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Chapter 9: Liabilities

By: Stephen K. Nkundabanyanga

6/8/2012

Definitions (1)
2

 A liability is a present obligation of the enterprise arising

from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

By: Stephen K. Nkundabanyanga

6/8/2012

Definitions (2)
3

A contingent liability (provisions) is:  (a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise; or  (b) a present obligation that arises from past events but is not recognized because:
(i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or  (ii) the amount of the obligation cannot be measured with sufficient reliability.

By: Stephen K. Nkundabanyanga

6/8/2012

Liabilities
4

 Current (<= 1 year)  Accounts payable (creditors)  Advances from customers  Dividends payable  Current portion of long-term loans  Long-Term (> 1 year)  Long-term Loans

By: Stephen K. Nkundabanyanga

6/8/2012

Management Issues: Current Liabilities (1)
5

 Meeting needs for cash during the operating cycle  Management of cash flow related to current liabilities is essential

to business management; failure leads to bankruptcy  Liquidity measures


working capital, current ratio, quick ratio

By: Stephen K. Nkundabanyanga

6/8/2012

Management Issues: Current Liabilities (2)
6

 Recognition  Valuation  Classification

 Disclosure

By: Stephen K. Nkundabanyanga

6/8/2012

Management Issues: Current Liabilities: Recognition
7

 Liabilities are recorded when an obligation occurs. Obligations

occur:
 

by transactions (goods are bought on credit) by passage of time (interest payable, accrual)

 No liabilities are recorded for future transactions

By: Stephen K. Nkundabanyanga

6/8/2012

Management Issues: Current Liabilities: Valuation
8

 amount of money needed to pay the debt  estimation: taxes payable  estimation: warranty

By: Stephen K. Nkundabanyanga

6/8/2012

Management Issues: Current Liabilities: Classification
9

 current:  payable within (<=) one year  long-term:  payable beyond (>) one year  important in evaluation of company's liquidity

By: Stephen K. Nkundabanyanga

6/8/2012

Management Issues: Current Liabilities: Disclosure
10

 large amounts require disclosure of balances, maturities,

interest rate  special arrangements


(commercial paper, lines of credit)

 commercial paper:  unsecured current loans sold to the public (through investment firms) by companies with excellent credit ratings

By: Stephen K. Nkundabanyanga

6/8/2012

Common Categories of Current Liabilities
11

 Definitely Determinable Liabilities  Estimated Liabilities

By: Stephen K. Nkundabanyanga

6/8/2012

Current Definitely Determinable Liabilities
12

 Definitely Determinable Liabilities:  current liabilities that are set by contract or statute and can be measured exactly

 Accounting problems:  determination of existence  measurement  properly recording

By: Stephen K. Nkundabanyanga

6/8/2012

Classes of Current Definitely Determinable Liabilities
13

Accounts Payable  Bank Loans and Commercial Paper  Notes Payable  Accrued Liabilities  Dividends Payable  Sales and Excise Taxes Payable  Current Portion of Long-Term Debt  Payroll Liabilities  Unearned Revenues

By: Stephen K. Nkundabanyanga

6/8/2012

Notes payable: Interest stated separately
14

Initial recognition Cash Notes Payable Repayment Notes Payable Interest expense Cash

5 000 5 000 5 000 100

5 100

By: Stephen K. Nkundabanyanga

6/8/2012

Notes payable: Interest in face amount
15

 Initial recognition Cash 4 900 Discount on Notes payable Notes Payable

100 5 000 5 000 5 000 100 100

 Repayment Notes Payable Cash Interest expense Discount on Notes payable

By: Stephen K. Nkundabanyanga

6/8/2012

Notes Payable: effective interest
16

 Interest stated separately: 100/50000 = 2.000%

 Interest in face amount: 100/4900 = 2.0408%

By: Stephen K. Nkundabanyanga

6/8/2012

Notes Payable: accrued interest
17

 Interest stated separately: Interest Expense 50 Interest Payable

50

 Interest in face amount Interest Expense Discount on Notes Payable

50 50

By: Stephen K. Nkundabanyanga

6/8/2012

Dividends Payable
18

 NL: General Meeting of Shareholders decides on Profit

distribution


Dividends and Reservations

 Balance Sheet shows the situation at 31 December before

appropriations of net income

By: Stephen K. Nkundabanyanga

6/8/2012

Payroll Liabilities
19

 Much depends on Social and Tax legislation  Specialized entries

By: Stephen K. Nkundabanyanga

6/8/2012

Common Categories of Current Liabilities: Estimated Liabilities
20

 Debts or obligations for which the exact amount cannot be

known until a later date.  Four classes

  

Income Taxes Payable Property Taxes Payable Product Warranty Liability Vacation Pay Liability

By: Stephen K. Nkundabanyanga

6/8/2012

Income Taxes
21

 Income tax depends on taxable income
 Taxable income is known as the tax return is definitive. This

may be (months, years) after the accounting period  Tax liability is estimated:
Income Tax Expense Income Tax Payable 53 000 53 000

By: Stephen K. Nkundabanyanga

6/8/2012

Product Warranty Liability
22

 Every month an adjustment is recorded based on the sales of

the warranted products:
Product Warranty Expense Estimated Product Warranty Liability 525

525
20

 Replacement under warranty
Estimated Product Warranty Liability

Inventory

20

By: Stephen K. Nkundabanyanga

6/8/2012

Contingent Liabilities (1)
23

 A potential liability depending on a future event based on a

past transaction or event  Meeting two Recognition criteria:
 

liability is probable and amount can reasonably be estimated

leads to presentation at the Balance Sheet  not meeting the recognition criteria leads to reporting in the Notes

By: Stephen K. Nkundabanyanga

6/8/2012

Contingent Liabilities (2)
24

Tax liability Product Warranty Liability Vacation Pay Liability

meet the recognition criteria and are therefore accrued in the accounting records (Debits: Income Statement and Credits: Balance Sheet)

By: Stephen K. Nkundabanyanga

6/8/2012

Time Value of Money
25

 Simple interest  interest cost for a period assuming the Principal stays the same  Compound interest  interest cost for a period assuming the interest of the period is added to the Principal  During a period: simple interest  More than one period: compound interest

By: Stephen K. Nkundabanyanga

6/8/2012

Time Value of Money: Simple interest
26

 Interest = Principal * Rate * Time 600 = 30 000 * 8% * 90/360

By: Stephen K. Nkundabanyanga

6/8/2012

Time Value of Money: Compound interest
27

Interest = Principal * (1+Rate)time - Principal 955.08 = 5 000 * (1+0.06)3 - 5 000

By: Stephen K. Nkundabanyanga

6/8/2012

Management Issues: Long-Term Liabilities
28

 Long-Term Debt is issued to Finance Long-Term Projects  Three management Issues:
Whether or not to have long-tem Debt  How much long-term debt to have  What type of long-term debt to have.


By: Stephen K. Nkundabanyanga

6/8/2012

Long-Term Liabilities: The Decision
29

 Advantages of Loans over Shares  No voting rights  Interest paid is tax deductible  Financial leverage (trading on the equity)  Disadvantage of Loans  Fixed payments of Interest and Principal

By: Stephen K. Nkundabanyanga

6/8/2012

Nature of Bonds (1)
30

 A bond is a security representing money borrowed by a

company from the public


Bond certificate


evidence of the company’s debt total amount of bonds issued at one time definition of rights, privileges and limitations of bondholders



Bond issue




Bond covenant:


By: Stephen K. Nkundabanyanga

6/8/2012

Bonds Prices
31

 Stated in percentage of face value  Sold  at a premium (103 ½)  at face value, nominal value (100)  at a discount (87.62)

By: Stephen K. Nkundabanyanga

6/8/2012

Nature of Bonds (2)
32

 Secured or unsecured (debenture bonds)  Secured: pledge of assets as a guarantee of repayment
 Term or serial  Term bonds: maturity on the same date  Serial bonds: maturity on several dates  Registered or Coupon Bonds  Register of Bondholder or pays at the presented Coupon

By: Stephen K. Nkundabanyanga

6/8/2012

Accounting for Bonds Payable (1)
33

 Balance Sheet Disclosures of Bonds  Bonds Issued at Face Value  Face and market Interest Rate

 Bonds Issued at Discount

By: Stephen K. Nkundabanyanga

6/8/2012

Accounting for Bonds Payable (2)
34

 Balance Sheet Disclosures of Bonds  Long-term liabilities: Bonds payable and unamortized premiums and discounts  If maturity is one year or less and retirement is done by current assets Bonds payable are Current liabilities  If retirement is done by fixed assets or by issuing new bonds the Bonds payable are still long-term liabilities

By: Stephen K. Nkundabanyanga

6/8/2012

Accounting for Bonds Payable (3)
35

Disclosures in the Notes  Important provisions on the bond covenant
all bond issues  kinds of bonds  interest rates  any securities connected to the bonds  interest payment dates  maturity dates  effective interest rates


By: Stephen K. Nkundabanyanga

6/8/2012

Accounting for Bonds Payable (4)
36

 Bonds Issued at Face Value  Issuance of Bonds 100 000, face value, 9%, 5 years, interest payment dates January 1 and July 1, simple interest
Cash Bonds Payable 100 000 100 000

By: Stephen K. Nkundabanyanga

6/8/2012

Accounting for Bonds Payable (5)
37

 Interest payment on July 1  Issuance of Bonds 100 000, face value, 9%, 5 years, interest payment dates January 1 and July 1
Bond Interest Expense Cash 4 500 4 500

By: Stephen K. Nkundabanyanga

6/8/2012

Accounting for Bonds Payable (6)
38

 Face and Market Interest Rate  If market interest rate is higher than the face interest rate bonds

are sold at a discount  If market interest rate is lower than the face interest rate bonds are sold at a premium  Resulting in: Effective bond interest rate equals market interest rate

By: Stephen K. Nkundabanyanga

6/8/2012

Accounting for Bonds Payable (7)
39

 Bonds Issued at a Discount  Issuance of Bonds 100 000, at discount (96.149), 9% (market rate is 10%), 5 years, interest payment dates January 1 and July 1 Cash 96 149 Unamortized Bond Discount 3 851 Bonds Payable 100 000

By: Stephen K. Nkundabanyanga

6/8/2012

Accounting for Bonds Payable (8)
40

 Bonds Issued at a Discount  Unamortized Bond Discount is a contra-liability account  Bonds Payable are stated at the net amount: 100 000 - 3 851 = 96 149  During the life of the bonds the Bond Discount will amortized and added to the bonds Payable account

By: Stephen K. Nkundabanyanga

6/8/2012

Tabel 9-1

Interest Effective

and Interest

Amortisation Method

of

Bond

Discount

Gegevens: Nominale waarde Discount Marktrente 5% half jaar Nominale rente 4,5% half jaar Looptijd Renteperiode 0 1 2 3 4 5 6 7 8 9 10

100,000 3,851 5% 4.50% 10 * half jaar

Initiële boeking Kas Discount aan Obligatielening

96,149 3,851 100,000

Boekwaarde begin Rentekosten (effectief) Rentebetaling (nominaal) Amortization Discount Niet-afgeschreven Discount Boekwaarde einde 3,851 96,149 96,149 4,807 4,500 307 3,544 96,456 96,456 4,823 4,500 323 3,221 96,779 96,779 4,839 4,500 339 2,882 97,118 97,118 4,856 4,500 356 2,526 97,474 97,474 4,874 4,500 374 2,152 97,848 97,848 4,892 4,500 392 1,760 98,240 98,240 4,912 4,500 412 1,348 98,652 98,652 4,933 4,500 433 915 99,085 99,085 4,954 4,500 454 461 99,539 99,539 4,961 4,500 461 0 100,000 Eerste boeking rentekosten en betaling Rentekosten 4,807 aan Kas aan afschrijving discount

4,500 307

By: Stephen K. Nkundabanyanga

41

6/8/2012

Accounting for Bonds Payable (9)
42

 Bonds Issued at a Premium  Issuance of Bonds 100 000, at premium (104.1), 9% (market rate is 8%), 5 years Cash 104 100 Unamortized Bond Premium 4 100 Bonds Payable 100 000  Bonds Payable are stated at the net amount: 100 000 + 4 100 = 104 100

By: Stephen K. Nkundabanyanga

6/8/2012

Accounting for Bonds Payable (10)
43

Bond Issue Costs
Separate account that is amortized over the bond’s life or (the method used in the book)  Issue Cost treated as a decrease of Cash (and so increase of discount or decrease of premium)


By: Stephen K. Nkundabanyanga

6/8/2012

Amortizing a Bond Discount (1)
44

 Calculation of Total Interest Cost  Total interest cost (interest expense) is interest actually paid plus amortization of the discount

 Effective Interest Method of Amortizing a Bond Discount

By: Stephen K. Nkundabanyanga

6/8/2012

Amortizing a Bond Discount (2)
45

Carrying * effective minus interest = amortization amount * interest payment of discount rate

96 149 * 5%

- 4 500

=

307

By: Stephen K. Nkundabanyanga

6/8/2012

Amortizing a Bond Premium
46

 Logic is the same  Effect: amortization of premium decreases the effective interest

payable

By: Stephen K. Nkundabanyanga

6/8/2012

Other Bonds Payable Issues
47

Year-End Accrual for Bond Interest Expense


If interest payment dates do not corresponded to accounting year, adjustments should be recorded in order to account for the right expenses in the right periods

By: Stephen K. Nkundabanyanga

6/8/2012

Other Bonds Payable Issues
48

 Conversion of Bonds into Shares Converted 9% Bonds Payable (face value 100 000) into 4 000 shares (nominal value 8): no gain, no loss Bonds Payable 100 000 (face value) Unamortized Bond Discount 1 348 Shares 32 000 (nominal) Share Premium 66 652 (balance)

By: Stephen K. Nkundabanyanga

6/8/2012

Other Long-Term Liabilities
49

 Mortgages Payable  Installment Notes payable  Long-Term leases

 Pensions

By: Stephen K. Nkundabanyanga

6/8/2012

Other Long-Term Liabilities: Mortgages payable
50

 Many systems  Fixed amount each period  interest goes down, reduction in debt goes up

By: Stephen K. Nkundabanyanga

6/8/2012

Other Long-Term Liabilities: Installment Notes payable
51

 Periodic payment goes down because of lower interest

expenses

By: Stephen K. Nkundabanyanga

6/8/2012

Other Long-Term Liabilities: Long-Term leases (1)
52

 Long-Term Leases are Finance Leases  lead to recognizing an asset and a Lease Commitment  Short-Term Leases are Operating Leases  debit to Rent Expense. No balance sheet recognition; disclosures are provided in the Notes

By: Stephen K. Nkundabanyanga

6/8/2012

Other Long-Term Liabilities: Long-Term leases (2)
53

 Advantages  no immediate cash payment  rental payment tax deductible  less expensive than short-term lease  Economic risk lies with the lessee: leased asset and lease

commitment are recognized at the balance sheet of the lessee

By: Stephen K. Nkundabanyanga

6/8/2012

Other Long-Term Liabilities: Long-Term leases (3)
54

 Difficult to distinct exactly between Operating and Finance

Lease  Leased assets are depreciated according to the company’s accounting policies  Lease payment is to be divided into Interest Expense and Reduction of Lease Obligation

By: Stephen K. Nkundabanyanga

6/8/2012

Other Long-Term Liabilities: Pensions (1)
55

 Difficult subject because:  long funding and paying periods  uncertainties  dependable on local social security

By: Stephen K. Nkundabanyanga

6/8/2012

Other Long-Term Liabilities: Pensions (2)
56

 Defined contribution plan Company pays periodically an agreed amount of money to the pension fund. The pension is based on the funding at retirement date. The employee bears the risk.  Defined benefit plan Employee gets a specified right at retirement date (70% of last salary). The Company bears the risk.

By: Stephen K. Nkundabanyanga

6/8/2012

Other Long-Term Liabilities: Pensions (3)
57

 Defined contribution plan Easy accounting Pension Expense Cash

By: Stephen K. Nkundabanyanga

6/8/2012

Other Long-Term Liabilities: Pensions (4)
58

Defined benefit plan  complex accounting (simple procedure)

Pension Expense Cash balance is either a liability (Pension Expense is higher than Cash payment) or an asset (Pension Expense is lower than Cash payment)

By: Stephen K. Nkundabanyanga

6/8/2012

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