Liabilities: Introduction 4/17/2017 Liabilities: Introduction

Objectives of the Chapter To learn the basic concepts of liabilities and liability recognition. To learn accounting for current liabilities, including estimated and contingent liabilities. To learn accounting for long-term liabilities (i.e., issuance of bonds for cash). Liabilities: Introduction

Objectives of the Chapter (contd.) To study the accounting procedures for interest payments of bonds and the amortization of bond discount or premium. To study the accounting procedures for debt retirements either at or before maturity. To learn the accounting for issuance of long-term note for assets or cash. Liabilities: Introduction

Liabilities: Introduction Legal obligations require future payments of cash or services or the creation of other liabilities as a result of past transactions. Recognition principle: accrual basis (i.e., A liability should be recognized when it occurs, not when it is paid.) Liabilities: Introduction

The Importance of Understanding the GAAP’s Definition of a Liability Lenders often require the borrowers to keep debt/equity under a specific level (i.e., not more than 50%) in the loan agreement. If the ratio is greater than the constraint, the lender may have additional rights, such as to charge a higher interest rate. Investors (creditors) often use the debt/equity ratio to make their credit decisions. Liabilities: Introduction

Off-Balance Sheet Liabilities When calculating the debt/equity ratio, attention should be given to the off-balance sheet liabilities which are obligations not reported as liabilities on the balance sheet and only disclosed in the footnotes. Examples: operating lease obligations, pension liabilities, SPE’s liabilities guaranteed by the corporation/sponsor, etc. Off-balance liabilities will be discussed in chapter 10. Liabilities: Introduction

Liabilities: Introduction 2. Current Liabilities Obligations must be fulfilled in one year or one operating cycle, whichever is longer. Examples of current liabilities as a result of a business transaction: (with definite amount) A/P (accounts payable) N/P (notes payable) Current maturity portion of a long-term debt (i.e., bonds payable) Sales taxes payable Payroll taxes withholdings Liabilities: Introduction

Liabilities: Introduction Employee Related Liabilities: FICA, Federal I/T, state I/T, Medical Insurance Premiums… i.e. Salaries Expense 50,000 Employee F.I.C.A. Taxes Payable* 3,825 Federal I/T Payable 10,000 State I/T Payable 2,500 Salaries Payable 32,675 *0.0765 * 50,000 Liabilities: Introduction

Employee Related Liabilities (contd.) Employer payroll taxes: Payroll Taxes Expense 6,925 Employer F.I.C.A. Taxes Payable 3,825 F.U.T.A. Taxes Payablea 400 State Unemployment Tax Payableb 2,700 a. 6.2% of the first $7,000 of salaries paid to employees. b. assuming a state unemployment tax = 5.4%. Liabilities: Introduction

Other Current Liabilities (with definite amount) Refundable Deposits Cash xxx Refund Deposit Liabilities xxx Unearned Revenue (i.e., subscription fees received in advance, advances from customers before delivery, etc.) Cash xxx Unearned Subscription Revenue xxx (or Advances from Customers) Liabilities: Introduction

Liabilities: Introduction Accrued Liabilities Obligations accumulated on a daily basis but not recorded until the end of period through adjusting entries (i.e., Interest payable, salaries payable, rent payable…) J. E. Interest Expense xxx Interest Payable xxx Liabilities: Introduction

Estimated Liabilities Liabilities exist but the amount is unknown, i.e., Property taxes Warranty obligations Coupon and premium obligations Vacation Wage and Fringes Payable Liabilities: Introduction

Expense Warranty Using Accrued Method (for financial Reporting Purposes) Estimate the warranty expense associated with the sales during the period at the end of the period and recognize it. Liabilities: Introduction

Expense Warranty Using Accrued Method (contd.) Journal Entry: Warranty Expense xxx Estimated Warranty Liability xxx When warranty services provided: Estimated warranty liability xxx Cash (or Inventory) xxx If the estimated warranty liabilities are not enough to cover the current year’s warranty services, additional warranty expense would be debited. Liabilities: Introduction

Premiums and Coupons Obligations Liabilities of premiums and coupons should be estimated and recognized in the year when sales are made. Journal Entry Premium (or Coupon) Expense xxx Estimated Premium Claims (or coupon) outstanding xxx Liabilities: Introduction

Premiums and Coupons Obligations (contd.) When premiums (or coupons) are claimed: Journal Entry Estimated Premium Claims (coupon) outstanding xxx Inventory xxx * If the actual redemption of coupons (or premiums) is greater than the estimated liabilities, the underestimated amount would be recognized as the expense of the current year. (APB 20) Liabilities: Introduction

Liabilities: Introduction Contingencies Contingent Liabilities Contingent Losses Contingent Gains Liabilities: Introduction

Contingent Liabilities Obligations may arise because of the occurrence or not occurrence of future event(s). (i.e., warranty obligations) Liabilities: Introduction

Contingent Losses and Gains Losses (gains) may arise because of the occurrence or not occurrence of future event(s). (i.e., the uncollectable accounts, the pending lawsuit losses (gains), possible damage of a fire, etc.…) Liabilities: Introduction

Accounting Treatments of Contingencies The accounting treatments of the contingencies depend on the occurrence probability of the related future event(s).(FASB No. 5) If the future event is a. Probable, and b. amount of liability can be reasonable estimated. The liability should be estimated, and recognized on the balance sheet. Liabilities: Introduction

Accounting Treatments of Contingencies (contd.) Probable: defined by the FASB as “the future event(s) is(are) likely to occur”; no specific % is given. Common practice of probable by accountants: probability of occurrence is between 80% to 85%. IASC: Probable is defined as “more likely than not” . Liabilities: Introduction

Accounting Treatments of Contingencies (contd.) Examples: 1. Bad Debt Expenses xxx Allowance for Bad Debt xxx 2. Warranty Expense xxx Estimated Warranty Liabilities xxx 3. Lawsuit Expenses xxx Estimate Liability under litigation xxx Liabilities: Introduction

Accounting Treatments of Contingencies (contd.) If the future event is probable, but the amount of loss/liability cannot be estimated, the contingent loss/liability should be disclosed (i.e., Merck’s disclosure of Vioxx lawsuits). Contingent gains: No unrealized gain can be recognized under the current accounting standards (conservatism!!!) Liabilities: Introduction

3. Long-Term Liabilities 4/17/2017 3. Long-Term Liabilities Issuance of bonds (at a premium or discount)- cash inflow Issuance of bonds between interest payment dates Extinguishment of debt – cash outflow Convertible Bonds, callable bonds Mortgage payable and Long-term Notes Payable Liabilities: Introduction

Liabilities: Introduction 4/17/2017 Present Value of $1 Present value concept: Present value of $1 is the value today of $1 to be received in the future, given a specific interest rate. Example: 1. What is the present value of $100 to be received a year from now given an annual market interest rate of 10%? P.V.  (1+10%) = $100 P.V. = $100/1.1 = $100  0.9091 = $90.91 Liabilities: Introduction

Liabilities: Introduction 4/17/2017 Present Value (contd.) 2. What is the present value of $100 to be received two years from now given an annual interest rate of 10%? P.V  (1+10%)  (1+10%) = $100 P.V  (1+10%)2 = $100 P.V.  1.21 = $100 P.V. = $100 / 1.21 = $100  0.8264 = $82.64 Liabilities: Introduction

Liabilities: Introduction An Ordinary Annuity: Receiving (or paying)a constant amount of money at the end of each period (equal time internal) for a given number of periods $100 1 year What is the present value of receiving $100 every year for the following 5 years starting a year from now? Liabilities: Introduction

The Present Value of an Ordinary Annuity: 4/17/2017 The Present Value of an Ordinary Annuity: 1. Using the example above given a10% Interest rate: P.V. of the first $100 = $100  0.9091 = $90.91 P.V. of the second $100 = $100  0.8264 = $82.64 P.V. of the third $100 = $100  0.7513 = $75.13 P.V. of the fourth $100 = $100  0.6830 = $68.30 P.V. of the fifth $100 = $100  0.6209 = $62.09 Total 3.7907 $379.07 Liabilities: Introduction

Present Value (P.V.) of an Annuity (contd.): The P.V. of $100 annuity receiving every year for the following 5 years, starting a year from now => $100 * 3.7907 = $379.07 The P.V. of this annuity can be obtained from an annuity table under 10%, 5 periods. Liabilities: Introduction

Present Value (P.V.) of an Annuity (contd.): 2. What is the P.V. of $300 annuity receiving every 6 months for the following 30 months, starting 6 months from now ? The annual interest rate is 12%. P.V. = $300 x 4.2124 = 1,263.7 Annuity Table, 5 periods at 6% (30/6=5) (12%/2=6%) Liabilities: Introduction

Liabilities: Introduction 4/17/2017 Corporate Bonds: Bonds are securities issued by a corporation to borrow money from the public (i.e., from many lenders/investors). This is a source to raise funds. The corporation will receive cash when bonds are issued. Liabilities: Introduction

Liabilities: Introduction 4/17/2017 Corporate Bonds: The face value of the bonds must be repaid to the bondholders on the maturity date of the bonds. Also, the bond issuers (the borrower) will have to pay interests to the bondholders (the lender/investor) periodically (i.e., semi-annually). Liabilities: Introduction

Liabilities: Introduction Bonds Payable Long-Term Liability: if bonds mature in more than one year. Short-Term Liability: if bonds mature in less than one year Liabilities: Introduction

Liabilities: Introduction Bonds Payable (contd.) Bond Indenture is an agreement States the following: Interest rate of bonds; Interest Payment dates; The maturity date of bonds; The type of bonds: callable, convertible,.. The indenture is held by a trustee appointed by the issuing firm to represent the rights of the bondholders. Liabilities: Introduction

The Process of Bond Issuance 1. Receive the approval from the stockholders and regulatory authorities (i.e., the SEC). 2. Print bond certificates and write indenture (to set the terms of bond issue such as the stated interest rate, the interest payment date and the maturity date…) 3. Make a public announcement of its intent to sell the bonds on a particular date. Liabilities: Introduction

The Process of Bond Issuance (cont.) 4/17/2017 The Process of Bond Issuance (cont.) 4. Negotiate the appropriate selling price with the underwriters based on the terms of bond issue (i.e., the stated inters rate), the general bond market conditions, the risk of the bonds and the expected state of the economy. Liabilities: Introduction

The Process of Bond Issuance (cont.) 4/17/2017 The Process of Bond Issuance (cont.) 5. The underwriter will determine the effective interest rate (yield) and thus, the selling price that it believes best reflects the current market condition and the risk the bond for a particular bond issue. 6. The underwriter will either purchase the bonds from the issuing company and resell them to the public or sell these bonds for a commission. Liabilities: Introduction

The Process of Bond Issuance (cont.) Companies can sell the entire issue of bonds to an underwriter or sell it to a single investor (i.e., a pension fund) (referred to as a private placement). Any expenditures connected with a bond issue (legal fee, printing costs, accounting fee, underwriter's charges …) should be deferred and amortized as expense over the life of the bond using a straight line method. Liabilities: Introduction

The Process of Bond Issuance (Contd.) The yield is the market rate (effective rate) for the bond issue. The yield is often different from the stated interest rate as a result of : 1) different opinion between the underwriter and the company, or 2) a change in the economic conditions between the date the terms were set and the date the bonds were issued. Liabilities: Introduction

The Process of Bond Issuance (Contd.) Three possible outcomes of bond issuance: 1. Stated rate = effective rate (yield) => the bonds are sold at par 2. Stated rate < effective rate => bonds are sold at discount 3. Stated rate > effective rate => bonds are sold at premium Liabilities: Introduction

Liabilities: Introduction Units of bonds: At $1,000 denominations or a multiple of $1,000. Price of bonds: stated at 100s Example: $1,000 issued at 98 The issuing price is $1,000  98 = $980 Liabilities: Introduction

Liabilities: Introduction Types of bonds: On the basis whether the bonds are secured: Secured Bonds Unsecured Bonds (Debentures) On the basis of how the interests are paid: Registered Bonds Coupon Bonds Liabilities: Introduction

Liabilities: Introduction Types of bonds: On the basis of how the bonds mature: Term Bonds Serial Bonds Convertible Bonds Callable Bonds Liabilities: Introduction

Determination of Bond Price The obligations of bond issuers: (1) to pay the principal when bond matures on the maturity date. (2) to pay interests periodically (i.e., semiannually) over the life the bond. Liabilities: Introduction

Determination of Bond Price (Contd.) Bond Price: the present value of the bond. Present value of bonds => The sum of (1) the present value of the principal plus (2) the present value of the periodic interests (an annuity). Liabilities: Introduction

Determination of Bond Price (Contd.) Discount rate = effective rate = market rate =yield This rate depends on the riskiness of the issuer, the general state of the economy, the duration of the bond, etc. In general, a higher risk will result in a higher effective rate. Liabilities: Introduction

Determination of Bond Price (Contd.) Bonds Issued at Face Value When the stated interest rate equals the effective interest rate, the bond price will equal the face value. Liabilities: Introduction

Determination of Bond Price (Contd.) Example 1: Page company issued a 5-year term bond with a face amount $100,000 and a stated annual interest rate of 10%. Interests are paid semiannually. Assume that the annual effective interest rate demanded by investors for bonds of this level of risk is also 10%, what is the present value of the bond (the bond price)? Liabilities: Introduction

Determination of Bond Price (Contd.) Example 1: Page company issued a 5-year term bond with a face amount $100,000 and a stated annual interest rate of 10%. Interests are paid semiannually. Assume that the annual effective interest rate demanded by investors for bonds of this level of risk is also 10%, what is the present value of the bond (the bond price)? Liabilities: Introduction

Determination of Bond Price (Contd.) (1)P.V. of the principal ($100,000 mature in 5 years, discount rate 5%, 10 periods): $100,000  0.6139 = $61,390 (2)P.V. of the interests received semiannually for 10 periods (annuity, discount rate = 5%, 10 periods) $5,000  7.7217 = 38,608.5 annuity table, 5%, 10periods Liabilities: Introduction

Determination of Bond Price (Contd.) The P.V. of the bond = the sum of (1) and (2) = $61,390 + 38,608.5 = $100,000 Therefore, when the stated rate equals the effective rate (the discount rate), the bond price (the P.V. of bonds) equals the face value. Liabilities: Introduction

Determination of Bond Price (Contd.) Therefore, when the stated rate equals the effective rate (the discount rate), the bond price (the P.V. of bonds) equals the face value. J.E. (when bonds are issued at face value) Cash 100,000 Bonds payable 100,000 Liabilities: Introduction

Determination of Bond Price (Contd.) Question: What’s is the total interest expense of the bond (issued at face value)? Cash payments by the issuer* ($150,000) Cash Rece. from issuing bonds $100,000 Interest Expense ($50,000) * Principal on maturity date + semiannual interest payments = $100,000 + $5,000 x 10 = $150,000 Liabilities: Introduction

Bond Issued at A Discount When the stated interest rate is less than the effective interest rate, the present value of a bond will be less than its face value. Example 2: Use the same information as in Example 1, except that the effective rate is 12%, rather than 10% to compute the present value of the bond. Liabilities: Introduction

Bond Issued at A Discount (Contd.) Since the interests are paid semiannually, the discount rate is 6% with 10 periods. (1)P.V. of the principal = $100,000 .5584 = $55,840  P.V. table, 6%, 10periods (2) P.V. of the semiannual interest: $5,000  7.3601 = 36,800.5 Annuity table, 6%, 10periods P.V. of the bond = (1) + (2) $55,840 + 36,800.5 = $92,640.5 Liabilities: Introduction

Bond Issued at A Discount (Contd.) P.V. of bond < Face vale => when the stated rate is less than the effective rate (i.e., 10% < 12%), the P.V. of the bond will be less than the face value. J.E. (when bonds are issued at discount) Cash 92,640.5 Discount on Bonds 7,359.5 Bonds Payable 100,000 Liabilities: Introduction

Bond Issued at A Discount (Contd.) Question: What is the total interest expense of this bond (issued at Discount)? Cash payment by the issuer ($150,000) Cash received from issuing the bond (at Discount) 92,640.5 Interest Expense $57,359.50* Discount would increase the actual interest expense and needs to be amortized over the life of the bond. *Interest Expense = interest payment + Discount = $50,000 + 7,359.50 = $57,359.50 Liabilities: Introduction

Bond Issued at A Premium When the stated interest rate is higher than the effective interest rate demanded by the investors for the level of the risk of the bonds, the present value of the bonds would be greater than its face value. Example 3: use the same information as in Example 1, except that the effective interest rate is 8%. (the stated interest rate is still at 10%) Liabilities: Introduction

Bond Issued at A Premium (Contd.) Compute the P.V. of the bond: Since the interests are paid semiannually, the discount rate would be 4% and the discounting periods are 10 periods. (1) P.V. of the principal: $100,000 x 0.6756 = $67,560 Liabilities: Introduction

Bond Issued at A Premium (Contd.) (2) P.V. of the semiannual interest: $5,000 x 8.1109 = $40,554.5 P.V. of the bond = (1) + (2) = $67,560 + 40,554.5 = $108,114.5 $108,114.5 > $100,000 (Premium = 8,114.5) Liabilities: Introduction

Bond Issued at A Premium (Contd.) Example 3 J.E. (Bonds are issued at a Premium) Cash 108,114.5 Bonds Payable 100,000 Premium on Bonds Payable 8,114.50 Liabilities: Introduction

Bond Issued at A Premium (Contd.) Question: What is the total interest expense of the bond (issued at Premium)? Cash payments by the issuer (150,000) Cash received from issuing the bond 108,114.5 Interest Expense ($41,885.5) Liabilities: Introduction

Bond Issued at A Premium (Contd.) Question: What is the total interest expense of the bond (issued at Premium)? Cash payments by the issuer (150,000) Cash received from issuing the bond 108,114.5 Interest Expense ($41,885.5) Note: Regardless of the market interest rate, the total cash payments are the sample (i.e., $150,000) with the same stated interest rate and same par value. Liabilities: Introduction

Bond Issued at A Premium (Contd.) A premium account: an adjunct account to the bonds payable account and is shown as an addition to the bonds payable account. A discount account: a contra account to the bonds payable and is shown as a deduction from the bonds payable. Liabilities: Introduction

Bond Issued at A Premium (Contd.) Book value (carrying value) of the bond issued: the face value plus any unamortized premiums or minus any unamortized discounts. If an effective interest method is used to amortize the discount (or premium), the carrying value equals the present value under the historical effective interest rate. Liabilities: Introduction

4. Accounting for Bonds Payable - Bonds Are Issued at A Discount Information of example 2 is summarized below with some additional information: Stated Interest = 10% (annual) Effective Interest = 12% (annual) Date of Issuance = 1/1/x2 (sold on 1/1/x2) Date of Maturity = 1/1/x7 Interest Payment Dates = 6/30 and 12/31 Face Value = $100,000 P.V. of the Bond = 92,640.50 (as computed earlier) Liabilities: Introduction

Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.) This discount would increase the interest expense and would be amortized over the life of the bond -5 year, 10 periods) Liabilities: Introduction

Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.) Amortization methods: 1. Straight-Line: the Discount would be amortized equally over the life of the bond. i.e., Amortization in 10 periods: $7349.5010 = $735.95 Therefore, the interest expense every period is $5,000 + 7,35.95 = $5,735.95 Semiannual the amortized Discount Interest Payment Liabilities: Introduction

Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.) Total Interest expense = 5,735.95 x 10 = $5,7359.5 = 50,000 + 7,359.5   Int. payment Discount 2. Effective Interest Method Interest Expense = P.V. of Bond  effective rate Liabilities: Introduction

Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.) J.E (Bonds are issued at a discount and use the straight-line method to amortize the discount) 1/1/x2 Cash 92640.50 Discount on B/P 7359.50 B/P 100,000 6/30/x2 Interest Expense 5,736 Cash 5000* Discount on B/P 735.95** 12/31/x2 Interest Expense 5,736 Cash 5,000 Discount on B/P 735.95 Liabilities: Introduction

Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.) 12/31/x6 Interest Expense 5,736 Cash 5,000 Discount on Bonds Payable 735.95 1/1/x7 B/P 100,000 Cash 100,000 Discount on Bonds 1/1/x2 7,359.50 735.95 6/30/x2 735.95 12/31/x2 735.95 6/30/x3 735.95 12/31/x6 Interest Expense from 1/1/x2 to 12/31/x6 = $ 5,735.95 * 10 = $5,7,359.50 = $50,000 + 7,359.5 Interest payments Liabilities: Introduction

Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.) J.E. for bonds issued at a discount and use the effective interest method to amortize the discount: using the example on p.48. Interest Payment = $100,000 * 5%= $5,000 Interest Expense = P.V. of Bond at the Beginning of the period  Effective Rate Amortized Discount = Interest Expense - Interest payment Liabilities: Introduction

Effective Interest Amortization Table-bond are issued at a discount Liabilities: Introduction

Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.) J.E : 1/1/x2 Cash 92,641 Discount on B/P 7,359 B/P 100,000 6/30/x2 Interest Expense 5,558 (period 1) Cash 5,000 Discount on B/P 558 12/31/x2 Interest Expense 5,592 (period 2) Cash 5,000 Discount on B/P 592 Liabilities: Introduction

Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.) 6/30/x3 Interest Expense 5,672 Cash 5,000 Discount on B/ P 672 : 6/30/x6 Interest Expense 5,890 Discount on B/P 890 12/31/x6 Interest Expense 5,944 Discount on B/P 944 1/1/x7 B/P 100,000 Cash 100,000 Liabilities: Introduction

Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.) Discount on Bonds Payable 1/1/x2 7,359 558…6/30/x2 592…12/31/x2 672…6/30/x3 890…6/30/x6 944…12/31/x6 Interest Expense over 10 periods => Period 1 $5,558 Period 2 $5,592 period 3 $5,627 Period 9 $ 5,890 Period 10 $ 5,944 $57,359 $57360= $50,000 + 7,359 Liabilities: Introduction

Accounting for Bonds Payable -Bonds Are Issued at A Premium Information of example 3 is summarized with some additional information: Stated Interest Rate (annual) = 10% Effective Interest Rate (annual) = 8% Date of Issuance = 1/1/x2 (sold on 1/1/x2) Date of Maturity = 1/1/x7 Interest Payment Date = 6/30 and 12/31 Face Value = $100,000 P.V. of the Bond = $108,115 (as computed earlier) Liabilities: Introduction

Accounting for Bonds Payable-Bonds Are Issued at A Premium The premium would decrease the interest expense and should be amortized over the life (5 years, 10 periods) of the bond. J.E. (Amortization Method= Straight-Line) $8,114.5 / 10 = $8114.5 => $811.45 would be amortized for every period. The interest expense would be decreased by $816 every period. 1/1/x2 Cash 108,114.5 B/P 100,000 Premium on Bonds Payable 8,114.5 Liabilities: Introduction

Effective Interest Amortization Table-bond are issued at a premium Interest Expense = Cash payment - Amortized premium = 50,000 - 8114.5 = 41,885.5 * Rounding Error of $ 7 (968-961 = 7) Liabilities: Introduction

Accounting for Bonds Payable (Contd.) Premium on Bonds 6/30/x2… 675 8114.5 …1/1/x2 12/31/x2 … 702 730 760 790 822 855 889 924 968 Interest Expense over 10 periods => Period $ 1 4,325 2 4,298 4,270 10 41,885.50 Liabilities: Introduction

Accounting for Bonds Sold Between Interest Payment Dates: Policy of interest payment for bonds: Interest are always paid in full regardless how long the bonds being held by the bondholder. Thus, the bond issuing company collects the accrued interests in addition to the issuing price when bonds are sold between interest payment dates. Liabilities: Introduction

Accounting for Bonds sold Between Interest Payment Dates at Par: Example: assume that on 2/1/x2, Page company issued a 5- year term bond with a face amount of $100,000 and a stated interest rate of 10%. The bonds were issued at Par and interests were paid semiannually on 2/1 and 8/1. The bonds were sold on 5/1/x2. Liabilities: Introduction

Accounting for Bonds Sold Between Interest Payment Dates at Par: J.E. 5/1/x2 (bond sold at par on 5/1/x2) Cash 102,500 Bonds Payable 100,000 Interest Payable* 2,500 * Accrued interest of 3 months (From 2/1 ~ 5/1) 8/1/x2 Interest Payable* 2,500 Interest Payable 2,500 Cash 5,000 * 100,000 x 10% x 6/12 = 5,000 (6 month interest) Actual Interest Expense (from 5/1/x2 - 8/1/x2) => 5,000 -2,500 = 2,500 Liabilities: Introduction

5. Bond Retirements Before Maturity Use example 2 (issued at a discount), assume that bonds are retired at the end of period 3 for $98,000 Discount on Bonds 7,359 558…..Period 1 592…..Period 2 627…..Period 3 5,582 Unamortized at the end of period 3 BV of the Bond = 100,000 - 5,582 = 94,418 Liabilities: Introduction

Bond Retirements Before Maturity B/P 100,000 Loss on Retirement of Bonds 3,582 Discount on Bonds Payable 5,582 Cash 98,000 Liabilities: Introduction

6. Long-Term Notes Payable APB Opinion No. 21 requires the long-term notes payable to be recorded at their present values and the effective interest method is used to record the subsequent interest. The effective interest rate (or implicit rate) is the rate that equates the future net cash flows to the present value. Liabilities: Introduction

Long-Term Notes Payable (contd.) Therefore, if the present value (p.v.) and future net cash flows are known, the effective interest can be calculated. Also, if both the effective interest rate and future net cash flows are known, the present value can be calculated. Liabilities: Introduction

Long-Term Notes Payable (contd.) In other cases, when the P.V. is not known, the incremental interest rate of the borrower is used as the effective rate to calculate the P.V. of the note. Liabilities: Introduction

Long-Term Notes Payable (contd.) A. Notes payable issued for cash: When a long-term note is exchanged for cash, the note is assumed to have a present value equals the cash proceeds. The difference between the cash proceeds and the face value of the note is recorded as a discount (or premium) The discount (or premium) is amortized over the life of the note using the effective interest method. Liabilities: Introduction

Liabilities: Introduction Example A Johnson Company issued a 3-year, non-interest-bearing note with a face value of $8,000 and received $5,694.24 in exchange. The journal entry to record the issuance is: Cash 5,694.24 Discount on Notes Payable 2,305.76 Note Payable 8,000 Liabilities: Introduction

Liabilities: Introduction Example (contd.) The discount account is a contra account to notes payable. The effective interest rate that equates the P.V. of 5,694.24 to $8,000 at the end of 3 years is 12%. 5,694.24 = 8,000 x 0.71178  3-period, 12% Liabilities: Introduction

Liabilities: Introduction Example (contd.) The Interest Expense Per Year is Computed as: Liabilities: Introduction

Liabilities: Introduction Example (contd.) Recognition of Interest Expense of Year 1: Interest Expense 683.31 Discount on N/P 683.31 Cash (non-interest bearing note) 0 Liabilities: Introduction

Notes Payable Exchanged for Property, Goods, or Services APB opinion No.21 requires the note be recorded at the fair market value of the property, goods, or services or the fair market value of the note (I.e., the present value of the note is known), whichever is more reliable. And, the effective interest rate is calculated (when both the P.V. and future cash flows are known) and used to calculate subsequent interest expense using the effective interest method. Liabilities: Introduction

Notes Payable Exchanged for Property, Goods, or Services (contd.) If neither of these values is determinable, the incremental borrowing rate of the borrower is used as the effective interest rate to calculate the P.V. of the note and the interest expense of subsequent years using the effective interest method. Liabilities: Introduction

Liabilities: Introduction Example B On 1/1/x5, Marden Company purchases an equipment by issuing a non-interest-bearing 5-year note with a face value of $10,000. Neither the fair market value of the equipment nor that of the note is determinable. The incremental borrowing rate of Marden is 12%. Liabilities: Introduction

Liabilities: Introduction Example (contd.) J.E. 1/1/x5 Equipment 5,674.27* Discount on N/P 4,325.73 N/P 10,000 * P.V. of the note using 12% as the effective interest rate => 10,000 x 0.567427 Liabilities: Introduction

Liabilities: Introduction Example (contd.) 12/31/x5 Int. Exp. (5674.27 x 12%) 680.91 Discount on N/P 680.91 Depreciation Expense 567.43 Accumulated Depreciation 567.43 (Assuming a S-L depreciation method is used and a 10-year life is assumed for the equipment) Liabilities: Introduction

Liabilities: Introduction Example (contd.) 12/31/x6 Int. Exp. (5,674.27 + 680.91) x 12% 762,62 Discount on N/P 762.62 Depreciation Expense 567.43 Accumulated Depreciation 567.43 Liabilities: Introduction

Liabilities: Introduction Example C Using the Example B, except that the fair market value the equipment was determined at $6,209.21. The interest rate that equates the future cash flows to the present value of $6,209.21 is 10%. Liabilities: Introduction

Liabilities: Introduction Example (contd.) The following entries would be recorded for 20x5 and 20x6: 1/1/x5 Equipment 6,209.21 Discount on N/P 3,790.89 N/P 10,000 12/31/x5 Int. Exp. (6,209.21 x 10%) 621 Discount on N/P 621 12/31/x6 Int. Exp. (6,209.21 + 621) x 10% 683 Discount on N/P 683 Liabilities: Introduction

Liabilities: Introduction Example (contd.) Regardless of the effective interest rate on the long-term note payable, the total expense (interest expense on the unpaid portion of the note plus the depreciation expense of the acquired asset) charged by the company is the same (i.e., $10,000). Liabilities: Introduction

Installment Notes – Example D Notes could be paid by installments (a constant amount paid periodically) rather than by a single amount at maturity. Using Example B (on p95), assuming an installment payment at the end of each year for the following 5 years, ( starting 12/31/x5), the annual installment payment for the note (loan) equals: $6,209.21/ 3.79079=$1,638 Liabilities: Introduction

Installment Notes: (Contd.) Journal Entries: 1/1/x5 Equipment 6,209.21 Note Payable 6,209.21 12/31/x5 Interest Exp. * 621 N/P 1,017 Cash 1,638 *6,209.21 x 10% = 621 12/31/x6 Interest Exp. * 519 N/P 1,119 Cash 1,638 *(6,209.21 - 1,017) x 10% = 519.2 Liabilities: Introduction

Installment Notes: (Contd.) Journal Entries: 12/31/x7 Interest Exp. * 407 N/P 1,231 Cash 1,638 *(6,209-1,017-1,119) x 10% = 407 12/31/x8 Interest Exp. * 284 N/P 1,354 Cash 1,638 *(6,209-1,017-1,119-1,231) x 10% = 284 12/31/x9 Interest Exp. * 149 N/P 1,489 Cash 1,638 *(6,209-1,017-1,119-1,231- 1,354) x10% = 149 Liabilities: Introduction

Installment Notes: (Contd.) N/P 1017 6209 1119 1231 1354 1489 0* rounding error = $1 Liabilities: Introduction

Liabilities: Introduction Mortgage Payable If the note of Example C was issued for cash, it becomes a mortgage payable example. The journal entries are as follows: Cash 6,209.21 Mortgage Payable 6,209.21 Liabilities: Introduction

Mortgage Payable (contd.) 12/31/x5 Interest Exp. * 621 Mortgage Pay.1,017 Cash 1,638 *6,209.21 x 10% = 621 12/31/x6 Interest Exp. * 519 M/P 1,119 Cash 1,638 *(6,209.21 - 1,017) x 10% = 519.2 Liabilities: Introduction

Installment Notes: (Contd.) An installment note typically is recorded at its carrying amount (i.e., the face amount - the unamortized discount). This is because the outstanding balance of an installment does not become its face amount as in the case for notes with a single payment at maturity. Liabilities: Introduction