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Chapter 11: Liabilities, on and off balance sheet Liabilities, definition and classification:

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Chapter 11: Liabilities, on and off balance sheet Liabilities, definition and classification:
Chapter 11:
Liabilities, on and off balance sheet
Liabilities, definition and classification:
• present obligations based on past transactions or events that require
either future payment or future performance of services
A liability is a present obligation of the enterprise arising from past
events, the settlement of which is expected to result in an outflow
from the enterprise of resources embodying economic benefits.
[IASB Framework, paragraph 49]
−recognized when incurred; end-of-period adjustments may be necessary
−valued at the amount due or at fair market value
−classified as current or long-term; determinable or contingent
1
Long-term / current
•
Long-term Liability
– due beyond the current period or the normal operating cycle, whichever
is longer
– used to cover long-term financing needs
•
Current Liability
– due within one year or within the normal operating cycle, whichever is
longer
– incurred in connection with operating process
– long-term liabilities may contain a current portion according to the lapse
of time
• to be shown separately
2
Part I: Current Liabilities
•
Accounts Payable
– sometimes called trade accounts payable
– balances owed to others for goods and services purchased on open
account
– time lag between resource inflow and payment
•
Short-Term Loans
– „line of credit“ – short-term borrowing when needed
– promissory note
• interest rate may vary over time
3
Notes Payable,
accounting treatment when granted
– written promises to pay a certain sum on a specified future date
– used to secure loans or to pay suppliers for goods
Case 1 - Interest stated separately
Sep 30
Cash
10.000
Notes Payable
10.000
(To record issuance of 9%,
90-day note to Commerzbank)
money received equal
to face value of note
Case 2 - Interest in face amount
money received equal to
present value of note
Sep 30
Cash
9.779
Discount on Notes Payable
_221
Notes Payable
10.000
(To record issuance of zero-interest-bearing
90-day note to Commerzbank)
4
Accounting treatment of payment
Case 1 - Interest stated separately
Dec 30
Notes Payable
10.000
Interest Expense
_225
Cash
10.225
(To record payment of
Commerzbank interest-bearing
note and accrued interest at
maturity)
interest expense
= 10.000 x 9% x 90/360
Case 2 - Interest in face amount
interest expense is lower in
case 2 than in case 1 since the
effective amount borrowed
was lower, too.
Dec 30
Notes Payable
10.000
Cash
10.000
(To record payment of note
with interest included in
face amount)
Dec 30
Interest Expense
____221
Discount on Note Payable
221
(To record interest
expense on note payable)
5
other current debt
•
Current Maturities of Long-Term Debt
– portions of long-term debt maturing within the next year are classified as
current liabilities
– e.g. installment due on a long-term liability, i.e. a loan
•
Dividends Payable
– liability is incurred after the board‘s decision to pay out dividends
– liability exists until dividends are paid
6
Unearned Revenues
•
examples:
–
–
–
–
•
sale of season tickets for a sports club
subscription of magazines
gift certificates
meal tickets
accounting treatment
– when payment is received: debit cash, and credit unearned revenue
account
– when revenue is earned: debit unearned revenue, and credit an earned
revenue account
Type of
Business
Airline
Restaurant
Magazine Publisher
Sports Club
Account Title
Unearned Revenue
Unearned Passenger Ticket Revenue
Unearned Meal Revenue
Unearned Subscription Revenue
Unearned Ticket Revenue
Earned Revenue
Passenger Revenue
Meal Revenue
Subscription Revenue
Ticket Revenue
7
7
Economic function of unearned revenue
•
recognize unearned revenue when customers are entitled to receive
future service for their present payment with certainty
– to be distinguished from warranty reserves
Example – Microsoft
¾ unearned revenue increased year after year
¾ u.r. arise from sale of Windows and Office
you do not buy just the current version but future
improvements as well
¾ if sales are growing so is unearned revenue
Increases in unearned revenues may signal favorable future
development!
8
Contingencies
•
Definition
„ ... an existing condition, situation, or set of circumstances involving
uncertainty as to possible gain (gain contingency) or loss (loss
contingency) to an enterprise that will ultimately be resolved when
one or more future events occur or fail to occur.“ [FASB] Statement of
Financial Accounting Standards No.5, par.1 (1975)
– Gain contingencies are not recorded.
– Loss contingencies are not existing liabilities, but potential liabilities
– liabilities contingent on occurence or nonoccurence of a future event
9
Example
•
Dream Cars Inc., a car dealer, offers various specialties to its
customers:
– Free repair of newly bought cars in case of defect within the next two
years
– Free inspection on request by new customers within the next six months
with purchase of 4 new tires before christmas (as a christmas customer
appreciation special)
•
No definite liability incurred; Uncertain:
– payee
– due
– amount.
•
Nevertheless
– it is probable, that a liability has been incurred, and
– the liability can reasonably be estimated.
Ö Record
liability!
the estimated amount as a contingent
10
Accounting for contingencies under US-GAAP
Event
Contingent Loss
Probability of
Occurence
High
Contingent Gain
Reasonable
Remote
High
Reasonable
Remote
Disclose
Ignore
Disclose
Ignore
Ignore
Is it estimable?
Accounting
Treatment
Yes
No
Accrue
Disclose
Source: Pratt, p. 432.
11
Common instances of loss
contingencies/contingent liabilities:
•
Litigation, claims, and assessments
•
Guarantee and warranty costs
– guarantee for credit default
– product warranty
•
•
•
Premiums and coupons.
Environmental liabilities.
Pensions and other postemployment benefit obligations.
see following pages
– the cause for legal action occurred in the past
– probability of unfavorable outcome assessed according to past
experience
– estimate of expected loss: legal action is decided but number of
claimants uncertain
– pending litigation vs. actual/possible claims and assessments: no exact
amounts disclosed due to influence on position before the court
12
Guarantee and warranty costs
•
•
Warranty: guarantee to repair or replace defective goods during a
predetermined period following the sale
accounting either
– Cash Basis – warranty costs charged to period in which
company complies with the warranty
– Accrual Basis – warranty costs charged to period of sale as
operating expense
• Example (accrual basis): Michael Drums sells music instruments. Per
100 units sold, 2 require warranty service. The cost per service is
estimated at € 70. In 2002, he sold 800 units. Five warranty services
have already been performed at costs totaling € 430. So there remain
eleven warranty services as an estimated liability.
13
Journal entries for the example:
1.
Sale of 800 units at average price € 100
Cash or Accounts Receivable
Sales
2.
3.
80.000
80.000
Recognition of warranty expense
Warranty Expense
Cash,Inventory, or Accrued Payroll
(warranty costs incurred)
430
Warranty Expense
Estimated Liability under Warranties
(to accrue estimated warranty costs)
770
_ _430
_ _770
Recognition of warranty costs incurred in 2003 (on 2002 sales)
Estimated Liability under Warranties
Cash, Inventory, or Accrued Payroll
770
_ _770
14
Premiums and coupons
•
Examples
– frequent-flyer programs
– bonus cards of department stores
•
Accounting problem again: estimation of the liability incurred with
the sales
– (to comply with the matching principle)
•
Journal entries – similar to „Drums example“
15
Environmental liabilities
•
result from obligation to clean up, say, toxic waste or to landscape
sites no longer used for business
– sometimes very hard to estimate the liability
– indemnity claims after environmental catastrophes
•
For example: Bayer AG
“[28 ] Other provisions
Other provisions are valued in accordance with IAS 37 (Provisions,
Contingent Liabilities and Contingent Assets) using the best
estimate of the extent of the obligation. Interest-bearing provisions
are discounted to present value. Personnel commitments mainly
include annual bonus payments, long service awards and other
personnel costs. The miscellaneous provisions include € 131 million
for restructuring. Provisions for environmental protection relate to
future relandscaping, landfill modernization and the remediation of
land contaminated by past industrial operations. Sufficient
provisions have been established for such commitments.” [Bayer
AG, Annual Report 2000, notes to financial statements.]
16
Part II: Long-term liabilities
•
Bonds
–
–
–
–
–
•
•
Definition of a bond
Why issuing bonds
Types of bonds
Accounting for bond issues
Accounting for bond retirements
Long-Term Notes Payable
Reporting and Analysis of Long-Term Debt
17
Bonds
•
•
•
•
•
securities issued by, e.g. corporations or governmental agencies, to
obtain large-sum long-term financing
normally due ten to fifty years after issue
various covenants and restrictions for protection of both lenders and
borrowers
small denominations allows collection of large sums of money
interest payment
– annually or semiannually
– zero bonds
•
„bond issue“ refers to total number of bonds issued at one time
18
Why issue bonds?
•
•
to obtain large sums of money for long time that cannot be collected
otherwise e.g. from banks
debt financing has some advantages over equity financing
– stockholder control remains unaffected
– tax savings: interest expense is tax deductible
– leverage effect: spread between return on assets and interest cost is
usually positive and increases return on equity
•
Stock financing vs. bond financing – an example
– € 2 million needed to fund a project
– alternative I – issues 100.000 shares at current price of € 20 per share
– alternative II – issuance of € 2 million, 9% bonds at face value
19
Funds obtained by
... issuance of
additional shares
(250.000 shares
outstanding)
... issuance of
bonds
(150.000 shares
outstanding)
Earnings before interest
and income taxes
Interest
€ 700.000
0
€ 180.000
0
€ 700.000
180.000
€ 180.000
180.000
Earnings before income taxes
Income taxes at 35%
€ 700.000
245.000
€ 180.000
63.000
€ 520.000
182.000
€0
0
Net income
€ 455.000
€ 117.000
€ 338.000
0
Earnings per share
€ 1,82
€ 0,47
€ 2,25
0
RoE
9.1%
2.34%
11.27%
0%
Note: Net income under bond financing is lower than under stock financing, but return
on equity may be higher.
Note that interest cost will increase with leverage because of an increasing default
risk.
Volatility of earning increases.
20
How to issue bonds ?
•
usually, approval by board of directors and general meeting of
shareholders necessary; authorized:
– number of bonds
– total face value and nominal interest rate
• face value: amount of principal the issuer must repay at maturity
• nominal interest rate determines amount of cash interest the issuer
has to pay (also stated rate of interest)
– bonds are taken by investment banks („underwriters“) and sold to the
public
– underwriters buy bonds for resale or on a commission basis
– bondholders are represented by a trustee, typically a large bank
– contract between company and bank is called bond indenture
– specifies terms of the bond, rights, privileges, and limitations of
bondholders
•
bondholders receive bond certificates as evidence of the company‘s
debt to the bondholder; bondholders are creditors !
21
Types of Bonds
•
Secured and Unsecured Bonds
– secured bonds: bondholders have a claim to certain assets of the
company upon default, e.g. mortgage bond
– unsecured bonds: issued against general credit of borrower (debenture
bonds)
•
Term and Serial Bonds
– term bonds: all bonds of an issue mature on the same date
– serial bonds: bonds mature over several maturity dates
•
Registered and Coupon Bonds
– registered bonds: corporation maintains record of all bondholders
– coupon bonds: bond not recorded in the name of the owner;
transferable by delivery
cont‘d next page
22
Types of Bonds, cont‘d
•
Convertible and Callable Bonds
– convertible bonds: bonds that can be converted into common stock at
the option of the holder
• bonds furnished with a stock option to reduce coupon
– callable bonds: bonds that can be retired before maturity at the issuer‘s
option
•
Income and Revenue Bonds
– income bonds: interest payment only if company is profitable
– revenue bonds: interest on the bonds is paid from specific revenue
sources
23
Accounting for Bonds Payable
•
bonds are traded in the capital market
– market rate (effective yield) of interest and (current) bond prices are
inversely related
• yield rate: the virtual interest rate r a bond purchased at the current
price in the market yields to the owner
• Let c denote the coupon, B the bond price, T the maturity (time to
repayment), face value = F.
• Then r is the solution to the following equation:
⎛ T
c
⎜⎜ ∑
t
(
)
+
1
r
t
=
1
⎝
⎞
F
⎟⎟ +
=B
T
⎠ (1 + r )
• The yield for longer term debt uses to be higher than for shorter
term debt (normal term structure of interest rates)
• yield rate (bond price) depend on credit rating
24
Accounting for Bonds Payable
face value
€ 300.000
stated rate of interest
7%
market rate of interest
10%
12%
schedule of payments
year 1
year 2
year 3
interest
principal
€ 21.000
€ 21.000
€ 21.000
year 4
€ 21.000
€ 300.000
year 1
year 2
year 3
€ 21.000
€ 21.000
€ 21.000
present value of interest
present value of principal
€ 66.567
€ 204.904
€ 63.784
€ 190.655
present value (selling price) of the bond
€ 271.471
€ 254.440
year 4
€ 21.000
€ 300.000
25
Inverse relation between interest rates
and bond prices
B
bond #1 – stated
rate of interest of c1
= 5% and term to
maturity of T1= 10
bond #2 - stated
rate of interest of
c2 > c1 and term to
maturity of T2=T1
bond #3 - stated
rate of interest of
c3=c1 and time to
maturity T3 = 5 < T1
%r
assumption: bonds 1-3 have the same face value = 100
26
Stated rate of interest, market rate of interest,
effective rate of interest, and bond issue prices:
•
The stated rate of interest i = c/F may differ from the market rate of
interest
– since the yield must be equal to the market rate the issue price must be
adapted accordingly:
•
If the stated rate is
– lower than the market rate: issue price lower than face value, bond sells
at a discount
– higher than the market rate: issue price exceeds face value, bond sells
at a premium
•
at the date of issue
⎛ T
c
⎜⎜ ∑
t
(
)
⎝ t =1 1 + r
⎞
F
⎟⎟ +
=B
T
⎠ (1 + r )
must hold with a given market rate r
27
Issuing Bonds At Face Value (“at par”)
•
•
stated rate of interest i = r market rate of interest
accounting entry: cash proceeds = face value of the bonds
– Example: 5-year term bonds, face value of € 900.000, dated January 1,
2009, interest rate 8%, annual interest payments on January 1.
To record issuance of bonds on January 1
Cash
Bonds Payable
900.000
900.000
To record accrued interest expense at year end
(December 31)
Bond interest expense
Bond interest payable
72.000
72.000
28
Issuing Bonds at Discount
•
stated rate of interest i < r market rate of interest
– Example: as before, but market rate of interest now 10% (stated rate of
interest 8%).
5
72.000 900.000
+
= 831.766
5
∑
t
1,1
1,1
t =1
– discount is 68.234
– has to be amortized over the time to maturity
• usually: straight line method: 68.234 / 5 = 13.647
29
Issuing Bonds at Discount
To record issuance of bonds on January 1
Cash
831.766
Discount on Bonds Payable
68.234
Bonds payable
900.000
To record accrued interest expense and accrued amortization at
year-end (December 31)
Bond interest expense
85.647
Discount on Bonds Payable
Interest Payable
13.647
72.000
Balance sheet presentation: Long-term liabilities
Bonds Payable
Less: Discount on Bonds Payable
900.000
€ €900
000
112.159 € 831.766
€ 787.841
68.234
30 30
Issuing bonds at a premium
•
stated rate of interest i > r market rate of interest
– Example: as before, but market rate of interest now 6%
To record issuance of bonds on January 1
Cash
975.823
Premium on Bonds Payable
75.823
Bonds payable
900.000
To record accrued interest expense and accrued amortization at year-end
(December 31)
Bond interest expense
56.835
Premium on Bonds Payable
15.165
Interest Payable
Balance sheet presentation
72.000
Long-term liabilities
Bonds Payable
Add: Premium on Bonds Payable
€ 900€000
900.000
31
133.901
€ 1.033.901
75.823
€31
975.823
Amortizing Bond Premium / Bond Discount
•
the bond premium (discount) is amortized over the life of the bonds
– straight-line method
– effective interest method
•
Straight-line method
– equal amounts of the premium (discount) are amortized in each period,
equal interest expense recorded in each period
– interest expense = interest to be paid + amortized discount
– amortized discount = (face value – issue price) / number of interest
periods
– interest expense = interest to be paid – amortized premium
– amortized premium = (issue price – face value) / number of interest
periods
32
Effective interest method
•
interest expense = bond carrying value × effective rate of interest
– discount amortization = interest expense – interest to be paid
– premium amortization = interest to be paid – interest expense
– increasing amounts are amortized in each period
• interest expense is equal to a constant percentage of the
carrying value of the bonds
• interest expense recorded is, thus, increasing under discount
and decreasing under premium amortization
33
Effective interest discount amortization
schedule for an 8% bond sold to yield 10%
Annual
interest paid
period
issue date
1
72.000
2
72.000
3
72.000
4
72.000
5
72.000
interest
expense
83.177
84.294
85.524
86.876
88.364
discount
unamortized bond carrying
amortization
discount
value
68.234
831.766
11.177
57.057
842.943
12.294
44.763
855.237
13.524
31.239
868.761
14.876
16.363
883.637
16.364
0
900.000
34
The journal entry to record accrued interest at December 31, 2004, is
Bond interest expense
Discount on bonds payable
Bond interest payable
83.177
11.177
72.000
... and bond interest expenses will keep rising as the carrying value of the
bonds increases.
35
Effective interest premium amortization
schedule for 8% bonds sold to yield 6%
Annual
interest paid
period
issue date
1
72.000
2
72.000
3
72.000
4
72.000
5
72.000
interest
expense
58.549
57.742
56.887
55.980
55.019
premium unamortized bond carrying
amortization premium
value
75.823
975.823
13.451
62.372
962.372
14.258
48.115
948.115
15.113
33.002
933.002
16.020
16.982
916.982
16.981
1
900.001
36
The journal entry to record accrued interest on December 31, 2009, is
Bond interest expense
Premium on bonds payable
Bond interest payable
58.549
13.451
72.000
... and bond interest expenses will keep falling as the carrying value of
the bonds decreases.
37
Zero Bonds
•
•
bonds that bear no interest (explicitly) and are issued solely for cash
also called deep discount bonds
– Example: An 8-year zero bond with face value of € 10 million (10.000 x
€ 1.000 each) is issued and sold at a price of € 3.270.000.
•
What is the implicit interest rate ?
€3.270.000 = €10.000.000 ⋅ (1 + i ) −8
10.000.000
i=
− 1 = 0,14999
3.270.000
8
•
The implicit interest rate is 15%. It is the interest rate that equates
(in present value terms) the cash received with the amounts to be
paid in the future.
38
Disclosure Requirements for
Long-Term Debt
•
•
•
•
composition of long-term debt
long-term debt maturing within one year should be reported as a
current liability
maturities of long-term debt during each of the next five years
any special arrangements, e.g. refinancing, conversion into stock,
„off-balance-sheet financing“
39
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