A307 Exam 3 (Part 1)

Accounting treatment for a contingent liability depends on :

- Likelihood of having to pay - Ability to estimate

Three options for contingent liabilities:

- Recognize (on BS as an expense on IS) - Disclose (only) (just put the word contingencies on BS, no amount or detail) - Do nothing

What you need to PV:

1. # periods (n) 2. Interest rate (discount rate) per period (i) 3. Amount (PV or FV) 4. Type of cash flows (single sum or ordinary annuity)

Two main sources of financing for a company's economic resources (assets):

1. Liabilities/debt (funds from creditors) 2. Equity (funds from the company's owners; contributed capital + RE)

Probable (>_____%) Reasonably possibly (_____-_____%) Remote (<_____50%)

75; 50-75; 50

Annuity or single sum: $50,000 in 6 months and $50,000 in 1 year with an annual rate of 3%

Annuity (receive same amount at regularly scheduled intervals)

Why do bond prices go down when interest rates go up?

Bond payments are fixed but if our discount rate changes, our PV change; if our discount rate increases and cash payments stay the same, PV goes down

_____ are a type of debt (a debt security) that consists of a principal component and an interest component

Bonds

This is the bond liability reported on the BS at a given point in time:

Carrying value

_____ interest: where we are heading now. Interest calculated on principal + accumulating interest

Compounding

What are these examples of: Pending lawsuits, warranties and product recalls, data breaches, natural and environmental disasters, and performance target payouts

Contingent liabilities

What is an existing, uncertain situation that might result in loss depending on the outcome of a future event?

Contingent liability

This is the interest rate stated on the face of the bond - what the issuer is paying in interest:

Coupon rate

_____ liability: due within one year (<= 12 months) from BS date

Current

Coupon rate < market interest --> issued at _____

DISCOUNT

If a short-term lease, then (do or do not?) record an asset or liability on BS

DO NOT

If reasonably probable likelihood...

Disclose in footnotes (no amounts on financial statements)

Coupon rate = market interest rate --> issued at _____

FACE

This is the principal payment due at maturity of the bond:

Face value

Why lease?

Flexibility, generally lower payments, downside protection

Why might the coupon rate and market interest rate (at issuance) differ?

Investors perceive credit/default risk as being different from the rate of return the company is offering

The life of a bond:

Issuance --> Life --> Maturity

This is the price investors are willing to pay (willing to lend) for the bond at issuance:

Issue price

This is the interest rate investors demand on the day the bond is issued:

Market interest rate

This is the rate used to discount future cash flows to the present and to calculate interest expense on the IS:

Market interest rate

How do price changes on the secondary market after issuance affect how we account for bonds?

No impact! WE only care about the market interest rate at the date of issuance

_____ liability: due beyond one year (<= 12 months) from BS date

Non-current

Coupon rate > market interest rate --> issued at _____

PREMIUM

When are cash flows the same and at even intervals?

PV of an annuity

- Not required to under GAAP - What if amount changes - DO not admit blame

Reasons to NOT recognize

- Restore faith in public relations - Cookie jar reserve - Show total cost and that the company will survive - Be overly conservative

Reasons to recognize

_____ interest: what we have talked about so far in class

Simple

Annuity or single sum: $20,000 in one year and $25,000 in 2 years with an annual rate of 3%

Single sum (different payments over time)

Annuity or single sum: $20,000 in 3 years from now with an annual rate of 3%

Single sum (one payment)

1. The issuance of a note payable and receipt of cash 2. Accrual of interest expense at period end (if note is not paid off yet) 3. The repayment of the note along with any interest

The three events that impact the financial statements for short-term debt financing

- Interest expense on bonds is tax deductible - Shareholders maintain control of the company and do not dilute ownership - Signaling positive future prospects

Why to issue a bond vs. issue equity

- A company may need more money than a single bank is willing to loan - Typically, bonds have more favorable interest rates and fewer financial covenants - Access a broader set of investors

Why to issue. bond vs. get a loan from the bank

Are contingent liabilities difficult to estimate?

Yes, - Uncertain; depend of future events - Depend on management's incentives and horizon

Face value * coupon rate =

cash payment

Interest expense - cash payment =

change in carrying value

If remote likelihood...

do nothing

Trade off is attempting to _____ or _____ contingent liabilities - which one provides better information to financial statement users?

estimate; ignore

If short-term lease/rent, expense on IS as _____

incurred

Carrying value * market rate at issuance =

interest expense

There is a(n) _____ relation between market interests rates and bond prices

inverse

PV of a single sum (face value) + PV of ordinary annuity =

issue price

Companies often _____ assets rather than _____ them

lease; purchasing

If long-term lease, then record asset as a _____ on the BS at _____ values at lease inception

liability; present

Most liabilities on the BS are _____

long-term

Report bonds as a _____ on the BS at _____ value

long-term liability; present

Prior to 2019, most leases were NOT reported on BS; they were a major form of...

off-balance sheet financing

Coupon rate * face value =

periodic cash interest payments

WE measure and report long-term liabilities at their _____ _____

present values

Issue price is the _____ value of the bond's future cash flows, which are discounted using the _____ rate at issuance

present; market interest

Companies issue bonds to...

raise capital ($$)

If reasonably estimable and probable...

recognize liability as an expense and disclose details in footnotes

Many companies use _____ debt financing from banks for things like payroll, inventory purchases, dividends, etc.

short-term