Week 8, Liabilities

I. Bond Pricing Summary

a. $400,000 bond sold at par: i. Market Rate 8% = Coupon rate 8% ii. Issue price of bonds = face value = $400,000 b. $400,000 bonds sold at a disount i. Market rate 10%>Coupon rate 8% ii. Issue price of bonds = $369,113 < Face value of $400,000 c. $400,000 bond sold at a premium i. Market rate 6%< coupon rate 8% ii. Issue price of bons = $434,121 > face value of $400,000

I. Effective Cost of Debt

a. $400,000 bonds sold at par i. Issue price of bonds $400,000 ii. Cost of debt: interest payments of $16,000 * 10 = $160,000 b. $400,000 bons sold at a discount i. Issue price of bonds: $369,113 ii. Cost of debt: 1. Interest payments of $16,000 * 10 = $160,000 2. + Discount: $400,000 - $369,113 = $30,887 3. Total: $190,887 c. $400,000 bonds sold at a premium i. Issue price of bonds: $434,121 ii. Cost of Debt: 1. Interest payments of $16,000 * 10 = $160,000 2. - premium: $434,121 - $400,000 = (34,121) 3. Total = $125,879

I. Leases

a. A lease is a contract between an owner of an asset and a party desiring to use the asset i. Lessor: the owner of the asset ii. Lessee: party desiring to use the asset b. Common lease provisions: i. Lessee has unrestricted right to use the asset during the lease term ii. Lessee agrees to make periodic payments to the lessor and to maintain the asset iii. Lessor retains title to the leased asset

I. Warranty Example on balance sheet/Income statement: 3 year warranty; in first year of business, they estimate warranty liability for current period sales at $2,000 and spent $400 for warranty claims

a. Beg balance: Warranty Liability $0 b. Estimate of liability for year 1 sales: Warranty Liability +$2,000 , Retained Earnings -2,0000 , Warranty Expense +$2,000 , NI +$2,000 c. Actual Warranty Payments: Cash +$400, Warranty Liability - $400 d. Ending Warranty Balance: $1,600 : represents remaining warranty liability for existing sales (portion of liability that hasn't been taken advantage of by customers) e. For next period, would add expected warranty liability/expense for year two to ending warranty balance (as well as to retained earnings, expense, and net income) f. Won't know if projected warranty expense was correct until 3 year warranty period expires, at which time they would make an adjusting entry to expenses

I. Repurchase of Bonds

a. Bonds trade in secondary markets between bondholders b. Sometimes repurchased by issuers prio to maturity i. Through opern market purchase, or through a call provision specified in the bond agreement (indenture) 1. Call provision gives company the right to repurchase its bonds c. When repurchased, a gain or loss may result

I. Notes and Bonds Payable

a. Companies borrow large amounts of money with notes or bonds b. Receive the face or principal amount of loan c. Repay: i. Face amount 1. Principal amount of note or bond 2. Often repaid at maturity ii. Interest payments 1. Usually repaid semi-annually d. When a company issues a bond, it is borrowing money

Summary of Accounting for Long-Term Leases

a. Finance Lease - seems more like a purchase, requires you account for it different than Operating lease i. Classification Rule: meets at least one of the five lease classification criteria ii. Balance sheet: (1) recognize a right-of-use asset and test for impairment; and (2) recognize a lease liability iii. Income Statement: (1)Recognize amortization expense on the right of use asset (typically straight line over lease term or useful life); (2) recognize interest expense on the lease liability using the effective interest method iv. Cash flows: (1)interest is operating cash flow; (2) principal is financing b. Operating Lease i. Classification Rule: Meets none of the t 5 lease classification criteria ii. Balance Sheet: (1) Recognize a right of use asset and test for impairment; (2) Recognize a lease liability iii. Income Statement: Recognize lease expense on a straight line basis as a single line item iv. Cash Flows: Lease payment is operating cash flow

I. Ways company can raise cash

a. Issue shares of common stock i. Problem is you lose control/voting rights b. Borrow from bank (notes payable) i. Problem is you pay high interest rate c. Issue out bonds i. Bond is mechanism for company to raise cash ii. Market where interest rates are low, it is attractive to issue out bonds iii. Buyer side: people in retirement like bonds, safe investment, conservative cash flow iv. Seller side: companies don't have to borrow from bank and don't relinquish control

I. Accounting for Finance Lease

a. Lease equipment: Right of use Asset +$ , Lease liability +$ b. Record amortization of asset: Accumulated Amortization (asset) -$ , Retained Earnings-$, Expense NI... c. Record interest and cash payments; Cash Asset -$, Lease Liability -$ , retained Earnings -$ , Expense NI...

I. Accounting for Operating Lease (no amortization)

a. Lease equipment: Right of use Asset +$ , Lease liability +$ b. Record lease expense: Right of use asset -$ , Lease Liability -$ , Retained earnings -$, exp NI... c. Record cash payments: Cash -$, Lease Liability -$

I. Bonds

a. Long term debt instrument issued by borrower to a group of lenders i. Initially issued by firm ii. Subsequently traded among investors in bond market b. Represents a contract i. Face value: dollar amount printed on the instrument's face, to be repaid by the borrower at the maturity date ii. Coupon rate: percentage applied to the instrument's face value to determine periodic coupon payments (what drives payment for coupons) Date of maturity: date when the instrument is to be repaid in full

I. Lease Example: Phelps Swimming leases truck from Reyder Trucks by signing a 5 year lease with annual payment of $3,256 due at end of each year, based on 8% interest.

a. Map it out: 5 payments of $3,256 b. Asset and liability amounts are valued at the present value of the lease payments i. PV of lease payments=3.99271 * $3256 =$13,000 c. Payments can occur at the beginning or end of lease period and how much of payment is principal d. Amortization table: Point of this is to figure out how much interest belongs in each period i. Year ii. Bginning year lease liability: start with PV of lease pmts of $13,000 iii. Interest: interest rate of 8%* beginning year lease liability iv. Payment: $3,256 v. Principal repayment: total payment - interest vi. Ending year lease liability= beg yr lease liability - principal repayment e. Accounting (finance lease) i. Lease: Right of use asset +$13,000 , Lease Liability +$13,000 ii. Amortization of asset: Accumulated amortization -$2600, Retained earnings -$2,600 ; Income statement... 1. 13,000/5=2600 iii. Interes and cash pmt: Cash asset -$3,256 , Lease Liability - $2,216 , Retained Earnigns -$1,040 ; Income statement... f. Accounting if it were operating lease i. Lease: Right of use asset +$13,000 , Lease Liability +$13,000 ii. Record lease expense: Right of use asset -$2,216 , Lease Liability +1,040 , Retained Earnings -$3,256 ; income statement... iii. Record Cash payment: Cash - $3,256 , Lease liability - $3,256

I. Contingent Liabilities

a. Not all liabilities are certain; contingent on some outcome b. Criteria to be met before recognizing liabilities: (1) potential obligation must be probable, and (2) the amount must be reasonably estimable c. Recognition of contingent liability creates an accrued liability; means an increase to a liability and expense (decrease in retained earnings) d. Obligations that are reasonably possible (but not probable) are i. Disclosed in financial statement notes ii. No accrual iii. Possible : chance of future event happening is >remote and <probable; discuss possible in footnote 1. Remote: nothing gets mentioned e. 3 different categories: Probable (FSET), possible (footnote), remote (nothing) a. Examples: Warranty claims, restructuring programs, lawsuits

Amortization Table important summary

a. On discount, you issue bond and are paid $360k. Each month you pay coupon pmt of $16k. The Interest expense of $18kish is for your own internal accounting in order to eat away at discount to get back to face value of $400k b. Same concept of premium except eating away at premium to get to $400K III. When you issue bonds at discount, you pay the same amount in coupon but didn't get as much money coming in so you better have a good use for that money. I. When you issue at a premium, you get more money up front, but pay the same amount in coupon

I. Lease Accounting Classification Rule: any of the following qualify as finance lease

a. Ownership transfer: The lease transfers ownership of asset to the lessee by end of term b. Purchase option: lessee is reasonably expected to exercise c. Lease term length: the lease term is for the major part of the remaining economic life of asset d. PV of lease payments: PV equals or exceeds substantially fair value of asset e. Alternative use: asset is expected to have no alternative use to the lessor at end of term

I. Pricing of Bonds

a. Paid by borrower b. Two different cash flows associated with most bonds i. Periodic coupon payments during the bond's life (part of operating cash flows) 1. Usually semi-annual 2. Referred to as an annuity 3. Rate is printed on the bond certificate ii. Single payment of the face value of the bonds at maturity c. Bond prices are quoted as a percentage of the face value of the bond; thus a $1,000 bond with a quoted price of 97 sells at a price 97% of the face value, or $970 (market value is $970) d. The price of bond is the market value, which is determined by the present value of the cash flows i. Dollar amounts to be received (coupon payments and principal) ii. Length of time until the amounts are received iii. Market interest rate

I. Amortization table columns

a. Periods or Semi-annual periods; should correspond to number of payments b. Interest expense: corresponds to the market rate, that percentage of net bond value (divide by 2 for semiannual) c. Cash interest paid: corresponds to the coupon rate. Get this amount by doing FV * coupon rate d. Discount/premium amortization: Cash interest paid - interest expense e. Discount/premium balance: at start is difference between bond payable - face value, at each pament period it is last years premium/discount balance - amortization amount f. Bond payable, net: at first year is pv of bond, then it is last year bond payable + premium/discount balance

I. Lessor and Lessee's Perspective

a. Receives an acceptable return on investment i. Included as part of the lease payment ii. Credit standing of the lessee is considered in setting up the return b. Lessee i. Gains use of an asset Often at less equity investing than purchasing

I. Interest Expense Related to Bonds

a. Reported on the income statement b. Represents the effective cost of debt c. Cash interest paid (AKA coupon) + Amortization of discount = interest expense d. OR if bond is offered at a premium: Cash interest Paid - amortization of premium = interest expense

I. Note payable Example

a. Sign note payable: Cash + 400,000 , Note Payable +$400,000 b. June Interest Payment: Cash - $16,000 , Retained Earnings - $16,000 , Expense +$16,000 , NI _16,000 c. December Interest Payment: Cash - 16,000 , Retained Earnings - $16,000 , Interest Expense +$16,000, NI - $16,000 d. Ending Liabilities: $400,000

Two Interest rates that are crucial for pricing debt

a. The Coupon Rate i. The rate stated in the bond contract ii. Used to compute the amount of interest paid to bondholders iii. Also known as the contract or stated rate b. The Market Rate i. The rate that investors expect to earn on the loan ii. Used to price a bond issue iii. Also known as the yield or effective rate c. The reason Coupon and market rate aren't the same is because when company puts together bonds that they want to issue, they don't know what market rate is when they actually issue bonds. Bond contract created before bond is actually issued. It is created with the coupon rate, and issued with the market rate. Must issue bond at rate that market is willing to buy.

I. Does the Lessee have an asset on balance sheet?

a. Used to be no, but now it is yes in most cases b. Asset and liability on balance sheet

I. Long Term Liabilities

a. Usually part of most companies' capital structure b. Typically used to fund long term assets Examples: Notes payable, bonds, leases

I. Warranty Liabilities

a. What are warranties: commitments made by manufacturers to their customers to repair or replace defective products within a specified time period b. Expected cost of commitment should be estimated at the time of sale based on past experience (match up expected expense associated with warranty along with the sale) i. Estimated obligation recognized as a liability and an expense in the period of the sale ii. At the time the repair or replacement is made, the warranty liability is decreased. c. Ending Warranty Balance= Beginning Balance + Warranty Expense for Current yr sales - Warranty Claims

I. Valuing Bonds issued at a Discount

a. When issued at a discount: Market rate > Coupon rate b. Ex/ Investors wish to value a bond with a face amount of $400,000 , an 8% annual coupon rate, 10% market rate, interest payable semiannually, and a maturity of 5 years i. Step 1: calculated the coupon payment: 1. $400,000 x 8% x 6/12 = $16,0000 ii. Step 2: map out payments 1. Semiannually over 5 years means 10 total coupon payments a. C=$16,000 b. Each coupon reflects 8% return on $400,000 2. Face value = $400,000 paid out at end of five years after 10th coupon payment 3. LOGIC: you can buy this bond for $400,000 which pays 8%, but you could spend money elsewhere in market and get a 10% return, so you wouldn't buy bond 4. Can't change amounts in contract, so solution to get people to buy bond is to charge less than $400,000 for bond (discount) iii. Step 3: Calculate present value of cash flows to give buyer 10% return 1. Market Interest Rate per period: 10% annual rate / 2 pmts per year = 5% per period 2. PV of principal: $400,000 * .61391 = $245,564 (PV of single pmts for 10 periods at 5% per period (table A.2)) 3. PV of coupon pmts: $16,000 * 7.72173 = $123,548 4. Present value of cash flows = 123,548 + 245,564 = $369,112 5. The issuer will receive $369,112 from the investor iv. Step 4: Amortization table to figure out interest for transactions (not just coupon rate but also difference between $400,000 and $369,112 1. Interest expense 5%: calculated for each of semi-annual period as 5% of net payable bond a. Period 1: $369,113*.05= $18,465 i. Discount Amorization = 18,465 - 16,000 = $2,456 ii. Discount Balance: original discount ($30,887) - $2,456 = $28,431 iii. Bond Payable, Net = $369,113 - $2,456 = $371,569 1. Reason for this is that you've paid $16,000 coupon rate, but there was still an excess interest expense of $2,456 that was not covered in coupon payment, and this is added to what is owed. b. Period 2: $371,569 * .05=$18,578.... v. Step 5: Record Transactions (FSET) 1. Issuance at 1/1/20Y5: Cash + 369,113, Bond Payable: +$400,000, Discount on Bond Payable - 30,887, 2. Coupon pmt: Cash - 16,000 , Discount on Bonds payable: +$2,456 , Retained Earnings - 18,456 , Expense + 18,456 , NI - 18,456 a. Do this 10 times 3. Payoff at Dex 31, 20Y9: Cash - $400,000 , Bond Payable - $400,000

I. Valuing Bonds Issued at a Premium

a. When issued at a premium: Market rate < coupon rate b. Investors wish to value a bond with a face amount of $400,000, and 8% annual coupon rate, 6% market rate, coupon payable semiannually, and a maturity fo 5 years i. Step 1: calculate the coupon payment: 400,000*8%*6/12=$16,000 ii. Step 2: Map out the payments iii. Step 3: Calculate PV of cash flows 1. Market interest rate per period: 6% annual rate / 2 payments per year = 3% per period 2. PV of principal $400,000 * .74409=$297,636 a. PV of single payment for 10 periods at 3% per period 3. PV of interest payments $16,000 * 8.53020 = $136,483 a. PV of annuity for 10 periods at 3% per period 4. Present value of cash flows: 297,636+136,483= $434,119 a. This is amount issuer will receive from investor. c. Step 5: create amortization table to see what interest expense should be and how it should be amortized over 10 periods

I. Valuing Bonds Issued at Par

a. When issued at par (Face) value: market rate = coupon rate b. Investors wish to value a bond with a face amount of $400,000, an 8% annual coupon rate, coupon payable semiannually, and a maturity of 5 years i. Step 1: Calculate the coupon payment: $400,000 * 8% * 6/12 = $16,000 1. Only six month coupons are paid each period with semiannual interest payments ii. Step 2: map out payments 1. Semiannually over 5 years means 10 total coupon payments a. C=$16,000 b. Each coupon reflects 8% of $400,000 2. Face value = $400,000 paid out at end of five years after 10th coupon payment iii. Step 2 Alternative: Calculate the present value (PV) of the cash flows 1. Number of coupon payments = 10 periods 2. Interest rate per period: 8% annual rate + 2 payments per year = 4% per period 3. PV of principal $400,000*.6755642=$270,226 4. PV of coupon payments $16,000*8.1108958=$129,774 5. Present value of cash flows: PV of principal + PV of coupon pmts = $400,000 iv. Step 3: FSET Transactions 1. Issuance of bonds: Cash + $400,000 , Bonds Payable +$400,000 2. Coupon payments for each of the 5 years: Cash - $16,000 , Retained Earnings - $16,000 , Exp +$16,000 , NI -$16,000 Retirement/Payoff of bonds on Dec 31, 20Y9: Cash-$400,000 , Bonds Payable - $400,000