Learning Objectives (LO)

After studying this chapter, you should be able to

Liabilities and Interest

CHAPTER

1. 2. 3. 4. 5. 6. 7.

Account for current liabilities Measure and account for long-term liabilities Account for bond issues over their entire life Value and account for long-term lease obligations Evaluate pensions and other postretirement benefits Interpret deferred tax liabilities Use ratio analysis to assess a companys debt levels 8. Compute and interpret present and future values
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LO 1 Current Liabilities
Liabilities - obligations to pay cash or to provide goods and services to others
Current liabilities are obligations that fall due within the coming year or within the companys normal operating cycle Long-term liabilities are those that fall due more than 1 year beyond the balance sheet date

LO 1 Current Liabilities
Accounts payable amounts owed to suppliers Note Payable - promissory note or written promise to pay a loans principal and interest when due Commercial paper - a debt contract issued by prominent companies that borrow directly from investors (shorter than 9 month payback period; usually 60 days) Line of credit a predetermined maximum amount a company can borrow without additional credit checking Accrued Liabilities expenses that a company has recognized on the income statement but not yet paid; normally arise with the passage of time and are recorded with an adjusting journal entry.

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LO 1 Current Liabilities
Accrued Liabilities
Salaries and wages payable Income tax withholding payable Social Security withholding payable Income tax payable Sales tax (value added tax) payable Current portion of long-term debt Returnable deposits Unearned revenues (e.g. lease rentals, magazine subscriptions, insurance premiums, advance airline or theater ticket sales, etc.) Product Warranties a provision accrued at the time of sale, not when the actual repair service is provided
Introduction to Financial Accounting, 10/e

LO 2 Long-term Liabilities
Bonds - formal certificates of debt that include promises to pay interest at a specified annual rate and the principal Negotiable bonds are transferable Private Placement sold directly to specific investors rather than the general public Mortgage bond - secured by the pledge of specific property. In case of default, these bondholders have the first right to proceeds from the sale of that property. Debenture - a debt security with a general claim against the companys total assets, instead of a particular asset. Subordinated debenture - has claims against only the assets that remain after satisfying the claims of other general creditors.
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LO 2 Long-term Liabilities
Order of priority when a company is in liquidation
Mortgage bond Debentures and accounts payable Subordinated debentures

LO 2 Long-term Liabilities
Callable bonds - allow the issuer the option to redeem (call) the bond before maturity
Call premium - the difference between the redemption price and the face value of the bond

Mortgage bonds have the lowest interest rate; subordinated debentures the highest. Bond covenants - restrict the ability of the borrower to take certain actions or give the lender the ability to force early payment, i.e., protect the investor
Immediate repayment if the borrower misses a payment, Restrict sale of particular property Restrict payment of dividends, etc.
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Sinking fund bonds - require the issuer to make annual payments into a fund that can be used to redeem the bonds at maturity Convertible bonds - bonds that lenders may exchange for a preset number of shares of the issuing companys common stock (a privilege to the investor)
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LO 2 Long-term Liabilities
Coupon rate determines the amount of each semiannual interest payment. Market rate rate available on investments in similar bonds at the time the company issues the bond Market rate > Coupon rate => Bond sells at discount Market rate < Coupon rate => Bond sells at premium
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LO 2 Long-term Liabilities
Yield to Maturity - the interest rate that equates cash flows for interest and principal to the bonds current price Determinants of the yield to maturity:
Real interest rate the return investors want for use of their money without risk (risk-free rate), or for delaying their consumption Inflation premium interest that investors require because the prices may increase between now and the time they receive their money Firm-specific risk Risk the firm will not repay 1) the loan, 2) interest, 3) on time
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LO 3 Accounting for Bonds

Example 1 Company X issued 10,000 $1,000 face value debentures, with 10% Coupon rate at a time when annual market interest ratesare 10%, interest is payable semiannually, Bonds principal is due in 2 years, Bonds were sold at par Cash 10,000,000 Bonds payable To record proceeds upon issuance 10,000,000

LO 3 Accounting for Bonds

Example 2 Company X issued 10,000 $1,000 face value debentures, with 10% Coupon rate at a time when annual market interest ratesare 12%, interest is payable semiannually, Bonds principal is due in 2 years, Bonds were sold at discount Cash Discount on bonds payable Bonds payable 9,653,500 346,500 10,000,000

Interest expense 500,000 Cash To record four payments of interest, one each 6-month period Bonds payable 10,000,000 Cash To record payment of maturity value of bonds and their retirement
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500,000

Discount on bonds payable is a contra account, which is deducted from the debts face amount to show the balance sheet carrying amount (book value) Bonds Payable 10,000,000 Less Discount on bonds payable (346,500) Net Liability (book value) 9,653,500
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10,000,000

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LO 3 Accounting for Bonds

For bonds issued at a discount, interest takes two forms: Semiannual coupon payments (5%*10MLN=$500,000) An extra lump-sum payment cash payment of $346,500 at maturity (as the bonds were sold for $9,653,500, but the actual liability was $10,000,000 i.e. the total face value of the bonds) Discount Amortization spreading of bond discount over the life of the bonds as interest expense

LO 3 Accounting for Bonds

Payment 1. 2. 3. 4. Debit Interest Expense 579,207 583,959 588,997 594,337 Credit Discount 79,207 83,959 88,997 94,337 Credit Cash 500,000 500,000 500,000 500,000

2,346,500 346,500 2,000,000 The complete last payment would be Interest Expense 594,337 Bonds Payable 10,000,000 Discount 94,337 Cash 10, 500,000

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LO 3 Accounting for Bonds

Example 3 Company X issued 10,000 $1,000 face value debentures, with 10% Coupon rate at a time when annual market interest ratesare 8%, interest is payable semiannually, Bonds principal is due in 2 years, Bonds were sold at premium. Cash 10,363,000 Premium on bonds payable Bonds payable 363,000 10,000,000

LO 3 Accounting for Bonds

Payment 1. 2. 3. 4. Debit Interest Expense 414,517 411,098 407,542 403,843 Debit Premium 85,483 88,902 92,458 96,157 Credit Cash 500,000 500,000 500,000 500,000

Premium on bonds payable is an adjunct account, which is added to the debts face amount to show the balance sheet carrying amount (book value) Bonds Payable 10,000,000 Plus Premium on bonds payable 363,000 Net Liability 10,362,989
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1,637,000 363,000 2,000,000 The complete last payment would be Interest Expense 403,843 Bonds Payable 10,000,000 Premium 96,157 Cash 10, 500,000

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LO 3 Accounting for Bonds

Cash flows from financing activities
Receipts from proceeds of the bond issue Repayment of the borrowed amounts

LO 3 Accounting for Bonds

Cash flows from operating activities

Direct method Interest expense is an operating cash outflow (maybe listed as financing activity under IFRS) Indirect method Interest expense is included in net income Amortization of discounts and premiums is a non-cash transaction and should be treated as depreciation Premiums are subtracted from net income Discounts are added to net income

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LO 3 Accounting for Bonds

Zero coupon bonds
No interest during the time the bonds are open Pay all interest due at maturity But interest is amortized over the life of the bond Example 2-year, zero coupon bond, $10,000 face-value note issued December 20X3, when market interest rates were 10% (5% semiannually)
Cash 8,227 Discount 1, 773 Bonds Payable 10,000
N = 4, I = 5; Present value of a $1 Table 9A-2

LO 3 Accounting for Bonds

12/31/X3 Cash Discount on note payable Note payable Interest expense (8,227 .06) Discount on note payable Interest expense Discount on note payable Interest expense Discount on note payable Interest expense Discount on note payable Note payable Cash 8,227 1,773 10,000 411 411 432 432 454 454 476 476 10,000 10,000 Book value = 10,000 1773 = 8,227

6/30/X4

12/31/X4

6/30/X5

12/31/X5

6/30/X6

PV
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LO 4 Lease Obligations
Lease is a contract whereby
Lessor (owner) grants the use of property to a Lessee in exchange for regular payments

LO 4 Lease Obligations
Operating lease
Lessor keeps the asset on his/her books and depreciates it Lessee does not record the asset nor depreciates it; Lessee records a liability for future lease payments

Legal title to the property remains with the lessor, but the lessee uses the property as if it had ownership Accountants categorize leases into two categories:
Operating Capital (finance)
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Capital (finance) lease

Similar to installment sales, transfers most of the risks and benefits of ownership to the lessee. Must record the leased item as if the company has borrowed money and purchased the leased asset the property becomes and asset and the obligation to pay for it becomes a liability.

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LO 4 Lease Obligations
Under US GAAP, a lease is considered to be capital if it meets at least one of the following
Lessor transfers ownership of the asset to the lessee by the end of the lease term Lease contains a bargain purchase option - can purchase the asset at the end of the lease for a price substantially lower than the market value Lease term equals or exceeds 75% of the estimated economic life of the property Present value of minimum lease payments is at least 90% of the propertys fair value (like buying on time)

LO 4 Lease Obligations
Income statement:
Capital leases tend to produce heavier expenses and lower income than operating leases in the early years

Balance sheet:
Capital leases create an asset and liability Operating leases do not

Statement of cash flows:

Cash payments for operating leases are operating activities Capital leases affect both operating (for interest) and financing sections (for payments against the liability)
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LO 5 Pensions/Postretirement Benefits
Pensions - post-retirement payments to employees
Defined contribution plans Employer contributions belong to the employees Payments depend on how well the fund performs Risk rewards belong to the employee Defined benefit plans Retirement pay is guaranteed or fixed The pension liability obligation is the present value of the expected future benefits to employees Pension obligation and assets available are calculated and disclosed yearly in the footnotes
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LO 6 Deferred Tax Liabilities

Deferred Tax Liabilities may arise because of the difference between GAAP reporting and tax reporting, whereby companies record some income tax expense long before the tax payments are actually made. Permanent differences one set recognizes a revenue or expense, the other does not. Permanent differences do not create deferred tax liability. Temporary differences while both sets recognize a revenue (income) or expense (deduction), they permit such at different times (e.g. depreciation)

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LO 7 Ratio Analysis
The more the borrowing and the less the stockholders equity, the riskier it is to lend money to the firm; thus the higher the interest rate it must pay when borrowing Alternate ways of expressing the proportion of the firms resources obtained by borrowing:
Debt-to-equity ratio = Total liabilities Total shareholders equity

LO 7 Ratio Analysis
This ratio measures the firms ability to meet its interest obligation
The lower the ratio, the more likely the company will have difficulty making payments
Interest-coverage ratio = Pretax income + Interest expense Interest expense

Long-term-debtto-total-capital ratio Debt-to-total assets ratio

= Total long-term debt Total shareholders equity + long-term debt = Total liabilities Total assets

Debt burdens and interest coverage ratios vary across firms and industries

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