Financial Accounting & Reporting

Review Chapter 9

Short-Term vs. Long-Term Liabilities

Current (or short-term) liabilities:

Obligations that are to be repaid or performed within one year. Generally shown in nominal terms, not present value terms. Examples: accounts payable, accrued expenses payable, taxes payable, unearned revenues, product warranty liabilities, the current portion of long-term debt, notes payable, and commercial paper.

Noncurrent (or long-term) liabilities:

Obligations that are to be repaid or performed after one year. Most are shown in present value terms (except e.g. deferred income taxes). Examples: bonds, leases, mortgages, pensions, and postretirement benefits.

Lucile Faurel Review Chapter 9

Current Liabilities Warranties

Sony sells $200,000 of a particular TV model. Estimated warranty cost is 3% of sales. Journal entry at the time of sale: Note: Estimated warranty expense = $200,000 * .03 = $6,000. Dr. Warranties Expense (I/S) 6,000 Cr. Liability for Warranties (B/S) 6,000

A customer brings a TV in for repair under the warranty. Repairs total $500, including parts and labor. Journal entry at the time of the repair: Dr. Liability for Warranties (B/S) 500 Cr. Cash (and/or AP, Wages Payable, etc.) (B/S) 500
3

Lucile Faurel Review Chapter 9

Noncurrent Liabilities Bonds

Bonds are formal certificates of debt that promise to pay: A specified amount of interest in cash annually or semi-annually. A specified principal at a specific maturity date.

Vocabulary:
Bonds are issued by companies (issuers) that wish to borrow money from the general public. Bonds are issued to multiple lenders / investors (bondholders). The face value (also called par value or maturity value) is the principal the company is required to pay at maturity. The coupon rate (also called nominal interest rate, contractual rate, stated rate) determines the amount of interest the company is required to pay every year. Bonds generally pay interest every 6 months (i.e. semi-annually).

Lucile Faurel Review Chapter 9

Valuing Bonds

Because bonds create cash flows in future periods, they are recorded at the present value of those future payments, discounted at the market interest rate in effect when the liability is created. When valuing bonds, the present value tables are used to determine the amount of proceeds that will be received (i.e. the price of the bonds).
The present value of $1 table (Table 9A-2, p.422) is used to determine the present value of the face amount (principal) of the bonds. The present value of an annuity of $1 (Table 9A-3, p.423) is used to determine the present value of the series of interest payments. The amounts are added together to determine the amount of proceeds and any resulting discount or premium.

Lucile Faurel Review Chapter 9

Present Value of $1, Table 9A-2, p.422.

Lucile Faurel Review Chapter 9

Present Value of Ordinary Annuity of $1, Table 9A-3, p.423.

Lucile Faurel Review Chapter 9

Proceeds on Bond Issuance

Bond: Face Amount: Term: Coupon Rate: Interest Payments: $100,000 3 years ($100,000 * .07)/2 7% $3,500 paid semi-annually

A. Market Interest Rate = 7% = Coupon Rate

Proceeds = $100,000. Bond sold at par.

B. Market Interest Rate = 8% > Coupon Rate

Proceeds = $100,000 * 0.7903 + $3,500 * 5.2421 = $97,377. Bond sold at a discount.
4%, 6 periods, Table 9A-2 4%, 6 periods, Table 9A-3

C. Market Interest Rate = 6% < Coupon Rate

Proceeds = $100,000 * 0.8375 + $3,500 * 5.4172 = $102,710. Bond sold at a premium.
3%, 6 periods, Table 9A-2
Lucile Faurel Review Chapter 9

3%, 6 periods, Table 9A-3

8

Par, Discount & Premium

If the market rate is EQUAL to the coupon rate, the bond will sell at PAR. If the market rate is ABOVE the coupon rate, the bond will sell at a DISCOUNT. If the market rate is BELOW the coupon rate, the bond will sell at a PREMIUM.

Lucile Faurel Review Chapter 9

Coupon Rate vs. Market Rate

The coupon (interest) rate is:

The rate of interest stated on the bond. The interest to be paid in cash every year by the issuing company. Used to calculate the amount of interest payments (paid in cash).

The market (interest) rate (or effective interest rate, yield to maturity) is:
The rate available on investments in similar bonds at a moment in time. Used in the present value calculations when determining the

proceeds on issuance.
Used to calculate the amount of interest expense to recognize. Changes in the market rate after the bonds are issued do NOT affect the interest expense recognized.
Lucile Faurel Review Chapter 9 10

Effective Interest Amortization

How do we decrease the bond discount or bond premium?

Effective interest amortization The discount or premium is amortized over the life of the debt (but not using a straight-line amortization). The interest expense is equal to the market interest rate (at the time of issuance) multiplied by the amount of debt outstanding at the beginning of the given period. The difference between the interest expense and the cash paid (for interest payments) represents the amortization of the discount or premium.

Lucile Faurel Review Chapter 9

11

Coupon rate = 7%, Market Rate = 8%, FV = $100,000, Proceeds = $97,377 (see slide 4, B).
Period Bonds Payable, Beg. (a) 97,377 97,772 98,183 98,610 99,055 99,517 Interest Expense (4%) (b=a*4%) 3,895 3,911 3,927 3,944 3,962 3,983 Cash Payment (c) 3,500 3,500 3,500 3,500 3,500 3,500 Amortization of Discount (d=b-c) 395 411 427 444 462 483 Bonds Payable, End (e=a+d) 97,772 98,183 98,610 99,055 99,517 100,000

Discount Amortization

1 2 3 4 5 6

Journal entry upon bond issuance: Dr. Cash 97,377 Cr. Bonds Payable 97,377 Journal entry for interest expense, end of Period 1 (6 months after issuance): Dr. Interest Expense 3,895 Cr. Cash (or Interest Payable) 3,500 Cr. Bonds Payable 395 Journal entry at maturity (end of Period 6): Dr. Bonds Payable 100,000 Cr. Cash 100,000 Lucile Faurel Review Chapter 9

12

Coupon rate = 7%, Market Rate = 6%, FV = $100,000, Proceeds = $102,710 (see slide 4, C).
Period Bonds Payable, Beg. (a) 102,710 102,291 101,860 101,416 100,958 100,487 Interest Expense (3%) (b=a*3%) 3,081 3,069 3,056 3,042 3,029 3,013 Cash Payment (c) 3,500 3,500 3,500 3,500 3,500 3,500 Amortization of Premium (d=b-c) -419 -431 -444 -458 -471 -487 Bonds Payable, End (e=a+d) 102,291 101,860 101,416 100,958 100,487 100,000

Premium Amortization

1 2 3 4 5 6

Journal entry upon bond issuance: Dr. Cash 102,710 Cr. Bonds Payable 102,710 Journal entry for interest expense, end of Period 4 (2 years after issuance): Dr. Interest Expense 3,042 Dr. Bonds Payable 458 Cr. Cash (or Interest Payable) 3,500 Journal entry at maturity (end of Period 6): Dr. Bonds Payable 100,000 Cr. Cash 100,000 Lucile Faurel Review Chapter 9

13

Coupon rate = 7%, Market Rate = 7%, FV = $100,000, Proceeds = $100,000 (see slide 4, A).
Period Bonds Payable, Beg. (a) 100,000 100,000 100,000 100,000 100,000 100,000 Interest Expense (3.5%) (b=a*3.5%) 3,500 3,500 3,500 3,500 3,500 3,500 Cash Payment (c) 3,500 3,500 3,500 3,500 3,500 3,500 Amortization of Discount / Premium (d=b-c) Bonds Payable, End (e=a+d) 100,000 100,000 100,000 100,000 100,000 100,000

Bond Issued at Par

1 2 3 4 5 6

Journal entry upon bond issuance: Dr. Cash 100,000 Cr. Bonds Payable 100,000 Journal entry for interest expense at the end of each period: Dr. Interest Expense 3,500 Cr. Cash (or Interest Payable) 3,500 Journal entry at maturity (end of Period 6): Dr. Bonds Payable 100,000 Cr. Cash 100,000
Lucile Faurel Review Chapter 9 14

Early Extinguishment of Bonds

Early extinguishments of debt usually result in a gain or loss. Gain (loss) on early extinguishment = Book value of debt price paid for debt (i.e. market value).
Book value of bond = face value unamortized discount or premium = balance of Bonds Payable account at the time of the early extinguishment.

Since 2002, gains and losses from early extinguishment of debt are usually classified as other income on the income statement.
Special item above the line, i.e. not included in operating income. Prior to 2002, such gains and losses were reported as Extraordinary Items, i.e. below the line.

Lucile Faurel Review Chapter 9

15

CASELLA WASTE SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands)
Revenues Operating expenses: Cost of operations General and administration Depreciation and amortization Impairment charge Restructuring charge Operating income Other expense/(income), net: Interest income Interest expense Income from equity method investments Loss on debt extinguishment Minority interest Other expense/(income) Other expense, net Income from continuing operations
Lucile Faurel Review Chapter 9

Fiscal Year Ended April 30, 2002 2003 2004 $ 421,235 $ 420,863 $ 439,686 276,693 54,456 50,712 (438) 381,423 39,812 (904) 31,451 (1,899) (154) (4,480) 24,014 15,798 278,347 55,772 47,930 4,864 386,913 33,950 (318) 26,572 (2,073) 3,649 (152) (1,599) 26,079 7,871 287,309 58,198 59,673 1,663 406,843 32,843 (251) 25,648 (2,261) 5,948 29,084 3,759
16

Early Extinguishment of Bonds

Journal Entry

Consider the discount bond examined in slide 8. The company decides to repurchase this bond on the first day of Year 3. At the end of Year 2 (i.e. Period 4), the book value is $99,055. Assume the company repurchases the bond for $90,000:
Gain (Loss) = $99,055 $90,000 = $9,055 of GAIN. Dr. Bonds Payable 99,055 Cr. Cash Cr. Gain on Early Extinguishment Gain (Loss) = $99,055 $110,000 = $(10,945) of LOSS. Dr. Bonds Payable Dr. Loss on Early Extinguishment Cr. Cash 99,055 10,945 110,000
17

90,000 9,055

Now, assume the company repurchases the bond for $110,000:

Lucile Faurel Review Chapter 9

Zero Coupon Bonds

Zero coupon bonds (also called noninterest-bearing bonds):

Pay no interest (i.e. the coupon rate is 0%) during their life and thus are issued at very deep discounts.

Example:
Consider a 4-year zero coupon bond with a face value of $1,000. The market rate at the time of issue is 10% (compounded semi-annually). Journal entry to record the issuance:
Proceeds = 1,000 * 0.6768 = $677. Journal entry:
5%, 8 periods, Table 9A-2

Dr. Cash Cr. Bonds Payable

Lucile Faurel Review Chapter 9

677 677
18

Zero Coupon Bonds

Example (contd):
Amortization schedule:
Period Bonds Payable, Beg. (a) 677 711 747 784 823 864 907 952 Interest Expense (5%) (b=a*5%) 34 36 37 39 41 43 45 48 Cash Payment (c) Amortization of Discount (d=b-c) 34 36 37 39 41 43 45 48 Bonds Payable, End (e=a+d) 711 747 784 823 864 907 952 1,000

1 2 3 4 5 6 7 8

Lucile Faurel Review Chapter 9

19

Zero Coupon Bonds

Example (contd):
Journal entries to record accrued interest:
At end of period 1: Dr. Interest Expense Cr. Bonds Payable At end of period 2: Dr. Interest Expense Cr. Bonds Payable At end of period 3: Dr. Interest Expense Cr. Bonds Payable At end of period 4: Dr. Interest Expense Cr. Bonds Payable
677 * .05

34 34
(677+34) * .05

At end of period 5: Dr. Interest Expense Cr. Bonds Payable At end of period 6: Dr. Interest Expense Cr. Bonds Payable At end of period 7: Dr. Interest Expense Cr. Bonds Payable At end of period 8: Dr. Interest Expense Cr. Bonds Payable

41 41

36 36

43 43

37 37

45 45

39 39

48 48
20

Lucile Faurel Review Chapter 9

10