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Liabilities: Introduction

Liabilities: Introduction. Objectives of the Chapter. To learn the basic concepts of liabilities and liability recognition. To learn accounting for current liabilities, including estimated and contingent liabilities.

emmanuel-ramos
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Liabilities: Introduction

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  1. Liabilities: Introduction

  2. Objectives of the Chapter • To learn the basic concepts of liabilities and liability recognition. • To learn accounting for current liabilities, including estimated and contingent liabilities. • To learn accounting for long-term liabilities (i.e., issuance of bonds for cash). Liabilities: Introduction

  3. Objectives of the Chapter (contd.) • To study the accounting procedures for interest payments of bonds and the amortization of bond discount or premium. • To study the accounting procedures for debt retirements either at or before maturity. • To learn the accounting for issuance of long-term note for assets or cash. Liabilities: Introduction

  4. 1. Liabilities • Legal obligations require future payments of cash or services or the creation of other liabilities as a result of past transactions. • Recognition principle: accrual basis (i.e., A liability should be recognized when it occurs, not when it is paid.) Liabilities: Introduction

  5. The Importance of Understanding the GAAP’s Definition of a Liability • Lenders often require the borrowers to keep debt/equity under a specific level (i.e., not more than 50%) in the loan agreement. • If the ratio is greater than the constraint, the lender may have additional rights, such as to charge a higher interest rate. • Investors (creditors) often use the debt/equity ratio to make their credit decisions. Liabilities: Introduction

  6. Off-Balance Sheet Liabilities • When calculating the debt/equity ratio, attention should be given to the off-balance sheet liabilities which are obligations not reported as liabilities on the balance sheet and only disclosed in the footnotes. • Examples: operating lease obligations, pension liabilities, SPE’s liabilities guaranteed by the corporation/sponsor, etc. • Off-balance liabilities will be discussed in chapter 10. Liabilities: Introduction

  7. 2. Current Liabilities • Obligations must be fulfilled in one year or one operating cycle, whichever is longer. • Examples of current liabilities as a result of a business transaction: (with definite amount) • A/P (accounts payable) • N/P (notes payable) • Current maturity portion of a long-term debt (i.e., bonds payable) • Sales taxes payable • Payroll taxes withholdings Liabilities: Introduction

  8. Employee Related Liabilities: FICA, Federal I/T, state I/T, Medical Insurance Premiums… • i.e. • Salaries Expense 50,000 • Employee F.I.C.A. Taxes Payable* 3,825 • Federal I/T Payable 10,000 • State I/T Payable 2,500 • Salaries Payable 32,675 • *0.0765 * 50,000 Liabilities: Introduction

  9. Employee Related Liabilities (contd.) • Employer payroll taxes: • Payroll Taxes Expense 6,925 • Employer F.I.C.A. Taxes Payable 3,825 • F.U.T.A. Taxes Payablea 400 • State Unemployment Tax Payableb 2,700 • a. 6.2% of the first $7,000 of salaries paid to employees. • b. assuming a state unemployment tax = 5.4%. Liabilities: Introduction

  10. Other Current Liabilities (with definite amount) • Refundable Deposits • Cash xxx • Refund Deposit Liabilities xxx • Unearned Revenue (i.e., subscription fees received in advance, advances from customers before delivery, etc.) • Cash xxx • Unearned Subscription Revenue xxx (or Advances from Customers) Liabilities: Introduction

  11. Accrued Liabilities • Obligations accumulated on a daily basis but not recorded until the end of period through adjusting entries (i.e., Interest payable, salaries payable, rent payable…) • J. E. Interest Expense xxx • Interest Payable xxx Liabilities: Introduction

  12. Estimated Liabilities • Liabilities exist but the amount is unknown, i.e., • Property taxes • Warranty obligations • Coupon and premium obligations • Vacation Wage and Fringes Payable Liabilities: Introduction

  13. Expense Warranty Using Accrued Method • (for financial Reporting Purposes) • Estimate the warranty expense associated with the sales during the period at the end of the period and recognize it. Liabilities: Introduction

  14. Expense Warranty Using Accrued Method (contd.) • Journal Entry: • Warranty Expense xxx • Estimated Warranty Liability xxx • When warranty services provided: • Estimated warranty liability xxx • Cash (or Inventory) xxx • If the estimated warranty liabilities are not enough to cover the current year’s warranty services, additional warranty expense would be debited. Liabilities: Introduction

  15. Premiums and Coupons Obligations • Liabilities of premiums and coupons should be estimated and recognized in the year when sales are made. • Journal Entry • Premium (or Coupon) Expense xxx • Estimated Premium Claims • (or coupon) outstanding xxx Liabilities: Introduction

  16. Premiums and Coupons Obligations (contd.) • When premiums (or coupons) are claimed: • Journal Entry • Estimated Premium Claims • (coupon) outstanding xxx • Inventory xxx • * If the actual redemption of coupons (or premiums) is greater than the estimated liabilities, the underestimated amount would be recognized as the expense of the current year. (APB 20) Liabilities: Introduction

  17. Contingencies • Contingent Liabilities • Contingent Losses • Contingent Gains Liabilities: Introduction

  18. Contingent Liabilities • Obligations may arise because of the occurrence or not occurrence of future event(s). (i.e., warranty obligations) Liabilities: Introduction

  19. Contingent Losses and Gains • Losses (gains) may arise because of the occurrence or not occurrence of future event(s). • (i.e., the uncollectable accounts, the pending lawsuit losses (gains), possible damage of a fire, etc.…) Liabilities: Introduction

  20. Accounting Treatments of Contingencies • The accounting treatments of the contingenciesdepend on the occurrence probability of the related future event(s).(FASB No. 5) • If the future event is a. Probable, and b. amount of liability can be reasonable estimated. The liability should be estimated, and recognized on the balance sheet. Liabilities: Introduction

  21. Accounting Treatments of Contingencies (contd.) • Probable: defined by the FASB as “the future event(s) is(are) likely to occur”; no specific % is given. • Common practice of probable by accountants: probability of occurrence is between 80% to 85%. • IASC: Probable is defined as “more likely than not” . Liabilities: Introduction

  22. Accounting Treatments of Contingencies (contd.) • Examples: • 1. Bad Debt Expenses xxx • Allowance for Bad Debt xxx • 2. Warranty Expense xxx • Estimated Warranty Liabilities xxx • 3. Lawsuit Expenses xxx • Estimate Liability under litigation xxx Liabilities: Introduction

  23. Accounting Treatments of Contingencies (contd.) • If the future event is probable, but the amount of loss/liability cannot be estimated, the contingent loss/liability should be disclosed (i.e., Merck’s disclosure of Vioxx lawsuits). • Contingent gains: • No unrealized gain can be recognized under the current accounting standards (conservatism!!!) Liabilities: Introduction

  24. 3. Long-Term Liabilities • Issuance of bonds (at a premium or discount)- cash inflow • Issuance of bonds between interest payment dates • Extinguishment of debt – cash outflow • Convertible Bonds, callable bonds • Mortgage payable and Long-term Notes Payable Liabilities: Introduction

  25. Present Value of $1 • Present value concept: • Present value of $1 is the value today of $1 to be received in the future, given a specific interest rate. • Example: • 1. What is the present value of $100 to be received a year from now given an annual market interest rate of 10%? • P.V.  (1+10%) = $100 • P.V. = $100/1.1 • = $100 0.9091 • = $90.91 Liabilities: Introduction

  26. Present Value (contd.) • 2. What is the present value of $100 to be received two years from now given an annual interest rate of 10%? • P.V  (1+10%)  (1+10%) = $100 • P.V  (1+10%)2 = $100 • P.V.  1.21 = $100 • P.V. = $100 / 1.21 • = $100 0.8264 • = $82.64 Liabilities: Introduction

  27. $100 $100 $100 $100 $100 1 year An Ordinary Annuity: • Receiving (or paying)a constant amount of money at the end of each period (equal time internal) for a given number of periods • What is the present value of receiving $100 every year for the following 5 years starting a year from now? Liabilities: Introduction

  28. The Present Value of an Ordinary Annuity: • 1. Using the example above given a10% Interest rate: • P.V. of the first $100 = $100  0.9091 = $90.91 • P.V. of the second $100 = $100  0.8264 = $82.64 • P.V. of the third $100 = $100  0.7513 = $75.13 • P.V. of the fourth $100 = $100  0.6830 = $68.30 • P.V. of the fifth $100 = $100 0.6209 = $62.09 • Total 3.7907 $379.07 Liabilities: Introduction

  29. Present Value (P.V.) of an Annuity (contd.): • The P.V. of $100 annuity receiving every year for the following 5 years, starting a year from now => • $100 * 3.7907 = $379.07 • The P.V. of this annuity can be obtained from an annuity table under 10%, 5 periods. Liabilities: Introduction

  30. P.V. = $300 x 4.2124 = 1,263.7 Annuity Table, 5 periods at 6% (30/6=5) (12%/2=6%) Present Value (P.V.) of an Annuity (contd.): • 2. What is the P.V. of $300 annuity receiving every 6 months for the following 30 months, starting 6 months from now ? The annual interest rate is 12%. Liabilities: Introduction

  31. Corporate Bonds: • Bonds are securities issued by a corporation to borrow money from the public (i.e., from many lenders/investors). • This is a source to raise funds. • The corporation will receive cash when bonds are issued. Liabilities: Introduction

  32. Corporate Bonds: • The face value of the bonds must be repaid to the bondholders on the maturity date of the bonds. • Also, the bond issuers (the borrower) will have to pay interests to the bondholders (the lender/investor) periodically (i.e., semi-annually). Liabilities: Introduction

  33. Bonds Payable • Long-Term Liability: if bonds mature in more than one year. • Short-Term Liability: if bonds mature in less than one year Liabilities: Introduction

  34. Bonds Payable (contd.) • Bond Indenture is an agreement States the following: • Interest rate of bonds; • Interest Payment dates; • The maturity date of bonds; • The type of bonds: callable, convertible,.. • The indenture is held by a trustee appointed by the issuing firm to represent the rights of the bondholders. Liabilities: Introduction

  35. The Process of Bond Issuance • 1. Receive the approval from the stockholders and regulatory authorities (i.e., the SEC). • 2. Print bond certificates and write indenture (to set the terms of bond issue such as the stated interest rate, the interest payment date and the maturity date…) • 3. Make a public announcement of its intent to sell the bonds on a particular date. Liabilities: Introduction

  36. The Process of Bond Issuance (cont.) • 4. Negotiate the appropriate selling price with the underwriters based on the terms of bond issue (i.e., the stated inters rate), the general bond market conditions, the risk of the bonds and the expected state of the economy. Liabilities: Introduction

  37. The Process of Bond Issuance (cont.) • 5. The underwriter will determine the effective interest rate (yield) and thus, the selling price that it believes best reflects the current market condition and the risk the bond for a particular bond issue. • 6. The underwriter will either purchase the bonds from the issuing company and resell them to the public or sell these bonds for a commission. Liabilities: Introduction

  38. The Process of Bond Issuance (cont.) • Companies can sell the entire issue of bonds to an underwriter or sell it to a single investor (i.e., a pension fund) (referred to as a private placement). • Any expenditures connected with a bond issue (legal fee, printing costs, accounting fee, underwriter's charges …) should be deferred and amortized as expense over the life of the bond using a straight line method. Liabilities: Introduction

  39. The Process of Bond Issuance (Contd.) • The yield is the market rate (effective rate) for the bond issue. • The yield is often different from the stated interest rate as a result of : • 1) different opinion between the underwriter and the company, or • 2) a change in the economic conditions between the date the terms were set and the date the bonds were issued. Liabilities: Introduction

  40. The Process of Bond Issuance (Contd.) • Three possible outcomes of bond issuance: • 1. Stated rate = effective rate (yield) • => the bonds are sold at par • 2. Stated rate < effective rate • => bonds are sold at discount • 3. Stated rate > effective rate • => bonds are sold at premium Liabilities: Introduction

  41. Units of bonds: • At $1,000 denominations or a multiple of $1,000. • Price of bonds: stated at 100s • Example: $1,000 issued at 98 • The issuing price is $1,000  98 = $980 Liabilities: Introduction

  42. Types of bonds: • On the basis whether the bonds are secured: • Secured Bonds • Unsecured Bonds (Debentures) • On the basis of how the interests are paid: • Registered Bonds • Coupon Bonds Liabilities: Introduction

  43. Types of bonds: • On the basis of how the bonds mature: • Term Bonds • Serial Bonds • Convertible Bonds • Callable Bonds Liabilities: Introduction

  44. Determination of Bond Price • The obligations of bond issuers: • (1) to pay the principal when bond matures on the maturity date. • (2) to pay interests periodically (i.e., semiannually) over the life the bond. Liabilities: Introduction

  45. Determination of Bond Price (Contd.) • Bond Price: the present value of the bond. • Present value of bonds => The sum of • (1) the present value of the principal plus • (2) the present value of the periodic interests (an annuity). Liabilities: Introduction

  46. Determination of Bond Price (Contd.) • Discount rate = effective rate = market rate =yield • This rate depends on the riskiness of the issuer, the general state of the economy, the duration of the bond, etc. • In general, a higher risk will result in a higher effective rate. Liabilities: Introduction

  47. Determination of Bond Price (Contd.) • Bonds Issued at Face Value • When the stated interest rate equals the effective interest rate, the bond price will equal the face value. Liabilities: Introduction

  48. Determination of Bond Price (Contd.) • Example 1: • Page company issued a 5-year term bond with a face amount $100,000 and a stated annual interest rate of 10%. • Interests are paid semiannually. • Assume that the annual effective interest rate demanded by investors for bonds of this level of risk is also 10%, what is the present value of the bond (the bond price)? Liabilities: Introduction

  49. Determination of Bond Price (Contd.) • Example 1: • Page company issued a 5-year term bond with a face amount $100,000 and a stated annual interest rate of 10%. • Interests are paid semiannually. • Assume that the annual effective interest rate demanded by investors for bonds of this level of risk is also 10%, what is the present value of the bond (the bond price)? Liabilities: Introduction

  50. Determination of Bond Price (Contd.) • (1)P.V. of the principal ($100,000 mature in 5 years, discount rate 5%, 10 periods): • $100,000  0.6139 = $61,390 (2)P.V. of the interests received semiannually for 10 periods (annuity, discount rate = 5%, 10 periods) $5,000  7.7217 = 38,608.5 annuity table, 5%, 10periods Liabilities: Introduction

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