Download cash - Initial Set Up

OBJECTIVES:
•Contingent Liabilities
•Present Value Concepts
•Types of Long Term Liabilities
•Notes Payable
•Bonds Payable
•Shareholders Equity ??
Commitments
 significant
agreements that can affect the
future operations of the company
 require disclosure in the notes to the
financial statements
 but are not recorded in the financial
statements until the agreement is
executed (in whole or in part)
For Example: A Note appearing in the financial statement.
‘The company has entered into agreements with certain wellknown celebrities to endorse the Company's products. The
agreements, among other things, require the Company to
make certain guaranteed payments in the future.’
Contingencies
defined as something of uncertain occurrence
 an event has occurred which will result in a gain or loss in
the future, but will not be known for sure until another
event occurs or fails to occur in the future

Accounting Rules for Contingencies
gains: never anticipate the gain; only disclose the
possible gain in the notes to the financial
statements until the outcome is known
losses: record the event (i.e., the liability & loss) if the
loss outcome is likely and the amount of the loss
can be reasonably estimated
Present Value Concepts
you are responsible for understanding the concept
 and its application to accounting
 but not the underlying methods of calculating present
values

The Concept:
money received today can be invested to earn interest
 $10 invested today at 10% = $11 next year
 $11 next year is the same as $10 today
 the present value of $11 to be received next year = $10


the present value of $11 to be paid next year = $10
Present Value Concepts

the present value (pv) of $11 to be paid next year = $10
Cash
Payment
B/S
(liability)
interest
$1
$10
principal
$11
record only the principal (pv) when the liability is incurred
 interest is incurred (and recorded) as time passes

On January 1, Air Canada purchased parts from American Airlines by
issuing a note payable of $12,000, due in two years. At 7% interest rates,
the note is equivalent to $10,481 now.
Required:
Prepare the journal entries that are required during the first and
second year.
Note Payable
Dr. Aircraft Parts
$10,481
10,481
Cr. Note Payable
$10,481
734
(to record the purchase of parts)
11,215
Dr. Interest Expense
$734
785
Cr. Note Payable
$734
12,000
(to record the interest on the note in year 1 = 7% x 10,481)
Dr. Interest Expense
$785
Cr. Note Payable
$785
(to record the interest on the note in year 2 = 7% x 11,215)
Notes Payable
A note payable is is a written promise to pay a stated sum at one or
more specified future dates. A note payable may require a singlesum repayment at the due date or maturity date or it may call for
installment payments. If it requires regular payments in installments
it is called an annuity.
Notes payable require the payment of interest and the recording of
interest expense. Interest expense is incurred on liabilities because
of the time value of money.
To calculate interest three important variables must be considered.
(1) the principal; (2) the rate ; and (3) duration or time period
Interest = Principal x Rate x Time
Accounting for an Interest-Bearing Note
The accounting entry to record $10,000 cash borrowed on a fiveyear 10% interest bearing note payable, with interest being payable
at maturity would be:
Dr. Cash
Cr. Note Payable
10,000
10,000
Important Considerations – Interest Expense
Interest is an expense of the period when the money is used,
therefore it is measured, recorded and reported on a time basis
rather than when the cash is actually paid.
Accounting for a ‘Noninterest’-Bearing Note
A no interest-bearing note includes the interest amount in the face
value of the note. This causes a difference in the accounting entries.
Assume in the previous example that the note was non-interest
bearing, the accounting entries will be as follows:
Dr. Cash
Dr. Discount on note payable
Cr.
Note Payable
10,000
600
10,600
At the end of the first period, your accounting entries as it relates to
interest will be as follows:
Dr. Interest Expense
Cr. Discount on note payable
XX
XX
Future income taxes
(a.k.a. deferred income taxes)
3 types of income taxes ...
(i) income taxes withheld from employees' pay
Dr. Wages & salaries expense
Cr. Employee income tax payable
Cr. Wages & salaries payable
(ii) income taxes as calculated on the company's tax return
Dr. Income tax expense
Cr. Income taxes payable (CL)
(iii) income taxes that will arise in the future but haven't
yet become payable based on the company's tax return
Future income taxes
Future income taxes
CCRA (Canada Customs & Revenue Agency) allows some reporting
policies for tax purposes that aren't allowed by GAAP
Tax Return
Income Statement
Sales Revenues
Sales Revenues
COGS
COGS
Operating Expenses
Operating Expenses
Amortization Expense
Amortization Expense
(CCA)
Interest Expense
Interest Expense
Etc.
Etc.
GAAP
Tax Rules
Future income taxes
CCRA (Canada Customs & Revenue Agency) allows some reporting
policies for tax purposes that aren't allowed by GAAP

for example, CCRA sometimes allows very high deductions for
amortization on tax returns in the early years of a capital asset's life, but
GAAP may not
thus, taxes owed using "income tax policies" may differ from taxes based
on "financial statement policies"

these tax vs. accounting differences are called "temporary differences"
(because eventually they will reverse)
- report as "taxes payable" the amount of taxes owed according to the tax
return (i.e., using "income tax policies")
- report as "future income taxes" any liabilities (or assets) that are likely to
arise in the future when the temporary differences reverse
Long Term Liabilities - Bonds
Bond Liabilities: What is a bond?




a formal, legal debt agreement
it sets-out how the borrower will repay the lender
it’s like a long-term note payable, except that bonds can be owed to
multiple entities (called bondholders)
the bond describes the conditions of the debt agreement
Some Terms



maturity date (i.e., when it has to be repaid)
amount to be repaid at maturity (i.e., face value)
interest to be paid periodically until maturity (i.e.,bond
interest rate / a.k.a. “coupon rate”)
Finance Terms Related to Bonds
 amount to be repaid at maturity
FACE VALUE
interest to be paid periodically until maturity
BOND RATE
Finance Terms Related to Bonds
8% per year
$1,000 FACE VALUE
8% per year
8% per year
8% per year
8% per year
BOND RATE

Finance Terms Related to Bonds
Cash
Received
Cash
Payment
(Liability)
Cash
Payment
Cash
Payment
Cash
Payment
Cash
Cash
Payment Payment
Cash
Payment
interest
?
bond
price
$40
$40
$40
$40
$40
$40
$1,000
face
value
bond price = p.v. of face value + p.v. of bond interest payments
Finance Terms Related to Bonds
Cash
Received
(liability)
Cash
Payment
Cash
Payment
Cash
Payment
Cash
Payment
Cash
Cash
Payment Payment
Cash
Payment
interest
$40
$40
$40
$40
$40
$40
$1,000
$1,000
face
bond
value
price
bond price = p.v. of face value + p.v. of bond interest payments
Bonds Issued At Par
 simply means that bond price = face value
 means bond interest rate (8%) = market rate (8%)
 in other words, interest paid by bond = interest demanded
Accounting for Bonds Issued at Par
interest
?
bond
$40
$40
$40
$40
$40
price



$40
$1,000
face
value
record the bond liability at the p.v. of future payments
Dr. Cash
$1,000
Cr. Bond Payable
$1,000
record interest expense = effective interest rate x liability
Dr. Interest Expense
$ 40 = 1000 x 8% x 6/12
Cr. Interest Payable
$ 40
record the bond interest payment
Dr. Interest Payable
Cr. Cash
$ 40
$ 40
Finance Terms Related to Bonds
Cash
Received
(liability)
Cash
Payment
Cash
Payment
Cash
Payment
Cash
Payment
Cash
Cash
Payment Payment
Cash
Payment
interest
$ 949 $40
$40
$40
$40
$40
$40
$1,000
face
bond
value
price
bond price = p.v. of face value + p.v. of bond interest payments
Bonds Issued At a Discount
 discount means that bond price < face value
 means bond interest rate (8%) < market rate (10%)
 in other words, interest paid by bond < interest demanded
Accounting for Bonds Issued at a Discount

interest
?
bond
$40
$40
$40
$40
price
$40
$40
$1,000
face
value
record the bond liability at the p.v. of future payments
Dr. Cash (A)
$ 949
Dr. Bond Discount (xL) $ 51
effective
liability
Cr. Bond Payable (L)
$1,000
Balance Sheet
Liabilities
Bond Payable $1,000
Bond Discount
(51)
Effective Liab. $ 949

Accounting for Bonds Issued at a Discount
interest
?
bond
price
$40
$40
$40
$40
$40
$40
$1,000
face
value
record the bond liability at the p.v. of future payments
Dr. Cash
$ 949
Dr. Bond Discount
$ 51
effective
liability
Cr. Bond Payable
$1,000
 record interest expense = market interest rate x liability
Dr. Interest Expense $ 47.45 = (1000-51) x 10% x 6/12
$ 7.45
Cr. Bond Discount
$ 40.00
Cr. Interest Payable
 record the bond interest payment
Dr. Interest Payable
$ 40
Cr. Cash
$ 40
Balance Sheet
Liabilities
Income Statement
Expenses
at issue 6 months 6 months
Bond Payable $1,000 $ 1,000 $1,000
Bond Discount
(51) (43.55) (35.73)
$ 949 956.45 964.27
Interest
6 months
6 months
$ 47.45
$ 47.82
= 949 x 10% x 6/12
another 6 months later ...
record interest expense = market interest rate x liability
Dr. Interest Expense
$ 47.82 = 10% x 6/12 x (1000-43.55)
Cr. Bond Discount
$ 7.82
Cr. Interest Payable
$ 40.00
 record the bond interest payment
Dr. Interest Payable
$ 40
Cr. Cash
$ 40

Finance Terms Related to Bonds
Cash
Received
(liability)
Cash
Payment
Cash
Payment
Cash
Payment
Cash
Payment
Cash
Cash
Payment Payment
Cash
Payment
interest
$1,054 $40
$40
$40
$40
$40
$40
$1,000
face
bond
value
price
bond price = p.v. of face value + p.v. of bond interest payments
Bonds Issued At a Premium
premium means that bond price > face value
 means bond interest rate (8%) > market rate (6%)
 in other words, interest paid by bond > interest demanded

Accounting for Bonds Issued at a Premium

interest
?
bond
$40
$40
$40
$40
$40
$40
$1,000
face
value
price
record the bond liability at the p.v. of future payments
Dr. Cash
$ 1,054
Cr. Bond Premium (L)
$ 54
effective
liability
Cr. Bond Payable (L)
$1,000
Balance Sheet
Liabilities
at issue
Bond Payable $1,000
Bond Premium
54
$1,054

Accounting for Bonds Issued at a Premium
interest
?
bond
price
$40
$40
$40
$40
$40
$40
$1,000
face
value
record the bond liability at the p.v. of future payments
Dr. Cash
$ 1,054
Cr. Bond Premium
$ 54
effective
liability
Cr. Bond Payable
$1,000
 record interest expense = effective interest rate x liability
Dr. Interest Expense
$ 31.62
= 6% x 6/12 x (1000+54)
Dr. Bond Premium
$ 8.38
Cr. Interest Payable
$ 40.00
 record the bond interest payment
Dr. Interest Payable
$ 40
Cr. Cash
$ 40
Balance Sheet
Liabilities
Income Statement
Expenses
at issue 6 months 6 months
Bond Payable $1,000 $ 1,000 $1,000
Premium
54
36.99
45.62
$ 1,054 1,045.62 1,036.99
Interest
6 months
6 months
$ 31.62
$ 31.37
another 6 months later ...
record interest expense = effective interest rate x liability
Dr. Interest Expense
$ 31.37 = 6% x 6/12 x (1000-45.62)
Cr. Bond Premium
$ 8.63
Cr. Interest Payable
$ 40.00
 record the bond interest payment
Dr. Interest Payable
$ 40
Cr. Cash
$ 40

Early Retirement of Bonds

remove the bonds payable (& any premium/discount)

record the cash given up to retire the bonds

record the gain/loss = amount by which liability >/< cash
Assume the $1,000 bond issued at 105.4 (the previous example) is
retired after only 1 year. The cash payment made to bondholders
to retire the bond was $964. What’s the journal entry?
Dr. Bond Payable
$1,000 (given)
Dr. Bond Premium $ 37 (as per acctg records)
Cr. Cash
$ 964 (assumed)
Cr. Gain on Bond Retirement $ 73 (plug)
Practice
Rose Corporation sold 10-year, 8 percent bonds with a
$100,000 par value on January 1, 2001. Interest is paid
on June 30 and December 31. If the bonds were sold at
104 for a return of 7.42%, give the journal entries for
2001.
Relevant facts:
bonds were
 face value of bonds is $100,000
issued at a
 bonds were sold at 104 (i.e., $104,000)
premium
 8% is bond interest rate
 7.42% is market discount rate
Liability
June
Payment
December
June
Payment Payment
December
Payment
...
Final Cash
Payments
interest
$104
bond price
$4
$4
$4
$4
...
$4
$100
face value
Rose Corporation sold 10-year, 8 percent bonds with a
$100,000 par value on January 1, 2001. Interest is paid
on June 30 and December 31. If the bonds were sold at
104 for a return of 7.42%, give the journal entries for
2001.
Relevant facts:
bonds were
 face value of bonds is $100,000
issued at a
 bonds were sold at 104 (i.e., $104,000)
premium
 8% is bond interest rate
 7.42% is market discount rate
Liability
June
Payment
December
June
Payment Payment
December
Payment
...
Final Cash
Payments
interest
$104
bond price
$4
$4
$4
$4
...
$4
$100
face value
Accounting for Bonds Issued at a Premium



record the bond liability at the p.v. of future payments
Dr. Cash
$ 104,000
Cr. Bond Premium
$ 4,000
Cr. Bond Payable
$100,000
record interest expense = effective interest rate x liability
= 7.42% x 6/12 x (100+4)
Dr. Interest Expense
$ 3858
Dr. Bond Premium
$ 142
Cr. Interest Payable
$ 4000
record the bond interest payment
Dr. Interest Payable
$ 4000
Cr. Cash
$ 4000
Accounting for Bonds Issued at a Premium

record interest expense = effective interest rate x liability
= 7.42% x 6/12 x (100,000+4,000-142)
= 3,853
Dr. Interest Expense
$ 3853
Dr. Bond Premium
$ 147
Cr. Interest Payable
$ 4000

record the bond interest payment
Dr. Interest Payable
Cr. Cash
$ 4000
$ 4000
Ratios for Long-term Liabilities

=
debt/equity ratio
Total Liabilities
Total Liabilities + Shareholders' Equity
shows the proportion of financing from debt
 suggests corporate financing strategy

Ratios for Long-term Liabilities

times interest earned ratio
=
Net Income + Tax Expense + Interest
Interest
shows whether sufficient income is generated to
cover interest costs
 suggests the likelihood of interest payment

Leases


an agreement that allows one entity to obtain (from
another entity) the use of assets
two types of leases exist:
1) "OPERATING LEASES"
these
are simple rental agreements that allow one
company the right to use another company's
property in exchange for a rental payment
the
company providing the rented property is called
the "lessor" and the company obtaining the use of the
property is called the "lessee"
Leases


an agreement that allows one entity to obtain (from
another entity) the use of assets
two types of leases exist:
2) "CAPITAL LEASES"
"rental"
agreements whereby the lessor transfers
substantially all of the risks & rewards of property
ownership to the lessee
in substance, this is just like the lessee going out
and buying the property from the lessor with a
long-term promissory note
if a lease meets any one of three criteria, it is a
capital lease (otherwise, it's an operating lease)
Accounting for the 2 Types of Leases
1) "OPERATING LEASES"

this is what we have been doing all along so far
Lessee
Dr. Rent Expense
Cr. Rent Payable
note
that the lessee does
not record the leased asset
on the balance sheet
Lessor
Dr. Rent Receivable
Cr. Rental Revenue
Accounting for the 2 Types of Leases
1) "OPERATING LEASES"
this is what we have been doing all along so far
Lessee
Lessor
Dr. Rent Expense
Dr. Rent Receivable
Cr. Rent Payable
Cr. Rental Revenue

2) "CAPITAL LEASES"

because substantially all the risks and rewards of ownership pass
from the lessor to the lessee, the lessee records a purchase & loan
and the lessor records a sale
Lessee
Dr. Capital Asset under Lease $ (pv of lease pmts)
Cr. Obligation under Capital Lease $ (pv of lease pmts)
both
an asset & liability appear on the balance sheet
Accounting for the 2 Types of Leases
1) "OPERATING LEASES"
this is what we have been doing all along so far
Lessee
Lessor
Dr. Rent Receivable
Dr. Rent Expense
Cr. Rental Revenue
Cr. Rent Payable

2) "CAPITAL LEASES"

because substantially all the risks and rewards of ownership pass
from the lessor to the lessee, the lessee records a purchase & the
lessor records a sale
Lessor
 don't worry about the journal entry details
 essentially, the lessor records a "lease sale" and related
"cost of lease sales"
Criteria for Identifying Capital Leases
a
guide for determining whether substantially all of the
risks & rewards have been transferred
IF...
1) ownership transfers sometime during the lease
2) the lease covers substantially all ( 75%) of the asset's life
or
3) the lease payments are substantially all of the
asset value ( pvmlp > 90% fmv )
IT'S A CAPITAL LEASE
More on Accounting for Capital Leases
Lessee
Dr. Capital Asset under Lease records a capital asset
Cr. Obligation under Capital
Lease
first capitalize ... then amortize
(just like any other capital asset)
usually use straight-line amortization method
amortization period often = lease term
More on Accounting for Capital Leases
Lessee
Dr. Capital Asset under Lease
Cr. Obligation under Capital
a long-term liability
Lease
lease payments include principal & interest
(just like any other long-term debt payments)
principal portion reduces the liability
interest portion recorded as an expense
Lessee’s
Point of
View
Similar
Asset?



Liability?
OPERATING
LEASE
make periodic pmts
no asset appears on the
balance sheet
liability for lease
payments only as they
come due
full payment shown as rent
Expense? expense on I/S

CAPITAL
LEASE




make periodic pmts
capital asset appears with
long-term assets on the
balance sheet
liability for present value of
all lease payments before
they come due
interest portion of lease
payment & amortization
shown as expenses