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Liabilities

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  • 2 Chapter 10: Liabilities.
  • Learning objective number 1 is to define liabilities and distinguish between current and long-term liabilities.
  • Liabilities are debts owed from past transactions. Liabilities can be separated into two categories: Current and Non-current. Current liabilities are due to be paid within one year or the normal operating cycle of the business, whichever is longer. For most businesses, one year is longer than the operating cycle. Noncurrent liabilities are due to be paid sometime after one year.
  • A company can finance its operations from two sources. One is debt. Debt is a borrowing from a creditor, such as a bank. It has a definite due date and in most cases bears an interest rate. Another way a company can finance its operations is through equity. This requires companies to sell additional stock in the company to new or existing shareholders.
  • Current liabilities are defined as those liabilities that must be paid within one year or within the normal operating cycle, whichever is longer. Working capital is defined as current assets minus current liabilities.
  • Part I Review this information for Devon Manufacturing. Is this a current or non-current liability? Part II Because the debt has a maturity term of 20 years, it is non-current.
  • Accounts Payable are short-term obligations for purchases of merchandise and other goods and services that are used in the normal operations of a business.
  • Learning objective number 2 is to account for notes payable and interest expense.
  • Many Notes Payable require payments on a regular basis during the life of the note. For example, many home mortgages are for fifteen or thirty years. But homeowners do not wait until the end of the fifteen or thirty years to make a payment. They usually make monthly payments during the loan term. Remember that any debt due within one year is classified as current. The portion of a note payable that is due within one year would be classified as a current liability. The remainder of the note that is due outside of one year is classified as noncurrent.
  • A note is a written promise to pay a specific amount at a specific future date. A note includes the following necessary information about the agreement. The payee on the note is the recipient of the cash at maturity. In this example, the payee is Security National Bank. The maker on the note is the debtor who owes the money. In this example, the maker is Porter Company. Notes also include information about the principal, interest rate, and due date. This note is for $10,000, has an interest rate of 12%, and is due six months from the date of the note. Let’s look at the entry Porter Company will make on November 1 st .
  • Porter debits Cash and credits Note Payable for $10,000.
  • Most notes have an interest rate associated with them. For borrowers, this is the interest expense they will incur and for lenders, this is the interest revenue they will receive.
  • Interest is calculated as Principal times the Interest Rate times the Time the note was outstanding.
  • Part I On December 31 st , Porter Company needs an adjusting entry to record the interest expense. Let’s look at that entry. Part II On December 31 st , Porter debits Interest Expense and credits Interest Payable for $200. The two hundred dollars in interest is calculated as the original note amount of ten thousand dollars times the interest rate of twelve percent times the outstanding time of the note. At December 31 st , the outstanding time for this note is two months.
  • Part I On January 31 st , Porter Company will pay back the principal amount of the note plus the interest for three months. Let’s look at that entry. Part II Porter eliminates the note payable for $10,000 and the interest payable for $200. The company must recognize the interest expense for the month of January of $100. Cash will be credited for the principal plus interest of $10,300. The two hundred dollars in interest is calculated as the original note amount of ten thousand dollars times the interest rate of twelve percent times the outstanding time of the note. At December 31 st , the outstanding time for this note is two months.
  • Learning objective number 3 is to describe the costs and basic accounting activities related to payrolls.
  • Ever wondered what happens to the money deducted from your paycheck? Employers do not keep this money; instead it’s remitted to the appropriate entity. For example, money withheld for taxes is remitted to the proper taxing authority. Money voluntarily taken out of your paycheck for retirement funds and insurance is also remitted to the proper place. All of these withholdings are liabilities for employers. They are due and payable to the appropriate entity within certain time periods.
  • Most of the time people in debt owe money, but sometimes a business can be in debt for services. For example, assume a new client asks his accounting firm to perform next year’s audit. After checking, the firm sees that it has just enough time to add one client to the schedule next year. The firm tells the client it would be glad to perform the audit but needs $10,000 to hold their spot on the schedule. The client agrees and gives the accounting firm $10,000. When it is time to do the audit, how happy would the client be if the accounting firm just gave them back the $10,000 instead of performing the audit? Not too happy. They do not want money; they want auditing services. The accounting firm is not in debt for money but for auditing services valued at $10,000. When the client paid in advance for the audit services, the firm debited Cash and credited a liability called Unearned Revenue.
  • When a company has a relatively small need for cash, the need can usually be met by a single lender, such as a bank.
  • However, when a company needs large amounts of cash, one creditor may not be willing to take on all the risk of repayment. In this case, many companies issue bonds to lots of different people and entities to spread out the risk.
  • Installment notes call for a series of payments. Each payment includes some payment on the principal and some payment for interest. Most car loans and home loans are set up on installment payments. Often, the required payments are the same each month. For each payment made, the amount of the principal payment increases and the amount of the interest payment decreases.
  • When allocating a payment between interest and principal, follow these four steps. First, identify the unpaid principal balance. Second, calculate the interest expense. Third, determine the reduction in the principal balance. Fourth, compute the new unpaid principal balance. Let’s look at an example.
  • Learning objective number 4 is to prepare an amortization table allocating payments between interest and principal.
  • Review the information for Rocket Corporation. On January 1 st , Rocket Corporation borrowed money from First Bank. The annual payment is $2,000. Let’s look at the amortization table for this loan.
  • Notice the annual payment is always $2,000. Also notice that for each payment the interest portion decreases and the principal portion increases. Let’s review how to get the interest expense and the principal payment amounts for the first installment payment on the note. Interest is calculated by taking the unpaid balance at the beginning of the period of $7,581.57 and multiplying it by the 10% interest rate. The principal is calculated by taking the annual payment and subtracting the interest. Let’s look at the entry for the first payment.
  • The entry includes a debit to Interest Expense and Note Payable and a credit to Cash.
  • Learning objective number 5 is to describe corporate bonds and explain the tax advantage of debt financing.
  • As mentioned earlier, when companies need large amounts of cash, they often issue bonds. The principal on bonds is typically paid at the end of the bond period. Bonds are often denominated with a face value, or par value, of $1,000.
  • Bonds normally have an interest rate called a stated or contract rate. Interest is normally paid semiannually and is computed as Principal times Rate times Time. This computation should look familiar to you.
  • Bonds are issued through an underwriter. A large number of bonds are traded on the New York Exchange and the American Exchange. Since bonds are bought and sold in the market, they have a market value, or price. For convenience, bond market values are expressed as a percent of their face or par value.
  • There are several types of bonds. For Mortgage bonds, the issuer pledges specific assets as collateral. Debenture bonds are backed by the issuer’s general credit standing. Convertible bonds can be exchanged for a fixed number of common shares of the issuing corporation. Junk bonds have very high risk associated with them.
  • Part I Review this information for Rocket Corporation. Assume the bonds are issued at face value. Let’s see how to record this bond issue. Part II To record this bond issue, Rocket debits Cash and credits Bonds Payable for $1,500,000.
  • Part I Let’s record the interest payment. Part II On July 1 st , the interest payment is recorded as a debit to Interest Expense and a credit to Cash for $90,000. Interest is calculated as principal of one million five hundred thousand dollars times the interest rate of twelve percent times the time period of half a year.
  • One complicating factor that can occur is when a company issues bonds between interest dates. This is a common occurrence because bonds are sold when there is a willing buyer and seller, and that can take place on any date, not just an interest payment date. When bonds are issued between interest payment dates, the investor pays for the bond PLUS the accrued interest since the last interest payment date. This allows the issuing company to pay all the investors the same interest amount on the interest payment date. On the interest payment date, the investor receives the full interest payment for the period even though the bond was only outstanding for a portion of the period. The interest payment actually represents two factors: One is a mere repayment of the accrued interest that the investor paid on the purchase date of the bond; the other is interest earned since the bond was purchased.
  • Learning objective number 6 is to account for bonds issued at a discount or premium.
  • The selling price of a bond is determined by comparing the market interest rate with the stated interest rate on the bond. If the stated interest rate on the bond is equal to the market interest rate, then the bond sells at par value. That is, the selling price of the bond is equal to its par value. In most cases, the stated rate and the market rate of interest will not agree. When these two interest rates differ, it seems to make sense to just change the stated rate to equal the market rate. However, this cannot be done because the bond certificate that lists all of the specifics about the bond, including the interest rate, was printed in advance of the issue date. Thus, we must pay the interest printed on the bond certificate. The only thing not printed on the bond certificate is the selling price. The issuing company and the bond investors come to an agreement on a selling price that incorporates the difference in the stated interest rate and the market interest rate. If a bond is paying 10 percent and the market is paying 12 percent, how many investors will want to buy bonds? None! Bonds must be made more attractive by reducing the selling price to make up the difference in the interest rates. In this case, the bond will sell at a discount, or below par value. This discount raises the effective interest rate investors will earn to 12 percent. Now, if a bond is paying 10 percent and the market is paying 8 percent, how many investors will want to buy bonds? All of them! The selling price can be increased and still be attractive to bond investors. In this case, the bond sells at a premium, or above par value. This premium reduces the effective interest rate that investors will earn to 8 percent.
  • In almost all cases, the stated rate and the market rate of interest will not agree. When these two interest rates are different, it might make sense to you for us to just change our stated rate to equal the market rate and then everything would be fine. Well, we can’t do that. The bond certificate lists all of the specifics about the bond including the stated interest rate. Because we have to print the bond certificates in advance, we are stuck having to pay the interest printed on the bond certificate. The only thing that is not printed on the bond certificate is the selling price. So, the issuing company and the bond investors come to an agreement on the selling price that incorporates the difference in the stated interest rate and the market interest rate at the time of issue. For example, if the market rate of interest is more than 9%, investors will be unwilling to pay the full face amount of $1,000,000 for Matrix’s 9% bonds. The issue price of Matrix’s 9% bonds will have to be lower to entice investor interest. The difference between the lower issue price and the face amount of one million dollars is called a discount. Let’s see how we account for bonds issued at a discount.
  • Because the market rate of interest is more than 9%, Matrix must reduce the issue price of its 9% bonds from $100,000 to $950,000 to attract investors. The difference between the $1,000,000 face value of the bonds and the cash issue price of $950,000 is the $50,000 discount that Matrix offers to the bond investors.
  • On the issue date, Matrix will debit Cash for the $950,000 of cash received, credit Bonds Payable for the face amount of $1,000,000, and debit Discount on Bonds Payable for the $50,000 difference. Discount on Bonds Payable is a contra-liability account and has a normal debit balance.
  • On the balance sheet, the discount account is subtracted from the face value of the bonds to arrive at the net carrying value of the bonds.
  • The discount represents an additional interest factor that will be amortized to Interest Expense over the life of the bond. Amortizing the discount will increase the total Interest Expense recorded for the bond each interest payment period. Using the straight-line method to amortize the discount, Matrix will divide the total discount by the number of interest payment periods to get the the amount of the discount amortized each interest payment period. Since this is a 20-year bond and it pays interest semiannually, there are 40 interest payment periods. This calculation determines that the discount amortization will be $1,250 at each interest payment date.
  • Part I Interest is paid semiannually, so Matrix will pay $45,000 every six months to the bond investors. Part II At each interest payment date Matrix, Inc. will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. The credit to Discount on Bonds Payable is determined using the straight-line method we discussed on the previous screen. The debit to Bond Interest Expense is the total of the two amounts in this entry.
  • On the balance sheet at the end of 2007, the discount account is subtracted from the principal amount of the bonds to arrive at the net carrying value of the bonds. As the discount is amortized, the carrying value will increase to exactly $1,000,000 on the maturity date.
  • On the maturity date, Matrix, Inc. will record the payment of the face amount of the bonds by debiting Bonds Payable and crediting Cash for $1,000,000.
  • Remember that in almost all cases, the stated rate and the market rate of interest will not agree. When this happens, the issuing company and the bond investors come to an agreement on the selling price that incorporates the difference in the stated interest rate and the market interest rate at the time of issue. For example, if the market rate of interest is less than 9%, investors will be willing to pay more than the full face amount of $1,000,000 for Matrix’s 9% bonds. The issue price of Matrix’s 9% bonds will rise because of investor demand for the 9% bonds. The difference between the higher issue price and the face amount of $1,000,000 is called a premium. Let’s look at a premium on the bonds issued by Matrix.
  • Because the market rate of interest is less than 9%, Blair will increase the issue price of its 9% bonds from $1,000,000 to $1,050,000. The difference between the $1,000,000 face value of the bonds and the cash issue price of $1,050,000 is the $50,000 premium.
  • On the issue date, Matrix will debit Cash for the $1,050,000 of cash received, credit Bonds Payable for the face amount of $1,000,000, and credit Premium on Bonds Payable for the $50,000 difference. Premium on Bonds Payable is a adjunct-liability account and has a normal credit balance.
  • On the balance sheet, the premium is added to the face value of the bonds to arrive at the net carrying value of the bonds.
  • The premium represents a reduction in interest that will be amortized to Interest Expense over the life of the bond. Amortizing the premium will decrease the total Interest Expense recorded for the bond each interest payment period. Using the straight-line method to amortize the premium, Matrix, Inc. will divide the total premium by the number of interest payment periods to get the the amount of the premium amortized each interest payment period. Since this is a 20-year bond and it pays interest semiannually, there are 40 interest payment periods. This calculation determines that the premium amortization will be $1,250 at each interest payment date.
  • Every six months, Matrix will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. The debit to Premium on Bonds Payable is determined using the straight-line method we discussed on the previous screen. The debit to Interest Expense is the difference between the $45,000 of cash paid and the $1,250 of premium amortization.
  • On the balance sheet, the premium account is added to the face value of the bonds to arrive at the current carrying value of the bonds. As the premium is amortized, the carrying value will decrease to exactly $1,000,000 on the maturity date.
  • On the maturity date, Matrix will record the payment of the face amount of the bonds by debiting Bonds Payable and crediting Cash for $1,000,000.
  • Learning objective number 7 is to explain the concept of present value as it relates to bond prices.
  • Part I The basis of the present value concept is that money can grow over time because of the interest it can earn. Part II For example, $1,000 invested today at 10% will be worth $1,610.51 in five years and worth $10,834.71 in twenty-five years. The present value concept is used to price bonds. Bonds are priced at the present value of their future cash flows.
  • In many transactions the future amount to be received is known, and the present value of this amount can be determined. This is typically the case with bonds. The next slide will show how to determine the present value of future cash flows for a bond.
  • To determine the present value of a future amount, three things must be known: the future amount to be received, the interest rate, and the number of interest compounding periods. For a bond, the future amount may take two forms. First, a bond typically has a lump sum payment for principal due on a maturity date in the future. Second, bonds may also have periodic interest payments made during the life of the bond. For a bond, the calculated present value would be its selling price. Let’s take a closer look at the two types of future cash flows associated with bonds.
  • As mentioned, there are two types of future cash flows involved with bonds. First, periodic interest payments made to bondholders. The bond contract specifies how frequently interest payments will be made—in most cases, either annually or semiannually. Interest payment amounts are called annuities and are calculated as the Bond Principal times the Stated Interest Rate on the bond times the Outstanding Time Period in the year. The second cash flow for a bond is a principal payment at maturity. This is a lump sum payment at the end of a bond term to repay principal borrowed at the beginning.
  • Bonds can be retired by exercising a call provision or purchasing the bonds on the open market. If bonds are retired before the maturity date, a gain or loss is recorded. The gain or loss is determined by comparing the carrying value of the bond on the retirement date with the cash price paid to retire the bond. Gains or losses due to bond retirement should be reported as other income or other expense on the income statement.
  • Learning objective number 8 is to explain how estimated liabilities, loss contingencies, and commitments are disclosed in financial statements.
  • Loss contingencies result from an existing situation that involves a potential loss, depending on whether a future event occurs. An example of a loss contingency is a lawsuit. In this example, the potential loss depends on whether the lawsuit is successful or not. There are two factors that affect whether a loss contingency must be accrued and reported as a liability: One is the likelihood that the confirming event will occur, and the other is whether the loss amount can be reasonably estimated. If it is probable that a loss contingency will occur and if the loss amount can be reasonably estimated, then a loss is accrued and reported as a liability.
  • Some liabilities must be estimated when recorded. These liabilities are known to exist, but the exact dollar amount is uncertain. Product warranties are an example of this.
  • Learning objective number 9 is to evaluate the safety of creditor’s claims.
  • The Interest Coverage ratio indicates a margin of protection for creditors. It is calculated as Operating Income divided by Interest Expense.
  • Part I See if you can calculate Devon’s interest coverage ratio. Part II Devon has an interest coverage ratio of 10. This means that Devon was able to earn its annual interest expense payment 10 time during the year. This is a very comforting measure for creditors.
  • Many companies use financial leverage to increase investment earnings. By borrowing at a low rate and investing at a higher rate, the company will have a net increase in investment profits.
  • Learning objective number 10 is to describe reporting issues related to leases, postretirement benefits, and deferred taxes.
  • If you rent an apartment, you probably have an operating lease. You have the right to use the property, within certain limits, but the landlord still owns the property. You probably make monthly rent payments and at the end of your rental period, you will move out of the apartment. This typical rental agreement involves the lessee recording rent expense as rent payments are made. However, there are situations that may look like a rental agreement but that are more like a purchase of the assets being rented. These are called capital leases, and in these situations the lease agreement transfers risks and benefits associated with ownership to the lessee. Because the lessee basically becomes the owner of the property, the lessee must record an asset and a liability. Let’s look in more detail at the characteristics of a capital lease.
  • To qualify as a capital lease, a lease contract must have one of the following criteria: The lease transfers ownership to the lessee at the end of the lease. The lease contains a bargain purchase option to buy the asset for a small amount. The lease term is equal to or greater than seventy-five percent of the life of the asset under lease. The present value of the minimum lease payments is equal to or greater than ninety percent of the fair market value of the asset under lease. If any one of these criteria is met, the lease must be recorded as a capital lease.
  • Another liability companies record is related to pensions. Many companies offer pension plans to their employees as part of their benefit packages. During employment, the company invests specified amounts of money to be able to meet anticipated retirement payments in the future. These investments are usually made to an independent pension fund, managed by a professional fund manager. When employees retire, the company pays their pensions from these investments.
  • Actuaries determine the amount of payments required to be paid to the pension fund annually. These computations are based on employees’ average age, anticipated retirement dates, life expectancy, turnover rates, compensation levels, and the expected rate of return on the fund. Actuaries provide specified payment amounts to accountants, who then record the pension expense and pension liability for the period.
  • Companies also incur liabilities for other parts of their postretirement benefit package, such as continuing health coverage. Amounts expected to be paid within one year are reported as current liabilities. Amounts expected to be paid outside of one year are reported as long-term liabilities.
  • Corporations pay income taxes quarterly. Let’s see how income taxes affect the liabilities of a corporation.
  • Remember, generally accepted accounting principles, or GAAP, are used to prepare financial statements, and the Internal Revenue Code is used to prepare tax returns. Because there are two different sets of rules, the financial statement income tax expense determined using GAAP and the income taxes payable determined using the Internal Revenue Code will not agree. The difference between tax expense and tax payable is recorded as deferred taxes. Let’s look at an example.
  • Here is information for Matrix Incorporated. Notice that the depreciation method used for financial reporting is the straight-line method. For tax purposes, an accelerated depreciation method is used. For the year 2007, depreciation expense on the financial statements was $200,000 using straight-line depreciation. However, for tax purposes, the depreciation expense used to determine income taxes payable was $320,000 dollars. Let’s see how this difference is resolved.
  • This slide shows how Matrix determined its income tax expense of $45,000 for financial reporting purposes.
  • However, their taxes payable was determined using the Internal Revenue Code and resulted in income taxes payable for the period of $9,000.
  • The difference between the $45,000 in tax expense and the $9,000 in taxes payable is the deferred tax for the period. In this case, the deferred tax is $36,000 and is reported as a liability on Matrix’s financial statements.
  • 4 End of chapter 10.
  • Transcript

    • 1. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin LIABILITIES Chapter 10
    • 2. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Learning ObjectiveLearning Objective LO1 To define liabilities an distinguish between current and long-term liabilities.
    • 3. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin I.O.U. Defined as debts or obligations arising from past transactions or events. Defined as debts or obligations arising from past transactions or events. Maturity = 1 year or less Maturity > 1 year Current Liabilities Noncurrent Liabilities The Nature of LiabilitiesThe Nature of Liabilities
    • 4. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin The acquisition of assets is financed from two sources: Funds from creditors, with a definite due date, and sometimes bearing interest. Funds from owners DEBTDEBT EQUITYEQUITY Distinction Between Debt and Equity Distinction Between Debt and Equity
    • 5. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Current LiabilitiesCurrent Liabilities Obligations that must be paid within oneObligations that must be paid within one year or within the operating cycle,year or within the operating cycle, whichever is longer.whichever is longer. Obligations that must be paid within oneObligations that must be paid within one year or within the operating cycle,year or within the operating cycle, whichever is longer.whichever is longer.
    • 6. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Devon Mfg. borrows $100,000 from First Bank. The loan will be repaid in 20 years and has an annual interest rate of 8%. Is this a current liability or a noncurrent liability? Devon Mfg. borrows $100,000 from First Bank. The loan will be repaid in 20 years and has an annual interest rate of 8%. Is this a current liability or a noncurrent liability? Liabilities – QuestionLiabilities – Question The obligation will not be paid within one year or one operating cycle, so it is a noncurrent liability. The obligation will not be paid within one year or one operating cycle, so it is a noncurrent liability.
    • 7. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Short-term obligations to suppliers for purchases of merchandise and to others for goods and services. Short-term obligations to suppliers for purchases of merchandise and to others for goods and services. Merchandise inventory invoices Merchandise inventory invoices Shipping charges Shipping charges Utility and phone bills Utility and phone bills Office supplies invoices Office supplies invoices Accounts PayableAccounts Payable
    • 8. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Learning ObjectiveLearning Objective LO2 To account for notes payable and interest expense.
    • 9. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Total Notes Payable Current Notes Payable Noncurrent Notes Payable When a company borrows money, a note payable is created. Current Portion of Notes Payable The portion of a note payable that is due within one year, or one operating cycle, whichever is longer. When a company borrows money, a note payable is created. Current Portion of Notes Payable The portion of a note payable that is due within one year, or one operating cycle, whichever is longer. Notes PayableNotes Payable
    • 10. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin PROMISSORY NOTE Location Date after this date promises to pay to the order of the sum of with interest at the rate of per annum. signed title Miami, Fl Nov. 1, 2007 Six months Porter Company John Caldwell Security National Bank $10,000.00 12.0% treasurer Notes PayableNotes Payable
    • 11. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin On November 1, 2007, Porter Company would make the following entry. Notes PayableNotes Payable
    • 12. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin • Interest expenseInterest expense is theis the compensation to the lender forcompensation to the lender for giving up the use of money for agiving up the use of money for a period of time.period of time. • The liability is calledThe liability is called interestinterest payablepayable.. • To the lender, interest is aTo the lender, interest is a revenuerevenue.. • To the borrower, interest is anTo the borrower, interest is an expenseexpense.. • Interest expenseInterest expense is theis the compensation to the lender forcompensation to the lender for giving up the use of money for agiving up the use of money for a period of time.period of time. • The liability is calledThe liability is called interestinterest payablepayable.. • To the lender, interest is aTo the lender, interest is a revenuerevenue.. • To the borrower, interest is anTo the borrower, interest is an expenseexpense.. Interest Rate Up! Interest PayableInterest Payable
    • 13. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin The interest formula includes three variables that must be considered when computing interest: The interest formula includes three variables that must be considered when computing interest: Interest = Principal × Interest Rate × Time When computing interest for one year, “Time” equals 1. When the computation period is less than one year, then “Time” is a fraction. When computing interest for one year, “Time” equals 1. When the computation period is less than one year, then “Time” is a fraction. Interest PayableInterest Payable For example, if we needed to compute interest for 3 months, “Time” would be 3/12. For example, if we needed to compute interest for 3 months, “Time” would be 3/12.
    • 14. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin What entry would Porter Company make on December 31, the fiscal year-end? What entry would Porter Company make on December 31, the fiscal year-end? Interest Payable – ExampleInterest Payable – Example $10,000 × 12% × 2 /12 = $200$10,000 × 12% × 2 /12 = $200
    • 15. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Porter will pay the note on January 31, 2008. Let’s look at the entry. Porter will pay the note on January 31, 2008. Let’s look at the entry. Interest Payable – ExampleInterest Payable – Example $10,000 × 12% × 1 /12 = $100$10,000 × 12% × 1 /12 = $100
    • 16. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Learning ObjectiveLearning Objective LO3 To describe the costs and basic accounting activities related to payrolls.
    • 17. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Net Pay Payroll LiabilitiesPayroll Liabilities Medicare Taxes State and Local Income Taxes FICA Taxes Federal Income Tax Voluntary Deductions Gross Pay
    • 18. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Deferred revenue is recorded. a liability account.a liability account. Cash is received in advance. Cash is sometimes collected from the customer before the revenue is actually earned. Cash is sometimes collected from the customer before the revenue is actually earned. Unearned RevenueUnearned Revenue Earned revenue is recorded. As the earnings process is completed . .
    • 19. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Relatively small debt needs can be filled from single sources. Relatively small debt needs can be filled from single sources. Banks Insurance Companies Pension Plans oror oror Long-Term LiabilitiesLong-Term Liabilities
    • 20. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Large debt needs are often filled by issuing bonds. Large debt needs are often filled by issuing bonds. Long-Term LiabilitiesLong-Term Liabilities
    • 21. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin With each payment, the interest portion gets smaller and the principal portion gets larger. With each payment, the interest portion gets smaller and the principal portion gets larger. Installment Notes PayableInstallment Notes Payable Long-term notes that call for a series of installment payments. Long-term notes that call for a series of installment payments. Each payment covers interest for the period AND a portion of the principal. Each payment covers interest for the period AND a portion of the principal.
    • 22. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin • Identify the unpaid principal balance. • Interest expense = Unpaid Principal × Interest rate. • Reduction in unpaid principal balance = Installment payment – Interest expense. • Compute new unpaid principal balance. • Identify the unpaid principal balance. • Interest expense = Unpaid Principal × Interest rate. • Reduction in unpaid principal balance = Installment payment – Interest expense. • Compute new unpaid principal balance. Allocating Installment Payments Between Interest and Principal Allocating Installment Payments Between Interest and Principal
    • 23. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Learning ObjectiveLearning Objective LO4 To prepare an amortization table allocating payments between interest and principal.
    • 24. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin On January 1, 2007, Rocket Corp. borrowed $7,581.57 from First Bank of River City. The loan was a five-year loan and had an interest rate of 10%. The annual payment is $2,000. Prepare an amortization table for Rocket Corp.’s loan. On January 1, 2007, Rocket Corp. borrowed $7,581.57 from First Bank of River City. The loan was a five-year loan and had an interest rate of 10%. The annual payment is $2,000. Prepare an amortization table for Rocket Corp.’s loan. Allocating Installment Payments Between Interest and Principal Allocating Installment Payments Between Interest and Principal
    • 25. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Now, prepare the entry for the first payment on December 31, 2007. Now, prepare the entry for the first payment on December 31, 2007. Allocating Installment Payments Between Interest and Principal Allocating Installment Payments Between Interest and Principal
    • 26. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin The information needed for the journal entry can be found on the amortization table. The payment amount, the interest expense, and the amount to debit to principal are all on the table. The information needed for the journal entry can be found on the amortization table. The payment amount, the interest expense, and the amount to debit to principal are all on the table. Allocating Installment Payments Between Interest and Principal Allocating Installment Payments Between Interest and Principal
    • 27. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Learning ObjectiveLearning Objective LO5 To describe corporate bonds and explain the tax advantage of debt financing.
    • 28. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Bonds usually involve theBonds usually involve the borrowing of a large sum ofborrowing of a large sum of money, calledmoney, called principalprincipal.. The principal is usually paidThe principal is usually paid back as aback as a lump sumlump sum at the endat the end of the bond period.of the bond period. Individual bonds are oftenIndividual bonds are often denominated with a par value,denominated with a par value, oror face valueface value, of $1,000., of $1,000. Bonds usually involve theBonds usually involve the borrowing of a large sum ofborrowing of a large sum of money, calledmoney, called principalprincipal.. The principal is usually paidThe principal is usually paid back as aback as a lump sumlump sum at the endat the end of the bond period.of the bond period. Individual bonds are oftenIndividual bonds are often denominated with a par value,denominated with a par value, oror face valueface value, of $1,000., of $1,000. Bonds PayableBonds Payable
    • 29. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Bonds usually carry a stated rate of interest, also called a contract rate. Interest is normally paid semiannually. Interest is computed as: Bonds usually carry a stated rate of interest, also called a contract rate. Interest is normally paid semiannually. Interest is computed as: Interest = Principal × Stated Rate × TimeInterest = Principal × Stated Rate × Time Bonds PayableBonds Payable
    • 30. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin  Bonds are issued through an intermediary called an underwriter.  Bonds can be sold on organized securities exchanges.  Bond prices are usually quoted as a percentage of the face amount. For example, a $1,000 bondFor example, a $1,000 bond priced at 102 would sell forpriced at 102 would sell for $1,020$1,020..  Bonds are issued through an intermediary called an underwriter.  Bonds can be sold on organized securities exchanges.  Bond prices are usually quoted as a percentage of the face amount. For example, a $1,000 bondFor example, a $1,000 bond priced at 102 would sell forpriced at 102 would sell for $1,020$1,020.. Bonds PayableBonds Payable
    • 31. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Mortgage Bonds Mortgage Bonds Convertibl e Bonds Convertibl e Bonds Junk Bonds Junk Bonds Debenture Bonds Debenture Bonds Types of BondsTypes of Bonds
    • 32. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin On January 1, 2007, Rocket Corp. issues $1,500,000 of 12%, 10-year bonds payable. Interest is payable semiannually, each July 1 and January 1. Assume the bonds are issued at face value. Record the issuance of the bonds. On January 1, 2007, Rocket Corp. issues $1,500,000 of 12%, 10-year bonds payable. Interest is payable semiannually, each July 1 and January 1. Assume the bonds are issued at face value. Record the issuance of the bonds. Accounting for Bonds PayableAccounting for Bonds Payable
    • 33. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Record the interest payment on July 1, 2007. Record the interest payment on July 1, 2007. Accounting for Bonds PayableAccounting for Bonds Payable
    • 34. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Bonds Sold Between Interest DatesBonds Sold Between Interest Dates • Bonds are often sold between interest dates.Bonds are often sold between interest dates. • The selling price of the bond is computedThe selling price of the bond is computed as:as: • Bonds are often sold between interest dates.Bonds are often sold between interest dates. • The selling price of the bond is computedThe selling price of the bond is computed as:as:
    • 35. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Learning ObjectiveLearning Objective LO6 To account for bonds issued at a discount or premium.
    • 36. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin The Present Value Concept and Bond Prices The Present Value Concept and Bond Prices The selling price of the bond is determined by the market based on the time value of money. = > < > < =
    • 37. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Bonds Issued at a DiscountBonds Issued at a Discount Matrix, Inc. is attempting to issue $1,000,000Matrix, Inc. is attempting to issue $1,000,000 principal amount of 9% bonds. The bonds payprincipal amount of 9% bonds. The bonds pay interest on June 30 and December 31 each yearinterest on June 30 and December 31 each year and mature in 20 years. Investors are unwilling toand mature in 20 years. Investors are unwilling to pay the full face amount for Matrix’s bonds becausepay the full face amount for Matrix’s bonds because they believe the interest rate is too low. To enticethey believe the interest rate is too low. To entice investors, Matrix must lower the price of the bonds.investors, Matrix must lower the price of the bonds. The difference between the new lower issue priceThe difference between the new lower issue price and the principal of $1,000,000 is called a discount.and the principal of $1,000,000 is called a discount. Let’s see how we account for these bonds.Let’s see how we account for these bonds. Matrix, Inc. is attempting to issue $1,000,000Matrix, Inc. is attempting to issue $1,000,000 principal amount of 9% bonds. The bonds payprincipal amount of 9% bonds. The bonds pay interest on June 30 and December 31 each yearinterest on June 30 and December 31 each year and mature in 20 years. Investors are unwilling toand mature in 20 years. Investors are unwilling to pay the full face amount for Matrix’s bonds becausepay the full face amount for Matrix’s bonds because they believe the interest rate is too low. To enticethey believe the interest rate is too low. To entice investors, Matrix must lower the price of the bonds.investors, Matrix must lower the price of the bonds. The difference between the new lower issue priceThe difference between the new lower issue price and the principal of $1,000,000 is called a discount.and the principal of $1,000,000 is called a discount. Let’s see how we account for these bonds.Let’s see how we account for these bonds.
    • 38. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Principal Cash Proceeds Discount 1,000,000$ - 950,000$ = 50,000$ Bonds Issued at a DiscountBonds Issued at a Discount Matrix, Inc. issues bonds on January 1, 2007.Matrix, Inc. issues bonds on January 1, 2007. Principal = $1,000,000Principal = $1,000,000 Issue price = $950,000Issue price = $950,000 Stated Interest Rate = 9%Stated Interest Rate = 9% Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2026 (20 years)Maturity Date = Dec. 31, 2026 (20 years) Matrix, Inc. issues bonds on January 1, 2007.Matrix, Inc. issues bonds on January 1, 2007. Principal = $1,000,000Principal = $1,000,000 Issue price = $950,000Issue price = $950,000 Stated Interest Rate = 9%Stated Interest Rate = 9% Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2026 (20 years)Maturity Date = Dec. 31, 2026 (20 years)
    • 39. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Bonds Issued at a DiscountBonds Issued at a Discount To record the bond issue, Matrix, Inc. wouldTo record the bond issue, Matrix, Inc. would make the following entry on January 1, 2007:make the following entry on January 1, 2007: To record the bond issue, Matrix, Inc. wouldTo record the bond issue, Matrix, Inc. would make the following entry on January 1, 2007:make the following entry on January 1, 2007:
    • 40. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Partial Balance Sheet as of January 1, 2007 Long-term Liabilities: Bonds Payable 1,000,000$ Less: Discount on Bonds Payable 50,000 950,000$ Maturity ValueMaturity ValueMaturity ValueMaturity Value Carrying ValueCarrying ValueCarrying ValueCarrying Value Bonds Issued at a DiscountBonds Issued at a Discount
    • 41. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Amortizing the discount over the term of theAmortizing the discount over the term of the bond increases Interest Expense eachbond increases Interest Expense each interest payment period.interest payment period. Amortizing the discount over the term of theAmortizing the discount over the term of the bond increases Interest Expense eachbond increases Interest Expense each interest payment period.interest payment period. Bonds Issued at a DiscountBonds Issued at a Discount Using theUsing the straight-linestraight-line method, themethod, the discount amortization will be $1,250discount amortization will be $1,250 every six months.every six months. $50,000 ÷ 40 periods = $1,250$50,000 ÷ 40 periods = $1,250 Using theUsing the straight-linestraight-line method, themethod, the discount amortization will be $1,250discount amortization will be $1,250 every six months.every six months. $50,000 ÷ 40 periods = $1,250$50,000 ÷ 40 periods = $1,250
    • 42. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Amortization of the DiscountAmortization of the Discount We prepare the following journal entry to recordWe prepare the following journal entry to record the first interest payment.the first interest payment. We prepare the following journal entry to recordWe prepare the following journal entry to record the first interest payment.the first interest payment. $1,000,000 × 9% = $90,000 ÷ 2 = $45,000$45,000 Interest paid every six months is calculated as follows:Interest paid every six months is calculated as follows:Interest paid every six months is calculated as follows:Interest paid every six months is calculated as follows:
    • 43. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Partial Balance Sheet as of December 31, 2007 Long-term Liabilities: Bonds Payable 1,000,000$ Less: Discount on Bonds Payable 47,500 952,500$ Maturity ValueMaturity ValueMaturity ValueMaturity Value Carrying ValueCarrying ValueCarrying ValueCarrying Value $50,000 – $1,250 – $1,250$50,000 – $1,250 – $1,250$50,000 – $1,250 – $1,250$50,000 – $1,250 – $1,250 The carrying value willThe carrying value will increase to exactly $1,000,000increase to exactly $1,000,000 on the maturity date.on the maturity date. The carrying value willThe carrying value will increase to exactly $1,000,000increase to exactly $1,000,000 on the maturity date.on the maturity date. Bonds Issued at a DiscountBonds Issued at a Discount
    • 44. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin To record an the principal repayment, Matrix, IncTo record an the principal repayment, Matrix, Inc would make the following entry on December 31, 2026:would make the following entry on December 31, 2026: To record an the principal repayment, Matrix, IncTo record an the principal repayment, Matrix, Inc would make the following entry on December 31, 2026:would make the following entry on December 31, 2026: Bonds Issued at a DiscountBonds Issued at a Discount
    • 45. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Bonds Issued at a PremiumBonds Issued at a Premium If bonds of other companies are yielding less thanIf bonds of other companies are yielding less than 9 percent, investors will be willing to pay more than9 percent, investors will be willing to pay more than the face amount for Matrix’s 9% bonds. The issuethe face amount for Matrix’s 9% bonds. The issue price of Matrix’s 9% bonds will rise because ofprice of Matrix’s 9% bonds will rise because of investor demand for the 9% bonds. Theinvestor demand for the 9% bonds. The difference between the higher issue price and thedifference between the higher issue price and the principal of $1,000,000 is called a premium.principal of $1,000,000 is called a premium. Let’s look at accounting for a premium.Let’s look at accounting for a premium. If bonds of other companies are yielding less thanIf bonds of other companies are yielding less than 9 percent, investors will be willing to pay more than9 percent, investors will be willing to pay more than the face amount for Matrix’s 9% bonds. The issuethe face amount for Matrix’s 9% bonds. The issue price of Matrix’s 9% bonds will rise because ofprice of Matrix’s 9% bonds will rise because of investor demand for the 9% bonds. Theinvestor demand for the 9% bonds. The difference between the higher issue price and thedifference between the higher issue price and the principal of $1,000,000 is called a premium.principal of $1,000,000 is called a premium. Let’s look at accounting for a premium.Let’s look at accounting for a premium.
    • 46. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Cash Proceeds Principal Premium 1,050,000$ - 1,000,000$ = 50,000$ Matrix, Inc. issues bonds on January 1, 2007.Matrix, Inc. issues bonds on January 1, 2007. Principal = $1,000,000Principal = $1,000,000 Issue price = $1,050,000Issue price = $1,050,000 Stated Interest Rate = 9%Stated Interest Rate = 9% Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2026 (20 years)Maturity Date = Dec. 31, 2026 (20 years) Matrix, Inc. issues bonds on January 1, 2007.Matrix, Inc. issues bonds on January 1, 2007. Principal = $1,000,000Principal = $1,000,000 Issue price = $1,050,000Issue price = $1,050,000 Stated Interest Rate = 9%Stated Interest Rate = 9% Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2026 (20 years)Maturity Date = Dec. 31, 2026 (20 years) The only change from previous Matrix example. Bonds Issued at a PremiumBonds Issued at a Premium
    • 47. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin To record the bond issue, Matrix, Inc. wouldTo record the bond issue, Matrix, Inc. would make the following entry on January 1, 2007:make the following entry on January 1, 2007: To record the bond issue, Matrix, Inc. wouldTo record the bond issue, Matrix, Inc. would make the following entry on January 1, 2007:make the following entry on January 1, 2007: Bonds Issued at a PremiumBonds Issued at a Premium
    • 48. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Partial Balance Sheet as of January 1, 2007 Long-term Liabilities: Bonds Payable 1,000,000$ Add: Premium on Bonds Payable 50,000 1,050,000$ Maturity ValueMaturity ValueMaturity ValueMaturity Value Carrying ValueCarrying ValueCarrying ValueCarrying Value Bonds Issued at a PremiumBonds Issued at a Premium
    • 49. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Amortizing the premium over the term of theAmortizing the premium over the term of the bond decreases Interest Expense eachbond decreases Interest Expense each interest payment period.interest payment period. Amortizing the premium over the term of theAmortizing the premium over the term of the bond decreases Interest Expense eachbond decreases Interest Expense each interest payment period.interest payment period. Using theUsing the straight-linestraight-line method, themethod, the premium amortization will bepremium amortization will be $1,250 every six months.$1,250 every six months. $50,000 ÷ 40 periods =$50,000 ÷ 40 periods = $1,250$1,250 Using theUsing the straight-linestraight-line method, themethod, the premium amortization will bepremium amortization will be $1,250 every six months.$1,250 every six months. $50,000 ÷ 40 periods =$50,000 ÷ 40 periods = $1,250$1,250 Bonds Issued at a PremiumBonds Issued at a Premium
    • 50. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Bonds Issued at a PremiumBonds Issued at a Premium To record an interest payment, Matrix, Inc. would makeTo record an interest payment, Matrix, Inc. would make the following entry on each June 30 and December 31:the following entry on each June 30 and December 31: To record an interest payment, Matrix, Inc. would makeTo record an interest payment, Matrix, Inc. would make the following entry on each June 30 and December 31:the following entry on each June 30 and December 31:
    • 51. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Bonds Issued at a PremiumBonds Issued at a Premium Partial Balance Sheet as of December 31, 2007 Long-term Liabilities: Bonds Payable 1,000,000$ Add: Premium on Bonds Payable 47,500 1,047,500$ Maturity ValueMaturity ValueMaturity ValueMaturity Value Carrying ValueCarrying ValueCarrying ValueCarrying Value $50,000 – $1,250 – $1,250$50,000 – $1,250 – $1,250$50,000 – $1,250 – $1,250$50,000 – $1,250 – $1,250 The carrying value willThe carrying value will decrease to exactly $1,000,000decrease to exactly $1,000,000 on the maturity date.on the maturity date. The carrying value willThe carrying value will decrease to exactly $1,000,000decrease to exactly $1,000,000 on the maturity date.on the maturity date.
    • 52. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin To record an the principal repayment, Matrix would makeTo record an the principal repayment, Matrix would make the following entry on December 31, 2026:the following entry on December 31, 2026: To record an the principal repayment, Matrix would makeTo record an the principal repayment, Matrix would make the following entry on December 31, 2026:the following entry on December 31, 2026: Bonds Issued at a PremiumBonds Issued at a Premium
    • 53. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Learning ObjectiveLearning Objective LO7 To explain the concept of present value as it relates to bond prices.
    • 54. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Present Value Present Value The Concept of Present ValueThe Concept of Present Value Future Value Future Value $1,000 invested today at 10%. In 25 years it will be worth $10,834.71! Money can grow over time, because it can earn interest. In 5 years it will be worth $1,610.51.
    • 55. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin How much is a future amount worth today?How much is a future amount worth today? Present Value Future Value Interest compounding periods Today The Concept of Present ValueThe Concept of Present Value
    • 56. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin The Concept of Present ValueThe Concept of Present Value How much is a future amount worth today? Three pieces of information must be known to solve a present value problem: o The future amount. o The interest rate (i). o The number of periods (n) the amount will be invested. How much is a future amount worth today? Three pieces of information must be known to solve a present value problem: o The future amount. o The interest rate (i). o The number of periods (n) the amount will be invested.
    • 57. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Two types of cash flows are involved with bonds: Today  Principal payment at maturity. Periodic interest payments called annuities. Maturity The Concept of Present ValueThe Concept of Present Value
    • 58. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Gains or losses incurred as a result of retiring bonds should be reported as other income or other expense on the income statement. Gains or losses incurred as a result of retiring bonds should be reported as other income or other expense on the income statement. E x e r c i s i n g a c a ll p r o v i s i o n . P u r c h a s i n g t h e b o n d s o n t h e o p e n m a r k e t. B o n d s c a n b e r e t i r e d b y . . . Early Retirement of DebtEarly Retirement of Debt
    • 59. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Learning ObjectiveLearning Objective LO8 To explain how estimated liabilities, loss contingencies, and commitments are disclosed in financial statements.
    • 60. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Loss ContingenciesLoss Contingencies An existing uncertain situation involving potential loss depending on whether some future event occurs. An existing uncertain situation involving potential loss depending on whether some future event occurs. Two factors affect whether a loss contingencyTwo factors affect whether a loss contingency must be accrued and reported as a liability:must be accrued and reported as a liability: 1.1. The likelihood that the confirming event willThe likelihood that the confirming event will occur.occur. 2.2. Whether the loss amount can be reasonablyWhether the loss amount can be reasonably estimated.estimated. Two factors affect whether a loss contingencyTwo factors affect whether a loss contingency must be accrued and reported as a liability:must be accrued and reported as a liability: 1.1. The likelihood that the confirming event willThe likelihood that the confirming event will occur.occur. 2.2. Whether the loss amount can be reasonablyWhether the loss amount can be reasonably estimated.estimated.
    • 61. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Estimated LiabilitiesEstimated Liabilities 1.1.Liabilities that are known to exist.Liabilities that are known to exist. 2.2.Uncertain as to dollar amount.Uncertain as to dollar amount. 3.3.Reasonable estimate of dollarReasonable estimate of dollar amount is available.amount is available. 1.1.Liabilities that are known to exist.Liabilities that are known to exist. 2.2.Uncertain as to dollar amount.Uncertain as to dollar amount. 3.3.Reasonable estimate of dollarReasonable estimate of dollar amount is available.amount is available. Example: Product warranties
    • 62. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Learning ObjectiveLearning Objective LO9 To evaluate the safety of creditor’s claims.
    • 63. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Evaluating the Safety of Creditors’ Claims Evaluating the Safety of Creditors’ Claims This ratio indicates a margin of protection for creditors. This ratio indicates a margin of protection for creditors. Operating Income Interest Expense Interest Coverage Ratio =
    • 64. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Devon Mfg. reports annual operating income of $100,000 and annual interest expense of $10,000. What is Devon’s interest coverage ratio? Devon Mfg. reports annual operating income of $100,000 and annual interest expense of $10,000. What is Devon’s interest coverage ratio? Liabilities – QuestionLiabilities – Question
    • 65. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Borrowing at one rate and investing at a higher rate. If we borrowIf we borrow $1,000,000 at 8%$1,000,000 at 8% and invest it atand invest it at 10%, we will clear10%, we will clear $20,000 profit!$20,000 profit! Financial LeverageFinancial Leverage
    • 66. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Learning ObjectiveLearning Objective LO10 To describe reporting issues related to leases, postretirement benefits, and deferred taxes.
    • 67. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Lease agreement transfers risks and benefits associated with ownership to lessee. Lease agreement transfers risks and benefits associated with ownership to lessee. Lessee records a leased asset and lease liability. Lessee records a leased asset and lease liability. Lessor retains risks and benefits associated with ownership. Lessor retains risks and benefits associated with ownership. Lessee records rent expense as incurred. Lessee records rent expense as incurred. Lease Payment ObligationsLease Payment Obligations Operating LeasesOperating Leases Capital LeasesCapital Leases
    • 68. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin T h e le a s e t r a n s f e r s o w n e r s h i p t o t h e l e s s e e . T h e le a s e c o n t a i n s a b a r g a i n p u r c h a s e o p t i o n . T h e l e a s e t e r m i s e q u a l to o r > 7 5 % o f t h e e c o n o m ic l i f e o f t h e p r o p e r t y . T h e P V o f th e m i n i m u m l e a s e p a y m e n t s = 9 0 % o f t h e F M V o f th e p r o p e r t y . A l e a s e m u s t b e r e c o r d e d a s a C a p i t a l L e a s e if i t m e e ts a n y o f th e f o l l o w i n g c r i t e r i a . Capital Lease CriteriaCapital Lease Criteria
    • 69. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Employers offer pension plans to employees. Employers offer pension plans to employees. Retirees receive pension payments from the pension fund. Retirees receive pension payments from the pension fund. The employer makes payments to a pension fund. Usually, this is an independent entity managed by a professional fund manager. The employer makes payments to a pension fund. Usually, this is an independent entity managed by a professional fund manager. PensionsPensions
    • 70. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Actuaries make the pension expense computations, based on: • Average age, retirement age, life expectancy. • Employee turnover rates. • Compensation levels. • Expected rate of return for the fund. Actuaries make the pension expense computations, based on: • Average age, retirement age, life expectancy. • Employee turnover rates. • Compensation levels. • Expected rate of return for the fund. The accountant then posts theThe accountant then posts the entry to record pension expenseentry to record pension expense and pension liability.and pension liability. The accountant then posts theThe accountant then posts the entry to record pension expenseentry to record pension expense and pension liability.and pension liability. PensionsPensions
    • 71. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Many companies offer benefits to retirees other than pensions, such as health coverage or fitness club memberships. Many companies offer benefits to retirees other than pensions, such as health coverage or fitness club memberships. Other Postretirement BenefitsOther Postretirement Benefits Unfunded liability for nonpension postretirement benefits Current liability Long-term liability Amount to be funded next year Remainder of unfunded amount
    • 72. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Corporations pay income taxes quarterly. Deferred Income TaxesDeferred Income Taxes
    • 73. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin The difference between tax expense and tax payable is recorded in an account called deferred taxes. The difference between tax expense and tax payable is recorded in an account called deferred taxes. The Internal Revenue Code is the set of rules for preparing tax returns. The Internal Revenue Code is the set of rules for preparing tax returns. Financial statement income tax expense. Financial statement income tax expense. IRS income taxes payable. IRS income taxes payable. GAAP is the set of rules for preparing financial statements. GAAP is the set of rules for preparing financial statements. Results in . . . Results in . . .Usually. . . Deferred Income TaxesDeferred Income Taxes
    • 74. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Examine the December 31, 2007, information for Matrix, Inc. Matrix uses straight-line depreciation for financial reporting and accelerated depreciation for income tax reporting. Matrix’s tax rate is 30%. Deferred Income Taxes – ExampleDeferred Income Taxes – Example
    • 75. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Income Tax Statement Return Difference Revenues 1,000,000$ Less: Depreciation 200,000 Other expenses 650,000 Income before taxes 150,000$ × Tax rate 30% Income taxes 45,000$ The income tax amount computed based on financial statement income is income tax expense for the period. The income tax amount computed based on financial statement income is income tax expense for the period. Compute Matrix’s income tax expense and income tax payable. Deferred Income Taxes – ExampleDeferred Income Taxes – Example
    • 76. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Compute Matrix’s income tax expense and income tax payable. Income Tax Statement Return Difference Revenues 1,000,000$ 1,000,000$ Less: Depreciation 200,000 320,000 Other expenses 650,000 650,000 Income before taxes 150,000$ 30,000$ × Tax rate 30% 30% Income taxes 45,000$ 9,000$ Income taxes based on tax return income are the taxes payable for the period. Income taxes based on tax return income are the taxes payable for the period. Deferred Income Taxes – ExampleDeferred Income Taxes – Example
    • 77. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Income Tax Statement Return Difference Revenues 1,000,000$ 1,000,000$ -$ Less: Depreciation 200,000 320,000 (120,000) Other expenses 650,000 650,000 - Income before taxes 150,000$ 30,000$ 120,000$ × Tax rate 30% 30% 30% Income taxes 45,000$ 9,000$ 36,000$ The deferred tax for the period of $36,000 is the difference between income tax expense of $45,000 and income tax payable of $9,000. The deferred tax for the period of $36,000 is the difference between income tax expense of $45,000 and income tax payable of $9,000. Deferred Income Taxes – ExampleDeferred Income Taxes – Example
    • 78. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin End of Chapter 1OEnd of Chapter 1O

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