©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 1 Learning Objective 1 addresses accounting for current and contingent liabilities. Account for current liabilities and contingent liabilities ©2008 Pearson Prentice Hall. All rights reserved.

Categories of Current Liabilities
Known amounts Unknown amounts Current liabilities are obligations due with one year of balance sheet date Current liabilities are obligations due with one year of balance sheet date. They are placed into two categories: those with a known amount and those where the amount is unknown. ©2008 Pearson Prentice Hall. All rights reserved.

Current Liabilities of Known Amount
Accounts Payable Amounts owed for products and services purchased on account Short-Term Notes Payable Common form of financing; company incurs interest expense Accrued Liabilities Expense incurred, but not yet paid; often an adjusting entry includes salaries & interest payable Sales Tax Payable Tax levied by state on retail sales; company collects from customer and remits to gov’t Amounts owed for products or services purchased on account are accounts payable. Short-term notes payable, a common form of financing, are notes payable due within 1 year. The company will pay interest on a note payable. Sales taxes are levied in many states on retail sales. The retailer collects the sales tax from the customer and then remits it to the government agency. Accrued liabilities are expenses that have been incurred, but not yet paid. They are often recorded through the adjusting process. Some common accrued liabilities are salaries payable, interest payable and taxes payable. Any company that has employees will have payroll liabilities. Compensation to employees are recorded at the end of each pay period. In addition, the company withholds income and FICA (Social Security) taxes form the employees’ pay. Unearned revenues occur when the customer pays before receiving a good or service. The company owes the customer the product or service. Payroll Liabilities Salaries & wages paid to employees; also includes income taxes and FICA taxes withheld Unearned revenues Customers makes payment before receiving product or service ©2008 Pearson Prentice Hall. All rights reserved.

Entries for Short-Term Notes Payable
Suppose a company purchases inventory by signing a $10,000, 12% 90-day note payable on December 1 Date Accounts Debit Credit 1-Dec Inventory $10,000 Notes Payable, Short-Term Purchased inventory by issuing a $10,000, 12%, 90-day note payable 31-Dec Interest Expense $100 Interest Payable Accrual of interest at year-end (10,000 x 12% x 30/360) Entries for short-term notes payable transactions can be illustrated by an example. Suppose a company purchases inventory by signing a $10,000, 12%, 90-day note payable. On the date of the purchase, inventory would be debited and short-term notes payable would be credited for the $10,000. Assuming a December 31 year end, an adjusting entry would be needed to accrue the interest expense on the note. The interest formula multiplies the principal of the note ($10,000) by the interest rate of 12% by the days the note has been outstanding. December 1 to December 31 is 30 days. Interest rates are expressed annually. So the fraction used is 30 over Interest expense is recorded as is interest payable. ©2008 Pearson Prentice Hall. All rights reserved.

Entries for Short-Term Notes Payable
The maturity date of the note would be March 1 of the following year 1-Mar Notes Payable, Short-Term $10,000 Interest Payable ________ Interest Expense $200 Cash $10,300 Payment of the note and interest at maturity What amount would “zero it out” ? The maturity date would fall on March 1 of the following year. On this date, the company would be the $10,000 plus the interest for the 90 days. Notes payable is debited for the $10,000 and interest payable is debited for the $100. This will “zero out” the amount from the December 31 accrual. Interest expense is recognized for the remaining 60 days the note was outstanding (Jan 1 – March 1). Cash is credited for the full maturity value. ©2008 Pearson Prentice Hall. All rights reserved.

Recording Payroll Each pay period salary expense and withholdings are recorded Salary Expense $$$$ Employee Income Tax Payable FICA Tax Payable Salary Payable Gross Pay Each pay period, an entry is made to record payroll. Salary expense is debited for the gross pay of the employees. This is the amount they earned before any deductions. Employee income tax payable is credited for any federal and state income taxes withheld from wages. At regular intervals, the company deposits these tax withholdings at a financial institution, which in turn, remits the taxes to the appropriate government body. FICA Taxes work in a similar manner. FICA refers to Social Security and Medicare taxes. Salaries Payable is credited for net pay – the gross pay less the withholdings. This is also called “take-home” pay. Net Pay ©2008 Pearson Prentice Hall. All rights reserved.

Current Portion of Long-Term Debt
Some long-term debt is paid in installments Any amount due in the upcoming year is reclassified as a current liability Long-term debt are liabilities that have due dates more than one year from balance sheet date. Some long-term debt is due in installments. Any portion that is due in the upcoming year must be reclassified as a current liability. That means the amount is transferred from the long-term liability section to the current liability section. ©2008 Pearson Prentice Hall. All rights reserved.

Current Liabilities That Are Estimated (Amounts Unknown)
Estimated Warranty Payable Contingent Liabilities The second category of current liabilities are those with amounts unknown, which must be estimated. These include estimated warranty liability and contingent liabilities. ©2008 Pearson Prentice Hall. All rights reserved.

Estimated Warranty Payable
Companies guarantee products through warranty agreements Warranty expense is estimated in same period as sale of product Matching principle JOURNAL Date Accounts Debit Credit Warranty Expense $$$$ Estimated Warranty Payable When customers purchase products. often they are covered by a warranty. This creates a liability for the company. Instead of waiting until products are brought in for warranty work, the liability is estimated in the year of the sale. This provides proper matching of the expense to the revenue. The entry to estimate the warranty liability is above. When products are brought in for warranty work, the liability is reduced. ©2008 Pearson Prentice Hall. All rights reserved.

Contingent Liabilities
Potential liability that depends on a future event arising out of past events Likelihood of future event is assessed as: Probable Reasonably possible Unlikely A contingent liability is not an actual liability. Instead, it’s a potential liability that depends on a future event arising out of past events. Management must assess the likelihood of the future event occurring and categorize it as: probable, reasonably possible or unlikely. ©2008 Pearson Prentice Hall. All rights reserved.

Accounting for Contingent Liabilities
Likelihood Accounting Probable Record liability if amount can be estimated Reasonably Possible Include in notes to financial statements Unlikely Do not report The Financial Accounting Standards Board (FASB) provides these guidelines to account for contingent liabilities: 1. Record an actual liability if it’s probable that the loss (or expense) will occur and the amount can be reasonably estimated. Warranty expense is an example. 2. Report the contingency in a financial statement note if it’s reasonably possible that a loss (or expense) will occur. Lawsuits in progress are a prime example. 3. There is no need to report a contingent loss that is unlikely to occur. Instead, wait until an actual transaction clears up the situation. ©2008 Pearson Prentice Hall. All rights reserved.

Long-Term Liabilities: Bonds
To raise capital, companies sell bonds to the public Bonds payable are groups of notes payable issued to multiple lenders, called bondholders Large companies cannot borrow billions from a single lender. So how do large corporations borrow huge amounts? They issue (sell) bonds to the public. Bonds payable are groups of notes payable issued to multiple lenders, called bondholders. A company that needs large amounts of capital borrow large amounts by issuing bonds to thousands of individual investors, who each lend the company a modest amount. The company receives the cash it needs, and each investor limits risk by diversifying investments—not putting all the “eggs in one basket.” Each bond payable is, in effect, a note payable. Bonds payable are debts of the issuing company ©2008 Pearson Prentice Hall. All rights reserved.

Bond Terms Principal Maturity Date Interest Underwriter
Amount borrowed; usually in $1000 units Also called face value, or par value Date bond is due; 5, 10 or 20 year terms are common Maturity Date Company must pay bondholders interest in regular intervals over the term of the bond Interest Purchasers of bonds receive a bond certificate, which carries the issuing company’s name. The certificate also states the principal, which is typically stated in units of $1,000; principal is also called the bond face value, maturity value, or par value. The bond obligates the issuing company to pay the debt at a specific future time called the maturity date. Interest is the rental fee on borrowed money. The bond certificate states the interest rate that the issuer will pay the holder and the dates that the interest payments are due (generally twice a year). Issuing bonds usually requires the services of a securities firm, such as Merrill Lynch, to act as the underwriter of the bond issue. The underwriter purchases the bonds from the issuing company and resells them to its clients, or it may sell the bonds to its clients and earn a commission on the sale. A securities firm that purchases the bond issue and resells to clients Underwriter ©2008 Pearson Prentice Hall. All rights reserved.

Types of Bonds Term bonds All bonds in an issue mature at one specific date Serial bonds Bonds in the issue mature installments Secured (mortgage) bonds Bondholders have right to company assets if interest and principal is not paid Unsecured (debenture) bonds Backed only by the good faith of the issuing company All the bonds in a particular issue may mature at a specified time (term bonds) or in installments over a period of time (serial bonds). Serial bonds are like installment notes payable. Some of Southwest Airlines long-term debts are serial in nature because they are payable in installments. Secured, or mortgage, bonds give the bondholder the right to take specified assets of the issuer if the company defaults—that is, fails to pay interest or principal. Unsecured bonds, called debentures, are backed only by the good faith of the borrower. Debentures carry a higher rate of interest than secured bonds because debentures are riskier investments. ©2008 Pearson Prentice Hall. All rights reserved.

Bond Premium and Discount
Issue price above face value Market rate of interest is greater than stated rate of interest Discount Issue price below face value Market rate of interest is less than stated rate of interest A bond issued at a price above its face (par) value is said to be issued at a premium. Premium on Bonds Payable has a credit balance and discount on Bonds Payable carries a debit balance. Bond Discount is, therefore, a contra liability account and a bond issued at a price below face (par) value has a discount. Bonds are always sold at their market price, which is the amount investors will pay for the bond. Two interest rates work to set the price of a bond. ■ The stated interest rate, also called the coupon rate, is the interest rate printed on the bond certificate. The stated interest rate determines the amount of cash interest the borrower pays—and the investor receives—each year. ■ The market interest rate, or effective interest rate, is the rate that investors demand for loaning their money. The market rate varies by the minute. A company may issue bonds with a stated interest rate that differs from the prevailing market interest rate. In fact, the 2 interest rates often differ. Market interest rate = rate investors demand for loaning money; changes frequently Stated interest rate = printed on the bond certificate; determines amount of cash interest; remains constant ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 2 Account for bonds payable
Now that bond terminology has been explained, Learning Objective 2 addresses how to account for bonds payable. ©2008 Pearson Prentice Hall. All rights reserved.

Issuing Bonds Payable at Face Value
Suppose a company issues $100,000 of 8% bonds payable that mature in ten years; the bonds pay interest semi-annually Date Accounts Debit Credit 1-Jan Cash $100,000 Bond payable Issued $100,000, 8%, 10-year bonds at face value 1-Jul Interest Expense _________ ______________ Paid semi-annual interest on bonds The most straightforward situation occurs when a company issues bonds at face value. Suppose a company issues $100,000 of 8% bonds payable that mature in ten years. Like most bonds, interest is paid semi-annually. On the date of issue, cash is received and the bonds are issued. Every six months, an interest payment is made to bondholders. Interest expense is debited and cash is credited for $ The $4000 was computed by multiplying the face value of $100,000 by the 8% interest by ½ for half of a year. Face value x interest rate x 1/2 ©2008 Pearson Prentice Hall. All rights reserved.

Issuing Bonds at a Discount
If stated interest rate of bonds is less than market interest rate, bondholders will not pay face value for bond Market price of bond drops below face value Cash received from bond issue is less than face value If the stated rate of interest is less than the current market rate, investors will not pay full face value for the bond. The price of bond drops below face value. The cash the company receives will be less than face value. This is called a discount. ©2008 Pearson Prentice Hall. All rights reserved.

Issuing Bonds at a Discount
Suppose a company issues $100,000 of 9%, five-year bonds when the market interest rate is 10% The market price of the bonds is $96,149 Date Accounts Debit Credit 1-Jan Cash $96,149 Discount on Bonds Payable $3,851 Bonds payable $100,000 Issued $100,000, 9%, 10-year bonds at a discount Market conditions may force a company to issue bonds at a discount. Suppose a company issued $100,000 of 9%, 5-year bonds when the market interest rate is 10%. Since the bonds pay less interest than the market demands, the price of the bonds drops to $96,149. The difference between the face value and price is debited to the discount account. ©2008 Pearson Prentice Hall. All rights reserved.

Carrying Amount: Bonds Issued at a Discount
Bonds are shown at their carrying amount on the balance sheet Carrying amount = Face value Less Discount Balance Balance Sheet January 1 Long-Term Liabilities: Bonds Payable $100,000 Less: Discount ($3,851) $96,149 Bonds are shown at their carrying amount on the balance sheet. For bonds issued at a discount, the carrying amount is the face value minus the balance in the bond discount. For the company on the previous slide, the balance sheet presentation for the bond is above. Bonds Payable are in the long-term liability section. The bond is listed at face and discount is shown as a reduction. The carrying amount is the difference. At the issue date, the carrying amount is the same as the price. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 3 Measure interest expense 5-22
Learning Objective 3 shows how to measure interest expense associated with bonds payable. Measure interest expense 5-22 ©2009 Prentice Hall ©2008 Pearson Prentice Hall. All rights reserved. 22

Interest Expense on Bonds Issued at a Discount
The company must pay interest based on the face value even though it received less than face value Interest Expense > Cash Payment Interest Expense = Carrying Amount of Bond x Market Interest Rate Discount is amortized (reduced) over the bond term. Interest expense on a bond issued at a discount is greater than the cash interest payment. This is because the company pays interest based on the face value of the bonds ($100,000) but did not receive the full face value from the bondholders. To compute interest expense, the carrying amount of the bond is multiplied by the market rate of interest. Since most bonds pay interest semi-annually, the market rate is halved. The discount is also amortized, which means reduced. The amount of amortization is the difference between the interest expense and cash payment. Discount Amortization = Interest Expense - Cash Payment ©2008 Pearson Prentice Hall. All rights reserved.

Recording Interest on Bonds Issued at a Discount
Referring to the previous example, interest expense on July 1 would be recorded as follows: Interest expense is debited for the carrying amount x market rate x 1/2 Cash is credited for the face value x stated rate x 1/2 Discount is credited for the difference between the expense and payment Date Accounts Debit Credit 1-July Interest Expense (96,149 x 5%) $4,807 Discount on Bonds Payable $307 Cash ($100,000 x____) _________ To pay semiannual interest and amortize bond discount For the company we have been looking at, interest expense for the first payment would be recorded as follows: Interest expense is debited for the carrying amount multiplied by the market rate cut in half. The carrying amount at this date is the same as the price—$96,149. The market rate is 10%, half of which is 5%. Cash is credited for the face value times the stated rate cut in half. The face value is $100,000 and stated rate is 9%, half of which is 4.5% Discount is credited for the difference between the interest expense and cash payment. This will reduce the discount. Stated rate x 1/2 ©2008 Pearson Prentice Hall. All rights reserved.

Discount on Bonds Payable Issue Date, Jan. 1 1st Int. Pmt, July 1 $3,851 $307 Balance, July. 1 $3,544 Balance Sheet July 1 Long-Term Liabilities: Bonds Payable $100,000 Less: Discount ($3,544) $96,456 A T-account of the Discount shows the impact of the two entries. On the issue date, the account was increased by $3851–the difference between the price of the bond and the face value. With the first interest payment entry, the discount was amortized $307, resulting in a balance of $ The carrying amount of the bond is now $96,456. The face value has stayed the same (and will always), but the discount is now smaller. The result is a larger carrying amount. This process will continue with each interest payment. The discount will get smaller until it is zero at maturity. The carrying amount will grow larger until it reaches face value at maturity. ©2008 Pearson Prentice Hall. All rights reserved.

Issuing Bonds at a Premium
If stated interest rate of bonds is greater than market interest rate, bondholders will pay more than face value for bond Market price of bond increases above face value Cash received from bond issue is greater than face value If the stated rate of interest is greater than the current market rate, investors will pay full more than face value for the bond. The price of bond increases above face value. The cash the company receives will be greater than face value. This is called a premium. ©2008 Pearson Prentice Hall. All rights reserved.

Issuing Bonds at a Premium
Suppose a company issues $100,000 of 9%, five-year bonds when the market interest rate is 8% The market price of the bonds is $104,100 Date Accounts Debit Credit 1-Jan Cash $104,100 Premium on Bonds Payable _______ Bonds payable $100,000 Issued $100,000, 9%, 10-year bonds at a premium Market conditions may be such that the company can issue bonds at a premium. Suppose a company issued $100,000 of 9%, 5-year bonds when the market interest rate is 8%. Since the bonds pay more interest than the market demands, the price of the bonds increases to $104,100. The difference between the face value and price is credited to the premium account. Cash price – face value ©2008 Pearson Prentice Hall. All rights reserved.

Carrying Amount: Bonds Issued at a Premium
Bonds are shown at their carrying amount on the balance sheet Carrying amount = Face value Plus Premium Balance Balance Sheet January 1 Long-Term Liabilities: Bonds Payable $100,000 Plus: Premium $ 4,100 $104,100 Bonds are shown at their carrying amount on the balance sheet. For bonds issued at a premium, the carrying amount is the face value plus the balance in the bond premium. For the company on the previous slide, the balance sheet presentation for the bond is above. Bonds Payable are in the long-term liability section. The bond is listed at face and premium is shown as an addition. The carrying amount is the sum. At issue date, the carrying amount is the same as the price. ©2008 Pearson Prentice Hall. All rights reserved.

Interest Expense on Bonds Issued at a Premium
The company pays interest based on only the face value even though it received more than face value. Interest Expense < Cash Payment Interest Expense = Carrying Amount of Bond x Market Interest Rate Interest expense on a bond issued at a premium is less than the cash interest payment. This is because the company pays interest based on the face value of the bonds ($100,000) but received more the full face value from the bondholders. To compute interest expense, the carrying amount of the bond is multiplied by the market rate of interest. Since most bonds pay interest semi-annually, the market rate is halved. The premium is also amortized, which means reduced. The amount of amortization is the difference between the interest expense and cash payment. Premium is amortized (reduced) over the bond term. Premium Amortization = Cash Payment – Interest Expense ©2008 Pearson Prentice Hall. All rights reserved.

Recording Interest on Bonds Issued at a Premium
Referring to the previous example, interest expense on July 1 would be recorded as follows: Interest expense is debited for the carrying amount x market rate x 1/2 Cash is credited for the face value x stated rate x 1/2 Premium is debited for the difference between the expense and payment Date Accounts Debit Credit 1-July Interest Expense (104,100 x 4%) $4,164 Premium on Bonds Payable $336 Cash ($100,000 x 4.5%) $4,500 Issued $100,000, 9%, 10-year bonds at a discount For the company we have been looking at, interest expense for the first payment would be recorded as follows: Interest expense is debited for the carrying amount multiplied by the market rate cut in half. The carrying amount at this date is the same as the price - $96,149. The market rate is 8%, half of which is 4%. Cash is credited for the face value times the stated rate cut in half. The face value is $100,000 and stated rate is 9%, half of which is 4.5% Premium is debited for the difference between the interest expense and cash payment. This will reduce the premium. ©2008 Pearson Prentice Hall. All rights reserved.

Premium on Bonds Payable 1st Int. Pmt, July 1 Issue Date, Jan. 1 $336 $4,100 $3,764 Balance, July. 1 Balance Sheet July 1 Long-Term Liabilities: Bonds Payable $100,000 Plus: Premium $3,764 $103,764 A T-account of the Premium shows the impact of the two entries. On the issue date, the account was increased by $4100–the difference between the price of the bond and the face value. With the first interest payment entry, the premium was amortized $336, resulting in a balance of $ The carrying amount of the bond is now $103,764. The face value has stayed the same (and will always) but the premium is now smaller. The result is a smaller carrying amount. This process will continue with each interest payment. The premium will get smaller until it is zero at maturity. The carrying amount will grow smaller until it reaches face value at maturity. ©2008 Pearson Prentice Hall. All rights reserved.

Retiring Bonds Before Maturity
Interest rates may change causing companies to retire bonds early Borrowing rates may become less than interest rate on bonds Some bonds are callable Company can pay off bonds a specific price Normally, companies wait until maturity to pay off, or retire, their bonds payable. But companies sometimes retire bonds early. The main reason for retiring bonds early is to relieve the pressure of making high interest payments. Also, the company may be able to borrow at a lower interest rate. Some bonds are callable, which means that the issuer may call, or pay off, those bonds at a prearranged price (this is the call price) whenever the issuer chooses. The call price is often a percentage point or two above the par value, perhaps 101 or Callable bonds give the issuer the benefit of being able to pay off the bonds whenever it is most favorable to do so. The alternative to calling the bonds is to purchase them in the open market at their current market price. ©2008 Pearson Prentice Hall. All rights reserved.

Convertible bonds Bondholders may exchange bonds for company’s stock Offers investor: Assured receipt of interest and principal on bonds Opportunity for gains on stock Some corporate bonds may be converted into the issuing company’s common stock. These bonds are called convertible bonds (or convertible notes). For investors, these combine the safety of (a) assured receipt of interest and principal on the bonds with (b) the opportunity for gains on the stock. The conversion feature is so attractive that investors usually accept a lower interest rate than they would on nonconvertible bonds. The lower cash interest payments benefit the issuer. If the market price of the issuing company’s stock gets high enough, the bondholders will convert the bonds into stock. Investors will accept a lower interest rate on bonds because of the attractiveness of this feature. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 4 Learning Objective 4 helps us to understand the advantages and disadvantage of borrowing. Understand the advantages and disadvantages of borrowing ©2008 Pearson Prentice Hall. All rights reserved.

Financing Operations with Bonds or Stock
When a company needs funds, they can raise money by: Issuing stock No liabilities or interest expense Less risky More costly Issuing bonds or notes Does not dilute control of company Results in higher earnings per share More debt increases risk Managers must decide how to get the money they need to pay for assets. Companies can raise capital by issuing stock or by issuing bonds (or notes) payable. Each strategy has its advantages and disadvantages. Issuing stock creates no liabilities or interest expense and is less risky to the issuing corporation. But issuing stock is more costly. Issuing bonds or notes payable does not dilute control of the corporation. It often results in higher earnings per share because the earnings on borrowed money usually exceed interest expense. But creating more debt increases the risk of the company. Earnings per share (EPS) is the amount of a company’s net income for each share of its stock. EPS is the single most important statistic for evaluating companies because EPS is a standard measure of operating performance that applies to companies of different sizes and from different industries. ©2008 Pearson Prentice Hall. All rights reserved.

Net income divided by shares of stock
Plan A—Borrow at 8% Net Income before expansion $500,000 Additional income 420,000 Less interest expense (500K x 8%) (40,000) 380,000 Less income tax expense (114,000) Expected additional income 266,000 Total company net income $766,000 Earnings per share $________ Example 8-31 illustrates the concept of choosing between stock or bonds to raise funds. Altman & Associates is considering 2 plans for raising $500,000 to expand operations. Plan A is to borrow at 8%, and plan B is to issue 100,000 shares of common stock. Before any new financing, Altman has net income of $500,000 and 100,000 shares of common stock outstanding. Assume you own most of Altman’s existing stock. Management believes the company can use the new funds to earn additional income of $420,000 before interest and taxes. Altman’s income tax rate is 30%. The information above shows how Plan A would impact the income statement. With bonds, the company would incur additional interest expense. The result, after taxes, is additional income of $266,000, bringing total net income of $766,000. To compute earnings per share, net income is divided by the 100,000 shares of stock. Net income divided by shares of stock ©2008 Pearson Prentice Hall. All rights reserved.

Plan B—Issue Stock Net Income before expansion $ 500,000 Additional income 420,000 Less interest expense -- Less income tax expense (126,000) Expected additional income 294,000 Total company net income $ 794,000 Earnings per share: $ In Plan B, Example 8-31, there would be no interest expense and the additional income would amount to $294,000, bringing total net income to $794,000. But earnings per share is much lower in this plan. This is because the company issued 100,000 additional shares. So to compute EPS, the net income is divided by 200,000 shares. So Plan A results in the highest earnings per share and allows the company to retain control. However, Plan A has more risk because of the additional debt. ©2008 Pearson Prentice Hall. All rights reserved.

Times-Interest-Earned
Also called interest-coverage ratio Relates income to interest expense Operating income Interest expense We have just seen how borrowing can increase EPS. But too much debt can lead to bankruptcy if the business cannot pay liabilities as they come due. UAL Inc., the parent company of United Airlines, fell into the debit trap. The debt ratio measures the effect of debt on the company’s financial position but says nothing about the ability to pay interest expense. Analysts use a second ratio—the times-interest-earned ratio—to relate income to interest expense. To compute this ratio, we divide income from operations (also called operating income) by interest expense. This ratio measures the number of times that operating income can cover interest expense. The times-interest-earned ratio is also called the interest-coverage ratio. A high times-interest-earned ratio indicates ease in paying interest expense; a low value suggests difficulty. ©2008 Pearson Prentice Hall. All rights reserved.

Leases Lease–rental agreement in which the tenant (lessee) agrees to make rent payments to the property owner (lessor) Two categories: Operating Capital A lease is a rental agreement in which the tenant (lessee) agrees to make rent payments to the property owner (lessor) in exchange for the use of the asset. Leasing allows the lessee to acquire the use of a needed asset without having to make the large up-front payment that purchase agreements require. Accountants distinguish between 2 types of leases: operating leases and capital leases. ©2008 Pearson Prentice Hall. All rights reserved.

Operating Leases Usually short-term or cancelable Lessor retains risks and rewards of owning asset Lessee records “rent expense” when payments are made Operating leases are often short-term or cancelable. They give the lessee the right to use the asset but provide no continuing rights to the asset. The lessor retains the usual risks and rewards of owning the leased asset. To account for an operating lease, the lessee debits Rent Expense (or Lease Expense) and credits Cash for the amount of the lease payment. Operating leases require the lessee to make rent payments, so an operating lease creates a liability even though that liability does not appear on the lessee’s balance sheet. ©2008 Pearson Prentice Hall. All rights reserved.

Capital Leases Long-term noncancelable debt Four criteria Title transfers to lessee at end of lease Lease contains a bargain purchase option Lease term is 75% or more of asset’s life Present value of lease payments is 90% or more than fair value of leased asset Capital leases. Most businesses use capital leasing to finance the acquisition of some assets. A Capital lease is a long-term noncancelable debt. How do we distinguish a capital lease from an operating lease? FASB Statement No. 13 provides the guidelines. To be classified as a capital lease, the lease must meet any 1 of the following criteria: 1. The lease transfers title of the leased asset to the lessee at the end of the lease term. Thus, the lessee becomes the legal owner of the leased asset. 2. The lease contains a bargain purchase option. The lessee can be expected to purchase the leased asset and become its legal owner. 3. The lease term is 75% or more of the estimated useful life of the leased asset. The lessee uses up most of the leased asset’s service potential. 4. The present value of the lease payments is 90% or more of the market value of the leased asset. In effect, the lease payments are the same as installment payments for the leased asset. Accounting for a capital lease is much like accounting for the purchase of an asset. The lessee enters the asset into the lessee’s accounts and records a lease liability at the beginning of the lease term. Thus, the lessee capitalizes the asset even though the lessee may never take legal title to the asset. Most companies lease some of their plant assets. If lease meets one of the above criteria, it is considered a capital lease ©2008 Pearson Prentice Hall. All rights reserved.

Liabilities on the Balance Sheet
Current liabilities are listed and include the current portion of long-term debt Long-term debt is often reported as one amount on the balance sheet A disclosure note provides the detail of long-term debt On the balance sheet, liabilities are categorized as current or long-term. Current liabilities are listed individually and include any current portion of long-term debt. Long-term debt is often just reported as one lump sum. To find the details, one would look to the disclosures notes. ©2008 Pearson Prentice Hall. All rights reserved.

Long-Term Liabilities on the Cash Flow Statement
Issuing bonds and long-term borrowing are reported as financing inflows Payments of bond and loan principal are reported as financing inflows Interest expense is reported in the operating section On the Cash Flow Statement, long-term debt is categorized as financing activity. Receiving the proceeds from bond issue or notes payable provides an inflow of cash. Payment of bonds at maturity and note principal is an outflow. Interest expense paid on bonds and notes is in the operating section. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved.

Similar presentations

Presentation on theme: "©2008 Pearson Prentice Hall. All rights reserved."— Presentation transcript:

Similar presentations

About project

Feedback

Log in

Auth with social network:

©2008 Pearson Prentice Hall. All rights reserved.

Similar presentations

Presentation on theme: "©2008 Pearson Prentice Hall. All rights reserved."— Presentation transcript:

Similar presentations

About project

Feedback