BUS512M
Session 9
Accounting for Financing
Decisions:
Long-Term Liabilities
and Stockholders Equity
Liabilities
• Current or Short-term Liabilities
• Long-term Debt (borrowed funds)
• Lease Liabilities
• Deferred Taxes
• Contingencies and Commitments
Accounting for liabilities is a subject that can be very
technical. There is a tendency for some institutions
to create exotic instruments for marketing of funds in
recent years. Despite this, there are some basic
principles that govern the accounting for liabilities….
NIKE
Basis for Valuing Liabilities
• Because money has time value, the amount of money
needed today to pay a future debt is less than the future
obligation.
• Historically, the best basis for valuing a liability was its
economic present value (the present value of the future
cash flows, i.e., the amount of money that would have to
be set aside today to accumulate to the future cash flows
required to pay the interest and the principal of the debt).
• Most current liabilities are reported on the BS at their face
(or nominal value)—the amount that will be paid.
• Most Long-term liabilities are reported on the BS at their
present value (the time-discounted value of the future cash
flows).
Short-term Liabilities
• Report at Face value: Accounts payable, Accrued
expenses, Unearned revenue, Taxes payable, Warranties
payable
• Non-interest bearing ST Notes Payable generally are
reported at maturity value less any unamortized interest
discount. i.e., BS shows either: Note payable $950 or
Note payable $1,000 less Unamortized discount $50.
• Interest-bearing ST Notes Payable generally are reported
at the maturity (face) value plus any accrued interest.
i.e., Note Payable $1,000 and Interest payable $50 on BS.
• Short-term debt which company has no intentions of
liquidating, but plans to continually refinance, should be
classified as long-term. Also, the current portion (the
amount that will be paid within one year) of any longterm debt should be classified on the BS as a current
liability.
Long-term Debts
• Since interest accounts for the difference between the
amount received and the amount paid back, the interest
rate is the basis for computing interest.
• On all long-term debt contracts there are two interest
rates: The stated rate and the effective rate, they may
not be the same…
• The stated rate is the interest rate on interest-bearing
debt that is used to calculate the amount of cash interest
payments that will be made to the lender.
• The effective rate is the compounded interest rate that
mathematically accounts for the total difference
between the amount borrowed and the amount repaid.
Figure 11-2
 Key Questions:
-Present Value? Issue value or Proceeds
-Future Value? Maturity value or Face value
-n= number of periods?
-r=effective or market interest rate?
-Bond or Note stated rate or face rate?
-Single payment or Ordinary annuity (multiple
payments)?
-Interest bearing or Noninterest bearing? What
is the interest payment? How often?
Draw a Timeline and fill in:
-Issue date
-When pay interest and amortize discount
or premium
-Maturity date
Debt Terminology
Basic Definitions and Different Contractual Forms
Some contracts, called interest-bearing obligations,
require periodic (annual or semiannual) cash payments
(called interest) that are determined as a percentage of
the face, principal, or maturity value, which must be
paid at the end of the contract period.
Non-interest-bearing obligations, on the other hand,
require no periodic payments, but only a single cash
payment at the end of the contract period.
These contractual forms may contain additional terms
that specify assets pledged as security or collateral in
case the required cash payments are not met (default),
as well as additional provisions (restrictive covenants).
BE11-2 Bond Terms
In October 1997 HP issued zero-coupon bonds with a face
of 1.8 billion, due in 2017, for proceeds of $968 million.
a. What is the life of these bonds?
b. What is the stated rate on these bonds?
c. Estimate the effective interest rate of these
bonds. (hint: $PV/$FV = approximate Table value)
d. How many bonds did HP issue?
e. What entry did HP make when the bonds were
issued?
Long-Term Liabilities
Non-Interest bearing
Bonds
E11-5, E11-8
E11-8 Present Value of a Non-interest-bearing Note
Purchased a building 1.1.2012 in exchange for a 3
year non-interest-bearing note with a face of
$693,000. Building appraisal is $550,125.
a. What amount should this building be
capitalized?
E11-8 Present Value of a Non-interest-bearing Note
Purchased a building 1.1.2012 in exchange for a 3
year non-interest-bearing note with a face of
$693,000. Building appraisal is $550,125.
b. Compute the present value of the note’s future
cash flows, using the following discount rates:
1. 6 percent
2. 8 percent
3. 10 percent
c. What is the effective rate of this note?
d. Explain how one could more quickly compute the
effective interest rate on the note.
E11-5 Discounted Non-interest-bearing Notes
Purchase equipment with a FMV of $11,348 in
exchange for a 5 year non-interest-bearing note
with a face of $20,000.
a. Compute the effective interest rate on the note
payable.
b. Prepare entry to record the purchase.
E11-5 Discounted Non-interest-bearing Notes
Purchase equipment with a FMV of $11,348 in
exchange for a 5 year non-interest-bearing note
with a face of $20,000.
c. How much interest expense should be recognized
in the first year?
d. What is the BS value of the note at the end of the
first year?
E11-5 Discounted Non-interest-bearing Notes
Purchase equipment with a FMV of $11,348 in
exchange for a 5 year non-interest-bearing note
with a face of $20,000.
e. Will the interest expense recognized in the
second year be greater, equal, or less than the
interest expense recognized in the first year? Why?
Sample Non-interest bearing Long-term Notes Payable
• Problem 1: On January 2, 2008, Pearson Company purchases a
section of land for its new plant site. Pearson issues a 5 year noninterest bearing note, and promises to pay $50,000 at the end of
the 5 year period. What is the cash equivalent price of the land, if
a 6 percent discount rate is assumed?
PV1 = 50,000 x ( 0.74726) = $37,363
[ i=6%, n=5]
Journal entry Jan. 2, 2008:
Dr. Land
Dr. Discount on N/P
Cr. Notes Payable
37,363
12,637
50,000
Sample Problem 1 Solution, continued
The Effective Interest Method:
Interest Expense =
Carrying value x Effective interest rate x Time period
(CV)
(Per year)
(Portion of year)
Where carrying value = face - discount.
For Example 1, CV= 50,000 - 12,637 = 37,363
Interest expense = 37,363 x 6% per year x 1year
= $2,242
Sample Problem 1 Solution, continued
Journal entry, December 31, 2008:
Interest expense
Discount on N/P
2,242
2,242
Carrying value on B/S at 12/31/2008:
Notes Payable
Discount on N/P
(Discount = $12,637 - 2,242 = $10,395)
$50,000
(10,395)
$39,605
Sample Problem 1 Solution, continued
Interest expense at Dec. 31, 2009:
39,605 x 6% x 1 = $2,376
Journal entry, December 31, 2009:
Interest expense
Discount on N/P
2,376
Carrying value on B/S at 12/31/2009:
Notes Payable
$50,000
Discount on N/P
(8,019)
2,376
$41,981
(Discount = 10,395 - 2,376)
Carrying value on 12/31/2012 (before retirement)?
$50,000
Accounting for Non-Interest Bearing Notes Payable Recap
Long-Term Liabilities
Interest bearing Bonds
E11-3, E11-4, E11-13, E11-14
Long-Term Liabilities
Notes, Bonds, and Leases
• Long-term liabilities are recorded at the present value of the
future cash flows.
• Two components determine the “time value” of money:
– interest (discount) rate
– number of periods of discounting
• Types of activities that require PV calculations:
– notes payable
– bonds payable and bond investments
– capital leases
Interest bearing: Bond Prices
E 11-3 Bond Terms
The stated and effective interest rates for several
notes and bonds follow:
Is Note or Bond issued a
Par, Premium, or
Discount?
Bond Stated Interest Rate
Effective or Market
Interest Rate
1.
10%
10%
2.
7%
8%
3.
9%
8%
4.
11.5%
9%
E11-4 Interest-bearing and Non-interest-bearing Note Payable Proceeds
Compute the proceeds from the following notes
payable. Interest payments are made annually.
PV
Principal
PV Interest
Payments
= Proceeds Stated Rate
Effective
Rate
Face Value
Life
0%
8%
$1,000
4 years
0%
6%
$5,000
6 years
4%
12%
$8,000
6 years
8%
8%
$3,000
7 years
10%
6%
$10,000
10 years
Key Questions:
>Present Value? Issue value or Proceeds
>Future Value? Maturity value or Face value
>n= number of periods?
>r=effective or market interest rate?
>Bond or Note stated rate or face rate?
>Single payment or Ordinary annuity (multiple
payments)?
>Interest bearing or Noninterest bearing? What is
the interest payment? How often?
Draw a Timeline
>Issue date
>Pay interest and amortize discount or
premium
>Maturity date
Bonds Payable Issued at a Discount
• If bonds are issued at a discount, the carrying value
will be below face value at the date of issue.
• The Discount on B/P account has a normal debit
balance and is a contra to B/P (similar to the
Discount on N/P).
• The Discount account is amortized with a credit.
Note that the difference between Cash Paid and
Interest Expense is still the amount of amortization.
• Interest expense for bonds issued at a discount will
be greater than cash paid.
• The amortization table will show the bonds
amortized up to face value.
E11-13 Bonds issued at a Discount
Issued 500 five-year bonds on 7.1.12. Interest
payments are due semiannually at 1.1 and 7.1 at an
interest rate of 6%. The effective rate is 8%. The
face value of each bond is $1,000.
a. 7.1.12 entry when bonds are issued?
b. 12.31.12 entry at yearend?
E11-13 Bonds issued at a Discount
Issued 500 five-year bonds on 7.1.12. Interest
payments are due semiannually at 1.1 and 7.1 at an
interest rate of 6%. The effective rate is 8%. The
face value of each bond is $1,000.
c. 12.31.12 Balance sheet value?
d. PV of bonds remaining cash flows as of
12.31.12?
Your Turn
E11-14 Bonds issued at a Premium
Issued 100 ten-year bonds on 7.1.12. Interest
payments are due semiannually (1.1 and 7.1) at
an annual rate of 8%. The effective rate is 6%.
The face of each bond is $1,000.
a. 7.1.12 entry to issue bonds?
b. 12.31.12 entry?
E11-14 Bonds issued at a Premium
Issued 100 ten-year bonds on 7.1.12. Interest
payments are due semiannually (1.1 and 7.1) at
an annual rate of 8%. The effective rate is 6%.
The face of each bond is $1,000.
c. 12.31.12 balance sheet value?
d. PV of remaining cash flows as of 12.31.12?
Your Turn
Investor’s Bond Yield= annual cash received/note price
“The yield on a 10 year note, which was
hovering at about 2.2% before the release of the
non-farm report [on Friday] plummeted to
about 2.07% in a matter of minutes. Yields,
which move in the opposite direction to prices,
continued to move lower, ending the day at
2.056%, compared with 2.173% late Thursday.”
Page B2, The Wall Street Journal, 4.7-8.2012
Sample Problem 2: Bonds Payable issued at Premium,
semiannual interest payments
• On July 1, 2007, Mustang Corporation issues $100,000
of its 5-year bonds which have an annual stated rate of
7%, and pay interest semiannually each June 30 and
December 31, starting December 31, 2007. The bonds
were issued to yield 6% annually.
• Calculate the issue price of the bond:
(1) What are the cash flows and factors?
Face value at maturity = $100,000
Stated Interest =
Face value x stated rate x time period
100,000 x 7% x (1/2) = $3,500
Number of periods = n = 5 years x 2 = 10
Discount rate = 6% / 2 = 3% per period
Sample Problem 2 - calculations
PV of interest annuity:
PVOA Table
PVOA = 3,500 (8.53020) = $29,856
i = 3%, n = 10
PV of face value:
PV1 Table
PV = 100,000 (0.74409)=$74,409
i=3%, n=10
Total issue price =
$104,265
Issued at a premium of $4,265 because the company
was offering an interest rate greater than the market
rate, and investors were willing to pay more for the
higher interest rate.
Sample Problem 2 - Amortization Schedule
To recognize interest expense using the effective interest
method, an amortization schedule must be constructed.
(This expands the text discussion.)
To calculate the columns (see next slide):
Cash interest paid = Face x Stated Rate x Time
= 100,000 x 7% x 1/2 year = $3,500
(this is the same amount every period)
Int. Expense = CV x Market Rate x Time
at 12/31/07 = 104,265 x 6% x 1/2 year = 3,128
at 6/30/08 = 103,893 x 6% x 1/2 year = 3,117
The difference between cash paid and interest expense is the
periodic amortization of premium.
Note that the carrying value is amortized down to face value
by maturity.
Sample Problem 2 - Amortization Schedule
Date
7/01/07
12/31/07
6/30/08
12/31/08
6/30/09
12/31/09
6/30/10
12/31/10
6/30/11
12/31/11
6/30/12
Cash
Paid
3,500
3,500
3,500
3,500
3,500
3,500
3,500
3,500
3,500
3,500
Interest
Expense
3,128
3,117
3,105
3,093
3,081
3,069
3,056
3,042
3,029
3,015
Premium
372
383
395
407
419
431
444
458
471
485
Carrying
Value
104,265
103,893
103,510
103,115
102,708
102,289
101,858
101,414
100,956
100,485
100,000
Sample Problem 2 - Journal Entries
JE at 7/1/07 to issue the bonds:
Cash
104,265
Premium on B/P
4,265
Bonds Payable
100,000
JE at 12/31/07 to pay interest:
Interest Expense
Premium on B/P
Cash
3,128
372
3,500
Note that the numbers for each interest payment come
from the lines on the amortization schedule.
Sample Bonds Issued at Face Value
Sample Bonds Issued at a Discount
Sample Bond Amortization Table
Recap: Cash Flows for Bonds Payable
Recap: Non-Interest Bearing Notes and Bonds
>Issue date
>Amortize discount
>Maturity date
Recap: Interest Bearing Notes and Bonds
>Issue date
>Pay interest and amortize discount or premium
>Maturity date
Long-Term Liabilities
Bond Retirement and
Leases
P11-10, P11-14
Bond Redemptions
When bonds are redeemed at the maturity date,
the issuing company simply pays cash to the
bondholders in the amount of the face value
and removes the bond payable from the
balance sheet.
To illustrate the redemption of a bond issuance
prior to maturity at a loss, assume that bonds
with a $100,000 face value and a $5,000
unamortized discount are redeemed for
$102,000. The $7,000 loss on redemption
would decrease net income
P11-10 Callable Bond Redemptions
12.31.11 account balances are:
Bond payable
$500,000
Premium on bond payable $ 12,600
The bonds have an annual stated rate of 8% and an effective rate
of 6%. Interest is paid 6.30 and 12.31.
a. Compute the gain or loss if the bonds are called for
104 on 1.1.2012?
P11-10 Callable Bond Redemptions
12.31.11 account balances are:
Bond payable
$500,000
Premium on bond payable $ 12,600
The bonds have an annual stated rate of 8% and an effective rate of 6%. Interest is paid
6.30 and 12.31.
b. Compute the gain or loss if the bonds are called for 108 on 1.1.2012?
c. Compute the gain or loss if the bonds are called for 110 on 7.1.2012?
Bond Conversions
The Jolly Corporation has $400,000 of 6 percent bonds outstanding. There is $20,000 of
unamortized discount remaining on these bonds after the July 1, 2011, semiannual interest
payment. The bonds are convertible at the rate of 20 shares of $5 par value common stock
for each $1,000 bond. On July 1, 2011, bondholders presented $300,000 of the bonds for
conversion.
1. Is there a gain or loss on conversion, and if so, how much is it?
2. How many shares of common stock are issued in exchange for the bonds?
3. In dollar amounts, how does this transaction affect the total liabilities and the total
stockholders' equity of the company? In your answer, show the effects on four accounts.
Contingencies
International Perspective
• The accounting disclosure requirements in non-U.S. countries
and IFRS are not as comprehensive as those in the United
States, partially because the information needs of the major
capital providers (i.e., banks) are satisfied in a relatively
straightforward way—through personal contact and direct
visits.
• A second way in which the heavy reliance on debt affects nonU.S. accounting systems is that the required disclosures and
regulations tend to be designed either to protect the creditor
or to help in the assessment of solvency.
Economic Consequences of Reporting
Long-Term Liabilities
• Improved credit ratings can lead to
lower borrowing costs
• Management has strong incentive to
manage the balance sheet by using
“off-balance-sheet financing” i.e.,
operating leases
Stockholders Equity
Stock and Treasury Stock Transactions
BE12-2, E12-1, E12-3, E12-5, E12-6,
E12-13, E12-14, P 12-10
Chapter 12: Shareholders’ Equity
How to Finance the Corporation?
• Borrow
– Notes, Bonds, Leases
– The debt holders are legally entitled to repayment of their
principal and interest claims
• Issue Equity
– Common and Preferred Stock
– The shareholders, as owners, have voting rights, limited
liability, and a residual interest in the corporate assets
• Retained Earnings
Debt versus Equity
Debt
Formal legal contract
Fixed maturity date
Fixed periodic payments
Security in case of default
No voice in management
Interest expense deductible
Equity
No legal contract
No fixed maturity date
Discretionary dividends
Residual asset interest
Voting rights - common
Dividends not deductible
Double taxation
Distinctions between Debt and Equity
Interested Party
Debt
Equity
Investors /
Creditors
Lower investment risk
Fixed cash receipts
Higher investment risk
Variable cash receipts
Management
Contractual future
cash payments
Dividends are
discretionary
Effects on credit
rating
Interest is tax
deductible
Effects of dilution/
takeover
Dividends are not
tax deductible
Accountants/
Auditors
Liabilities section
of the balance sheet
Income statement
effects from debt
Shareholders’ equity
of the balance sheet
No income statement
effects from equity
Preferred Stock vs Common Stock
Advantages
Preferred Stock
Common Stock
Preference over common in
liquidation
Voting Rights
Stated dividend
Rights to residual profits
(after preferred)
Preference over common in
dividend payout
Disadvantages
Subordinate to debt in liquidation
Last in liquidation
Stated dividend can be skipped
No guaranteed return
No voting rights (versus common)
Debt or Equity?
Components of both
Usually classified as equity
E12-3 Authorizing and Issuing Stock
Prepare entries for each event:
1. Authorized to issue: (a) 100,000 shares of $100 par value , 8%
preferred stock (b) 150,000 shares of no-par, $5 preferred stock;
and (c) 250,000 shares of $5 par value common stock.
2. Issued 10,000 shares of $5 par value common stock for $30 per
share.
3. Issued 25,000 shares of the $100 par value preferred stock for $150
per share.
4. Issued 50,000 shares of no-par preferred stock for $50 each.
Journal Entries-Sample Co.
For Sample Company, record the following
additional issues of common (CS) and preferred
stock (PS):
Issued 100 shares of PS at $102 per share:
Cash (100 x $102)
10,200
PS (100 x $100 par)
10,000
PIC - PS (plug)
200
Issued 500 shares of CS at $5 per share:
Cash (500 x $5)
2,500
CS (500 x $1 par)
500
PIC - CS (plug)
2,000
Treasury Stock
• Created when a company buys back shares of its own common
stock.
• Reasons for buyback?
• The debit balance account called “Treasury Stock” is reported in
shareholders’ equity as a contra account to SE.
– Note: Treasury Stock is not an asset.
• The stock remains issued, but is no longer outstanding.
– does not have voting rights
– cannot receive cash dividends
• May be reissued (to the market or to employees) or retired.
• No gains or losses are ever recognized from these equity
transactions.
E12-5 Treasury Stock
Company was incorporated on 4.1.12 and was authorized to issue
100,000 shares of $5 par value common stock and 10,000 shares of $8,
no-par preferred stock.
a. Record the following transactions:
1. Issued 25,000 shares of common stock in exchange for $500,000
cash.
2. Issued 5,000 shares of preferred stock in exchange for $60,000
cash.
3. Purchased 3,000 common shares for $15 per share and held them
in the treasury.
4. Sold 1,000 treasury shares for $18 per share.
5. Issued 1,000 treasury shares to executives who exercised stock
options for a reduced price of $5 per share.
E12-6 Treasury Stock
12.31.2011 Shareholders’ section
Common stock
$80,000
Additional paid-in capital
10,000
Retained earnings
60,000
Total shareholders’ equity
$150,000
During 2012, the company entered into the following transactions:
1. Purchased 1,000 shares of treasury stock for $60 per share.
2. As part of a compensation package, reissued half of the treasury shares to
executives who exercised stock options for $20 per share.
3. Reissued the remainder of the treasury stock on the open market for $66 per
share.
a. Provide the journal entries for each transaction, and prepare the shareholders’ equity
section of the balance sheet as of 12.31.2012. Company generated $20,000 in net
income and did not declare dividends during 2012.
b. What portion of the additional paid-in capital account is attributed to treasury stock
transactions?
TS - Example Problem
Tiger Corporation has 100,000 shares of $1 par value stock
authorized, issued and outstanding at January 1, 2007.
The stock had been issued at an average market price of
$5 per share, and there have been no treasury stock
transactions to this point.
• In February of 2007, Tiger Corp. repurchases 10,000
shares of its own stock at $7 per share.
• In July of 2007, Tiger Corp. reissues 2,000 shares of the
treasury stock for $8 per share.
• In December of 2007, Tiger Corp. reissues the
remaining 8,000 shares for $6 per share.
Prepare the journal entries for 2007 regarding the
treasury stock.
TS Example -Journal Entries
Feb: repurchase 10,000 sh. @ $7 = $70,000.
TS
70,000
70,000
Cash
July: reissue 2,000 sh @ $ 8 = $16,000
(cost = 2,000 @ $7 = 14,000)
Cash
16,000
TS
PIC - TS
14,000
2,000
TS Example -Journal Entries
Dec: reissue 8,000 sh. @ $ 6 = $48,000
(cost = 8,000 sh.@ $7 = 56,000)
Cash
48,000
PIC - TS (1) 2,000
RE (2)
6,000
TS
56,000
Now we need to debit one or more accounts to
compensate for the difference.
(1) Debit PIC -TS (but lower limit is to -0-).
(2) debit RE if necessary for any remaining balance
(this is only necessary when we are decreasing
equity).
Sample Co. Shareholders’ Equity
Common stock, $1 par value, 500,000 shares
authorized, 80,000 shares issued, and
75,000 shares outstanding
Common stock dividends distributable
Preferred stock, $100 par value, 1,000 shares
authorized, 100 shares issued and
outstanding
Paid in capital on common
$ 20,000
Paid in capital on preferred
3,000
Paid in capital on treasury stock
2,000
Retained earnings:
Unappropriated
$18,000
Appropriated
4,000
Less: Treasury stock, 5,000 shares (at cost)
Less: Other comprehensive income items
(unrealized loss on AFS securities)
Total Shareholders’ Equity
$ 80,000
2,000
10,000
25,000
22,000
(6,000)
(2,000)
$131,000
TS Example from Sample Co.
Look again at the information for Sample Co.
Note that Sample Company has 5,000 shares of TS at a
total cost of $6,000, or a cost of $1.20 per share. The
journal entry to record that purchase would have
been:
Treasury Stock
6,000
Cash
6,000
Note that Sample Company also has PIC - TS of $2,000
in the balance sheet. This must be from previous TS
transactions, where the TS was purchased, then
reissued for more than original cost. All that remains
of those transactions is the PIC -TS.
Retained Earnings
We will be expanding the basic retained earnings formula
in this chapter. Now the Statement of Retained Earnings
will include the following:
RE, beginning (unadjusted)
Add/Subtract: Prior period adjustment
RE, beginning (restated)
Add: net income
Less dividends:
Cash dividends-common
Cash dividends - preferred
Stock dividends
Property dividends
Less: Adjustment for TS transactions
Appropriation of RE
RE, ending
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
E12-9 Inferring Transactions from SHE
Preferred stock (no par)
Common stock ($1 par value)
2012
2011
$ 700
$ 400
1,000
900
40
10
20
---
130
150
Additional paid-in capital:
Common stock
Treasury stock
Less Treasury stock
Provide the journal entries for the following:
a.
Issuance of preferred stock during 2012.
b.
Issuance of common stock during 2012.
c.
Sale of treasury stock during 2012.
Example of Stock Split
IZM Company has 100,000 shares of $2 par
value stock authorized, 10,000 shares issued
and outstanding.
The SE section of the balance sheet shows:
– Common stock
$20,000
– Retained earnings 80,000
The market price of the outstanding shares is
$50 per share before the split is distributed.
Example of Stock Split
• If IZM declared a 2 for 1 stock split, the old
shares would be turned in and new shares would
be issued with the following description:
• Common stock, $1 par value, 200,000 shares
authorized, 20,000 shares issued and
outstanding.
• The total SE is still $100,000:
– Common stock
– Retained earnings
$20,000
80,000
• The market price per outstanding share would
now be $25 per share.
• Note: No journal entry is necessary.