acct5001 week 10 sem 1 2010 completed for students

7/30/2019 ACCT5001 Week 10 Sem 1 2010 Completed for Students

1/6

ACCT5001 Semester 1, 2010Week 10

Reporting and Analysing Liabilities

Developed by Dr Anne AbrahamAdapted by Ron Day

2009 John Wiley & Sons Australia, Ltd

2

0verview Week 10

Text: Chapter 9 LO 1 -4, pp. 498 - 515; LO 10, pp. 523 -527.

Demo Questions: BE9.2, E9.2, PSA9.5,Add iti onal Demon str atio n Ques tio nSelf-Study Questions: Q3, Q8, Q9,; E9.3; E9.5; PSA9.1; PSA9.2; PSA9.4, 5; * BSB9.5

NB. Additional Self Study Questions on Debenture (Bond) Issues

Explain the difference between current and non-current liabilities.

Identify types of current liabilities and explain how to account for them.

Identify types of non-current liabilities, such as debentures and

unsecured notes, and explain how to account for them

Calculate the issue price, and record the debentures (bonds) issues

at: a) par, b) at a discount, c) at a a premium

Calculate and record the relevant interest expense and payment

entries required under the effective interest method

Prepare journal entries forloans payable by instalment and distinguish

between current and non-current components of long term debt.

2

3

CURRENT LIABILITIES

Current liabilities

Def: are obligations that can reasonably be expected to be paid

within one yearor within the operating cycle, whichever is the longer

Eg. - accounts payable, (Chp 2 & 5)

- accrued liabilities and revenue received in advance (Chp 3 & 4)

- other payables (e.g. payroll deductions payable etc.),

- notes payable (due < 1 year )

- Short term provisions (due < 1 year)

Liabilities that dont meet this definition are non-current liabilities

- Eg - Loans payable and Mortgages (loans secured by property)

- Unsecured notes and Debentures (Bonds)

- Long-term provisions (due > 1 year)

- Finance leases

4

Other Payables

Other Payables amounts owing to other than suppliers of inventory

E.g. Wages and other payroll deductions payable

Employers deduct amounts from employees wages and salaries if they

are required to be paid to other parties:

See E9.2

Mar 31 Dr Wages Expense 70 000

Cr ABC Health Fund payable 4 500

Cr Pay-as-you-go withheld tax payable 7 500Cr Superannuation fund payable 2 200

Cr Union Fees payable 500

Cr Wages payable 55 300

(To record payroll and other payables withheld on March 31)

5

Notes Payable

Notes Payable

Formal contract to record obligations in the form of a legal document

- Usually require borrower to pay interest or borrowing costs as well

- Frequently issued to meet short-term financing needs

- Issued for varying medium periods of time (say 3 mths, 6 mths or 1 year)

Eg. BE 9.2

Borrowed $60 000 from XXX Bank 0n July 1 by issuing a one year 10%note (interest payable on settlement at maturity date)

Journal entry when note issued

July 1 DrCash 60 000

CrNotes Payable 60 000

(To record issue of 10%, one year note payable to XXX Bank)

6

Notes Payable (Continued)

Journal entry to record accrued interest at balance-day December 31

Dec 31 Dr Interest expense 3 000

Cr Interest payable 3 000

(Entry to record accrual of interest owing to XXX Bank at end of

period 10% x $60,000 x 6/12)

Journal entry to settle the liability

June 1 Dr Notes payable 60 000

Dr Interest expense 3 000

Dr Interest payable 3 000

Cr Cash 66 000

(To record payment of note and interest to XXX Bank at maturity)


2/6

7

NON-CURRENT LIABILITIES

are obligations where the future sacrifice of economic benefits is not expected

to be paid until after 1 year Referred to as debt financing/borrowing from single or multiple lenders

Common forms ofsingle lender borrowing are:- Bank loans- Long-term notes payable

Common forms ofmultiple lender borrowing direct from the public

- Unsecured notes no security over assets (therefore higher ri sk and interest)

- Debentures (Bonds)

subject to a secured charge on the issuers assets

Why would a company raise money direct from the publicfrom multiple lenders?

8

Why issue long-term debt?

Advantages of Debt Financing

Shareholder control is not affected Why? Debt is often cheaperWhy?

Financial leverage can benefit shareholders by increasing EPS How?

Disadvantage of Debt Financing

Increases financial risk How?

- Debt creates contractual obligations that must be paid in good or bad times

- Interest must be paid periodically (unlike dividends that can be varied) and the

- Principal must be paid at maturity (unlike shares that are not usually repaid)

9

Loans payable by Instalments

Instalment Loans

money is borrowed from a single lenderin the form ofrepayable loan

If the loan is secured by a charge over property it is called a mortgage.

- if the borrower defaults the lender may sell the property to repay the loan

the total loan repayments - the amount originally borrowed = interest

Equal periodic loan instalments consist of part interest, part principal

- (i) interest expense (fixed percentage by principal balance)

- (ii) remainder of instalment is a reduction of the principal of the loan

Jan 31 Dr Interest Expense 1 062

Dr Mortgage Loan Payable 3 938

Cr Cash at Bank 5 000

(To record loan repayment for January)

10

Loans Payable by Instalments (Continued)

A mortgage schedule can be prepared to outline the amount of each

instalment to apportion between interest and principal reduction, which

provides the details for the journal entry for each mortgage payment

- See Example in Fig 9.6 p.512 for a $106 220 two year loan at 12% p.a

Note:

- Each instalment of cash is the same amount each time

- Interest expense (interest rate x balance of principal decreases over time asthe principal reduces

- Loan payable reduction (instalment - interest expense) increases over timeas the interest portion of the instalment decreases.

- The schedule (calculated on present value principles discussed later)continues these trends until the last instalment at end of loan pays the finalinterest and the remaining portion of the loan payable

Do PSA9.5 - Partial completion of schedule and entries for 1 yr loan at 24% pa

11

Presentation of long-term debtin the financial statements

In presenting long term debt in the Statement of Financial Position

- Reduction of principal within a one year from balance-date is classified as

a current liability, with the remainder as a non-current liability.

The mortgage schedule can be used to calculate the amount of principal

to be reduced in the next year (CL) , and the remainder then is a NCL.

- Refer to Fig. 9.6, p.512 and calculate the current and non-current portion of

mortgage payable as at reporting date of 31 March 2012

- NCL = Mortgage balance at 31/03/2013 (1 yr after balance date)

= $42 833

- CL = Mortgage bal at 31//3/2012 - Mortgage bal at 31/3/2013

= $94 288 - $42 833

= $51 455

- Fig 9.8, p.515 calculates this by summing the reduction in principal amounts for

next 12 months for the CL, and summing the remaining amounts for the NCL.

12

Present Value Concepts

Most long-term debts are required to be measured at present value,

but before proceeding, we need to understand time value of money.

Q. Would you rather receive $1 000 now or $1 000 in a years time?

- If now, you recognise that money received/paid in the future (FV) is worth less

than the same amount in present value (PV) dollars received/paid today. Why?

- The PV of $1 000 in a years time, is equivalent to the present amount you would

need to invest at the current interest rate, to give you $1,000 in a years time.

PV of $1 formula/tables provides a discount factor to convert FV to PV.

The PV of $1 000 in a years time, if interest rate is 10%

PV = FV / (1 + r) n = $1 000/(1 + 0.1)1 = $909.09


3/6

13

Present Value of a Single Sum(PV of $1 Table)

Example 1:You have won a lottery, and must choose to receive

$90 000 in 3 years time (current interest rate = 10%), or $70 000 now

- To answer, you need to calculate the PV of the $90,000 in 3 yrs by discounting it

at the current int rate, so that you can compare the PVs on an equivalent basis

Present Value of a single sum of $1 table helps us to calculate this by

providing the relevant discount rate for each interest rate and period .

- Refer to the PV of $1 table and find the discount factor at 10% int for 3 periods

- Calculate the PV by multiply the FV by the discount factor

- Compare to the amounts in present value terms

PV [i=10%, n=3] of$90 000 0.751 (see Table 1) = $67 590

Amount to be received immediately 70 000 *Choose

Difference - 2 410

14

Present Value of an Annuity(PV of an annuity of $1)

Assume that you have also received an option to choose to receive

$70 000 now or $30 000 each year for 3 yrs (current int rate = 10%) To answer this, you could calculate the PV of $30 000 in each period by

discounting it at the current interest rate and period, then sum the amounts

Future amount PV factor of 10% PV

$30 000 (1 year away) 0.909 $ 27 270

$30 000 (2 years away) 0.826 24 780

$30 000 (3 years away) 0.751 22 530

2.486 $74 580

Alternatively, you can look up discount factors for a PV of an annuity $1

(Table 2 bottom half of PV tables page)

PV of an annuity of $30 000 per yr for 3yrs [i=10%, n=3]

= $30 000 x 2.487 (see Table 2) = $74 610 *Choose

Amount to be received immediately 70 000

Difference + 4 610

15

Measurement of long-term debt- Debentures (bonds)

Most long-term debt is measured at present value (PV) to report the

fair value of the long-term liability

The present value of a debenture (bond) consists of:

- (i) PV of the principal to be repaid on maturity

- (ii) PV of the annuity of periodic interest payments:

Calculation of present value is affected by the:

- cash amounts to be paid (face value + face or contract interest rate),

- time period over which the payments are made

- relevant market interest rates at the issue date

16

Measurement of long-term debtDebentures (Bonds)

Terminology

Debenture (Bond) Certificate provides details of the contract (name of

issuer, face value due on maturity, maturity date, face rate of interest)

Face Value (FV) is the principal amount due at maturity

Book Value (BV) is the carrying amount of the note/debenture/bond in the

companys ledger and statement of financial position

Face Rate (FR) is the coupon rate on the face of the note/debenture/bond

that determines the amount of interest paid to the holder each period

Market Rate (MR) - the rate ofinterest on similar securities at date of issue,

It is used in discounting the PV of the Principal and PV of interest annuity

when determining issue price, and used to calculate interest exp (FR x FV)

Issue Price- the amount paid by the borrower to the lender at time of issue.

It may be > or < the face value, if the MR differs from FR at time of issue

17

Calculation of Present Value

of Debentures (Bonds)Example 2

Illustrate the calculation of the issue price of 100 $1 000 10% Bonds with 5

years to maturity if the market rate of interest at issue date is 10%,

PV calculations where interest is paid semi-annually (twice a yr)

In this case: i) adjust the interest rate (i) to that rate per period

ii) adjust number of periods (n) to number of interest periods .

Example 3

Calculate issue price of a 10% semi annual 5 yr, $100 000 bond issued at par

(market rate of interest also is 10%), with interest paid semi annually

interest rate becomes 10/2 = 5% and No. of periods becomes 5 2 = 10

Refer to PV Tables [i = 10%, n = 5] PV factor Present Value

PV of a single sum of $100 000 x 0.621 (Table 1) $ 62 100

PV annuity of $ 10 000 x 3.791 (Table 2) $ 37 910

Present value (issue price) $ 100 000 rounded

18

Example 3- Solution

PV of principal (i = 5%, n = 10)

= $100 000 x 0.614 = $ 61 400

PV of interest payments (MR = 5% , n = 10)

= $5 000 x 7.722 = $ 36 110= $ 100 000 rounded


4/6

19

Discount and Premium on Debentures (Bonds)

BondFace Rate (FR)

Of interestrate 10%

Issued when:

8%

10%

12%

Premium

Face Value

Discount

Market Rates Issued at:

See interactive spreadsheet that illustrates the effects when market interest rate ofsimilar securities differs from the face rate at date of issue

20

Discount and Premium on Debentures (Bonds)

Where MR > FR the debentures (Bonds) will be issued at a discount

- Investors are compensated for a lower face rate of interest (FR) that theywill receive, compared to the market rate (MR) on similar investments.

- The discount result in an effective rate = the market rate at date of issue

- Present value calculations using the market rate will = the issue price

Where MR < FR the debentures (Bonds) will be issued at a premium

- Investors will pay more for a higher face rate of interest (FR) that they

will receive, compared to the market rate (MR) on similar investments.

- The premium results in an effective rate = the market rate at issue date

- Present value calculations using the market rate will = the issue price

21

Debentures (Bonds) issued at par

Refer to Additional Demonstration Question

Debentures (bonds) issued on 1/1/2020: Face value $500 000;

face rate of 8%, maturing in 10 years with semi annual interest paid.

(a) Debentures (Bonds) issued at par

(i) Calculate issue price if the market rate is also 8% at issue date

[I = 4%, n = 20]

PV of face value 500 000 x (.456) = 228 000

PV of interest 20 000 x (13.590) = 271 800500 000* (rounding)

(ii) Record the issue of the debentures:

1/1/2010 Dr Cash 500 000

Cr Debentures payable 500 000

(to record issue of debentures at par)

22

Debentures (Bonds) issued at par

(iii) Record interest at semi annual interest dates:

2010

30/06/10 Dr Interest expense 20 000

Cr Cash 20 000

31/12/10 Dr Interest expense 20 000

Cr Cash 20 000

(NB. Above entries would normally be recoded in cash payment journal)

(iv) Record the Balance Sheet presentation:

Non-current Liabilities:

Debentures Payable 500 000

23

Debentures (Bonds) issued at a Discount


face rate of 8%, maturing in 10 yrs with semi annual interest paid

(b) Debentures (Bonds) issued at a discount

(i) Calculate the Issue price if the market rate =10% [I = 5% n = 20]:

PV of face value 500 000 x (.377) = 188 500

PV of interest 20 000 x (12.462) = 249 240

437 740

(ii) Record the J ournal entry at issue date:

1/1/10 Dr Cash 437 740


(to record issue of debentures at a discount)

24

Debentures (Bonds) issued at a Discount

(iii) Calculate and record the Semi-annual interest Yr 1

Date Interest expense

5% x BV

Interest paid

4% x FV

Increase in

Bond Payable

Book value

01/01/10 437 740

30/06/10 21 887 20 000 + 1,887 439 627

31/12/10 21 981 20 000 + 1,891 441 608

Journal entries to record interest expense and interest payments

30/06/10 Dr Interest expense (5% x 437 740) 21 887Cr Debenture Payable 1 887

Cr Cash (4% x 500 000) 20 000

31/12/10 Dr Interest expense (5% x 439 627) 21 981Cr Debenture Payable 1 981

Cr Cash (4% x 500 000) 20 000

(iv) Prepare an extract of the Balance Sheet (at end of year)


5/6

25

Debentures (Bonds) issued at a Premium


face rate of 8%, maturing in 10 yrs with semi annual interest paid

(c) Debentures (Bonds) issued at a premium

(i) Calculate the Issue price if the market rate =6% [i = 3 n =2 0]:

PV of face value 500 000 x 0.544 = 277 000

PV of interest 20 000 x 14.877 = 297 540

574 540

(ii) Record the J ournal entry at issue date:

1/1/10 Dr Cash 574 540


(to record issue of debentures at a discount)

26

Debentures (Bonds) issued at a Premium

(iii) Calculate and record the Semi-annual interest Yr 1

Date Interest expense

3% x BV

Interest paid4% x FV

Increase inBond Payable

Book value

01/01/10 574 540

30/06/10 17 236 20 000 - 2 764 571 776

31/12/10 17 153 20 000 -2 847 568 929

Journal entries to record interest expense and interest payments

30/06/10 Dr Interest expense (3% x 574 540) 17 236

Dr Debenture Payable 2 764

Cr Cash (4% x 500,000) 20 000

31/12/10 Dr Interest expense (5% x 571 776) 17 153

Dr Debenture Payable 2 847

Cr Cash (4% x 500 000) 20 000

(iv) Prepare an extract of the Balance Sheet (at end of year)

27

Summary of calculation of effective interest

(1) Calculate debenture (bond) interest expense (BV x MR)

(2) Calculate debenture (bond) interest paid (FV x FR)

(3) Calculate the increase or decrease to debentures (Bonds) payable

by finding the difference between (1) and (2)

Bond int erest expense

Book value (carryingamt) at beg of period

(BV)

Marketrate(MR)

x

Bond interest paid

xFace Rateof interest

(FR)

Facevalue(FV)

28

28

Redeeming debentures (bonds)at maturity date

Redeeming at Maturity

Debentures (bonds) are redeemed at the end of their maturity date bybeing repurchased (repaid) by the issuing company

The Carrying amount of the notes will always equal their face value

- If issued at a discount, debentures payable was increased towards par each

interest period by the difference between interest expense and interest paid

- If issued at a premium debentures payable was decreased towards par each

interest period by the difference between interest expense and interest paid

Entry to record redemption at maturity

30/6/2030 Dr Debentures Payable 1 000 000Cr Cash 1 000 000

(To record redemption of debentures at maturity)

29

Redeeming debentures (bonds)

before maturity Redeeming before maturity

- A company may decide to redeem notes early

- to reduce interest cost or remove debt from its statement of financial position

To account for this, the company must

- eliminate carrying amount of debentures (bonds) at redemption date

- record cash paid

- recognise the difference as a gain or loss on redemption

Eg. Entry to record redemption before maturity at 103% of face value

Dr Debentures Payable 1 000 000

Dr Loss on Redemption of Debentures 30 000

Cr Cash 1 030 000

(To record redemption of debentures at 103)

30

Financial Statement Analysis

- Liquidity ratios

1. Liquidity Ratios

These measure the short-term ability of an entity to pay its maturing

obligations and to meet unexpected needs for cash.

3 useful measures:

(a) Working capital

= Current assets Current liabilities

Example:

($ in millions) 2008 2007

Tel stra $5513 $ 8123 = $2610 $5353 $ 9434 = $4081Corporation

More working capital indicates more current assets available to meetcurrent liabilities.


6/6

31

Financial Statement AnalysisLiquidity ratios (continued)

(b) Current ratio

= Current assets

Current liabilities

Example:


Telstra $5513 = 0.68:1 $5353 = 0.57:1Corporation $8123 $9434

A higher ratio indicates better liquidity.

32

Financial Statement AnalysisLiquidity ratios (continued)

(c) Quick ratio

= Cash + Marketable securities + Net receivables

Current liabilities

- Provides a measure of immediate short-term liquidity

Example:


Telstra $899 + $3952 = 0.60:1 $823 + $3891 = 0.50:1Corporation $8123 $9434

A higher ratio indicates better liquidity.

33

Financial Statement AnalysisSolvency ratios

2. Solvency Ratios

These measure the ability of an entity to surviveover a long period of time

2 useful measures:

(a) Debt to total assets ratio = Total liabilitiesTotal assets

Example:

($ in millions) 2008 2007Telstra $25 676 = 0.68:1 $25 295 = 0.67:1Corporation $37 921 $37 875

The ratio indicates the extent to which the entitys assets are financed bycreditors.

34

Financial Statement AnalysisSolvency ratios (Continued)

(b) Times interest earned

= Profit before income tax + Interest expense

Interest expense

- Provides an indication of an entitys ability to meet interest paymentsas they become due

Example:

($ in millions) 2008 2007Tel st ra $5140 + $1158 = 5.4 t im es $4692 + $1144 = 5.1 t imes

Corporation $1158 $1144

A higher interest coverage is interpreted as indicatinga greater ability to meet interest payments.

35

Before next week

1. Do Week 10 Self-Study Questions.

2. Check solutions on Blackboard after doing the questions yourself.

3. You may want to complete reflective, self-evaluation and learningstrategies exercise.

4. Skim read ch apter 10; LO 1-9, pp.552-585 Start with Summary ofLearning objectives on pp. 587-588

5. Obtain a copy of Week 11 lecture material from Blackboard to b ringto class

Feedback from Mid semester Test available on blackboard this week

Part B of Assignment due Friday May 14 at 2pm

acct5001 week 10 sem 1 2010 completed for students

Documents