ACG 2021 Financial Accounting

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ACG 2021Financial Accounting

• Current Long-Term Liabilities

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Learning Objectives

• Account for current liabilities and contingent
  liabilities
• Account for bonds-payable transactions
• Measure interest expense
• Understand the advantages and disadvantages of
  borrowing
• Statement of Cash Flow Effects

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Current Liabilities

• Liabilities due within 1 year or the companys
  operating cycle if longer
• Known amounts
• Accounts Payable
• Short-term Notes Payable
• Sales Tax Payable
• Current Installment of Long-Term Debt
• Accrued Expenses
• Payroll Liabilities
• Unearned Revenues

• We increase Liabilities with a credit.
• So to increase any of the Known payables on the
  left, we credit the payable for the known amount.
• We must therefore, debit
• a corresponding expense account (accrued
  expenses)
• Cash (deferred liability)
• Long-term debt
• Cash (if recording receipt from a note payable)

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Accounts Payable

• Amounts owed for purchases of goods or services
  on account
• The purchase can be for an Asset
• Inventory (generally largest)
• The purchase could also be an Expense
• Legal Fees (service)
• No interest associated with money owed, and it is
  assumed the A/P will be paid quickly
• If we have an A/P for Inventory purchased on
  account, what does the company we purchased the
  inventory from have?
• An Accounts Receivable

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Note Payable

• Unlike Accounts Payable
• Usually contains interest payments that are due
• Record
• Issuance of Note Payable
• We borrowed Cash and have an obligation to pay
  back
• Interest Expense
• Payment of Note Payable

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Notes Payable
On Jan. 30, 20X5 the company received a one year
8,000 note payable at 10 interest to purchase
inventory.
Jan 30 Cash 8,000
Note Payable, Short-term 8,000
Purchase of inventory by issuing a 1-year 10
note payable
Interest must be accrued at fiscal year end
(April 30) for interest owed but not yet due.
Apr 30 Interest Expense (8,000 x .10 x 3/12) 200
Interest Payable 200
Adjusting entry to accrue interest expense
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Notes Payable
To record repayment at maturity Jan 30 20x6
Jan. 30 Note Payable, short-term 8,000
Interest Payable 200
Interest Expense (8,000 x .10 x 9/12) 600
Cash (8,000 x .10) 8,000 8,800
Payment of a note payable and interest at
maturity
Step 1 Reverse the balance in the Note Payable
account to 0 Step 2 Reduce the amount of any
Interest Payable from a previous period to 0 Step
3 Record the Interest Expense for the
period Step 4 Record the cash (Principal and
Interest paid)
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Payroll Liabilities

• Types of Compensation
• Salary
• Wage
• Commission
• Bonus
• Salary expense is gross pay.
• Salary payable is net pay.

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Payroll Liabilities
To record payroll
Jan. 30 Salary Expense 10,000
Employee Income Tax Payable 1,200
FICA Tax Payable 800
Salary Payable to Employees 8,000
To record salary expense
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Sales Tax Payable
To record sales of 200,000 plus 5 sales tax
Cash (200,000 x 1.05) 210,000
Sales Revenue 200,000
Sales Tax Payable (200,000 x .05) 10,000
To record cash sales and related sales tax
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Unearned Revenues
To record collection of cash in payment for
future services
Jan 30 Cash 1,200
Unearned Ticket Revenue 1,200
Received cash in advance for ticket sales
To record revenue after 50 of services have been
performed.
Apr 30 Unearned Ticket Revenue 600
Ticket Revenue 600
Earned revenue that was collected in advance
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Current Liabilities

• Amounts that must be estimated
• Estimated Warranty Payable
• How many products will need repair / replacement
• Matching Principle
• Estimate based on past historical data
• Contingent Liabilities
• An company may incur an expense in the future
• Most commonly associated with law suits

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Estimated Warranty Payable
Warranty expense should be recognized in the year
the product is sold. For example, a company made
sales of 200,000 subject to product warranties.
They estimate that 3 of the products will
require repair or replacement.
Warranty Expense 6,000
Estimated Warranty Payable 6,000
To accrue warranty expense
When 5,800 of products are replaced under the
warranty
Estimated Warranty Payable 5,800
Inventory 5,800
To replace defective products under warranty
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Contingent Liabilities

• Contingent liability depends on a future event
  arising out of past events.
• To account for contingent losses
• Record liability if it is probable and can be
  reasonably estimated.
• Report the liability in the notes to the
  financial statements (but do not record an entry)
  if it is reasonably possible that a loss will
  occur.
• Do not report a contingent loss that is not
  likely to occur.

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ACG 2021Financial Accounting

• Long Term Liabilities
• Bonds Payable

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Bonds

• IOUs
• 1000 or 5000 Increments
• Sold in the Market
• Structure
• Maturity Date
• Interest Rate
• Interest Payment Dates
• Provide two payments
• Interest every 6 months
• Principal amount of Bond

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(No Transcript)
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Bond Market

• Bloomberg.com

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Bonds Payable

• Bonds payable are debt (i.e. a liability) of the
  issuing company.
• Types of bonds
• term bonds
• All bonds mature at the same time (end of the
  term)
• serial bonds
• Bonds mature in installments over a period of
  time.
• secured bonds (mortgage bonds)
• debentures (unsecured bonds)

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Bonds Payable

• Bonds can be issued (bought)
• at face value
• for a premium
• at a discount
• Bond Price is determined by
• Market Interest Rate Effective Rate
• Bonds Interest Rate Contract Rate
• THESE RATES ARE USUALLY DIFFERENT!

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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
• present value of principal to be received at
  maturity

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Present Value

• The amount invested today to receive a greater
  amount at a future date
• It depends on
• amount of the future receipt
• length of time to future receipt
• interest rate for the period

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Bond Interest Rates

• Contract rate stated rate
• Market rate effective rate

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Present Value Calculation (Discount)

• 100,000 10 year bond, 9 stated interest, 10
  market rate
• Two parts PV of principle and PV of interest
  payments
• 100,000 x .614 61,400
• 100,000 x. 045 x 7.722 34,749
• PV of Bonds 96,149
• From Appendix C

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Bond Prices

• Bond Face Value Stated Principal
• Bond issued above face (par) value - premium
• Bond issued at below face (par) value - discount
• As a bond nears maturity, its market price moves
  toward par value

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Bond Prices

• Quoted at a percent of their maturity value.
• A 1,000 bond quoted at 101½ sells for

1,000 1.015 1,015.
A 1,000 bond quoted at 88-3/8 sellsfor
1,000 0.88375 883.75.
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Bond Payable

• Purchase a 1,000 Bond
• Bond Pays 9
• Bond Interest 90
• Bond Pays 10
• Bond Interest 100
• Bond Pays 8
• Bond Interest 80

• Invest 1,000 in Market at 9
• Market Interest 90

How much would you pay for 9 bond, 10 bond, 8
bond?
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ACG 2021Financial Accounting

• Accounting for Bonds Payable

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Accounting for Bonds

• Record Issuance of Bond
• Record Payment of Interest
• Record Accrual of Interest
• Record Amortization of Discount/Premium
• Effective Interest Method
• Straight-Line Method
• Record Retirement of Bond

Credit Cash
Credit Interest Payable
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Bonds Payable
50 million in 9, 5 year bonds are issued on Jan
1, 2006 at par.
Cash 50,000,000
Bonds Payable 50,000,000
To issue bonds at par
First interest payment on July 1.
Interest Expense 2,250,000
Cash 2,250,000
To pay semiannual interest
50,000,000 x .09 x 6/12
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Bonds Payable
At year end, accrue interest to be paid on Jan.1
Interest Expense 2,250,000
Interest Payable 2,250,000
To accrue interest
50,000 x .09 x 6/12
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Bonds Payable at Discount
100,000 in 9, 5 year bonds are issued when the
market rate is 10 for 96,149.
Cash 96,149
Discount on Bonds Payable 3,851
Bonds Payable 100,000
To issue bonds at a discount
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Bonds Payable at Discount

• Discount on Bonds Payable is a contra account to
  Bonds Payable.
• Carrying amount of the bonds equals Bonds Payable
  less Discount on Bonds Payable.
• Interest payments are fixed by contract, but
  interest expense varies as the bond discount is
  amortized.

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Bonds Payable Premium
100,000 in 9, 5 year bonds are issued when the
market rate is 8 for 104,100.
Cash 104,100
Premium on Bonds Payable 4,100
Bonds Payable 100,000
To issue bonds at a premium
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Bonds Payable at Premium

• Premium on Bonds Payable is normal liability
  account (not a contra-account)
• Carrying amount of the bonds equals Bonds Payable
  plus Premium on Bonds Payable.
• Interest payments are fixed by contract, but
  interest expense varies as the bond premium is
  amortized.

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Bonds Payable Discount Example

• Issue Date January 1, 2006
• Maturity value - 100,000
• Stated interest rate 9
• Interest paid 4 ½ semiannually
• Market rate at time of issue 10 annually, 5
  semiannually
• Issue Price 96,149

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Bonds Payable Discount Example
3851
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Bonds Payable Discount Journal Entries
First semiannual interest payment at Jul 1.
Interest Expense 4,807
Discount on Bonds Payable 307
Cash 4,500
To pay semiannual interest and amortize bond
discount
Second semiannual interest accrual at Dec 31.
Interest Expense 4,823
Discount on Bonds Payable 323
Interest Payable 4,500
To accrue semiannual interest and amortize bond
discount
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Bonds Payable Premium Example

• Issue Date January 1, 2006
• Maturity value - 100,000
• Stated interest rate 9
• Interest paid 4 ½ semiannually
• Market rate at time of issue 8 annually, 4
  semiannually
• Issue Price 104,100

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Bonds Payable Premium Example
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Bonds Payable Premium Example
First semiannual interest payment at Jul 1.
Interest Expense 4,164
Premium on Bonds Payable 336
Cash 4,500
To pay semiannual interest and amortize bond
premium
Second semiannual interest accrual at Dec 31.
Interest Expense 4,151
Premium on Bonds Payable 349
Interest Payable 4,500
To accrue semiannual interest and amortize bond
premium
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Exercise 8-13
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Straight-Line Amortization

• Divide bond discount (or premium) into equal
  periodic amounts over the bonds term.
• This equal amount is Interest Expense
• Interest expense is the same each period.
• GAAP permits straight line only when the amounts
  differ insignificantly from amounts determined
  using the effective interest method.

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Straight-Line

• Using the previous Chrysler Example
• Premium Amortization 4100/10 410
• 10 5 years x 2 interest payments per year

100,000 in 9, 5 year bonds are issued when the
market rate is 8 for 104,100.
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Straight Line Journal Entries
First semiannual interest payment at Jul 1.
Interest Expense 4,090
Premium on Bonds Payable 410
Cash 4,500
To pay semiannual interest and amortize bond
premium
Second semiannual interest accrual at Dec 31.
Interest Expense 4,090
Premium on Bonds Payable 410
Interest Payable 4,500
To accrue semiannual interest and amortize bond
premium
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Issuing Bonds Payableat a Discount

• Chryslers 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
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Issuing Bonds Payableat a Premium

• Chryslers 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
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Exercise 8-10
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ACG 2021Financial Accounting

• Retiring Bonds

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Bonds Retired at Maturity

• After Recording final interest payment
• Reduce Bond Payable
• Reduce Cash Account
• Bonds Payable 100,000
• Cash 100,000

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Retiring Callable Bonds

• Callable Bonds
• Bonds that can be paid off early
• Call Price
• Often at greater then par value (101 or 102)
• Thus management has to decide to pay call premium
  or
• Buy Bonds on the Open Market

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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.

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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 0.9925)
69,475 Extraordinary gain on retirement 175
Bonds Payable 70,000 Discount on Bonds
Payable 350 Cash 69,475 Gain on Retirement
of Bonds 175 To record bond retirement
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Convertible Bonds and Notes

• May be converted into the issuing companys
  common stock.
• Assume note holders convert half of 300 million
  convertible notes into 4 million shares of stock
  (1 par).

Notes Payable 150,000,000
Common Stock (4 million at 1 par) 4,000,000
Paid-in Capital in Excess of par-Common 146,000
,000
To record conversion of notes payable
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Financing with Bonds or Stock?

• Issuing stock
• creates no liabilities
• incurs no interest expense
• less risky to issuing corporation
• Issuing notes or bonds payable
• does not dilute stock ownership or control of the
  corporation
• usually results in higher earnings per share EPS
  is the amount of net income for each share of its
  stock

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Reporting Financing Activities on the Statement
of Cash Flows
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ACG 2021Financial Accounting

• Ratio Analysis
• Times Interest Earned

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Times interest earned ratio
Income from Operations

Times interest earned
Interest Expense
The ability of a company to pay its Interest
Expense Obligations from Earnings Generated from
Operations
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BlackBoard Inc.
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BlackBoard T.I.E.

• 2006
• -11,826 / 5354 -2.21
• 2005
• 24,447 / 49 498.92
• 2004
• 10,033 / 179 56.05

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Best Buy, Inc.
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Best Buy T.I.E.

• 2007
• 1,999 / 31 64.48
• 2006
• 1,644 / 30 54.8
• 2005
• 1,442 / 44 32.77

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End of Chapter 8