9-1 definitely determinable liabilities obligations that can be measured exactly e.g., bank loans,...
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9-1
Definitely Determinable Definitely Determinable LiabilitiesLiabilities
Obligations that can be measured exactlyE.g., bank loans, accounts payable,
notes payable, salaries payableAccounting for payroll
Firms must supply the government with information for each workerFederal, state, and Social Security taxes
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Definitely Determinable Definitely Determinable LiabilitiesLiabilities
Accounting for payrollGross pay
Wages/salary before any deductionsDeductions
Federal income tax (FIT) withheldFIT Payable
FICA tax withheld (6.2% of salary)FICA Payable
Medicare tax withheld (1.45% of salary)Medicare Taxes Payable
Accounting for payrollEmployer must match employee
deduction for FICA and MedicareEmployer’s Payroll Tax Expense
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Estimated LiabilitiesEstimated LiabilitiesAccounting for warranties
Obligation is not certain, so it is estimatedWarranty Payable and related Warranty
Expense recognized in year product is sold regardless of duration of the warranty
Accounting for warrantiesRepairs or replacement under warranty
Cash, parts inventory, and/or merchandise inventory decreases (credit)
Warranty Payable decreases (debit) because part of the warranty liability is satisfied
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Warranty Example1. Electronics Universe (EU) sells $20,000 of
consumer electronics for cash during September with a 2-year warranty (ignore CoGS)
2. EU estimates that warranty work related to the sales will be 3% of sales.
3. During September, EU pays $100 cash and uses $80 of parts to satisfy warranty claims
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Long-term Notes Payable and Long-term Notes Payable and MortgagesMortgages
Short-term notes Mature in < 1 yrInterest and principal usually paid at the
end of the term Long-term notes
Mature in > 1 yrOptions for repayment
Repay in one lump sum (principal + interest)Repay in equal annual payments
Payments combine principal and interestAs loan is repaid outstanding balance of loan
decreases, so the interest portion of the payment decreases and the principal portion increases
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Long-term Notes Payable and Long-term Notes Payable and MortgagesMortgages
Present valueValue today of a given amount to be
paid or received in the futureBoth the principal and interest not paid
or received are earning interest at the discount rate
Discount rateInterest rate used to compute the present
value of the future cash flows
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Long-term Notes Payable and Long-term Notes Payable and MortgagesMortgages
Present value (continued)If you deposited $100 in the bank at
5% interest, at the end of the year you would have $105The present value of receiving $105 one
year from now at a 5% discount rate is $100
Repaying a mortgage
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Repaying a MortgageThe Universe borrows $200,000 on
1/1/08Discount rate: 7% Term of loan: 4 yearsPayments at end of each year:
$59,046Make journal entries for first two
yearsSee the amortization table on the
next slide?
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Repaying a Mortgage
A B C D E
Yr Beg Prin
Mtg Pmt
Int ExpA x int %
Prin Paid B - C
End PrinA + D
1 200,000 59,046 14,000 45,046 154,954
2 154,954 59,046 10,847 48,199 106,756
3 106,756 59,046 7,473 51,573 55,183
4 55,183 59,046 3,863 55,183 0
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Long-term Liabilities: Long-term Liabilities: Raising Money by Issuing Raising Money by Issuing
BondsBondsWhat is a bond?Types of bondsIssuing bonds payablePaying interest to bondholdersMarket for trading bonds
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What Is A Bond?
An interest-bearing, long-term note payableInterest is usually paid to the
bondholder semi-annuallyPrincipal is repaid at maturityOnly corporations and governmental
agencies can issue bondsFace value (stated value) usually $1,000
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Types of BondsSecured vs. unsecured
Do bondholders have a claim to specific assets if the corp defaults on the bonds?
Term vs. serialDo bonds mature all at once or do they mature
periodically over several years?Convertible
Bondholder has option to convert bond into specified # of shares of stock Callable
Corp has option to redeem bond before maturity, usually for more than the bond’s face value
Junk bondRated at below investment grade
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Issuing Bonds PayableBond terminologyIssue priceIssuing bonds at parIssuing bonds at a discountIssuing bonds at a premium
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Bond TerminologyMarket rate of interest
Interest rate based on the type of bond, the duration, and the risk that the issuer will default on the bond
Market interest rate fluctuates dailyUsed as the discount rate to determine
The issue priceInterest expense issuer recognizes
Stated rate of interestInterest rate on face of bondDetermines cash flow of interest
Face value x stated rate = interest paymentDoes not fluctuate over life of bond
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Issue PriceStated Rate = Market Rate
Interest payments received = mkt rateBonds sell at a PAR
No difference between issue price and face value
Issuing corp’s interest payments equal to interest expense
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Issue PriceStated Rate < Market Rate
Interest payments received < mkt rateBonds sell at a DISCOUNT
Difference between issue price and face value fairly compensates investor for accepting lower interest payments
Issuing corp’s interest expense is greater than the interest paid to investors
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Issue PriceStated Rate > Market Rate
Interest payments received > mkt rateBonds sell at a PREMIUM.
Difference between issue price and face value reduces investor’s return to equal the market interest rate because interest payments are greater than the market rate
Issuing corp’s interest expense is less than the interest paid to investors
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Issuing Bonds at Par
Start-up Corporation issues 100, $1,000 5-year bonds at 6% when the market rate = 6%
No discount or premium because stated rate = market rate
The bonds are issued at 100100% of par
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Issuing Bonds at a Discount
Start-up Corporation issues 100, $1,000 5-year bonds at 6% when the market rate = 7%
The discount is $4,100What is the issue price?
Bond discount is a contra-liabilityCarrying value
Bond Payable - Discount on Bond Payable
9-20
Issuing Bonds at a Premium
Start-up Corporation issues 100, $1,000 5-year bonds at 6% when the market rate = 5.3%
The premium is $3,000What is the issue price?
Bond premium is an adjunct liabilityCarrying value
Bond Payable + Premium on Bond Payable
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Paying Interest to Bondholders
Interest = principal x int rate x timeBonds issued at par
No discount or premium to amortizeStraight-line amortization per payment
Discount (or premium) / # of paymentsAs the bond matures, the carrying
value gets closer to the par valuePremium/discount account gets smaller
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Paying Interest to Bondholders
Bonds issued at a discountA portion of the discount is ADDED to
the interest payment to compute the interest expenseInterest pmt + discount amortized
5-year bond with a $4,100 discountCompute the discount amortized per
year
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Paying Interest to Bondholders
Bonds issued at a premiumA portion of the discount is SUBTRACTED
from the interest payment to compute the interest expenseInterest pmt - premium amortized
5-year bond with a $3,000 premiumCompute the premium amortized per yearMake the journal entry for the first year
9-24
Market for Trading BondsAfter bonds are issued, they are
traded in a secondary marketThe value of a bond fluctuates
daily depending on the market rate of interest
What happens to the value of a bond if the market interest rate increases? Decreases?
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Capital StructureThe combination of debt and
equity a company uses as its source of capital
What other source of capital does a company have besides debt and contributed capital?
Generally, a company should only use debt financing when the return exceeds the cost of borrowing
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Financial LeverageUsing borrowed funds to increase
earnings for the shareholders (owners)Increase return on equity
Positive financial leverageEarnings on borrowed money > cost of
borrowing moneyWhat is the cost of borrowing money?
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Debt-to-equity RatioCompares value of creditors’ claims
to value of owners’ claimsMeasure of long-term risk
Which is riskier, financing with equity or financing with debt? Why?
Total liabilities _ Total shareholders’ equity
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Times-interest-earned RatioMeasures a company’s ability to
make interest payments on its debtMeasure of short-term solvency
Income from operationsInterest Expense
Income from operations is used because it is more comparable across companies than net income. Why?
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Business Risk, Control, and Business Risk, Control, and EthicsEthics
Risk associated with long-term debtNot being able to make debt
paymentsHow to minimize risk of defaulting
on debtSound business analysis accompanies
any decision to borrow moneyEvaluate types of debt for company’s
circumstances
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Time Value of MoneyYou did some gardening for a
neighbor. The neighbor offers to pay you $100. Would you rather receive it when the job is finished or a year later?Receiving a dollar today is worth more
than receiving a dollar in the future. Why?
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Simple vs. Compound Interest
Simple interestInterest is computed on principal
onlyShort-term loans use simple interest
Compound interestInterest computed on principal
PLUS interest accrued, but not paidInvestments grow much faster
when interest is compounded (Exhibit 9A.1)
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Present Value of a Single Amount
FVn = PV (1 + i)n
where n = the number of yearsi = the interest ratePV = the present value of the future
sum of moneyFVn = the future value of the
investment at the end of n years
PV = FVn x [1/(1+i)n]
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Present Value of an AnnuityAnnuity
A series of equal cash flows over equally spaced time intervals
Ordinary annuityPayments made at the end of the period
PV = (1/i) x {1-[1/(1+i)n]}
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Appendix B: Bond Appendix B: Bond ProceedsProceeds
Proceeds from a bond is the sum of two cash flowsPresent of a single amount
Receiving the face value upon maturity of the bond
Present value of an annuityThe periodic interest payments
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Appendix B: Bond Appendix B: Bond ProceedsProceeds
Bond issued at a premiumStated rate > market rate
Compute price on 10-year $1,000 bondStated rate is 6% and market rate is
5%How much interest is received each
period?
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Appendix B: Bond Appendix B: Bond ProceedsProceeds
1.Present value of the annuity 10 periods, 5% per period, $60 per
pmt. $60 x 7.72173 = $463
2.Present value of the face value 10 periods, 5%, $1,000. $1,000 x 0.61391 = $614
Bond price: $463 + $614 = $1,077
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Appendix B: Bond Appendix B: Bond ProceedsProceeds
Bonds issued at a discountStated rate < market rate
Compute price on 10-year $1,000 bondStated rate is 4% and market rate is
5%How much interest is received each
period?
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Appendix B: Bond Appendix B: Bond ProceedsProceeds
1.Present value of the annuity 10 periods, 5% per period, $40 per
pmt. $40 x 7.721735 = $309
2.Present value of the face value 10 periods, 5%, $1,000. $1,000 x 0.61391 = $614
Bond price: $309 + $614 = $923
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Appendix C: Bond Appendix C: Bond AmortizationAmortization
Effective interest methodActual interest expense on outstanding
principal balanceActual interest expense
[carrying value] x [mkt rate at issue] x [time]
Difference between interest payment and interest expense is the amount of premium/discount amortized for the period
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Appendix C: Bond Appendix C: Bond AmortizationAmortization
Straight-line vs. effective interest methodStraight-line
Interest rate changes; interest expense is constantEffective interest method
Interest rate is constant; interest expense changesGAAP, but straight-line may be used if difference
between the two methods is not material
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Appendix D: Leases and Appendix D: Leases and PensionsPensions
Capital leasesAccounted for as a purchase and a
loanAsset recorded on booksLiability recorded for future lease pmts
Obligations Under Capital LeasesDetails in notes to financial
statements
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Appendix D: Leases and Appendix D: Leases and PensionsPensions
PensionsLiability increases for defined benefit
plans when cash payment to pension fund is less than the annual obligation
FASB requires disclosure of a great deal of information about pension plan and funding
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Assign #3: pg. 477-478 - E9-6A, E9-9A; Assign #4: pg. 483-484 - P9-1A, P9-4A.