Chapter 9 Reporting and Understanding Liabilities

In Chapter 8 You learned: o How to account for the purchase and use of long-term assets o How to calculate depreciation using various methods

In Chapter 9 and Appendix A You will learn: o How firms account for current and non-current liabilities o Types of Liabilities (definite, estimated, contingent) o Notes, mortgages o BONDS!

Appendix A Time Value of $$$$$$$$$$ Present Value Future Value

Reporting Current and Non-Current Liabilities Current Liabilities are debts that will be settled within the next year Long-term Liabilities are debts that will NOT be settled within the next year

Payroll related liabilities I worked 40 hours this week. My hourly rate is $ I’ll take your time sheet and you’ll get your check on Friday I wonder how much my check will be

Gross Pay Where does your paycheck go?

Payday!

Think about your pay stub…. Gross Pay FITFICA- SS FICA – Med OtherNet Pay Gross Pay = # of hours worked at hourly rate 40 $12.50 $ FIT = Federal Income Tax Withholding The amount is determined based on the employee’s wages, marital status and number of dependents Assume 20% 20% of $500 = $ FICA (SS) = Social Security Taxes withheld. This amount is 6.2% of gross wages $500 * 6.2% $31.00 FICA (Med) = Medicare Taxes withheld. This amount is 1.45% of gross wages $500 * 1.45% $7.25 As authorized Other Employee-Authorized deductions to include: Health Insurance, Union Dues, 401k contributions, gifts to charity Gross Pay – FIT – FICA – Medicare = Net Pay $ $ $ $7.25 = $ $361.75

Journal Entry for Salaries Expense Gross Pay FITFICA- SS FICA – Med OtherNet Pay Debit Salaries Expense $ Credit FIT Payable $ Credit FICA Payable $31.00 Credit Medicare Payable $7.25 Credit Other Payables Credit Cash $361.75

Employer Payroll Tax Expense In addition to the Gross Pay, the employer is responsible for: o Matching amounts for Social Security and Medicare o State and Federal Unemployment Taxes o Other State and Local taxes

$7.25 Employer’s Payroll Tax Expense Gross Pay FITFICA- SS FICA – Med OtherNet Pay Debit Salaries Expense $ Credit FIT Payable $ Credit Other Payables Credit Cash $ $31.00 Amounts withheld from Employees $7.25 Matched by Employer $31.00 Matched by Employer $7.25 Paid to the Governmental Agency Total Withheld. Total Withheld plus Employer’s Tax is paid to Governmental Agency + Employer Match

Accounting for Warranties When products are sold with warranties, a liability is estimated and recorded. This records the expense in the same time period as the resulting revenue (Matching Principle)

Warranty ??? How do companies know how much to put in the Warranty accrual?? (Where did the $1,400 come from)???

Satisfying Warranty Obligations When a warranty claim is made, the cost is written off against the liability This transaction has no affect on net income, even if the claim is made in a subsequent accounting period.

Disclosing Warranty Information Details of Warranty obligations are disclosed in the notes to the financial statements

Contingent Liabilities – must be: Probable Reasonably estimated

Long-Term Notes Payable and Mortgages Company has borrowed funds for more than one year Principal payments may be made periodically (e.g. a car payment) or as a lump-sum at the maturity date. “Discounting” is the process of eliminating the interest portion of each payment. Formula for Interest:

Repaying principal and interest Payment amounts are calculated using present value charts, found in the appendix of your text Each payment is allocated to partly to principal and partly to interest. A schedule of principal versus interest is called an amortization schedule Payment = $38, Interest = $8,000 Principal = $30,803.35

Let’s assume that you borrow $100,000 at 8% for three years. And that your payment has been calculated at $38, Beginning Balance Interest Rate Interest Expense PaymentsEnding Balance Beginning Debt Balance = $100,000 Principal $100,000 $8,000 $38, $69, X 8% = Since payments will be made annually, the annual interest rate is used. $8,000 Interest is added to the amount owed. $108,000 is owed before the payment is applied Using Present Value Factors, Annual Payments are determined to be $38,803.35

Total Payment = $38, ($8,000 Interest + $30, Principal) Let’s follow this for the remaining two years….. Beginning Balance Interest Rate Interest Expense PaymentsEnding Balance Amount Owed $100,000 8% annual rate $8, Annual Payment $38, $69, X 8% = $69, X 8% = $5, Since the Balance owed has decreased, so has the interest amount. $38, $35, Total Payment = $38, ($5, Interest + $33, Principal) $35, X 8% = $2, $38, Total Payment = $38, = ($2, Interest + $35, Principal) $0

Change in Debt Balance + 8% Interest - $38,803 payment + 8% Interest - $38,803 payment + 8% Interest - $38,803 payment ____________ The carrying value of the debt changes based on the relationship between the interest expense and the payments on the debt

Long-term bonds Bonds are long-term debt agreements The contractual agreement specifies a fixed series of repayments to include  A series of either annual or semi-annual interest payments  A lump sum payment (face value)

Bonds – Contractual Agreements

Bonds - Terminology Example: On January 1, 2006, Hewlett-Packard issues a 5-year, 4.5%, $1,000 bond with interest payable annually. Face Value – Lump Sum payment at the end of the bond Term – Number of years until the Face Value is Repaid Stated “Interest” Rate – Cash Repayment Rate used to calculate the annual or semi-annual payments. This amount may be more or less than the actual interest rate Compounding Mode – # of payments per year

Types of Bonds

Bonds – Calculating the Cash Flows Example: On January 1, 2006, Hewlett-Packard issues a 5-year, 4.5%, $1,000 bond with interest payable annually. Calculating the periodic interest payments 1. Multiply the Face Value by the Stated % 2. Divide by the number of payments per year (1 for annual, 2 for semi-annual) $1,000 X 4.5% = $45 ÷ 1 pay/year = $45

Bonds – Promise to repay fixed amounts Example: On January 1, 2006, Hewlett-Packard issues a 5-year, 4.5%, $1,000 bond with interest payable annually $ $ $ $ $45 Face Value $1,000 Total Repayments = $1,225 (5 payments of $ payment of $1,000)

Bond prices fluctuate inversely with market rates I have read the bond several times, but I don’t know how much I will be able to borrow! That’s true! The amount you will be able to raise from the bonds Is dependent on the Market Rate of Interest

This promise is evaluated by the market Example: On January 1, 2006, Hewlett-Packard issues a 5-year, 4.5%, $1,000 bond with interest payable annually $ $ $ $ $45 Face Value $1,000 The market rate of interest is used to calculate the selling price of the bond 2006 Amount Borrowed = Present Value

So the More I Repay, the More I Can Borrow! The Stated Rate is the Payment Rate The Higher the Stated Rate, The Higher the Selling Price

Stated Rate is Lower Amount Borrowed is Lower Stated Rate is Higher Amount Borrowed is Higher

Journal Entries for Bonds Issued at Par

Interest is the Difference between the amount borrowed and the amount repaid Hewlett-Packard issues a 5-year, 4.5%, $1,000 bond with interest payable annually. Amount Repaid - Amount Borrowed = Interest $1,225 - $1,000 = $ 225 If the Stated Rate = Market Rate If the Stated Rate < Market Rate $1,225 - $1,000 = $ 225 If the Stated Rate > Market Rate $1,225 - $1,000 = $ 225 LowerHigher Lower $245 $ 980 $1,020 $205

Journal Entries for Bonds Issued at a Discount ◄ A contra-liability account Balance Sheet Presentation ◄ Selling Price is 98% of Face Value

Journal Entries for Interest on Bonds issued at a Discount Amount Repaid - Amount Borrowed = Interest $1,225 - $1,000 = $ 225 $245 $ 980 $245 Total ÷ 5 years = $20 Discount ÷ 5 years =

Amortization Schedule – Bonds Issued at a Discount The Carrying Value always moves toward the Face Value

Journal Entries for Bonds Issued at a Premium ◄ An adjunct liability account Balance Sheet Presentation ◄ Selling Price is 102% of Face Value

Journal Entries for Interest on Bonds issued at a Discount Amount Repaid - Amount Borrowed = Interest $1,225 - $1,000 = $ 225 $205 $ 1,020 $205 Total ÷ 5 years = $20 premium ÷ 5 years =

Amortization Schedule – Bonds Issued at a Premium The Carrying Value always moves toward the Face Value

Financial Statement Ratios

Risk/Controls Risk – can’t pay back debt when DUE Review before borrowing Pick the BEST loan around for your needs: Best interest rate? Quickest funding source? Be WARY of “Off Balance Sheet financing” schemes……  Enron….

Appendix A….

Appendix A Do compound interest calculations! Future Value Present Value

Time Value of Money.... What is Simple Interest? You borrow $5,000 For 2 years At 12% $5000 * 12% = 600 $1,200  __________

Time Value of Money.... What is Compound Interest? You put $7,938 in a bank For 3 years At 8% $7938 * 8% = 635 $8574 * 8% = 686 $9259 * 8% = 741 $2,062  __________

What about Annuities? If I put $3000 in an account each December, what will it be worth in 3 years? “ We know Present Value: $3,000 Interest Rate: 8% Table ____ Factor: ____ Future Value? _____

Present Value: what’s it worth now? Single Amount Example: What do I have to put into the bank NOW, to have $10,000 in 3 years? “ assume 8% We know Present Value: _____ Interest Rate: 8% Table ____ Factor: ____ Future Value? $10,000

Present Value: what’s it worth now? Annuity Example: "I'm making payments of $3,000 for the next 3 years. If I chose NOT to pay on time, but pay in CASH, what would they charge me?" We know Present Value: _____ Interest Rate: 8% Table ____ Factor: ____ Payments: $3,000

Appendix A – applications -3 I’m promised $100 in one year. How much is it worth TODAY (assume 10%) We know Present Value: _____ Interest Rate: 10% Table ____ Factor: ____ Future Value $100 Payment: ________

Appendix A – applications -4 You sell your motorcycle and the person will pay you $500 for four years. Assume interest = 5%) We know: Present Value: _____ Interest Rate: 5% Table ____ Factor: ____ Future Value ______ Payment: $500

Appendix A – applications –other Installment notes Valuing a bond Recording leases Pension obligations Debt Depreciation of PPE Capital expenditure decisions Anywhere TIME is involved.....

Summary AP Turnover Definitely determinable liabilities Contingent Liabilities Know SIMPLE & COMPOUND interest Use Appendix D and solve time value problems

End – Chapter 9

What would happen to your credit card balance….. Beginning Balance Interest Rate Finance Charge PaymentsEnding Balance If each month, your payment was equal to the finance charges Amount Owed $2, % annual rate 1% per month $25.00 Payments equal 1% $25.00 $2, x 1% = Your debt balance would stay constant throughout the term of the debt. When the Interest Rate is equal to the payment rate, the debt balance is unchanged.

What would happen to your credit card balance….. Beginning Balance Interest Rate Finance Charge Payments Received Ending Balance If each month, your payment was less than the finance charges Amount Owed $2, % annual rate 2% per month $50.00 Payments equal 1.5% $37.50 $2, X 2% = Your debt balance increases throughout the term of the debt. When the Interest Rate is greater than the payment rate, the debt balance increases.

What would happen to your credit card balance….. Beginning Balance Interest Rate Finance Charge Payments Received Ending Balance If each month, your payment was more than the finance charges Amount Owed $2, % annual rate 1% per month $25.00 Payments equal 1.5% $37.50 $2, X 1% = Your debt balance decreases throughout the term of the debt. When the Interest Rate is less than the payment rate, the debt balance decreases.

Appendix A – applications -1 Investing IDLE CASH.... Let’s invest $10,000,000 for half a year at 12%, compounded monthly. We know Present Value: _____ Interest Rate: 12% Table ____ Factor: ____ Future Value? ______ Payment ______

Appendix A – applications - 2 We need to pay off a loan, worth $100,000 in five years, by making annual deposits into a bank account. We know Present Value: _____ Interest Rate: 12% Table ____ Factor: ____ Future Value ______ Payment: ________

If Stated Rate When we apply this logic to bonds, we see that the carrying value will increase to the face value + 5.0% MR - 4.5% SR % MR - 4.5% SR + 5.0% MR - 4.5% SR ____ ____________ Selling Price < Market Rate < Face Value SR = Stated Rate < MR = Market Rate

If Market Rate When Market Rate = Stated Rate Bonds Sell at Face Value + 4.5% Market Rate - 4.5% Stated Rate + 4.5% Market Rate - 4.5% Stated Rate + 4.5% Market Rate - 4.5% Stated Rate ____________ Interest Expense = Stated Rate = Payments. Selling Price Face Value =

If Stated Rate When we apply this logic to bonds, we see that the carrying value will decrease to the face value + 4.0% MR - 4.5% SR % MR - 4.5% SR + 4.0% MR - 4.5% SR ____ __ _ Selling Price > Market Rate > Face Value SR = Stated Rate > MR = Market Rate