Lecture 17-19 Post-class - ACCT 101 UPENN

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Lecture 17-19 Liabilities

description

Lecture for Acct 101 class at Upenn Wharton school.

Transcript of Lecture 17-19 Post-class - ACCT 101 UPENN

  • Lecture 17-19

    Liabilities

  • 2Part A

    Current Liabilities

  • 3Current Liabilities

    Liability - A present responsibility to sacrifice assets in the future due to a transaction or other event that happened in the past.

    Current liabilities are usually, but not always, due within one year. Notes payable, accounts payable, and payroll liabilities are the three main categories. Note: If a company has an operating cycle longer than

    one year, its current liabilities are defined by the operating cycle rather than by the length of a year.

    Current liabilities are also sometimes called short-term liabilities.

  • 4Current v. Long-Term Liabilities

    LIABILITIES

    Payable within oneyear

    With in the company

    LONG-TERM

    Payable more thanone year

    CURRENT

  • 5Reporting Current Liabilities

    Distinguishing between current and long-term liabilities helps investors and creditors assess risk.

    Companies often prefer to report a liability as long-term--it may cause the firm to appear less risky.

    Many companies list notes payable first, followed by accounts payable, and then other current liabilities from largest to smallest.

  • 6Examples of Current Liabilities

    Accrued expenses Accounts/Notes payables Unearned revenues Sales taxes payable The current portion of long-term debt

  • 7Sales Taxes Payable

    Company selling products subject to sales taxes is responsible for collecting the sales tax directly from customers and periodically sending the sales taxes collected to the state and local governments.

    When the company collects the sales taxes, it increases cash (a debit) and increases sales taxes payable (a credit).

  • 8Current Portion of Long-Term Debt

    Currently maturing portion of a long-term debt is reported as a current liability on the balance sheet.

    Assume Southwest Airlines had total borrowings of $3,515 million at December 31, 2009, of which $190 million was payable in 2010 and the remaining $3,325 million is due after 2010. In its 2009 balance sheet, the company records the $3,515 million in current and long-term debt, as shown below

    Current liabilities: Current portion of long-term debt $190Long-term debt

    Long-term liabilities: 3,325Total borrowings $3,515

    SOUTHWEST AIRLINES Balance Sheet (partial)

    December 31, 2009($ in millions)

  • Contingencies

  • 10

    Apply the appropriate accounting treatment for contingencies Contingent liability:

    An existing, uncertain situation that might result in a loss.

    Examples: Lawsuits, product warranties, environmental problems, and premium offers

  • 11

    Contingent Liabilities Whether we report a loss contingent liability depends

    on two criteria: The likelihood of payment can be:

    Probablelikely to occur Reasonably possiblemore than remote but

    less than probable; or Remotethe chance is slight

    The ability to estimate the payment amount is either:

    Known or reasonably estimable; or Not reasonably estimable.

    We record a liability if the loss is probable and the amount is at least reasonably estimable.

    The journal entry to record a contingent liability requires a debit to a loss (or expense) account and a credit to a liability.

  • 12

    Contingent Liabilities

    If the likelihood of payment is probable and if one amount within a range appears more likely, we record that amount.

    When no amount within the range appears more likely than others, we record the minimum amount and disclose the potential additional loss.

    If the likelihood of loss is reasonably possible rather than probable, we record no entry but make full disclosure in a footnote to the financial statements to describe the contingency.

    If the likelihood of payment is remote, disclosure usually is not required.

  • 13

    Warranties When you buy a new Dell notebook, it comes with a warranty

    covering the hardware from defect for either a 90-day, one-year, or two-year period depending on the product. Why does Dell offer a warranty?

    To increase sales, of course. Based on the matching principle, the company needs to

    record warranty expense in the same accounting period as the sale.

    A warranty represents an expense and a liability at the time of the sale, because it meets the criteria for recording a contingent liability.

    Even though Dell doesnt know exactly at the time of the sale what that warranty expense will be, it can, based on experience, reasonably estimate the amount.

  • Recording Contingent Liabilities

    Dell Computer sells a computer product for $5,000 with a one-year warranty. In 2010, 100 computers were sold for a total sales revenue of $500,000. Analyzing past records, Dell estimates that repairs will average 2% of total sales.

    Warranty expenses 10,000Warranty liability 10,000

    Example:

  • 15

    Contingent Gains Is an existing uncertain situation that might result in

    a gain, which often is the flip side of contingent liabilities.

    In a pending lawsuit, one sidethe defendantfaces a contingent liability, while the other sidethe plaintiffhas a contingent gain.

    We record contingent liabilities when the loss is probable and the amount is reasonably estimable.

    We do not record contingent gains Though firms do not record contingent gains in the

    accounts, they sometimes disclose them in notes to the financial statements

  • 16

    Assess liquidity

    Liquidity Analysis Liquidity refers to having sufficient cash to pay currently maturing

    debts. Working Capital:

    It is the difference between current assets and current liabilities. Current ratio:

    We calculate it by dividing current assets by current liabilities. Acid-test ratio/Quick ratio:

    We calculate it by dividing quick assets by current liabilities. Quick assets include cash, short-term investments, and accounts

    receivable.

  • 17

    Lets Review

    1. Calculate working capital for United Airlines and Southwest Airlines. 2. Calculate the current ratio for United Airlines and Southwest Airlines. 3. Calculate the acid-test (quick) ratio for United Airlines and Southwest Airlines.

    Selected financial data regarding current assets and current liabilities for United and Southwest Airlines are as follows

    ($ in millions) United SouthwestCurrent assets

    Cash and cash equivalents $3,046 $1,368Current investments 435Net receivables 977 574Inventory 237 203Other current assets 601 313

    Total current assets $4,861 $2,893Current liabilities

    Accounts payable $3,231 $2,643Short/current long-term debt 1,808 163Other current liabilities 2,242

    Total current liabilities $7,281 $2,806

  • 18

    Solution:

    3.

    ($ in millions)

    Total Current Assets

    Total Current Liabilities

    =

    Current Ratio

    United $4,861 $7,281 = 0.67Southwest $2,893 $2,806 = 1.03

    ($ in millions)

    Quick Assets

    Total Current Liabilities =

    Acid-Test Ratio

    United $4,023 $7,281 = 0.55Southwest $2,377 $2,806 = 0.85

    Lets Review($ in millions)

    Total Current Assets -

    Total Current Liabilities

    =

    WorkingCapital

    United $4,861 - $7,281 = $(2,420)Southwest $2,893 - $2,806 = $ 87

    2.

    1.

  • Part BLong Term

    Debt

  • 20

    Explain financing alternatives Financing Options

    Debt Financing - borrowing money (liabilities)

    Equity Financing - obtaining additional investment from stockholders (stockholders equity)

    Capital Structure - is the mixture of liabilities and stockholders equity used by a business

  • 21

    A formal debt instrument that obligates the borrower to repay a stated amount, referred to as the principal or face amount, at a specified maturity date.

    In return, the borrower agrees to pay interest over the life of the bond.

    Similar to notes payable, except bonds are usually issued to many lenders at the same time.

    Traditionally, interest on bonds is paid twice a year (semi-annually).

    Bonds are sold or underwritten by investment houses like JPMorgan, Citibank and Bank of America.

    What is a Bond?

  • Bonds - ExampleNote that the bond terms simply communicate a flow of cash payments

    5.25% interest

    15 year life

    $10,000 face value

    Pays $525 of interest each period plus $10,000 at the end

  • Pricing a Bond

  • 24

    Valuing BondsWe are issuing bonds of $1,000 face value, 10% coupon rate, due in 2 years. Interest is paid semiannually.

    What will be the price of the bonds when they are issued (i.e., how much cash proceeds will we get?)

    Period 0 1 2 3 4

    Cash flow $50 $50 $50 $50+ 1,000 principal

    It depends on the market interest rate on the day the bonds are issued!

    Bondholders are willing to give the company an amount equal to the present value of future cash flows discounted at the market rate of interest. So Proceeds at issuance depend on:

    Face value of the Bonds ($1,000)Coupon interest rate (5% semi-annually)Effective Interest Rate at Issuance (i.e., market interest rate when

    issued)

  • 25

    Determine the price of a bond issue

    Issue price is calculated as the present value of the face amount plus the present value of the periodic interest payments. Bonds can be issued at:

    Face amount Below face amount (discount) Above face amount (premium)

    Ways to determine the issue price of bonds: Financial calculator Excel Spreadsheet Calculate the price of the bonds using present

    value tables

  • 26

    Market Interest Rate true interest rate used by investors to value a companys bond issue. The higher the market interest rate, the

    lower will be the bond issue price. Stated Interest Rate (coupon rate) rate

    quoted in the bond contract used to calculate the cash payments for interest.

    Periods to Maturity number of years to maturity multiplied by the number of interest payments per year.

    Determine the price of a bond issue (Cont.)

  • 27

    Bonds Issued at Face Amount

    Pricing Bonds Issued at Face Amount Using a Financial Calculator

    Illustration of RC Enterprises: The face amount equals $100,000. The interest payment every

    six months is $3,500 (= $100,000 x 7% x year). The market rate can be equal to, less than, or greater than the

    stated 7% interest rate paid to investors. Lets first assume the market interest rate is 7%. RCs bonds pay interest semi-annually for 10 years .

  • 28

    Bonds Issued at Face Amount

    An alternative to using a financial calculator is to calculate the issue price of the bonds using present value tables.

    Present value of face amount = $100,000 x 0.50257* $ 50,257

    Present value of interest payments = $3,5001 x14.21240** 49,743

    Issue price of the bonds $100,000

    1 $100,000 x 7% x year = $3,500

    * Table 2, i = 3.5% , n = 20

    ** Table 4, i = 3.5% , n = 20

  • 29

    Bonds Issued at a Discount RC Enterprises issues the same $100,000 of 7% bonds when

    other bonds of similar risk and maturity are paying 8%. RCs bonds are less attractive to investors because they can

    purchase bonds of similar risk that are paying the higher 8% rate. RC will have to issue its 7% bonds below its $100,000 face

    amount. Bonds issued below face amount are said to be issued at a

    discount. Pricing Bonds Issued at a Discount Using a Financial Calculator

  • 30

    Bonds Issued at a DiscountPricing bonds issued at a discount using present

    value tables.

    The bond issue price is below the face amount of $100,000. The issuing company receives only $93,205 from investors, but will pay back $100,000 when the bonds mature in 10 years.

    Present value of principal = $100,000 x 0.45639* $45,639

    Present value of interest payments = $3,5001 x 13.59033** 47,566

    Issue price of the bonds $93,205

    1 $100,000 x 7% x year = $3,500* Table 2, i = 4% , n = 20 ** Table 4, i = 4% , n = 20

  • 31

    Bonds issued at a Premium

    RC Enterprises issues $100,000 of 7% bonds when other bonds of similar risk and maturity are paying only 6%.

    Investors will pay more than $100,000 for 7% bonds since they look relatively attractive compared with bonds paying only 6%.

    These bonds will sell for a premium. A premium occurs when the issue price of a bond is above its face amount. In this case, RCs bonds will sell for more than $100,000.

    Pricing of Bonds Issued at a Premium using a Financial Calculator shown below

  • 32

    Bonds issued at a Premium

    The bond issue price is above the face amount of $100,000. RC Enterprises receives $107,439 from investors, but will need to pay back only $100,000 when the bonds mature in 10 years.

    Pricing bonds issued at a premium using present value tables.

    Present value of principal = $100,000 x 0.55368* $ 55,368

    Present value of interest payments = $3,5001 x 14.87747** 52,071

    Issue price of the bonds $107,439

    1 $100,000 x 7% x year = $3,500* Table 2, i = 3% , n = 20 ** Table 4, i = 3% , n = 20

  • 33

    Determine the price of a bond issue

  • Recording Bonds Payable

  • 35

    Account for the issuance of bonds On January 1, 2012, RC Enterprises issues $100,000 of 7% bonds, due

    in 10 years, with interest payable semi-annually on June 30 and December 31 each year.

    The bonds issue for exactly $100,000, assuming a 7% market interest rate. RC Enterprises records the bond issue as:

    On June 30, 2012, RC Enterprises records the first semi-annual interest payment:

    June 30, 2012 Debit CreditInterest Expense 3,500

    Cash 3,500

    (Record semiannual interest payment)($100,000 x 7% x 1/2 = $3,500)

    January 1, 2012 Debit CreditCash 100,000

    Bonds Payable 100,000(Issued bonds at face amount)

  • 36

    Recording Bonds Issued at a Discount In the preceding example we assumed the stated interest rate (7%) and the

    market interest rate (7%) were the same. If the market interest rate is 8%, the bonds will issue at only $93,205. This is less than $100,000. The bonds are paying only 7%, while investors

    can purchase bonds of similar risk paying 8%. The entry RC Enterprises makes to record the bond issue at a discount is:

    The balance in the bonds payable account is (100,000-6,792) and is called the net carrying value. The carrying value will increase from the amount originally borrowed ($93,205) to the amount due at maturity ($100,000) over the 10-year life of the bonds.

    Cash 93,205Discount on Bonds Payable 6,795

    Bonds Payable 100,000

    Cash 93,205Discount on Bonds Payable 6,795

    Bonds Payable 100,000

  • 37

    Recording Bonds Issued at a DiscountWe calculate interest expense as the carrying value (the amount actually owed during that period) times the market rate (4% semi-annually or 8% annually, in our example)

    Cash paid for interest is equal to the face amount times the stated rate (3.5% semi-annually or 7% annually, in our example).

    Interest expense =

    Carrying value of

    bond X

    Market interest rate per period

    $3,728 = $93,205 8% x

    Cash paid for

    Interest =

    Face amount of

    bond X

    Stated interest rate per period

    $3,500 = $100,000 7% x

  • 38

    RC Enterprises records the following journal entries:

    June 30, 2012 Debit CreditInterest Expense ($93,205 x 8% x ) 3,728

    Discount Bonds Payable (difference) 228Cash ($100,000 x 7% x ) 3,500

    (Record semiannual interest payment)

    Dec 31, 2012 Debit CreditInterest Expense ([$93,205 +228]x 8% x ) 3,737

    Discount on Bonds Payable (difference) 237Cash ($100,000 x 7% x ) 3,500

    (Record semiannual interest payment)

  • 39

    Amortization Schedule for Bond Discount

    An amortization schedule provides a nice summary of the cash interest payments, interest expense, and changes in carrying value for each semi-annual interest period.

    The amounts for the June 30, 2012 and the December 31, 2012 semi-annual interest payment entries can be taken directly from the amortization schedule.

  • 40

    (1)

    Date

    (2)Cash Paidfor interest

    (3)Interest Expense

    (4)Discount

    Amortization

    (5)Carrying

    Value

    (6)Ending

    Unamortized Discount

    Face Amount x Stated Rate

    Carrying Value x Market Rate

    (3) (2) Prior Carrying Value + (4)

    Face Amount- (5)

    1/1/2012 $93,205 $6,795

    6/30/2012 $3,500 $3,728 $228 93,433 6,567

    12/31/2012 3,500 3,737 237 93,670 6,330

    * * * * * *

    * * * * 99,057 9436/30/2021 3,500 3,962 462 99,519 481

    12/31/2021 3,500 3,981 481 $100,000 0

  • 41

    Recording Bonds Issued at a Premium

    RC Enterprises issues $100,000 of 7% bonds when other bonds of similar risk are paying only 6%.

    The bonds will issue at $107,439. Investors will pay more than $100,000 for these 7% bonds because bonds of similar risk are paying only 6% interest.

    The entry to record the bond issue at a premium is:

    Cash 107,439Premium on Bonds Payable 7,439Bonds Payable 100,000

    Cash 107,439Premium on Bonds Payable 7,439Bonds Payable 100,000

    The carrying value of bond is $107,439.

  • 42

    June 30, 2012 Debit Credit

    Interest Expense ($107,439 x 6% x ) 3,223Premium on Bonds Payable (difference) 277

    Cash ($100,000 x 7% x ) 3,500(Semi-annual interest payment)

    RC Enterprises records the following journal entries:

    Dec. 31, 2012 Debit Credit

    Interest Expense ([$107,439 -227]x 6% x ) 3,215Premium on Bonds Payable (difference) 285

    Cash ($100,000 x 7% x ) 3,500(Semi-annual interest payment)

  • 43

    Amortization Schedule for Bond Premium

    An amortization schedule provides a nice summary of the cash interest payments, interest expense, and changes in carrying value for each semi-annual interest period.

    The amounts for the June 30, 2012 and the December 31, 2012 semi-annual interest payment entries can be taken directly from the amortization schedule.

  • 44

    (1)

    Date

    (2)Cash Paidfor interest

    (3)Interest Expense

    (4)Premium

    Amortization

    (5)Carrying

    Value

    (6)Ending

    Unamortized Premium

    Face Amount x Stated Rate

    Carrying Value x Market Rate

    (2) (3) Prior Carrying Value - (4)

    (5)-Face Amount

    1/1/2012 $107,439 $7,439

    6/30/2012 $3,500 $3,223 $277 107,162 7,162

    12/31/2012 3,500 3,215 285 106,877 6,877

    * * * * * *

    * * * * 100,956 9566/30/2021 3,500 3,029 471 100,485 485

    12/31/2021 3,500 3,015 485 $100,000 0

  • 45

    Changes in Carrying Value Over Time

  • 46

    Record the retirement of bonds

    When the issuing corporation buys back its bonds from the investors, it is said that the company has retired those bonds.

    It can wait until the bonds mature to retire them, or in most cases, the issuer will choose to buy the bonds back early

    BOND RETIREMENTS AT MATURITY Regardless of whether bonds are issued at face amount, a

    discount, or a premium, their carrying value at maturity will equal their face amount.

    RC Enterprises records the retirement of its bond at maturity as:

    December 31, 2021 Debit CreditBonds Payable 100,000

    Cash 100,000(Retire bonds at maturity)

  • 47

    Bond Retirements Before Maturity

    Firms need not necessarily wait until the maturity date before retiring an obligation. Particularly, in the case of publicly traded bonds, firms may choose to retire all or a part of the issue prior to maturity. Purchase on open market Redeem callable bonds

    When the issuer retires debt before its scheduled maturity date, the transaction is called an early extinguishment

    If the amount paid to retire a bond is different from its carrying value, the firm recognizes a gain or loss from the transaction. Amount paid>carrying value => Loss Amount paid Gain

  • Early Retirement of Bond

    Suppose the company purchases the bond on the open market on Jan. 1, 2013. The market price (purchase price) of the bonds was $93,000.

    From bonds issued at discount example:

    Bond Payable 100,000Gain on Bond Retirement 670Discount on Bond Payable 6,330Cash 93,000

    Bond Payable 100,000Gain on Bond Retirement 670Discount on Bond Payable 6,330Cash 93,000

    (1)

    Date

    (2)Cash Paidfor interest

    (3)Interest Expense

    (4)Discount

    Amortization

    (5)Carrying

    Value

    (6)Ending

    Unamortized Discount

    1/1/2012 $93,205 $6,795 6/30/2012 $3,500 $3,728 $228 93,433 6,567

    12/31/2012 3,500 3,737 237 93,670 6,330

  • Early Retirement of Bond

    Suppose the company purchases the bond on the open market on Jan. 1, 2013. The market price (purchase price) of the bonds was $107,000.

    From bonds issued at premium example:

    Bond Payable 100,000Loss on Bond Retirement 123Premium on Bond Payable 6,877

    Cash 107,000

    Bond Payable 100,000Loss on Bond Retirement 123Premium on Bond Payable 6,877

    Cash 107,000

    (1)

    Date

    (2)Cash Paidfor interest

    (3)Interest Expense

    (4)Premium

    Amortization

    (5)Carrying

    Value

    (6)Ending

    Unamortized Premium

    1/1/2012 $107,439 $7,439

    6/30/2012 $3,500 $3,223 $277 107,162 7,162

    12/31/2012 3,500 3,215 285 106,877 6,877

  • 50

    Summary of Bonds PayablePar/Face value Discount Premium

    Interest Rate Coupon = Market Coupon < Market Coupon > Market

    Cash Interest Pymts Use coupon rate Use coupon rate Use coupon rate

    Interest Expense*

    = Cash Interest Pymts

    > Cash Interest Pymts < Cash Interest Pymts

    Balance Sheet Carrying Value Face Value

    Face Value Discount

    Face Value +Premium

    * In all three cases, Interest expense=Carrying value*Market interest rate

  • 51

    On Jan. 1, 2010. XL Corp issued bonds of $1,000 face value, 10% coupon rate, due in 2 years, interest paid semiannually. Record the journal entries of bond issuance, all interest payments, and repayment at maturity. Assume following three scenarios:1) The market interest rate is 10%.2) The market interest rate is 12%.3) The market interest rate is 8%.

    Suppose XL Corp purchased the bonds back on Jan. 1, 2011 at a price of $960. Record the journal entries for each scenario.

    Group Exercise

  • 52

    Issuing bonds of $1,000 face value, 10% coupon, due in 2 years, interest paid semiannually. The market interest rate is 10%.When the market rate equals the coupon rate, bonds are issued at par.

    1) Bonds Issued at Face Value

    Cash 1,000Bonds Payable 1,000

    Cash 1,000Bonds Payable 1,000

    Journal entry for payments (made every 6 months):

    Interest Expense 50Cash 50

    Interest Expense 50Cash 50

    Journal entry at maturity on 12/31/2011:

    Bonds Payable 1,000Cash 1,000

    Bonds Payable 1,000Cash 1,000

  • 53

    Issuing bonds of $1,000 face value, 10% coupon, due in 2 years, interest paid semiannually. The market interest rate is 12%.

    Cash Proceeds = PV Principal + PVAnnuity Coupon= ( $1,000 * 0.7921 ) + ( $50 * 3.4651 ) = $792.10 + 173.25= $965.35

    When the market rate is greater than the coupon rate, bonds are issued at a discount.

    Cash 965.35Discount on Bonds Payable 34.65

    Bonds Payable 1,000.00

    Cash 965.35Discount on Bonds Payable 34.65

    Bonds Payable 1,000.00

    2) Bonds Issued at Discount

    PV factor of 6% @ 4 periods

    PVA factor of 6% @ 4 periods

  • 54

    2) Amortization of Bond Discount

    Date

    BeginningCarryingValue

    InterestExpense(6%)

    CashPayment

    DiscountAmortization

    EndingUnamortizedDiscount

    EndingCarryingValue

    6/30/2010 965.35 57.92 50.00 7.92 26.73 973.2712/31/2010 973.27 58.40 50.00 8.40 18.33 981.676/30/2011 981.67 58.90 50.00 8.90 9.43 990.5712/31/2011 990.57 59.43 50.00 9.43 0 1000.00

    Interest Expense 57.92Discount on Bond Payable 7.92Cash 50.00

    Interest Expense 57.92Discount on Bond Payable 7.92Cash 50.00

    Journal entry for first interest payment on 6/30/2010:

    Bonds Payable 1,000Cash 1,000

    Bonds Payable 1,000Cash 1,000

    Journal entry at maturity on 12/31/2011:

    Journal entry of early retirement on Jan. 1, 2011 with purchase price of $960.Bond Payable 1000.00

    Gain on Bond Retirement 21.67Discount on Bond Payable 18.33Cash 960.00

    Bond Payable 1000.00Gain on Bond Retirement 21.67Discount on Bond Payable 18.33Cash 960.00

  • 55

    Issuing bonds of $1,000 face value, 10% coupon, due in 2 years, interest paid semiannually. The market interest rate is 8%.

    Cash Proceeds = PV Principal + PVA Coupon= ( $1,000 * 0.8548 ) + ( $50 * 3.6299 )= $854.80 + 181.50= $1,036.30

    When the market rate is less than the coupon rate, bonds are issued at a premium.

    3) Bonds Issued at Premium

    PV factor of 4% @ 4 periods

    PVA factor of 4% @ 4 periods

    Cash 1,036.30Premium on Bonds Payable 36.30Bonds Payable 1,000.00

    Cash 1,036.30Premium on Bonds Payable 36.30Bonds Payable 1,000.00

  • 56

    Period:

    BeginningCarryingValue

    InterestExpense(4%)

    CashPayment

    PremiumAmortization

    EndingUnamortizedPremium

    EndingCarryingValue

    6/30/2010 1,036.30 41.45 50.00 8.55 27.75 1,027.7512/31/2010 1,027.75 41.11 50.00 8.89 18.86 1,018.866/30/2011 1,018.86 40.75 50.00 9.25 9.61 1,009.6112/31/2011 1,009.61 40.39 50.00 9.61 0 1,000.00

    Interest Expense 41.45Premium on Bond Payable 8.55

    Cash 50.00

    Interest Expense 41.45Premium on Bond Payable 8.55

    Cash 50.00

    Journal entry for first interest payment on 6/30/2010:

    3) Amortization of Bond Premium

    Bonds Payable 1,000Cash 1,000

    Bonds Payable 1,000Cash 1,000

    Journal entry at maturity on 12/31/2011:

    Journal entry of early retirement on Jan. 1, 2011 with purchase price of $960.

    Bond Payable 1000.00Premium on Bond Payable 18.86

    Gain on Bond Retirement 58.86Cash 960.00

    Bond Payable 1000.00Premium on Bond Payable 18.86

    Gain on Bond Retirement 58.86Cash 960.00

  • Leases

  • Accounting for Leases

    Lease: Contract whereby an owner grants the use of property to a second party in exchange for regular rental payments Lessor: Owner of property who grants usage

    rights to the lessee Lessee: Party that has the right to use leased

    property and makes lease payments to the lessor

    Legal title to property remains with lessor

  • Types of Leases

    Capital (finance) leases: Transfers most risks and benefits of ownership to the lessee Property accounted for as an asset and obligation

    to pay as liability Operating leases: Should not be recognized

    as liabilities on the balance sheet Should be accounted for by the lessee as

    ordinary rent expenses

  • Criteria for a Capital LeaseIf any one of the following criteria are met, the lease is accounted for as a capital lease:

    1) Ownership of the asset is transferred to the lessee at the end of the lease term.

    2) A "bargain purchase" option exists. A bargain purchase option exists if the lessee can purchase the asset for a price that seems sufficiently less than the estimated fair market value on the exercise date that the option is likely to be exercised.

    3) The lease term is 75% or more of the estimated useful life of the asset.

    4) The present value of the minimum lease payments is 90% or more of the estimated fair market value of the equipment.

    If none of these four criteria are met, the lease is treated as an operating lease.

  • Criteria for a Capital Lease The determination of whether a lease qualifies as a

    capital lease or as an operating lease is highly subjective and discretionary.

    When is a purchase option a "bargain purchase" option? What is the "useful life" of the asset? What is the "fair market value" of a (customized) asset?

    If the lease qualifies as a capital lease, the answers to these questions will influence the recorded value of the lease assets and liabilities.

  • Lease ExampleRalphCo decides to lease a truck from Jerry's Truck Mart. The truck is estimated to have a cash purchase price of $16,000, a useful life of four years, and an estimated salvage value of $0.

    On January 1, 2006, RalphCo signs a two-year lease, with annual payments of $5,000 to be made at the end of each year. At the end of the lease term, RalphCo must return the truck to Jerrys. If RalphCo were to get a bank loan to purchase the truck directly, the interest rate would be 10% per year.

    True or False? This is an Capital Lease.False (operating lease):1. Ownership transfer at end of lease? No.2. Bargain purchase option? No.3. Term 75% of useful life? 2/4 = 50% 75%? No.4. PV of payments 90% of Fair Value?$5,000 x 1.7355 = $8,678 90% of Fair Value (=90%*16,000= $14,400 )? No.

    Prepare the journal entries for RalphCo resulting from the lease.

  • Lease ExampleRalphCo decides to lease a truck from Jerry's Truck Mart. The truck is estimated to have a cash purchase price of $16,000, a useful life of four years, and an estimated salvage value of $0.

    On January 1, 2006, RalphCo signs a two-year lease, with annual payments of $5,000 to be made at the end of each year. At the end of the lease term, RalphCo must return the truck to Jerrys. If RalphCo were to get a bank loan to purchase the truck directly, the interest rate would be 10% per year.

    Prepare the journal entries for RalphCo resulting from the lease.

    Each year, the journal entry for RalphCo is:

    Rent Expense 5,000Cash 5,000

    The lease payment is expensed in the year it is incurred No recognition of any asset or liability associated with the lease

  • Lease ExampleRalphCo decides to lease a truck from Jerry's Truck Mart. The truck is estimated to have a cash purchase price of $16,000, a useful life of four years, and an estimated salvage value of $0.

    Now suppose January 1, 2006, RalphCo signs a four-year lease, with annual payments of $5,000 to be made at the end of each year. At the end of the lease term, RalphCo must return the truck to Jerrys. If RalphCo were to get a bank loan to purchase the truck directly, the interest rate would be 10% per year.

    True or False? This is an Capital Lease.True:1. Ownership transfer at end of lease? No.2. Bargain purchase option? No.3. Term 75% of useful life? 4/4 = 100% 75%? YES.4. PV of payments 90% of Fair Value?

    $5,000 x 3.1699 = 15,850 14,400 = 90% of Fair Value? YES.

    Prepare the journal entries for RalphCo resulting from the lease.

  • Lease ExampleThe lease is accounted for as if the truck had been purchased via a financing agreement. The initial asset and liability amounts are recorded at the present value of the lease payments.

    1/1/06 (record the lease):Leased Asset Truck 15,850

    Capital Lease Liab., current 3,415Capital Lease Liab., long-term 12,435

    PV of payments = annuity of $5,000 for 4 years at 10% = $15,850

    Current portion = First years payment First years interest= $5,000 - $15,850 * 10%= $5,000 - $1,585= $3,415

  • Lease Example Schedule of Payments

    (1) (2) (3) (4) (5)

    CapitalLeaseLiabilityat

    BeginningofYearInterestExpenseat10%perYear

    CashforCapitalLeasePayment

    (3)(2)ReductioninLeaseLiability

    (1)(4)CapitalLease

    LiabilityatEndofYear

    15,850 1,585 5,000 3,415 12,43512,435 1,244 5,000 3,757 8,6798,679 868 5,000 4,132 4,5464,546 454 5,000 4,546 (0)

  • Lease Example End of Year Entries: 2006

    Depreciate Leased Asset (assuming straight line, 4 years)Leased Asset Truck Amort. Exp. 3,963

    Acc. Amort. of Leased Asset Truck 3,963 Record Lease Payment

    Interest Exp. (carrying value*interest rate) 1,585Capital Lease Liab., current 3,415

    Cash 5,000 Reclassify Lease Obligation

    Capital Lease Liab., long-term 3,757*Capital Lease Liab., current 3,757

    *Current portion=Next periods payment - Next periods interest=5,000-12,435*10%=3,757

  • Lease Example End of Year Entries: 2007

    Depreciate Leased AssetLeased Asset Truck Amort. Exp. 3,963

    Acc. Amort. of Leased Asset Truck 3,963 Record Lease Payment

    Interest Exp. 1,244Capital Lease Liab., current 3,757

    Cash 5,000 Reclassify Lease Obligation

    Capital Lease Liab., long-term 4,132Capital Lease Liab., current 4,132

  • Lease Example End of Year Entries: 2008

    Depreciate Leased AssetLeased Asset Truck Amort. Exp. 3,962

    Acc. Amort. of Leased Asset Truck 3,962 Record Lease Payment

    Interest Exp. 868Capital Lease Liab., current 4,132

    Cash 5,000 Reclassify Lease Obligation

    Capital Lease Liab., long-term 4,546Capital Lease Liab., current 4,546

  • Lease Example End of Year Entries: 2009

    Depreciate Leased AssetLeased Asset Truck Amort. Exp. 3,962

    Acc. Amort. of Leased Asset Truck 3,962 Record Lease Payment

    Interest Exp. 454Capital Lease Liab., current 4,546

    Cash 5,000

  • Lease Example Schedule of Payments(1) (2) (3) (4) (5)

    EndofYear

    CapitalLeaseLiabilityat

    BeginningofYearInterestExpenseat10%perYear

    CashforCapitalLeasePayment

    (3)(2)ReductioninLeaseLiability

    (1)(4)CapitalLease

    LiabilityatEndofYear

    2006 15,850 1,585 5,000 3,415 12,4352007 12,435 1,244 5,000 3,757 8,6792008 8,679 868 5,000 4,132 4,5462009 4,546 454 5,000 4,546 (0)

    TotalInterestExp 4,150TotalAmort.Exp 15,850TotalInt.&Amort. 20,000 20,000 TotalCashPayments

  • 73

    Make financial decisions using long-term liability ratios

  • 74

    Debt to equity ratio

    Debt requires payment on specific dates. Failure to repay a debt or the interest on the debt on a timely basis may result in default or in some cases bankruptcy.

    A companys risk increases as it accumulates more debt. Debt can also be an advantage. This occurs when a company earns

    a return that is greater than the cost of borrowing those funds, thereby increasing the return to stockholders.

    We calculate the debt to equity ratio as:

    Debt to equity ratio

    =Total liabilities

    Stockholders equity

  • 75

    Times interest earned ratio

    Lenders require interest payments in return for the use of their money. Failure to pay interest when it is due may invoke penalties, possibly leading to bankruptcy.

    The times interest earned ratio compares interest expense with income available to pay those charges.

    To measure the amount available to pay interest we need to add interest expense back to net income. Similarly, because interest expense is deductible for income tax purposes, we need to add back tax expense as well.

    Times interest earned ratio =

    Net income + Interest expense + Tax expense

    Interest expense

  • 76

    SmithCo decides to lease a jet from DaveCo. The jet is estimated to have a cash purchase price of $16,000, a useful life of four years, and an estimated salvage value of $0. On January 1, 2006, SmithCosigns a four year non-cancellable lease, with annual payments of $5,000 to be made at the end of each year. At the end of the lease term, SmithCo must return the jet to DaveCo. If SmithCo were to get a bank loan to purchase the jet directly, the interest rate would be 11% per year.

    1) How much interest expense related to this lease was recognized by SmithCo during the first year of the lease term? 2) How much was the balance in the lease obligation (liability) at the end of year 2006?

    Group Exercise-Leases

  • Group Exercise-Leases

    True or False? This is an Capital Lease.True:1. Ownership transfer at end of lease? No.2. Bargain purchase option? No.3. Term 75% of useful life? 4/4 = 100% 75%? YES.4. PV of payments 90% of Fair Value?

    $5,000 x 3.1024 (annuity factor at 11% discount rate) = 15,512 14,400 = 90% of Fair Value? YES.

  • Group Exercise-Leases

    Prepare the journal entries for SmithCo resulting from the capital lease.

    1/1/06 (record the lease):Leased Asset Jet 15,512

    Capital Lease Liab., current 3,294Capital Lease Liab., long-term 12,218

    PV of payments = annuity of $5,000 for 4 years at 11% = $15,512

    Current portion = First years payment First years interest= $5,000 - $15,512 * 11%= $5,000 - $1,706= $3,294

  • End of Year Entries: 2006

    Depreciate Leased Asset (assuming straight line, 4 years)Leased Asset Jet Amort. Exp. 3,878

    Acc. Amort. of Leased Asset Jet 3,878 Record Lease Payment

    Interest Exp. (carrying value*interest rate) 1,706Capital Lease Liab., current 3,294

    Cash 5,000

    So outstanding lease obligation at end of 2006 is: 1,5512-3,294=12,218