Prof Johnson Acct 202 CHAPTER 8 & Appd B PowerPoint Lecture Slides

Prof Johnson Acct 202
CHAPTER 8 & Appd B
PowerPoint Lecture Slides
Ch8-- Accounting for Current and
Long-Term Liabilities
Appd B-- Time Value of Money
Opening Vignette - AMR
Corporation
Alliances between companies in different industries
 Transportation = airlines
 Hospitality = hotels
often create obligations for one party in the alliance.
 Refer to the AMR Corporation situation described
in the opening pages of the textbook
Opening Vignette - AMR
Corporation
Opening Vignette - AMR
Corporation
 Holiday Inn and other partner
companies pay AMR to credit
air miles to customer frequent
flyer accounts
 These payments represent
liabilities for AMR Corporation
 Payments represent obligation
to provide future
transportation to frequent
flyers
Chapter Learning Objectives
1. Account for current liabilities
2. Identify and report contingent
liabilities
3. Account for basic bonds payable
transactions
4. Measure interest expense, amortize
bond discount and premium by the
effective-interest method
Chapter Learning Objectives
5. Explain the advantages and
disadvantages of borrowing
6. Account for lease transactions
7. Report liabilities on the balance
sheet
Chapter Objective 1
Account for current liabilities
Liabilities
 Obligation to transfer assets
 Or provide future services
 Resulting from past transactions
Liabilities
 Obligation to transfer assets
 Or provide future services
 Resulting from past transactions
 Can you think of examples?
Liabilities Incurred When a
Business ...
 Purchases inventory
on account
Liabilities Incurred When a
Business ...
 Borrows money and
makes (signs) a
note payable
Liabilities Incurred When a
Business ...
 Accrues interest
payable on a note or
loan with the
passage of time
Current Liabilities
 Payable within one year
 Company’s operating cycle, if longer than
one year
 Current liabilities classified in two ways
(1) Known amount
(2) Estimated amount
Current Liabilities of Known
Amount
 Accounts Payable
 Short-Term Notes Payable
 Short-Term Notes Issued at Discount
 Sales Tax Payable
 Current Portion of Long-Term Debt
 Accrued Expenses
Accounts Payable
 Amounts owed to
vendors (suppliers)
for goods or
services purchased
on account
 Journalize Asian Art,
Inc.’s $350 purchase
of office supplies on
account
Accounts Payable
9/28/x6
Office Supplies
A/P
$350
$350
To record supplies purchased on account
 Businesses often maintain subsidiary A/P
ledgers to track amounts owed to individual
vendors
 Task made easier by computers
Short-Term Notes Payable
 Promissory note signed by the company payable
within the year
 Company recognizes liability to repay principal
amount borrowed
 Plus accrued interest expense/payable
EXAMPLE:
The Valley Chamber Orchestra signs a $10,000,
60-day note payable in exchange for some
remodeling done in its leased office space.
Short-Term Notes Payable
 The 60-day note bears interest at 9% annually,
and is made on November 15, 1998.
11/15/98
Leasehold Improvements $10,000
Note Payable, Short-Term
$10,000
To record note issued for leasehold improvement
Short-Term Notes Payable
 At fiscal year-end, December 31, the Orchestra
must accrue interest payable on the note.
12/31/98
Interest Expense
Interest Payable
$115
$115
To accrue 1998 interest expense on note
($10,000 x .09 x 46*/360)
* Nov. = 15 days
Dec. = 31 days
Short-Term Notes Payable Issued
at a Discount
 Entity taking the note
deducts interest from
amount being
borrowed
 Remits less than
note’s face value to
the borrower
 Borrower repays face
value at note’s
maturity
Short-Term Notes Payable Issued
at a Discount
 Same $10,000, 60-day,
$150 interest
9% note as a “discounted”
note payable ...
$9,850
proceeds
remitted to
borrower
 Same $10,000, 60-day,
9% note as a “discounted”
note payable ...
 $10,000 x .09 x 60/360 =
$150 total interest
FACE VALUE = $10,000
Short-Term Notes Payable Issued
at a Discount
$150 interest
 Same $10,000, 60-day,
9% note as a “discounted”
note payable ...
 $10,000 x .09 x 60/360 =
$150 total interest
 $10,000 - $150 = $9,850
remitted to borrower
FACE VALUE = $10,000
Short-Term Notes Payable Issued
at a Discount
$150 interest
$9,850
proceeds
remitted to
borrower
 Same $10,000, 60-day,
9% note as a “discounted”
note payable ...
 $10,000 x .09 x 60/360 =
$150 total interest
 $10,000 - $150 = $9,850
remitted to borrower
 Borrower repays $10,000
face value on January 15,
1999
FACE VALUE = $10,000
Short-Term Notes Payable Issued
at a Discount
$150 interest
$9,850
proceeds
remitted to
borrower
Short-Term Notes Payable Issued
at a Discount
11/15/98
Cash
$9,850
Discount on Note Payable
500
Notes Payable, Short-Term
$10,000
To record discounted note payable
 Accrued interest expense at year-end:
12/31/98
Interest Expense
$150
Discount on Note Payable
To record 1998 interest expense
$150
Sales Tax Payable
 State and local taxes
DEPT. OF REVENUE
assessed on retail sales
 Sales tax collected by
company along with
sales revenue
 Sales tax periodically
remitted to local/state
government agencies
Sales Tax Payable
 Ray’s Seafood Shack sold $3,475
of food and beverages (excluding
tax) on a busy summer Friday
evening
 Florida state sales tax is 6%, and
Monroe County imposes a Tourist
Development tax of .5%
 What is the journal entry to
recognize Ray’s sales tax
payable?
Sales Tax Payable
7/9/x3
Cash
$3,701
Sales Revenue
$3,475
State Sales Tax Payable
209
County Sales Tax Payable
17
To record sales revenue for July 9
 Retail POS systems easily capture sales
revenue and related tax data
Current Portion of Long-Term
Debt
 Portion of long-term debt principal due within one
year
 Adjusting entry reclassifies principal from long-term
liability to current liability
12/31/x7 Cur. Portion of Long-Term Debt $5,000
Note Payable, Long-Term
$5,000
To adjust current liabilities for current portion of
long-term note payable
Current Portion of Long-Term
Debt
Liability section of Asian Art, Inc.’s balance sheet
Current Liabilities
Accounts Payable
Interest Payable
$20,000
6,000
Current Portion of Long-Term
Debt
Liability section of Asian Art, Inc.’s balance sheet
Current Liabilities
Accounts Payable
Interest Payable
Current Portion of Long-Term Debt
$20,000
6,000
21,000
Current Portion of Long-Term
Debt
Liability section of Asian Art, Inc.’s balance sheet
Current Liabilities
Accounts Payable
Interest Payable
Current Portion of Long-Term Debt
Total Current Liabilities
$20,000
6,000
21,000
$47,000
Current Portion of Long-Term
Debt
Liability section of Asian Art, Inc.’s balance sheet
Current Liabilities
Accounts Payable
Interest Payable
Current Portion of Long-Term Debt
$20,000
6,000
21,000
Total Current Liabilities
$47,000
Long-Term Notes Payable
190,000
Current Portion of Long-Term
Debt
Liability section of Asian Art, Inc.’s balance sheet
Current Liabilities
Accounts Payable
Interest Payable
Current Portion of Long-Term Debt
$20,000
6,000
21,000
Total Current Liabilities
$47,000
Long-Term Notes Payable
190,000
TOTAL LIABILITIES
$237,000
Accrued Expenses
 Result of adjusting entries accruing expenses





incurred but not yet recognized
Wages/Salary Payable
Interest Payable
Taxes Payable
AMR Corporation’s Air Traffic Liability
Marriott International’s Other Payables and
Accruals, including such frequent stay programs
as Marriott Miles, INNsiders’ Club, and Courtyard
Club
Payroll Liabilities
 Significant expense for many companies
 Total wages, salary, commissions, bonuses
paid to company employees in exchange for
their services
 Refer to Textbook Exhibit 8-1 for adjusting
entry prepared at end of accounting period to
recognize payroll expense and related current
liabilities
Payroll Liabilities
Deductions from employee payroll include:
 Federal income taxes
 Social Security taxes
 State/local income taxes
 Group insurance (health/life) premiums
 Union dues
 Credit union savings or loan repayment
 Contribution to 401(k) pension plans
Unearned Revenues
 Cash received from
customers prior to
earning revenue
 Prior to delivering
goods or providing
services to
customers
Unearned Revenues
When customer prepays for a
product or service, company has
obligation to:
(1) Provide the
product/service in the
future
(2) Refund the unearned
revenue to customer
Unearned Revenues
Customers of the Des
Moines Register can
prepay a 52-week
newspaper subscription
in advance. If the
subscription costs $108,
how does the Register
adjust its balance sheet
for unearned revenues?
Unearned Revenues
 A customer prepays her 52-week newspaper
subscription beginning October 13, 19x4
10/13/x4
Cash
$108
Unearned Subscription Rev.
$108
To record prepaid 52-week subscription
 The Register’s fiscal year ends on December 27,
19x4. What adjusting entry must be made?
Unearned Revenues
12/27/x4 Unearned Subscript. Rev.
Subscription Revenue
$22.55
$22.55
To recognize revenue earned in 19x4*
*$108 / 52 weeks = $2.0769 / week
$2.0769 / 7 days = $.2967 / day
$.2967 x 76 days (October 13 through December 27)
Current Liabilities That Must Be
Estimated
 Estimated Warranty
Payable
 Estimated Vacation
Pay and Sick Pay
Liability
Estimated Warranty Payable
Estimated Warranty Payable
 Manufacturing and retailing companies often
provide guarantees on products
 30-60-90 days or one year in length
 Matching principle requires company to
estimate expense of providing warranty and
recognize it in same accounting period as
revenue earned from product sale
Estimated Warranty Payable
Suppose Cisco Systems  a manufacturer of
networking hubs and
routers
offers a 90-day warranty on
equipment it sells
Further, suppose Cisco’s
recent actual warranty work
amounts to .75% of all
products sold.
Estimated Warranty Payable
 If Cisco’s December 19x1 revenues are
$3,500,000, what adjusting entry is necessary to
estimate expense and current liability?
12/31/x1 Warranty Expense
$26,250
Est. Warranty Payable
$26,250
To record December warranty expense
Estimated Warranty Payable
 When Cisco Systems
actually replaces hubs
or routers under
warranty ...
Estimated Warranty Payable
 When Cisco Systems
actually replaces hubs
or routers under
warranty ...
2/2/x2 Est. Warranty Payable
Inventory
$2,000
$2,000
To record products replaced under warranty
Estimated Vacation
and Sick Pay
Estimated Vacation and Sick Pay
 Vacation and sick pay accrued in
accounting period when earned
 If Asian Art, Inc. employees earn
one sick day and one vacation
day per month, what adjusting
entry is necessary at end of June
to accrue these liabilities?
Estimated Vacation and Sick Pay
 Use a 40-hour work week (160 hours per month) and
total monthly payroll of $8,700
6/30/x6
Vacation Pay Expense
$435
Sick Pay Expense
435
Estimated Vacation Pay Liab.
Estimated Sick Pay Liab.
$435
435
To record vacation and sick pay accruals for June
Chapter Objective 2
Identify and report contingent liabilities
Contingent Liabilities
 Liability related to a
past transaction
 Dependent upon a
future event
 Guaranteeing debts of
others
 Awaiting outcome of
pending lawsuit
Contingent Liabilities
Reporting guidelines rooted in several
accounting principles:
 Full disclosure
 Conservatism
 Materiality
 Representational faithfulness
Contingent Liabilities
3 Ways to
Classify
Contingencies
Contingent Liabilities
 Probable
 Possible
 Remote
Contingent Liabilities
 Probable
 More likely than not that a loss will be incurred
 $ amount of loss can be reasonably estimated
 Possible
 Reasonably possible loss will be incurred
 Remote
 Not likely that loss will be incurred
Contingent Liabilities
Probable and reasonably
estimable
 Asian Art agrees to pay
note payable of one of its
suppliers if the supplier
defaults on the note
 At time supplier defaults,
Asian Art knows the
liability is probable
(certain) and knows the
amount of the loss
LOAN
PAYMENT
Contingent Liabilities
Probable and reasonably
estimable
 Asian Art will record
adjusting entry to accrue
expense and liability
 Disclose additional
information about liability
in footnotes to financial
statement
LOAN
PAYMENT
Contingent Liabilities
Possible
 Ray’s Seafood Shack is
defendant in negligence
lawsuit
 Customer slipped off
sailboat during one of Ray’s
sunset champagne cruises
 At year-end, case has not been
decided
 Ray’s lawyer does not believe
the plaintiff will be successful
in her claim against restaurant
Contingent Liabilities
Possible
 Ray’s Seafood Shack would
prepare a brief disclosure to be
included in the financial
statement footnotes only
Contingent Liabilities
Remote
 A former member of the Valley Chamber
Orchestra’s staff sues the organization for
wrongful discharge after being fired
 The Orchestra’s labor attorney is confident the
organization will be found innocent, especially in
light of the former employee’s work record which
includes warnings about sexual and discriminatory
harassment of organization employees
Contingent Liabilities
Remote
 The Orchestra neither accrues
the estimated gain/loss nor
reports details in footnotes to
the financials
Begin Discussion of Appendix B:
Time Value of Money
Appendix B: Accounting and the Time Value of Money
After studying this chapter you should be able to:
 Identify accounting topics where time value of money
is relevant.
 Distinguish between simple and compound interest.
 Learn how to use appropriate compound interest
tables.
 Identify variables fundamental to solving interest
problems.
 Solve future and present value of 1 problems.
 Solve future value of ordinary problems.
 Solve present value of ordinary annuity problems.
Introduction
 Concept of the time value of money is very
important especially when interest rates are high
and/or time periods are long.
 Simply put--You are not indifferent as to when you
receive or pay an identical sum of money. That is, a
dollar received or paid today (the present) is not
worth a dollar received or paid tomorrow (the future).
 Someone owes you, a rational person, $100. They
say to you--Which would you prefer: I pay you $100
today or I pay you $100 one year from now?
3
Introduction
 Your response should be--Pay me $100 today
(present). WHY? Assuming there is no inflation,
would your answer change?
 Again, your response should be to be paid today.
You could take the funds today, invest them, earn a
return and have more than $100 a year from now.
How much more than $100 would depend on the
return you could earn (interest).
 Suppose, instead, someone offers you $100 one year
from today. You wish the funds now (today),
however. Will you accept less than $100 in
settlement of the debt?
4
Introduction
 Considering the interest rates, you will accept
less than $100 today to settle the debt.
WHY?
 If you had the settlement today you could
invest it, earn a return and have $100 one
year from now. If the interest rate is high you
would accept less to settle the debt than if the
interest rate was low.
Simply put, at any interest rate:
• A dollar received today is worth
more than a dollar in the future.
• A dollar in the future is worth less
than a dollar today.
5
Introduction
 The concept of the time value of money is pervasive.
We see this concept in many topics including (to
name a few):
 Leases
 Pensions
 Non-interest bearing notes
 Installment contracts
 Valuation of bonds
 Sinking fund provisions
 The FASB will simplify calculations by stating, at
times, the time value of money is to be ignored. You
must realize the import of that assumption as well!
6
Interest
 Definitions of interest:
 A fee for the use of money
 Principle x Interest Rate x Time =
Interest
Principle: The amount borrowed or
invested.
Interest rate: A percentage of the
outstanding principle. Always
expressed as an annual rate.
Time: The number of years or fraction
thereof that the principle is
outstanding.
7
Interest
 Selection of
appropriate interest
rate is critical and, at
times, very difficult.
Would you be a
wealthy person if you
could accurately
predict the interest
rate?
 The interest for us
will be a given figure.
In practice it can be
the hardest figure to
derive accurately.
8
Interest
 Elements of the interest rate: The interest rate is
the sum of
Pure rate of interest (system risk) Initial rate
charged assuming no possibility of default and
no inflation.
Credit risk rate of interest (individual risk)
Additional rate charged as a result of an
individual entity’s risk of default.
Expected inflation rate of interest (inflation
premium) Additional rate charged to
compensate for the decrease in the purchasing
power of the dollar over time.
9
Interest
 Simple interest is computed on the
principle only. That is, interest is earned
and removed. The interest does not earn
interest.
– Compound interest is computed on the principle and any
accumulated interest. Both the principal and interest then
earn interest.
10
Types of Problems
 For our calculations we will assume compound
interest. The greater the number of periods and the
higher the interest rate, the greater will be the effect
of compounding interest.
 Types of problems we will be working with:
 Single Sum. One sum ($1) will be received or
paid either in the
Present (Present Value of a Single Sum or PV)
Future (Future Value of a Single Sum or FV)
11
Types of Problems
 Types of annuity problems:
Ordinary annuity (OA)
A series of equal payments (or rents)
received or paid at the end of a period,
assuming a constant rate of interest.
Value today of a series of equal, end-ofperiod payments received in the future is
the Present Value of an Ordinary Annuity or
PV-OA.
Value in the future of a series of equal, endof-period payments received in the future is
the Future Value of an Ordinary Annuity or
FV-OA.
12
Types of Problems
Annuity Due (AD)
A series of equal payments (or rents)
received or paid at the beginning of a
period, assuming a constant rate of
interest.
Value today of a series of equal, beginning-ofperiod payments received in the future is
the Present Value of an annuity due or PVAD.
Value in the future of a series of equal,
beginning-of-period payments received in
the future is the Future Value of an annuity
due or FV-AD.
13
Types of Problems
Note: The difference between an ordinary annuity
and an annuity due is that:
Each rent or payment compounds (interest
added) one more period in a annuity due,
future value situation.
Each rent or payment is discounted (interest
removed) one less period under the annuity
due situation.
Given the same i, n and periodic rent, the
annuity due will always yield a greater
present value (less interest removed) and a
greater future value (more interest added).
14
Calculation Variables
 There will always be at least four variables in any
present or future value problem. Three of the four
will be known and you will solve for the fourth.
 Single sum problems:
n = number of compounding periods
i = interest rate
PV = Value today of a single sum ($1)
FV = Value in the future of a single sum ($1)
15
Calculation Variables
 Annuity problems:
n = number of payments or rents
i = interest rate
R = Periodic rent received or paid
And either:
FV-OA or AD = Value in the future of a series of
future payments (either ordinary or due). OR
PV-OA or AD= Value today of a series of
payments in the future (either ordinary or due).
• Note: The “n” and the “i” must match. That is, if the time
period is semi-annual then so must the interest rate. Interest
rates are assumed to be annual unless otherwise stated so
you may have to adjust the rate to match the time period.
16
Single Sum Problems
Let’s review the derivation of the single sum
formula:
 Suppose you have $100 today (present) and wish to
deposit it at 10% for three periods, in this case years.
What is the value of this single sum in the future?
 At the end of the first year (n = 1): (Compound
interest)
$100 + $100(.1) = $110
 At the end of the second year ( n = 2)
$110 + $110(.1) = $121
 At the end of third year (n = 3)
$121 + $121(.1) = $133 (rounded)
 So the future value of $100 three years hence at
17
10% = $133
Single Sum Problems
 I realize there is a simpler way to approach this:
$100 (1 +.1)(1+.1)(1+.1) = $133
$100 (1+.1)3 = $133
Generally for any “n” and “i” the single sum formula
would be:
PV (1+ i)n = FV
$100 (1+.1)3 = $133
18
Single Sum Problems
 Not wishing to have to constantly raise the term to
the required power I name the term (1+ i)n, the
Future Value Factor for a single term (FVFn,i ). I
then employ the table on page 320-321. The table is
the result of the required multiplications at various “n”
and “i” and is to be read vertically for the “n” and
horizontally for the “i”.
 To solve my problem using the table:
PV(FVFn,i ) = FV where n = 3 and i = 10%
$100 (1.331) = $133
19
Single Sum Problems
Note:
For single sum problems the “n” refers to
periods not necessarily defined as years!
The period may be annual, semi-annual,
quarterly or another time frame.
In manual calculations the use of the table is
strongly recommended. It enhances both
speed and accuracy.
20
Single Sum Problems
 Now suppose instead of $100 today I am to receive
$133 three years from now. Again the interest rate is
10%. I don’t want to wait three years for my money.
How much will I accept today in lieu of the future
payment?
Going back to the general formula for a single sum:
PV(FVFn,i ) = FV
 I realize I can isolate the term I wish to solve for on
one side of the equation:
PV = FV divided by (FVFn,i )
and rearranging terms:
PV = FV ( 1/ FVFn,i )
21
Single Sum Problems
 Not wishing to have to constantly raise the term to
the required power and then divide it into 1, I name
the term 1/ FVFn,i the Present Value Factor for a
single sum (PVF n,i ). I restate the formula
PV = FV (PVF n,i )
 I then employ the table on page ???. The table is the
result of the required multiplications and division at
various “n” and “i” and is to be read vertically for the
“n”
and horizontally for the “i”
22
Single Sum Problems
 To solve my problem using the table:
Please look up the values on the tables as
we go along!
n = 3, i = 10%, FV = $133
PV = FV (PVF n,i )
PV = $133 (.75132)
PV = $100
23
Single Sum Problems
Note: Review the tables and note their
characteristics. They are very logical.
All sums in the future are worth less than themselves
in the present. All factors on the present value of a
single sum table are less than one.
All factors on the future value of a single sum table
are greater than one. All present sums are worth
more than themselves in the future.
Notice how the factors change dramatically as the “i”
increases and the “n” lengthens!
24
Single Sum Problems
Single Sum problems, other unknowns.
 Suppose you have $6,000 today (PV ) and
you need $9,000 five years hence. What
rate of annual interest must you earn to
achieve your goal?
Note: This can be solved as either a future or present value of a
single sum problem. The formulas are reciprocals of each other.
25
Single Sum Problems
 To solve as a future value of a single sum problem:
PV(FVFn,i ) = FV where n = 5 and i = ?
$6,000 (FVFn,i ) = $9,000
FVFn,i = $9,000/$6,000 = 1.500
Looking on the future of a single sum table (page ???)
for n = 3 and a FVF of 1.500, I find the
corresponding “i” to be between 8-9%.
26
Single Sum Problems
 Alternatively, suppose I have $750 today. How long
will I have to wait to have $1,200 when the interest
rate is 10%? I will solve this as a PV problem.
PV = FV (PVF n,i )
$750 = $1,200 (PVF n,i )
where n = ? and i = 10%
PVF n,i = $750/$1,200 = .625
Reading on the present value of a single sum table
(page ???) for 10% the “n” for the factor .625 is
between 4-5 periods.
A more precise answer may be derived through the use of the
mathematical technique of interpolation.
27
Annuity Problems
 Suppose I am to receive three equal $100 payments
(R) each at the end of the period (in this case a
period is a year) when the interest rate is a constant
15%. This is an ordinary annuity since payments are
at the end of the period. What is the value to me at
the end of the third year from receiving this annuity?
This is a future value of an ordinary annuity
problem. How do I go about solving it?
 I realize an annuity is really a series of single
sums.
 If I take the FV for each single sum and add them
I will have the value of the entire stream of
payments.
 I will use the FV formula which is:
PV(FVFn,i ) = FV
28
Annuity Problems
Rent #
Cmpd periods
Sum FVF
FV
All at i = 15%
1
2
$100 1.322
$132
2
1
$100 1.150
$115
3
0
$100 1.000
$100
Totals
3.472
$347
 This is tedious! I notice I am multiplying a constant rent
($100) by a changing interest factor. What if I added the
three factors and multiplied the total by the rent? That
would be less work! I’ll call the sum of the appropriate
factors the FVF-AO n,i. I’ll derive the general formula
where R equals the constant rent:
FV-OA = R (FVF-AO n,i ) when I = 15% and n = 3
payments
29
FV-OA = $100 (3.472) = $347 (rounded)
Annuity Problems
 Where do I get these summed factors? From
the future value of an ordinary annuity table
on pages ???. The addition for the
appropriate “n” and “i” has already been
done. The annuity tables are derived directly
from the single sum tables.
30
Annuity Problems
 Let’s take the case of the present value of
an ordinary annuity. That is, what is a
stream of future payments worth today?
What sum do you need today to draw out a
series of equal payments and have nothing
left over? This situation is very common in
retirement cases or the payment of debt.
Bonds Payable
ABC Company
32
Annuity Problems
 Suppose you are to pay three rents of $500, each at
the end of the next three years. The interest rate is
8%. How much should I set aside today to have the
required rents?
 Again I realize an annuity is simply a series of
single sums. I take the same approach as before
in that I discount (remove) interest from each of
the rents.
 I take the present value of each, add, and I will
have the required sum (total present value) that I
will need.
I use the formula: PV = FV (PVF n,i )
33
Annuity Problems
Rent #
Disc periods
Sum PVF
PV
All at i = 8%
1
1
$500 .92593
$463
2
2
$500 .85734
$429
3
3
$500 .79383
$397
Totals
2.5771
$1,289
 This is tedious! I notice I am multiplying a constant rent
($500) by a changing interest factor. What if I added
the three factors and multiplied the total by the rent?
That would be less work! I’ll call the sum of the
appropriate factors the PVF-AO n,i. I’ll derive the
general formula where R is the constant rent:
PV-OA = R (PVF-AO n,i) for n = 3 payments and i = 8%
PV-OA = $500 (2.5771) = $1,289 (rounded)
34
Annuity Problems
 Where do I get these summed factors? From
the present value of an ordinary annuity table
on pages ???. The addition for the
appropriate “n” and “i” has already been
done. The annuity tables are derived directly
from the single sum tables.
35
End Discussion of Appendix B:
Time Value of Money and Start
Discussion of Long Term
Liabilities-- Bonds Payable
Chapter Objective 3
Account for basic bonds
payable transactions
Financing Operations with
Long-Term Debt
 Large corporations




borrow huge amounts
of money by issuing
bonds to lenders
Individuals
Corporate investors
Pension plans
Insurance
Financing Operations with
Long-Term Debt
 Bonds are interest-bearing, long-term notes
payable
 Bond certificate provides written evidence of
borrowing company’s obligation to repay
lender for principle borrowed plus
accumulated interest
 Refer to textbook Exhibit 8-2 for a picture of a
bond certificate
Financing Operations with
Long-Term Debt
 Bond certificate states
Debenture Bonds
Financing Operations with
Long-Term Debt
 Bond certificate states
Debenture Bonds
MGM Grand, Inc.
$10,000.00
 Principle (face or maturity
value)
Financing Operations with
Long-Term Debt
 Bond certificate states
Debenture Bonds
MGM Grand, Inc.
$10,000.00
Eight percent
 Principle (face or maturity
value)
 Contract interest rate
(annual %)
Financing Operations with
Long-Term Debt
 Bond certificate states
Debenture Bonds
MGM Grand, Inc.
$10,000.00
Eight percent
November 30, 2008
 Principle (face or maturity
value)
 Contract interest rate
(annual %)
 Interest payment dates
(usually semi-annually)
Types of Bonds
 Secured (mortgage) bonds
 Entitle bondholders rights to specific assets
in event company defaults on bond interest
payments or maturity payment
 Unsecured (debenture) bonds
 Bondholders backed by reputation and
integrity of the company
 More risky, therefore pay higher interest
rate than secured bonds
Bond Prices
 Initial bond issue
prices
determined by
borrower and
bond underwriter
 Prices of bonds
traded on
secondary
market based on
variety of factors
Bond Prices
Affected by:
 Time to maturity
 Credit rating of
issuing company
 Contract interest
rate compared to
market interest rate
Bond Prices
 Expressed in terms
of percent of face
value
Bond Prices
 Expressed in terms
of percent of face
value
$10,000 face value bond
Bond Prices
 Expressed in terms
of percent of face
value
 Bond price might be:
 98.75
$10,000 face value bond
Bond Prices
 Expressed in terms
of percent of face
value
 Bond price might be:
 98.75
$10,000 face value bond
98.75% of face value
$9,875
BOND SOLD AT A “DISCOUNT”
Bond Prices
 Expressed in terms
of percent of face
value
 Bond price might be:
 100
$10,000 face value bond
Bond Prices
 Expressed in terms
of percent of face
value
 Bond price might be:
$10,000 face value bond
 100
BOND SOLD AT “PAR”
100% of face value
$10,000
Bond Prices
 Expressed in terms
of percent of face
value
 Bond price might be:
 104.5
$10,000 face value bond
Bond Prices
 Expressed in terms
of percent of face
value
 Bond price might be:
 104.5
$10,000 face value bond
104.5% of face value
$10,450
BOND SOLD AT A “PREMIUM”
Present Value
Money earns income (interest) with passage of time
Present Value
 Amount of a dollar invested
today is referred to as the
present value of a future
amount
 Amounts invested today
accumulate interest and
grow to a larger amount in
the future
Present Value
 $1,000 invested
today is worth more
than $1,000 to be
received two years
from now
 You can invest the
$1,000 now
 It will be worth more
in three years
Issuing Bonds Payable to
Borrow Money
 The City of Blacksburg, Virginia, issues
$15,000,000 of 6% 10-year bonds on
May 1, 19x3, to fund construction of a
new water treatment plant
 What is the City’s journal entry if the
bonds are issued at par?
Issuing Bonds Payable to
Borrow Money
5/1/x3
Cash
$15,000,000
Bonds Payable
$15,000,000
To record bonds issued at par
 After initial bond issue, secondary market bond
transactions do not involve the City of Blacksburg
 City makes no journal entries
 Keeps record of bond owners only for payment of
periodic interest
Issuing Bonds Payable to
Borrow Money
 The City’s bonds
pay interest each
May 1 and
November 1
 What is the journal
entry to record the
first interest
payment on Nov. 1,
19x3?
Issuing Bonds Payable to
Borrow Money
11/1/x3
Interest Expense
Cash
$450,000
$450,000
To record interest expense
Can you think of the adjusting entry necessary on
November 30, 19x3, the City’s fiscal year-end?
Issuing Bonds Payable to
Borrow Money
11/30/x3 Interest Expense
Interest Payable
$75,000
$75,000
To record interest accrual for 19x3
Issuing Bonds and Notes Payable
Between Interest Dates
 Bonds issued between interest payment dates
are priced to include accrued interest
WHY?
 Semiannual interest payments are paid in full to
the current bondholder of record
 Too time-consuming and impractical to track all
bondholders during the semiannual period
 Consider that some bondholders may hold
bonds only for several days or weeks before
selling them
Issuing Bonds and Notes Payable
Between Interest Dates
Suppose the City of Blacksburg issued its bonds
(dated 5/1/x3) on July 1, 19x3
7/1/x3
Cash
$15,150,000
Interest Payable
$150,000
Bonds Payable
15,000,000
To record bonds issued between interest
dates
Issuing Bonds and Notes Payable
Between Interest Dates
How would the first interest payment on November
1 would be recorded?
11/1/x3
Interest Expense
Interest Payable
Cash
$300,000
150,000
To record interest expense
$450,000
Issuing Bonds and Notes Payable
Between Interest Dates
Interest Expense
Interest Payable
$150,000 7/1
Issuing Bonds and Notes Payable
Between Interest Dates
Interest Expense
11/1 $300,000
Interest Payable
$150,000 7/1
Issuing Bonds and Notes Payable
Between Interest Dates
Interest Expense
11/1 $300,000
Interest Payable
11/1 $150,000
$150,000 7/1
Issuing Bonds Payable at a
Discount
 When would bonds be
issued at a discount?
 When contractual rate
of interest is lower
than market rate
 Bondholders will pay
amount less than face
value for investment
yielding less than
current market rate
Issuing Bonds Payable at a
Discount
 Suppose the City of Blacksburg, Virginia,
issues the $15,000,000 of 6% 10-year
bonds on May 1, 19x3, when similar
bonds of comparable quality and risk pay
8% interest
 What is the City’s journal entry if the
bonds are issued at a discount?
Issuing Bonds Payable at a
Discount
5/1/x3 Cash
$12,955,500
Discount on Bonds Payable 2,044,500
Bonds Payable
$15,000,000
To record bonds issued at discount
 Discount on Bonds Payable is a contra account to
Bonds Payable
 Net amount of Discount and Bonds Payable accounts
referred to as the bond’s carrying value
Issuing Bonds Payable at a
Discount
 Discount represents
additional interest
expense to be
allocated over life of
bonds
 Effect is to increase
entity’s interest
expense incurred on
bond to equivalent of
the market rate of
interest
Issuing Bonds Payable at a
Discount
City of Blacksburg would report its newly-issued
bonds on the balance sheet:
Long-Term Liabilities
Bonds Payable (6%, due 5/1/20x3)
$15,000,000
Less Bond Discount
2,044,500
Carrying Value
$12,955,500
Issuing Bonds Payable at a
Discount
City of Blacksburg would report its newly-issued
bonds on the balance sheet:
Long-Term Liabilities
Bonds Payable (6%, due 5/1/20x3)
$15,000,000
Less Bond Discount
2,044,500
Carrying Value
$12,955,500
Carrying value is
Issuing Bonds Payable at a
Discount
City of Blacksburg would report its newly-issued
bonds on the balance sheet:
Long-Term Liabilities
Bonds Payable (6%, due 5/1/20x3)
$15,000,000
Less Bond Discount
2,044,500
Carrying Value
$12,955,500
Carrying value is face value
Issuing Bonds Payable at a
Discount
City of Blacksburg would report its newly-issued
bonds on the balance sheet:
Long-Term Liabilities
Bonds Payable (6%, due 5/1/20x3)
$15,000,000
Less Bond Discount
2,044,500
Carrying Value
$12,955,500
Carrying value is face value minus unamortized bond
discount
Chapter Objective 4
Measure interest expense; amortize
bond discount and premium by the
effective-interest method
Effective-Interest Method of
Debt Amortization
 GAAP requires bond discount to be amortized
(allocated) over life of bond to yield interest
expense equivalent to market interest rate
 Known as effective-interest method
 Semiannual cash interest payment to
bondholders remains same
 Interest expense recognized by entity grows
slightly each period
Effective-Interest Method of
Debt Amortization
 Textbook Exhibit 8-6
shows an
amortization
schedule for a bond
issued at a discount
 Notice ....
Effective-Interest Method of
Debt Amortization
 Interest payments to bondholders do not
change over time
 Interest expense recognized by company
increases as bond carrying value increases
 Unamortized bond discount decreases as
bonds get closer to maturity
 Bond carrying value rises to face value as it
nears maturity
Interest Expense on Bonds
Issued at a Discount - Amortizing
Discount on Bonds Payable
 Bond discount represents additional interest
expense to entity
 “Unstated” cost of issuing bonds when
contractual interest rate is lower than market
rate of interest on similar bonds
 Refer to textbook Exhibit 8-7 to see
relationship between interest payments and
interest expense
Interest Expense on Bonds
Issued at a Discount - Amortizing
Discount on Bonds Payable
 Let’s amortize the first semiannual interest
payment for the City of Blacksburg’s bonds
11/1/x3 Interest Expense
$518,220
Discount on Bonds Payable
$68,220
Cash
450,000
To record bond interest payment
Interest Expense on Bonds
Issued at a Discount - Amortizing Discount
on Bonds Payable
After recording interest expense, related
account balances look like this:
Discount on
Bonds Payable
Interest
Expense
Interest Expense on Bonds
Issued at a Discount - Amortizing Discount
on Bonds Payable
After recording interest expense, related
account balances look like this:
Discount on
Bonds Payable
5/1 $2,044,500
Interest
Expense
Interest Expense on Bonds
Issued at a Discount - Amortizing Discount
on Bonds Payable
After recording interest expense, related
account balances look like this:
Discount on
Bonds Payable
5/1 $2,044,500
$68,220 11/1
Interest
Expense
Interest Expense on Bonds
Issued at a Discount - Amortizing Discount
on Bonds Payable
After recording interest expense, related
account balances look like this:
Discount on
Bonds Payable
5/1 $2,044,500
$68,220 11/1
Interest
Expense
11/1 $518,220
Interest Expense on Bonds
Issued at a Discount - Amortizing Discount
on Bonds Payable
After recording interest expense, related
account balances look like this:
Discount on
Bonds Payable
5/1 $2,044,500
$68,220 11/1
Bal $1,976,280
Interest
Expense
11/1 $518,220
Issuing Bonds Payable at a
Premium
 Suppose the City of
Blacksburg had issued
its water treatment plant
bonds at an interest rate
higher than market rates
 How would the May 1,
19x3, journal entry
change if the contract
rate of the bonds was
10% and the market rate
of interest at 8%?
Issuing Bonds Payable at a
Premium
5/1/x3 Cash
$17,032,500
Premium on Bonds Payable
$2,032,500
Bonds Payable
15,000,000
To record bonds issued at premium
 Net amount of Premium and Bonds Payable accounts
equal bond’s carrying value
Issuing Bonds Payable at a
Premium
 Premium, like a discount, is amortized over
life of bond
 Premium represents a reduction in total
interest expense
 Created by bondholders’ willingness to pay
more than face value for the bond issue
 Effect of premium is to reduce bond interest
expense
Issuing Bonds Payable at a
Premium
City of Blacksburg would report its bonds on the
balance sheet:
Long-Term Liabilities
Bonds Payable (10%, due 5/1/20x3)
$15,000,000
Plus Bond Premium
2,032,500
Carrying Value
$17,032,500
Issuing Bonds Payable at a
Premium
City of Blacksburg would report its bonds on the
balance sheet:
Long-Term Liabilities
Bonds Payable (10%, due 5/1/20x3)
$15,000,000
Plus Bond Premium
2,032,500
Carrying Value
$17,032,500
Carrying value is
Issuing Bonds Payable at a
Premium
City of Blacksburg would report its bonds on the
balance sheet:
Long-Term Liabilities
Bonds Payable (10%, due 5/1/20x3)
$15,000,000
Plus Bond Premium
2,032,500
Carrying Value
$17,032,500
Carrying value is face value
Issuing Bonds Payable at a
Premium
City of Blacksburg would report its bonds on the
balance sheet:
Long-Term Liabilities
Bonds Payable (10%, due 5/1/20x3)
$15,000,000
Plus Bond Premium
2,032,500
Carrying Value
$17,032,500
Carrying value is face value plus unamortized bond
premium
Issuing Bonds Payable at a
Premium
 How would the City’s first semi-annual interest
payment on the bonds be recorded?
11/1/x3 Interest Expense
Premium on Bonds Payable
Cash
To record bond interest payment
$681,300
68,700
$750,000
Interest Expense on Bonds
Issued at a Premium - Amortizing
Premium on Bonds Payable
 Textbook Exhibit 8-9
shows a bond
premium
amortization
schedule
 Observe the
differences between
it and Exhibit 8-6
Interest Expense on Bonds
Issued at a Premium - Amortizing
Premium on Bonds Payable
 Interest payments to bondholders do not change
over time
 Interest expense recognized by company decreases
as bond carrying value decreases toward maturity
 Unamortized bond premium decreases as bonds get
closer to maturity, similar to unamortized bond
discount
 Bond carrying value falls to its face value as it nears
maturity
Interest Expense on Bonds
Issued at a Premium - Amortizing
Premium on Bonds Payable
 Bond premium represents a reduction of
interest expense to entity
 Reduction in cost of issuing bonds when
contractual interest rate is higher than market
rate of interest on similar bonds
 Refer to textbook Exhibit 8-10 to see
relationship between interest payments and
interest expense
Straight-Line Amortization
of Bond Discount and Bond Premium
 GAAP requires bond
discounts and premiums
to be amortized using
effective-interest method
 Companies permitted to
use straight-line method
provided it yields similar
results
 That is, differences are
not material
Straight-Line Amortization
of Bond Discount and Bond Premium
Consider the difference for the City of Blacksburg
bonds issued at a premium:
 Effective-interest method
Bond premium - $2,032,500
First period amortization - $68,700
Straight-Line Amortization
of Bond Discount and Bond Premium
 Straight-line method
Bond premium - $2,032,500
First period amortization $101,625
 Straight-line amortization
understates period interest
expense by almost 5%
$681,300 - effective rate
$648,375 - straight-line rate
Straight-Line Amortization
of Bond Discount and Bond Premium
Amt. Amortized
Total Interest
 Straight-line method
Bond premium - $2,032,500
First period amortization $101,625
$700,000
$600,000
$500,000
$400,000
$300,000
$200,000
$100,000
 Straight-line amortization
Straihgtline
Interest
Method
Effective
Interest
Method
$-
understates period interest
expense by almost 5%
$681,300 - effective rate
$648,375 - straight-line rate
Early Retirement of Bonds
Payable
 Bonds typically
retired (paid off) at
maturity date
 Some bonds
retired prior to
maturity date
 Why?
Early Retirement of Bonds
Payable
 Early retirement allows entity to reduce bond
interest payments
 By paying off debt early
 Eliminating interest expense and cash outflow
associated with bond interest payments
 Or by reissuing bonds at a lower interest rate
 Reducing interest expense and cash outflow
related to interest payments
Early Retirement of Bonds
Payable
Issuer can retire bonds before
maturity by:
 Purchasing bonds on the
secondary market (buying
up all bonds currently held
by bondholders)
 Exercising call option
 Clause allowing issuer
to redeem bonds at
specified price as of
specific date
Early Retirement of Bonds
Payable
 After 6 years, the City of Blacksburg decides
to call its 10% bonds
 Perhaps interest rates have fallen, and the
City believes it can reissue the debt at lower
rate
 Suppose the bonds came with a call
provision, allowing the City to call bonds at
101
Early Retirement of Bonds
Payable
 What journal entry should the City make to retire
these bonds?
5/1/x9
Bonds Payable
$15,000,000
Premium on Bonds Payable
1,000,229
Gain on Bond Retirement
Cash
To record early bond retirement
$850,229
15,150,000
Early Retirement of Bonds
Payable
 GAAP requires gain or
loss on bond retirement
to be shown as an
extraordinary item on
entity’s income
statement
 Reported on separate
section of income
statement, net of
income tax effect
Convertible Bonds and Notes
 Convertible bonds allow bondholder to exchange
bonds for specified number of shares of common
stock in the company
 Bonds issued with conversion feature generally
carry lower interest rate
 Bondholder willing to accept lower rate due to
benefits of stock ownership
 When bonds converted into common stock,
company increases stockholders’ equity for
carrying value of bonds
Chapter Objective 5
Explain the advantages and
disadvantages of borrowing
Advantage of Financing
Operations with Bonds v. Stock
 Businesses can acquire
assets through debt or
equity
 Debt: can issue bonds,
take mortgages, borrow
funds to purchase assets
 Equity: can issue stock
in the company, use
proceeds to purchase
assets
Advantage of Financing
Operations with Bonds v. Stock
 Financing with debt
 Doesn’t dilute ownership in
company
 Usually results in higher earnings
per share
 Refer to textbook Exhibit 8-12
 Reduces total net income
 Increases debt ratios and may
impose financial restrictions on
company
Advantage of Financing
Operations with Bonds v. Stock
 Financing with equity
 No liabilities = no increase in debt ratios
 No fixed interest payments
 Generally higher total net income
 Will dilute ownership interest and
earnings per share of current
stockholders
Chapter Objective 6
Account for lease transactions
Lease Liabilities
 Rental agreement
permitting lessee
(user) to possess
and use asset
without long-term
commitments or
large cash downpayment
Lease Liabilities
Operating leases
2 types of
leases
Lease Liabilities
Operating leases
2 types of
leases
Capital leases
Operating Leases
 Short-term in nature
 Generally cancelable
 Right to undisturbed use of asset during lease
period
6/1/98
Prepaid Rent
Cash
$12,000
$12,000
To record 12-month rent prepayment
Capital Leases
 Long-term, non-
cancelable method of
financing asset
purchases
 Airlines, railways, large
retailers enter into longterm leases for many of
their plant assets
 Lease must meet 1 of 4
criteria to be classified
as a capital lease
Capital Leases
1. Leased asset becomes property of lessee at end
of lease period
2. Lease includes “bargain purchase” option - for
example, can buy asset for $100 at conclusion of
lease
3. Lease term is 75% or more of asset’s estimated
useful life
4. Present value of lease payments is greater than
90% of asset’s market value
Accounting for Capital Leases
 Accounting similar to purchased assets
 Lessee records leased asset and related
lease liability
 Lessor removes asset from its records
 Record depreciation on lease cost
 Recognize interest expense as part of “cost”
of acquiring leased asset (financing the asset
acquisition over time)
Off-Balance-Sheet Financing
 Some business financing
activities use debt that is
not required to be reported
on the balance sheet
 Operating leases are an
example
 Operating lease
disclosures in footnotes
are important to
understanding company’s
future obligations
Pension Liabilities
 A pension is money employees receive after
their retirement from an organization
 Companies match (accrue) pension expense in
the accounting period employees worked to
generate revenues
 If company doesn’t accrue sufficient funds,
excess liability is recognized as long-term
pension liability
 Detailed footnotes explain the current and future
pension liabilities of the company
Chapter Objective 7
Report liabilities on the balance sheet
Reporting Current and Long-Term
Liabilities on the Balance Sheet
 Balance sheets of
actual companies
have wide variety of
account titles and
situations for which
liabilities are recorded
 Reported on face of
balance sheet
 Disclosed in footnotes
to statements
Reporting Financing Activities on
the Statement of Cash Flows
Financing activities on the statement of
cash flows include:
 Cash received from issuing debt
 Cash paid to retire debt
 Cash received upon sale of stock
 Cash dividends paid to stockholders
World Wide Web Sites to Visit
AMR Corporation
 http://www.amrcorp.com/amr/amr_home.htm
Chrysler Corporation
 http://www.chrysler.com/
THE END
Of Ch 8
Presentation
Slides
Ch 8 Teaching Slides are Next
Categories of Current Liabilities
Amount of Liability Known When Recorded
Trade accounts payable
Short-term notes payable
Sales taxes payable
Current portion of long-term debt
Accrued expenses:
Interest payable
Payroll liabilities such as:
Salaries and wages payable
FICA tax payable
Employee income tax payable
Unearned revenues (collected in advance)
Amount of Liability Must Be Estimated When Recorded
Estimated warranty payable
Income tax payable
Estimated vacation pay liability
Contingent liabilities
© 1998 by Prentice Hall, Inc.
Contingent Liabilities
Potential liability dependent
upon a future event arising out
of a past transaction
Accounting treatment
° Record a liability if probable
and the amount of loss can
be reasonably estimated
° Report in a note only if
reasonably possible
° No need to report if remote
(unlikely to occur)
© 1998 by Prentice Hall, Inc.
Nature and Types of Bonds
Nature of Bonds
• In effect, a long-term note payable that bears
interest.
• States that the issuer will repay the principal
and specific interest payments.
• Usually in units of $1,000 called face value,
maturity value, or par value.
• Interest is paid annually or semi-annually.
$1,000
Bond
Types of Bonds
Term bonds - mature at the same time
Serial bonds - mature in installments over time
Secured (mortgage) bonds - give the bond holder the right
to claim of assets if the issuer defaults
Debenture bonds - unsecured bonds
© 1998 by Prentice Hall, Inc.
Interest Payments and Interest
Expense
on Bonds Payable Bonds Issued at a Discount
$5,000
$4,900
$4,800
$4,700
Interest Expense
$4,600
$4,500
$4,400
$4,300
$4,200
Interest Payments
1
2
3
4
5
6
7
8
9
10
Bonds Issued at a Premium
$4,500
$4,400
$4,300
$4,200
$4,100
$4,000
$3,900
$3,800
$3,700
Interest Payments
Interest Expense
© 1998 by Prentice Hall, Inc.
1
2
3
4
5
6
7
8
9
10
Financing with Debt Versus Stock
Long-term
Debt
Common
Stock
Investment Risk
Low
High
Corporate Obligation
to Repay
Yes
No
Dividends
or Interest
Taxdeductible
Interest
Dividends
Obligation to Pay
Dividends or Interest
At Fixed
Dates
Only After
Declaration
Market Value
Fluctuations under
Normal Conditions
Low
High
© 1998 by Prentice Hall, Inc.
Other Types of Liabilities
Current Portion of Long-term Debt
The amount of long-term notes or bonds payable within the
current period
Mortgage Notes
Borrowing agreement with assets pledged as collateral
Leases
• Capital leases
long-term non-cancelable financing obligation
reported as a liability
• Operating lease short-term cancelable rental agreements
Off-balance-sheet Financing
Acquisition of assets or services with debt that is not reported
on the balance sheet
Pensions and Post-retirement Benefits
Employee compensation and health benefits that will be
received during retirement
Deferred Income Taxes
© 1998 by Prentice Hall, Inc.
Income tax liabilities that the company can defer and pay later
Financing Activities on the
Statement of Cash Flows
Cash Flows From Financing Activities
Proceeds from issuance of
long-term debt
Other short-term borrowings
Payments on long-term debt
Payments on capital leases
Payment of cash dividends
Net Cash used for Financing Activities
$12,000
10,000
(4,000)
(11,000)
(8,000)
$( 1,000)
© 1998 by Prentice Hall, Inc.
App D: Accounting for
Partnership Slides Should be
Inserted Here!