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17-19
Liabilities
Part A
Current Liabilities
Current Liabilities
Liability - A present responsibility to sacrifice assets in
the future due to a transaction or other event that
happened in the past.
CURRENT
Payable within one
year
LONG-TERM
With in the
Payable
more
company
than
one year
4
Reporting Current
Liabilities
Distinguishing between current and long-term
liabilities helps investors and creditors assess
risk.
Companies often prefer to report a liability as
long-term--it may cause the firm to appear
less risky.
Many companies list notes payable first,
followed by accounts payable, and then other
current liabilities from largest to smallest.
5
Accrued expenses
Accounts/Notes payables
Unearned revenues
Sales taxes payable
The current portion of long-term debt
Sales Taxes
Payable
Company selling products subject to sales
taxes is responsible for collecting the sales
tax directly from customers and periodically
sending the sales taxes collected to the
state and local governments.
When the company collects the sales taxes,
it increases cash (a debit) and increases
sales taxes payable (a credit).
7
$190
3,325
$3,515
8
Contingencies
10
Contingent Liabilities
Whether we report a loss contingent liability depends
on two criteria:
The likelihood of payment can be:
Probablelikely to occur
Reasonably possiblemore than remote but
less than probable; or
Remotethe chance is slight
The ability to estimate the payment amount is
either:
Known or reasonably estimable; or
Not reasonably estimable.
We record a liability if the loss is probable and the
amount is at least reasonably estimable.
The journal entry to record a contingent liability
requires a debit to a loss (or expense) account and a
credit to a liability.
11
Contingent
Liabilities
If the likelihood of payment is probable and if one
amount within a range appears more likely, we
record that amount.
When no amount within the range appears more
likely than others, we record the minimum amount
and disclose the potential additional loss.
If the likelihood of loss is reasonably possible
rather than probable, we record no entry but make
full disclosure in a footnote to the financial
statements to describe the contingency.
If the likelihood of payment is remote, disclosure
usually is not required.
12
Warranties
Recording
Contingent Liabilities
Example:
10,000
10,000
Contingent Gains
Is an existing uncertain situation that might result in
a gain, which often is the flip side of contingent
liabilities.
In a pending lawsuit, one sidethe defendant
faces a contingent liability, while the other sidethe
plaintiffhas a contingent gain.
We record contingent liabilities when the loss is
probable and the amount is reasonably estimable.
We do not record contingent gains
Though firms do not record contingent gains in the
accounts, they sometimes disclose them in notes to
the financial statements
15
Assess liquidity
Liquidity Analysis
Liquidity refers to having sufficient cash to pay currently maturing
debts.
Working Capital:
It is the difference between current assets and current liabilities.
Current ratio:
We calculate it by dividing current assets by current liabilities.
16
Lets
Review
Selected financial data regarding current assets and current liabilities for
United and Southwest Airlines are as follows
($ in millions)
Current assets
Cash and cash equivalents
Current investments
Net receivables
Inventory
Other current assets
Total current assets
Current liabilities
Accounts payable
Short/current long-term debt
Other current liabilities
Total current liabilities
United
$3,046
977
237
601
$4,861
$3,231
1,808
2,242
$7,281
Southwest
$1,368
435
574
203
313
$2,893
$2,643
163
$2,806
17
Lets
Review
Solution:
1. ($ in
Total
Current
Assets
United
$4,861
$7,281
$(2,420)
Southwest
$2,893
$2,806
$ 87
($ in
millions)
Total
Current
Assets
United
$4,861
$7,281
0.67
Southwest
$2,893
$2,806
1.03
($ in
millions)
Quick
Assets
Total Current
Liabilities
Acid-Test
Ratio
United
$4,023
$7,281
0.55
Southwest
$2,377
$2,806
0.85
millions)
2.
Total Current
Liabilities
Working
Capital
=
Total Current
Liabilities
Current
Ratio
=
3.
18
Part B
Long Term
Debt
What is a Bond?
Bonds - Example
Note that the bond terms simply communicate a flow of cash payments
15 year life
Pricing a Bond
Valuing Bonds
We are issuing bonds of $1,000 face value, 10% coupon rate, due in 2 years. Interest
is paid semiannually.
Period 0
Cash flow
$50
$50
$50
4
$50
+ 1,000
principal
What will be the price of the bonds when they are issued (i.e., how much cash
proceeds will we get?)
It depends on the market interest rate on the day the bonds are issued!
Bondholders are willing to give the company an amount equal to the present
value of future cash flows discounted at the market rate of interest. So Proceeds at
issuance depend on:
issued)
24
25
The market rate can be equal to, less than, or greater than the
stated 7% interest rate paid to investors. Lets first assume the
market interest rate is 7%. RCs bonds pay interest semi-annually
for 10 years .
27
= $100,000 x 0.50257*
= $3,5001
x14.21240**
$ 50,257
49,743
$100,000
* Table 2, i = 3.5% , n = 20
** Table 4, i = 3.5% , n = 20
28
29
= $100,000 x 0.45639*
x 13.59033**
$45,639
47,566
$93,205
* Table 2, i = 4% , n = 20
** Table 4, i = 4% , n = 20
30
31
= $100,000 x 0.55368*
$ 55,368
x 14.87747**
52,071
$107,439
* Table 2, i = 3% , n = 20
** Table 4, i = 3% , n = 20
32
33
Debit
100,000
Credit
100,000
On June 30, 2012, RC Enterprises records the first semiannual interest payment:
June 30, 2012
Interest Expense
Cash
(Record semiannual interest
payment)
($100,000 x 7% x 1/2 = $3,500)
Debit
3,500
Credit
3,500
35
In the preceding example we assumed the stated interest rate (7%) and the
market interest rate (7%) were the same.
If the market interest rate is 8%, the bonds will issue at only $93,205.
This is less than $100,000. The bonds are paying only 7%, while investors
can purchase bonds of similar risk paying 8%.
The entry RC Enterprises makes to record the bond issue at a discount is:
Cash
Discount on Bonds Payable
Bonds Payable
93,205
6,795
100,000
The balance in the bonds payable account is (100,0006,792) and is called the net carrying value. The
carrying value will increase from the amount originally
borrowed ($93,205) to the amount due at maturity
($100,000) over the 10-year life of the bonds.
36
Interest
expense
Carrying
value of
bond
$3,728
$93,205
Market
interest rate
per period
8% x
Cash paid for interest is equal to the face amount times the stated
rate (3.5% semi-annually or 7% annually, in our example).
Cash paid
for
Interest
Face
amount of
bond
$3,500
$100,000
Stated
interest rate
per period
7% x
37
Debit
3,728
Credit
228
Cash ($100,000 x 7% x )
3,500
Debit
3,737
Credit
237
3,500
38
39
(1)
Date
(2)
Cash Paid
for interest
(3)
Interest
Expense
(4)
Discount
Amortization
(5)
Carrying
Value
(6)
Ending
Unamortized
Discount
Face Amount x
Stated Rate
Carrying
Value x
Market
Rate
(3) (2)
Prior Carrying
Value + (4)
Face Amount
- (5)
$93,205
$6,795
1/1/2012
6/30/2012
$3,500
$3,728
$228
93,433
6,567
12/31/2012
3,500
3,737
237
93,670
6,330
99,057
943
481
6/30/2021
3,500
3,962
462
99,519
12/31/2021
3,500
3,981
481
$100,000
0
40
Cash
107,439
Premium on Bonds Payable
Bonds Payable
7,439
100,000
41
Debit
3,223
Credit
277
Cash ($100,000 x 7% x )
3,500
Debit
3,215
Credit
285
3,500
42
(1)
Date
(2)
Cash Paid
for interest
(3)
Interest
Expense
(4)
Premium
Amortization
(5)
Carrying
Value
(6)
Ending
Unamortized
Premium
Face Amount x
Stated Rate
Carrying
Value x
Market
Rate
(2) (3)
Prior Carrying
Value - (4)
(5)Face Amount
$107,439
$7,439
1/1/2012
6/30/2012
$3,500
$3,223
$277
107,162
7,162
12/31/2012
3,500
3,215
285
106,877
6,877
100,956
956
6/30/2021
3,500
3,029
471
100,485
485
12/31/2021
3,500
3,015
485
$100,000
0
44
45
When the issuing corporation buys back its bonds from the
investors, it is said that the company has retired those bonds.
It can wait until the bonds mature to retire them, or in most
cases, the issuer will choose to buy the bonds back early
BOND RETIREMENTS AT MATURITY
Regardless of whether bonds are issued at face amount, a
discount, or a premium, their carrying value at maturity will equal
their face amount.
RC Enterprises records the retirement of its bond at maturity as:
December 31, 2021
Bonds Payable
Cash
(Retire bonds at maturity)
Debit
Credit
100,000
100,000
46
47
(2)
Cash Paid
for interest
(3)
Interest
Expense
(4)
Discount
Amortization
1/1/2012
(5)
Carrying
Value
(6)
Ending
Unamortized
Discount
$93,205
$6,795
6/30/2012
$3,500
$3,728
$228
93,433
6,567
12/31/2012
3,500
3,737
237
93,670
6,330
(2)
Cash Paid
for interest
(3)
Interest
Expense
(4)
Premium
Amortization
1/1/2012
(5)
Carrying
Value
(6)
Ending
Unamortized
Premium
$107,439
$7,439
6/30/2012
$3,500
$3,223
$277
107,162
7,162
12/31/2012
3,500
3,215
285
106,877
6,877
Discount
Premium
Interest Rate
Coupon = Market
Cash Interest
Pymts
= Cash Interest
Pymts
Face Value
Face Value
Discount
Face Value +
Premium
Interest
Expense*
Balance Sheet
Carrying Value
Group Exercise
On Jan. 1, 2010. XL Corp issued bonds of $1,000 face value, 10%
coupon rate, due in 2 years, interest paid semiannually. Record the
journal entries of bond issuance, all interest payments, and
repayment at maturity.
Assume following three scenarios:
1) The market interest rate is 10%.
2) The market interest rate is 12%.
3) The market interest rate is 8%.
Suppose XL Corp purchased the bonds back on Jan. 1, 2011 at a
price of $960. Record the journal entries for each scenario.
51
Cash
1,000
Bonds Payable
1,000
Interest Expense
Cash
50
50
Bonds Payable
Cash
1,000
1,000
52
PVA factor of
6% @ 4 periods
Cash
Discount on Bonds Payable
Bonds Payable
965.35
34.65
1,000.00
53
Discount
Amortization
7.92
8.40
8.90
9.43
Ending
Ending
Unamortized Carrying
Discount
Value
26.73
973.27
18.33
981.67
9.43
990.57
0
1000.00
7.92
50.00
54
PVA factor of
4% @ 4 periods
When the market rate is less than the coupon rate, bonds
are issued at a premium.
Cash
1,036.30
Premium on Bonds Payable
36.30
Bonds Payable
1,000.00
55
Beginning
Carrying
Interest
Cash
Value
Expense(4%) Payment
1,036.30
41.45
50.00
1,027.75
41.11
50.00
1,018.86
40.75
50.00
1,009.61
40.39
50.00
Premium
Amortization
8.55
8.89
9.25
9.61
Ending
Unamortized
Premium
27.75
18.86
9.61
0
Ending
Carrying
Value
1,027.75
1,018.86
1,009.61
1,000.00
50.00
1000.00
18.86
58.86
960.00
56
Leases
Types of Leases
Capital (finance) leases: Transfers most
risks and benefits of ownership to the lessee
Property accounted for as an asset and obligation
to pay as liability
Lease Example
RalphCo decides to lease a truck from Jerry's Truck Mart. The truck is
estimated to have a cash purchase price of $16,000, a useful life of four years,
and an estimated salvage value of $0.
On January 1, 2006, RalphCo signs a two-year lease, with annual payments of
$5,000 to be made at the end of each year. At the end of the lease term,
RalphCo must return the truck to Jerrys. If RalphCo were to get a bank loan to
purchase the truck directly, the interest rate would be 10% per year.
True or False? This is an Capital Lease.
False (operating lease):
1. Ownership transfer at end of lease? No.
2. Bargain purchase option? No.
3. Term 75% of useful life? 2/4 = 50% 75%? No.
4. PV of payments 90% of Fair Value?
$5,000 x 1.7355 = $8,678 90% of Fair Value (=90%*16,000= $14,400 )? No.
Prepare the journal entries for RalphCo resulting from the lease.
Lease Example
RalphCo decides to lease a truck from Jerry's Truck Mart. The truck is
estimated to have a cash purchase price of $16,000, a useful life of four years,
and an estimated salvage value of $0.
On January 1, 2006, RalphCo signs a two-year lease, with annual payments of
$5,000 to be made at the end of each year. At the end of the lease term,
RalphCo must return the truck to Jerrys. If RalphCo were to get a bank loan to
purchase the truck directly, the interest rate would be 10% per year.
Prepare the journal entries for RalphCo resulting from the lease.
Each year, the journal entry for RalphCo is:
Rent Expense
Cash
5,000
5,000
Lease Example
RalphCo decides to lease a truck from Jerry's Truck Mart. The truck is
estimated to have a cash purchase price of $16,000, a useful life of four years,
and an estimated salvage value of $0.
Now suppose January 1, 2006, RalphCo signs a four-year lease, with annual
payments of $5,000 to be made at the end of each year. At the end of the
lease term, RalphCo must return the truck to Jerrys. If RalphCo were to get a
bank loan to purchase the truck directly, the interest rate would be 10% per
year.
True or False? This is an Capital Lease.
True:
1. Ownership transfer at end of lease? No.
2. Bargain purchase option? No.
3. Term 75% of useful life? 4/4 = 100% 75%? YES.
4. PV of payments 90% of Fair Value?
$5,000 x 3.1699 = 15,850 14,400 = 90% of Fair Value? YES.
Prepare the journal entries for RalphCo resulting from the lease.
Lease Example
The lease is accounted for as if the truck had been purchased via a
financing agreement. The initial asset and liability amounts are
recorded at the present value of the lease payments.
1/1/06 (record the lease):
Leased Asset Truck
15,850
Capital Lease Liab., current
3,415
Capital Lease Liab., long-term
12,435
PV of payments = annuity of $5,000 for 4 years at 10% = $15,850
Current portion = First years payment First years interest
= $5,000 - $15,850 * 10%
= $5,000 - $1,585
= $3,415
CapitalLease
Liabilityat
BeginningofYear
15,850
12,435
8,679
4,546
(2)
InterestExpense
at10%perYear
1,585
1,244
868
454
(3)
CashforCapital
LeasePayment
5,000
5,000
5,000
5,000
(4)
(5)
(3)(2)
Reductionin
LeaseLiability
3,415
3,757
4,132
4,546
(1)(4)
CapitalLease
LiabilityatEndof
Year
12,435
8,679
4,546
(0)
3,963
5,000
4,132
Endof
Year
2006
2007
2008
2009
CapitalLease
Liabilityat
BeginningofYear
15,850
12,435
8,679
4,546
TotalInterestExp
TotalAmort.Exp
TotalInt.&Amort.
(2)
InterestExpense
at10%perYear
1,585
1,244
868
454
4,150
15,850
20,000
(3)
CashforCapital
LeasePayment
5,000
5,000
5,000
5,000
(4)
(5)
(3)(2)
Reductionin
LeaseLiability
3,415
3,757
4,132
4,546
(1)(4)
CapitalLease
LiabilityatEndof
Year
12,435
8,679
4,546
(0)
20,000 TotalCashPayments
73
Debt to
equity
ratio
Total liabilities
=
Stockholders equity
74
Times interest
earned ratio
75
Group Exercise-Leases
SmithCo decides to lease a jet from DaveCo. The jet is estimated to
have a cash purchase price of $16,000, a useful life of four years,
and an estimated salvage value of $0. On January 1, 2006, SmithCo
signs a four year non-cancellable lease, with annual payments of
$5,000 to be made at the end of each year. At the end of the lease
term, SmithCo must return the jet to DaveCo. If SmithCo were to get
a bank loan to purchase the jet directly, the interest rate would be
11% per year.
1) How much interest expense related to this lease was recognized
by SmithCo during the first year of the lease term?
2) How much was the balance in the lease obligation (liability) at the
end of year 2006?
76
Group Exercise-Leases
True or False? This is an Capital Lease.
True:
1. Ownership transfer at end of lease? No.
2. Bargain purchase option? No.
3. Term 75% of useful life? 4/4 = 100% 75%? YES.
4. PV of payments 90% of Fair Value?
$5,000 x 3.1024 (annuity factor at 11% discount rate) = 15,512
14,400 = 90% of Fair Value? YES.
Group Exercise-Leases
Prepare the journal entries for SmithCo resulting from the capital lease.
1/1/06 (record the lease):
Leased Asset Jet
15,512
Capital Lease Liab., current
3,294
Capital Lease Liab., long-term
12,218
PV of payments = annuity of $5,000 for 4 years at 11% = $15,512
Current portion = First years payment First years interest
= $5,000 - $15,512 * 11%
= $5,000 - $1,706
= $3,294