Module 8: Liabilities

What is a liability?
– “Probable future sacrifice of economic benefits
arising from present obligations of a particular
entity to transfer assets or provide services to
other entities in the future as a result of past
transactions or events.”
– Future sacrifice of economic benefits.
– Present obligations.
– Past transactions or events.
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Current Liabilities

Classification
– expected to require the use of current assets (or
the creation of other current liabilities) to settle the
obligation.

Valuing current liabilities on the balance sheet
– Ignore present value
– Report at face value

Reporting current liabilities
– Primary problem is ensuring that all existing
current liabilities are reported on the balance
sheet.
2
Current Operating Liabilities
1. Accounts payable - for purchase of goods and
services (usually no interest).
A/P Turnover = COGS/Avg. Acct. Pay
A/P Days Out. =Acct. Pay./Avg. Daily COGS
2. Accrued liabilities - short-term payables usually
settled with cash in the near future. Ex: Wages,
Interest, Income Tax, Utilities, Vacation Pay,
Bonuses, Property Taxes.
3. Unearned revenues - usually settled with delivery
of goods and services.
4. Estimated accruals - amounts not known at the
end of the period and must be estimated. Ex:
Warranties.
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Warranties
Companies generate sales revenue when they sell
products; offering warranties is part of the cost of
selling the product; the amount of the future warranty
costs is not known, but may be estimated.
– Record estimated expense and liability when products
are sold (matching concept):
Warranty Expense
xx
Estimated Warranty Liability
xx
– As costs are incurred (usually in subsequent periods),
charge expenditure to warranty liability:
Estimated Warranty Liability
xx
Cash, etc.
xx
Note: warranties, like other estimates, may be subject to
manipulation.
4
Lawsuits
What about lawsuits where the company is the
defendant? Should we accrue for the possible
future liability?
Only if the settlement is “probable” and “reasonably
estimable”.
Since the criteria are vague, and legal staff can
usually find sufficient evidence to indicate some
level of probability that the defendant will prevail,
estimated liabilities for lawsuits are rarely
recorded.
However, most lawsuits meet the minimum
requirement of “reasonably possible” and must
be disclosed in the notes to the financials; these
disclosures inform investors as to the potential
exposure. Most companies have a section for
“Contingencies” in their footnotes.
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Current Non-Operating Liabilities
Short-Term Interest-Bearing Debt borrowing from bank is a financing activity,
and not part of operations.
 Current Portion of Long-Term Debt - the
portion of long-term liabilities, like bonds and
mortgages, that will come due within the
next 12 months (as of the financial statement
date), will require the use of current assets
(specifically cash) to settle the liabilities;
these liabilities must be classified as current
liabilities.

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Long-Term Liabilities: Bonds Payable
Long-term liabilities are initially recorded at
the present value of the future cash flows.
 The subject of calculation of present value
is covered in Appendix 8A, and present
value tables are included in Appendix A at
the back of the book. These tables will be
supplied with Exam 2 if you choose to use
them.

7
Present Value Concepts
Appendix 8A (pages 25-28)
The value of a dollar today will decrease
over time. Why?
 Two components determine the “time
value” of money:

– interest (discount) rate
– number of periods of discounting

For financial reporting, we are
concerned primarily with present value
concepts.
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Present Value Concepts
To record activities in the general ledger
dealing with future cash flows, we should
calculate the present value of the future
cash flows using present value formulas or
techniques.
 Types of activities that require PV
calculations:

– long-term notes payable
– bonds payable and bond investments
– capital leases (Module 10)
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Types of Present Value Calculations

PV of a single sum (PV1): discounting a future
value of a single amount that is to be paid in the
future (ex: face value of bonds payable).
 PV of an ordinary annuity (PVOA): discounting
a set of payments, equal in amount over equal
periods of time, where the first payment is made
at the end of each period (ex: interest on bonds
payable).
 PV of an annuity due (PVAD): discounting a set
of payments, equal in amount over equal periods
of time, where the first payment is made at the
beginning of each period (ex: lease payments) more on this in Module 10.
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Present Value of a Single Sum
All present value calculations presume a
discount rate (i) and a number of periods of
discounting (n).There are 3 different ways you
can calculate the PV1:
n
1. Formula: PV1 = FV1 [1/(1+i) ]
2. Tables: see page A2, Table 1
PV1 Table
PV1 = FV1(
)
i, n
3.Calculator (if you have time value functions).
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Long-term Notes Payable


Usually issued to financial institutions.
May be interest bearing or non-interest bearing
(we will look at non-interest bearing).
 May be serial notes (periodic payments) or term
notes (balloon payments). We will look at balloon
payments here.
 Note: zero coupon bonds are similar in treatment
to non-interest bearing notes.
 Illustration 1: On January, 2, 2005, Pearson
Company purchases a section of land for its new
plant site. Pearson issues a 5 year non-interest
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?
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Illustration1 Solution
See page A2, Table 1
PV1 Table
PV1 = FV1(
)
i, n
PV1 Table
PV1 = 50,000 ( 0.74726) = $37,363
i=6%, n=5
Journal entry Jan. 2, 2005:
Land
37,363
Discount on N/P
12,637
Notes Payable
50,000
13
Illustration1 Solution, continued
What amount would be recognized for interest
expense at December 31, 2005?
In this chapter we will use the effective interest
method to calculate interest expense. The
formula for interest is:
Interest Expense =
Carrying value x interest rate x time period
(CV)
(per year)
(portion of yr.)
Where carrying value = face - discount.
For Example 1, CV at Dec. 31 before amortization?
CV = 50,000 - 12,637 = 37,363
Int. expense = 37,363 x .06 per yr. x 1yr. = 2,242
14
Illustration1 Solution, continued
Journal entry, December 31, 2005:
Interest expense
2,242
Discount on N/P
2,242
Carrying value on B/S at 12/31/2005?
Notes Payable
Discount on N/P
$50,000
(10,395)
$39,605
(Discount = 12,637 - 2,242 = 10,395)
15
Illustration 1 Solution, continued
Interest expense at Dec. 31, 2006:
39,605 x .06 x 1 = $2,376
Journal entry, December 31, 2006:
Interest expense
2,376
Discount on N/P
2,376
Carrying value on B/S at 12/31/2006?
Notes Payable
$50,000
Discount on N/P
(8,019) $41,981
(Disc.=10,395-2,376)
Carrying value on 12/31/2009 (before
retirement)? $50,000
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2. Present Value of an Ordinary Annuity (PVOA)
An annuity is defined as equal payments over equal
periods of time. An ordinary annuity assumes that
each payment occurs at the end of each period.
PVOA calculations presume a discount rate (i), where
(A) = the amount of each annuity, and (n) = the
number of annuities (or rents), which is the same as
the number of periods of discounting. There are 3
different ways you can calculate PVOA:
n
1. Formula: PVOA = A [1-(1/(1+i) )] / i
2. Tables: see page A-2, Table 2
PVOA Table
PVOA = A(
)
i, n
3.Calculator (if you have time value functions).
17
Bonds Payable




Bonds payable are issued by a company
(usually to the marketplace) to generate cash
flow.
The bonds represent a promise by the
company to pay a stated interest each period
(yearly, semiannually, quarterly), and pay the
face amount of the bond at maturity.
The marketplace values bonds by
discounting the cash flows using the market
rate of interest. This is also called the yield
rate, discount rate, or effective rate.
There are two types of cash flows with
bonds: PVOA and PV1.
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Illustration 2: Bonds Payable

On July 1, 2005, 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, 2005. The bonds were
issued to yield 6% annually.
 Calculate the issue price of the bond:
What are the cash flows and factors?
(1) Face value at maturity = $100,000
(2) Stated Interest =
Face value x stated rate x time period
100,000 x .07 x 1/2 = $3,500
Number of periods = n = 5 yrs x 2 = 10
Discount rate = 6% / 2 = 3% per period
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Illustration 2 - Solution
PV of interest annuity:
PVOA Table
PVOA = A(
PVOA Table
) = 3,500 (8.53020) = $29,856
i, n
i = 3%, n = 10
PV of face value:
PV1 Table
PV =FV1(
PV1 Table
) = 100,000(0.74409)=$74,409
i, n
Total issue price =
i=3%, n=10
$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.
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Illustration 2 - Amortization Schedule
To recognize interest expense using the effective
interest method, an amortization schedule must be
constructed.
To calculate the columns (see next slide):
Cash paid = Face x Stated Rate x Time
= 100,000 x .07 x 1/2 year = $3,500
(this is the same amount every period)
Int. Expense =
CV x Market Rate x Time
at 12/31/05 = 104,265 x .06 x 1/2 year = 3,128
at 6/30/06 = 103,893 x .06 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.
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Illustration 2 - Amortization Schedule
Date
7/01/05
12/31/05
6/30/06
12/31/06
6/30/07
12/31/07
6/30/08
12/31/08
6/30/09
12/31/09
6/30/10
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
Carrying
Difference Value
104,265
372
103,893
383
103,510
395
103,115
407
102,708
419
102,289
431
101,858
444
101,414
458
100,956
471
100,485
485
100,000
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Illustration 2 - Journal Entries
JE at 7/1/05 to issue the bonds:
Cash
104,265
Premium on B/P
4,265
Bonds Payable
100,000
JE at 12/31/05 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.
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Bonds Payable 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.
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Illustration 3: Bonds Payable (Discount)

On January 1, 2006, Corvette Corporation
issues $100,000 of its 5 year bonds which have
an annual stated rate of 5%, and pay interest
annually each December 31, starting December
31, 2006. The bonds were issued to yield 6%
annually.
 Calculate the issue price of the bond:
What are the cash flows and factors?
(1) Face value at maturity = $100,000
(2) Stated Interest =
Face value x stated rate x time period
100,000 x .05 per yr x 1 yr. = $5,000
Number of periods = n = 5 yrs
Discount rate = 6% per year
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Illustration 3 : Present Value Calculations
PV of interest annuity:
PVOA Table
PVOA Table
) = 5,000 (4.21236) = $21,062
PVOA=A(
i, n
i = 6%, n=5
PV of face value:
PV1 Table
PV =FV1(
PV1 Table
) = 100,000(0.74726)=$74,726
i, n
Total issue price =
I = 6%, n=5
$95,788
Issued at a discount of $4,212 because the
company was offering an interest rate less than
the market rate, and investors were not willing to
pay as much for the lower interest rate.
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Illustration 3 : Journal Entry at Issue
JE at 1/1/06 to issue the bonds:
Cash
Discount on B/P
Bonds Payable
95,788
4,212
100,000
Discount on Bonds Payable is located in the
liability section of the balance sheet, as a
contra, and offsets Bonds Payable.
On the balance sheet at 1/1/06:
Liabilities
Bonds Payable
100,000
Discount on B/P
(4,212) 95,788
(the carrying value is 95,788)
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Illustration 3 : Journal Entry to Pay Interest
JE at 12/31/06 to pay interest:
Calculations first:
Cash paid=Face x stated rate x time =
= 100,000 x .05 x 1 yr. = $5,000
Interest expense = CV x market rate x time =
= 95,788 x .06 x 1 yr = $5,747 (rounded)
Amortization of discount = difference (plug)
= 5,747 – 5,000 = 747 (credit)
Now journal entry:
Interest Expense
Discount on B/P
Cash
5,747
747
5,000
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Early Retirement of Bonds



Bonds are retired when the company pays
the investors the amount owed.
If bonds are held to maturity, the amount on
the books is face value and the amount paid
is face value.
If bonds are retired before maturity, the
amount on the books is the carrying value,
and the amount paid is the market value at
the point of retirement. Because these two
amounts are seldom the same, a gain or loss
must be recognized.
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Retirement of Bonds

The gain or loss is the difference between
carrying value and cash paid.
– If cash paid is greater than CV, recognize
loss (paid more than book liability).
– If cash paid is less than CV, recognize gain
(paid less than book liability).
 The gain or loss is recognized as part of
Income from Continuing Operations (Other
Revenues and Gains or Other Expenses and
Losses).
 Note that the gain or loss does not represent
an economic event; it is simply an adjustment
to book value at the time of retirement to
reflect the market value of the debt.
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