Definitely Determinable Liabilities

1. Definitely Determinable Liabilities • Obligations that can be measured exactly • E.g., bank loans, accounts payable, notes payable, salaries payable • Accounting for payroll • Firms must supply the government with information for each worker • Federal, state, and Social Security taxes

2. Definitely Determinable Liabilities • Accounting for payroll • Gross pay • Wages/salary before any deductions • Deductions • Federal income tax (FIT) withheld • FIT Payable • FICA tax withheld (6.2% of salary) • FICA Payable • Medicare tax withheld (1.45% of salary) • Medicare Taxes Payable • Accounting for payroll • Employer must match employee deduction for FICA and Medicare • Employer’s Payroll Tax Expense

3. Estimated Liabilities • Accounting for warranties • Obligation is not certain, so it is estimated • Warranty Payable and related Warranty Expense recognized in year product is sold regardless of duration of the warranty • Accounting for warranties • Repairs or replacement under warranty • Cash, parts inventory, and/or merchandise inventory decreases (credit) • Warranty Payable decreases (debit) because part of the warranty liability is satisfied

4. Warranty Example Electronics Universe (EU) sells $20,000 of consumer electronics for cash during September with a 2-year warranty (ignore CoGS) EU estimates that warranty work related to the sales will be 3% of sales. During September, EU pays $100 cash and uses $80 of parts to satisfy warranty claims

5. Long-term Notes Payable and Mortgages • Short-term notes • Mature in < 1 yr • Interest and principal usually paid at the end of the term • Long-term notes • Mature in > 1 yr • Options for repayment • Repay in one lump sum (principal + interest) • Repay in equal annual payments • Payments combine principal and interest • As loan is repaid outstanding balance of loan decreases, so the interest portion of the payment decreases and the principal portion increases

6. Long-term Notes Payable and Mortgages • Present value • Value today of a given amount to be paid or received in the future • Both the principal and interest not paid or received are earning interest at the discount rate • Discount rate • Interest rate used to compute the present value of the future cash flows

7. Long-term Notes Payable and Mortgages • Present value (continued) • If you deposited $100 in the bank at 5% interest, at the end of the year you would have $105 • The present value of receiving $105 one year from now at a 5% discount rate is $100 • Repaying a mortgage

8. Repaying a Mortgage • The Universe borrows $200,000 on 1/1/08 • Discount rate: 7% • Term of loan: 4 years • Payments at end of each year: $59,046 • Make journal entries for first two years • See the amortization table on the next slide?

9. Repaying a Mortgage

10. Long-term Liabilities: Raising Money by Issuing Bonds • What is a bond? • Types of bonds • Issuing bonds payable • Paying interest to bondholders • Market for trading bonds

11. What Is A Bond? • An interest-bearing, long-term note payable • Interest is usually paid to the bondholder semi-annually • Principal is repaid at maturity • Only corporations and governmental agencies can issue bonds • Face value (stated value) usually $1,000

12. Types of Bonds • Secured vs. unsecured • Do bondholders have a claim to specific assets if the corp defaults on the bonds? • Term vs. serial • Do bonds mature all at once or do they mature periodically over several years? • Convertible • Bondholder has option to convert bond into specified # of shares of stock Callable • Corp has option to redeem bond before maturity, usually for more than the bond’s face value • Junk bond • Rated at below investment grade

13. Issuing Bonds Payable • Bond terminology • Issue price • Issuing bonds at par • Issuing bonds at a discount • Issuing bonds at a premium

14. Bond Terminology • Market rate of interest • Interest rate based on the type of bond, the duration, and the risk that the issuer will default on the bond • Market interest rate fluctuates daily • Used as the discount rate to determine • The issue price • Interest expense issuer recognizes • Stated rate of interest • Interest rate on face of bond • Determines cash flow of interest • Face value x stated rate = interest payment • Does not fluctuate over life of bond

15. Issue Price • Stated Rate = Market Rate • Interest payments received = mkt rate • Bonds sell at a PAR • No difference between issue price and face value • Issuing corp’s interest payments equal to interest expense

16. Issue Price • Stated Rate < Market Rate • Interest payments received < mkt rate • Bonds sell at a DISCOUNT • Difference between issue price and face value fairly compensates investor for accepting lower interest payments • Issuing corp’s interest expense is greater than the interest paid to investors

17. Issue Price • Stated Rate > Market Rate • Interest payments received > mkt rate • Bonds sell at a PREMIUM. • Difference between issue price and face value reduces investor’s return to equal the market interest rate because interest payments are greater than the market rate • Issuing corp’s interest expense is less than the interest paid to investors

18. Issuing Bonds at Par • Start-up Corporation issues 100, $1,000 5-year bonds at 6% when the market rate = 6% • No discount or premium because stated rate = market rate • The bonds are issued at 100 • 100% of par

19. Issuing Bonds at a Discount • Start-up Corporation issues 100, $1,000 5-year bonds at 6% when the market rate = 7% • The discount is $4,100 • What is the issue price? • Bond discount is a contra-liability • Carrying value • Bond Payable - Discount on Bond Payable

20. Issuing Bonds at a Premium • Start-up Corporation issues 100, $1,000 5-year bonds at 6% when the market rate = 5.3% • The premium is $3,000 • What is the issue price? • Bond premium is an adjunct liability • Carrying value • Bond Payable + Premium on Bond Payable

21. Paying Interest to Bondholders • Interest = principal x int rate x time • Bonds issued at par • No discount or premium to amortize • Straight-line amortization per payment • Discount (or premium) / # of payments • As the bond matures, the carrying value gets closer to the par value • Premium/discount account gets smaller

22. Paying Interest to Bondholders • Bonds issued at a discount • A portion of the discount is ADDED to the interest payment to compute the interest expense • Interest pmt + discount amortized • 5-year bond with a $4,100 discount • Compute the discount amortized per year

23. Paying Interest to Bondholders • Bonds issued at a premium • A portion of the discount is SUBTRACTED from the interest payment to compute the interest expense • Interest pmt - premium amortized • 5-year bond with a $3,000 premium • Compute the premium amortized per year • Make the journal entry for the first year

24. Market for Trading Bonds • After bonds are issued, they are traded in a secondary market • The value of a bond fluctuates daily depending on the market rate of interest • What happens to the value of a bond if the market interest rate increases? Decreases?

25. Capital Structure • The combination of debt and equity a company uses as its source of capital • What other source of capital does a company have besides debt and contributed capital? • Generally, a company should only use debt financing when the return exceeds the cost of borrowing

26. Financial Leverage • Using borrowed funds to increase earnings for the shareholders (owners) • Increase return on equity • Positive financial leverage • Earnings on borrowed money > cost of borrowing money • What is the cost of borrowing money?

27. Debt-to-equity Ratio • Compares value of creditors’ claims to value of owners’ claims • Measure of long-term risk • Which is riskier, financing with equity or financing with debt? Why? Total liabilities _ Total shareholders’ equity

28. Times-interest-earned Ratio • Measures a company’s ability to make interest payments on its debt • Measure of short-term solvency Income from operations Interest Expense • Income from operations is used because it is more comparable across companies than net income. Why?

29. Business Risk, Control, and Ethics • Risk associated with long-term debt • Not being able to make debt payments • How to minimize risk of defaulting on debt • Sound business analysis accompanies any decision to borrow money • Evaluate types of debt for company’s circumstances

30. Time Value of Money • You did some gardening for a neighbor. The neighbor offers to pay you $100. Would you rather receive it when the job is finished or a year later? • Receiving a dollar today is worth more than receiving a dollar in the future. Why?

31. Simple vs. Compound Interest • Simple interest • Interest is computed on principal only • Short-term loans use simple interest • Compound interest • Interest computed on principal PLUS interest accrued, but not paid • Investments grow much faster when interest is compounded (Exhibit 9A.1)

32. Present Value of a Single Amount • FVn= PV (1 + i)n • where n = the number of years • i = the interest rate • PV = the present value of the future sum of money • FVn= the future value of the investment at the end of n years • PV = FVn x [1/(1+i)n]

33. Present Value of an Annuity • Annuity • A series of equal cash flows over equally spaced time intervals • Ordinary annuity • Payments made at the end of the period • PV = (1/i) x {1-[1/(1+i)n]}

34. Appendix B: Bond Proceeds • Proceeds from a bond is the sum of two cash flows • Present of a single amount • Receiving the face value upon maturity of the bond • Present value of an annuity • The periodic interest payments

35. Appendix B: Bond Proceeds • Bond issued at a premium • Stated rate > market rate • Compute price on 10-year $1,000 bond • Stated rate is 6% and market rate is 5% • How much interest is received each period?

36. Appendix B: Bond Proceeds • Present value of the annuity • 10 periods, 5% per period, $60 per pmt. • $60 x 7.72173 = $463 • Present value of the face value • 10 periods, 5%, $1,000. • $1,000 x 0.61391 = $614 • Bond price: $463 + $614 = $1,077

37. Appendix B: Bond Proceeds • Bonds issued at a discount • Stated rate < market rate • Compute price on 10-year $1,000 bond • Stated rate is 4% and market rate is 5% • How much interest is received each period?

38. Appendix B: Bond Proceeds • Present value of the annuity • 10 periods, 5% per period, $40 per pmt. • $40 x 7.721735 = $309 • Present value of the face value • 10 periods, 5%, $1,000. • $1,000 x 0.61391 = $614 • Bond price: $309 + $614 = $923

39. Appendix C: Bond Amortization • Effective interest method • Actual interest expense on outstanding principal balance • Actual interest expense • [carrying value] x [mkt rate at issue] x [time] • Difference between interest payment and interest expense is the amount of premium/discount amortized for the period

40. Appendix C: Bond Amortization • Straight-line vs. effective interest method • Straight-line • Interest rate changes; interest expense is constant • Effective interest method • Interest rate is constant; interest expense changes • GAAP, but straight-line may be used if difference between the two methods is not material

41. Appendix D: Leases and Pensions • Capital leases • Accounted for as a purchase and a loan • Asset recorded on books • Liability recorded for future lease pmts • Obligations Under Capital Leases • Details in notes to financial statements

42. Appendix D: Leases and Pensions • Pensions • Liability increases for defined benefit plans when cash payment to pension fund is less than the annual obligation • FASB requires disclosure of a great deal of information about pension plan and funding

43. Assign #3: pg. 477-478 - E9-6A, E9-9A; Assign #4: pg. 483-484 - P9-1A, P9-4A.