Accounting Chapter 10: Reporting and Analyzing Liabilities

Redeeming Bonds Before Maturity

A company may decide to redeem bonds before maturity in order to reduce interest cost and remove debt from its balance sheet. A company should redeem debt early only if it has sufficient cash resources. When bonds are redeemed before matuirty, it is necessary to eliminate the carrying value of the bonds at the redemption date, record the cash paid, and recognize the gain or loss on redemption.

Accounting for Bond Issues

A corporation records transactions when it issues (sells) or redeems (buys back) bonds and when bondholders convert bonds into common stock. If bondholders sell their bond investments to other investors, the issuing firm receives no further money on the transaction nor does the issuing corporation journalize the transaction. Bond prices for both new issues and existing bonds are quoted as a percentage of the face value of the bond, usually 1,000.

Current Liability

A debt that a company reasonably expects to pay from existing current assets or through the creation of other current liabilities and within one year of the operating cycle, whichever is longer. A company that has more current liabilities than current assets often lacks liquidity, or short term debt paying ability. Different types of current liabilities include: notes payable, accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages and interest.

Long Term Liabilities

Obligations that a company expects to pay more than one year in the future in the form of bonds or long term notes.

Payroll and Payroll taxes Payable

Payroll deductions such as insurance, pensions, and/or union dues, FICA taxes, federal income tax, state and city income tax, and charity are withheld from paychecks that must be paid to other parties. You incur a liability as a company to pay these third parties and must report this liability on the balance sheet. In addition to the liabilities incurred as a result of withholding, employers also incur payroll taxes levied upon the employer which include the employers share of social security (FICA) taxes and the state and federal unemployment taxes.

Redeeming Bonds at Maturity

Regardless of the issue price of bonds, the book value of bonds at maturity will equal their face value.

Sales Taxes Payable

Sales taxes are expressed as a percentage of the sales price. The selling company collects the tax from the customer when the sale occurs and periodically (usually monthly) remits the collections to the state department of revenue. Under most state laws, the selling company must enter separately on the cash register the amount of sales and the amount of sales tax collected and the company then uses the cash register readings to credit sales revenue and sales taxes payable. When the company remits the taxes to the taxing agency it decreases (debits) sales taxes payable and decreases (credits) cash. The company does not report sales taxes as an expense.

Effective Interest Rate

The percentage established when the bonds are issued and remains constant in each interest period.

Discount

When a bond is sold for less than face value, the difference between the face value of a bond and its selling price.

Premium

When a bond is sold for more than its face value, the difference between the face value and its selling price is called a premium.

Secured Bonds

Have specific assets pledged as collateral for the bonds.

Effective Interest Method Steps

1. compute the bond interest expense by multiplying the carrying value of the bonds at the beginning of the interest period by the effective interest rate.2. Compute the bond interest paid or accrued b multiplying the face value of the bonds by the contractual interest rate. 3. Compute the amortization amount by determining the difference between the amounts computed in steps 1 and 2.

Bonds

A form of interest bearing note payable issued by corporations, universities and governmental agencies. Bonds are sold in small denominations such as 1,000 and attract many investors. When a corporation issues bonds, it is borrowing money. The person who buys the bonds (bondholder) is investing in bonds.

Accounting for Bond Redemptions

Bonds are redeemed when the issuing corporation buys them back.

Callable Bond

Bonds that an issuing company can redeem (buy back) at a stated dollar amount prior to maturity.

Convertible Bond

Bonds that can be converted into common stock at the bondholders option. The conversion feature often gives bondholders an opportunity to benefit if the market price of the common stock increases substantially. Furthermore, until conversion, the bondholder receives interest on the bond. For the issuer, the bonds sell at a higher price and pay a lower rate of interest than comparable debt securities that do not have the conversion option.

Current Maturities of Long Term Debt

Companies often identify current maturities of long term dent on the balance sheet as long term debt due within one year. it is not necessary to prepare an adjusting entry to recognize the current maturity of long term debt. At the balance sheet date, all obligations are due within one year are classified as current, and all other obligations long term.

Unsecured Bonds

Issued against the general creditworthiness of the borrower. ex-debenture

Bond Certificate

Issued to an investor to provide evidence of the investors claim against the company. The bond certificate provides information such as the name pof the company that issued the bonds, the face value of the bonds, and the contractual interest rate. The face value is the amount of principal due at the maturity date. The maturity date is the date that the final payment is due to the investor from the issuing company. The contractual interest rate is the rate used to determine the amount of cash interest the borrower pays and the investor receives,usually stated as an annual rate with interest paid semiannually.

Notes Payable

Obligations in the form of written notes, provide written documentation of the obligation in case legal remedies are needed to collect the debt. Companies frequently issue notes payable to meet short term financing needs, borrower usually needs to pay interest. Current notes payable are due for payment within one year of the balance sheet. Interest accrues over the life of the note, and the issuer must periodically record that accrual.

Unearned Revenues

Revenue received before goods are delivered or services are performed. When the company receives an advance, it increases (debits) cash and increases (credits) a current liability account identifying the source of the unearned revenue. When the company recognizes revenue, it decreases (debits) the unearned revenue account and increases (credits) a revenue account.

Effective-Interest Method

The amortization of bond discount or bond premium results in periodic interest expense equal to a constant percentage of the carrying value of the bonds. The effective interest method results in varying amounts of amortization and interest expense per period but a constant percentage rate.

Issuing Bonds at a Discount

The bond payable less the discount on bonds payable gives you the carrying or book value of the bonds. On the date of issue this amount equals the market price of the bonds. The issuance of bonds below face value causes the total cost of borrowing to differ from the bond interest paid. The difference between the issuance price and the face value of the bonds- the discount is an additional cost of borrowing. The company records this cost as interest expense over the life of the bonds. To follow the expense recognition principle, companies allocate bond discount to expense in each period in which the bonds are outstanding. This is referred to as amortizing the discount. Amortization of the discount increases the amount of interest expense reported each period. That is , after the company amortizes the discount, the amount of interest expense it reports in a period will exceed the contractual amount. As the discount is amortized, its balance declines. As a consequence, the carrying value of the bonds will increase, until at maturity the carrying value of bonds equals their face amount.

Carrying Value of Bonds

The face value of the bonds less unamortized bond discount or plus unamortized bond premium at the redemption date.

Contractual Interest Rate

The rate applied to the face (par) value to arrive at the interest paid in a year.

Market interest rate

The rate investors demand for loaning funds to the corporation. When the contractual interest rate and the market interest rate are the same bonds sell at face value. market interest rates change daily, the type of bond issued, the state of the economy, current industry conditions and the company individual performance all affect interest rates.

Issuing Bonds at a Premium

The sale of bonds above face value causes the total cost of borrowing to be less than the bond interest paid because the borrower is not required to pay the bond premium at the maturity date of the bonds. Thus, the premium is considered to be a reduction in the cost of borrowing that reduces bond interest expense over the life of the bonds. Similar to a bond discount, companies allocate bond premium to expense in each period in which the bonds are outstanding. This is referred to as amortizing the premium. Amortization of the premium decreases the amount of interest expense reported each period. That is after the company amortizes the premium, the amount of interest expense it reports in a period will be less than the contractual amount.

Present Value

The value today of the amount to be received in the future after taking into account current interest rates. The present value or current market price is a function of three factors : the dollar amounts to be recieved, the length of time until the amounts are receieved and the market interest rate. The process of finding the present value is discounting the future amounts.

Time Value of Money

A dollar received today is worth more than a dollar received in the future.

Long Term Notes Payable

A long term note may be secured by a document called a mortgage that pledges title to specific assets as security for the loan. Individuals widely use mortgage notes payable to purchase homes, as do many small and some large companies to aquire plant assets. Like other long term notes payable the mortgage loan terms may stipulate either a fixed or an adjustable interest rate. typically the terms require the borrower to make equal installment payments over the term of the loan. Each payment consists of (1) interest on the unpaid balance of the loan and (2) a reduction of loan principle. While the total amount paid remains constant, the interest decreases each period and the portion applied to the loan principle increases. On the balance sheet, the company reports the reduction in principal for the next year as a current liability and classifies the remaining unpaid principal balance as a long term liability.