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Liabilities

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Liabilities

  1. 1. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin LIABILITIES Chapter 10
  2. 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. 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. 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. 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. 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. 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. 8. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Learning ObjectiveLearning Objective LO2 To account for notes payable and interest expense.
  9. 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. 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. 11. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin On November 1, 2007, Porter Company would make the following entry. Notes PayableNotes Payable
  12. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 35. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Learning ObjectiveLearning Objective LO6 To account for bonds issued at a discount or premium.
  36. 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. 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 $1,000,000 is called a discount. Let’s see how we account for these bonds.Let’s see how we account for these bonds.
  38. 38. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Principal Cash Proceeds Discount 1,000,000$ - 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 = $950,000 Stated Interest Rate = 9%Stated Interest Rate = 9% Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2026 (20 years)Maturity Date = Dec. 31, 2026 (20 years)
  39. 39. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Bonds Issued at a DiscountBonds Issued at a Discount To record the bond issue, Matrix, Inc. wouldTo record the bond issue, Matrix, Inc. would make the following entry on January 1, 2007:make the following entry on January 1, 2007: To record the bond issue, Matrix, Inc. wouldTo record the bond issue, Matrix, Inc. would make the following entry on January 1, 2007:make the following entry on January 1, 2007:
  40. 40. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Partial Balance Sheet as of January 1, 2007 Long-term Liabilities: Bonds Payable 1,000,000$ 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. 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. 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$45,000 Interest paid every six months is calculated as follows:Interest paid every six months is calculated as follows:Interest paid every six months is calculated as follows:Interest paid every six months is calculated as follows:
  43. 43. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Partial Balance Sheet as of December 31, 2007 Long-term Liabilities: Bonds Payable 1,000,000$ 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. 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. 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 $1,000,000 is called a premium. Let’s look at accounting for a premium.Let’s look at accounting for a premium.
  46. 46. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Cash Proceeds Principal Premium 1,050,000$ - 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 = $1,050,000 Stated Interest Rate = 9%Stated Interest Rate = 9% Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2026 (20 years)Maturity Date = Dec. 31, 2026 (20 years) The only change from previous Matrix example. Bonds Issued at a PremiumBonds Issued at a Premium
  47. 47. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin To record the bond issue, Matrix, Inc. wouldTo record the bond issue, Matrix, Inc. would make the following entry on January 1, 2007:make the following entry on January 1, 2007: To record the bond issue, Matrix, Inc. wouldTo record the bond issue, Matrix, Inc. would make the following entry on January 1, 2007:make the following entry on January 1, 2007: Bonds Issued at a PremiumBonds Issued at a Premium
  48. 48. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Partial Balance Sheet as of January 1, 2007 Long-term Liabilities: Bonds Payable 1,000,000$ 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. 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$1,250 Bonds Issued at a PremiumBonds Issued at a Premium
  50. 50. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Bonds Issued at a PremiumBonds Issued at a Premium To record an interest payment, Matrix, Inc. would makeTo record an interest payment, Matrix, Inc. would make the following entry on each June 30 and December 31:the following entry on each June 30 and December 31: To record an interest payment, Matrix, Inc. would makeTo record an interest payment, Matrix, Inc. would make the following entry on each June 30 and December 31:the following entry on each June 30 and December 31:
  51. 51. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Bonds Issued at a PremiumBonds Issued at a Premium Partial Balance Sheet as of December 31, 2007 Long-term Liabilities: Bonds Payable 1,000,000$ 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 62. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Learning ObjectiveLearning Objective LO9 To evaluate the safety of creditor’s claims.
  63. 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. 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. 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. 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. 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. 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. 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. 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. 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. 72. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin Corporations pay income taxes quarterly. Deferred Income TaxesDeferred Income Taxes
  73. 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. 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. 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. 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. 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. 78. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin End of Chapter 1OEnd of Chapter 1O

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