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)
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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
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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)
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Recognition Valuation Classification
Disclosure
By: Stephen K. Nkundabanyanga
6/8/2012
Management Issues: Current Liabilities: Recognition
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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
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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
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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
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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
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
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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
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
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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
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Interest = Principal * Rate * Time 600 = 30 000 * 8% * 90/360
By: Stephen K. Nkundabanyanga
6/8/2012
Time Value of Money: Compound interest
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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
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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
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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)
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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
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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
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)
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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)
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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)
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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
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Logic is the same Effect: amortization of premium decreases the effective interest
payable
By: Stephen K. Nkundabanyanga
6/8/2012
Other Bonds Payable Issues
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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
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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)
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)
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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)