10 Learning Objectives Explain how to account for current liabilities Describe the major characteristics of bonds Explain how to account for bond transactions 3 Explain how to account for longterm notes payable ID: 570907
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Slide1Slide2
Liabilities
10
Learning Objectives
Explain how to account for current liabilities.
Describe the major characteristics of bonds.
Explain how to account for bond transactions.
3
Explain how to account for long-term notes payable.
2
1
4
Discuss how liabilities are reported and analyzed.
5Slide3
A
debt that a
company expects to pay within one year or the operating cycle, whichever is longer.
Current liabilities include
notes payable
,
accounts
payable, unearned
revenues, and accrued liabilities such as
taxes payable
, salaries
and wages payable
, and interest
payable.
LO 1
LEARNING
OBJECTIVE
Explain how to account for current liabilities.
1
What Is a Current Liability?Slide4
To be classified as a current liability, a debt must be expected to be paid within:
one year.
the operating cycle.
2 years.(a) or (b), whichever is longer
Question
What Is a Current Liability?
LO 1Slide5
Notes Payable
Written promissory note.
Frequently issued to meet short-term financing needs.
Requires the borrower to pay interest.
Issued for varying periods.
Current Liabilities
LO 1Slide6
Illustration:
First National Bank agrees to lend $100,000 on September 1, 2017, if Cole Williams Co. signs a $100,000, 12%, four-month note maturing on January 1.
Instructions
Prepare the entry on September 1st.Prepare the adjusting entry on December 31st, assuming monthly adjusting entries have not been made.
Prepare the entry required on January 1, 2018, the maturity date.
Notes Payable
LO 1Slide7
Notes Payable 100,000
Cash 100,000
Interest Payable 4,000
Interest Expense 4,000
$100,000 x 12% x 4/12 = $4,000
b) Prepare the adjusting entry on December 31
st
.
Illustration:
First National Bank agrees to lend $100,000 on September 1, 2017, if Cole Williams Co. signs a $100,000, 12%, four-month note maturing on January 1.
a) Prepare the entry on September 1
st
.
LO 1
Notes PayableSlide8
Cash 104,000
Illustration:
First National Bank agrees to lend $100,000 on September 1, 2017, if Cole Williams Co. signs a $100,000, 12%, four-month note maturing on January 1, 2018.
c) Prepare the entry at maturity.
Interest Payable 4,000
Notes Payable 100,000
LO 1
Notes PayableSlide9
Sales Taxes Payable
Current Liabilities
LO 1
Sales taxes are expressed as a stated percentage of the sales price.
Selling company (retailer)
collects tax from the customer.
enters tax separately in cash register or includes in total receipts.
remits the collections to the state’s department of revenue.Slide10
Illustration:
The March 25 cash register reading for Cooley Grocery shows sales of $10,000 and sales taxes of $600 (sales tax rate of 6%), the journal entry is:
Mar. 25
Sales Revenue 10,000
Cash 10,600
Sales Tax Payable 600
Sales Taxes Payable
LO 1Slide11
Illustration:
Cooley Grocery enters total receipts of $10,600. Because the amount received from the sale is equal to the sales price 100% plus 6% of sales, (sales tax rate of 6%), the journal entry is:
Mar. 25
Sales revenue 10,000
Cash 10,600
Sales tax payable 600
Sometimes companies do not enter sales taxes separately in the cash register.
*
$10,600 ÷ 1.06
= $10,000
*
Sales Taxes Payable
LO 1Slide12
The term “payroll” pertains to both:
Salaries
- managerial, administrative, and sales personnel (monthly or yearly rate).
Wages - store clerks, factory employees, and manual laborers (rate per hour).
Payroll and Payroll Taxes Payable
Determining the payroll involves computing three amounts: (1)
gross earnings
, (2)
payroll deductions
, and (3)
net pay
.
Current Liabilities
LO 1Slide13
Payroll and Payroll Taxes Payable
LO 1
Illustration 10-2
Payroll deductionsSlide14
Illustration:
Assume Cargo Corporation records its payroll for the week of March 7 as follows:
Salaries and Wages Expense 100,000
Federal Income Taxes Payable 21,864
FICA Taxes Payable 7,650
State Income Taxes Payable 2,922
Salaries and Wages Payable 67,564
Cash 67,564
Salaries and Wages Payable 67,564
Record the payment of this payroll on March 7.
LO 1
Payroll and Payroll Taxes PayableSlide15
Payroll tax expense
results from additional taxes that governmental agencies levy
on employers
.
These taxes are:
Employer’s share of Social Security (FICA) taxes
Federal unemployment taxes
State unemployment taxes
LO 1
Payroll and Payroll Taxes PayableSlide16
Illustration:
Based on Cargo Corp.’s $100,000 payroll,
the company would record the
employer’s expense and liability for these payroll taxes as follows.
Payroll Tax Expense 13,850
State Unemployment Taxes Payable 800
FICA Taxes Payable 7,650
Federal Unemployment Taxes Payable 5,400
LO 1
Payroll and Payroll Taxes PayableSlide17
Employer payroll taxes do
not
include:
Federal unemployment taxes.State unemployment taxes.Federal income taxes.FICA taxes.
Question
LO 1
Payroll and Payroll Taxes PayableSlide18
THE MISSING CONTROLS
Human resource controls.
Thorough background checks should be performed.
No employees should begin work until they have been approved by the Board ofEducation and entered into the payroll system. No employees should be enteredinto the payroll system until they have been approved by a supervisor. All paychecksshould be distributed directly to employees at the official school locations by designatedemployees.Independent internal verification. Budgets should be reviewed monthly to identifysituations where actual costs significantly exceed budgeted amounts.Source: Adapted from Wells, Fraud Casebook (2007), pp. 164–171.
Total take: $150,000
ANATOMY OF A FRAUD
Art was a custodial supervisor for a large school district. The district was supposed to employ between 35 and 40 regular custodians, as well as 3 or 4 substitute custodians to fill in when regular custodians were absent. Instead, in addition to the regular custodians, Art “hired” 77 substitutes. In fact, almost none of these people worked for the district. Instead, Art submitted time cards for these people, collected their checks at the district office, and personally distributed the checks to the “employees.” If a substitute’s check was for $1,200, that person would cash the check, keep $200, and pay Art $1,000.
Advance slide in slide show to reveal missing controls.
LO 1Slide19
During the month of September, Lake Corporation’s employees earned wages of $60,000. Withholdings related to these wages were $4,590 for Social Security (FICA), $6,500 for federal income tax, and $2,000 for state income tax. Costs incurred for unemployment taxes were $90 for federal and $150 for state.
Prepare the September 30 journal entries for
salaries and wages expense and salaries and wages payable, assuming that all September wages will be paid in October, and
the company’s payroll tax expense.DO IT!
Wages and Payroll Taxes
1a
LO 1Slide20
Salaries and Wages Expense 60,000
FICA Taxes Payable 4,590
Federal Income Taxes Payable 6,500
State Income Taxes Payable 2,000 Salaries and Wages Payable 46,910
Prepare the September 30 journal entries for
salaries and wages expense and salaries and wages payable, assuming that all September wages will be paid in October.
DO IT!
Wages and Payroll Taxes
1a
LO 1Slide21
Prepare the September 30 journal entries for
the company’s payroll tax expense.
DO IT!
Wages and Payroll Taxes1a
Payroll Tax Expense 4,830
FICA Taxes Payable 4,590
Federal Unemployment Taxes Payable 90
State Unemployment Taxes Payable 150
LO 1Slide22
Unearned Revenue
Revenues
received before
the company
delivers goods or
provides services.
Current Liabilities
LO 1
Illustration 10-3
Unearned revenue and revenue accountsSlide23
Illustration:
Superior University sells 10,000 season football tickets at $50 each for its five-game home schedule. The entry for the sale of season tickets is:
Unearned Ticket Revenue 500,000
Cash 500,000
Aug. 6
Ticket Revenue 100,000
Unearned Ticket Revenue 100,000
Sept. 7
As each game is completed, Superior records the recognition of revenue with the following entry.
Unearned Revenue
LO 1Slide24
Illustration:
Wendy Construction issues a five-year, interest-bearing $25,000 note on January 1, 2017. This note specifies that each January 1, starting January 1, 2018, Wendy should pay $5,000 of the note. When the company prepares financial statements on December 31, 2017,
What amount should be reported as a current liability? ___________
What amount should be reported as a long-term liability? _________
Current Maturities of Long-Term Debt
Portion of long-term debt that comes due in the current year.
No adjusting entry required.
$5,000
$20,000
Current Liabilities
LO 1Slide25
You and several classmates are studying for the next accounting examination. They ask you to answer the following questions.
If cash is borrowed on a $50,000, 6-month, 12% note on September 1, how much interest expense would be incurred by December 31?
Solution
DO IT!Current Liabilities
1b
LO 1
$50,000 x 12% x 4/12 =
$2,000Slide26
You and several classmates are studying for the next accounting examination. They ask you to answer the following questions.
How is the sales tax amount determined when the cash register total includes sales taxes?
Solution
DO IT!Current Liabilities
1b
LO 1
First
, divide the total cash register receipts by 100% plus the sales tax percentage to find the sales revenue amount.
Second
, subtract the sales revenue amount from the total cash register receipts to determine the sales taxes.Slide27
You and several classmates are studying for the next accounting examination. They ask you to answer the following questions.
If $15,000 is collected in advance on November 1 for 3 months’ rent, what amount of rent revenue should be recognized by December 31?
Solution
DO IT!Current Liabilities
1b
LO 1
$15,000 x 2/3 =
$10,000Slide28
Long-term liabilities
are obligations that are expected to be paid after one year.
Bonds
are a form of interest-bearing notes payable.
Sold in small denominations (usually $1,000 or multiples of $1,000). Attract many investors.
Corporation issuing bonds is borrowing money.
Person who buys the bonds (the bondholder) is investing in bonds.
LO 2
LEARNING
OBJECTIVE
Describe the major characteristics of bonds.
2Slide29
Types of Bonds
LO 2Slide30
State laws grant corporations the power to issue bonds.
Board of directors and stockholders must approve bond issues.
Board of directors must stipulate number of bonds to be authorized, total
face value, and contractual interest rate.Bond terms set forth in legal document known as a bond indenture.Bond certificate, typically a $1,000 face value.
Bonds
Issuing Procedures
LO 2Slide31
Represents a promise to pay:
sum of money at designated
maturity date
, plusperiodic interest at a contractual (stated) rate on the maturity amount (face value).Interest payments usually made semiannually. Issued to obtain large amounts of long-term capital.Investment company sells the bonds for the issuing company.
Bonds
LO 2
Issuing ProceduresSlide32
LO 2
Illustration 10-4
Bond certificate
BondsSlide33
Bond Trading
Bondholders can sell their bonds on national exchanges.
Bond prices are quoted as a percentage of the face value.
A quoted price of 97 means 97% of face value.
LO 2
Illustration 10-5
Market information for bonds
Boeing Co.
has outstanding 5.125%, $1,000 bonds that mature in 2014. They currently yield a 5.747% return. On this day, $33,965,000 of these bonds were traded. At the close of trading, the price was 96.595% of face value, or $965.95.Slide34
Determining the Market Value of a Bond
Current market price (present value) is a function of the three factors:
dollar amounts to be received,
length of time until the amounts are received, and
market rate of interest.
The
market interest rate
is the rate investors demand for loaning funds.
LO 2Slide35
State whether each of the following statements is
true
or
false. If false, indicate how to correct the statement._______ 1. Mortgage bonds and sinking fund bonds are both examples of secured bonds._______ 2. Unsecured bonds are also known as debenture bonds._______ 3. The stated rate is the rate investors demand for loaning funds._______ 4. The face value is the amount of principal the issuing company must pay at the maturity date._______ 5. The market price of a bond is equal to its maturity value.
DO IT!
Bond Terminology
2
LO 2
True
True
False
True
FalseSlide36
Corporation records bond transactions
when it
issues (sells),redeems (buys back) bonds, and when bondholders convert bonds into common stock. NOTE:
If bondholders sell their bond investments to other investors, the issuing company receives no further money on the transaction, nor does the issuing company journalize the transaction.
LO 3
LEARNING
OBJECTIVE
Explain how to account for bond transactions.
3Slide37
Issue at Face Value, Discount, or Premium?
Bond Contractual Interest
Rate
10%
Accounting for Bond Transactions
LO 3
Illustration 10-8
Interest rates and bond prices
Run slide show to reveal “Bonds Sell at.”Slide38
The rate of interest investors demand for loaning funds to a corporation is the:
contractual interest rate.
face value rate.
market interest rate. stated interest rate.
Question
LO 3
Accounting for Bond TransactionsSlide39
Karson Inc. issues 10-year bonds with a maturity value of $200,000. If the bonds are issued at a premium, this indicates that:
the contractual interest rate exceeds the market interest rate.
the market interest rate exceeds the contractual interest rate.
the contractual interest rate and the market interest rate are the same. no relationship exists between the two rates.
LO 3
Question
Accounting for Bond TransactionsSlide40
Illustration:
On January 1, 2017, Candlestick, Inc. issues $100,000, five-year, 10% bonds at 100 (100% of face value). The entry to record the sale is:
Jan. 1 Cash 100,000
Bonds Payable 100,000
LO 3
Issuing Bonds at Face ValueSlide41
Illustration:
On January 1, 2017, Candlestick, Inc. issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest is payable annually on January 1. At December 31, 2017, Candlestick recognizes interest expense incurred with the following entry. Assume monthly accruals have not been made.
Dec. 31 Interest Expense 10,000
Interest Payable 10,000
LO 3
Issuing Bonds at Face ValueSlide42
Illustration:
On January 1, 2017, Candlestick, Inc. issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest is payable annually on January 1. Candlestick records the payment on January 1, 2018 as follows.
Jan. 1 Interest Payable 10,000
Cash 10,000
LO 3
Issuing Bonds at Face ValueSlide43
Illustration:
On January 1, 2017, Candlestick, Inc. sells $100,000, five-year, 10% bonds for $98,000 (98% of face value). Interest is payable annually January 1. The entry to record the issuance is:
Jan. 1 Cash 98,000
Discount on Bonds Payable 2,000
Bonds Payable 100,000
LO 3
Issuing Bonds at a DiscountSlide44
Sale of bonds below face value (discount)
=
total cost of borrowing > interest paid.
Reason: Borrower is required to pay the bond discount at the maturity date. Therefore, the bond discount is considered to be a increase in the cost of borrowing.
Statement Presentation
Illustration 10-9
Statement presentation of
discount on bonds payable
Carrying value or book value
LO 3
Issuing Bonds at a DiscountSlide45
Total Cost of Borrowing
LO 3
Illustration 10-11
Illustration 10-10
OR
Issuing Bonds at a DiscountSlide46
LO 3
Issuing Bonds at a Discount
Illustration 10-12
Amortization of bond discountSlide47
Discount on Bonds Payable:
has a credit balance.
is a contra account.
is added to bonds payable on the balance sheet. increases over the term of the bonds.
Question
LO 3
Issuing Bonds at a DiscountSlide48
Jan. 1 Cash 102,000
Bonds Payable 100,000
Premium on Bonds Payable 2,000
Illustration:
On January 1, 2017, Candlestick, Inc. sells $100,000, five-year, 10% bonds for $102,000 (102% of face value). Interest is payable annually January 1. The entry to record the issuance is:
LO 3
Issuing Bonds at a PremiumSlide49
Sale of bonds above face value (premium)
=
total cost of borrowing < interest paid.
Reason: Borrower is not required to pay the bond premium at the maturity date of the bonds. Therefore, the bond premium is considered to be a reduction in the cost of borrowing.
LO 3
Statement Presentation
Illustration 10-13
Statement presentation of
discount on bonds payable
Issuing Bonds at a PremiumSlide50
Total Cost of Borrowing
LO 3
Illustration 10-15
Illustration 10-14
OR
Issuing Bonds at a PremiumSlide51
LO 3
Issuing Bonds at a Premium
Illustration 10-16
Amortization of bond premiumSlide52
Giant Corporation issues $200,000 of bonds for $189,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the balance sheet at the date of issuance.
Solution
DO IT!Bond Issuance
3a
(a) Cash 189,000
Discount on Bonds Payable 11,000
Bonds Payable 200,000
(b) Long-term liabilities
Bonds payable $200,000
Less: Discount on bonds payable 11,000 $189,000
LO 3Slide53
Jan. 1 Bonds Payable 100,000
Cash 100,000
Assuming that the company pays and records separately the interest for the last interest period, Candlestick records the redemption of its bonds at maturity as follows:
Redeeming Bonds at Maturity
LO 3Slide54
When bonds are redeemed before maturity, it is necessary to:
eliminate carrying value of bonds at redemption date;
record cash paid; and
recognize gain or loss on redemption.
The
carrying value
of the bonds is the face value of the bonds less any remaining bond discount or plus any remaining bond premium at the redemption date.
Redeeming Bonds Before Maturity
LO 3Slide55
When bonds are redeemed before maturity, the gain or loss on redemption is the difference between the cash paid and the:
carrying value of the bonds.
face value of the bonds.
original selling price of the bonds. maturity value of the bonds.
Question
LO 3
Redeeming Bonds Before MaturitySlide56
Illustration:
Assume Candlestick, Inc. has sold its bonds at a premium. At the end of the fourth period, Candlestick retires these bonds at 103 after paying the annual interest. The carrying value of the bonds at the redemption date is $100,400. Candlestick makes the following entry to record the redemption at the end of the fourth interest period (January 1, 2021):
Jan. 1 Bonds Payable 100,000
Premium on Bonds Payable 400
Loss on Bond Redemption 2,600
Cash 103,000
LO 3
Redeeming Bonds Before MaturitySlide57
Until conversion
, the bondholder receives interest on the bond.
For the issuer
, the bonds sell at a higher price and pay a lower rate of interest than comparable debt securities without the conversion option.Upon conversion, the company transfers the carrying value of the bonds to paid-in capital accounts. No gain or loss is recognized.
Converting Bonds into Common Stock
LO 3Slide58
Illustration:
On July 1, Saunders Associates converts $100,000 bonds sold at face value into 2,000 shares of $10 par value common stock. Both the bonds and the common stock have a market value of $130,000. Saunders makes the following entry to record the conversion:
July 1 Bonds Payable 100,000
Common Stock (2,000 x $10) 20,000
Paid-in Capital in Excess of Par— Common Stock
80,000
LO 3
Converting Bonds into Common StockSlide59
When bonds are converted into common stock:
a gain or loss is recognized.
the carrying value of the bonds is transferred to paid-in capital accounts.
the market price of the stock is considered in the entry. the market price of the bonds is transferred to paid-in capital.
Question
LO 3
Converting Bonds into Common StockSlide60
How About Some Green Bonds?
Unilever
recently began producing popular frozen treats such as Magnums and Cornettos, funded by green bonds. Green bonds are debt used to fund activities such as renewable- energy projects. In Unilever’s case, the proceeds from the sale of green bonds are used to clean up the company’s manufacturing operations and cut waste (such as related to energy consumption).
The use of green bonds has taken off as companies now have guidelines as to how to disclose and report on these green-bond proceeds. These standardized disclosures provide transparency as to how these bonds are used and their effect on overall profitability. Investors are taking a strong interest in these bonds. Investing companies are installing socially responsible investing teams and have started to integrate sustainability into their investment processes. The disclosures of how companies are using the bond proceeds help investors to make better financial decisions. Source: Ben Edwards, “Green Bonds Catch On.” Wall Street Journal (April 3, 2014), p. C5.People, Planet, and Profit InsightUnilever
LO 3Slide61
R & B Inc. issued $500,000, 10-year bonds at a discount. Prior to maturity, when the carrying value of the bonds is $496,000, the company redeems the bonds at 98. Prepare the entry to record the redemption of the bonds.
Solution
DO IT!Bond Redemption
3b
LO 3
Bonds Payable 500,000
Discount on Bonds Payable 4,000
Gain on Bond Redemption 6,000
Cash ($500,000 x 98%) 490,000Slide62
Accounting for Long-Term Notes Payable
LO 4
May be secured by a
mortgage
that pledges title to specific assets as security for a loan.
Typically, the terms require the borrower to make installment payments over the term of the loan. Each payment consists of
interest on the unpaid balance of the loan and
a reduction of loan principal.
Companies initially record mortgage notes payable at face value.
LEARNING
OBJECTIVE
Explain how to account for long-term notes payable.
4Slide63
Illustration:
Porter Technology Inc. issues a $500,000, 8%, 20-year mortgage note on December 31, 2017. The terms provide for annual installment payments of $50,926 (not including real estate taxes and insurance).
LO 4
Accounting for Long-Term Notes Payable
Illustration 10-17
Mortgage installment payment scheduleSlide64
Dec. 31 Cash 500,000
Mortgage Payable 500,000
Dec. 31 Interest Expense 40,000
Mortgage Payable 10,926
Cash 50,926
Illustration:
Porter Technology Inc. issues a $500,000, 8%, 20-year mortgage note on December 31, 2017. The terms provide for semiannual installment payments of $50,926 (not including real estate taxes and insurance).
Prepare the entries
to record the mortgage and first payment.
LO 4
Accounting for Long-Term Notes PayableSlide65
Each payment on a mortgage note payable consists of:
interest on the original balance of the loan.
reduction of loan principal only.
interest on the original balance of the loan and reduction of loan principal. interest on the unpaid balance of the loan and reduction of loan principal.
Question
LO 4
Accounting for Long-Term Notes PayableSlide66
Cole Research issues a $250,000, 6%, 20-year mortgage note to obtain needed financing for a new lab. The terms call for annual payments of $21,796 each. Prepare the entries to record the mortgage loan and the first payment.
Solution
DO IT!
Long-Term Notes
4
LO 4
Cash 250,000
Mortgage Payable 250,000
Interest Expense
($250,000 x 6%)
15,000*
Mortgage Payable 6,796
Cash 21,796Slide67
LO 5
LEARNING
OBJECTIVE
Discuss how liabilities are reported and analyzed.5
Illustration 10-18
Balance sheet presentation
of current liabilitiesSlide68
Presentation
LO 5
Illustration 10-19
Balance sheet presentation
of long-term liabilities
Companies report the current maturities of long-term debt under current liabilities if they are to be paid within one year or the operating cycle, whichever is longer.
LEARNING
OBJECTIVE
Discuss how liabilities are reported and analyzed.
5Slide69
Liquidit
y refers to the ability to pay maturing obligations and meet unexpected needs for cash.
The relationship of current assets to current liabilities is critical in analyzing liquidity. We can express this relationship
as a dollar amount (working capital) and as a ratio (current ratio).
Use of Ratios
LO 5Slide70
Liquidity
refers to the ability to pay maturing obligations and meet unexpected needs for cash.
Current ratio
permits us to compare the liquidity of different-sized companies and of a single company at different times.
LO 5
Use of Ratios
Illustration 10-20
Working capital formula and computation
Illustration 10-21
Current ratio formula and computationSlide71
Two ratios
that provide information
long-run solvency
and the ability to meet interest payments as they come due are:Debt to Assets RatioTimes Interest Earned
Use of Ratios
LO 5Slide72
Illustration:
Kellogg Company reported total liabilities of $8,925 million, total assets of $11,200 million, interest expense of $295 million, income taxes of $476 million, and net income of $1,208 million.
LO 5
The higher the percentage of
debt to assets
, the greater the risk that the company may be unable to meet its maturing obligations.
Illustration 10-22
Debt to assets ratio
Use of RatiosSlide73
Illustration:
Kellogg Company reported total liabilities of $8,925 million, total assets of $11,200 million, interest expense of $295 million, income taxes of $476 million, and net income of $1,208 million.
LO 5
Illustration 10-23
Times interest earned
Times interest earned
indicates the company’s ability to meet interest payments as they come due.
Use of RatiosSlide74
“Covenant-Lite” Debt
In many corporate loans and bond issuances, the lending agreement specifies debt covenants. These covenants typically are specific financial measures, such as minimum levels of retained earnings, cash flows, times interest earned, or other measures that a company must maintain during the life of the loan. If the company violates a covenant, it is considered to have violated the loan agreement. The creditors can then demand immediate repayment, or they can renegotiate the loan’s terms. Covenants protect lenders because they enable lenders to step in and try to get their money back before the borrower gets too deeply into trouble. During the 1990s, most traditional loans specified between three to six covenants or “triggers.” In more recent years, when lots of cash was available, lenders began reducing or completely eliminating covenants from loan agreements in order to be more competitive with other lenders. Lending to weaker companies on easy terms is now common as investors’ appetite for higher-yielding debt grows stronger and the Federal Reserve keeps money flowing at ultralow rates. Since the 2008 financial crisis, companies have been able to borrow more without offering investors what were once considered standard protections against possible losses.
Sources: Cynthia Koons, “Risky Business: Growth of ’Covenant-Lite’ Debt,” Wall Street Journal (June 18, 2007), p. C2; and Katy Burne, “More Loans Come with Few Strings Attached,” Wall Street Journal June 12, 2014).
Investor Insight
LO 5Slide75
Working capital is calculated as:
current assets minus current liabilities.
total assets minus total liabilities.
long-term liabilities minus current liabilities.both (b) and (c).
Question
Use of Ratios
LO 5Slide76
Debt and Equity Financing
Illustration 10-24
Advantages of bond financing
over common stock
LO 5Slide77
Illustration:
Microsystems, Inc.
is considering two plans for financing the construction of a new $5 million plant
. It is considering two alternatives for raising an additional $5 million: Plan A involves issuing 200,000 shares of common stock at the current market price of $25 per share. Plan B involves issuing $5 million of 8% bonds at face value. Income before interest and taxes will be $1.5 million; income taxes are expected to be 30%.
Debt and Equity Financing
Illustration 10-25Slide78
Trout Company balance sheet information as of December 31, 2017.
Current assets $10,500 Current liabilities $ 8,000
Long-term assets 24,200 Long-term liabilities 16,000
Total assets $34,700 Stockholders’ equity 10,700 Total liabilities and stockholders’ equity $34,700In addition, Trout reported net income for 2017 of $14,000, income tax expense of $2,800, and interest expense of $900.Instructions
Compute the current ratio and working capital for Trout for 2017.
DO IT!
Analyzing Liabilities
5
Current ratio is 1.31:1
($10,500 ÷ $8,000).
Working capital is $2,500
($10,500 - $8,000).
LO 5Slide79
Trout Company balance sheet information as of December 31, 2017.
Current assets $10,500 Current liabilities $ 8,000
Long-term assets 24,200 Long-term liabilities 16,000
Total assets $34,700 Stockholders’ equity 10,700 Total liabilities and stockholders’ equity $34,700In addition, Trout reported net income for 2017 of $14,000, income tax expense of $2,800, and interest expense of $900.Instructions
Assume that at the end of 2017, Trout used $2,000 cash to pay off $2,000 of accounts payable. How would the current ratio and working capital have changed?
DO IT!
Analyzing Liabilities
5
Current ratio is 1.42:1
($8,500 ÷ $6,000).
Working capital is $2,500
($8,500 - $6,000).
LO 5Slide80
Trout Company balance sheet information as of December 31, 2017.
Current assets $10,500 Current liabilities $ 8,000
Long-term assets 24,200 Long-term liabilities 16,000
Total assets $34,700 Stockholders’ equity 10,700 Total liabilities and stockholders’ equity $34,700In addition, Trout reported net income for 2017 of $14,000, income tax expense of $2,800, and interest expense of $900.Instructions
Compute the debt to assets ratio and the times interest earned for Trout for 2017.
DO IT!
Analyzing Liabilities
5
Debt to assets ratio is 71.2%
($24,000 ÷ $34,700).
Times interest earned is 19.67 times
[($14,000 + $2,800 + $900) ÷ $900].
LO 5Slide81
Illustration:
Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $98,000 (discount of $2,000). Interest is payable on January 1.
Illustration 10C-2
Amortizing Bond Discount
LEARNING
OBJECTIVE
APPENDIX 10A: Apply the straight-line method of amortizing bod discount and bond premium.
6
Illustration 10A-2
Bond discount amortization schedule
LO 6Slide82
Illustration:
Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $98,000 (discount of $2,000). Interest is payable on January 1. The bond discount amortization for each interest period is $400 ($2,000 ÷ 5).
Journal entry to record the
first accrual of bond interest and the amortization of bond discount on December 31 as follows.
Interest Expense 10,400
Cash 10,000
Discount on Bonds Payable 400
Dec. 31
Amortizing Bond Discount
LO 6Slide83
Illustration:
Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $102,000 (premium of $2,000). Interest is payable on January 1.
Amortizing Bond Premium
Illustration 10A-4
Bond premium amortization
schedule
LO 6Slide84
Illustration:
Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $102,000 (premium of $2,000. Interest is payable on January 1. The bond premium amortization for each interest period is $400 ($2,000 ÷ 5).
Candlestick records the first accrual of interest on December 31 as follows.
Interest Expense 9,600
Cash 10,000
Premium on Bonds Payable 400
Dec. 31
Amortizing Bond Premium
LO 6Slide85
Under the
effective-interest method
, the amortization of bond discount or bond premium results in period interest expense equal to a constant percentage of the carrying value of the bonds.
Required steps:
Compute the
bond interest expense.
Compute the bond interest paid
or accrued.Compute the amortization amount
.
LEARNINGOBJECTIVE
APPENDIX 10B: Apply the effective-interest method of amortizing bod discount and bond premium.
7
LO 7Slide86
Required steps:
Compute the
bond interest expense
.
Compute the
bond interest paid or accrued.
Compute the amortization amount.
Effective-Interest Method
Illustration 10B-1
Computation of amortization
using effective-interest method
LO 7Slide87
Illustration:
Candlestick, Inc. issues $100,000 of 10%, five-year bonds on January 1, 2017, for $98,000, with interest payable each January 1. This results in a discount of $2,000.
Illustration 10B-2
Amortizing Bond Discount
Effective-Interest Method
Illustration 10B-2
Bond discount amortization schedule
LO 7Slide88
Candlestick, Inc. records the accrual of interest and amortization
of bond discount on December 31 as follows.
Interest Expense 10,319
Interest Payable 10,000
Discount on Bonds Payable 319
Dec. 31
Amortizing Bond Discount
Illustration 10B-2
Bond discount amortization schedule
LO 7Slide89
For the
second interest period
, at December 31, Candlestick
makes the following adjusting entry.
Interest Expense 10,353
Interest Payable 10,000
Discount on Bonds Payable 353
Dec. 31
Amortizing Bond Discount
Illustration 10B-2
Bond discount amortization schedule
LO 7Slide90
Illustration:
Candlestick, Inc. issues $100,000 of 10%, five-year bonds on January 1, 2017, for $102,000, with interest payable January 1. This results in a
premium
of $2,000.
Amortizing Bond Premium
Illustration 10B-4
Bond premium amortization
schedule
LO 7Slide91
Interest Expense 9,670
Interest Payable 10,000
Premium on Bonds Payable 330
Dec. 31
The entry Candlestick makes on December 31 is:
Amortizing Bond Premium
Illustration 10B-4
Bond premium amortization
schedule
LO 7Slide92
Similarities
The basic definition of a liability under
GAAP
and IFRS is very similar. Liabilities are defined by the IASB as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
The accounting for current liabilities such as notes payable, unearned revenue, and payroll taxes pa y able are similar between GAAP and IFRS.
Key Points
LEARNING
OBJECTIVE
Compare the accounting for liabilities under GAAP and IFRS.
8
LO 8Slide93
IFRS requires that companies classify liabilities as current or noncurrent on the face of the statement of financial position (balance sheet), except in industries where a presentation based on liquidity would be considered to provide more useful information (such as financial institutions). When current liabilities (also called short-term liabilities) are presented, they are generally presented in order of liquidity.
Under IFRS, liabilities are classified as current if they are expected to be paid within 12 months.
Similar to GAAP, items are normally reported in order of liquidity. Companies sometimes show liabilities before assets. Also, they will sometimes show long-term liabilities before current liabilities.
Key Points
LO 8Slide94
The basic calculation for bond valuation is the same under GAAP and IFRS. In addition, the a c counting for bond liability transactions is essentially the same between GAAP and IFRS.
IFRS
requires use of the effective-interest method for amortization of bond discounts and premiums.
GAAP allows use of the straight-line method where the difference is not material. Under IFRS, companies do not use a premium or discount account but instead show the bond at its net amount. For example, if a $100,000 bond was issued at 97, under IFRS a company would record: Cash 97,000 Bonds Payable 97,000Key Points
LO 8Slide95
Differences
The accounting for convertible bonds differs across
IFRS
and GAAP, Unlike GAAP, IFRS splits the proceeds from the convertible bond between an equity component and a debt component. The equity conversion rights are reported in equity.
Under IFRS, companies sometimes will net current liabilities against current assets to show working capital on the face of the statement of financial position.
Key Points
LO 8Slide96
The
FASB
and
IASB are currently involved in two projects, each of which has implications for the accounting for liabilities. One project is investigating approaches to differentiate between debt and equity instruments. The other project, the elements phase of the conceptual framework project, will evaluate the definitions of the fundamental building blocks of accounting. The results of these projects could change the classification of many debt and equity securities.
Looking to the Future
LO 8Slide97
The accounting for bonds payable is:
essentially the same under IFRS and GAAP.
differs in that GAAP requires use of the straight-line method for amortization of bond premium and discount.
the same except that market prices may be different because the present value calculations are different between IFRS and GAAP.not covered by IFRS.
IFRS Self-Test Questions
LO 8Slide98
Which of the following is false?
Under IFRS, current liabilities must always be presented before noncurrent liabilities.
Under IFRS, an item is a current liability if it will be paid within the next 12 months.
Under IFRS, current liabilities are shown in order of liquidity.Under IFRS, a liability is only recognized if it is a present obligation.IFRS Self-Test Questions
LO 8Slide99
The joint projects of the FASB and IASB could potentially:
change the definition of liabilities.
change the definition of equity.
change the definition of assets.All of the above.IFRS Self-Test Questions
LO 8Slide100
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