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Financial Accounting: A Business Process Approach Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7-1 Accounting for Liabilities Chapter 7 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7-2 Learning Objectives When you are finished studying Chapter 7, you will be able to: 1. Define definitely determinable liability and explain how payroll is recorded. 2. Define estimated liability and explain how warranties are recorded. 3. Explain how long-term notes and mortgages work. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7-3 Learning Objectives 4. Record the issue of bonds and payment of interest to bondholders. 5. Prepare financial statements that include long-term debt. 6. Explain capital structure and compute the debt-to-equity ratio. 7. Identify the major risk associated with longterm debt and the related controls. 8. (Appendix 7) Compute present value and proceeds from a bond issue. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7-4 Ethics Matters The question of ethics always a legal issue. When a company wants isn’t to borrow large sums of money, it Hundreds people in these agencies focused on the often issuesof bonds. Similar to issuing stock, issuing bonds deal rather than the credit quality of thecomplicated securities isAs a way to finance a business with money from investors. Frank Raiter, a former managing director at Standard & financial firms were putting together they were rating. In this case, the goal profit For months, the(related rating firms were giving AAA ratings However, a bond is a debt andof doesn’t Poor’s, believes the credit rating agencies could have debt securities toinstrument subprime mortgages), the to maximization came face-to-face with ethical decision complicated debt securities without actually able represent ownership like stock does. Acame bondholder—an stopped the financial meltdown that tobeing a the crisis rating agencies were hired by the firms to rate making and the consequences involved the most to assess the riskiness of those securities. ratings investor a bond—is loaning money toThe the company point inbuying 2008. Simply stated, greed got the best of the securities. The best rating is AAA and indicates very serious crisis the Great Depression of agencies admit now that they just didn’t have the data that issues the bond. To since help investors evaluate the risk agencies. Joseph Stiglitz, a Nobel prize-winning little riskfinancial with an investment. (After that, the ratings the The resulting discussion continues, as to make ratings. But they were getting paid to doBB the associated with corporate bonds, rating provide economist, called the ratings “hocus pocus.” Raiter, go to1930s. AA,the A, BBB, BB, B, CCC, CC, and C.agencies Bonds rated Congress and the SEC continue to with ratings. The more AAA ratings they gave, more credit ratings for bonds. Standard &grapple Poor’s, Moody’s, once demoted for his unwillingness tobonds.) gothe along withand and below are sometimes called junk changes to resigned this industry in than an effort to in make sure this business they got. Fitch are the three most well-known. These agencies the deceit, rather giving to the doesn’t happen again. played a major role in the his financial crisis of 2008. pressure to compromise standards. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7-5 Learning Objective 1 Types of Liabilities Estimated Liability: Obligations that have some uncertainty in the amount to record for the obligation. Warranty Definitely determinable liability: Obligations that can be measured exactly. Note Payable Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7-6 Payroll Payroll is a common business expense that results in a definitely determinable liability. A company acts as an agent for the government; it must withhold Social Security, Medicare, federal, and state income taxes from its employees’ paychecks. After the withholdings are deducted from an employee’s gross pay, s/he will receive net pay. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7-7 Payroll Home Depot hires a security guard for a salary of $500 per week. The gross pay is subject to FIT, FICA, and Medicare. $500.00 - 50.00 – 31.00 – 7.25 = $411.75 Gross Pay – FIT – FICA – Medicare = Net Pay •When Home Depot records the disbursement to the employee, the payment affects the financial statements as follows. Assets = Liabilities + Shareholders’ Equity Contributed Capital (411.75) cash 50.00 FIT Payable 31.00 FICA Payable 7.25 Medicare Taxes Payable Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall Retained Earnings (500) salary expense 7-8 Payroll Home Depot will match the FICA and Medicare amounts. When Home Depot records the payment to the government for federal income taxes and social security, the payment affects the financial statements as follows: Assets = Liabilities + Shareholders’ Equity Contributed Capital (126.50) cash (50.00) FIT Payable (31.00) FICA Payable (7.25) Medicare Taxes Payable Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall Retained Earnings (38.25) payroll tax expense 7-9 Your Turn 7-1 Sandy’s paycheck will at beher in the of $1,085.25. Sandy earned $1,500 jobamount at Paula’s Bookstore The transaction recorded follows: during February.would Sandybe has 20% ofas her gross pay withheld for federal income taxes, 6.2% withheld for social security (FICA) taxes, and 1.45% withheld for Assets = Liabilities + Shareholders’ Equity Medicare taxes. Contributed Capital Retained Earnings What will be the net amount of Sandy’s February (1,085.25) 1,500.00 paycheck? 300.00 FIT Payable cash How will Sandy in 93.00 FICA Taxes Payable Paula’s Bookstore record the 21.75 Medicare the accounting equation? Taxes Payable Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall salary expense payment to 7 - 10 Learning Objective 2 Warranties Companies provide warranties as a sales or marketing tool. An accountant estimates the future repairs and replacement costs related to current sales. Warranty expense is estimated and a liability (warranties payable) is created. We will repair or replace this item... Warranty When a warranty is honored in the future, the warranties payable account will be reduced for the costs. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 11 Warranties A company sold $4,000 worth of merchandise with a warranty. The accountant estimated that $100 of warranty cost will be incurred over the next two years on the goods sold. Liabilities increase by $100 and Retained Earnings decrease by $100. Assets = Liab. + Cont. Cap. + Ret. Earnings +100 (100) Income Statement: Decreases income Statement of Changes in Equity: No effect on cash flow Statement of Cash Flows: Decreases equity Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 12 Warranties A customer returned goods under warranty for Repair. The cost of the repair was $30 cash. Assets and liabilities decrease by $30. Assets = Liab. + Cont. Cap. + Ret. Earnings (30) (30) Income Statement: No effect Statement of Changes in Equity: No effect Statement of Cash Flows: Decreases cash flow Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 13 Your Turn 7-2 Suppose that Brooke’s Bike Company did some repairs related to warranties on previous sales. The total spent was $500. The 1. No warranty expense would be on the July 31 liability (warranty payable) is $2,750. August income statement. What amount of warranty expense would appear on Brooke’s Bike Company’s income 2. The liability would be $2,250 ($2,750 – statement for the month ended August 31? $500). What is the amount of the August 31 liability (warranty payable or estimated warranty liability)? Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 14 Learning Objective 3 Notes Payable and Mortgages When a company borrows money (issues a note payable) from the bank for longer than a year, the obligation is called a long-term note payable. The borrower receives the principal and promises to repay the principal plus interest. These obligations are frequently repaid in equal installments, part of which are repayment of principal and part of which are interest. A mortgage is a special kind of “note” payable-one issued for property. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 15 Payments of Interest and Principal Suppose you sign, January 1, a $100,000, 3-year mortgage with an 8% annual interest rate. The annual payment is $38,803.35. How much of the first payment is interest and how much is principal? Interest is the cost of using someone else’s money. Annual Interest Balance Outstanding Principal Interest Rate $100,000 X .08 x Time 1 (year) $8,000 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 16 Payments of Interest and Principal After three payments, the interest and principal will be repaid. Notice the amount of interest owed the bank is smaller each year because the outstanding balance is smaller. Mortgage Balance Beginning Balance After 1st payment After 2nd payment After 3rd payment $100,000 $69,196.65 $35,929.03 $0.00 Interest Amount of Annual Portion - 8% Mortgage Payment of Balance Reduction $38,803.35 $8,000.00 $30,803.35 $38,803.35 $5,535.73 $33,267.62 $38,803.35 $2,874.32 $35,929.03 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 17 Learning Objective 4 Characteristics of Bonds Payable A bond is an interest-bearing long-term note payable issued by corporations, universities, and governmental agencies to borrow money from individual investors. Bonds usually involve the borrowing of a large sum of money, called principal. The principal is usually paid back as a lump sum at the end of the bond period. Individual bonds are often denominated with a par value, or face value, of $1,000. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 19 Bonds This is the information shown on a bond certificate... $1,000—principal 10%—interest rate (annual) 5yrs.—time to maturity annual—interest payments The cash flows associated with the bonds are defined by the terms on the face of the bond. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 20 Characteristics of Bonds Payable Bonds usually carry a stated rate of interest. Interest is normally paid semiannually. Interest is computed as: Interest = Principal × Stated Rate × Time Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 21 Characteristics of Bonds Payable The new bondholder receives a bond certificate. The bond certificate identifies the par value, the stated interest rate, the interest dates, and the maturity date. The trustee makes sure the issuing company fulfills all of the provisions of the bond indenture, or agreement. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 22 Bond Classifications Unsecured bonds (also called debentures) do not have pledged assets as a guarantee of repayment at maturity. Secured bonds include a pledge of specific assets as a guarantee of repayment at maturity. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 23 Bond Classifications Ordinary bonds (also called singlepayment bonds) The full face amount is paid at the maturity. Serial bonds The principal is paid in installments on a series of specified maturity dates. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 24 Bond Classifications Callable bonds May be retired and repaid (called) at any time at the option of the issuer. Redeemable bonds May be turned in at any time for repayment at the option of the bondholder. Convertible bonds May be exchanged for other securities of the issuer (usually shares of common stock) at the option of the bondholder. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 25 Bond Classifications Registered bonds Payment of interest is made by check and mailed directly to the bondholder whose name must be registered. Coupon bonds Coupons are attached to the bond for each interest payment. The bondholder “clips” each coupon and presents it for payment on the interest date. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 26 Trading Bonds When a bondholder sells a bond, there is no effect on the books of the issuing company. Bondholders trade among themselves in the bond market. Changes in the market rate of interest and the risk related to specific bonds cause the prices of bonds to change. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 27 Bonds Payable and Interest Expense The interest rate used to compute the present value is the market interest rate (also called yield, effective rate, or true rate). Creditors demand a certain rate of interest to compensate them for the risks related to bonds. The stated rate, or coupon rate, is only used to compute the periodic interest payments. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 28 Issuing Bonds When the market rate of interest and the stated rate of interest are NOT the same •the market rate of interest is used to calculate the issue price of the bonds, and •the stated rate of interest is (always) used to calculate the interest payments to the bondholders. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 29 Determining the Selling Price Bonds sell at: “Par” (100% of face value) less than par (discount) more than par (premium) Market rate of interest vs. bond’s stated rate of interest determines the selling price (market price of the bond) Therefore, if market rate > stated rate: Discount market rate < stated rate: Premium Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 30 Cash Flows Associated with a Bond Bonds that sell below 100 are issued for less than the face value. They are called bonds issued at a discount. The price of a bond when it is issued is calculated by the bond market and is stated in Bonds that sell for more than 100 are issued terms of a percentage of the face value. The for more than the face value. They are called cash the company receives when issuing a bond bonds issued at a premium. is call the proceeds. Bonds that sell at 100 are issued at exactly the face amount of the bond. They are called bonds issued at par. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 31 Bonds Bond Premium: is an adjunct-liability that is added to bonds payable on the balance sheet; it is the difference between the face value of the bond and its selling price, when the selling price is more than the face (par) value. Bond Discount: is a contra-liability that is deducted from bonds payable on the balance sheet; it is the difference between the face value of the bond and its selling price when the selling price is less than the face (par) value. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 32 Your Turn 7-4 If a $1,000 bond is selling for 95.5, how much cash does the bondholder pay for the bond? If a $1,000 bond is selling for 102, how much cash does the bondholder pay for the bond? A $1,000 bond issued at 95.5 will sell for $955. A $1,000 bond issued at 102 will sell for $1,020. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 33 Bonds Sold at a Discount $1,000, 5% stated rate. The market rate of interest is 6%. Who will buy this bond at face value? Nobody. It will have to sell (issue) at a discount, e.g., bondholders will give me less than face value for the bond. Bonds sell at 95.1. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 34 Cash Flows Associated with a Bond Interest payments of $50 (that’s 5% of the $1,000 face value) each year for 6 years. A lump sum payment of $1,000 (the face amount of the bonds) in 6 years. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 35 Bond Discount The discount must be amortized over the outstanding life of the bonds. The discount amortization increases the periodic interest expense for the issuer. Two methods are commonly used: Effective-interest amortization Straight-line amortization Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 36 Straight-Line Amortization of a Bond Discount Identify the amount of the bond discount. Divide the bond discount by the number of interest periods. Include the discount amortization amount as part of the periodic interest expense entry. The discount will be reduced to zero by the maturity date. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 37 Straight-Line Amortization of Bond Discount Bonds sell for $951. 00 Discount is 49.00 Interest payment is always $50.00 Discount amortization is $49.00 = $8.17. 6 That means that the discount will be amortized by $8.17 every time a payment is made. Interest expense will be $58.17 each time a payment is made. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 38 Reporting A Bond Sold at a Discount If we prepared a balance sheet on the date of issue, the bond would be reported like this: Bonds Payable $ 1,000.00 Less Discount on B/P 49.17 Net Bonds Payable $ 950.83 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 39 Bonds Sold at a Premium $1,000, 5% stated rate. The market rate of interest is 4%. Who will buy these bonds at face value? EVERYONE! So the market will bid up the price of the bond; e.g., it will sell for a premium since it has such good cash flows. Bondholders will pay more than the face value. Bonds sell at 105.2. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 40 Bonds Issued at a Premium The premium must be amortized over the term of the bonds. The premium amortization decreases the periodic interest expense for the issuer. Two methods are commonly used: Effective-interest amortization Straight-line amortization Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 41 Straight-Line Amortization of Bond Premium Identify the amount of the bond premium. Divide the bond premium by the number of interest periods. Include the premium amortization amount as part of the periodic interest expense entry. The premium will be reduced to zero by the maturity date. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 42 Amortization of Bond Premium Bonds sell for $1,052.00 Interest payment is always $50. Premium amortization is $52.00 = $8.67. 6 That means that the premium will be amortized by $8.67 every time a payment is made. Interest expense will be $41.33 each time a payment is made. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 43 Bond Amortization Effective-interest method of amortization is preferred by GAAP. Straight-line amortization may be used if it is not materially different from effective interest amortization. Most companies do not disclose the method used for bond interest amortization. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 44 Carrying Value Of BONDS PAYABLE While the specific long-term liability (Bonds Payable) is always recorded (and kept) at face value, the Discount or Premium (on Bonds Payable) will be either subtracted (discount) or added (premium) to the BP amount to get the carrying value of the bond at any given date. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 45 Learning Objective 5 Capital Structure Two ways to finance a business are debt and equity. The combination of debt and equity is called its capital structure. Closely related is the concept of financial leverage, the use of borrowed funds to increase earnings. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 46 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 47 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 48 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 49 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 50 Learning Objective 6 Ratio Analysis The debt-to-equity ratio measures a company’s debt position and its ability to meet its interest payments. It compares the amount of creditors’ claims to the assets of the firm with the owners’ claims to those assets. The Home Depot, Inc. had $23,387 in total debt and total shareholders’ equity of $17,777 as of 2/1/2009. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 51 Learning Objective 7 Business Risk, Control, and Ethics The risks associated with long-term debt is the risk of not being able to make the debt payments. Two major things a company can do to minimize the risk associated with long-term debt: 1. 2. Be sure that a thorough business analysis accompanies any decision to borrow money. Study the characteristics of various types of debt - terms, interest rates, ease of obtaining the money - and evaluate their attractiveness in your specific circumstances, given the purpose of the loan and the financial situation of the company. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 52 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7 - 53