BSAD 221 Introductory Financial Accounting Donna Gunn, CA

Liabilities Current Liabilities Noncurrent Liabilities Obligations that result from past transactions, which will be paid with assets or services. Maturity = 1 year or less Maturity > 1 year Current Liabilities Noncurrent Liabilities

Liabilities Defined and Classified Liabilities are measured at their current cash equivalent (the amount a creditor would accept to cancel the debt) at the time incurred.

Known Current Liabilities Accounts payable Short-term notes payable Goods and services tax payable Accrued expenses Payroll liabilities Unearned revenues Current portion of long-term debt Current portion of capital leases

Account Name Also Called Definition Accounts Payable Trade Accounts Payable Obligations to pay for goods and services used in the basic operating activities of the business. Accrued Liabilities Accrued Expenses Obligations related to expenses that have been incurred, but will not be billed or paid until the subsequent period. Notes Payable N/A Obligations due supported by a formal written contract. Deferred Revenues Unearned Revenues Obligations arising when cash is received prior to the related revenue being earned. These are likely the most common current liabilities.

Short-Term Notes Payable In addition to recording the note payable, the business must also pay interest expense.

Short-Term Notes Payable The interest formula includes three variables that must be considered when computing interest: Interest = Principal × Interest Rate × Time When computing interest for one year, “Time” equals 1. When the computation period is less than one year, then “Time” is a fraction.

Short-Term Notes Payable On October 1, a business purchased inventory for $8,000 by issuing a 6-month, 10% note payable. How much interest was accrued at December 31st?

Short-Term Notes Payable On October 1, a business purchased inventory for $8,000 by issuing a 6-month, 10% note payable. How much interest was accrued at December 31st? $8,000 × 10% × (3/12) = $200

Short-Term Notes Payable October 31st Inventory 8,000 Notes Payable, Short-Term 8,000 Purchase of inventory by issuing a note payable December 31st Interest Expense 200 Accrued Interest 200 To record interest accrued at year end

Short-Term Notes Payable March 31, 2012 Note Payable, Short-Term 8,000 Interest Payable 200 Interest Expense* 200 Cash 8,400 *$8,000 x 0.10 x 3/12 – interest for Jan-Mar

Unearned revenue is a liability account. Cash is received in advance. Unearned Revenues Cash is collected from the customer before the revenue is actually earned. Unearned revenue is a liability account. Cash is received in advance. Unearned revenue is recorded. Generally with liabilities it is that you owe someone money. In this case you don’t owe them money but you do owe them the product or service that they paid for. That’s still an obligation to you and you have to recognize it on the balance sheet.

Unearned Revenues Cash is collected from the customer before the revenue is actually earned. As the earnings process is completed . . . Cash is received in advance. Unearned revenue is recorded. As you meet the obligation (e.g. you provide the product or service) you remove the liability and recognize the revenue. Earned revenue is recorded.

The flight to Montreal will occur on Unearned Revenues Assume on September 1st WestJet collects $800 for a round-trip from Vancouver to Montreal (taxes and fees are not considered in this example) The flight to Montreal will occur on September 26th.

Unearned Revenues Assume on September 1st WestJet collects $800 for a round-trip from Vancouver to Montreal (taxes and fees are not considered in this example) September 1st Cash 800 Unearned Revenue 800 To receive cash for plane fare

Unearned Revenues The passenger flies from Vancouver to Montreal on September 26, 2011. September 26 Unearned Revenue 400 Revenue ($800/2) 400 To record revenue earned on Sept. 26th flight

Unearned Revenues The passenger flies from Vancouver to Montreal on September 26, 2011. September 26 Unearned Revenue 400 Revenue ($800/2) 400 To record revenue earned on Sept. 26th flight The balance in the unearned revenue account is now the remaining $400, which will be recognized when the return flight is taken

Warranties Examples of products with warranties: Automobiles An agreement that obligates the seller to pay for replacing or repairing the product (or service) when it fails to perform as expected within a specified period. Examples of products with warranties: Automobiles Appliances Computers

Warranties The estimated liability and expense related to the warranty is recorded in the period when the revenue from the sale is recorded. Example: Warranty Expense 1,000 Estimated Warranty Liability 1,000 To record estimated warranty expense and liability.

Warranties As the warranty work is done, the costs related to the warranty is applied to the liability account. Warranty Liability* 700 Cash 400 Accounts Payable 300 To record costs of warranty repairs. *The actual warranty costs may differ from the estimated expense. This is monitored by management and may require adjustments in future estimates.

Warranties T-World sold $12,000 worth of trampolines with an extended warranty. It estimates that 2% of the sales will result in warranty work. T-World should:    Recognize warranty expense at the time of sale.   Recognize warranty expense at the time warranty work is performed.   Recognize warranty liability at the time of sale.   Both A and C.   Both B and C.

Warranties T-World sold $12,000 worth of trampolines with an extended warranty. It estimates that 2% of the sales will result in warranty work. T-World should:    Recognize warranty expense at the time of sale.   Recognize warranty expense at the time warranty work is performed.   Recognize warranty liability at the time of sale.   Both A and C.   Both B and C. You debit the expense and credit the liability. When you actually perform the warranty work the expense will already have been recorded so you just remove the liability.

Contingent Liabilities Per the CICA Handbook – A contingency is defined as an existing condition or situation involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.

Contingent Liabilities Potential liabilities that arise because of events or transactions that have already occurred.

Long-Term Liabilities

Capital Structure – Long-term Debt Significant debt needs of a company are often filled by issuing notes and bonds. Bonds Cash One way to get cash is to sell bonds.

Advantages of Bonds Bonds are debt, not equity, so the ownership and control of the company are not diluted. Cash payments are limited to the scheduled payments of interest and principal. Interest expense is tax deductible. The impact on earnings is often positive (positive financial leverage) because money can often be borrowed at a low interest rate and invested at a higher interest rate. Bonds have some significant pros and some significant cons. What is in the best interest of the company depends on their particular circumstances and on how much risk the company is willing to take on.

Disadvantages of Bonds Risk of bankruptcy exists because the interest and principal are legal obligations and must be paid back as scheduled or creditors will force legal action. A single, large principal payment is required at the maturity date. Negative impact on cash flows exists because interest and principal must be repaid in the future.

Characteristics of Bonds Payable At Bond Issuance Date $$$$ Company Issuing Bonds Investor Buying Bonds Bond Certificate Bonds payable are long-term debt for the issuing company. 5

Characteristics of Bonds Payable Periodic Interest Payments $ Company Issuing Bonds Investor Buying Bonds Principal Payment at End of Bond Term $ One of the great things about bonds vs. regular debt is you don’t have large regular payments – you just pay interest. It does mean, however, that at the end you pay the principal back all at once. 6

Reporting Bond Transactions When a company issues bonds, it specifies two cash flows related to the transaction: 1) Principal 2) Interest Assume Dino Oil issues $100,000 in bonds at par on January 1, 2011. The bonds pay 8% interest annually on December 31. What journal entry should be made on January 1, 2011?

Reporting Bond Transactions When a company issues bonds, it specifies two cash flows related to the transaction: 1) Principal 2) Interest Assume Dino Oil issues $100,000 in bonds at par on January 1, 2011. The bonds pay 8% interest annually on December 31. What journal entry should be made on January 1, 2011? Cash 100,000 Bonds Payable 100,000

Reporting Bond Transactions Periodically, interest must be accrued and recorded. Annual interest = principal x stated interest rate Dino Oil issues $100,000 in bonds at par on Jan. 1/11. The bonds pay 8% interest annually on December 31. What journal entry should be made on December 31, 2011?

Reporting Bond Transactions Periodically, interest must be accrued and recorded. Annual interest = principal x stated interest rate Dino Oil issues $100,000 in bonds at par on Jan. 1/11. The bonds pay 8% interest annually on December 31. What journal entry should be made on December 31, 2011? Interest Expense* 8,000 Cash 8,000 *$100,000 x 8% x 1year

Characteristics of Bonds Payable Bonds Characteristics Face Value Maturity Date Stated Interest Rate Interest Payment Dates Bond date

Characteristics of Bonds Payable Bonds Characteristics Face Value Maturity Date Stated Interest Rate Interest Payment Dates Bond date External Factors Market interest rate Issue date One of the major factors in how much you pay for a bond is the interest rate. Interest rates of a bond don’t always match what the rest of the market is paying. This can be for a variety of reasons. One of the main ones is that bonds are constantly bought and sold (just like shares) on the market. The stated interest rate doesn’t change, so as market rates change the variance between the stated rate and the market rate will change as well.

Time Value of Money The amount invested today receives a greater amount at a future date, which is called the present value of a future amount. It depends upon... 1.) the amount of the future receipt. 2.) the length of time to the future receipt. 3.) the interest rate for the period.

Reporting Bond Transactions The issue price of the bond is determined by the market, based on the time value of money. The interest rate used to compute the present value is the market interest rate.

Reporting Bond Transactions The stated rate is only used to compute the periodic interest payments. Interest = Principal x Stated Rate x Time

The difference is accounted Interest Bond Accounting for Rates Price the Difference Stated = Market Par Value There is no difference Rate of the Bond to account for.   < The difference is accounted for as a bond discount. > for as a bond premium.

This bond is issued at a par. Bonds Issued at Par January 1, 2012, Petro-Canada issues: $400,000 in bonds Stated rate of 10% annually The bonds mature in 10 years and interest is paid semiannually. The market rate is 10% annually. This bond is issued at a par.

January 1, 2012, Petro-Canada issues $400,000 in bonds at par. Bonds Issued at Par January 1, 2012, Petro-Canada issues $400,000 in bonds at par. Cash 400,000 Bond Payable 400,000

Bonds Issued at Par Every 6 months Petro-Canada will make an interest payment on the bond, and the following entry will be made. Interest Expense* 20,000 Cash 20,000 *$400,000 x 10% x 6/12

At maturity, Petro Canada will repay the principal to the bondholder. Bonds Issued at Par At maturity, Petro Canada will repay the principal to the bondholder. Bond Payable 400,000 Cash 400,000

Are Petro-Canada bonds issued at par, at a discount, or at a premium? Issuing Bonds On Jan 1, 2012, Petro-Canada issues $400,000 in bonds having a stated rate of 10%. The bonds mature in 10 years and interest is paid semiannually. The market rate is 12% annually. Are Petro-Canada bonds issued at par, at a discount, or at a premium?

Bonds Issued at a Discount On January 1, 2012, Petro-Canada issues $400,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2016) and interest is paid semiannually. The market rate is 12% annually. If the bond is paying less than what you would get from investing your money in the market, than you will purchase the bond at a discount. It’s like it’s on sale.  Basically you’ll pay less for it than the face value because the interest you are missing out on will be compensated with a higher amount of principal at maturity. Stated < Market Bond Par Value The difference is accounted Rate Price of the Bond for as a bond discount.

Bonds Issued at a Discount The issue price of a bond is composed of the present value of two items: Principal (a single amount) Interest (an annuity)

Note: You are not responsible for calcualating the issuance price of a bond. We will give that to you. I have included slides on how to do it because, in my opinion, if you understand that it makes understanding the amortization of the bond easier.

Bonds Issued at a Discount First, let’s compute the present value of the principal. Market rate of 12% ÷ 2 interest periods per year = 6% Term of 10 years × 2 periods per year = 20 periods

Bonds Issued at a Discount First, let’s compute the present value of the principal. Market rate of 12% ÷ 2 interest periods per year = 6% Term of 10 years × 2 periods per year = 20 periods

Bonds Issued at a Discount Now, let’s compute the present value of the interest. Market rate of 12% ÷ 2 interest periods per year = 6% Term of 10 years × 2 periods per year = 20 periods

Bonds Issued at a Discount Now, let’s compute the present value of the interest. Market rate of 12% ÷ 2 interest periods per year = 6% Term of 10 years × 2 periods per year = 20 periods

Bonds Issued at a Discount The $354,118 is less than the face amount of $400,000, so the bonds are issued at a discount of $45,882.

Bonds Issued at a Discount Here is the journal entry to record the bond issued at a discount: Cash 354,118 Discount on Bond Payable 45,882 Bond Payable 400,000 This is a contra-liability account and appears in the liability section of the balance sheet.

Bonds Issued at a Discount Financial Statement Presentation The discount will be amortized over the 10-year life of the bonds. Two methods of amortization are commonly used: Straight-line or Effective-interest. Effective interest is the proper method, however for simplicity we will only ever test the straight line method in large problems.

Reporting Interest Expense: Straight-line Amortization 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.

Reporting Interest Expense: Effective-interest Amortization The effective interest method is the theoretically preferred method. Compute interest expense by multiplying the current unpaid balance times the market rate of interest. The discount amortization is the difference between interest expense and the cash paid (or accrued) for interest.

Reporting Interest Expense: Effective-interest Amortization Petro-Canada issued their bonds on Jan. 1, 2012. Issue Price: $354,118 Face Value: $400,000 Market Rate: 12% Stated Rate: 10% Interest Expense = Balance × Market Rate × Time $354,118 × 12% × 6/12 = $21,247

Reporting Interest Expense: Effective-interest Amortization Here is the journal entry to record the payment of interest and the discount amortization for the six months ending on June 30, 2012: Interest Expense 21,247 Discount on Bond Payable 1,247 Cash 20,000

PV of the Principal = Issue Price of the Bonds Zero Coupon Bonds Zero coupon bonds do not pay periodic interest Because there is no interest annuity . . . This is called a deep discount bond PV of the Principal = Issue Price of the Bonds

Bonds Issued at a Premium On January 1, 2012, Petro-Canada issues $400,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2021) and interest is paid semiannually. The market rate is 8% annually. This bond is issued at a premium. A premium is when the bond is paying a higher interest rate than what you would get if you invested elsewhere in the market. If you want that higher rate you are going to pay more for the bond. Stated > Market Bond Par Value The difference is accounted Rate Price of the Bond for as a bond premium.

Bonds Issued at a Premium The issue price of a bond is composed of the present value of two items: Principal (a single amount) Interest (an annuity)

Bonds Issued at a Premium First, let’s compute the present value of the principal. Market rate of 8% ÷ 2 interest periods per year = 4% Term of 10 years × 2 periods per year = 20 periods

Bonds Issued at a Premium Now, let’s compute the present value of the interest. Market rate of 8% ÷ 2 interest periods per year = 4% Term of 10 years × 2 periods per year = 20 periods

Bonds Issued at a Premium The $454,366 is more than the face amount of $400,000, so the bonds are issued at a premium of $54,366.

Bonds Issued at a Premium Here is the journal entry to record the bond issued at a premium: Cash 454,366 Premium on Bond Payable 54,366 Bond Payable 400,000 This is called an adjunct-liability account and appears in the liability section of the balance sheet as an addition to Bonds Payable.

Bonds Issued at a Premium Financial Statement Presentation The premium will be amortized over the 10-year life of the bonds. Let’s look at the amortization tables using Straight-line and Effective-interest.

Reporting Interest Expense: Effective-interest Amortization Petro-Canada issued their bonds on Jan. 1, 2012. Issue Price: $454,366 Face Value: $400,000 Market Rate: 8% Stated Rate: 10% Interest Expense = Balance × Market Rate × Time $454,366 × 8% × 6/12 = $18,175

Reporting Interest Expense: Effective-interest Amortization Here is the journal entry to record the payment of interest and the premium amortization for the six months ending on June 30, 2012: Interest Expense 18,175 Premium on Bond Payable 1,825 Cash 20,000

Early Retirement of Debt Occasionally, the issuing company will call (repay early) some or all of its bonds. Gains/losses are calculated by comparing the bond call amount with the book value of the bond. Book Value > Retirement Price = Gain Book Value < Retirement Price = Loss