Chapter 11: Liabilities, on and off balance sheet General issues
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Chapter 11: Liabilities, on and off balance sheet General issues Long-term debt, contingent liabilities 1 Liabilities, definition and classification z present obligations based on past transactions or events that require either future payment or future performance of services 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. [IASB Framework, paragraph 49] recognized when incurred; end-of-period adjustments may be necessary valued at the amount due or at fair market value classified as current or long-term; determinable or contingent 2 Long-term / current z Long-term Liability due beyond the current period or the normal operating cycle, whichever is longer used to cover long-term financing needs z Current Liability due within one year or within the normal operating cycle, whichever is longer incurred in connection with operating process long-term liabilities may contain a current portion according to the lapse of time • to be shown separately 3 Part I: Current Liabilities z Accounts Payable sometimes called trade accounts payable balances owed to others for goods and services purchased on open account time lag between resource inflow and payment z Short-Term Loans „line of credit“ – short-term borrowing when needed promissory note • interest rate may vary over time 4 Notes Payable, accounting treatment when granted written promises to pay a certain sum on a specified future date used to secure loans or to pay suppliers for goods Case 1 - Interest stated separately Sep 30 Cash 10.000 Notes Payable 10.000 (To record issuance of 9%, 90-day note to Commerzbank) money received equal to face value of note Case 2 - Interest in face amount money received equal to present value of note Sep 30 Cash 9.779 Discount on Notes Payable _221 Notes Payable 10.000 (To record issuance of zero-interest-bearing 90-day note to Commerzbank) 5 Accounting treatment of payment Case 1 - Interest stated separately Dec 30 interest expense Notes Payable 10.000 Interest Expense _225 Cash 10.225 (To record payment of Commerzbank interest-bearing note and accrued interest at maturity) = 10.000 x 9% x 90/360 Case 2 - Interest in face amount interest expense is lower in case 2 than in case 1 since the effective amount borrowed was lower, too. Dec 30 Notes Payable 10.000 Cash 10.000 (To record payment of note with interest included in face amount) Dec 30 Interest Expense ____221 Discount on Note Payable 221 (To record interest expense on note payable) 6 other current debt z Current Maturities of Long-Term Debt portions of long-term debt maturing within the next year are classified as current liabilities e.g. installment due on a long-term liability, i.e. a loan z Dividends Payable liability is incurred after the board‘s decision to pay out dividends liability exists until dividends are paid 7 Unearned Revenues z examples: sale of season tickets for a sports club subscription of magazines gift certificates meal tickets z accounting treatment when payment is received: debit cash, and credit unearned revenue account when revenue is earned: debit unearned revenue, and credit an earned revenue account Type of Business Airline Restaurant Magazine Publisher Sports Club Account Title Unearned Revenue Unearned Passenger Ticket Revenue Unearned Meal Revenue Unearned Subscription Revenue Unearned Ticket Revenue Earned Revenue Passenger Revenue Meal Revenue Subscription Revenue Ticket Revenue 8 Economic function of unearned revenue z recognize unearned revenue when customers are entitled to receive future service for their present payment with certainty to be distinguished from warranty reserves Example – Microsoft ¾ unearned revenue increased year after year ¾ u.r. arise from sale of Windows and Office you do not buy just the current version but future improvements as well ¾ if sales are growing so is unearned revenue Increases in unearned revenues may signal favorable future development! 9 Contingencies z Definition „ ... an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.“ [FASB] Statement of Financial Accounting Standards No.5, par.1 (1975) Gain contingencies are not recorded. Loss contingencies are not existing liabilities, but potential liabilities liabilities contingent on occurence or nonoccurence of a future event 10 Example z Dream Cars Inc., a car dealer, offers various specialties to its customers: Free repair of newly bought cars in case of defect within the next two years Free inspection on request by new customers within the next six months with purchase of 4 new tires before christmas (as a christmas customer appreciation special) z No definite liability incurred; Uncertain: payee due amount. z Nevertheless it is probable, that a liability has been incurred, and the liability can reasonably be estimated. Ö Record the estimated amount as a contingent liability! 11 Accounting for contingencies under US-GAAP Event Contingent Loss Probability of Occurence High Contingent Gain Reasonable Remote High Reasonable Remote Disclose Ignore Disclose Ignore Ignore Is it estimable? Accounting Treatment Yes No Accrue Disclose Source: Pratt, p. 432. 12 Common instances of loss contingencies/contingent liabilities: z Litigation, claims, and assessments z Guarantee and warranty costs guarantee for credit default product warranty z Premiums and coupons. z Environmental liabilities. z Pensions and other postemployment benefit obligations. see following pages the cause for legal action occurred in the past probability of unfavorable outcome assessed accoding to past experience estimate of expected loss: legal action is decided but number of claimants uncertain pending litigation vs. actual/possible claims and assessments: no exact amounts disclosed due to influence on position before the court 13 Guarantee and warranty costs z z Warranty: guarantee to repair or replace defective goods during a predetermined period following the sale accounting either Cash Basis – warranty costs charged to period in which company complies with the warranty Accrual Basis – warranty costs charged to period of sale as operating expense • Example (accrual basis): Michael Drums sells music instruments. Per 100 units sold, 2 require warranty service. The cost per service is estimated at € 70. In 2002, he sold 800 units. Five warranty services have already been performed at costs totalling € 430. So there remain eleven warranty services as an estimated liability. 14 Journal entries for the example: 1. Sale of 800 units at average price € 100 Cash or Accounts Receivable Sales 2. 3. 80.000 80.000 Recognition of warranty expense Warranty Expense Cash,Inventory, or Accrued Payroll (warranty costs incurred) 430 Warranty Expense Estimated Liability under Warranties (to accrue estimated warranty costs) 770 _ _430 _ _770 Recognition of warranty costs incurred in 2003 (on 2002 sales) Estimated Liability under Warranties Cash, Inventory, or Accrued Payroll 770 _ _770 15 Premiums and coupons z Examples frequent-flyer programs bonus cards of department stores z Accounting problem again: estimation of the liability incurred with the sales z (to comply with the matching principle) Journal entries – similar to „Drums example“ 16 Environmental liabilities z result from obligation to clean up, say, toxic waste or to landscape sites no longer used for business sometimes very hard to estimate the liability indemnity claims after environmental catastrophes z For example: Bayer AG “[28 ] Other provisions Other provisions are valued in accordance with IAS 37 (Provisions, Contingent Liabilities and Contingent Assets) using the best estimate of the extent of the obligation. Interestbearing provisions are discounted to present value. Personnel commitments mainly include annual bonus payments, long service awards and other personnel costs. The miscellaneous provisions include € 131 million for restructuring. Provisions for environmental protection relate to future relandscaping, landfill modernization and the remediation of land contaminated by past industrial operations. Sufficient provisions have been established for such commitments.” [Bayer AG, Annual Report 2000, notes to financial statements.] 17 Part II: Long-term liabilities z Bonds z z Definition of a bond Why issuing bonds Types of bonds Accounting for bond issues Accounting for bond retirements Long-Term Notes Payable Reporting and Analysis of Long-Term Debt 18 Bonds z z z z z securities issued by, e.g. corporations or governmental agencies, to obtain large-sum longterm financing normally due ten to fifty years after issue various covenants and restrictions for protection of both lenders and borrowers small denominations allows collection of large sums of money interest payment annually or semiannually zero bonds z „bond issue“ refers to total number of bonds issued at one time 19 Why issue bonds? z z to obtain large sums of money for long time that cannot be collected otherwise e.g. from banks debt financing has some advantages over equity financing stockholder control remains unaffected tax savings: interest expense is tax deductible leverage effect: spread between return on assets and interest cost is usually positive and increases return on equity z Stock financing vs. bond financing – an example € 2 million needed to fund a project alternative I – issues 100.000 shares at current price of € 20 per share alternative II – issuance of € 2 million, 9% bonds at face value 20 Funds obtained by ... issuance of additional shares (250.000 shares outstanding) ... issuance of bonds (150.000 shares outstanding) Earnings before interest and income taxes Interest € 700.000 0 € 180.000 0 € 700.000 180.000 € 180.000 180.000 Earnings before income taxes Income taxes at 35% € 700.000 245.000 € 180.000 63.000 € 520.000 182.000 €0 0 Net income € 455.000 € 117.000 € 338.000 0 Earnings per share € 1,82 € 0,47 € 2,25 0 RoE 9.1% 2.34% 11.27% 0% Note: Net income under bond financing is lower than under stock financing, but return on equity may be higher. Note that interest cost will increase with leverage because of an increasing default risk. Volatility of earning increases. 21 How to issue bonds ? z usually, approval by board of directors and general meeting of shareholders necessary; authorized: z number of bonds total face value and nominal interest rate • face value: amount of principal the issuer must repay at maturity • nominal interest rate determines amount of cash interest the issuer has to pay (also stated rate of interest) bonds are taken by investment banks („underwriters“) and sold to the public underwriters buy bonds for resale or on a commission basis bondholders are represented by a trustee, typically a large bank contract between company and bank is called bond indenture specifies terms of the bond, rights, privileges, and limitations of bondholders bondholders receive bond certificates as evidence of the company‘s debt to the bondholder; bondholders are creditors ! 22 Types of Bonds z Secured and Unsecured Bonds secured bonds: bondholders have a claim to certain assets of the company upon default, e.g. mortgage bond unsecured bonds: issued against general credit of borrower (debenture bonds) z Term and Serial Bonds term bonds: all bonds of an issue mature on the same date serial bonds: bonds mature over several maturity dates z Registered and Coupon Bonds registered bonds: corporation maintains record of all bondholders coupon bonds: bond not recorded in the name of the owner; transferable by delivery cont‘d next page 23 Types of Bonds, cont‘d z Convertible and Callable Bonds convertible bonds: bonds that can be converted into common stock at the option of the holder • bonds furnished with a stock option to reduce coupon callable bonds: bonds that can be retired before maturity at the issuer‘s option z Income and Revenue Bonds income bonds: interest payment only if company is profitable revenue bonds: interest on the bonds is paid from specific revenue sources 24 Accounting for Bonds Payable z bonds are traded in the capital market market rate (effective yield) of interest and (current) bond prices are inversely related • yield rate: the virtual interest rate r a bond purchased at the current price in the market yields to the owner • Let c denote the coupon, B the bond price, T the maturity (time to repayment), face value = F. • Then r is the solution to the following equation: ⎛ T c ⎜⎜ ∑ t ( ) + 1 r ⎝ t =1 ⎞ F ⎟⎟ + =B T ⎠ (1 + r ) • The yield for longer term debt uses to be higher than for shorter term debt (normal term structure of interest rates) • yield rate (bond price) depend on credit rating 25 Accounting for Bonds Payable face value € 300.000 stated rate of interest 7% market rate of interest 10% 12% schedule of payments year 1 year 2 year 3 interest principal € 21.000 € 21.000 € 21.000 year 4 € 21.000 € 300.000 year 1 year 2 year 3 € 21.000 € 21.000 € 21.000 present value of interest present value of principal € 66.567 € 204.904 € 63.784 € 190.655 present value (selling price) of the bond € 271.471 € 254.440 year 4 € 21.000 € 300.000 26 Inverse relation between interest rates and bond prices B bond #1 – stated rate of interest of c1 = 5% and term to maturity of T1= 10 bond #2 - stated rate of interest of c2 > c1 and term to maturity of T2=T1 bond #3 - stated rate of interest of c3=c1 and time to maturity T3 = 5 < T1 %r assumption: bonds 1-3 have the same face value = 100 27 Stated rate of interest, market rate of interest, effective rate of interest, and bond issue prices: z The stated rate of interest i = c/F may differ from the market rate of interest z since the yield must be equal to the market rate the issue price must be adapted accordingly: If the stated rate is lower than the market rate: issue price lower than face value, bond sells at a discount higher than the market rate: issue price exceeds face value, bond sells at a premium z at the date of issue ⎛ T c ⎜⎜ ∑ t ( ) ⎝ t =1 1 + r ⎞ F ⎟⎟ + =B T ⎠ (1 + r ) must hold with a given market rate r 28 Issuing Bonds At Face Value (“at par”) z stated rate of interest i = r market rate of interest z accounting entry: cash proceeds = face value of the bonds Example: 5-year term bonds, face value of € 900.000, dated January 1, 2009, interest rate 8%, annual interest payments on January 1. To record issuance of bonds on January 1 Cash Bonds Payable 900.000 900.000 To record accrued interest expense at year end (December 31) Bond interest expense Bond interest payable 72.000 72.000 29 Issuing Bonds at Discount z stated rate of interest i < r market rate of interest Example: as before, but market rate of interest now 10% (stated rate of interest 8%). 5 72.000 900.000 + = 831.766 5 ∑ t 1,1 1,1 t =1 discount is 68.234 has to be amortized over the time to maturity • usually: straight line method: 68.234 / 5 = 13.647 30 Issuing Bonds at Discount To record issuance of bonds on January 1 Cash 831.766 Discount on Bonds Payable 68.234 Bonds payable 900.000 To record accrued interest expense and accrued amortization at year-end (December 31) Bond interest expense 85.647 Discount on Bonds Payable 13.647 Interest Payable 72.000 Balance sheet presentation: Long-term liabilities Bonds Payable Less: Discount on Bonds Payable 900.000 € €900 000 112.159 € 831.766 € 787.841 68.234 31 Issuing bonds at a premium z stated rate of interest i > r market rate of interest Example: as before, but market rate of interest now 6% To record issuance of bonds on January 1 Cash 975.823 Premium on Bonds Payable 75.823 Bonds payable 900.000 To record accrued interest expense and accrued amortization at year-end (December 31) Bond interest expense 56.835 Premium on Bonds Payable 15.165 Interest Payable Balance sheet presentation 72.000 Long-term liabilities Bonds Payable Add: Premium on Bonds Payable € 900€000 900.000 32 133.901 € 1.033.901 75.823 € 975.823 Amortizing Bond Premium / Bond Discount z the bond premium (discount) is amortized over the life of the bonds straight-line method effective interest method z Straight-line method equal amounts of the premium (discount) are amortized in each period, equal interest expense recorded in each period interest expense = interest to be paid + amortized discount amortized discount = (face value – issue price) / number of interest periods interest expense = interest to be paid – amortized premium amortized premium = (issue price – face value) / number of interest periods 33 Effective interest method z interest expense = bond carrying value × effective rate of interest discount amortization = interest expense – interest to be paid premium amortization = interest to be paid – interest expense increasing amounts are amortized in each period • interest expense is equal to a constant percentage of the carrying value of the bonds • interest expense recorded is, thus, increasing under discount and decreasing under premium amortization 34 Effective interest discount amortization schedule for an 8% bond sold to yield 10% Annual interest paid period issue date 1 72.000 2 72.000 3 72.000 4 72.000 5 72.000 interest expense 83.177 84.294 85.524 86.876 88.364 discount unamortized bond carrying amortization discount value 68.234 831.766 11.177 57.057 842.943 12.294 44.763 855.237 13.524 31.239 868.761 14.876 16.363 883.637 16.364 0 900.000 35 The journal entry to record accrued interest at December 31, 2004, is Bond interest expense Discount on bonds payable Bond interest payable 83.177 11.177 72.000 ... and bond interest expenses will keep rising as the carrying value of the bonds increases. 36 Effective interest premium amortization schedule for 8% bonds sold to yield 6% Annual interest paid period issue date 1 72.000 2 72.000 3 72.000 4 72.000 5 72.000 interest expense 58.549 57.742 56.887 55.980 55.019 premium unamortized bond carrying amortization premium value 75.823 975.823 13.451 62.372 962.372 14.258 48.115 948.115 15.113 33.002 933.002 16.020 16.982 916.982 16.981 1 900.001 37 The journal entry to record accrued interest on December 31, 2009, is Bond interest expense Premium on bonds payable Bond interest payable 58.549 13.451 72.000 ... and bond interest expenses will keep falling as the carrying value of the bonds decreases. 38 Zero Bonds z bonds that bear no interest (explicitly) and are issued solely for cash z also called deep discount bonds z Example: An 8-year zero bond with face value of € 10 million (10.000 x € 1.000 each) is issued and sold at a price of € 3.270.000. What is the implicit interest rate ? €3.270.000 = €10.000.000 ⋅ (1 + i ) −8 10.000.000 i= − 1 = 0,14999 3.270.000 8 z The implicit interest rate is 15%. It is the interest rate that equates (in present value terms) the cash received with the amounts to be paid in the future. 39 Disclosure Requirements for Long-Term Debt z z z z composition of long-term debt long-term debt maturing within one year should be reported as a current liability maturities of long-term debt during each of the next five years any special arrangements, e.g. refinancing, conversion into stock, „off-balance-sheet financing“ 40
