not be held responsible for them, but I
  thought you should know what happens when bonds
  are issued so that no interest payment date falls
  on the fiscal year end, and interest must accrue.

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These are a complicated version of the journal
entries for the discount.
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And the ledger accounts
The Carrying Value of the Bond obligation will
be the Bond Payable minus the Balance in the
Discount Account.
Of course the expense account will actually
close at the end of each fiscal year.
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And here is the premium
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And ledger accounts for the premium
Of course the interest Expense closes each
Fiscal year end.
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Get it? Got it? Good.

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We issued bonds to build this building. Now we
have to pay back the loan!

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The End