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1 Welcome Back Atef Abuelaish

2 Welcome Back Time for Any Question Atef Abuelaish

3 Chapter 09 review Atef Abuelaish

4 Chapter 09 Accounting for Atef Abuelaish

5 Accounting for Current Liabilities
Chapter 09 Accounting for Current Liabilities Atef Abuelaish

6 Defining Liabilities C 1
A liability is a probable future payment of assets or services that a company is presently obligated to make as a result of past transactions or events. This definition includes three crucial factors: A past transaction or event. A present obligation. A future payment of assets or services. C 1 Atef Abuelaish

7 Classifying Liabilities
Expected to be paid within one year or the company’s operating cycle, whichever is longer. Current Liabilities Not expected to be paid within one year or the company’s operating cycle, whichever is longer. Long-Term Liabilities Current liabilities, also called short-term liabilities, are obligations due within one year or the company’s operating cycle, whichever is longer. They are expected to be paid using current assets or by creating other current liabilities. Common examples of current liabilities are accounts payable, short-term notes payable, wages payable, warranty liabilities, lease liabilities, taxes payable, and unearned revenues. A company’s obligations not expected to be paid within the longer of one year or the company’s operating cycle are reported as long-term liabilities. They can include long-term notes payable, warranty liabilities, lease liabilities, and bonds payable. They are sometimes reported on the balance sheet in a single long-term liabilities total or in multiple categories. C 1 Atef Abuelaish

8 Uncertainty of Liabilities
Uncertainty in Whom to Pay Uncertainty in When to Pay Uncertainty in How Much to Pay Accounting for liabilities involves addressing three important questions: Whom to pay? When to pay? How much to pay? Answers to these questions are often decided when a liability is incurred. For example, if a company has a $100 account payable to a specific individual, payable on March 15, the answers are clear. The company knows whom to pay, when to pay, and how much to pay. However, the answers to one or more of these questions are uncertain for some liabilities. C 1 Atef Abuelaish

9 Short-Term Notes Payable Multi-Period Known Liabilities
Accounts Payable Sales Taxes Payable Unearned Revenues Short-Term Notes Payable Most liabilities arise from situations with little uncertainty. They are set by agreements, contracts, or laws and are measurable. These liabilities are known liabilities, also called definitely determinable liabilities. Known liabilities include accounts payable, notes payable, payroll, sales taxes, unearned revenues, and leases. Payroll Liabilities Multi-Period Known Liabilities C 2 Atef Abuelaish

10 1) Sales Tax Payable On August 31, Home Depot sold materials for $6,000 that are subject to a 5% sales tax. $6,000 × 5% = $300 If Home Depot sells materials on August 31 for $6,000 cash that are subject to a 5% sales tax, the revenue portion of this transaction is recorded as shown. (The entry for cost of sales is omitted for simplicity.) Sales Taxes Payable is debited and Cash credited when it remits these collections to the government. Sales Taxes Payable is not an expense. It arises because laws require sellers to collect this cash from customers for the government. C 2 Atef Abuelaish

11 2) Unearned Revenues On June 30, Rihanna sells $5,000,000 in tickets for eight concerts. On Oct. 31, Rihanna performs a concert. Unearned revenues (also called deferred revenues, collections in advance, and prepayments) are amounts received in advance from customers for future products or services. Advance ticket sales for sporting events or music concerts are examples. Rihanna, for instance, has “deferred revenues” from advance ticket sales. To illustrate, assume that Rihanna sells $5 million in tickets for eight concerts; the entry is shown first in the slide. When a concert is played, Rihanna would record revenue for the portion earned as shown in the second entry. Unearned Ticket Revenue is an unearned revenue account and is reported as a current liability. Unearned revenues also arise with airline ticket sales, magazine subscriptions, construction projects, hotel reservations, gift card sales, and custom orders. C 2 $5,000,000 / 8 = $625,000 Atef Abuelaish

12 3) Multi-Period Known Liabilities
Includes Unearned Revenues and Notes Payable Unearned Revenues from magazine subscriptions often cover more than one accounting period. A portion of the earned revenue is recognized each period and the Unearned Revenue account is reduced. Notes Payable often extend over more than one accounting period. A three-year note would be classified as a current liability for one year and a long-term liability for two years. Many known liabilities extend over multiple periods. These often include unearned revenues and notes payable. For example, if Sports Illustrated sells a four-year magazine subscription, it records amounts received for this subscription in an Unearned Subscription Revenues account. Amounts in this account are liabilities, but are they current or long term? They are both. The portion of the Unearned Subscription Revenues account that will be fulfilled in the next year is reported as a current liability. The remaining portion is reported as a long-term liability. The same analysis applies to notes payable. For example, a borrower reports a three-year note payable as a long-term liability in the first two years it is outstanding. In the third year, the borrower reclassifies this note as a current liability since it is due within one year or the operating cycle, whichever is longer. The current portion of long-term debt refers to that part of long-term debt due within one year or the operating cycle, whichever is longer. Long-term debt is reported under long-term liabilities, but the current portion due is reported under current liabilities. Some known liabilities are rarely reported in long-term liabilities. These include accounts payable, sales taxes, and wages and salaries. C 2 Atef Abuelaish

13 4) Short-Term Notes Payable
A written promise to pay a specified amount on a definite future date within one year or the company’s operating cycle, whichever is longer. A short-term note payable is a written promise to pay a specified amount on a definite future date within one year or the company’s operating cycle, whichever is longer. These promissory notes are negotiable (as are checks), meaning they can be transferred from party to party by endorsement. The written documentation provided by notes is helpful in resolving disputes and for pursuing legal actions involving these liabilities. Most notes payable bear interest to compensate for use of the money until payment is made. Short-term notes payable can arise from many transactions. A company that purchases merchandise on credit can sometimes extend the credit period by signing a note to replace an account payable. Such notes also can arise when money is borrowed from a bank. P 1 Atef Abuelaish

14 Note Given to Extend Credit Period
On August 23, Brady Company asks McGraw to accept $100 cash and a 60-day, 12% $500 note to replace its existing $600 Account Payable. A company can replace an account payable with a note payable. A common example is a creditor that requires the substitution of an interest-bearing note for an overdue account payable that does not bear interest. A less common situation occurs when a debtor’s weak financial condition motivates the creditor to accept a note, sometimes for a lesser amount, and to close the account to ensure that this customer makes no additional credit purchases. To illustrate, let’s assume that on August 23, Brady Company asks to extend its past-due $600 account payable to McGraw. After some negotiations, McGraw agrees to accept $100 cash and a 60-day, 12%, $500 note payable to replace the account payable. Brady records the transaction with this entry shown. P 1 Atef Abuelaish

15 Note Given to Extend Credit Period
On October 22, Brady pays the note plus interest to McGraw. Signing the note does not resolve Brady’s debt. Instead, the form of debt is changed from an account payable to a note payable. McGraw prefers the note payable over the account payable because it earns interest and it is written documentation of the debt’s existence, term, and amount. When the note comes due, Brady pays the note and interest by giving McGraw a check for $510. Brady records that payment with this entry: Interest expense is computed by multiplying the principal of the note ($500) by the annual interest rate (12%) for the fraction of the year the note is outstanding (60 days/360 days). Interest expense = $500 × 12% × (60 ÷ 360) = $10 P 1 Atef Abuelaish

16 Note Given To Borrow From Bank
A bank nearly always requires a borrower to sign a promissory note when making a loan. When the note matures, the borrower repays the note with an amount larger than the amount borrowed. The difference between the amount borrowed and the amount repaid is interest. The signer promises to pay principal (the amount borrowed) plus interest. In this case, the face value of the note equals principal. Face value is the value shown on the face (front) of the note. To illustrate, assume that a company needs $2,000 for a project and borrows this money from a bank at 12% annual interest. The loan is made on September 30, 2015, and is due in 60 days. Specifically, the borrowing company signs a note with a face value equal to the amount borrowed. The note includes a statement similar to this: “I promise to pay $2,000 plus interest at 12% within 60 days after September 30.” P 1 Atef Abuelaish

17 Note Given To Borrow From Bank
On Sept. 30, a company borrows $2,000 from a bank at 12% interest for 60 days. On Nov. 29, the company repays the principal of the note plus interest. The borrower records its receipt of cash and the new liability with the first entry shown. When principal and interest are paid, the borrower records payment with this second entry. P 1 Interest expense = $2,000 × 12% × (60 ÷ 360) = $40 Atef Abuelaish

18 End-of-Period Adjustment to Notes
Note Date End of Period Maturity Date An adjusting entry is required to record Interest Expense incurred to date. When the end of an accounting period occurs between the signing of a note payable and its maturity date, the expense recognition (matching) principle requires us to record the accrued but unpaid interest on the note. P 1 Atef Abuelaish

19 Recording End-of-Period Interest Adjustments
On December 16, TechCom accepts a $3,000, 60-day, 12% note from a customer in granting an extension on a past-due account. When TechCom’s accounting period ends on December 31, $15 of interest has accrued on the note. $3,000 x 12% x 15/360 = $15 When notes receivable are outstanding at the end of a period, any accrued interest earned is computed and recorded. To illustrate, on December 16, TechCom accepts a $3,000, 60-day, 12% note from a customer in granting an extension on a past-due account. When TechCom’s accounting period ends on December 31, $15 of interest has accrued on this note ($3,000 x 12% x 15/360). The adjusting entry shown records this revenue. P3 Atef Abuelaish

20 Recording End-of-Period Interest Adjustments
Recording collection on note at maturity. When the December 16 note is collected on February 14, TechCom’s entry to record the cash receipt is shown. Total interest earned on the 60-day note is $60. The $15 credit to Interest Receivable on February 14 reflects the collection of the interest accrued from the December 31 adjusting entry. The $45 interest earned reflects TechCom’s revenue from holding the note from January 1 to February 14 of the current period. Review what you have learned in the following NEED-TO-KNOW Slide. P3 $3,000 x 12% x 60/360 = $60 Atef Abuelaish

21 NEED-TO-KNOW Part 1. A retailer sells merchandise for $500 cash on June 30 (cost of merchandise is $300). The sales tax law requires the retailer to collect 7% sales tax on every dollar of merchandise sold. Record the entry for the $500 sale and its applicable sales tax. Also record the entry that shows the remittance of the 7% tax on this sale to the state government on July 15. General Journal Debit Credit Jun. 30 Cash 535 Sales 500 Sales taxes payable ($500 x .07) 35 Jun. 30 Cost of goods sold 300 Merchandise inventory 300 Jul. 15 Sales taxes payable 35 Cash 35 A retailer sells merchandise for $500 cash on June 30 (cost of merchandise is $300). The sales tax law requires the retailer to collect 7% sales tax on every dollar of merchandise sold. Record the entry for the $500 sale and its applicable sales tax. Also record the entry that shows the remittance of the 7% tax on this sale to the state government on July 15. To record the sale on June 30, we credit Sales for the $500. We also credit Sales taxes payable ($500 multiplied by 7% = $35), and debit Cash for the total, $535. On the same date, we also record the cost of goods sold, debiting Cost of goods sold, $300, and crediting Merchandise inventory. On July 15, the sales tax is remitted to the state government, debiting Sales taxes payable, $35, and crediting Cash. P 1 Atef Abuelaish

22 NEED-TO-KNOW Part 2. A ticket agency receives $40,000 cash in advance ticket sales for a four-date tour of Haim. Record the advance ticket sales on April 30. Record the revenue earned for the first concert date of May 15, assuming it represents one-fourth of the advance ticket sales. General Journal Debit Credit Apr. 30 Cash 40,000 Unearned ticket revenue 40,000 May 15 Unearned ticket revenue $40,000 / 4 concerts 10,000 Earned ticket revenue 10,000 A ticket agency receives $40,000 cash in advance ticket sales for a four-date tour of Haim. Record the advance ticket sales on April 30. Record the revenue earned for the first concert date of May 15, assuming it represents one-fourth of the advance ticket sales. To record the receipt of cash in advance, we debit Cash, $40,000, and credit the liability account, Unearned ticket revenue for the same amount. This liability is satisfied as the concerts are performed. The first concert is on May 15. We debit the liability account, Unearned ticket revenue, for one-fourth of the advance ticket sales, $10,000, and we credit the revenue account, Earned ticket revenue. P 1 Atef Abuelaish

23 NEED-TO-KNOW Part 3. On November 25 of the current year, a company borrows $8,000 cash by signing a 90-day, 5% note payable with a face value of $8,000. (a) Compute the accrued interest payable on December 31 of the current year, (b) prepare the journal entry to record the accrued interest expense at December 31 of the current year, and (c) prepare the journal entry to record payment of the note at maturity. General Journal Debit Credit Nov. 25 Cash 8,000 36 days Notes payable 8,000 Dec. 31 Interest expense ($8,000 x .05 x 36/360) 40 54 days Interest payable 40 Feb. 23 Interest expense ($8,000 x .05 x 54/360) 60 Interest payable ($8,000 x .05 x 36/360) 40 Notes payable 8,000 Cash 8,100 On November 25 of the current year, a company borrows $8,000 cash by signing a 90-day, 5% note payable with a face value of $8,000. (a) Compute the accrued interest payable on December 31 of the current year, (b) prepare the journal entry to record the accrued interest expense at December 31 of the current year and, (c) prepare the journal entry to record payment of the note at maturity. When the company borrows the $8,000, the journal entry is a debit to Cash, $8,000, and a credit to the liability account, Notes payable. On December 31, we accrue the interest for the number of days between November 25 and December 31. There are five days remaining in November plus 31 days in December; a total of 36 days. We record 36 days of interest expense; $8,000 multiplied by 5% multiplied by 36/360 is $40 of accrued interest, and we credit Interest payable. The maturity date is 90 days after November 25, February 23. On that date, the $8,000 plus 90 days of interest is repaid. The journal entry records an additional 54 days of interest; between December 31 and February 23. $8,000 multiplied by 5% multiplied by 54/360 is $60 of interest expense incurred in the second year. Debit interest payable for the 36 days of interest accrued in the first year, $40, debit Notes payable for the principal amount, $8,000, and we credit Cash for principal plus 90 days of interest, $8,100. P 1 Atef Abuelaish

24 Employers incur expenses and liabilities from having employees.
5) Payroll Liabilities Employers incur expenses and liabilities from having employees. An employer incurs several expenses and liabilities from having employees. These expenses and liabilities are often large and arise from salaries and wages earned, from employee benefits, and from payroll taxes levied on the employer. P 2 Atef Abuelaish

25 Employee Payroll Deductions
Gross pay is the total compensation an employee earns including wages, salaries, commissions, bonuses, and any compensation earned before deductions such as taxes. (Wages usually refer to payments to employees at an hourly rate. Salaries usually refer to payments to employees at a monthly or yearly rate.) Net pay, also called take-home pay, is gross pay less all deductions. Payroll deductions, commonly called withholdings, are amounts withheld from an employee’s gross pay, either required or voluntary. Required deductions result from laws and include income taxes and Social Security taxes. Voluntary deductions, at an employee’s option, include pension and health contributions, health and life insurance premiums, union dues, and charitable giving. P 2 Atef Abuelaish

26 Employee FICA Taxes Federal Insurance Contributions Act (FICA)
FICA Taxes — Soc. Sec. 2015: 6.2% of the first $118,000 earned in the year. FICA Taxes — Medicare 2015: 1.45% of all wages earned in the year. Employers must pay withheld taxes to the Internal Revenue Service (IRS). The federal Social Security system provides retirement, disability, survivorship, and medical benefits to qualified workers. Laws require employers to withhold Federal Insurance Contributions Act (FICA) taxes from employees’ pay to cover costs of the system. Employers usually separate FICA taxes into two groups: (1) retirement, disability, and survivorship and (2) medical. For the first group, the Social Security system provides monthly cash payments to qualified retired workers for the rest of their lives. These payments are often called Social Security benefits. Taxes related to this group are often called Social Security taxes. For the second group, the system provides monthly payments to deceased workers’ surviving families and to disabled workers who qualify for assistance. These payments are commonly called Medicare benefits; like those in the first group, they are paid with Medicare taxes (part of FICA taxes). Law requires employers to withhold FICA taxes from each employee’s salary or wages on each payday. The taxes for Social Security and Medicare are computed separately. For example, for 2014, the amount scheduled to be withheld from each employee’s pay for Social Security tax is 6.2% of the first $117,000 the employee earns in the calendar year. The Medicare tax is 1.45% of all amounts the employee earns; there is no maximum limit to Medicare tax. A 0.9% Additional Medicare Tax is imposed on the employee for pay in excess of $200,000 (this additional tax is not imposed on the employer). P 2 Atef Abuelaish

27 State and Local Income Taxes
Employee Income Tax Federal Income Tax State and Local Income Taxes Amounts withheld depend on the employee’s earnings, tax rates, and number of withholding allowances. Employers must pay the taxes withheld from employees’ gross pay to the appropriate government agency. Most employers are required to withhold federal income tax from each employee’s paycheck. The amount withheld is computed using tables published by the IRS. The amount depends on the employee’s annual earnings rate and the number of withholding allowances the employee claims. Allowances reduce the amount of taxes one owes the government. The more allowances one claims, the less tax the employer will withhold. Employees can claim allowances for themselves and their dependents. They also can claim additional allowances if they expect major declines in their taxable income for medical expenses. (An employee who claims more allowances than appropriate is subject to a fine.) Most states and many local governments require employers to withhold income taxes from employees’ pay and to remit them promptly to the proper government agency. Until they are paid, withholdings are reported as a current liability on the employer’s balance sheet. P 2 Atef Abuelaish

28 Employee Voluntary Deductions
Amounts withheld depend on the employee’s request. Examples include union dues, savings accounts, pension contributions, insurance premiums, and charities. Employers owe voluntary amounts withheld from employees’ gross pay to the designated agency. Beyond Social Security, Medicare, and income taxes, employers often withhold other amounts from employees’ earnings. These withholdings arise from employee requests, contracts, unions, or other agreements. They can include amounts for charitable giving, medical and life insurance premiums, pension contributions, and union dues. Until they are paid, such withholdings are reported as part of employers’ current liabilities. P 2 Atef Abuelaish

29 Recording Employee Payroll Deductions
An entry to record payroll expenses and deductions for an employee might look like this. Employers must accrue payroll expenses and liabilities at the end of each pay period. To illustrate, assume that an employee earns a salary of $2,000 per month. At the end of January, the employer’s entry to accrue payroll expenses and liabilities for this employee is Salaries Expense (debit) shows that the employee earns a gross salary of $2,000. The first five payables (credits) show the liabilities the employer owes on behalf of this employee to cover FICA taxes, income taxes, medical insurance, and union dues. The Salaries Payable account (credit) records the $1,524 net pay the employee receives from the $2,000 gross pay earned. When the employee is paid, another entry (or a series of entries) is required to record the check written and distributed (or funds transferred). The entry to record cash payment to this employee is to debit Salaries Payable and credit Cash for $1,524. *Amounts taken from employee’s employment records P 2 Atef Abuelaish

30 Employer Payroll Taxes
Federal and State Unemployment Taxes FICA Taxes Medicare Taxes Employers pay amounts equal to that withheld from the employee’s gross pay. Employers must pay payroll taxes in addition to those required of employees. Employer taxes include FICA and unemployment taxes. Employers must pay FICA taxes on their payroll to employees. For 2014, the employer must pay Social Security tax of 6.2% on the first $117,000 earned by each employee, and 1.45% Medicare tax on all earnings of each employee. An employer’s tax is credited to the same FICA Taxes Payable accounts used to record the Social Security and Medicare taxes withheld from employees. (A self-employed person must pay both the employee and employer FICA taxes.) P 3 Atef Abuelaish

31 Federal and State Unemployment Taxes
2015: 6.2% on the first $7,000 of wages paid to each employee. A credit up to 5.4% is given for SUTA paid, therefore the net rate is 0.8%. Federal Unemployment Tax (FUTA) 2015: Basic rate of 5.4% on the first $7,000 of wages paid to each employee. Merit ratings may lower SUTA rates. State Unemployment Tax (SUTA) The federal government participates with states in a joint federal and state unemployment insurance program. Each state administers its program. These programs provide unemployment benefits to qualified workers. The federal government approves state programs and pays a portion of their administrative expenses. Federal Unemployment Tax Act (FUTA). Employers are subject to a federal unemployment tax on wages and salaries paid to their employees. For the recent year, employers were required to pay FUTA taxes of as much as 6.0% of the first $7,000 earned by each employee. This federal tax can be reduced by a credit of up to 5.4% for taxes paid to a state program. As a result, the net federal unemployment tax is often only 0.6%. State Unemployment Tax Act (SUTA). All states support their unemployment insurance programs by placing a payroll tax on employers. (A few states require employees to make a contribution. In the book’s assignments, we assume that this tax is only on the employer.) In most states, the base rate for SUTA taxes is 5.4% of the first $7,000 paid each employee. This base rate is adjusted according to an employer’s merit rating. The state assigns a merit rating that reflects a company’s stability or instability in employing workers. A good rating reflects stability in employment and means an employer can pay less than the 5.4% base rate. A low rating reflects high turnover or seasonal hirings and layoffs. P 3 Atef Abuelaish

32 Recording Employer Payroll Taxes
An entry to record the employer payroll taxes for January might look like this. Employer payroll taxes are an added expense beyond the wages and salaries earned by employees. These taxes are often recorded in an entry separate from the one recording payroll expenses and deductions. To illustrate, assume that the $2,000 recorded salaries expense from the previous example is earned by an employee whose earnings have not yet reached $5,000 for the year. This means the entire salaries expense for this period is subject to tax because year-to-date pay is under $7,000. Also assume that the federal unemployment tax rate is 0.6% and the state unemployment tax rate is 5.4%. Consequently, the FICA portion of the employer’s tax is $153, computed by multiplying both the 6.2% and 1.45% by the $2,000 gross pay. Moreover, state unemployment (SUTA) taxes are $108 (5.4% of the $2,000 gross pay), and federal unemployment (FUTA) taxes are $12 (0.6% of $2,000). The entry to record the employer’s payroll tax expense and related liabilities is shown. Review what you have learned in the following NEED-TO-KNOW Slides. SUTA: $2,000 x 5.4% = $108 FUTA: $2,000 x (0.6) = 12 FICA amounts are the same as that withheld from the employee’s gross pay. P 3 Atef Abuelaish

33 NEED-TO-KNOW A company’s first weekly pay period of the year ends on January 8. On that date, the column totals in its payroll register show that sales employees earned $30,000, and office employees earned $20,000 in salaries. The employees are to have withheld from their salaries FICA Social Security taxes at the rate of 6.2%, FICA Medicare taxes at the rate of 1.45%, $9,000 of federal income taxes, $2,000 of medical insurance deductions, and $1,000 of pension contributions. No employee earned more than $7,000 in the first pay period. Part 1) Compute FICA Social Security taxes payable and FICA Medicare taxes payable. Prepare the journal entry to record the company’s January 8 (employee) payroll expenses and liabilities. General Journal Debit Credit Jan. 8 Sales salaries expense 30,000 Office salaries expense 20,000 FICA - Social security taxes payable ($50,000 x .062) 3,100 FICA - Medicare taxes payable ($50,000 x .0145) 725 Employee federal income taxes payable 9,000 Employee medical insurance payable 2,000 Employee pensions payable 1,000 Salaries payable 34,175 A company’s first weekly pay period of the year ends on January 8. On that date, the column total in its payroll register shows that sales employees earned $30,000, and office employees earned $20,000 in salaries. The employees are to have withheld from their salaries FICA Social Security taxes at the rate of 6.2%, FICA Medicare taxes at the rate of 1.45%, $9,000 of federal income taxes, $2,000 of medical insurance deductions, and $1,000 of pension contributions. No employee earned more than $7,000 in the first pay period. Compute FICA Social Security taxes payable and FICA Medicare taxes payable. Prepare the journal entry to record the company’s January 8 (employee) payroll expenses and liabilities. We begin by recording the salaries expense. We debit Sales salaries expense, $30,000, and Office salaries expense for $20,000. All $50,000 is now payable, either for deductions, or to the employees in the form of their net pay. We credit FICA - Social Security taxes payable, $50,000 multiplied by 6.2%, $3,100; we credit FICA - Medicare taxes payable, $50,000 multiplied by 1.45%, $725; credit employee Federal income taxes payable, $9,000; credit Employee medical insurance payable, $2,000; credit employee pensions payable, $1,000; and credit salaries payable for the net pay, $50,000 of gross pay minus $15,825 of deductions, net pay is $34,175. P2/P 3 Atef Abuelaish

34 NEED-TO-KNOW Part 2) Prepare the journal entry to record the company’s (employer) payroll taxes resulting from the January 8 payroll. Its merit rating reduces its state unemployment tax rate to 3.4% of the first $7,000 paid to each employee. The federal unemployment tax rate is 0.6%. General Journal Debit Credit Jan. 8 Sales salaries expense 30,000 Office salaries expense 20,000 FICA - Social security taxes payable ($50,000 x .062) 3,100 FICA - Medicare taxes payable ($50,000 x .0145) 725 Employee federal income taxes payable 9,000 Employee medical insurance payable 2,000 Employee pensions payable 1,000 Salaries payable 34,175 Jan. 8 Payroll taxes expense 5,825 FICA - Social security taxes payable ($50,000 x .062) 3,100 FICA - Medicare taxes payable ($50,000 x .0145) 725 SUTA - State unemployment taxes payable ($50,000 x .034) 1,700 FUTA - Federal unemployment taxes payable ($50,000 x .006) 300 Prepare the journal entry to record the company’s (employer) payroll taxes resulting from the January 8 payroll. Its merit rating reduces its state unemployment tax rate to 3.4% of the first $7,000 paid to each employee. The federal unemployment tax rate is 0.6%. The total payroll taxes expense is equal to: the matching amount of Social Security taxes payable, $50,000 multiplied by 6.2%, $3,100; the matching amount of Medicare taxes payable, $50,000 multiplied by 1.45%, $725; SUTA (state unemployment taxes) payable, which are paid entirely by the employer, $50,000 multiplied by 3.4%, $1,700; and Federal unemployment taxes payable, again paid entirely by the employer, $50,000 multiplied by 0.6%, $300. Total payroll taxes expense is $5,825. P2/P3 Atef Abuelaish

35 Estimated Liabilities
An estimated liability is a known obligation of an uncertain amount, but one that can be reasonably estimated. An estimated liability is a known obligation that is of an uncertain amount but that can be reasonably estimated. Common examples are employee benefits such as pensions, health care and vacation pay, and warranties offered by a seller. We discuss each of these in this section. Other examples of estimated liabilities include property taxes and certain contracts to provide future services. P 4 Atef Abuelaish

36 1) Health and Pension Benefits
Employer expenses for pensions or medical, dental, life, and disability insurance Assume an employer agrees to pay an amount for medical insurance equal to $8,000, and contribute an additional 10% of the employees’ $120,000 gross salary to a retirement program. Many companies provide employee benefits beyond salaries and wages. An employer often pays all or part of medical, dental, life, and disability insurance. Many employers also contribute to pension plans, which are agreements by employers to provide benefits (payments) to employees after retirement. Many companies also provide medical care and insurance benefits to their retirees. When payroll taxes and charges for employee benefits are totaled, payroll cost often exceeds employees’ gross earnings by 25% or more. To illustrate, assume that an employer agrees to (1) pay an amount for medical insurance equal to $8,000 and, (2) contribute an additional 10% of the employees’ $120,000 gross salaries to a retirement program. The entry to record these accrued benefits is shown. P 4 Atef Abuelaish

37 2) Vacation Benefits Assume an employee earns $20,800 per year and earns two weeks of paid vacation each year. $20,800 ÷ 50 weeks = $416 $20,800 ÷ 52 weeks = $400 Weekly vacation benefit $ 16 Many employers offer paid vacation benefits, also called paid absences or compensated absences. To illustrate, assume that salaried employees earn two weeks’ vacation per year. This benefit increases employers’ payroll expenses because employees are paid for 52 weeks but work for only 50 weeks. Total annual salary is the same, but the cost per week worked is greater than the amount paid per week. For example, if an employee is paid $20,800 for 52 weeks but works only 50 weeks, the total weekly expense to the employer is $416 ($20,800/50 weeks) instead of the $400 cash paid weekly to the employee ($20,800/52 weeks). The $16 difference between these two amounts is recorded weekly as shown. Vacation Benefits Expense is an operating expense, and Vacation Benefits Payable is a current liability. When the employee takes a vacation, the employer reduces (debits) the Vacation Benefits Payable and credits Cash (no additional expense is recorded). P 4 Atef Abuelaish

38 3) Bonus Plans Assume that a bonus will be paid to employees equal to 5% of the company’s annual net income of $210,000. B = .05 ($210,000 - B) B = $10, B 1.05B = $10,500 B = $10,500 / 1.05 *B = $10,000 Many companies offer bonuses to employees, and many of the bonuses depend on net income. To illustrate, assume that an employer offers a bonus to its employees equal to 5% of the company’s annual net income (to be equally shared by all). The company’s expected annual pre- bonus net income is $210,000. The year-end adjusting entry to record this benefit is shown. To calculate the amount of the bonus, we can set up the basic bonus equation which states that your bonus (B) is equal to 5% of the net income minus the bonus. Solving the equation, we find that the bonus is $10,000. Once the bonus has been calculated, the company will debit the Employee Bonus Expense account, and credit the Bonus Payable, for $10,000. When the bonus is paid to you, the company will debit, or eliminate, the Bonus Payable balance, and credit Cash. P 4 Atef Abuelaish

39 4) Warranty Liabilities
Seller’s obligation to replace or correct a product (or service) that fails to perform as expected within a specified period. To comply with the full disclosure and matching principles, the seller reports expected warranty expense in “the period when revenue from the sale is reported.” A warranty is a seller’s obligation to replace or correct a product (or service) that fails to perform as expected within a specified period. Most new cars, for instance, are sold with a warranty covering parts for a specified period of time. Ford Motor Company reported almost $8 billion in “dealer and dealers’ customer allowances and claims” in its annual report. To comply with the full disclosure and matching principles, the seller reports the expected warranty expense in the period when revenue from the sale of the product or service is reported. The seller reports this warranty obligation as a liability, although the existence, amount, payee, and date of future sacrifices are uncertain. This is because such warranty costs are probable and the amount can be estimated using, for instance, past experience with warranties. P 4 Atef Abuelaish

40 Warranty Liabilities On Dec. 1, 2015, a dealer sells a car for $16,000 with a maximum one-year or 12,000 mile warranty covering parts. Past experience indicates warranty expenses average 4% of a car’s selling price. On Jan. 9, 2016, the customer returns the car for repairs. The dealer replaces parts costing $200. To illustrate, a dealer sells a used car for $16,000 on December 1, 2015, with a maximum one-year or 12,000-mile warranty covering parts. This dealer’s experience shows that warranty expense averages about 4% of a car’s selling price, or $640 in this case ($16,000 x 4%). The dealer records the estimated expense and liability related to this sale with the first entry shown. This entry alternatively could be made as part of end-of-period adjustments. Either way, the estimated warranty expense is reported on the 2015 income statement and the warranty liability on the 2015 balance sheet. To further extend this example, suppose the customer returns the car for warranty repairs on January 9, The dealer performs this work by replacing parts costing $200. The entry to record partial settlement of the estimated warranty liability is shown in the second entry. This entry reduces the balance of the estimated warranty liability. Warranty expense was previously recorded in 2015, the year the car was sold with the warranty. Finally, what happens if total warranty expenses are more or less than the estimated 4%, or $640? The answer is that management should monitor actual warranty expenses to see whether the 4% rate is accurate. If experience reveals a large difference from the estimate, the rate for current and future sales should be changed. Differences are expected, but they should be small. P 4 Atef Abuelaish

41 Accounting for Contingent Liabilities
A contingent liability is a potential obligation that depends on a future event arising from a past transaction or event. An example is a pending lawsuit. Here, a past transaction or event leads to a lawsuit whose result depends on the outcome of the suit. Future payment of a contingent liability depends on whether an uncertain future event occurs. Accounting for contingent liabilities depends on the likelihood that a future event will occur and the ability to estimate the future amount owed if this event occurs. Three different possibilities are identified in the following chart: record liability, disclose in notes, or no disclosure. The conditions that determine each of these three possibilities follow: The future event is probable (likely) and the amount owed can be reasonably estimated. We then record this amount as a liability. Examples are the estimated liabilities described earlier such as warranties, vacation pay, and income taxes. The future event is reasonably possible (could occur). We disclose information about this type of contingent liability in notes to the financial statements. The future event is remote (unlikely). We do not record or disclose information on remote contingent liabilities. C 3 Atef Abuelaish

42 Reasonably Possible Contingent Liabilities
Potential Legal Claims – A potential claim is recorded if the amount can be reasonably estimated and payment for damages is probable. Debt Guarantees – The guarantor usually discloses the guarantee in its financial statement notes. If it is probable that the debtor will default, the guarantor should record and report the guarantee as a liability. If the future event is reasonably possible (could occur). We disclose information about this type of contingent liability in notes to the financial statements. Two common examples are potential legal claims resulting from lawsuits made against the company and debt guarantees. When a company guarantees the debt of an affiliated company, it may eventually have to pay the obligation. If the original debtor fails to pay, the obligation becomes the responsibility of the guarantor. Review what you have learned in the following NEED-TO-KNOW Slides. C 3 Atef Abuelaish

43 Expense recognition principle
NEED-TO-KNOW A company’s salaried employees earn two weeks vacation per year. It pays $208,000 in total employee salaries for 52 weeks but its employees work only 50 weeks. This means its total weekly expense is $4,160 ($208,000 / 50 weeks) instead of the $4,000 cash paid weekly to the employees ($208,000 / 52 weeks). Record the company’s regular weekly vacation benefits expense. General Journal Debit Credit Weekly Vacation benefits expense ($4,160 - $4,000) 160 Vacation benefits payable 160 Expense recognition principle Expense is recognized in the same period as the revenue it helped generate. A company’s salaried employees earn two weeks’ vacation per year. It pays $208,000 in total employee salaries for 52 weeks but its employees work only 50 weeks. This means its total weekly expense is $4,160 ($208,000 / 50 weeks) instead of the $4,000 cash paid weekly to the employees ($208,000 / 52 weeks). Record the company’s regular weekly vacation benefits expense. Each week, the company will debit Vacation benefits expense and credit Vacation benefits payable for the difference between the $4,160 and the $4,000 paid, $160. This is an example of the expense recognition principle; the expense is recognized in the same period as the revenue it helped generate. Every week that the employees worked, they also earned $160 of vacation. The total cost of the employees is $4,160 per week. P4/C3 Atef Abuelaish

44 Expense recognition principle
NEED-TO-KNOW For the current year ended December 31, a company has implemented an employee bonus program equal to 5% of its net income, which employees will share equally. Its net income (pre-bonus) is expected to be $840,000, and bonus expense is deducted in computing net income. (a) Compute the bonus payable to the employees at year-end using the method described in the chapter and round to the nearest dollar; then, prepare the journal entry at December 31 of the current year to record the bonus due. (b) Prepare the journal entry at January 20 of the following year to record payment of that bonus to employees. B = .05($840,000 - B) B = $42, B 1.05 B = $42,000 B = $40,000 General Journal Debit Credit Dec. 31 Employee bonus expense 40,000 Bonus payable 40,000 Jan. 20 Bonus payable 40,000 Cash 40,000 For the current year ended December 31, a company has implemented an employee bonus program equal to 5% of its net income, which employees will share equally. Its net income (pre-bonus) is expected to be $840,000, and bonus expense is deducted in computing net income. (a) Compute the bonus payable to the employees at year-end using the method described in the chapter and round to the nearest dollar; then, prepare the journal entry at December 31 of the current year to record the bonus due. (b) Prepare the journal entry at January 20 of the following year to record payment of that bonus to employees. OK, well first, let's do a little algebra, B = .05($840,000 - B). The bonus equals 0.05 multiplied by $840,000, $42,000, minus .05B. We add 0.05B to each side. 1.05B equals $42,000. We divide each side by 1.05; the bonus is $40,000. We can check our math: $840,000 minus $40,000 is $800,000; 5% of $800,000 is $40,000. The journal entry on December 31, is a debit to Employee bonus expense, $40,000, and a credit to Bonus payable. On January 20, the bonus is paid. Debit Bonus payable, $40,000, and credit Cash. This is another example of the expense recognition principle; the expense is recorded in the year it was earned, even though the payment is not made until the following year. Expense recognition principle Expense is recognized in the same period as the revenue it helped generate. P4/C3 Atef Abuelaish

45 Expense recognition principle
NEED-TO-KNOW On June 11 of the current year, a retailer sells a trimmer for $400 with a one-year warranty that covers parts. Warranty expense is estimated at 5% of sales. On March 24 of the next year, the trimmer is brought in for repairs covered under the warranty requiring $15 in materials taken from the Repair Parts Inventory. Prepare the (a) June 11 entry to record the trimmer sale, and (b) March 24 entry to record warranty repairs. General Journal Debit Credit Jun. 11 Cash 400 Sales 400 Jun. 11 Warranty expense ($400 x .05) 20 Estimated warranty liability 20 Mar. 24 Estimated warranty liability 15 Repair parts inventory 15 Expense recognition principle Expense is recognized in the same period as the revenue it helped generate. On June 11 of the current year, a retailer sells a trimmer for $400 with a one-year warranty that covers parts. Warranty expense is estimated at 5% of sales. On March 24 of the next year, the trimmer is brought in for repairs covered under the warranty requiring $15 in materials taken from the Repair Parts Inventory. Prepare the (a) June 11 entry to record the trimmer sale, and (b) March 24 entry to record warranty repairs. On the date of the sale, we debit Cash for the amount of the sale, $400, and credit Sales. This revenue is immediately matched with an expense, Warranty expense, equal to 5% of $400, $20, and we credit Estimated warranty liability. On March 24 of the following year, part of this liability is satisfied; debit Estimated warranty liability, $15, and credit Repair parts inventory. Again the expense, Warranty expense, is recorded in the same time period as the revenue it helped generate. P4/C3 Atef Abuelaish

46 NEED-TO-KNOW The following legal claims exist for a company. Identify the accounting treatment for each claim as either (i) a liability that is recorded or (ii) an item described in notes to its financial statements. If an item is to be recorded, prepare the entry. a. The company (defendant) estimates that a pending lawsuit could result in damages of $500,000; it is reasonably possible that the plaintiff will win the case. (ii) Is reasonably estimated but not a probable loss. b. The company faces a probable loss on a pending lawsuit; the amount is not reasonably estimable. (ii) Probable loss but cannot be reasonably estimated. c. The company estimates environmental damages in a pending case at $900,000 with a high probability of losing the case. General Journal Debit Credit (i) Environmental contingent expense 900,000 Environmental contingent liability 900,000 For a contingent liability to be recorded, the loss must be both probable and reasonably estimable. The following legal claims exist for a company. Identify the accounting treatment for each claim as either (i) a liability that is recorded or (ii) an item described in notes to its financial statements. If an item is to be recorded, prepare the entry. For a contingent liability to be recorded, the loss must be both probable and reasonably estimable. (a) The company (defendant) estimates that a pending lawsuit could result in damages of $500,000; it is reasonably possible that the plaintiff will win the case. This item should be described in the notes to its financial statements, because although it is reasonably estimated, it's not a probable loss. (b) The company faces a probable loss on a pending lawsuit; the amount is not reasonably estimable. This item must also be described in the notes to its financial statements. Although the loss is probable, it cannot be reasonably estimated. (c) The company estimates environmental damages in a pending case at $900,000 with a high probability of losing the case. This loss is both probable and reasonably estimable. The journal entry is a debit to Environmental contingent expense, $900,000, and a credit to Environmental contingent liability. P4/C3 Atef Abuelaish

47 Chapter 10 Accounting for Atef Abuelaish

48 Accounting for long-term Liabilities
Chapter 10 Accounting for long-term Liabilities Atef Abuelaish

49 A. Bond Financing Atef Abuelaish

50 Transactions during the bond life Bond Interest Payments
Bond Financing Transactions during the bond life Bond Interest Payments Corporation Investors Bond Issue Date Bond Interest Payments Interest Payment = Bond Par Value × Stated Interest Rate x Time Projects that demand large amounts of money often are funded from bond issuances. (Both for-profit and nonprofit companies, as well as governmental units, such as nations, states, cities, and school districts, issue bonds.) A bond is its issuer’s written promise to pay an amount identified as the par value of the bond with interest. The par value of a bond, also called the face amount or face value, is paid at a specified future date known as the bond’s maturity date. Most bonds also require the issuer to make semiannual interest payments. The amount of interest paid each period is determined by multiplying the par value of the bond by the bond’s contract rate of interest for that same period. A1 Atef Abuelaish

51 Bond Financing Advantages Disadvantages
Bonds do not affect owner control. Bonds require payment of both periodic interest and par value at maturity. Interest on bonds is tax deductible. There are three main advantages of bond financing: 1. Bonds do not affect owner control. Equity financing reflects ownership in a company, whereas bond financing does not. A person who contributes $1,000 of a company’s $10,000 equity financing typically controls one-tenth of all owner decisions. A person who owns a $1,000, 11%, 20-year bond has no ownership right. This person, or bond- holder, is to receive from the bond issuer 11% interest, or $110, each year the bond is outstanding and $1,000 when it matures in 20 years. 2. Interest on bonds is tax deductible. Bond interest payments are tax deductible for the issuer, but equity payments (distributions) to owners are not. To illustrate, assume that a corporation with no bond financing earns $15,000 in income before paying taxes at a 40% tax rate, which amounts to $6,000 ($15,000 x 40%) in taxes. If a portion of its financing is in bonds, however, the resulting bond interest is deducted in computing taxable income. That is, if bond interest expense is $10,000, the taxes owed would be $2,000 ([$15,000 x $10,000] x 40%), which is less than the $6,000 owed with no bond financing. 3. Bonds can increase return on equity. A company that earns a higher return with borrowed funds than it pays in interest on those funds increases its return on equity. This process is called financial leverage or trading on the equity. The two main disadvantages of bond financing are these: 1. Bonds can decrease return on equity. When a company earns a lower return with the borrowed funds than it pays in interest, it decreases its return on equity. This downside risk of financial leverage is more likely to arise when a company has periods of low income or net losses. 2. Bonds require payment of both periodic interest and the par value at maturity. Bond payments can be especially burdensome when income and cash flow are low. Equity financing, in contrast, does not require any payments because cash withdrawals (dividends) are paid at the discretion of the owner (or board). A company must weigh the risks and returns of the disadvantages and advantages of bond financing when deciding whether to issue bonds to finance operations. Bonds can decrease return on equity. Bonds can increase return on equity. A1 Atef Abuelaish

52 Bond Trading Bonds are securities that can be purchased or sold in the securities markets. They have a market value which is expressed as a percent of their par value. The closing price indicates that the IBM stock is being sold at % of face value. The IBM bond quote here is interpreted (left to right) as Bonds, issuer name; Rate, contract interest rate (5.7%); Mat, matures in year 2017 when principal is paid; Yld, yield rate (4.7%) of bond at current price; Vol, daily dollar worth ($130,000) of trades (in 1,000s); Close, closing price (121.18) for the day as percentage of par value; Chg, change (0.24%) in closing price from prior day’s close. A1 Atef Abuelaish

53 Bond Issuing Procedures
State and federal laws govern bond issuances. Bond issuers also want to ensure that they do not violate any of their existing contractual agreements when issuing bonds. Authorization of bond issuances includes the number of bonds authorized, their par value, and the contract interest rate. The legal document identifying the rights and obligations of both the bondholders and the issuer is called the bond indenture, which is the legal contract between the issuer and the bondholders (and specifies how often interest is paid). A bondholder may also receive a bond certificate as evidence of the company’s debt. A bond certificate, such as that shown in this slide, includes specifics such as the issuer’s name, the par value, the contract interest rate, and the maturity date. Many companies reduce costs by not issuing paper certificates to bondholders. A1 Atef Abuelaish

54 Issuing Bonds at Par Atef Abuelaish

55 Issuing Bonds at Par On Jan. 1, 2015, a company issued the following bonds: Par Value: $800,000 Stated Interest Rate: 9% Interest Dates: 6/30 and 12/31 Maturity Date = Dec. 31, 2034 (20 years) Suppose a company receives authorization to issue $800,000 of 9%, 20-year bonds dated January 1, 2015, that mature on December 31, 2034, and pay interest semiannually on each June 30 and December 31. After accepting the bond indenture on behalf of the bondholders, the trustee can sell all or a portion of the bonds to an underwriter. If all bonds are sold at par value, the issuer records the sale as shown. This entry reflects increases in the issuer’s cash and long-term liabilities. P1 Atef Abuelaish

56 This entry is made every six months until the bonds mature.
Issuing Bonds at Par On June 30, 2015, the issuer of the bond pays the first semiannual interest payment of $36,000. The issuer records the first semiannual interest payment as shown. The issuer pays and records its semiannual interest obligation every six months until the bonds mature. $800,000 × 9% × ½ year = $36,000 This entry is made every six months until the bonds mature. P1 Atef Abuelaish

57 Issuing Bonds at Par On December 31, 2034, the bonds mature and the issuer of the bond pays face value of $800,000 to the bondholders. When the bonds mature, the issuer records its payment of principal as shown in this slide. P1 Atef Abuelaish

58 Bond Discount or Premium
Many bond issuers try to set a contract rate of interest equal to the market rate they expect as of the bond issuance date. When the contract rate and market rate are equal, a bond sells at par value, but when they are not equal, a bond does not sell at par value. Instead, it is sold at a premium above par value or at a discount below par value. Exhibit 10.3 shows the relation between the contract rate, market rate, and a bond’s issue price. P1 Atef Abuelaish

59 Issuing Bonds at a Discount
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60 Issuing Bonds at a Discount
Fila issues bonds with the following provisions: Par Value: $100,000 Issue Price: % of par value Stated Interest Rate: 8% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2015 Maturity Date: Dec. 31, 2017 (2 years) } Bond will sell at a discount. A discount on bonds payable occurs when a company issues bonds with a contract rate less than the market rate. This means that the issue price is less than par value. To illustrate, assume that Fila announces an offer to issue bonds with a $100,000 par value, an 8% annual contract rate (paid semiannually), and a two-year life. Also assume that the market rate for Fila bonds is 10%. These bonds then will sell at a discount since the contract rate is less than the market rate. The exact issue price for these bonds is stated as (implying % of par value, or $96,454). P2 Atef Abuelaish

61 Issuing Bonds at a Discount
On Dec. 31, 2015, Fila should record the bond issue. Par value $ 100,000 Cash proceeds 96,454 * Discount $ ,546 *$100,000 x % Contra-Liability Account When Fila accepts $96,454 cash for its bonds on the issue date of December 31, 2015, it records the sale as shown. P2 Atef Abuelaish

62 Issuing Bonds at a Discount
Maturity Value Carrying Value These bonds are reported in the long-term liability section of the issuer’s December 31, 2015, balance sheet as shown in the top portion of this slide. A discount is deducted from the par value of bonds to yield the carrying (book) value of bonds. Discount on Bonds Payable is a contra liability account. Fila receives $96,454 for its bonds; in return it must pay bondholders $100,000 after two years (plus semiannual interest payments). The $3,546 discount is paid to bondholders at maturity and is part of the cost of using the $96,454 for two years. The upper portion of panel A in this slide shows that total bond interest expense of $19,546 is the difference between the total amount repaid to bondholders ($116,000) and the amount borrowed from bondholders ($96,454). Alternatively, we can compute total bond interest expense as the sum of the four interest payments and the bond discount. This alternative computation is shown in the lower portion of panel A. P2 Atef Abuelaish

63 Amortizing a Bond Discount
Fila will make the following entry every six months to record the cash interest payment and the amortization of the discount. The straight-line bond amortization method allocates an equal portion of the total bond interest expense to each interest period. To apply the straight-line method to Fila’s bonds, we divide the total bond interest expense of $19,546 by four (the number of semiannual periods in the bonds’ life). This gives a bond interest expense of $4,887 per period, which is $4, rounded to the nearest dollar per period. Alternatively, we can find this number by first dividing the $3,546 discount by four, which yields the $887 amount of discount to be amortized each interest period. When the $887 is added to the $4,000 cash payment, the bond interest expense for each period is $4,887. This slide shows how the issuer records bond interest expense and updates the balance of the bond liability account at the end of each of the four semiannual interest periods (June 30, 2016, through December 31, 2017). $3,546 ÷ 4 periods = $887 (rounded) $100,000 × 8% × ½ = $4,000 P2 Atef Abuelaish

64 Amortizing a Bond Discount
This slide shows the pattern of decreases in the Discount on Bonds Payable account and the pattern of increases in the bonds’ carrying value. The following points summarize the discount bonds’ straight-line amortization: At issuance, the $100,000 par value consists of the $96,454 cash received by the issuer plus the $3,546 discount. During the bonds’ life, the (unamortized) discount decreases each period by the $887 amortization ($3,546 / 4), and the carrying value (par value less unamortized discount) increases each period by $887. At maturity, the unamortized discount equals zero, and the carrying value equals the $100,000 par value that the issuer pays the holder. We see that the issuer incurs a $4,887 bond interest expense each period but pays only $4,000 cash. The $887 unpaid portion of this expense is added to the bonds’ carrying value. (The total $3,546 unamortized discount is “paid” when the bonds mature; $100,000 is paid at maturity but only $96,454 was received at issuance.) Review what you have learned in the following NEED-TO-KNOW Slides. These two columns always sum to par value for a discount bond. P2 Atef Abuelaish

65 NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of or $6,752. (a) Prepare an amortization table for these bonds; use the straight-line method to amortize the discount. Then, prepare journal entries to record (b) the issuance of bonds on December 31, 20X1; (c ) the first through fourth interest payments on each June 30 and December 31; and (d) the maturity of the bond on December 31, 20X3. Change in Carrying Value $248 / 4 semiannual periods = $62 per period Semiannual Period-End Unamortized Discount Carrying Value (0) 12/31/20X1 $248 $6,752 << $7,000 x = $6,752 (1) 06/30/20X2 186 6,814 (2) 12/31/20X2 124 6,876 (3) 06/30/20X3 62 6,938 (4) 12/31/20X3 $7,000 Discount on Bonds Payable Bonds Payable 12/31/20X1 248 12/31/20X1 7,000 A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of or $6,752. (a) Prepare an amortization table for these bonds; use the straight-line method to amortize the discount. Then, prepare journal entries to record (b) the issuance of bonds on December 31, 20X1; (c) the first through fourth interest payments on each June 30 and December 31; and (d) the maturity of the bond on December 31, 20X3. 06/30/20X2 62 12/31/20X2 62 06/30/20X3 62 12/31/20X3 62 12/31/20X3 12/31/20X3 7,000 P1/P2 Atef Abuelaish

66 NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of or $6,752. Discount on Bonds Payable Bonds Payable 12/31/20X1 248 12/31/20X1 7,000 06/30/20X2 62 12/31/20X2 62 06/30/20X3 62 12/31/20X3 62 12/31/20X3 12/31/20X3 7,000 General Journal Debit Credit 12/31/20X1 Cash ($7,000 x .9646) 6,752 Discount on Bonds Payable 248 Bonds Payable 7,000 The amortization schedule chronicles the change in the carrying value from the issue price, $6,752, to the par value of $7,000. The carrying value of all bonds always moves towards the par value. The initial selling price was calculated by taking the par value, $7,000, and multiplying by 96.46%, Because this bond sold for less than par value, it is said to sell at a discount. The amount of the discount is the difference between the carrying value and the par value. The carrying value will increase by $248 over the next four semiannual periods, $62 per period. The initial unamortized discount is $248. As the amount of the unamortized discount decreases by $62 every six months, the carrying value will increase. Until, at the end of the two-year period, the unamortized discount is $0, and the carrying value has increased to the par value of $7,000. The carrying value of the bonds is always held in two accounts. The Bonds payable account always holds the par value, $7,000. The balance in Bonds payable remains unchanged during the two-year period. Discount on bonds payable is a contra liability account. Since its purpose is to reduce the value of a liability, it has a normal debit balance. Eliminating the balance in Discount on bonds payable is called "amortizing the bond.” We credit Discount on bonds payable by $62 every six months over the two-year period. The journal entry to record the issuance of the bonds on December 31, 20X1 is a debit to Cash for the par value, $7,000, multiplied by the selling price, 96.46%; $6,752. We debit Discount on bonds payable for $248, and credit Bonds payable for the par value, $7,000. P1/P2 Atef Abuelaish

67 NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of or $6,752. Discount on Bonds Payable Bonds Payable 12/31/20X1 248 12/31/20X1 7,000 06/30/20X2 62 12/31/20X2 62 06/30/20X3 62 12/31/20X3 62 12/31/20X3 12/31/20X3 7,000 General Journal Debit Credit 06/30/20X2 Bond Interest Expense ($280 + $62) 342 Discount on Bonds Payable 62 Cash ($7,000 x 8% / 2) 280 12/31/20X2 Bond Interest Expense ($280 + $62) 342 Discount on Bonds Payable 62 Cash ($7,000 x 8% / 2) 280 The journal entry to record the semiannual interest payment on June 30, 20X2 is a debit to Bond interest expense, a credit to Discount on bonds payable for $62, a credit to Cash for the semiannual interest payment; $7,000 multiplied by the contract rate of 8%, divided by two, as these are semiannual payments. The semiannual cash payment is $280. Bond interest expense is $280 plus $62, a total of $342. Whenever a bond sells at a discount, bond interest expense is greater than the amount of the cash payment. Because the company is using the straight-line method of amortizing the bond discount, each of the four semiannual interest payments has the exact same journal entry. 06/30/20X3 Bond Interest Expense ($280 + $62) 342 Discount on Bonds Payable 62 Cash ($7,000 x 8% / 2) 280 12/31/20X3 Bond Interest Expense ($280 + $62) 342 Discount on Bonds Payable 62 Cash ($7,000 x 8% / 2) 280 P1/P2 Atef Abuelaish

68 NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of or $6,752. Interest expense = Amount repaid minus amount borrowed 4 payments of $280 $1,120 1 payment of $7,000 7,000 Total repaid 8,120 Borrowed 6,752 Total bond interest expense $1,368 ÷ 4 = $342 General Journal Debit Credit 06/30/20X2 Bond Interest Expense ($280 + $62) 342 Discount on Bonds Payable 62 Cash ($7,000 x 8% / 2) 280 12/31/20X2 Bond Interest Expense ($280 + $62) 342 Discount on Bonds Payable 62 Cash ($7,000 x 8% / 2) 280 The simplest definition of interest expense is the difference between the amount borrowed and the amount repaid. In this case, the borrower is promising to make four payments of $280, a total of $1,120, followed by one payment of $7,000, the $7,000 par value. The total to be repaid is $8,120. When we subtract the amount borrowed, the issue price of $6,752, total bond interest expense over the life of the bond is $1,368. When we divide by the four semiannual payments, this agrees with the $342 we calculated as the semiannual bond interest expense. 06/30/20X3 Bond Interest Expense ($280 + $62) 342 Discount on Bonds Payable 62 Cash ($7,000 x 8% / 2) 280 12/31/20X3 Bond Interest Expense ($280 + $62) 342 Discount on Bonds Payable 62 Cash ($7,000 x 8% / 2) 280 P1/P2 Atef Abuelaish

69 NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of or $6,752. Discount on Bonds Payable Bonds Payable 12/31/20X1 248 12/31/20X1 7,000 06/30/20X2 62 12/31/20X2 62 06/30/20X3 62 12/31/20X3 62 12/31/20X3 12/31/20X3 7,000 General Journal Debit Credit 12/31/20X3 Bonds Payable 7,000 Cash 7,000 The final journal entry repays the par value; debit Bonds payable, $7,000, and credit Cash. P1/P2 Atef Abuelaish

70 Issuing Bonds at a Premium
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71 Issuing Bonds at a Premium
Adidas issues bonds with the following provisions: Par Value: $100,000 Issue Price: % of par value Stated Interest Rate: 12% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2015 Maturity Date: Dec. 31, 2017 (2 years) } Bond will sell at a premium. When the contract rate of bonds is higher than the market rate, the bonds sell at a price higher than par value. The amount by which the bond price exceeds par value is the premium on bonds. To illustrate, assume that Adidas issues bonds with a $100,000 par value, a 12% annual contract rate, semiannual interest payments, and a two-year life. Also assume that the market rate for Adidas bonds is 10% on the issue date. The Adidas bonds will sell at a premium because the contract rate is higher than the market rate. The issue price for these bonds is stated as (implying % of par value, or $103,546); we show how to compute this issue price later in the chapter. These bonds obligate the issuer to pay out two separate future cash flows: 1. Par value of $100,000 cash at the end of the bonds’ two-year life. 2. Cash interest payments of $6,000 ($100,000 x 12% x 1/2 year) at the end of each semiannual period during the bonds’ two-year life. P3 Atef Abuelaish

72 Issuing Bonds at a Premium
On Dec. 31, 2013, Adidas will record the bond issue as: Par value $ 100,000 Cash proceeds 103,546 * Premium $ ,546 *$100,000 x % When Adidas accepts $103,546 cash for its bonds on the issue date of December 31, 2015, it records this transaction as shown. Adjunct-Liability Account P3 Atef Abuelaish

73 Issuing Bonds at a Premium
Maturity Value Carrying Value These bonds are reported in the long-term liability section of the issuer’s December 31, 2015, balance sheet as shown in this slide. A premium is added to par value to yield the carrying (book) value of bonds. Premium on Bonds Payable is an adjunct liability account. P3 Atef Abuelaish

74 Amortizing a Bond Premium
Adidas will make the following entry every six months to record the cash interest payment and the amortization of the discount. The straight-line method allocates an equal portion of total bond interest expense to each of the bonds’ semiannual interest periods. To apply this method to Adidas bonds, we divide the two years’ total bond interest expense of $20,454 by four (the number of semiannual periods in the bonds’ life). This gives a total bond interest expense of $5,113 per period, which is $5, rounded down so that the journal entry balances and for simplicity in presentation (alternatively, one could carry cents). This entry shows how the issuer records bond interest expense and updates the balance of the bond liability account for each semiannual period (June 30, 2016, through December 31, 2017). $3,546 ÷ 4 periods = $887 (rounded) $100,000 × 12% × ½ = $6,000 P3 Atef Abuelaish

75 Amortizing a Bond Premium
This amortization table shows the pattern of decreases in the unamortized Premium on Bonds Payable account and in the bonds’ carrying value. The following points summarize straight-line amortization of the premium bonds: At issuance, the $100,000 par value plus the $3,546 premium equals the $103,546 cash received by the issuer. During the bonds’ life, the (unamortized) premium decreases each period by the $887 amortization ($3,546 / 4), and the carrying value decreases each period by the same $887. At maturity, the unamortized premium equals zero, and the carrying value equals the $100,000 par value that the issuer pays the holder. Review what you have learned in the following NEED-TO-KNOW Slides. P3 Atef Abuelaish

76 NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 6%, which implies a selling price of or $7,260. (a) Prepare an amortization table for these bonds; use the straight-line method to amortize the premium. Then, prepare journal entries to record (b) the issuance of bonds on December 31, 20X1; (c ) the first through fourth interest payments on each June 30 and December 31; and (d) the maturity of the bond on December 31, 20X3. Change in Carrying Value $260 / 4 semiannual periods = $65 per period Semiannual Period-End Unamortized Premium Carrying Value (0) 12/31/20X1 $260 $7,260 << $7,000 x = $7,260 (1) 06/30/20X2 195 7,195 (2) 12/31/20X2 130 7,130 (3) 06/30/20X3 65 7,065 (4) 12/31/20X3 $7,000 Bonds Payable Premium on Bonds Payable 12/31/20X1 7,000 12/31/20X1 260 A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 6%, which implies a selling price of or $7,260. (a) Prepare an amortization table for these bonds; use the straight-line method to amortize the premium. Then, prepare journal entries to record (b) the issuance of bonds on December 31, 20X1; (c) the first through fourth interest payments on each June 30 and December 31; and (d) the maturity of the bond on December 31, 20X3. 06/30/20X2 65 12/31/20X2 65 06/30/20X3 65 12/31/20X3 65 12/31/20X3 7,000 12/31/20X3 P3 Atef Abuelaish

77 NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 6%, which implies a selling price of or $7,260. Semiannual payment = $280 ($7,000 x 8% x ½) Bonds Payable Premium on Bonds Payable 12/31/20X1 7,000 12/31/20X1 260 06/30/20X2 65 12/31/20X2 65 06/30/20X3 65 12/31/20X3 65 12/31/20X3 7,000 12/31/20X3 General Journal Debit Credit 12/31/20X1 Cash ($7,000 x ) 7,260 Premium on Bonds Payable 260 Bonds Payable 7,000 Interest expense = Amount repaid minus amount borrowed 4 payments of $280 $1,120 1 payment of $7,000 7,000 An amortization table shows the change in the carrying value from the issue price, $7,260, to the par value of $7,000. The selling price of the bond is equal to the par value, $7,000, multiplied by %; $7,260. Whenever the stated rate of bonds is greater than the market rate, a bond sells at a premium. The carrying value will decrease by $65 per period; the initial unamortized premium of $260 divided by four semiannual periods. The amortization of the premium reduces the carrying value by the same amount. The carrying value drops by $65 every six months until, at the end of the two-year period the unamortized premium is $0, and the carrying value is equal to the par value. The carrying value of the bonds is held in two accounts. Bonds payable holds the par value for the entire two-year period. Premium on bonds payable has a normal credit balance. On the date of issuance, the unamortized premium is $260. By the end of the two-year period, the balance in Premium on bonds payable must be $0. We amortize the premium, reducing the balance in Premium on bonds payable, and therefore the carrying value of the bonds, by $65 every six months. The journal entry to record the issuance of the bonds on December 31, 20X1 is a debit to Cash, $7,000 multiplied by , $7,260. We credit Premium on bonds payable for $260, and Bonds payable for the par value, $7,000. Total interest expense equals the amount to be repaid on the bond minus the amount borrowed. This bond requires semiannual payments of $280; the $7,000 par value, multiplied by the stated rate of 8%, multiplied by ½, as the interest payments are made semiannually. Total repaid 8,120 Borrowed 7,260 Total bond interest expense $ 860 ÷ 4 = $215 per period P3 Atef Abuelaish

78 NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 6%, which implies a selling price of or $7,260. Semiannual payment = $280 ($7,000 x 8% x ½) Bonds Payable Premium on Bonds Payable 12/31/20X1 7,000 12/31/20X1 260 06/30/20X2 65 12/31/20X2 65 06/30/20X3 65 12/31/20X3 65 12/31/20X3 7,000 12/31/20X3 General Journal Debit Credit 06/30/20X2 Bond Interest Expense ($280 - $65) 215 Premium on Bonds Payable 65 Cash ($7,000 x 8% x ½) 280 12/31/20X2 Bond Interest Expense ($280 - $65) 215 Premium on Bonds Payable 65 Cash ($7,000 x 8% x ½) 280 There will be four payments of $280; $1,120 of interest payments, plus one payment of the par value. The total amount to be repaid over the life of the bond is $8,120. When we subtract the amount borrowed, the issue price of $7,260, total bond interest expense over the two-year period is $860. Using the straight-line method, bond interest expense is recorded evenly over the life of the bond. $860 divided by four semiannual periods is $215 per period. The journal entry to record the first semiannual interest payment is a debit to Bond interest expense, $215; debit Premium on bonds payable, $65, and credit Cash for the semiannual payment, $280. Alternatively, we can calculate bond interest expense by taking the semiannual payment, $280, and subtracting the amortization of the premium. $280 - $65 is $215. Since we're using the straight-line method, bond interest expense, and therefore the journal entry, remains constant for each of the four semiannual periods. 06/30/20X3 Bond Interest Expense ($280 - $65) 215 Premium on Bonds Payable 65 Cash ($7,000 x 8% x ½) 280 12/31/20X3 Bond Interest Expense ($280 - $65) 215 Premium on Bonds Payable 65 Cash ($7,000 x 8% x ½) 280 P3 Atef Abuelaish

79 NEED-TO-KNOW A company issues 8%, two-year bonds on December 31, 20X1, with a par value of $7,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 6%, which implies a selling price of or $7,260. Semiannual payment = $280 ($7,000 x 8% x ½) Bonds Payable Premium on Bonds Payable 12/31/20X1 7,000 12/31/20X1 260 06/30/20X2 65 12/31/20X2 65 06/30/20X3 65 12/31/20X3 65 12/31/20X3 7,000 12/31/20X3 General Journal Debit Credit 12/31/20X3 Bonds Payable 7,000 Cash 7,000 The journal entry to record the repayment of the par value is a debit to Bonds payable and a credit to Cash. P3 Atef Abuelaish

80 Bond Pricing Cash Outflows related to Interest Payments
To compute the price of a bond, we apply present value concepts. A bond’s market value (price) at issuance equals the present value of its future cash payments, where the interest (discount) rate used is the bond’s market rate. Cash Outflows for par value at end of Bond life P3 Atef Abuelaish

81 Present Value of a Discount Bond
Fila issues bonds with the following provisions: Par Value: $100,000 Issue Price: ? Stated Interest Rate: 8% Market Interest Rate: 10% Interest Dates: 6/30 and 12/31 Bond Date: Dec. 31, 2015 Maturity Date: Dec. 31, 2017 (2 years) The issue price of bonds is found by computing the present value of the bonds’ cash payments, discounted at the bonds’ market rate. When computing the present value of the Fila bonds, we work with semiannual compounding periods because this is the time between interest payments; the annual market rate of 10% is considered a semiannual rate of 5%. Also, the two-year bond life is viewed as four semiannual periods. The price computation is twofold: Find the present value of the $100,000 par value paid at maturity; and Find the present value of the series of four semiannual payments of $4,000 each. P3 Atef Abuelaish

82 Present Value of a Discount Bond
To calculate Present Value, we need relevant interest rate and number of periods. Semiannual rate = 5% (Market rate 10% ÷ 2) Semiannual periods = 4 (Bond life 2 years × 2) These present values can be found by using present value tables. Appendix B at the end of this book shows present value tables and describes their use. Table B.1 at the end of Appendix B is used for the single $100,000 maturity payment, and Table B.3 in Appendix B is used for the $4,000 series of interest payments. Specifically, we go to Table B.1, row 4, and across to the 5% column to identify the present value factor of for the maturity payment. Next, we go to Table B.3, row 4, and across to the 5% column, where the present value factor is for the series of interest payments. We compute bond price by multiplying the cash flow payments by their corresponding present value factors and adding them together. Table B. 2 for “Present Value of 1” Table B. 4 for “Present Value of an Ordinary Annuity of 1” $100,000 × 8% × ½ = $4,000 P3 Atef Abuelaish

83 When we go to the Present Value of an Ordinary Annuity table, Table B
When we go to the Present Value of an Ordinary Annuity table, Table B.3, at the intersection of 5% and n = 4, the factor is C1/P5 Atef Abuelaish

84 Bond Retirement Atef Abuelaish

85 Bond Retirement Retirement of the Fila bonds at maturity for $100,000 cash. The carrying value of bonds at the end of their lives equals par value ($100,000). The retirement of these bonds at maturity, assuming interest is already paid and entered, is recorded as shown. Because any discount or premium will be fully amortized at maturity, the carrying value of the bonds will be equal to par value. P4 Atef Abuelaish

86 Bond Retirement Retirement of Bonds before Maturity
Carrying Value > Retirement Price = Gain Carrying Value < Retirement Price = Loss Assume that $100,000 of callable bonds will be retired on July 1, 2015, after the first interest payment. The bond carrying value is $104,500.The bonds have a call premium of $3,000. Issuers sometimes wish to retire some or all of their bonds prior to maturity. For instance, if interest rates decline greatly, an issuer may wish to replace high-interest-paying bonds with new low-interest bonds. Two common ways to retire bonds before maturity are to (1) exercise a call option or (2) purchase them on the open market. In the first instance, an issuer can reserve the right to retire bonds early by issuing callable bonds. The bond indenture can give the issuer an option to call the bonds before they mature by paying the par value plus a call premium to bondholders. In the second case, the issuer retires bonds by repurchasing them on the open market at their current price. Whether bonds are called or repurchased, the issuer is unlikely to pay a price that exactly equals their carrying value. When a difference exists between the bonds’ carrying value and the amount paid, the issuer records a gain or loss equal to the difference. To illustrate the accounting for retiring callable bonds, assume that a company issued callable bonds with a par value of $100,000. The call option requires the issuer to pay a call premium of $3,000 to bondholders in addition to the par value. Next, assume that after the June 30, 2015, interest payment, the bonds have a carrying value of $104,500. Then on July 1, 2015, the issuer calls these bonds and pays $103,000 to bondholders. The issuer recognizes a $1,500 gain from the difference between the bonds’ carrying value of $104,500 and the retirement price of $103,000. The issuer records this bond retirement as shown on this slide. P4 Atef Abuelaish

87 Conversion of Bonds to Stock
Bond Retirement Conversion of Bonds to Stock On January 1, $100,000 par value bonds of Converse, with a carrying value of $100,000, are converted to 15,000 shares of $2 par value common stock. Holders of convertible bonds have the right to convert their bonds to stock. When conversion occurs, the bonds’ carrying value is transferred to equity accounts and no gain or loss is recorded. To illustrate, assume that on January 1 the $100,000 par value bonds of Converse, with a carrying value of $100,000, are converted to 15,000 shares of $2 par value common stock. The entry to record this conversion is shown on this slide. P4 15,000 shares × $2 par value per share Atef Abuelaish

88 B. Installment Notes Atef Abuelaish

89 Long-Term Notes Payable
Cash Note Payable Company Lender When is the repayment of the principal and interest going to be made? Like bonds, notes are issued to obtain assets such as cash. Unlike bonds, notes are typically transacted with a single lender such as a bank. An issuer initially records a note at its selling price—that is, the note’s face value minus any discount or plus any premium. Over the note’s life, the amount of interest expense allocated to each period is computed by multiplying the market rate (at issuance of the note) by the beginning-of-period note balance. The note’s carrying (book) value at any time equals its face value minus any unamortized discount or plus any unamortized premium; carrying value is also computed as the present value of all remaining payments, discounted using the market rate at issuance. Note Date Note Maturity Date C1 Atef Abuelaish

90 Long-Term Notes Payable
Single Payment of Principal plus Interest Company Lender Single Payment of Principal plus Interest For some notes, the principal and interest are paid in a single payment at the end of the note term. Note Maturity Date Note Date C1 Atef Abuelaish

91 Long-Term Notes Payable
Regular Payments of Principal plus Interest Company Lender Regular Payments of Principal plus Interest Other notes require regular payments during the note term. In some cases, the regular payments consist of equal principal payments plus interest. In other cases, the regular payments consist of equal payments that include both principal payments and interest payments. Most car loans are like this latter example. The payment is the same every month and consists of interest and some principal payment. Note Date Note Maturity Date C1 Atef Abuelaish

92 Installment Notes On January 1, 2015, Foghog borrows $60,000 from a bank to purchase equipment. It signs an 8% installment note requiring 6 annual payments of principal plus interest. Compute the periodic payment by dividing the face amount of the note by the present value factor. An installment note is an obligation requiring a series of payments to the lender. Installment notes are common for franchises and other businesses when lenders and borrowers agree to spread payments over several periods. To illustrate, assume that Foghog borrows $60,000 from a bank to purchase equipment. It signs an 8% installment note requiring six payments on an installment note normally include the accrued interest expense plus a portion of the amount borrowed (the principal). The equal total payments pattern consists of changing amounts of both interest and principal. To illustrate, assume that Foghog borrows $60,000 by signing a $60,000 note that requires six equal payments of $12,979 at the end of each year. (The present value of an annuity of six annual payments of $12,979, discounted at 8%, equals $60,000.) The $12,979 includes both interest and principal, the amounts of which change with each payment. C1 Atef Abuelaish

93 Installment Notes with Equal Payments
This slide shows the pattern of equal total payments and its two parts, interest and principal. Column A shows the note’s beginning balance. Column B shows accrued interest for each year at 8% of the beginning note balance. Column C shows the impact on the note’s principal, which equals the difference between the total payment in column D and the interest expense in column B. Column E shows the note’s year-end balance. Although the six cash payments are equal, accrued interest decreases each year because the principal balance of the note declines. As the amount of interest decreases each year, the portion of each payment applied to principal increases. C1 Atef Abuelaish

94 Installment Notes with Equal Payments
Let’s record the first payment made on December 31, 2015 by Foghog to the bank. Refer back to the amortization schedule to make the December 31, 2016 payment on the note. Foghog uses the amounts in the prior slide to record its first two payments (for years 2015 and 2016) as shown in this slide. Foghog records similar entries but with different amounts for each of the remaining four payments. After six years, the Notes Payable account balance is zero. C1 Atef Abuelaish

95 Mortgage Notes and Bonds
A mortgage is a legal agreement that helps protect the lender if the borrower fails to make the required payments. It gives the lender the right to be paid out of the cash proceeds from the sale of the borrower’s assets specifically identified in the mortgage contract. A mortgage is a legal agreement that helps protect a lender if a borrower fails to make required payments on notes or bonds. A mortgage gives the lender a right to be paid from the cash proceeds of the sale of a borrower’s assets identified in the mortgage. A legal document, called a mortgage contract, describes the mortgage terms. Mortgage notes carry a mortgage contract pledging title to specific assets as security for the note. Mortgage notes are especially popular in the purchase of homes and the acquisition of plant assets. Less common mortgage bonds are backed by the issuer’s assets. Accounting for mortgage notes and bonds is similar to that for unsecured notes and bonds, except that the mortgage agreement must be disclosed. Review what you have learned in the following NEED-TO-KNOW Slides. C1 Atef Abuelaish

96 NEED-TO-KNOW PV of $1 FV of $1 PV Ord Ann FV Ord Ann C1/P5
On January 1, 20X1, a company borrows $1,000 cash by signing a four-year, 5% installment note. The note requires four equal total payments of accrued interest and principal on December 31 of each year from 20X1 through 20X4. 1. Compute the amount of each of the four equal total payments. $1,000 = Present Value of an Ordinary Annuity $1,000 = PVA (n=4, i=5%) x Payment PV of $1 $1,000 = Payment PVA (n=4, i=5%) FV of $1 PV Ord Ann FV Ord Ann On January 1, 20X1, a company borrows $1,000 cash by signing a four-year, 5% installment note. The note requires four equal total payments of accrued interest and principal on December 31 of each year from 20X1 through 20X4. Compute the amount of each of the four equal total payments. The loan is to be repaid with a series of equal payments spread out evenly over time; this is an ordinary annuity. The $1,000 is the present value of the ordinary annuity. The $1,000 is equal to the present value of an ordinary annuity factor for n = 4, and an interest rate of 5%, multiplied by the amount of the payment. To solve for the amount of the payment, we take the $1,000 and divide by the present value of an annuity factor. C1/P5 Atef Abuelaish

97 When we go to the Present Value of an Ordinary Annuity table, Table B
When we go to the Present Value of an Ordinary Annuity table, Table B.3, at the intersection of 5% and n = 4, the factor is C1/P5 Atef Abuelaish

98 NEED-TO-KNOW PV of $1 FV of $1 PV Ord Ann FV Ord Ann C1/P5
On January 1, 20X1, a company borrows $1,000 cash by signing a four-year, 5% installment note. The note requires four equal total payments of accrued interest and principal on December 31 of each year from 20X1 through 20X4. 1. Compute the amount of each of the four equal total payments. $1,000 = Present Value of an Ordinary Annuity $1,000 = PVA (n=4, i=5%) x Payment PV of $1 $1,000 = Payment PVA (n=4, i=5%) FV of $1 $1,000 = Payment 3.5460 PV Ord Ann $282 = Payment FV Ord Ann Four payments spread out evenly over time, at an interest rate of 5%, is the equivalent of payments received in advance. $1,000 divided by is an annual payment of $282. C1/P5 Atef Abuelaish

99 NEED-TO-KNOW On January 1, 20X1, a company borrows $1,000 cash by signing a four-year, 5% installment note. The note requires four equal total payments of accrued interest and principal on December 31 of each year from 20X1 through 20X4. 1. Compute the amount of each of the four equal total payments. $282 2. Prepare an amortization table for this installment note. (A) (B) (C) (D) (E) Beginning Debit Debit Credit Ending Balance Interest Notes Cash Balance Expense Payable [(A) - (C)] Period End [5% x (A)] [(D) - (B)] 12/31/20X1 $1,000 $50 $232 $282 $768 12/31/20X2 768 38 244 282 524 12/31/20X3 524 26 256 282 268 12/31/20X4 268 14 268 282 $128 $1,000 $1,128 2. Prepare an amortization table for this installment note. An amortization table shows the change in the carrying value of the note; how much of each payment is principal, and how much is interest. We know that on December 31 of each year, we'll make a $282 payment. Interest expense in 20X1 is equal to 5% multiplied by $1,000, $50. Since the total payment is $282, $50 of which is interest expense, the remaining $232 is a reduction in principal. The principal balance after the first payment is $768; $1,000 minus $232. In 20X2, the beginning balance of $768 multiplied by 5% is interest expense in 20X2 of $38. The total payment is $282; $38 is interest, and the remaining $244 is principal. The balance on the installment note at the end of 20X2 is $524; $768 minus $244. In 20X3, $524 multiplied by 5% is $26 of interest. $282 minus $26 is $256. The ending balance on the note at the end of 20X3 is $268; $524 minus $256. At the end of 20X4, the note balance must be $0. The total principal payment in 20X4 must be $268. $282 minus $268 is $14. The final amount of interest expense includes the cumulative amount of rounding from the earlier transactions. The total reduction in principal is $1,000; total cash payments, $1,128, which proves that total interest expense is $128. 3. Prepare journal entries to record the loan on January 1, 20X1, and the four payments from December 31, 20X1, through December 31, 20X4. C1/P5 Atef Abuelaish

100 NEED-TO-KNOW C1/P5 (A) (B) (C) (D) (E) Beginning Debit Debit Credit
Ending Balance Interest Notes Cash Balance Expense Payable [(A) - (C)] Period End [5% x (A)] [(D) - (B)] 12/31/20X1 $1,000 $50 $232 $282 $768 12/31/20X2 768 38 244 282 524 12/31/20X3 524 26 256 282 268 12/31/20X4 268 14* 268 282 General Journal Debit Credit 01/01/20X1 Cash 1,000 Notes payable 1,000 12/31/20X1 Interest expense ($1,000 x .05) 50 Notes payable 232 Cash 282 12/31/20X2 Interest expense ($768 x .05) 38 Notes payable 244 Cash 282 3. Prepare journal entries to record the loan on January 1, 20X1, and the four payments from December 31, 20X1, through December 31, 20X4. To record the borrowing, debit Cash, $1,000, and credit Notes payable. On December 31, 20X1: Debit Interest expense, $50; debit Notes payable, $232; and credit Cash for $282. At the end of 20X2, the principal balance is lower, as is the amount of interest expense; 5% of $768 is $38. Debit Notes payable, $244, and credit Cash. In 20X3, debit Interest expense, $26; debit Notes payable, $256; and credit Cash, $282. And, in 20X4, debit Interest expense for the amount to balance, $14; debit Notes payable, $268; and credit Cash, $282. 12/31/20X3 Interest expense ($524 x .05) 26 Notes payable 256 Cash 282 12/31/20X4 Interest expense (* Rounded) 14 Notes payable 268 Cash 282 C1/P5 Atef Abuelaish

101 Accounting for Bonds and Notes Accounting for Leases and Pensions
Global View Accounting for Bonds and Notes The definitions and characteristics of bonds and notes are broadly similar for both U.S. GAAP and IFRS. The accounting for issuances of bonds, market pricing, and retirement of both bonds and notes is similar. Both U.S. GAAP and IFRS also allow companies to account for bonds and notes using fair value. Accounting for Leases and Pensions Both U.S. GAAP and IFRS require companies to distinguish between operating leases and capital leases; with IFRS calling the latter finance leases. The accounting and reporting for leases are broadly similar, with the main difference that the criteria for identifying a lease as a capital or finance lease is more general under IFRS. For pensions, the methods of accounting and reporting are similar for both U.S. GAAP and IFRS. Accounting for Bonds and Notes The definitions and characteristics of bonds and notes are broadly similar for both U.S. GAAP and IFRS. Although slight differences exist, accounting for bonds and notes under U.S. GAAP and IFRS is similar. Specifically, the accounting for issuances (including recording discounts and premiums), market pricing, and retirement of both bonds and notes follows the procedures in this chapter. Nokia describes its accounting for bonds, which follows the amortized cost approach explained in this chapter (and in Appendix 10B), as follows: Loans payable [bonds] are recognized initially at fair value, net of transaction costs incurred. In the subsequent periods, loans payable are measured at amortized cost using the effective interest method. Both U.S. GAAP and IFRS allow companies to account for bonds and notes using fair value (different from the amortized value described in this chapter). This method is referred to as the fair value option. This method is similar to that applied in measuring and accounting for debt and equity securities. Fair value is the amount a company would receive if it settled a liability (or sold an asset) in an orderly transaction as of the balance sheet date. Companies can use several sources of inputs to determine fair value, and those inputs fall into the following three classes (ranked in order of preference). The procedures for marking liabilities to fair value at each balance sheet date are in advanced courses. Level 1: Observable quoted market prices in active markets for identical items. Level 2: Observable inputs other than those in Level 1 such as prices from inactive markets or from similar, but not identical, items. Level 3: Unobservable inputs reflecting a company’s assumptions about value. Accounting for Leases and Pensions Both U.S. GAAP and IFRS require companies to distinguish between operating leases and capital leases; the latter is referred to as finance leases under IFRS. The accounting and reporting for leases are broadly similar for both U.S. GAAP and IFRS. The main difference is the criteria for identifying a lease as a capital lease are more general under IFRS. However, the basic approach applies. For pensions, both U.S. GAAP and IFRS require companies to record costs of retirement benefits as employees work and earn them. The basic methods are similar in accounting and reporting for pensions. Atef Abuelaish

102 Features of Bonds and Notes
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103 Features of Bonds and Notes
Secured and Unsecured Convertible and Callable Secured or Unsecured Secured bonds (and notes) have specific assets of the issuer pledged (or mortgaged) as collateral. This arrangement gives holders added protection against the issuer’s default. If the issuer fails to pay interest or par value, the secured holders can demand that the collateral be sold and the proceeds used to pay the obligation. Unsecured bonds (and notes), also called debentures, are backed by the issuer’s general credit standing. Unsecured debt is riskier than secured debt. Subordinated debentures are liabilities that are not repaid until the claims of the more senior, unsecured (and secured) liabilities are settled. Term or Serial Term bonds (and notes) are scheduled for maturity on one specified date. Serial bonds (and notes) mature at more than one date (often in series) and thus are usually repaid over a number of periods. For instance, $100,000 of serial bonds might mature at the rate of $10,000 each year from six to 15 years after they are issued. Many bonds are sinking fund bonds, which to reduce the holder’s risk require the issuer to create a sinking fund of assets set aside at specified amounts and dates to repay the bonds. Registered or Bearer Bonds issued in the names and addresses of their holders are registered bonds. The issuer makes bond payments by sending checks (or cash transfers) to registered holders. A registered holder must notify the issuer of any ownership change. Registered bonds offer the issuer the practical advantage of not having to actually issue bond certificates. Bonds payable to whoever holds them (the bearer) are called bearer bonds or unregistered bonds. Sales or exchanges might not be recorded, so the holder of a bearer bond is presumed to be its rightful owner. As a result, lost bearer bonds are difficult to replace. Many bearer bonds are also coupon bonds. This term reflects interest coupons that are attached to the bonds. When each coupon matures, the holder presents it to a bank or broker for collection. At maturity, the holder follows the same process and presents the bond certificate for collection. Issuers of coupon bonds cannot deduct the related interest expense for taxable income. This is to prevent abuse by taxpayers who own coupon bonds but fail to report interest income on their tax returns. Convertible and/or Callable Convertible bonds (and notes) can be exchanged for a fixed number of shares of the issuing corporation’s common stock. Convertible debt offers holders the potential to participate in future increases in stock price. Holders still receive periodic interest while the debt is held and the par value if they hold the debt to maturity. In most cases, the holders decide whether and when to convert debt to stock. Callable bonds (and notes) have an option exercisable by the issuer to retire them at a stated dollar amount before maturity. Term and Serial Registered and Bearer A2 Atef Abuelaish

104 Debt-to-Equity Ratio Atef Abuelaish

105 13) Debt-to-Equity Ratio
Total liabilities Total equity = This ratio helps investors determine the risk of investing in a company by dividing its total liabilities by total equity. Beyond assessing different characteristics of debt as just described, we want to know the level of debt, especially in relation to total equity. Such knowledge helps us assess the risk of a company’s financing structure. A company financed mainly with debt is more risky because liabilities must be repaid—usually with periodic interest—whereas equity financing does not. A measure to assess the risk of a company’s financing structure is the debt-to-equity ratio. The debt-to-equity ratio varies across companies and industries. To apply the debt-to-equity ratio, let’s look at this measure for Amazon.com in this slide. Amazon’s 2013 debt-to-equity ratio is 3.1, meaning that debtholders contributed $3.10 for each $1 contributed by equity holders. This implies a riskier than usual financing structure for Amazon. A similar concern is drawn from a comparison of Amazon with its competitors, where the 2013 industry ratio is 1.6. Analysis across the years shows that Amazon’s financing structure has risen to a riskier level in recent years. Given its growth in revenues and innovative past, investors have been patient in waiting for income. However, debtholders will grow increasingly concerned if income doesn’t rise in the near future. A3 Atef Abuelaish

106 Present Values of Bonds and Notes
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107 Appendix 10A: Present Values of Bonds and Notes
Face amount = $100,000 Contract rate = 8% Market rate = 10% Interest paid semiannually First, we calculate the present value of the principal repayment in 4 periods (2 years × 2 payments per year, using 5% market rate (10% annual rate ÷ 2 payments per year). Present Value of $1 Rate Periods 3% 4% 5% 1 0.9709 0.9615 0.9524 2 0.9426 0.9246 0.9070 3 0.9151 0.8890 0.8638 4 0.8885 0.8548 0.8227 5 0.8626 0.8219 0.7835 6 0.8375 0.7903 0.7462 7 0.8131 0.7599 0.7107 8 0.7894 0.7307 0.6768 9 0.7664 0.7026 0.6446 10 0.7441 0.6756 0.6139 $100,000 × = $82,270 Let’s calculate the present value of a debt instrument that has a face amount of $100,000, contract rate of 8%, market rate of 10% with interest paid semiannually. The debt matures in two years. First, we calculate the present value of the principal repayment in four periods (2 years x 2 payments per year), using 5% market rate (10% annual rate ÷ 2 payments per year). The present value factor for four periods at 5% is , so the present value of the principal amount is $82,270. C2 Atef Abuelaish

108 Appendix 10A: Present Values of Bonds and Notes
Semiannual Interest Annuity Present Value of Annuity of $1 Rate Periods 3% 4% 5% 1 0.9709 0.9615 0.9524 2 1.9135 1.8861 1.8594 3 2.8286 2.7751 2.7232 4 3.7171 3.6299 3.5460 5 4.5797 4.4518 4.3295 6 5.4172 5.2421 5.0757 7 6.2303 6.0021 5.7864 8 7.0197 6.7327 6.4632 9 7.7861 7.4353 7.1078 10 8.5302 8.1109 7.7217 $100,000 × 8% × ½ = $4,000 $4,000 × = $14,184 The interest annuity is calculated by multiplying the face amount of $100,000 times the contract rate of 8% for one-half year, or $4,000. Now we can calculate the present value of the interest annuity using four-periods and 5% interest rate. The present value factor for an annuity for four-periods at 5% interest is , so the present value of the interest annuity is $14,184. The issue price of the debt is the sum of the present value of the interest annuity and the present value of the principal, $96,454. Present Amount PV Factor Value Principal $ 100,000 0.8227 $ 82,270 Interest 4,000 3.5460 14,184 Issue price of debt $ 96,454 C2 Atef Abuelaish

109 Effective Interest Amortization of a Discount Bond
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110 Appendix 10B: Effective Interest Amortization
Effective Interest Amortization of Bond Discount Stated Rate: 8% Effective Rate: 10% The effective interest method, or simply interest method, allocates total bond interest expense over the bonds’ life in a way that yields a constant rate of interest. This constant rate of interest is the market rate at the issue date. Thus, bond interest expense for a period equals the carrying value of the bond at the beginning of that period multiplied by the market rate when issued. This slide shows an effective interest amortization table for the Fila bonds example earlier in the slides. The key difference between the effective interest and straight-line methods lies in computing bond interest expense. Instead of assigning an equal amount of bond interest expense to each period, the effective interest method assigns a bond interest expense amount that increases over the life of a discount bond. Both methods allocate the same $19,546 of total bond interest expense to the bonds’ life, but in different patterns. Specifically, the amortization table in this slide shows that the balance of the discount (column D) is amortized until it reaches zero. Also, the bonds’ carrying value (column E) changes each period until it equals par value at maturity. P5 Atef Abuelaish

111 Effective Interest Amortization of a Premium Bond
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112 Appendix 10B: Effective Interest Amortization
Effective Interest Amortization of Bond Premium Stated Rate: 12% Effective Rate: 10% This slide shows the amortization table using the effective interest method for the Adidas bonds example earlier in the slides. Column A lists the semiannual cash payments. Column B shows the amount of bond interest expense, computed as the 5% semiannual market rate at issuance multiplied by the beginning-of-period carrying value. The amount of cash paid in column A is larger than the bond interest expense because the cash payment is based on the higher 6% semiannual contract rate. The excess cash payment over the interest expense reduces the principal. These amounts are shown in column C. Column E shows the carrying value after deducting the amortized premium in column C from the prior period’s carrying value. Column D shows the premium’s reduction by periodic amortization. P6 Atef Abuelaish

113 Issuing Bonds between Interest Dates
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114 Appendix 10C: Issuing Bonds Between Interest Dates
Avia sells $100,000 of its 9% bonds at par on March 1, 2015, 60 days after the stated issue date. The interest on Avia bonds is payable semiannual on each June 30 and December 31. Stated Issue date 1/1 First Interest date 6/30 Date of sale 3/1 $1,500 accrued $3,000 earned Bondholder pays $1,500 to issuer Issuer pays $4,500 to bondholder An issuer can sell bonds at a date other than an interest payment date. When this occurs, the buyers normally pay the issuer the purchase price plus any interest accrued since the prior interest payment date. This accrued interest is then repaid to these buyers on the next interest payment date. To illustrate, suppose Avia sells $100,000 of its 9% bonds at par on March 1, 2015, 60 days after the stated issue date. The interest on Avia bonds is payable semiannually on each June 30 and December 31. Since 60 days have passed, the issuer collects accrued interest from the buyers at the time of issuance. This amount is $1,500 ($100,000 x 9% x 60⁄360 year). This accrual is represented in the graphic in the middle of this slide. Avia records the issuance of these bonds on March 1, 2015, as shown. Liabilities for interest payable and bonds payable are recorded in separate accounts. When the June 30, 2015, semiannual interest date arrives, Avia pays the full semiannual interest of $4,500 ($100,000 x 9% x 1⁄2 year) to the bondholders. This payment includes the four months’ interest of $3,000 earned by the bondholders from March 1 to June 30 plus the repayment of the 60 days’ accrued interest collected by Avia when the bonds were sold. Avia records this first semiannual interest payment as shown. C3 Atef Abuelaish

115 Leases and Pensions Atef Abuelaish

116 Appendix 10D: Leases and Pensions
A lease is a contractual agreement between the lessor (asset owner) and the lessee (asset renter or tenant) that grants the lessee the right to use the asset for a period of time in return for cash (rent) payments. Operating Leases Operating leases are short-term (or cancelable) leases in which the lessor retains the risks and rewards of ownership. Examples include most car and apartment rental agreements. Capital Leases Capital leases are long-term (or non-cancelable) leases by which the lessor transfers substantially all risks and rewards of ownership to the lessee. Examples include leases of airplanes and department store buildings. A lease is a contractual agreement between a lessor (asset owner) and a lessee (asset renter or tenant) that grants the lessee the right to use the asset for a period of time in return for cash (rent) payments. Nearly one-fourth of all equipment purchases are financed with leases. The advantages of lease financing include the lack of an immediate large cash payment and the potential to deduct rental payments in computing taxable income. From an accounting perspective, leases can be classified as either operating or capital leases. Operating leases are short-term (or cancelable) leases in which the lessor retains the risks and rewards of ownership. Examples include most car and apartment rental agreements. The lessee records such lease payments as expenses; the lessor records them as revenue. The lessee does not report the leased item as an asset or a liability (it is the lessor’s asset). Capital leases are long-term (or noncancelable) leases by which the lessor transfers substantially all risks and rewards of ownership to the lessee. Examples include most leases of airplanes and department store buildings. The lessee records the leased item as its own asset along with a lease liability at the start of the lease term; the amount recorded equals the present value of all lease payments. C4 Atef Abuelaish

117 Appendix 10D: Leases and Pensions
A pension is a contractual agreement between an employer and its employees for the employer to provide benefits (payments) to employees after they retire. Defined Benefit Plans The employer’s contributions vary, depending on assumptions about future pension assets and liabilities. A pension liability is reported when the accumulated benefit obligation is more than the plan assets, a so-called underfunded plan. A pension plan is a contractual agreement between an employer and its employees for the employer to provide benefits (payments) to employees after they retire. Most employers pay the full cost of the pension, but sometimes employees pay part of the cost. An employer records its payment into a pension plan with a debit to Pension Expense and a credit to Cash. Many pensions are known as defined benefit plans that define future benefits; the employer’s contributions vary, depending on assumptions about future pension assets and liabilities. C4 Atef Abuelaish

118 Happiness is having all homework up to date
Homework assignment Using Connect – 5 Questions for 60 Points For Chapter 10. Prepare for EXAM # 3 for Chapters 7, 8, and 9 on 11/14. Please Log-in HCC website and complete EGLS3 Survey, available from 11/5 till 11/20, for this semester, for 10 Points; with proof !!!!! Prepare chapters 11 “Corporate Reporting and Analysis.” Happiness is having all homework up to date Atef Abuelaish

119 Thank you, and see you, Next Week at the Same Time
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