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Assignment Due Tues, 2/2 1. Go to WWW. FROSTBURG. EDU/DEPT/BUAD/RJOHNSON/PROFWEB 2. Navigate to the Assignment Due Tues, 2/2 1. Go to WWW. FROSTBURG. EDU/DEPT/BUAD/RJOHNSON/PROFWEB 2. Navigate to the 302 handouts page and download the following files: 302 Exam 1 PPT. ppt The file contains PPT Presentation slides on Ch 13 & 14 & Ex + Probs 3. Save the file to Disk-- Ex. A: 302 Exam 1 PPT. ppt Microsoft Explorer vs. Netscape Navigator 4. View the PPT slides for Ch 13 (Requires Powerpoint 97 or Viewer) 5. Print & Turn in just the 1 st page on Tuesday 6. Read Ch. 13 & compare coverage to slides

Chapter 13: Current Liabilities and Contingencies After studying this chapter you should be able Chapter 13: Current Liabilities and Contingencies After studying this chapter you should be able to: • Define current liabilities and describe how they are valued. • Identify the nature and types of current liabilities. • Explain the classification issues of short-term debt expected to be refinanced. • Identify types of employment related liabilities. • Identify the criteria used to account for and disclose contingencies. • Explain the accounting for different types of contingent liabilities. • Indicate how current liabilities and contingencies are presented analyzed.

Definition of a Liability • Definition of liability: A past event which gives rise Definition of a Liability • Definition of liability: A past event which gives rise to a present unavoidable obligation to transfer assets in the future. Notice how the definition is related to time. – More than pure debts of a firm for which you will receive a bill. – Can possess quasi-ownership characteristics, e. g. , convertible bonds payable. • Division of liabilities into current (short term) and noncurrent (long term) classifications. – This distinction is related to the operating cycle of a business. 3

Definition of a Liability • Current liabilities are those liabilities that are paid off Definition of a Liability • Current liabilities are those liabilities that are paid off or consume a current asset (CA) within one year or the operating cycle, if longer. – The concept of present value is not considered as the time period is considered very short. They are carried at maturity value. – Beware of the understatement of current liabilities (CL): » Working capital (or CA - CL) would be overstated if CL are understated. » Current ratio (or CA / CL) would be overstated as well. » You should follow conservatism. 4

Types of Current Liabilities • Accounts Payable (A/P) is a trade account. – This Types of Current Liabilities • Accounts Payable (A/P) is a trade account. – This represents what is owed to others for goods or services. – Short term, interest-free account (paid promptly). – This account should be reviewed in a purchases cut-off test to make sure the inventory is recorded in the proper period as well as the related liability. • Notes Payable (N/P) – Trade notes issued for inventory, supplies. – Short-term notes may arise from cash loans. 5

Types of Current Liabilities – Interest-bearing notes payable » N/P should be credited at Types of Current Liabilities – Interest-bearing notes payable » N/P should be credited at face value. » The interest paid on due dates, principal at maturity. » The notes are subject to accruals as any other account. Example of an interest bearing N/P (fair rate): Information: You issue a $6, 000, 10%, 6 month note to obtain a loan, on 1/1/x 1: Cash 6, 000 N/P 6, 000 6

Types of Current Liabilities 6/30 To repay: N/P 6, 000 Interest Expense 300 Cash Types of Current Liabilities 6/30 To repay: N/P 6, 000 Interest Expense 300 Cash 6, 300 – Non-interest bearing note may be issued. » This means there is no stated rate on the note. There is interest (bank fee) charged, however. » Note discounted (or sold to) bank. » Bank fee is initially stated as a percentage. 7

Types of Current Liabilities Example of a non-interest bearing discounted note: Information: You issue Types of Current Liabilities Example of a non-interest bearing discounted note: Information: You issue a $5, 000, zero-interest bearing, 6 month note to a bank. The bank's discount rate is 8%. – The maturity value of the note is the face value or $5, 000. – The bank’s fee is based on the maturity value x discount rate x time. This will yield how much cash interest you are charged. – The note is discounted. This means the effect of the interest is removed ahead of time. – The cash you receive is the maturity value less the bank fee. 8

Types of Current Liabilities – Bank fee = $5, 000 x. 08 x 6/12 Types of Current Liabilities – Bank fee = $5, 000 x. 08 x 6/12 = $200 – Cash proceeds = $5, 000 - 200 = $4, 800 Cash 4, 800 Discount N/P 200 N/P 5, 000 Payment: N/P 5, 000 Interest Expense Cash Discount N/P 200 5, 000 200 9

Types of Current Liabilities Note how the discounting (removal of interest at inception of Types of Current Liabilities Note how the discounting (removal of interest at inception of transaction) influences the rate paid. It raises the rate from the bank discount rate to the actual or effective rate actual annual interest rate = $400 = 8. 4% $4, 800 The prior non-interest bearing example could be contrasted to a present value calculation which reflects the removal of interest over time. Same example as before ($5, 000 N/P, no stated interest rate, 6 month duration and a prevailing interest rate for notes of this type of 8%. 10

Types of Current Liabilities – PV = $5, 000 (. 96154) = $4, 808 Types of Current Liabilities – PV = $5, 000 (. 96154) = $4, 808 where n = 1, i = 4% (semi) Cash 4, 808 Discount N/P actual i (semi) = $192 = 4% 192 N/P $4808 5, 000 Interest expense 192 Cash Discount N/P 5, 000 192 11

Types of Current Liabilities – What if the rate is unreasonable? Interest will be Types of Current Liabilities – What if the rate is unreasonable? Interest will be part cash and part amortized discount. Example: Suppose you have a $6, 000, 3 year note bearing 3% interest payable annually, when the prevailing rate of interest is 15%. Note was given in the purchase of equipment. The difference in rates is considered unreasonable. PV = $6, 000 (. 65752) = $3945 n = 3 and i = 15% plus PV-AO = $180 ( 2. 28323) = $411 n = 3 and i = 15% $4356 $180 =. 03 x $6, 000 (cash interest annuity) 12

Types of Current Liabilities To record issuance of note: Equipment 4, 356 Discount N/P Types of Current Liabilities To record issuance of note: Equipment 4, 356 Discount N/P 1, 644 N/P 6, 000 To amortize and record interest expense (at 15%): (First period) Interest expense 653 Cash 180 Discount N/P 473 13

Types of Current Liabilities Other Current Liabilities • Current maturities of long term debt. Types of Current Liabilities Other Current Liabilities • Current maturities of long term debt. – The amount due next fiscal year. Capital Stock – It is not a current liability if: » Paid from noncurrent assets. » It is to be restructured (topic of Advanced Accounting). » It is to be converted to capital stock. – Noncurrent portions will be considered current if they are callable and debtor is in violation of the agreement (other than grace period). 14

Types of Current Liabilities – Current liabilities expected to be refinanced: » Not a Types of Current Liabilities – Current liabilities expected to be refinanced: » Not a current liability if both the following criteria are met: • Intent to refinance is present. • Ability to refinance is present as demonstrated by an actual agreement (subsequent events). – Noncancelable agreement. 15

– At the balance sheet date the debtor not in violation of the agreement. – At the balance sheet date the debtor not in violation of the agreement. – The lender is capable of honoring the agreement. – The amount excluded cannot exceed amount of refinancing (conservative estimate). – Disclosure of obligations expected to be refinanced requires a description of the agreement, the terms of agreement, equity to be issued, if any. 16

Types of Current Liabilities • Dividends Payable – Cash dividends give rise to a Types of Current Liabilities • Dividends Payable – Cash dividends give rise to a current liability. – Arrearages on preferred stock are memo entry only. Disclosed in a footnote. – Stock dividends are a capitalization of retained earnings. » Transfer from retained earnings to the stock accounts an appropriate amount. » All accounts involved are owner equity accounts. No liability arises from stock dividends! 17

Types of Current Liabilities • Returnable Deposits – Usually contains both current and noncurrent Types of Current Liabilities • Returnable Deposits – Usually contains both current and noncurrent liability portions. – Liability on advance sale tickets, tokens, certificates, deferred revenues. » These are liabilities until the service is performed. Revenue or gain is recorded when service performed or time period lapses. – Collections for third parties-- A ”wash” transaction. » Sales taxes 18

Types of Current Liabilities Cash (A/R) XX Sales* XX Sales Tax Payable XX *If Types of Current Liabilities Cash (A/R) XX Sales* XX Sales Tax Payable XX *If the credit to sales is inclusive of sales tax you must separate the two. Sales = (Sales tax rate)(Sales ) + Sales. 19

Payroll • Payroll gives rise to a series of current liabilities – Withholdings – Payroll • Payroll gives rise to a series of current liabilities – Withholdings – Unemployment insurance, disability – Employee authorized deductions – Net payroll – Social Security Taxes (FICA plus Medicare) (page 656) » Employee and employer portions (matching). » FICA 6. 2% + Medicare 1. 45% = 7. 65% (will vary over time). » FICA first $65, 400; Medicare no ceiling (will vary over time). 20

Payroll – Unemployment Insurance: » FUI (Federal Unemployment Insurance) 6. 2% first $7, 000. Payroll – Unemployment Insurance: » FUI (Federal Unemployment Insurance) 6. 2% first $7, 000. » SUI (State Unemployment Insurance), first $7, 000, rate by individual company related to employment history. There is a maximum offset to the federal rate of 5. 4%. – Payroll entries: 21

Payroll Gross Payroll XX FICA withholdings (employee) (payable) XX Federal & State withholdings (payable) Payroll Gross Payroll XX FICA withholdings (employee) (payable) XX Federal & State withholdings (payable) XX Other withholdings, stock options, etc. (Pay) XX Net Payroll Payable Payroll Tax Expense XX XX FICA payable (employer) XX FUI payable XX SUI payable XX Disability payable XX 22

Types of Current Liabilities – These entries are followed by those to pay the Types of Current Liabilities – These entries are followed by those to pay the payroll and remit taxes to the government. – Bonus agreements are additional compensation which may give rise to an additional liability. (See chapter appendix. ) • Contingencies Following conservatism you are chiefly concerned with losses! It will depend on the particular scenario whether you journalize the potential loss, disclose the loss or do nothing – Has asset been impaired? Probable*, possible, remote – Can the loss be estimated? Yes*, No 23

Types of Current Liabilities – If both the conditions with a * are met Types of Current Liabilities – If both the conditions with a * are met then the contingency should be journalized. » If the contingency is probable and cannot be estimated it should be disclosed but not journalized. » If it is possible and can or cannot be estimated then it should be disclosed but not journalized. » If the contingency is remote then nothing is done. – Litigations, claims and assessments. » Accrual is rarely done. » Unasserted claims. If it is probable there is a claim, the outcome is fairly certain and can be estimated it should be accrued but is rarely done. Why not? 24

Types of Current Liabilities • Guarantee and Warranty Costs. – Cash (Tax) Method » Types of Current Liabilities • Guarantee and Warranty Costs. – Cash (Tax) Method » Pay as you go. Violates matching. – Accrual Methods: » Expense Warranty (best GAAP)--operating expense the period service performed » Sales Warranty. This defers some profit until the time when costs are incurred or the warranty expires » Please see pages 664 -665. – Different methods can be used on the return and on the books. 25

Types of Current Liabilities • Compensated absences (FASB #43) You should accrue if the: Types of Current Liabilities • Compensated absences (FASB #43) You should accrue if the: » Service has been rendered, payment is probable and can be reasonably estimated. » Vested or accumulated. • Vested--legal right to receive even if employee terminated. • Accumulated--legal right to receive unless employee terminated. » Sick pay is normally accrued if vested; vacation pay is normally accrued if it accumulates. 25 26

Types of Current Liabilities – A change in wage rate between time the accrual Types of Current Liabilities – A change in wage rate between time the accrual done and vacation/sick taken is treated as a change in accounting estimate. 27

Types of Current Liabilities • Pensions and Postretirement Health Care Benefits – Definition of Types of Current Liabilities • Pensions and Postretirement Health Care Benefits – Definition of liability had to be broadened to accommodate the changes in accounting for these areas. – Topic of Chapter 21. Complex topic, use of spreadsheets. – Pension expense has five basic sources (accounting for postretirement health care benefits is similar) 1. Current service component 2. Interest on the obligation 3. Asset return offset 28

Types of Current Liabilities 4. Amortization of prior service cost (“smoothing”) 5. Amortization of Types of Current Liabilities 4. Amortization of prior service cost (“smoothing”) 5. Amortization of actuarial and asset gains and losses (again “smoothing” through use of the corridor and averaged assets). – Expense is not always equal to the cash funding of plan. – Concept of off-B/S assets and liabilities. – Pension expense is tax deductible, health care is not. 29

Types of Current Liabilities • Property taxes – When should these payments be recorded? Types of Current Liabilities • Property taxes – When should these payments be recorded? – Against which accounting period should they be charged? – Review pages 653 -655. • Conditional Payments – These are estimated tax payments. – Amounts must be estimated as exact amounts are not known when partial payments made. 30

Types of Current Liabilities – Tax liabilities appear on the financial statements of corporations; Types of Current Liabilities – Tax liabilities appear on the financial statements of corporations; responsibility of individuals in sole proprietorships and partnerships. – If no differences exist in GAAP used on the return and financial statements then the final tax accrual is done. » Estimated payments made periodically--debit expense and credit cash. » To do the final entry first reverse tax expense off books--debit tax payable and credit tax expense. (You must do this so tax expense can be calculated on income before tax. ) Then do accrual: 31

Types of Current Liabilities » Debit tax expense and credit tax payable. Payables will Types of Current Liabilities » Debit tax expense and credit tax payable. Payables will net to the proper amount and expense will be correct. – More complex if principles on return and F/S are different. We will see Deferred Taxes in Chapter 20. • Premiums and Coupons The FASB did not specifically address these. – Follow matching. Toys in candy boxes, redemptions of UPC markers plus cash for a novelty item, etc. To buy: Premium inventory Cash XX XX 32

Types of Current Liabilities To sell good or service: Cash XX Sales XX Cash Types of Current Liabilities To sell good or service: Cash XX Sales XX Cash XX Premium Expense XX Premium inventory XX To record actual redemptions Premium Expense XX Provision for Premium (liability) XX To match remainder 33

Types of Current Liabilities Subsequent periods to honor offer: Provision for Premium XX Cash Types of Current Liabilities Subsequent periods to honor offer: Provision for Premium XX Cash XX Premium Inventory XX • Uninsured losses also known as self-insurance. – Actual losses only may be deducted; accrue current obligations. – In reality no insurance since risk of loss has not been assumed by independent third party. • Environmental liability. Please page 667. liability – Generally disclosed but not accrued. – If probable and you can estimate, accrue. 34

Intermediate Accounting, Ninth Edition Kieso and Weygandt Prepared by Catherine Katagiri, CPA The College Intermediate Accounting, Ninth Edition Kieso and Weygandt Prepared by Catherine Katagiri, CPA The College of Saint Rose Albany, New York John Wiley & Sons, Inc. 1

Chapter 14: Long-Term Liabilities After studying this chapter you should be able to: • Chapter 14: Long-Term Liabilities After studying this chapter you should be able to: • Describe the formal procedures associated with issuing long-term debt. • Identify various types of bond issues. • Describe the accounting valuation for bonds at date of issuance. • Apply the methods of bond discount and premium amortization. • Describe the accounting procedures for the extinguishment of debt. • Explain the accounting procedures for long-term notes payable. • Explain the reporting of off-balance sheet financing

Nature of a Long-Term Liabilities • Long-term liabilities: – Probable future sacrifices of economic Nature of a Long-Term Liabilities • Long-term liabilities: – Probable future sacrifices of economic benefits arising from present obligations that are not payable within a year or the operating cycle of a business, whichever is longer. – More or less permanent in some form (like stock financing). – Discrete maturity date. 3

Nature of a Long-Term Liabilities – Does not carry the right to select/participate in Nature of a Long-Term Liabilities – Does not carry the right to select/participate in management. – Tax deductible; interest a legal obligation. – Positive leverage possible. – Covenants and restrictions must be disclosed. 4

Bonds Payable Definitions • Bonds Payable is an agreement (indenture) to pay a series Bonds Payable Definitions • Bonds Payable is an agreement (indenture) to pay a series of cash interest payments and a final payment of principle. – Stated amount (principle or par). – Maturity date. – Periodic interest (stated rate determines cash interest). – Types of Bonds Payable: » Secured--backed by some form of collateral. » Unsecured--not backed by some form of collateral. » Term versus serial--term bonds all have a single maturity date, serial bonds have staggered maturity dates. 5

Bonds Payable Definitions » Convertible (holder)--convertible into another of the firm’s securities. Commodity-backed--redeemable in Bonds Payable Definitions » Convertible (holder)--convertible into another of the firm’s securities. Commodity-backed--redeemable in a measure of a commodity (wheat, oil, etc. ) » Deep discount--discounted at a high interest rate with interest paid at maturity (zero coupon bonds). » Registered--each time the bond is sold the security must be surrendered and a new one issued. » Bearer (coupon)--transfer of ownership accomplished by delivery of certificate. Bond Payable 5 6

Bonds Payable Definitions » Income bonds payable--no interest paid unless the firm is profitable. Bonds Payable Definitions » Income bonds payable--no interest paid unless the firm is profitable. » Revenue bonds payable--interest is paid from specific sources. » Callable bonds payable --gives the issuer the right to retrieve (call) the bonds prior to maturity. – Quality ratings--Moody’s, Standard & Poor’s 7

Valuation of Bonds Payable • Price set between buyer (holder) and seller (issuer) – Valuation of Bonds Payable • Price set between buyer (holder) and seller (issuer) – An interest-bearing bond normally involves an annuity (for the cash interest payments) and a single lump-sum payment (for the principal). – Concept of present value (time value of money) is important here! You need to know the “facts” of the situation: » Par (principal or face value) of bond payable. » Stated interest rate (SR)--determines cash interest. » Maturity date and interest periods. » Prevailing interest or rate of return required by the average investor (the market) for investments of this type. 8

Valuation of Bonds Payable Example of a B/P which will sell at the par, Valuation of Bonds Payable Example of a B/P which will sell at the par, i. e. , when the stated rate is equal to the market rate. – Information: On 1/1/x 1 offered and sold $80, 000, 5 year, semi-annual bonds with a stated rate of interest of 10% and a market (yield) rate of 10%. There is a meeting of the minds. Cash interest = $80, 000 x. 10 x 6/12 = $4, 000 PV-AO = $4, 000 (7. 722) = $ 30, 888 plus PV where n = 10 and i = 5% (MR) = $80, 000 (. 614) = $ 49, 120 $ 80, 000 (rounded) 9

Valuation of Bonds Payable Cash 80, 000 B/P No discount or 80, 000 premium Valuation of Bonds Payable Cash 80, 000 B/P No discount or 80, 000 premium arises Sale of B/P at a discount (below par) – Information: Same bond as before but sold to yield a market rate of 12%, semiannual; offered and sold on 1/1/x 1. PV-AO = $4, 000 (7. 360) = $29, 440 where n= 10, i = 6% plus PV = $80, 000 (. 558) = $44, 640 $74, 080 10

Valuation of Bonds Payable Journal entry: Cash 74, 080 Discount on B/P 5, 920 Valuation of Bonds Payable Journal entry: Cash 74, 080 Discount on B/P 5, 920 B/P 80, 000 Balance sheet presentation: B/P less Disc B/P, net $80, 000 5, 920 $74, 080 (book or carrying value) Note: Short term bonds--discount or premium is not separately reported. Not enough time to amortize it. 11

Valuation of Bonds Payable Sale of bonds at a premium (above par). – Arises Valuation of Bonds Payable Sale of bonds at a premium (above par). – Arises when the SR (cash interest you promise) is greater than what the market demands. Price of your bond is bid up until the cash interest divided by the amount given up for the bond equals the market rate of interest. – Do some calculations yourselves following our example but set the MR at 6% and keep the SR at 10% 12

Recording Bond Interest Expense – To record the issuance of a B/P at a Recording Bond Interest Expense – To record the issuance of a B/P at a premium: (create an adjunct rather than a contra account) Cash XX B/P, par XX Premium B/P XX • Long-term bonds--discount or premium must be amortized to properly reflect interest expense. –Effective interest method is GAAP. Yields a constant rate of interest on a fluctuating level of debt. You must report interest at the actual market or the effective yield you are paying, not some arbitrary stated rate. 13

Recording Bond Interest Expense – Straight-line method of amortizing the discount or premium. » Recording Bond Interest Expense – Straight-line method of amortizing the discount or premium. » Not GAAP if it yields results which are materially different from the effective interest method. » Yields a constant dollar amount of interest even though the debt level is changing. The implication is the rate is varying over the life of the debt (when in fact it is constant). – Interest expense = cash interest + discount amortization when the SR < MR. – Interest expense = cash interest - premium amortization when the SR > MR. 14

Recording Bond Interest Expense Our example when bond sold at a discount: Straight-line amortization: Recording Bond Interest Expense Our example when bond sold at a discount: Straight-line amortization: $5, 920 = $592 (divided by number of periods available) 10 Entry: (every six months) Interest Expense Discount B/P Cash 4, 592 4, 000 15

Recording Bond Interest Expense Effective Interest Method to amortize discount: 1 st period – Recording Bond Interest Expense Effective Interest Method to amortize discount: 1 st period – Cash interest = stated rate x par; $80, 000 x. 05 = $4, 000 – Interest expense = carrying value of debt x market rate = $74. 080 x. 06 = $4, 445 Entry: (first payment) Interest Expense Cash Discount B/P 4, 445 4, 000 445 15 16

Recording Bond Interest Expense 2 nd period: (Note: CV of debt has increased toward Recording Bond Interest Expense 2 nd period: (Note: CV of debt has increased toward par) Cash interest = $4, 000 Interest expense = ($74, 080+445)(. 06) = $4, 472 or = $74, 525 (. 06) = $4, 472 Interest Expense Cash Discount B/P 4, 472 4, 000 472 17

Recording Bond Interest Expense – Please see amortization tables on page 708 -709 --read! Recording Bond Interest Expense – Please see amortization tables on page 708 -709 --read! Note the characteristics of the table and its usefulness in drawing up the required journal entries. – Note in our example (discount situation): Cash interest = $4, 000 =. 05 (stated rate) $80, 000 but: $4, 472 = . 06 (market rate or effective yield) $74, 080 18

Bonds Issued Between Interest Dates • Bonds issued between interest dates: – Interest “runs” Bonds Issued Between Interest Dates • Bonds issued between interest dates: – Interest “runs” with the bond. – Bonds are subject to accruals. Example: Suppose in our prior example the $80, 000 B/P ( SR = 10%, MR = 12%, semiannual) is offered for sale on 1/1 and sold on 4/1. Interest dates are 6/30 & 12/31. – To issue (as before) present value of the cash flows = $74, 080 – Buyers also prepay three months worth of interest. $80, 000 x. 10 x 3/12 = $2, 000 19

Bonds Issued Between Interest Dates Entry: 4/1 Cash 76, 080 Disc B/P 5, 920 Bonds Issued Between Interest Dates Entry: 4/1 Cash 76, 080 Disc B/P 5, 920 Bonds Payable Interest Exp (or Pay) 80, 000 2, 000 –Interest payment is paid on 6/30 (3 months later): 20

Bonds Issued Between Interest Dates Interest Expense 4, 222 Cash 4, 000 Disc B/P Bonds Issued Between Interest Dates Interest Expense 4, 222 Cash 4, 000 Disc B/P 222 Discount amortized: Effective interest method $74, 080 x. 06 x 3/6 = $2, 222 (interest exp) - $2, 000 = $222 or straight-line: $5, 920 x 3 months = $312 57 months 21

Bonds Payable Concerns • Costs of Issuing Bonds – Deferred charges (not an offset Bonds Payable Concerns • Costs of Issuing Bonds – Deferred charges (not an offset to the proceeds). – Amortize over the life of the bonds. – Not expensed (APB # 21). • Treasury Bonds – Repurchase of your own bonds with intent to resell. – Contra bonds payable account. – Shown on the balance sheet at par value as a deduction from the bonds payable issued to disclose a net figure of bonds payable outstanding. 22

Bonds Payable Concerns • Extinguishment of Debt – At maturity (no premium or discount Bonds Payable Concerns • Extinguishment of Debt – At maturity (no premium or discount remaining). Bonds payable XX Cash, etc. XX – Early Payment FASB # 4 --Gain or Loss Extraordinary: Bonds payable, par XX Premium (if any) XX Loss (if any) XX Discount (if any) XX Gain (if any) XX Cash, etc. XX 23

Bonds Payable Concerns • In-substance defeasance--FASB #16 “as if” – A set aside of Bonds Payable Concerns • In-substance defeasance--FASB #16 “as if” – A set aside of assets for future use in repayment of the debt. The company still has the primary obligation to repay the debt. – Question: Can the company remove the debt and the assets from the balance sheet even though the debt has not been formally paid off? – Previous to 1996 the answer was “yes--it is called an insubstance defeasance”. – Please read page 711, footnote. FASB #125 no longer recognizes an in-substance defeasance. Liability must actually be retired prior to its removal from the balance sheet. 24

Long-Term Notes Payable • Long Term Notes Payable – In substance same as bonds. Long-Term Notes Payable • Long Term Notes Payable – In substance same as bonds. – Valuation: Present value of the future cash flows; market rate not as obvious! Example: Notes for cash: N/P $100, 000 for $80, 000 cash Cash 80, 000 Discount B/P 20, 000 N/P 100, 000 (impute i so PVCF = cash) 25

Notes Payable Note for cash and other rights. Example: You give a $10, 000 Notes Payable Note for cash and other rights. Example: You give a $10, 000 non-interesting bearing note payable for $10, 000 cash and your promise to offer discounts on future sales to the lender. Assume the present value of the cash flows is $8, 000. Entry: Cash 10, 000 Discount N/P 2, 000 Note Payable, face 10, 000 Deferred Revenues 2, 000 26

Notes Payable – Notes in non-cash transactions (building for note payable) – Interest rate Notes Payable – Notes in non-cash transactions (building for note payable) – Interest rate that is stated is presumed to be fair unless obviously unreasonable or wholly unrelated to the cash price. • Mortgage notes payable Long term secured note – Face value is equal to the present value of the future cash flows (no points). – Points = % of face value. They represent extra interest. – Divide between current and noncurrent portions. 27

Notes Payable • Mortgage Notes Payable: – Fixed and variable rates of interest. – Notes Payable • Mortgage Notes Payable: – Fixed and variable rates of interest. – SAM--shared appreciation mortgage. – Negative equity possible. • Short term obligations to be refinanced--Chapter 13 – Classified as current liabilities if » there is an ability to refinance. » management intents to refinance. 28

Off-Balance Sheet Financing • Financial Engineering--Please see page 719. – Debt swaps. – Off Off-Balance Sheet Financing • Financial Engineering--Please see page 719. – Debt swaps. – Off balance sheet financing may enhance a firm’s financial position because it reduces the presence of restrictive covenants, betters ratios, and enhances liquidity measures. For example, » R & D arrangements » Leases – Derivative financial instruments--value derived from the underlying asset or security. 29

Analysis of Long-Term Debt • Long-term creditors and stockholders are interested in a firm’s Analysis of Long-Term Debt • Long-term creditors and stockholders are interested in a firm’s long-term solvency. A financial ratio to help assess this solvency would be: Debt to total Assets = Total debt = % Total Assets The greater the percentage the greater the risk to the creditors. This must be compared to similar firms in the same industry to be judged acceptable or not. 30

Analysis of Long-Term Debt • Times interest earned is equal to: Times Interest Earned Analysis of Long-Term Debt • Times interest earned is equal to: Times Interest Earned = Income before income taxes and interest expense Interest expense – Times interest earned indicates the ability to pay interest on time. » It provides a measure of security to the debtholders. » Must be compared to similar firms by creditors and investors to determine if it is adequate. 31

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