MODULE 10 ACG REVIEW

Present Value

- The current value of some future sum of money or stream of cash to be received at future dates given a specified rate of return. • The present value of $1,000 to be received in one year assuming a 10% rate of return is $909.09. If a person earns 10% returns on investments then the person would be indifferent between $909.09 today or $1,000 in one year (ignoring taxes, transaction costs, and risk).

Long‐term notes payable (e.g., mortgage payable):

1. Mortgage payable is a common form of long‐term note payable. 2. Mortgage payable is a secured note with specific property pledged as collateral or security for the loan. 3. Mortgage payable represents the outstanding principal owed to the creditor. 4. Mortgage payable is an installment note. a. Each periodic payment pays the accrued interest in full and pays portion of the outstanding principal. b. Each periodic payment is the same amount. 5. As time passes and the debtor pays more and more of the principal, but the periodic payments continue at a fixed dollar amount. a. As the outstanding principal is reduced, less interest accrues from one period to the next. b. As the outstanding principal is reduced, a larger portion of each subsequent payment pays off principal.

Sales tax payable

1. Most states impose sales taxes requiring retailers collect them from customers and pay them to the state. i. Companies that collect sales taxes from customers have an obligation to remit the sales taxes to the state. ii. Retailers record sales tax collected as liabilities (i.e., a current liability); they do not record sales taxes as an expense. 2. Sales taxes are computed as a percentage of the sales price; states choose their own sales tax rate.

Redeeming bonds at maturity

1. Occasionally, bond issuers redeem outstanding bonds before their maturity dates if the bondholder issued callable bonds and calls them. 2. When a company redeems bonds before maturity (i.e., retires them), it is necessary to: a. Eliminate the carrying value of the bonds at the redemption date: i. Debit: Bonds payable ii. Debit: Premiums on bonds payable (if the bond had been issued at a premium) iii. Credit: Discount on bonds payable (if the bond had been issued at a discount) b. Record the cash paid to redeem them from bondholders. c. Recognize the gain or loss on redemption.

Current maturities of long‐term debt:

1. Some long‐term debts become due on one specific maturity date, but some others require one or more payments of principal before the final maturity date. Regardless, amount due within one year or operating cycle, whichever is longer should be classified as current liabilities. a. A portion of a debt could be a current liability and the remainder long‐term liability. b. As time passes and due dates approach, long‐term debt eventually become current liabilities. 2. What is the effect of failing to classify a portion of long‐term debts as current as they approach their due dates? a. Overstate long‐term liabilities b. Understate current liabilities 3. Does reclassification of a portion of long‐term debt as a current liability require or involve a journal entry? No.

Determining the market value of bonds

1. Three factors that affect the current market price of a bond (i.e., the present value of a bond): a. The dollar amounts to be received in exchanged for holding the bond b. The length of time until the amounts are received c. The market rate of interest or the marketplaces' prevailing rate of interest on loans determined associated with a specific risk class, loan duration, the type of security issued and determined by supply and demand of credit 2. Bonds usually promise a combination of two payments: a. Payment of the bond's principal or face value on its maturity date b. Periodic payments of interest (i.e., annually, semi‐annually).

Unearned revenue:

1. Unearned revenues are liabilities resulting from receiving payments from customers for goods or services in advance of providing them to customers. 2. Examples: Tickets (e.g., airline tickets, season tickets), subscriptions (e.g., magazines), service agreements 3. The company collecting customers' advance payments must record the cash collection: i. Debit: Cash ii. Credit: Unearned revenue 4. Most unearned revenues will be earned in the near future; most are current liabilities. 5. When the company ultimately performs it earns revenue and it eliminates (or reduces) the unearned revenue account: i. Debit Unearned revenue ii. Credit: Revenue

A corporation issues 10%, 10-year bonds with a face value of $100,000 for $104,000. Using the effective-interest amortization method, how much is the interest expense for the first year if the effective interest rate is 9.72%?

10,109 Using the effective-interest method, the bond interest expense equals the effective interest rate times the bond's carrying value: 9.72% x $104,000 = $10,108.80.

On January 1, a corporation issued $2,250,000, 7%, 12-year bonds for $2,648,846. Interest is payable annually on January 1. The effective interest rate on the bonds is 5%. Use the effective-interest method to determine the amount of interest expense for the first year.

132,442 5% x $2,648,846 = $132,442

A company has bonds with a principal value of $500,000 outstanding. The unamortized premium on the bonds is $12,000. The company redeemed the bonds at 103. What is the company's gain or loss on the redemption?

3,000 loss Carrying value = Principal plus unamortized premium = $500,000 + 12,000 = $512,000 $500,000 x 1.03 = $515,000 $515,000 - 512,000 = $3,000)

Effective interest rate method

Bond Interest Expense ( Carrying value of bonds at Beginning Period X effective interest rate) - Bond Interest Paid ( face amount of Bond X Contractual Interest Rate) = Amortization Amount

Bonds with a $4,000,000 face value are issued by a certain corporation at 97. The corporation's journal entry to record the issuance is

Cash....................................................... 3,880,000 Discount on Bonds Payable....................... 120,000 Bonds Payable .............4,000,000 Cash proceeds from issuing bonds = $4,000,000 x 97% = $3,880,000

The cash register tape indicates sales are $1,500 and sales taxes are $100. What journal entry is needed to record this information?

Debit the Cash account for $1,600, credit the Sales account for $1,500, and credit the Sales Taxes Payable for $100.

A company operates a consulting practice. New clients are required to pay the firm in two transactions. First, clients must pay $250 before receiving consulting services. Second, clients must pay $750 once the consulting firm finishes providing services to the client. How does the company account for the second transaction?

Debit the Cash account for $750, debit the Unearned Revenue account for $250, and credit the Service Revenue account for $1,000.

Bond prices or values are quoted as a percentage of their face value

Example no. 1: if a $1,000 bond was issued for $990 then it was issued at a discount, and it could be described as having been issued at 99 (or 99% of face value). Example no. 2: If a $1,000 bond was issued for $1,020 then it was issued at a premium, and it could be described as having been issued at 102 (or 102% of face value)

Compounding -

Interest is paid to bondholders periodically, such as annually, semi‐annually (i.e., twice per year). i. Most bonds pay interest semiannually meaning twice per year (i.e., each 6 months). ii. Some bonds pay interest annually meaning once per year.

Each payment on a mortgage note payable consists of

Interest on the unpaid balance of the loan and reduction of the loan principal

What is the effect of amortizing a bond discount?

It increases the carrying value of the bonds.

Which of the following least likely would be classified as a current liability?

Mortgage Payable

Contractual interest rate

The annual interest rate used to determine cash interest paid. Since the contractual interest rate is stated on the bond certificate it is sometimes called the stated interest rate

Secured Bonds

The bond issuer (i.e., the debtor) has specific assets that it pledges as collateral in case the bond issuer defaults on paying interest and/or repaying the principal.

Convertible Bonds

The bond issuer allows bondholders the option to exchange the bond for shares of stock of the issuing company.

Unsecured Bonds

The bond issuer does not pledge specific assets as collateral for the bond in case it defaults on paying interest and/or repaying the principal. These bonds are sometimes called debenture bonds or debentures

Callable Bonds

The bond issuer is allowed to call (i.e., redeem or buy back from bondholders) the outstanding bonds prior to the maturity date

When bonds are converted into common stock

The carrying value of the bonds is transferred to paid‐in capital accounts

Karson Inc. issues 10‐year bonds with a maturity value of $200,000. If the bonds are issued at premium, this indicates that:

The contractual interest rate exceeds the market interest rate

Future Value

The value of an asset at a specific future date given a specified rate of return. • The future value of $909.09 in one year assuming a 10% rate of return is $1,000. If a person earns 10% returns on investments then the person would be indifferent between $909.09 today or $1,000 in one year (ignoring taxes, transaction costs, and risk)

Effective interest amortization method of amortization of discounts or premiums on bonds payable

Under the effective‐interest method, the amortization of the discount or premium results in interest expense equal to a constant percentage of the carrying value. Required steps: 1. Compute the bond interest expense. 2. Compute the bond interest paid or accrued. 3. Compute the amortization of the discount or premium.

Which of the following statements regarding the amortization of discounts and premiums on bonds is true?

When the straight-line and effective interest methods of amortization result in interest that is materially different, GAAP requires use of the effective interest method.

A corporation issues $2,000,000 of 10-year, 9% bonds dated January 1 at 110. The journal entry to record the issuance will include

a credit to Premium on Bonds Payable for $200,000. = Face value times 110% = $2,000,000 x 110% = $2,200,000 $200,000 = $2,200,000 - $2,000,000

On September 1, a company borrowed $70,000 from a bank for six months at 9%. Interest was properly accrued on December 31. The journal entry needed to record the payment of the note and interest on the due date includes

a debit to Interest Payable for $2,100. $70,000 x 9% x 4/12 = $2,100. Debit: Notes Payable for $70,000 Debit: Interest Payable for $2,100 Debit: Interest Expense for $1,050 Credit: Cash for $73,150

Bonds may be issued at

a. Face value - This occurs when the bond's contractual rate (i.e., also called the stated rate) is the same as the market's rate (i.e., also called the effective rate). b. Below face value - This occurs when the bond's contractual rate (i.e., stated rate) is lower than the market's rate (i.e., effective rate). - Issued at a discount c. Above face value - This occurs when the bond's contractual rate (i.e., stated rate) is higher than the market's rate (i.e., effective rate). - Issued at a premium

Bond terms and concepts

a. Face value or principal value. The amount the issuing entity promises to pay at maturity other than interest. b. Maturity date - The date when the bond issuer promises to pay the face value. c. Time value of money - Money available today is worth more than the identical sum in the future due to its earning capacity—money could be invested to earn a positive return. "A dollar today is worth more than a dollar in the future."

There are two methods of computing how much discount or premium is amortized each period"

a. Straight‐line method of amortization (i.e., simple to learn, but violates GAAP) b. Effective interest method of amortization (i.e., does not violate GAAP)

When bonds are redeemed before maturity, the gain or loss on redemption is the difference between the cash paid and the:

carrying value of the bonds

Liquidity — The ability to pay obligations expected to become due within the next year or operating cycle Current Ratio :

current assets/ current liabilities

The following totals for the month of June were taken from the payroll records of a certain company: Salaries, $100,000 FICA taxes withheld, $7,650 Income taxes withheld, $18,000 Federal unemployment taxes, $450 State unemployment taxes, $2,100 The entry to record accrual of employer's payroll taxes would include a

debit to Payroll Tax Expense for $10,200 The employer's payroll taxes = FICA taxes + Federal unemployment taxes + State unemployment taxes The employer's payroll taxes = $7,650 + 450 + 2,100 = $10,200.

Employer payroll taxes do not include:

federal income taxes

Secured bonds are bonds that

have specific assets of the issuer pledged as collateral.

Discount on Bonds Payable

is a contra account

The rate of interest investors demand for loaning funds to a corporation is the:

market interest rate

To be classified as a current liability, a debt must be expected to be paid:

out of existing current assets and by creating other current liabilities

Types of bonds

secured, unsecured, convertible, callable, term bonds, and serial bonds

Solvency - The pay interest as it comes due and to repay the balance of a debt due at its maturity Debt to assets ratio :

total liabilities/total assets

Term Bonds

All of the bonds in a particular issuance mature on the same date (i.e., most bonds mature in 10 years, but some bonds have other maturities (e.g., 5 years to 100 years)).

Serial Bonds

- Bonds in a particular issue mature at different dates in an installment or staggered manner.

Examples of current liabilities:

1. Accounts payable - Liabilities or obligations to pay for goods and services purchased on account. 2. Short‐term notes payable - Liabilities that result from issuing a note promising future payment on a specific maturity date. Notes usually require the payment of interest. 2. Unearned revenues - Liabilities for goods or services owed to customers who paid the company in advance of receiving goods and services. 3. Accrued liabilities: i. Salaries and wages payable - Liabilities owed to employees for past services employees rendered to the company. ii. Interest payable - Liabilities for interest owed on debts. Caution: When interest is payable varies which affects whether it is current or long‐term. iii. Taxes payable - Liabilities for taxes owed to governments (e.g., federal, state) 4. Current maturities of long‐term debts - The portion of a liability that is due in one year or operating cycle, whichever is longer. • Example: Mortgages are usually payable over 15 to 30 years with a portion of the mortgage due in each year, and the portion that is current should be reported as a current liability on a classified balance sheet.

Current liabilities

1. Liabilities that a company expects to pay from existing current assets or as the result of creating other current liabilities. a. A company might settle an account payable by paying cash to the creditor. b. A company might settle an account payable by issuing a short‐term note payable. 2. Liabilities that a company expects to settle within one year or the operating cycle, whichever is longer

Bonds issued at a discount

1. Bond are issued at a discount if their stated interest rate is lower than the market's current market interest rate. 2. The discount bond increases the bond issuer's cost of borrowing because the bond issuer receives less than the bond's face value when issuing the bond but promises to payback the bond's face value plus interest. 3. To record the discount, the bond issuer records the discount in its own separate account called discount on bonds payable. i. Bond payable minus the discount on bonds payable is called the carrying value of the bond. ii. Bond discount is a contra liability; it is reported on the balance sheet immediately below bonds payable. 4. Interest expense is accrued and paid periodically, and the additional cost of borrowing due to the discount is similarly spread across the bond's term via an end‐of‐period adjusting entry. 5. The discount is reduced each period by an amount determined either by (i) straight‐line amortization or (ii) effective interest method amortization. Regardless of which method is used, the discount is reduced periodically with a simultaneous increase in interest expense. 6. When the bond matures, the last portion of the discount is amortized reducing the discount's balance to zero. The bond's carrying value equals its face value when it matures.

Bonds issued at a premium:

1. Bond are issued at a premium if their stated interest rate is higher than the market's current market interest rate. 2. The premium bond decreases the bond issuer's cost of borrowing because the bond issuer receives more than the bond's face value when issuing the bond but promises to payback the bond's face value plus interest. 3. To record the premium, the bond issuer records the premium in its own separate account called premium on bonds payable. i. Bond payable plus the premium on bonds payable is called the carrying value of the bond. ii. Bond premium cannot be referred to as a contra liability because it increases carrying value; it is referred to as an adjunct account; it is reported on the balance sheet immediately below bonds payable. 4. Interest expense is accrued and paid periodically, and the reduced cost of borrowing due to the premium is similarly spread across the bond's term via an end‐of‐period adjusting entry. 5. The premium is reduced each period by an amount determined either by (i) straight‐line amortization or (ii) effective interest method amortization. Regardless of which method is used, the premium is reduced periodically with a simultaneous decrease in interest expense. 6. When the bond matures, the last portion of the premium is amortized reducing the premium's balance to zero. The bond's carrying value equals its face value when it matures.

Bonds:

1. Bonds are a form of notes payable issued by corporations, governmental agencies, etc. 2. The entity or person who buys the bonds is called the bondholder. Bondholders buy bonds hoping to earn a return on their investment in the form of interest payments in addition to being paid the bond's face value at maturity. 3. When a corporation issues bonds, it is borrowing money. The bond certificate represents the loan and it identifies the loan's terms, including the identity of the debtor, the principal (i.e., face value), contractual interest rate, how frequently interest is paid to bondholders, the bond's maturity date, etc. 4. Bonds are usually solid in small denominations (such as $1,000). Example: If a company needs $10,000,000 for a project it might issue $10,000,000 in bonds. If the bonds have a $1,000 face value, it would issue 10,000 $1,000 bonds. Having affordable denominations makes it easier for individual investors to buy a small portion of the total bond issuance.

Amortizing discounts or premiums on bonds payable using the effective‐interest method of amortization

1. Discounts on bonds increase the cost of borrowing. Premiums on bonds decrease the cost of borrowing. 2. The expense recognition principle (i.e., matching principle) indicates that the additional cost of borrowing associated with discounts should be allocated to the periods when the bond is outstanding. Similarly, the reduced cost of borrowing associated with premiums should be allocated to the periods when the bonds are outstanding. 3. Allocation of discount and premiums on bonds payable is accomplished by amortizing a portion of the discount or premium each period that the bond. a. Amortizing discounts on bonds payable increases interest expense Debit: Interest expense Credit: Discount on bonds payable b. Amortizing premiums on bonds payable decreases interest expense Debit: Premium on bonds payable Credit: Interest expense 4. Using the effective‐interest method of amortization computes the interest expense for the period using the market rate of interest (i.e., the effective interest rate) times the bond's carrying value. a. Since the discount or premium is amortized period‐by‐period, the carrying value changes period‐by‐period. b. Interest expense according to the effective‐interest method changes period‐by‐period in a manner that reflects the cost of borrowing the carrying value associated with that period. i. If the carrying value is high then there is more interest expense. ii. If the carrying value is low then there is less interest expense.

Straight‐line method of amortization of discounts or premiums on bonds payable:

1. Discounts on bonds increase the cost of borrowing. Premiums on bonds decrease the cost of borrowing. 2. The expense recognition principle (i.e., matching principle) indicates that the additional cost of borrowing associated with discounts should be allocated to the periods when the bond is outstanding. Similarly, the reduced cost of borrowing associated with premiums should be allocated to the periods when the bonds are outstanding. 3. Allocation of discount and premiums on bonds payable is accomplished by amortizing a portion of the discount or premium each period that the bond. a. Amortizing discounts on bonds payable increases interest expense Debit: Interest expense Credit: Discount on bonds payable b. Amortizing premiums on bonds payable decreases interest expense Debit: Premium on bonds payable Credit: Interest expense

Notes payable

1. If a company borrows money and signs a formal note (i.e., sometimes called a promissory note) that shows the terms of the loan then it has issued a note and it records the obligation as a note payable. 2. Whether a note payable is a current liability or long‐term liability depends on the note's due date relative to the company's operating cycle or one year, whichever is longer. 3. Most notes require interest in addition to the payment of principal. The debtor should record accrued interest at the end of the period if the debtor uses the accrual method of accounting

A corporation issues a $600,000, 8%, 20-year mortgage note. The terms provide for annual installment payments of $61,111. What is the remaining unpaid principal balance of the mortgage payable account after the second annual payment?

572,728 48,000 (i.e., 8% x $600,000) 61,111-48,000 = 13,111 600,000-13,111 = 586,889 The second annual payment's interest is 8% of the outstanding mortgage principal of $585,364, or $46,951. The second annual payment of $61,111 is allocated as $46,951 paid towards interest and the remaining $14,160 allocated towards the payment of outstanding mortgage principal.

A corporation issues a $600,000, 6%, 20-year mortgage note. The terms provide for annual installment payments of $52,311. What is the remaining unpaid principal balance of the mortgage payable account after the first annual payment?

583,689 Since interest accrues annually, the first year's interest would be $36,000 (i.e., 6% x $600,000) 52,311-36,000 = 16,311 600,000-16,311

The current carrying value of a company's $600,000 face value bonds is $597,750. If the bonds are retired at 102, what would be the amount the company would pay its bondholders?

612,000 $600,000 x 1.02 = $612,000

In the current year, a corporation had net income of $100,000, interest expense of $20,000, and tax expense of $30,000. Its net sales were $1,000,000 and its cost of goods sold was $400,000. What was its times interest earned for the year?

7.50 ($100,000 + $20,000 + $30,000) / $20,000 = 7.50

On January 1, a corporation issued $800,000 of 6%, 5-year bonds at 98, which pays interest annually. Assuming straight-line amortization, what is the carrying value of the bonds at the end of the first year?

787,200 The original carrying value is $784,000 (i.e., $800,000 x 98% = $784,000 Straight-line annual amortization of the discount =[(Face value - carrying value)/life in years = [($800,000 − $784,000)/5] = $3,200 Carrying value of the bond after one year = Original carrying value + amortization for the first year = $784,000 + $3,200 = $787,200

Hartley Company sold $900,000, 10-year, 9% bonds on January 1 for $915,000. Interest is to be paid annually on January 1. If the issuing corporation uses the straight-line method to amortize discounts and premiums on bonds payable, the amount of bond interest expense to be recognized in the year issued is

79,500 Interest paid in cash = Face value times the contractual interest rate = $900,000 x 9% = $81,000. This bond has a premium of $15,000 (i.e., $915,000 - $900,000). Annual amortization = $15,000/10 years = $1,500 per year These bonds were issued at a premium: Interest expense = $81,000 - $1,500 = $79,500

Times interest earned

= (Net income + Interest Expense + Tax Expense)/Interest expense

When a bond is sold at a premium, at what value is it reported on the balance sheet?

Face value plus any unamortized premium