BSAD 221
Introductory Financial
Accounting
Donna Gunn, CA
Liabilities
Obligations that result from past transactions, which
will be paid with assets or services.
Maturity = 1 year or less
Current
Liabilities
Maturity > 1 year
Noncurrent
Liabilities
Liabilities Defined and
Classified
Liabilities are measured at their
current cash equivalent (the
amount a creditor would accept to
cancel the debt) at the time
incurred.
Known Current Liabilities
Accounts payable
Short-term notes payable
Goods and services tax payable
Accrued expenses
Payroll liabilities
Unearned revenues
Current portion of long-term debt
Current portion of capital leases
Account Name
Also Called
Definition
Obligations to pay for goods and
Accounts
Trade Accounts
services used in the basic
Payable
Payable
operating activities of the
business.
Obligations related to expenses
Accrued
Accrued
that have been incurred, but will
Liabilities
Expenses
not be billed or paid until the
subsequent period.
Obligations due supported by a
Notes Payable
N/A
formal written contract.
Obligations arising when cash is
Deferred
Unearned
received prior to the related
Revenues
Revenues
revenue being earned.
Short-Term Notes Payable
In addition to recording the note payable,
the business must also pay interest expense.
Short-Term Notes Payable
The interest formula includes three variables
that must be considered when computing
interest:
Interest = Principal × Interest Rate × Time
When computing interest for one year,
“Time” equals 1. When the
computation period is less than one
year, then “Time” is a fraction.
Short-Term Notes Payable
On October 1, a business purchased inventory
for $8,000 by issuing a 6-month,
10% note payable.
How much interest was accrued at
December 31st?
Short-Term Notes Payable
On October 1, a business purchased inventory
for $8,000 by issuing a 6-month,
10% note payable.
How much interest was accrued at
December 31st?
$8,000 × 10% × (3/12) = $200
Short-Term Notes Payable
October 31st
Inventory
Notes Payable, Short-Term
8,000
8,000
Purchase of inventory by issuing a note payable
December 31st
Interest Expense
Accrued Interest
To record interest accrued at year end
200
200
Short-Term Notes Payable
March 31, 2012
Note Payable, Short-Term
Interest Payable
Interest Expense*
Cash
8,000
200
200
*$8,000 x 0.10 x 3/12 – interest for Jan-Mar
8,400
Unearned Revenues
Cash is collected from the customer before
the revenue is actually earned.
Cash is
received
in
advance.
Unearned
revenue is
recorded.
Unearned
revenue is a
liability
account.
Unearned Revenues
Cash is collected from the customer before
the revenue is actually earned.
As the earnings
process is
completed . . .
Cash is
received
in
advance.
Unearned
revenue is
recorded.
Earned
revenue is
recorded.
Unearned Revenues
Assume on September 1st WestJet collects
$800 for a round-trip from Vancouver to
Montreal (taxes and fees are not considered in
this example)
The flight to Montreal will occur on
September 26th.
Unearned Revenues
Assume on September 1st WestJet collects
$800 for a round-trip from Vancouver to
Montreal (taxes and fees are not considered in
this example)
September 1st
Cash
800
Unearned Revenue
To receive cash for plane fare
800
Unearned Revenues
The passenger flies from Vancouver
to Montreal on September 26, 2011.
September 26
Unearned Revenue
400
Revenue ($800/2)
400
To record revenue earned on Sept. 26th flight
Unearned Revenues
The passenger flies from Vancouver
to Montreal on September 26, 2011.
September 26
Unearned Revenue
400
Revenue ($800/2)
400
To record revenue earned on Sept. 26th flight
The balance in the unearned revenue account is
now the remaining $400, which will be recognized
when the return flight is taken
Warranties
An agreement that obligates the seller to
pay for replacing or repairing the product
(or service) when it fails to perform as
expected within a specified period.
Examples of products with warranties:
Automobiles
Appliances
Computers
Warranties
The estimated liability and expense related to
the warranty is recorded in the period when the
revenue from the sale is recorded.
Example:
Warranty Expense
1,000
Estimated Warranty Liability
1,000
To record estimated warranty expense and
liability.
Warranties
As the warranty work is done, the costs related to
the warranty is applied to the liability account.
Warranty Liability*
700
Cash
400
Accounts Payable
300
To record costs of warranty repairs.
*The actual warranty costs may differ from the estimated
expense. This is monitored by management and may
require adjustments in future estimates.
Warranties
T-World sold $12,000 worth of trampolines with an extended
warranty. It estimates that 2% of the sales will result in
warranty work. T-World should:
A. Recognize warranty expense at the time of sale.
B. Recognize warranty expense at the time warranty work
is performed.
C. Recognize warranty liability at the time of sale.
D. Both A and C.
E. Both B and C.
Warranties
T-World sold $12,000 worth of trampolines with an extended
warranty. It estimates that 2% of the sales will result in
warranty work. T-World should:
A. Recognize warranty expense at the time of sale.
B. Recognize warranty expense at the time warranty work
is performed.
C. Recognize warranty liability at the time of sale.
D. Both A and C.
E. Both B and C.
Contingent Liabilities
Per the CICA Handbook –
A contingency is defined as an existing condition
or situation involving uncertainty as to possible
gain or loss to an enterprise that will ultimately
be resolved when one or more future events
occur or fail to occur.
Contingent Liabilities
Potential liabilities that arise because of events or
transactions that have already occurred.
Long-Term Liabilities
Capital Structure –
Long-term Debt
Significant debt needs of a company are
often filled by issuing notes and bonds.
Bonds
Cash
Advantages of Bonds
 Bonds are debt, not equity, so the ownership and
control of the company are not diluted.
 Cash payments are limited to the scheduled
payments of interest and principal.
 Interest expense is tax deductible.
 The impact on earnings is often positive (positive
financial leverage) because money can often be
borrowed at a low interest rate and invested at a
higher interest rate.
Disadvantages of Bonds
 Risk of bankruptcy exists because the interest and
principal are legal obligations and must be paid back as
scheduled or creditors will force legal action.
 A single, large principal payment is required at the
maturity date.
 Negative impact on cash flows exists because interest
and principal must be repaid in the future.
Characteristics of Bonds
Payable
At Bond Issuance Date
Company
Issuing
Bonds
$$$$
Bond Certificate
Investor
Buying
Bonds
Bonds payable are long-term debt for the
issuing company.
Characteristics of Bonds
Payable
$
Company
Issuing
Bonds
$
Periodic
Interest Payments
Principal
Payment at End of
Bond Term
$
Investor
Buying
Bonds
$
Reporting Bond Transactions
When a company issues bonds, it specifies two cash
flows related to the transaction:
1) Principal
2) Interest
Assume Dino Oil issues $100,000 in bonds at par on
January 1, 2011. The bonds pay 8% interest annually on
December 31.
What journal entry should be made on January 1, 2011?
Reporting Bond Transactions
When a company issues bonds, it specifies two cash
flows related to the transaction:
1) Principal
2) Interest
Assume Dino Oil issues $100,000 in bonds at par on
January 1, 2011. The bonds pay 8% interest annually on
December 31.
What journal entry should be made on January 1, 2011?
Cash
100,000
Bonds Payable
100,000
Reporting Bond Transactions
Periodically, interest must be accrued and recorded.
Annual interest = principal x stated interest rate
Dino Oil issues $100,000 in bonds at par on Jan. 1/11.
The bonds pay 8% interest annually on December 31.
What journal entry should be made on December 31, 2011?
Reporting Bond Transactions
Periodically, interest must be accrued and recorded.
Annual interest = principal x stated interest rate
Dino Oil issues $100,000 in bonds at par on Jan. 1/11.
The bonds pay 8% interest annually on December 31.
What journal entry should be made on December 31, 2011?
Interest Expense*
Cash
*$100,000 x 8% x 1year
8,000
8,000
Characteristics of Bonds Payable
Bonds Characteristics
• Face Value
• Maturity Date
• Stated Interest Rate
• Interest Payment Dates
• Bond date
Characteristics of Bonds Payable
Bonds Characteristics
• Face Value
External Factors
• Maturity Date
• Market interest rate
• Stated Interest Rate
• Issue date
• Interest Payment Dates
• Bond date
Time Value of Money
The amount invested today receives a greater
amount at a future date, which is called the
present value of a future amount.
It depends upon...
1.) the amount of the future receipt.
2.) the length of time to the future receipt.
3.) the interest rate for the period.
Reporting Bond Transactions
The issue price of the bond is determined by the
market, based on the time value of money.
Present Value of the Principal (a single payment)
+ Present Value of the Interest Payments (an annuity)
= Issue Price of the Bond
The interest rate used to compute the present value
is the market interest rate.
Reporting Bond Transactions
The stated rate is only used to compute the
periodic interest payments.
Interest
=
Principal x Stated Rate x Time
Interest
Bond
Accounting for
Rates
Price
Stated = Market
Rate
Rate
Bond = Par Value
Price
of the Bond
the Difference
There is no
difference
to account for.
Stated
<
Rate
Stated
Rate
Market
Rate
>
Market
Rate
The difference is
Bond
Par Value
accounted
<
for as a bond
Price
of the Bond
discount.
The difference is
Bond
Par Value
accounted
>
for as a bond
Price
of the Bond
premium.
Bonds Issued at Par
January 1, 2012, Petro-Canada issues:
$400,000 in bonds
Stated rate of 10% annually
The bonds mature in 10 years and interest is
paid semiannually.
The market rate is 10% annually.
This bond is issued at a par.
Bonds Issued at Par
January 1, 2012, Petro-Canada issues
$400,000 in bonds at par.
Cash
400,000
Bond Payable
400,000
Bonds Issued at Par
Every 6 months Petro-Canada will make an
interest payment on the bond, and the
following entry will be made.
Interest Expense*
Cash
*$400,000 x 10% x 6/12
20,000
20,000
Bonds Issued at Par
At maturity, Petro Canada will repay the
principal to the bondholder.
Bond Payable
Cash
400,000
400,000
Issuing Bonds
On Jan 1, 2012, Petro-Canada issues
$400,000 in bonds having a stated rate of
10%. The bonds mature in 10 years and
interest is paid semiannually. The market
rate is 12% annually.
Are Petro-Canada bonds issued at
par, at a discount, or at a premium?
Bonds Issued at a Discount
On January 1, 2012, Petro-Canada issues $400,000 in
bonds having a stated rate of 10% annually. The
bonds mature in 10 years (Dec. 31, 2016) and
interest is paid semiannually. The market rate is
12% annually.
Stated
Rate
<
Market
Rate
The difference is
Bond
Par Value
accounted
<
for as a bond
Price
of the Bond
discount.
Bonds Issued at a Discount
The issue price of a bond is
composed of the present value of
two items:
• Principal (a single amount)
• Interest (an annuity)
Note: You are not responsible for
calcualating the issuance price of a bond.
We will give that to you. I have included
slides on how to do it because, in my
opinion, if you understand that it makes
understanding the amortization of the
bond easier.
Bonds Issued at a Discount
First, let’s compute the present value of the
principal.
Market rate of 12% ÷ 2 interest periods per year = 6%
Term of 10 years × 2 periods per year = 20 periods
Bonds Issued at a Discount
First, let’s compute the present value of the
principal.
Market rate of 12% ÷ 2 interest periods per year = 6%
Term of 10 years × 2 periods per year = 20 periods
Bonds Issued at a Discount
Now, let’s compute the present value of the
interest.
Market rate of 12% ÷ 2 interest periods per year = 6%
Term of 10 years × 2 periods per year = 20 periods
Bonds Issued at a Discount
Now, let’s compute the present value of the
interest.
Market rate of 12% ÷ 2 interest periods per year = 6%
Term of 10 years × 2 periods per year = 20 periods
Bonds Issued at a Discount
$ 124,720 Present Value of the Principal
+
229,398 Present Value of the Interest
= $ 354,118 Present Value of the Bonds
The $354,118 is less than the face amount of
$400,000, so the bonds are issued at a discount of
$45,882.
Bonds Issued at a Discount
Here is the journal entry to record the bond
issued at a discount:
Cash
Discount on Bond Payable
Bond Payable
354,118
45,882
400,000
This is a contra-liability account and appears in the
liability section of the balance sheet.
Bonds Issued at a Discount
Financial Statement Presentation
The discount will
be amortized
over the 10-year
life of the bonds.
Two methods of
amortization are
commonly used:
Straight-line
or
Effectiveinterest.
Reporting Interest Expense:
Straight-line Amortization
 Identify the amount of the bond discount.
 Divide the bond discount by the number of
interest periods.
 Include the discount amortization amount as
part of the periodic interest expense entry.
 The discount will be reduced to zero by the
maturity date.
Reporting Interest Expense:
Effective-interest Amortization
 The effective interest method is the
theoretically preferred method.
 Compute interest expense by multiplying the
current unpaid balance times the market rate
of interest.
 The discount amortization is the difference
between interest expense and the cash paid
(or accrued) for interest.
Reporting Interest Expense:
Effective-interest Amortization
Petro-Canada issued their bonds on Jan. 1, 2012.
• Issue Price: $354,118
• Face Value: $400,000
• Market Rate: 12%
• Stated Rate: 10%
Interest Expense = Balance × Market Rate × Time
$354,118 × 12% × 6/12 = $21,247
Reporting Interest Expense:
Effective-interest Amortization
Here is the journal entry to record the payment
of interest and the discount amortization for the
six months ending on June 30, 2012:
Interest Expense
21,247
Discount on Bond Payable
Cash
1,247
20,000
Zero Coupon Bonds
 Zero coupon bonds do not pay periodic interest
 Because there is no interest annuity . . .
PV of the Principal = Issue Price of the Bonds
 This is called a deep discount bond
Bonds Issued at a Premium
On January 1, 2012, Petro-Canada issues $400,000 in
bonds having a stated rate of 10% annually.
The bonds mature in 10 years (Dec. 31, 2021) and
interest is paid semiannually.
The market rate is 8% annually.
This bond is issued at a premium.
Stated
Rate
>
Market
Rate
The difference is
Bond
Par Value
accounted
>
for as a bond
Price
of the Bond
premium.
Bonds Issued at a Premium
The issue price of a bond is
composed of the present value of
two items:
• Principal (a single amount)
• Interest (an annuity)
Bonds Issued at a Premium
First, let’s compute the present value of the
principal.
Market rate of 8% ÷ 2 interest periods per year = 4%
Term of 10 years × 2 periods per year = 20 periods
Bonds Issued at a Premium
Now, let’s compute the present value of the
interest.
Market rate of 8% ÷ 2 interest periods per year = 4%
Term of 10 years × 2 periods per year = 20 periods
Bonds Issued at a Premium
$ 182,560 Present Value of the Principal
+
271,806 Present Value of the Interest
= $ 454,366 Present Value of the Bonds
The $454,366 is more than the face amount of
$400,000, so the bonds are issued at a premium of
$54,366.
Bonds Issued at a Premium
Here is the journal entry to record the bond
issued at a premium:
Cash
454,366
Premium on Bond Payable
Bond Payable
54,366
400,000
This is called an adjunct-liability account and appears
in the liability section of the balance sheet as an
addition to Bonds Payable.
Bonds Issued at a Premium
Financial Statement Presentation
The premium will
be amortized over
the 10-year life of
the bonds.
Let’s look at the
amortization tables
using
Straight-line
and
Effective-interest.
Reporting Interest Expense:
Effective-interest Amortization
Petro-Canada issued their bonds on Jan. 1, 2012.
• Issue Price: $454,366
• Face Value: $400,000
• Market Rate: 8%
• Stated Rate: 10%
Interest Expense = Balance × Market Rate × Time
$454,366 × 8% × 6/12 = $18,175
Reporting Interest Expense:
Effective-interest Amortization
Here is the journal entry to record the payment
of interest and the premium amortization for the
six months ending on June 30, 2012:
Interest Expense
Premium on Bond Payable
Cash
18,175
1,825
20,000
Early Retirement of Debt
• Occasionally, the issuing company will call (repay
early) some or all of its bonds.
• Gains/losses are calculated by comparing the
bond call amount with the book value of the bond.
Book Value > Retirement Price = Gain
Book Value < Retirement Price = Loss