Assignment Due Tues, 2/2 1. Go to 2. Navigate to the 302 handouts page and download the following...

Assignment Due Tues, 2/2

1. Go to WWW.FROSTBURG.EDU/DEPT/BUAD/RJOHNSON/PROFWEB

2. Navigate to the 302 handouts page and download the following files: 302Exam1PPT.ppt

The file contains PPT Presentation slides on Ch 13 & 14 & Ex + Probs

3. Save the file to Disk-- Ex. A:\302Exam1PPT.ppt

Microsoft Explorer vs. Netscape Navigator

4. View the PPT slides for Ch 13 (Requires Powerpoint 97 or Viewer)

5. Print & Turn in just the 1st page on Tuesday

6. Read Ch. 13 & compare coverage to slides

Chapter 13: Current Liabilities and Contingencies

After studying this chapter you should be able to:After studying this chapter you should be able to:

• Define current liabilities and describe how they are valued.

• Identify the nature and types of current liabilities.

• Explain the classification issues of short-term debt expected to

be refinanced.

• Identify types of employment related liabilities.

• Identify the criteria used to account for and disclose

contingencies.

• Explain the accounting for different types of contingent

liabilities.

• Indicate how current liabilities and contingencies are presented

and analyzed.

333

• Definition of liability: A past event which gives rise to a

present unavoidable obligation to transfer assets in the

future. Notice how the definition is related to time.

– More than pure debts of a firm for which you will receive

a bill.

– Can possess quasi-ownership characteristics, e.g.,

convertible bonds payable.

• Division of liabilities into currentcurrent (short term) and

noncurrentnoncurrent (long term) classifications.

– This distinction is related to the operating cycleoperating cycle of a

business.

Definition of a Liability

444

Definition of a Liability

• Current liabilities are those liabilities that are paid off or

consume a current asset (CA) within one year or the

operating cycle, if longer.

– The concept of present value is not considered as the time period is considered very short. They are carried at maturity value.

– Beware of the understatement of current liabilities (CL):

» Working capital (or CA - CL) would be overstated if CL

are understated.

» Current ratio (or CA / CL) would be overstated as well.

» You should follow conservatism.

555

• Accounts PayableAccounts Payable (A/P) is a trade account.

– This represents what is owed to others for goods or

services.

– Short term, interest-free account (paid promptly).

– This account should be reviewed in a purchases cut-off

test to make sure the inventory is recorded in the proper

period as well as the related liability.

• Notes Payable (N/P)Notes Payable (N/P)

– Trade notes issued for

inventory, supplies.

– Short-term notes may arise

from cash loans.

Types of Current Liabilities

666

– Interest-bearing notes payable

» N/P should be credited at face value.

» The interest paid on due dates, principal at maturity.

» The notes are subject to accruals as any other

account.

Example of an interest bearing N/P (fair rate):

Information: You issue a $6,000, 10%, 6 month note to

obtain a loan, on 1/1/x1:


Cash 6,000

N/P 6,000

777


6/30 To repay:

N/P 6,000

Interest Expense 300

Cash 6,300

– Non-interest bearing note may be issued.

» This means there is no stated rate on the note. There is

interest (bank fee) charged, however.

» Note discounted (or sold to) bank.

» Bank fee is initially stated as a percentage.

888

Example of a non-interest bearing discounted note:

Information: You issue a $5,000, zero-interest bearing, 6

month note to a bank. The bank's discount rate is 8%.

– The maturity value of the note is the face value or

$5,000.

– The bank’s fee is based on the maturity value x discount

rate x time. This will yield how much cash interest you

are charged.

– The note is discounted. This means the effect of the

interest is removed ahead of time.

– The cash you receive is the maturity value less the bank

fee.


999

– Bank fee = $5,000 x .08 x 6/12 = $200

– Cash proceeds = $5,000- 200 = $4,800


Cash 4,800

Discount N/P 200

N/P 5,000

Payment:

N/P 5,000

Interest Expense 200

Cash 5,000

Discount N/P 200

101010


Note how the discounting (removal of interest at inception

of transaction) influences the rate paid. It raises the rate It raises the rate

from the bank discount rate to the actual or effective ratefrom the bank discount rate to the actual or effective rate.

actual annual interest rate = $400 = 8.4%

$4,800

The prior non-interest bearing example could be contrasted

to a present value calculation which reflects the removal of

interest over time.

Same example as before ($5,000 N/P, no stated interest rate,

6 month duration and a prevailing interest rate for notes of

this type of 8%.

111111

– PV = $5,000 ( .96154) = $4,808

where n = 1, i = 4% (semi)

Cash 4,808 actual i (semi) = $192 =

4%

Discount N/P 192 $4808

N/P 5,000

N/P 5,000

Interest expense 192

Cash 5,000

Discount N/P 192


121212

– What if the rate is unreasonable? Interest will be part

cash and part amortized discount.

Example: Suppose you have a $6,000, 3 year note bearing

3% interest payable annually, when the prevailing rate

of interest is 15%. Note was given in the purchase of

equipment. The difference in rates is considered

unreasonable.


PV = $6,000 ( .65752) = $3945 n = 3 and i = 15%

plus

PV-AO = $180 ( 2.28323) = $411 n = 3 and i = 15%

$4356

$180 = .03 x $6,000 (cash interest annuity)

131313

To record issuance of note:

Equipment 4,356

Discount N/P 1,644

N/P 6,000


To amortize and record interest expense (at 15%):

(First period)

Interest expense 653

Cash 180

Discount N/P 473

141414

Other Current LiabilitiesOther Current Liabilities

• Current maturities of long term debt.Current maturities of long term debt.

– The amount due next fiscal year.

– It is not a current liability if:

» Paid from noncurrent assets.

» It is to be restructured (topic of Advanced

Accounting).

» It is to be converted to capital stock.

– Noncurrent portions will be considered current if they

are callable and debtor is in violation of the agreement

(other than grace period).


Capital Stock

151515


– Current liabilities expected to be refinanced:

» Not a current liability if both the following criteria are

met:

• Intent to refinance is present.

• Ability to refinance is present as demonstrated by an actual agreement (subsequent events).

–Noncancelable agreement.

16

– At the balance sheet date the

debtor not in violation of the

agreement.

– The lender is capable of honoring

the agreement.

– The amount excluded cannot

exceed amount of refinancing

(conservative estimate).

– Disclosure of obligations

expected to be refinanced

requires a description of the

agreement, the terms of

agreement, equity to be issued, if

any.

17

• Dividends PayableDividends Payable

– Cash dividends give rise to a current

liability.

– Arrearages on preferred stock are memo

entry only. Disclosed in a footnote.

– Stock dividends are a capitalization of

retained earnings.

» Transfer from retained earnings to the

stock accounts an appropriate amount.

» All accounts involved are owner equity

accounts. No liability arises from stock

dividends!


18

• Returnable DepositsReturnable Deposits

– Usually contains both current and

noncurrent liability portions.

– Liability on advance sale tickets, tokens,

certificates, deferred revenues.

» These are liabilities until the service is

performed. Revenue or gain is recorded

when service performed or time period

lapses.

– Collections for third parties-- A ”wash”

transaction.

» Sales taxes


19


Cash (A/R) XX

Sales* XX

Sales Tax Payable XX

*If the credit to sales is inclusive of sales tax you must

separate the two. Sales = (Sales tax rate)(Sales ) +

Sales.

20

Payroll

• Payroll gives rise to a series of current liabilitiesPayroll gives rise to a series of current liabilities.

– Withholdings

– Unemployment insurance, disability

– Employee authorized deductions

– Net payroll

– Social Security Taxes (FICA plus Medicare) (page 656)

» Employee and employer portions (matching).

» FICA 6.2% + Medicare 1.45% = 7.65% (will vary

over time).

» FICA first $65,400; Medicare no ceiling (will vary

over time).

21

– Unemployment Insurance:

» FUI (Federal Unemployment Insurance) 6.2% first

$7,000.

» SUI (State Unemployment Insurance), first $7,000,

rate by individual company related to employment

history. There is a maximum offset to the federal

rate of 5.4%.

– Payroll entries:

Payroll

22

Gross Payroll XX

FICA withholdings (employee) (payable) XX

Federal & State withholdings (payable) XX

Other withholdings, stock options, etc. (Pay) XX

Net Payroll Payable XX

Payroll

Payroll Tax Expense XX

FICA payable (employer) XX

FUI payable XX

SUI payable XX

Disability payable XX

23

– These entries are followed by those to pay the payroll

and remit taxes to the government.

– Bonus agreements are additional compensation which

may give rise to an additional liability. (See chapter

appendix.)

• ContingenciesContingencies Following conservatism you are chiefly

concerned with losses! It will depend on the particular

scenario whether you journalize the potential loss, disclose

the loss or do nothing

– Has asset been impaired? Probable*, possible, remote

– Can the loss be estimated? Yes*, No


24


– If both the conditions with a * are met then the

contingency should be journalized.

» If the contingency is probable and cannot be

estimated it should be disclosed but not journalized.

» If it is possible and can or cannot be estimated then it

should be disclosed but not journalized.

» If the contingency is remote then nothing is done.

– Litigations, claims and assessments.

» Accrual is rarely done.Accrual is rarely done.

» Unasserted claims. If it is probable there is a claim, the outcome is fairly certain and can be estimated it should be accrued but is rarely done. Why not?

25

• Guarantee and Warranty Costs.Guarantee and Warranty Costs.

– Cash (Tax) Method

» Pay as you go. Violates matching.

– Accrual Methods:

» Expense Warranty (best GAAP)--operating expense

the period service performed

» Sales Warranty. This defers some profit until the

time when costs are incurred or the warranty

expires

» Please see pages 664-665.

– Different methods can be used on the return and on the

books.


2625

• Compensated absencesCompensated absences (FASB #43) You should accrue if the:

» Service has been rendered, payment is probable and

can be reasonably estimated.

» Vested or accumulated.

• Vested--legal right to receive even if employee

terminated.

• Accumulated--legal right to receive unless

employee terminated.

» Sick pay is normally accrued if vested; vacation pay is

normally accrued if it accumulates.


27


– A change in wage rate between time the accrual done

and vacation/sick taken is treated as a change in

accounting estimate.

28

• Pensions and Postretirement Health Care BenefitsPensions and Postretirement Health Care Benefits

– Definition of liability had to be broadened to

accommodate the changes in accounting for these

areas.

– Topic of Chapter 21. Complex topic, use of

spreadsheets.

– Pension expense has five basic sources (accounting for

postretirement health care benefits is similar)

1. Current service component

2. Interest on the obligation

3. Asset return offset


29


4. Amortization of prior service cost

(“smoothing”)

5. Amortization of actuarial and asset

gains and losses (again

“smoothing” through use of the

corridor and averaged assets).

– Expense is not always equal to the cash

funding of plan.

– Concept of off-B/S assets and liabilities.

– Pension expense is tax deductible,

health care is not.

30

• Property taxes Property taxes

– When should these payments be recorded?

– Against which accounting period should they be

charged?

– Review pages 653-655.

• Conditional PaymentsConditional Payments

– These are estimated tax payments.

– Amounts must be estimated as exact amounts are not

known when partial payments made.


31


– Tax liabilities appear on the financial statements of

corporations; responsibility of individuals in sole

proprietorships and partnerships.

– If no differences exist in GAAP used on the return and

financial statements then the final tax accrual is done.

» Estimated payments made periodically--debit

expense and credit cash.

» To do the final entry first reverse tax expense off

books--debit tax payable and credit tax expense.

(You must do this so tax expense can be calculated

on income before tax.) Then do accrual:

32


» Debit tax expense and credit tax payable. Payables

will net to the proper amount and expense will be

correct.

– More complex if principles on return and F/S are

different. We will see Deferred Taxes in Chapter 20.

• Premiums and CouponsPremiums and Coupons The FASB did not specifically

address these.

– Follow matching. Toys in candy boxes, redemptions of

UPC markers plus cash for a novelty item, etc. To buy:

Premium inventory XX

Cash XX

33

To sell good or service:

Cash XX

Sales XX


Cash XX

Premium Expense XX

Premium inventory XX

To record actual redemptions

Premium Expense XX

Provision for Premium (liability) XX

To match remainder

34

Subsequent periods to honor offer:

Provision for Premium XX

Cash XX

Premium Inventory XX

•Uninsured lossesUninsured losses also known as self-insurance.

– Actual losses only may be deducted; accrue current obligations.

– In reality no insurance since risk of loss has not been assumed by independent third party.

•Environmental liabilityEnvironmental liability. Please page 667.

– Generally disclosed but not accrued.

– If probable and you can estimate, accrue.


11111

Intermediate Accounting, Ninth EditionIntermediate Accounting, Ninth Edition

Kieso and WeygandtKieso and Weygandt

Prepared by

Catherine Katagiri, CPA

The College of Saint Rose

Albany, New York

John Wiley & Sons, IncJohn Wiley & Sons, Inc..

Chapter 14: Long-Term Liabilities

After studying this chapter you should be able to:After studying this chapter you should be able to:

• Describe the formal procedures associated with issuing long-term

debt.

• Identify various types of bond issues.

• Describe the accounting valuation for bonds at date of issuance.

• Apply the methods of bond discount and premium amortization.

• Describe the accounting procedures for the extinguishment of debt.

• Explain the accounting procedures for long-term notes payable.

• Explain the reporting of off-balance sheet financing arrangements.

• Indicate how long-term debt is presented and analyzed.

333

• Long-term liabilities:

– Probable future sacrifices of economic benefits arising

from present obligations that are not payable within a

year or the operating cycle of a business, whichever is

longer.

– More or less permanent in some form (like stock

financing).

– Discrete maturity date.

Nature of a Long-Term Liabilities

4

Nature of a Long-Term Liabilities

– Does not carry the right

to select/participate in

management.

– Tax deductible; interest

a legal obligation.

– Positive leverage

possible.

– Covenants and

restrictions must be

disclosed.

5

• Bonds Payable is an agreement (indenture) to pay a series

of cash interest payments and a final payment of principle.

– Stated amount (principle or par).

– Maturity date.

– Periodic interest (stated rate determines cash interest).

– Types of Bonds Payable:

» Secured--backed by some form of collateral.

» Unsecured--not backed by some form of collateral.

» Term versus serial--term bonds all have a single

maturity date, serial bonds have staggered maturity

dates.

Bonds Payable Definitions

655


» Convertible (holder)--convertible into another of the

firm’s securities. Commodity-backed--redeemable in

a measure of a commodity (wheat, oil, etc.)

» Deep discount--discounted at a high interest rate

with interest paid at maturity (zero coupon bonds).

» Registered--each time the bond is sold the security

must be surrendered and a new one issued.

» Bearer (coupon)--transfer of ownership

accomplished by delivery of certificate.

Bond

Payable

7


» Income bonds payable--no interest paid unless the

firm is profitable.

» Revenue bonds payable--interest is paid from

specific sources.

» Callable bonds payable --gives the issuer the right

to retrieve (call) the bonds prior to maturity.

– Quality ratings--Moody’s, Standard & Poor’s

8

• Price set between buyer (holder) and seller (issuer)

– An interest-bearing bond normally involves an annuity

(for the cash interest payments) and a single lump-sum

payment (for the principal).

– Concept of present value (time value of money) is important

here! You need to know the “facts” of the situation:

» Par (principal or face value) of bond payable.

» Stated interest rate (SR)--determines cash interest.

» Maturity date and interest periods.

» Prevailing interest or rate of return required by the

average investor (the market) for investments of this

type.

Valuation of Bonds Payable

9

Example of a B/P which will sell at the par, i.e., when the stated

rate is equal to the market rate.

– Information: On 1/1/x1 offered and sold $80,000, 5 year,

semi-annual bonds with a stated rate of interest of 10%

and a market (yield) rate of 10%. There is a meeting of the

minds.


Cash interest = $80,000 x .10 x 6/12 = $4,000

PV-AO = $4,000 (7.722) = $ 30,888

plus where n = 10 and i = 5% (MR)

PV = $80,000 (.614) = $ 49,120

$ 80,000 (rounded)

10

Cash 80,000 No discount or

B/P 80,000 premium arises

Sale of B/P at a discount (below par)

– Information: Same bond as before but sold to yield a market

rate of 12%, semiannual; offered and sold on 1/1/x1.

PV-AO = $4,000 (7.360) = $29,440 where n= 10, i = 6%

plus

PV = $80,000 (.558) = $44,640

$74,080


11


Journal entry:

Cash 74,080

Discount on B/P 5,920

B/P 80,000

Balance sheet presentation:

B/P $80,000

less Disc B/P 5,920

B/P, net $74,080 (book or carrying

value)Note: Short term bonds--discount or premium is not separately

reported. Not enough time to amortize it.

12

Sale of bonds at a premium (above par).

– Arises when the SR (cash interest you promise) is greater

than what the market demands. Price of your bond is bid

up until the cash interest divided by the amount given up

for the bond equals the market rate of interest.

– Do some calculations yourselves following our example

but set the MR at 6% and keep the SR at 10%


13

Recording Bond Interest Expense

– To record the issuance of a B/P at a premium: (create

an adjunct rather than a contra account)

Cash XX

B/P, par XX

Premium B/P XX

•Long-term bonds--discount or premium must be amortized to

properly reflect interest expense.

–Effective interest method is GAAP. Yields a constant rate of

interest on a fluctuating level of debt. You must report interest at

the actual market or the effective yield you are paying, not some

arbitrary stated rate.

14

– Straight-line method of amortizing the discount or premium.

» Not GAAP if it yields results which are materially

different from the effective interest method.

» Yields a constant dollar amount of interest even

though the debt level is changing. The implication

is the rate is varying over the life of the debt (when

in fact it is constant).

– Interest expense = cash interest + discount amortization

when the SR < MR.

– Interest expense = cash interest - premium amortization

when the SR > MR.


15

Our example when bond sold at a discount:


Straight-line amortization:

$5,920 = $592 (divided by number of periods available)

10

Entry: (every six months)

Interest Expense 4,592

Discount B/P 592

Cash 4,000

161515

Effective Interest Method to amortize discount: 1st period

– Cash interest = stated rate x par; $80,000 x .05 = $4,000

– Interest expense = carrying value of debt x market rate

= $74.080 x .06 = $4,445

Entry: (first payment)



Cash 4,000

Discount B/P 445

17


2nd period: (Note: CV of debt has increased toward par)

Cash interest = $4,000

Interest expense = ($74,080+445)(.06) = $4,472 or

= $74,525 (.06) = $4,472


Cash 4,000

Discount B/P 472

18

– Please see amortization tables on page 708-709--read!

Note the characteristics of the table and its usefulness

in drawing up the required journal entries.

– Note in our example (discount situation):


Cash interest = $4,000 = .05 (stated rate)

$80,000

but: $4,472 = .06 (market rate or effective yield)

$74,080

19

• Bonds issued between interest dates:

– Interest “runs” with the bond.

– Bonds are subject to accruals.

Example: Suppose in our prior example the $80,000 B/P

( SR = 10%, MR = 12%, semiannual) is offered for sale

on 1/1 and sold on 4/1. Interest dates are 6/30 & 12/31.

– To issue (as before) present value of the cash flows =

$74,080

– Buyers also prepay three months worth of interest.

$80,000 x .10 x 3/12 = $2,000

Bonds Issued Between Interest Dates

20


Entry:

4/1

Cash 76,080

Disc B/P 5,920

Bonds Payable 80,000

Interest Exp (or Pay) 2,000

–Interest payment is paid on 6/30 (3 months later):

21


Cash 4,000

Disc B/P 222


Discount amortized:

Effective interest method

$74,080 x .06 x 3/6 = $2,222 (interest exp) - $2,000 = $222

or straight-line:

$5,920 x 3 months = $312

57 months

22

• Costs of Issuing Bonds

– Deferred charges (not an offset to the proceeds).

– Amortize over the life of the bonds.

– Not expensed (APB # 21).

• Treasury Bonds

– Repurchase of your own bonds with intent to resell.

– Contra bonds payable account.

– Shown on the balance sheet at par value as a deduction

from the bonds payable issued to disclose a net figure

of bonds payable outstanding.

Bonds Payable Concerns

23

• Extinguishment of Debt

– At maturity (no premium or discount remaining).


Bonds payable XX

Cash, etc. XX

– Early Payment FASB # 4--Gain or Loss Extraordinary:

Bonds payable, par XX

Premium (if any) XX

Loss (if any) XX

Discount (if any) XX

Gain (if any) XX

Cash, etc. XX

24

• In-substance defeasance--FASB #16 “as if”

– A set aside of assets for future use in repayment of the

debt. The company still has the primary obligation to

repay the debt.

– Question: Can the company remove the debt and the

assets from the balance sheet even though the debt has

not been formally paid off?

– Previous to 1996 the answer was “yes--it is called an in-

substance defeasance”.

– Please read page 711, footnote. FASB #125 no longer

recognizes an in-substance defeasance. Liability must

actually be retired prior to its removal from the balance

sheet.


25

• Long Term Notes Payable

– In substance same as bonds.

– Valuation: Present value of the future cash flows;

market rate not as obvious!

Example: Notes for cash: N/P $100,000 for $80,000 cash

Long-Term Notes Payable

Cash 80,000

Discount B/P 20,000

N/P 100,000

(impute i so PVCF = cash)

26

Note for cash and other rights.

Example: You give a $10,000 non-interesting bearing

note payable for $10,000 cash and your promise to offer

discounts on future sales to the lender. Assume the

present value of the cash flows is $8,000.

Notes Payable

Entry:

Cash 10,000

Discount N/P 2,000

Note Payable, face 10,000

Deferred Revenues 2,000

27

Notes Payable

– Notes in non-cash transactions (building for note

payable)

– Interest rate that is stated is presumed to be fair

unless obviously unreasonable or wholly unrelated

to the cash price.

• Mortgage notes payable Long term secured note

– Face value is equal to the present value of the future

cash flows (no points).

– Points = % of face value. They represent extra interest.

– Divide between current and noncurrent portions.

28

• Mortgage Notes Payable:

– Fixed and variable rates of interest.

– SAM--shared appreciation mortgage.

– Negative equity possible.

• Short term obligations to be refinanced--Chapter 13

– Classified as current liabilities if

» there is an ability to refinance.

» management intents to refinance.

Notes Payable

29

• Financial Engineering--Please see page 719.

– Debt swaps.

– Off balance sheet financing may enhance a firm’s

financial position because it reduces the presence of

restrictive covenants, betters ratios, and enhances

liquidity measures. For example,

» R & D arrangements

» Leases

– Derivative financial instruments--value derived from the

underlying asset or security.

Off-Balance Sheet Financing

30

Analysis of Long-Term Debt

• Long-term creditors and stockholders are interested in a

firm’s long-term solvency. A financial ratio to help assess

this solvency would be:

Debt to total Assets = Total debt = %

Total Assets

The greater the percentage the greater the risk to the creditors. This must be compared to similar firms in the same industry to be judged acceptable or not.

31

Analysis of Long-Term Debt

• Times interest earned is equal to:

Times Interest Earned =

Income before income taxes and interest expense

Interest expense

– Times interest earned indicates the ability to pay interest on

time.

» It provides a measure of security to the debtholders.

» Must be compared to similar firms by creditors and

investors to determine if it is adequate.

32

Copyright

• Copyright John Wiley & Sons, Inc. All rights reserved.

Reproduction or translation of this work beyond that named in

Section 117 of the United States Copyright Act without the

express written consent of the copyright owner is unlawful.

Requests for further information should be addressed to the

Permissions Department, John Wiley & Sons, Inc. The purchaser

may make back-up copies for his/her own use only and not for

distribution or resale. The Publisher assumes no responsibility

for errors, omissions, or damages, caused by the use of these

programs or from the use of the information contained herein.

K& W

33

Copyright

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