C01 Class 10 - Lecture notes PDF

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Short-term liabilities Long-term liabilities: Long-term notes payable Interest only Fixed principal plus interest Fixed payments Bonds payable Contingent liabilities: the liability is not established yet, but it is possible. The occurrence of the liability is contingent on a future event Examples of contingent liabilities are warranties and litigation liabilities Warranties liability arises when a company sells a product with a warranty (or a guarantee). This is a contingent liability because the business will be liable when they have to honor the warranty in the future. Litigation liability: When a business is accused of wrongdoing and is being sued for damages. Examples include environmental damages, health damages, and financial ruin. Do we recognize litigation liability on the balance sheet? Is the loss under litigation likely? Company lawyers can answer that question. Can loss be reasonably estimated? We recognize a contingent liability only when loss is LIKELY and it can be reasonably estimated Long-term debt (due in more than one year) Notes payable Bonds payable Mortgage payable Pensions liability Notes payable (by the payment schedule) Interest only Fixed principal plus interest Fixed payment Interest only: over the term of the note payable, the company makes periodic interest payments, and the principal is due at maturity If you borrow a $100,000 that charges 5% interest, the note term is five year and the payment schedule is interest only. The payment schedule will be like this: At the end of each year of the five years of the five years

Interest payment = 100,000 x 5% = $5,000 At the end of the fifth year, the principal of $100,000 is also due. Fixed principal plus interest: A percentage of the principal is due at the end of each period, plus interest accrued on the loan balance Fixed payments, which is the most common type of long-term loans, such as mortgage loans and car loans. Each payment consists of interest and principal Bonds payable Bonds payable is borrowing from the public as opposed to borrowing from financial institutions. Each bond has a low nominal value ($1000 or $5000) so that small investors can afford it. Bonds are a form of interest only loans because the payment schedule of bonds consists of periodic interest payments, and the principal is due at maturity. Terminology of bonds payable Interest rate Contractual rate (other names are nominal rate, stated rate, coupon rate, face rate) is the rate stated on the face of the bond certificate. This rate is fixed and never changes after the bond is issued Market rate (other names are effective rate and yield) is the interest rate demanded by investors on the bond issue Face value is the value printed at the bond certificate (is usually $1,000 or $5,000) Market value (another name is issue price) is the price investors are willing to pay for the bond. Market value does not necessarily equal the face value. How is market value determined? Beyond the scope of this course. What you need to know is if the market value should be higher than, lower than, or equal to face value. The relationship between the face rate and the market rate determines whether the issue price is higher than, lower than, or equal to face value.

At the date of issuing bonds, there are three possibilities regarding the relationship between face and market rate 1. Face rate equals market rate: issue price equals face value 2. Face rate is less than market rate: the bonds will pay interest that is less than what is demanded by investors, the bond will sell at a discount to compensate for the lower face rate 3. Face rate is greater than market rate: the bonds will pay interest that is greater than what is demanded by investors, the bond will sell at a premium because investors are willing to pay extra for the higher face rate Accounting for bonds payable Bonds issued at face value Issuance of bonds payable Cash xx Bonds payable Periodic interest payments Interest expense Cash

xx

Final payment of principal Interest expense Cash

xx

Bonds payable

xx

xx

xx

xx

Cash Bonds issued at discount Issuance of bonds payable Cash xx Discount on B/P xx Bonds payable

xx

xx

We credit bonds payable with the face value of bonds We debit cash with the issue price. Since the issue price is less than the face value, the debits will be less than the credits Discount on bonds payable is a CONTRA-LIABILITY account, meaning that discount is reported against bonds payable on the balance sheet. Assume that a bond issue has a face value of $20,000 and $15,000 discount. It is reported as follows on the balance sheet Bonds payable Less: discount on B/P

200,000 (15,000)

Net bonds payable

185,000

Periodic interest payments Interest payment = face value x face rate Interest expense = carrying value x market rate Interest expense will be different from interest payment Carrying value = bonds payable - discount on bonds payable Which is greater: interest payment or interest expense? When bonds are issued at a discount, that means the market rate is greater than the face rate Interest payment is less than interest expense. In the journal entry to record periodic interest payments, we debit interest expense and credit cash with interest payment Interest expense xx Cash Discount on bonds payable

xx xx

Since interest payment is less than the interest expense, then the credit side is less than the debit side. We fill the difference by crediting discount on bonds payable Bonds issued at premium Issuance of bonds payable Cash xx Bonds payable xx Premium on bonds payable xx Since issue price is greater than the face value, the debit side will be greater than the credit side. To balance the journal entry, we add premium on bonds payable to the credit side. Premium on bonds payable is an ADJUNCT-LIABILITY account because it is added to bonds payable on the balance sheet. If bonds payable have a face value of $200,000 and $15,000 premium on bonds payable, bonds payable is reported as follows on the balance sheet Bonds payable Add: premium on B/P Carrying value

200,000 15,000 215,000

Periodic interest payments Interest payment = face value x face rate Interest expense = carrying value x market rate When bonds are issued at premium, the face rate is greater than the market rate. Therefore, interest payment is greater than interest expense.

Interest expense Premium on B/P

xx xx

Cash xx Since interest payment is greater than interest expense, then the debit side is less than the credit side. To balance the journal entry, we debit premium on bonds payable. When bonds are issued at discount, the journal entry of periodic interest payment is Interest expense Cash Discount Since discount has a normal debit balance, crediting it would reduce its balance. Therefore, we are effectively amortizing discount on bonds payable at each periodic interest payment date. By the end of the bond term, the balance of discount on bonds payable will be zero. Likewise, with premium. Methods of amortizing premium and discount 1. Effective interest method a. Discount amortization = interest expense - interest payment b. Premium amortization = interest payment - interest expense 2. Straight line method a. Discount amortization = total discount / total number of interest payments i. Interest expense = interest payment + discount amortization b. Premium amortization = total premium / total number of interest payments i. Interest expense = interest payment - premium amortization...