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Accounting Boot Camp Modules 6 and 8 Time Value of Money, Liabilities and Equity

Accounting Boot Camp Modules 6 and 8 Time Value of Money, Liabilities and Equity. What is a liability?

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Accounting Boot Camp Modules 6 and 8 Time Value of Money, Liabilities and Equity

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  1. Accounting Boot CampModules 6 and 8Time Value of Money,Liabilities and Equity

  2. What is a liability? “Probable future sacrifice of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” Future sacrifice of economic benefits. Present obligations. Past transactions or events. Liabilities

  3. Classification expected to require the use of current assets (or the creation of other current liabilities) to settle the obligation. Valuing current liabilities on the balance sheet Ignore present value Report at face value Reporting current liabilities Primary problem is ensuring that all existing current liabilities are reported on the balance sheet. A. Current Liabilities

  4. 1. Accounts payable - for purchase of goods and services (usually no interest). 2. Accrued liabilities - short-term payables usually settled with cash in the near future. Ex: Wages, Interest, Income Tax, Utilities, Vacation Pay, Bonuses, Property Taxes. 3. Unearned revenues - usually settled with delivery of goods and services. 4. Estimated accruals - amounts not known at the end of the period and must be estimated. Ex: Warranties. Current Operating Liabilities

  5. 5.Companies generate sales revenue when they sell products; offering warranties is part of the cost of selling the product; the amount of the future warranty costs is not known, but may be estimated. Record estimated expense and liability when products are sold (matching concept): Warranty Expense xx Estimated Warranty Liability xx As costs are incurred (usually in subsequent periods), charge expenditure to warranty liability: Estimated Warranty Liability xx Cash, etc. xx Note: warranties, like other estimates, may be subject to manipulation. Warranties

  6. 6. What about lawsuits where the company is the defendant? Should we accrue for the possible future liability? Only if the settlement is “probable” and “reasonably estimable”. Since the criteria are vague, and legal staff can usually find sufficient evidence to indicate some level of probability that the defendant will prevail, estimated liabilities for lawsuits are rarely recorded. However, most lawsuits meet the minimum requirement of “reasonably possible” and must be disclosed in the notes to the financials; these disclosures inform investors as to the potential exposure. Most companies have a section for “Contingencies” in their footnotes. Lawsuits

  7. 7.Short-Term Interest-Bearing Debt - borrowing from bank is a financing activity, and not part of operations. 8.Current Portion of Long-Term Debt - the portion of long-term liabilities, like bonds and mortgages, that will come due within the next 12 months (as of the financial statement date), will require the use of current assets (specifically cash) to settle the liabilities; these liabilities must be classified as current liabilities. Now Homework Questions1,2,5,6 Current Non-Operating Liabilities

  8. Long-term liabilities are initially recorded at the present value of the future cash flows. Before discussing long-term liabilities, we must first introduce the concept of present value. Future value applications are discussed in a later section. B. Long-Term Liabilities: Bonds Payable

  9. The value of a dollar today will decrease over time. Why? Two components determine the “time value” of money: interest (discount) rate number of periods of discounting For financial reporting, we are concerned primarily with present value concepts. Other investment decisions utilize future value concepts. Time Value of MoneyAppendix 8A (pages 8-27 through 8-32)

  10. To record activities in the general ledger dealing with future cash flows, we should calculate the present value of the future cash flows using present value formulas or techniques. Types of activities that require PV calculations: long-term notes payable bonds payable and bond investments capital leases Present Value Concepts

  11. PV of a single sum (PV1): discounting a future value of a single amount that is to be paid in the future (ex: face value of bonds payable). PV of an ordinary annuity (PVOA): discounting a set of payments, equal in amount over equal periods of time, where the first payment is made at the end of each period (ex: interest on bonds payable). Note: present value of an annuity due will also be discussed in ACCT 5301. Types of Present Value Calculations

  12. All present value calculations presume a discount rate (i) and a number of periods of discounting (n).There are 4 different ways you can calculate the PV1: 1. Formula: PV1 = FV1 [1/(1+i)n] 2. Tables: see page A2 (back of text), Table 1 PV1 Table PV1 = FV1( ) i, n 3.Calculator (with time value functions) 4.Spreadsheet Present Value of a Single Sum

  13. Long-term, usually issued to financial institutions. May be interest bearing or non-interest bearing (we will look at non-interest bearing). May be serial notes (periodic payments) or term notes (balloon payments). We will look at balloon payments here. Note: zero coupon bonds are similar in treatment to non-interest bearing notes. Illustration 1: On January, 2, 2009, Pearson Company purchases a section of land for its new plant site. Pearson issues a 5 year non-interest bearing note, and promises to pay $50,000 at the end of the 5 year period. What is the cash equivalent price of the land today, if a 6 percentdiscount rate is assumed? Illustration 1: L.T. Notes Payable

  14. See page A2 (back of the text), Table 1 PV1 Table PV1 = FV1( ) i, n PV1 Table i=6%, n=5 Journal entry Jan. 2, 2009: Illustration 1 Solution PV1 = 50,000 ( 0.74726) = $37,363 Land 37,363 Notes Payable 50,000 Discount on N/P 12,637

  15. An annuity is defined as equal payments over equal periods of time. An ordinary annuity assumes that each payment occurs at the end of each period. PVOA calculations presume a discount rate (i), where (A) = the amount of each annuity, and (n) =the number of annuities (or rents), which is the same as the number of periods of discounting. There are 4 different ways you can calculate PVOA: 1. Formula: PVOA = A [1-(1/(1+i)n)] / i 2. Tables: see page A-2 (back of text), Table 2 PVOA Table PVOA = A( ) i, n 3.Calculator (with time value functions) 4.Spreadsheet 2. Present Value of an Ordinary Annuity (PVOA)

  16. Illustration 2: On January, 2, 2008, Pearson Company purchases a section of land for its new plant site. Pearson issues a 5 year non-interest bearing note, and promises to pay $10,000per year at the end of each of the next 5 years. What is the cash equivalent price of the land, if a 6 percentdiscount rate is assumed? Illustration 2: Long Term Notes Payable

  17. See Appendix A, Table 2 PVA Table PVA = A ( ) i, n PVA Table i=6%, n=5 Journal entry Jan. 2, 2008: Illustration 2 Solution PVA = 10,000 ( 4.21236) = $42,124 Land 42,124 Discount on N/P 7,876 Notes Payable 50,000

  18. Bonds payable are issued by a company (usually to the marketplace) to generate cash flow. The bonds represent a promise by the company to pay a stated interest each period (yearly, semiannually, quarterly), and pay the face amount of the bond at maturity. The marketplace values bonds by discounting the cash flows using the market rate of interest. This is also called the yield rate, discount rate, or effective rate. There are two types of cash flows with bonds: PVOA (for interest payments) and PV1(for payment of maturity value). Bonds Payable

  19. On January 1, 2006, Corvette Corporation issues $100,000 of its 5 year bonds which have an annual stated rate of 5%, and pay interest annually each December 31, starting December 31, 2006. The bonds were issued to yield 6% annually. Calculate the issue price of the bond: What are the cash flows and factors? (1) Face value at maturity = (2) Stated Interest = Face value x stated rate x time period Number of periods = n = 5yrs Discount rate = 6% per year Illustration 3: Bonds Payable (Discount) $100,000 100,000 x .05 per yr x 1 yr. =$5,000

  20. PV of interest annuity: PVOA Table PVOA Table PVOA = A( ) = i, ni = 6%, n=5 PV of face value: PV1 Table PV1 Table PV =FV1( ) = i, n I = 6%, n=5 Total issue price = Issued at a discountof $4,212 because the company was offering an interest rate less than the market rate, and investors were not willing to pay as much for the lower interest rate. Illustration 3: Present Value Calculations 5,000 (4.21236) = $21,062 100,000(0.74726)=$74,726 $95,788

  21. Illustration 3: Journal Entry The journal entry to record the initial issue of the bond would be: Cash 95,788 Discount on B/P 4,212 Bonds Payable 100,000

  22. On July 1, 2005, Mustang Corporation issues $100,000 of its 5 year bonds which have an annual stated rate of 7%, and pay interest semiannually each June 30 and December 31, starting December 31, 2005. The bonds were issued to yield 6% annually. Calculate the issue price of the bond: What are the cash flows and factors? (1) Face value at maturity = $100,000 (2) Stated Interest = Face value x stated rate x time period 100,000 x .07 x 1/2 = $3,500 Number of periods = n = 5 yrs x 2 = 10 Discount rate = 6% / 2 = 3% per period Illustration 4: Bonds Payable(Premium)

  23. PV of interest annuity: PVOA Table PVOA Table PVOA = A( ) = 3,500 (8.53020) = $29,856 i, ni = 3%, n = 10 PV of face value: PV1 Table PV1 Table PV =FV1( ) = 100,000(0.74409)=$74,409 i, n i=3%, n=10 Total issue price = $104,265 Issued at a premium of $4,265 because the company was offering an interest rate greater than the market rate, and investors were willing to pay more for the higher interest rate. Illustration 4 - Solution

  24. Illustration 4: Journal Entry The journal entry to record the initial issue of the bond would be: Now work HW Questions 12, 13. Cash 104,265 Premium on B/P 4,265 Bonds Payable 100,000

  25. Other present value applications include financial decisions. For example: Illustration 4: On January, 2, 2008, Donna Smith won the lottery. She was offered an annuity of $100,000 per year for the next 20 years, or $1,000,000 today as an alternative settlement. Which option should Donna choose? Assume that she can earn an average 4 percent return on her investments for the next 20 years. Solution: calculate the present value of the annuity at a discount rate of 4%, then compare to the $1,000,000 settlement. Illustration 5: Annuity Income

  26. PVOA Table PVOA = A ( ) i, n PVOA Table i=4%, n=20 Which should she choose? At approximately what interest (discount) rate would she choose differently? (based on whole percentage rate) Illustration 5 Solution PVOA = 100,000 (13.59033) = $1,359,033 Choose the annuity, PV > $1,000,000 At 8 % interest, PV < $1,000,000

  27. FV of a single sum (FV1): compounding a future value of a single amount that is to be accumulated in the future. Example: projected future value of a savings bond. FV of an ordinary annuity (FVOA): compounding the future value of a set of payments, equal in amount over equal periods of time, where the first payment is made at the end of the first period. Examples: projected balance in a retirement account. amount of payments into retirement fund. Types of Future Value Calculations

  28. There are 4 different ways you can calculate the FV1: 1. Formula: FV1 = PV1 [(1+i)n] 2. Tables: see page A-3, Table 3 FV1 Table FV1 = PV1( ) i, n 3.Calculator (with time value functions). 4.Excel spreadsheet. 3. Future Value of a Single Sum (FV1)

  29. Holliman Company wants to invest $200,000 cash it received from the sale of land. What amount will it accumulate at the end of 10 years, assuming a 6% interest rate, compounded annually? FV1 Table FV1 = PV1 ( ) i=6%, n=10 FV1 Table FV1 = ( ) = i=6%, n=10 Illustration 6: Investment 200,000 1.79085 $358,170

  30. FVOA calculations presume a compound rate (i), where (A) = the amount of each annuity, and (n) =the number of annuities (or rents), which is the same as the number of periods of compounding. There are 4 different ways you can calculate FVOA: 1. Formula: FVOA = A [(1+i)n - 1] / i 2. Tables: see page A-3, Table 4 FVOA Table FVOA = A( ) i, n 3.Calculator (with time value functions). 4.Excel spreadsheets. 4.Future Value of an Ordinary Annuity (FVOA)

  31. Jane Smith wants to invest $10,000 at the end of each year for the next 20 years, for her retirement. What balance will she have at the end of 20 years (after the last deposit), assuming a 6% interest rate, compounded annually? FVOA Table FVOA = A ( ) = i=6%, n=20 FVOA Table FVOA = ( ) = i=6%, n=20 Illustration 7: Future Value of Investment 10,000 36.78559 $367,856

  32. James Holliman wants to accumulate $200,000 at the end of 10 years, for his son’s education fund. What equal amount must he invest annually to achieve that balance, assuming a 6% interest rate, compounded annually? FVOA Table FVOA = A ( ) = i=6%, n=10 FVOA Table = ( ) i=6%, n=10 Illustration 8: Future Value of Investment A 200,000 13.18079 A = 200,000/13.18079 = $15,173.60

  33. 1. Accounting for preferred and common 2. Treasury stock 3. Retained earnings 4. Other comprehensive income 5.Statement of stockholders’ equity C. Stockholders’ Equity

  34. Advantages Preference over common in liquidation Stated dividend Variety of features regarding dividends Preference over common in dividend payout Disadvantages Subordinate to debt in liquidation Stated dividend can be skipped No voting rights (versus common) Debt or equity? components of both usually (but not always) classified with equity 1. Preferred Stock

  35. Advantages Voting rights: election of board of directors vote on significant activities of management Rights to residual profits (after preferred) Disadvantages Last in liquidation No guaranteed return 1. Common Stock

  36. Par value - initially established to create a “minimum legal capital”. Ex: Minimum legal capital in some states is $1,000 for new corporations, so issue: 1,000 shares at $1par, or 100 shares at $10 par, or other combination. . . Par value is not market value. Credit CS or PS for par value. Excess over par credited to “Paid in Capital in Excess of Par or Stated Value” or abbreviated: “Additional Paid-in Capital” (APIC). Some newer stock issues (for common stock) are “no par” stock. 1. Accounting for Common Stock (CS) and Preferred Stock (PS)

  37. Issue PS at greater than par value: Cash xx mkt. value Preferred Stock xx total par APIC - PS xx excess(plug) Issue CS at greater than par value: Cash xx mkt. value Common Stock xx total par APIC - CS xx excess(plug) Note: most states do not allow companies to issue at less than par value. 1. Journal Entries

  38. Issue no par common stock: Cash xx mkt. value Common Stock xx mkt. value Note: many companies have newer stock issues that are no par, but most companies still have older stock issues which contain a par value and APIC. The Stockholders’ Equity section of the balance sheet of Sample Company illustrates many of the components of SE discussed in this chapter. 1. Journal Entries -continued

  39. Common stock, $1 par value, 500,000 shares authorized, 80,000 shares issued, and 75,000 shares outstanding $ 80,000 Preferred stock, $100 par value, 1,000 shares authorized, 100 shares issued and outstanding 10,000 Paid in capital on common $ 20,000 Paid in capital on preferred 3,000 Paid in capital on treasury stock 2,000 25,000 Retained earnings: Unappropriated $20,000 Appropriated 4,000 24,000 Less: Treasury stock, 5,000 shares (at cost) (6,000) Less: Other comprehensive income (loss) (2,000) Total Stockholders’ Equity $131,000 Sample Co. Stockholders’ Equity

  40. Now, using Sample Company information, record the following additional issues of common and preferred stock: Issued 100 shares of PS at $102 per share: Cash (100x $102) 10,200 PS (100x $100 par) 10,000 APIC - PS (plug) 200 Issued 500 shares of CS at $5 per share: Cash (500 x $5) 2,500 CS (500 x $1 par) 500 APIC - CS (plug) 2,000 Now work HW Questions 22,25,26,27,28. Journal Entries-Sample Co.

  41. Created when a company buys back shares of its own common stock. Reasons for buyback: reissue to employees for compensation. hold in treasury (or retire) to increase market price and earnings per share. reduce total dividend payouts while maintaining per share payouts. thwart takeover attempts by reducing proportion of shares available for purchase. give cash back to existing shareholders. 2. Treasury Stock

  42. The debit balance account called “Treasury Stock” is reported in stockholders’ equity as a contra (reduces SE). Note: not an asset. The stock remains issued, but is no longer outstanding. does not have voting rights cannot receive cash dividends May be reissued (to the market or to employees) or retired. No gains or losses are ever recognized from these equity transactions. 2. Treasury Stock - continued

  43. There are two techniques for recording TS transactions (Par Value method and Cost method). We will use only the Cost method. This technique establishes a “cost” for TS equal to the amount paid to acquire the TS. Par value is notused for TS transactions. To record purchase of TS from market: TS xx “cost” Cash xx market (cost equals the cash paid) 2. Treasury Stock(TS) - Journal Entries

  44. To reissue TS to market at greater than cost: Cash xx market APIC - TS xx over cost TS xx cost To reissue TS to market at less than cost: Cash xx market APIC - TS xx if available Retained Earnings xx if needed* TS xx cost *debit RE if no APIC-TS available to absorb the remaining debit difference. 2. Treasury Stock(TS) - Journal Entries

  45. TT Corporation has 100,000 shares of $1 par value stock authorized, issued and outstanding at January 1, 2008. The stock had been issued at an average market price of $5 per share, and there have been no treasury stock transactions to this point. Assume that, in February of 2008, TT Corp. repurchases 10,000 shares of its own stock at $7 per share. In July of 2008, TT Corp. reissues 2,000 shares of the treasury stock for $8 per share. In December of 2008, TT Corp. reissues the remaining 8,000 shares for $6 per share. Prepare the journal entries for 2008 regarding the treasury stock. TS - Example Problem

  46. Feb: repurchase 10,000 sh. @ $7 = $70,000. July: reissue 2,000 sh @ $ 8 = $16,000 (cost = 2,000 @ $7 = 14,000) TS Example -Journal Entries TS 70,000 Cash 70,000 Cash 16,000 TS 14,000 APIC - TS 2,000

  47. Dec: reissue 8,000 sh. @ $ 6 = $48,000 (cost = 8,000 sh.@ $7 = 56,000) Now we need to debit one or more accounts to compensate for the difference. (1) debit APIC-TS (but lower limit is to -0-). (2) debit RE if necessary for any remaining balance (this is only necessary when we are decreasing equity). Now work HW Questions 20,21,23,24. TS Example -Journal Entries Cash 48,000 APIC-TS (1) 2,000 RE (2) 6,000 TS 56,000

  48. We will be expanding the basic retained earnings formula in this chapter. Now, the Retained Earnings Column of the Statement of Stockholders’ Equity may include the following: RE, beginning xx Add: net income xx Less dividends: Cash dividends-common xx Cash dividends - preferredxx Stock dividends xx Property dividends xx Less: Adjustment for TS transactions xx Appropriation of RE xx RE, ending xx 3. Retained Earnings

  49. Comprehensive Income is a term that was defined in the Statements of Financial Accounting Concepts (SFAC 6). It consists of all non-owner changes in equity. This includes net income as we have been defining revenues and expenses throughout the semester, and it also includes “Other Comprehensive Income.” 4. Other Comprehensive Income

  50. “Other Comprehensive Income” (OCI) includes certain direct equity adjustments that are not part of the current income statement, but which may have eventual effect on income. One of these adjustments that will not be discussed until the fall class is the pension adjustment. The amount is recorded to reflect the full amount of the pension asset or liability in the balance sheet, with the offset to OCI, until the effect is eventually transferred to the income statement. 4. Other Comprehensive Income

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