Liabilities: Introduction

BUS 780

Chapter 9

Liabilities: Introduction

Liabilities: Introduction 2

Objectives of the Chapter

1. To learn the basic concepts of liabilities and liability recognition.

2. To learn accounting for current liabilities, including estimated and contingent liabilities.

3. To learn accounting for long-term liabilities (i.e., issuance of bonds for cash).


Objectives of the Chapter (contd.)

4. To study the accounting procedures for interest payments of bonds and the amortization of bond discount or premium.

5. To study the accounting procedures for debt retirements either at or before maturity.

6. To learn the accounting for issuance of long-term note for assets or cash.


1. Liabilities

Legal obligations require future payments of cash or services or the creation of other liabilities as a result of past transactions.

Recognition principle: accrual basis (i.e., A liability should be recognized when it occurs, not when it is paid.)


The Importance of Understanding the GAAP’s Definition of a Liability Lenders often require the borrowers to keep

debt/equity under a specific level (i.e., not more than 50%) in the loan agreement.

If the ratio is greater than the constraint, the lender may have additional rights, such as to charge a higher interest rate.

Investors (creditors) often use the debt/equity ratio to make their credit decisions.


Off-Balance Sheet Liabilities When calculating the debt/equity ratio,

attention should be given to the off-balance sheet liabilities which are obligations not reported as liabilities on the balance sheet and only disclosed in the footnotes.

Examples: operating lease obligations, pension liabilities, SPE’s liabilities guaranteed by the corporation/sponsor, etc.

Off-balance liabilities will be discussed in chapter 10.


2. Current Liabilities

Obligations must be fulfilled in one year or one operating cycle, whichever is longer.

Examples of current liabilities as a result of a business transaction: (with definite amount) A/P (accounts payable) N/P (notes payable) Current maturity portion of a long-term debt

(i.e., bonds payable) Sales taxes payable Payroll taxes withholdings


Employee Related Liabilities: FICA, Federal I/T, state I/T, Medical Insurance Premiums…

i.e. Salaries Expense 50,000

Employee F.I.C.A. Taxes Payable* 3,825

Federal I/T Payable 10,000State I/T Payable 2,500Salaries Payable 32,675

*0.0765 * 50,000


Employee Related Liabilities (contd.)

Employer payroll taxes:

Payroll Taxes Expense 6,925

Employer F.I.C.A. Taxes Payable 3,825

F.U.T.A. Taxes Payablea 400

State Unemployment Tax Payableb 2,700

a. 6.2% of the first $7,000 of salaries paid to employees.

b. assuming a state unemployment tax = 5.4%.


Refundable DepositsCash xxx

Refund Deposit Liabilities xxx

Unearned Revenue (i.e., subscription fees received in advance, advances from customers before delivery, etc.)

Cash xxx

Unearned Subscription Revenue xxx (or Advances from Customers)

Other Current Liabilities (with definite amount)


Accrued Liabilities

Obligations accumulated on a daily basis but not recorded until the end of period through adjusting entries (i.e., Interest payable, salaries payable, rent payable…)

J. E. Interest Expense xxx

Interest Payable xxx


Estimated Liabilities

Liabilities exist but the amount is unknown, i.e., Property taxes Warranty obligations Coupon and premium obligations Vacation Wage and Fringes Payable


Expense Warranty Using Accrued Method

(for financial Reporting Purposes) Estimate the warranty expense

associated with the sales during the period at the end of the period and recognize it.


Expense Warranty Using Accrued Method (contd.)

Journal Entry:

Warranty Expense xxxEstimated Warranty Liability xxx

When warranty services provided:Estimated warranty liability xxx

Cash (or Inventory) xxx

If the estimated warranty liabilities are not enough to cover the current year’s warranty services, additional warranty expense would be debited.


Premiums and Coupons Obligations

Liabilities of premiums and coupons should be estimated and recognized in the year when sales are made.

Journal Entry

Premium (or Coupon) Expense xxx

Estimated Premium Claims

(or coupon) outstandingxxx


Premiums and Coupons Obligations (contd.)

When premiums (or coupons) are claimed:Journal Entry Estimated Premium Claims (coupon) outstanding xxx

Inventory xxx* If the actual redemption of coupons (or premiums)

is greater than the estimated liabilities, the underestimated amount would be recognized as the expense of the current year. (APB 20)


Contingencies

Contingent Liabilities

Contingent Losses

Contingent Gains


Contingent Liabilities

Obligations may arise because of the occurrence or not occurrence of future event(s). (i.e., warranty obligations)


Contingent Losses and Gains

Losses (gains) may arise because of the occurrence or not occurrence of future event(s).

(i.e., the uncollectable accounts, the pending lawsuit losses (gains), possible damage of a fire, etc.…)


Accounting Treatments of Contingencies The accounting treatments of the

contingencies depend on the occurrence probability of the related future event(s).(FASB No. 5)

If the future event is a. ProbableProbable, and b. amount of liability can be reasonable estimated. The liability should be estimated, and recognized on the balance sheet.


Accounting Treatments of Contingencies (contd.) Probable: defined by the FASB as “the

future event(s) is(are) likely to occur”; no specific % is given.

Common practice of probable by accountants: probability of occurrence is between 80% to 85%.

IASC: Probable is defined as “more likely than not” .


Accounting Treatments of Contingencies (contd.) Examples:

1. Bad Debt Expenses xxx Allowance for Bad Debt xxx

2. Warranty Expense xxx Estimated Warranty Liabilities xxx

3. Lawsuit Expenses xxx Estimate Liability under litigationxxx


Accounting Treatments of Contingencies (contd.) If the future event is probable, but the

amount of loss/liability cannot be estimated, the contingent loss/liability should be disclosed (i.e., Merck’s disclosure of Vioxx lawsuits).

Contingent gains: No unrealized gain can be recognized

under the current accounting standards (conservatism!!!)


3. Long-Term Liabilities

Issuance of bonds (at a premium or discount)- cash inflow

Issuance of bonds between interest payment dates

Extinguishment of debt – cash outflow Convertible Bonds, callable bonds Mortgage payable and Long-term Notes

Payable


Present Value of $1 Present value concept:

Present value of $1 is the value today of $1 to be received in the future, given a specific interest rate.

Example:1. What is the present value of $100 to be received

a year from now given an annual market interest rate of 10%?

P.V. (1+10%) = $100P.V. = $100/1.1

= $100 0.9091 = $90.91


Present Value (contd.)

2. What is the present value of $100 to be received two years from now given an annual interest rate of 10%?

P.V (1+10%) (1+10%) = $100P.V (1+10%)2 = $100P.V. 1.21 = $100P.V. = $100 / 1.21

= $100 0.8264= $82.64


An Ordinary Annuity: Receiving (or paying)a constant amount of

money at the end of each period (equal time internal) for a given number of periods

$100 $100 $100 $100 $100

1 year What is the present value of receiving $100

every year for the following 5 years starting a year from now?


The Present Value of an Ordinary Annuity:1. Using the example above given a10% Interest rate:

P.V. of the first $100 = $100 0.9091 = $90.91

P.V. of the second $100 = $100 0.8264 = $82.64

P.V. of the third $100 = $100 0.7513 = $75.13

P.V. of the fourth $100 = $100 0.6830 = $68.30

P.V. of the fifth $100 = $100 0.6209 = $62.09

Total 3.7907 $379.07


Present Value (P.V.) of an Annuity (contd.):

The P.V. of $100 annuity receiving every year for the following 5 years, starting a year from now =>

$100 * 3.7907 = $379.07 The P.V. of this annuity can be

obtained from an annuity table under 10%, 5 periods.


Present Value (P.V.) of an Annuity (contd.):2. What is the P.V. of $300 annuity receiving

every 6 months for the following 30 months, starting 6 months from now ? The annual interest rate is 12%.

P.V. = $300 x 4.2124 = 1,263.7

Annuity Table, 5 periods at 6%

(30/6=5) (12%/2=6%)


Corporate Bonds:

Bonds are securities issued by a corporation to borrow money from the public (i.e., from many lenders/investors).

This is a source to raise funds. The corporation will receive cash when

bonds are issued.


Corporate Bonds:

The face value of the bonds must be repaid to the bondholders on the maturity date of the bonds.

Also, the bond issuers (the borrower) will have to pay interests to the bondholders (the lender/investor) periodically (i.e., semi-annually).


Bonds Payable

Long-Term Liability: if bonds mature in more than one year.

Short-Term Liability: if bonds mature in less than one year


Bonds Payable (contd.)

Bond Indenture is an agreement States the following:Interest rate of bonds;Interest Payment dates;The maturity date of bonds; The type of bonds: callable, convertible,..

The indenture is held by a trustee appointed by the issuing firm to represent the rights of the bondholders.


The Process of Bond Issuance

1. Receive the approval from the stockholders and regulatory authorities (i.e., the SEC).

2. Print bond certificates and write indenture (to set the terms of bond issue such as the stated interest rate, the interest payment date and the maturity date…)

3. Make a public announcement of its intent to sell the bonds on a particular date.


The Process of Bond Issuance (cont.)

4. Negotiate the appropriate selling price with the underwriters based on the terms of bond issue (i.e., the stated inters rate), the general bond market conditions, the risk of the bonds and the expected state of the economy.



5. The underwriter will determine the effective interest rate (yield) and thus, the selling price that it believes best reflects the current market condition and the risk the bond for a particular bond issue.

6. The underwriter will either purchase the bonds from the issuing company and resell them to the public or sell these bonds for a commission.



Companies can sell the entire issue of bonds to an underwriter or sell it to a single investor (i.e., a pension fund) (referred to as a private placement).

Any expenditures connected with a bond issue (legal fee, printing costs, accounting fee, underwriter's charges …) should be deferred and amortized as expense over the life of the bond using a straight line method.


The Process of Bond Issuance (Contd.)

The yield is the market rate (effective rate) for the bond issue.

The yield is often different from the stated interest rate as a result of :

1) different opinion between the underwriter and the company, or

2) a change in the economic conditions between the date the terms were set and the date the bonds were issued.


The Process of Bond Issuance (Contd.)

Three possible outcomes of bond issuance:1. Stated rate = effective rate (yield)

=> the bonds are sold at par

2. Stated rate < effective rate => bonds are sold at discount

3. Stated rate > effective rate => bonds are sold at premium


Units of bonds:

At $1,000 denominations or a multiple of $1,000.

Price of bonds: stated at 100s

Example: $1,000 issued at 98

The issuing price is $1,000 98 = $980


Types of bonds:

On the basis whether the bonds are secured: Secured Bonds Unsecured Bonds (Debentures)

On the basis of how the interests are paid: Registered Bonds Coupon Bonds


Types of bonds:

On the basis of how the bonds mature: Term Bonds Serial Bonds Convertible Bonds Callable Bonds


Determination of Bond Price

The obligations of bond issuers:

(1) to pay the principal when bondmatures on the maturity

date.

(2) to pay interests periodically (i.e., semiannually) over the life the bond.


Determination of Bond Price (Contd.)

Bond Price: the present value of the bond.

Present value of bonds => The sum of (1) the present value of the principal plus(2) the present value of the periodic

interests (an annuity).



Discount rate = effective rate = market rate =yield This rate depends on the riskiness

of the issuer, the general state of the economy, the duration of the bond, etc.

In general, a higher risk will result in a higher effective rate.



Bonds Issued at Face ValueWhen the stated interest rate equals the effective interest rate, the bond price will equal the face value.


Determination of Bond Price (Contd.) Example 1: Page company issued a 5-year term bond with a

face amount $100,000 and a stated annual interest rate of 10%.

Interests are paid semiannually.Assume that the annual effective interest rate

demanded by investors for bonds of this level of risk is also 10%, what is the present value of the bond (the bond price)?



(1)P.V. of the principal ($100,000 mature in 5 years, discount rate 5%, 10 periods):

$100,000 0.6139 = $61,390

(2)P.V. of the interests received semiannually for 10 periods (annuity, discount rate = 5%, 10 periods)

$5,000 7.7217 = 38,608.5annuity table, 5%, 10periods



The P.V. of the bond = the sum of (1) and (2)

= $61,390 + 38,608.5 = $100,000

Therefore, when the stated rate equals the effective rate (the discount rate), the bond price (the P.V. of bonds) equals the face value.



Therefore, when the stated rate equals the effective rate (the discount rate), the bond price (the P.V. of bonds) equals the face value.

J.E. (when bonds are issued at face value)Cash 100,000

Bonds payable 100,000



Question:What’s is the total interest expense of the bond (issued at face value)?Cash payments by the issuer* ($150,000)Cash Rece. from issuing bonds $100,000Interest Expense ($50,000)

* Principal on maturity date + semiannual interest payments= $100,000 + $5,000 x 10 = $150,000


Bond Issued at A Discount

When the stated interest rate is less than the effective interest rate, the present value of a bond will be less than its face value.

Example 2: Use the same information as in Example 1, except that the effective rate is 12%, rather than 10% to compute the present value of the bond.


Bond Issued at A Discount (Contd.) Since the interests are paid semiannually, the

discount rate is 6% with 10 periods.(1)P.V. of the principal = $100,000 .5584 = $55,840

P.V. table, 6%,

10periods

(2) P.V. of the semiannual interest:$5,000 7.3601 = 36,800.5

Annuity table, 6%, 10periods

P.V. of the bond = (1) + (2)$55,840 + 36,800.5 = $92,640.5


Bond Issued at A Discount (Contd.)

$92,640.5 < $100,000 (Discount = $7359.5)P.V. of bond < Face vale=> when the stated rate is less than the effective

rate (i.e., 10% < 12%), the P.V. of the bond will be less than the face value.

J.E. (when bonds are issued at discount)Cash 92,640.5Discount on Bonds 7,359.5

Bonds Payable 100,000


Bond Issued at A Discount (Contd.) Question:

What is the total interest expense of this bond (issued at Discount)?

Cash payment by the issuer ($150,000)

Cash received from issuing the bond (at Discount) 92,640.5

Interest Expense $57,359.50*Discount would increase the actual interest expense and needs to be amortized

over the life of the bond.*Interest Expense = interest payment + Discount

= $50,000 + 7,359.50 = $57,359.50


Bond Issued at A Premium When the stated interest rate is higher than

the effective interest rate demanded by the investors for the level of the risk of the bonds, the present value of the bonds would be greater than its face value.

Example 3: use the same information as in Example 1, except that the effective interest rate is 8%. (the stated interest rate is still at 10%)


Bond Issued at A Premium (Contd.)

Compute the P.V. of the bond:

Since the interests are paid semiannually, the discount rate would be 4% and the discounting periods are 10 periods.

(1) P.V. of the principal:

$100,000 x 0.6756 = $67,560



(2) P.V. of the semiannual interest:$5,000 x 8.1109 = $40,554.5

P.V. of the bond = (1) + (2)= $67,560 + 40,554.5 = $108,114.5$108,114.5 > $100,000 (Premium = 8,114.5)



Example 3J.E. (Bonds are issued at a Premium)Cash 108,114.5

Bonds Payable 100,000Premium on Bonds Payable 8,114.50



Question: What is the total interest expense of the bond (issued at Premium)?

Cash payments by the issuer (150,000)Cash received from

issuing the bond 108,114.5Interest Expense ($41,885.5)



Question: What is the total interest expense of the bond (issued at Premium)?

Cash payments by the issuer (150,000)Cash received from

issuing the bond 108,114.5Interest Expense ($41,885.5)Note: Regardless of the market interest rate, the total

cash payments are the sample (i.e., $150,000) with the same stated interest rate and same par value.



A premium account: an adjunct account to the bonds payable account and is shown as an addition to the bonds payable account.

A discount account: a contra account to the bonds payable and is shown as a deduction from the bonds payable.



Book value (carrying value) of the bond issued: the face value plus any unamortized premiums or minus any unamortized discounts.

If an effective interest method is used to amortize the discount (or premium), the carrying value equals the present value under the historical effective interest rate.


4. Accounting for Bonds Payable - Bonds Are Issued at A Discount

Information of example 2 is summarized below with some additional information:

Stated Interest = 10% (annual) Effective Interest = 12% (annual) Date of Issuance = 1/1/x2 (sold on 1/1/x2) Date of Maturity = 1/1/x7 Interest Payment Dates = 6/30 and 12/31 Face Value = $100,000 P.V. of the Bond = 92,640.50 (as computed

earlier)


Accounting for Bonds Payable - Bonds Are Issued at A Discount (Contd.)

Discount = $100,000 - 92,640.5 = 7,359.50

This discount would increase the interest expense and would be amortized over the life of the bond -5 year, 10 periods)



Amortization methods:1. Straight-Line: the Discount would be

amortized equally over the life of the bond.i.e., Amortization in 10 periods: $7349.5010 = $735.95Therefore, the interest expense every period

is$5,000 + 7,35.95 = $5,735.95

Semiannual the amortized DiscountInterest Payment



Total Interest expense = 5,735.95 x 10 = $5,7359.5 = 50,000 + 7,359.5

Int. payment Discount

2. Effective Interest MethodInterest Expense = P.V. of Bond effective rate



J.E (Bonds are issued at a discount and use the straight-line method to amortize the discount)

1/1/x2 Cash 92640.50 Discount on B/P 7359.50

B/P 100,0006/30/x2 Interest Expense 5,736

Cash 5000*Discount on B/P 735.95**

12/31/x2 Interest Expense 5,736Cash 5,000Discount on B/P 735.95



12/31/x6 Interest Expense 5,736Cash 5,000Discount on Bonds Payable 735.95

1/1/x7 B/P 100,000Cash 100,000

Discount on Bonds

1/1/x2 7,359.50 735.95 6/30/x2

735.95 12/31/x2

735.95 6/30/x3

735.95 12/31/x6

Interest Expense from 1/1/x2 to 12/31/x6

= $ 5,735.95 * 10

= $5,7,359.50

= $50,000 + 7,359.5

Interest payments

Discount on Bonds



J.E. for bonds issued at a discount and use the effective interest method to amortize the discount: using the example on p.48.

Interest Payment = $100,000 * 5%= $5,000

Interest Expense = P.V. of Bond at the Beginning of the period Effective Rate

Amortized Discount = Interest Expense - Interest payment


Effective Interest Amortization Table-bond are issued at a discount

1 2 3 4 5 6

PeriodP.V at Beg. Of Period

Interest Expense (1) * 6%

Cash (Interst)

payments

Amortized Discount (2) - (3)

Unamortized Discount

(5)-(4)

P.V. at end of Period

$100,000 - (5)

0 - - - - $7,359 $92,6411 492,641 $5,558 $5,000 $558 $6,801 93,1992 93,199 5,592 $5,000 592 6,209 93,7913 93,791 5,627 $5,000 627 5,582 94,4184 94,418 5,665 $5,000 665 4,917 95,0835 95,083 5,704 $5,000 704 4,213 95,7876 95,787 5,704 $5,000 747 3,466 96,5147 96,534 5,792 $5,000 792 2,674 97,3268 97,326 5,840 $5,000 840 1,834 98,1669 98,166 5,890 $5,000 890 944 99,05610 99,056 5,944 $5,000 944 - 100,000

Total $57,359 $50,000 7,359



J.E :1/1/x2 Cash 92,641

Discount on B/P 7,359 B/P 100,0006/30/x2 Interest Expense 5,558(period 1) Cash 5,000

Discount on B/P 55812/31/x2 Interest Expense 5,592(period 2) Cash 5,000

Discount on B/P 592



6/30/x3 Interest Expense 5,672Cash 5,000Discount on B/ P 672

::

6/30/x6 Interest Expense 5,890Cash 5,000Discount on B/P 890

12/31/x6 Interest Expense 5,944Cash 5,000Discount on B/P 944

1/1/x7 B/P 100,000Cash 100,000



Discount on Bonds Payable

1/1/x2 7,359 558…6/30/x2

592…12/31/x2

672…6/30/x3

890…6/30/x6

944…12/31/x6

0

Interest Expense over 10 periods =>

Period 1 $5,558

Period 2 $5,592

period 3 $5,627

Period 9 $ 5,890

Period 10 $ 5,944

$57,359

$57360= $50,000 + 7,359


Accounting for Bonds Payable -Bonds Are Issued at A Premium

Information of example 3 is summarized with some additional information:

Stated Interest Rate (annual) = 10% Effective Interest Rate (annual) = 8% Date of Issuance = 1/1/x2 (sold on 1/1/x2) Date of Maturity = 1/1/x7 Interest Payment Date = 6/30 and 12/31 Face Value = $100,000 P.V. of the Bond = $108,115 (as computed earlier)


Accounting for Bonds Payable-Bonds Are Issued at A Premium

Premium = $108,114.5 - 100,000 = $8,114.5 The premium would decrease the interest expense

and should be amortized over the life (5 years, 10 periods) of the bond.

J.E. (Amortization Method= Straight-Line)$8,114.5 / 10 = $8114.5 => $811.45 would be amortized for every period. The interest expense would be decreased by $816 every period.1/1/x2 Cash 108,114.5

B/P 100,000Premium on Bonds Payable 8,114.5


Effective Interest Amortization Table-bond are issued at a premium

1 2 3 4 5 6

PeriodP.V. at Beg

of Period

Interst Expense (1) * 4%

Cash Payments 100,000 x

5%

Amortizatied Premium (3) - (2)

Unamortized Premium (5) - (4)

P.V. at End 100,000 /

(5)

0 - - - - 8,114.50 108114.51 108,114.50 4,325 5,000 675 7,440 107,4402 107,440 4,298 5,000 702 6,738 106,7383 106,738 4,270 5,000 730 6,008 106,0084 106,008 4,240 5,000 760 5,248 108,2485 103,248 4,210 5,000 790 4,458 104,4586 104,458 4,178 5,000 822 3,616 103,6367 103,636 4,145 5,000 855 2,781 102,7818 102,781 4,111 5,000 889 ,892 101,8929 101,892 4,076 5,000 924 968 100,96810 100,965 4,039 5,000 968* 0 100,000

Total 41,885.50 50,000 8114.5

Interest Expense = Cash payment - Amortized premium = 50,000 - 8114.5 = 41,885.5

* Rounding Error of $ 7 (968-961 = 7)


Accounting for Bonds Payable (Contd.)

Premium on Bonds

6/30/x2… 675 8114.5 …1/1/x2

12/31/x2 … 702

730

760

790

822

855

889

924

968

0

Interest Expense over 10 periods =>

Period $

1 4,325

2 4,298

4,270

10

41,885.50


Accounting for Bonds Sold Between Interest Payment Dates:

Policy of interest payment for bonds: Interest are always paid in full

regardless how long the bonds being held by the bondholder.

Thus, the bond issuing company collects the accrued interests in addition to the issuing price when bonds are sold between interest payment dates.


Accounting for Bonds sold Between Interest Payment Dates at Par:

Example: assume that on 2/1/x2, Page company issued a 5- year term bond with a face amount of $100,000 and a stated interest rate of 10%. The bonds were issued at Par and interests were paid semiannually on 2/1 and 8/1. The bonds were sold on 5/1/x2.


Accounting for Bonds Sold Between Interest Payment Dates at Par:

J.E. 5/1/x2 (bond sold at par on 5/1/x2)Cash 102,500

Bonds Payable 100,000Interest Payable* 2,500

* Accrued interest of 3 months (From 2/1 ~ 5/1)

8/1/x2 Interest Payable* 2,500 Interest Payable 2,500

Cash 5,000* 100,000 x 10% x 6/12 = 5,000 (6 month interest)

Actual Interest Expense (from 5/1/x2 - 8/1/x2) => 5,000 -2,500 = 2,500


5. Bond Retirements Before Maturity

Use example 2 (issued at a discount), assume that bonds are retired at the end of period 3 for $98,000

Discount on Bonds

7,359 558…..Period 1

592…..Period 2

627…..Period 3

5,582

Unamortized at the end of period 3

BV of the Bond = 100,000 - 5,582 = 94,418


Bond Retirements Before Maturity

B/P 100,000

Loss on Retirement of Bonds 3,582

Discount on Bonds Payable 5,582

Cash 98,000


6. Long-Term Notes Payable

APB Opinion No. 21 requires the long-term notes payable to be recorded at their present values and the effective interest method is used to record the subsequent interest.

The effective interest rate (or implicit rate) is the rate that equates the future net cash flows to the present value.


Long-Term Notes Payable (contd.)

Therefore, if the present value (p.v.) and future net cash flows are known, the effective interest can be calculated.

Also, if both the effective interest rate and future net cash flows are known, the present value can be calculated.



In other cases, when the P.V. is not known, the incremental interest rate of the borrower is used as the effective rate to calculate the P.V. of the note.



A. Notes payable issued for cash: When a long-term note is exchanged for

cash, the note is assumed to have a present value equals the cash proceeds.

The difference between the cash proceeds and the face value of the note is recorded as a discount (or premium)

The discount (or premium) is amortized over the life of the note using the effective interest method.


Example A

Johnson Company issued a 3-year, non-interest-bearing note with a face value of $8,000 and received $5,694.24 in exchange. The journal entry to record the issuance is:

Cash 5,694.24

Discount on Notes Payable 2,305.76

Note Payable8,000


Example (contd.)

The discount account is a contra account to notes payable. The effective interest rate that equates the P.V. of 5,694.24 to $8,000 at the end of 3 years is 12%.

5,694.24 = 8,000 x 0.71178 3-period, 12%


Year 1 Year 2 Year 3N/P 8,000 8,000 8,000Less: Unamortized Discount

(2,305.76) (1,622.45) (857.14)

Carrying Value (at beg.)

5,694.24 6,377.55 7,142.86

x Effective Rate 12% 12% 12%Interest Expense 683.31 765.31 857.14 - Interest Payment 0 0 0 Amortized Discount 683.31 765.31 857.14

Example (contd.)

The Interest Expense Per Year is Computed as:


Example (contd.)

Recognition of Interest Expense of Year 1:

Interest Expense 683.31

Discount on N/P683.31

Cash (non-interest bearing note)

0


Notes Payable Exchanged for Property, Goods, or Services APB opinion No.21 requires the note be

recorded at the fair market value of the property, goods, or services or the fair market value of the note (I.e., the present value of the note is known), whichever is more reliable.

And, the effective interest rate is calculated (when both the P.V. and future cash flows are known) and used to calculate subsequent interest expense using the effective interest method.


Notes Payable Exchanged for Property, Goods, or Services (contd.)

If neither of these values is determinable, the incremental borrowing rate of the borrower is used as the effective interest rate to calculate the P.V. of the note and the interest expense of subsequent years using the effective interest method.


Example B

On 1/1/x5, Marden Company purchases an equipment by issuing a non-interest-bearing 5-year note with a face value of $10,000.

Neither the fair market value of the equipment nor that of the note is determinable.

The incremental borrowing rate of Marden is 12%.


Example (contd.)

J.E. 1/1/x5

Equipment 5,674.27*

Discount on N/P 4,325.73

N/P 10,000

* P.V. of the note using 12% as the effective interest rate => 10,000 x 0.567427


Example (contd.)

12/31/x5

Int. Exp. (5674.27 x 12%) 680.91

Discount on N/P 680.91

Depreciation Expense 567.43

Accumulated Depreciation 567.43

(Assuming a S-L depreciation method is used and a 10-year life is assumed for the equipment)


Example (contd.)

12/31/x6

Int. Exp. (5,674.27 + 680.91) x 12% 762,62

Discount on N/P762.62

Depreciation Expense 567.43

Accumulated Depreciation567.43


Example C

Using the Example B, except that the fair market value the equipment was determined at $6,209.21. The interest rate that equates the future cash flows to the present value of $6,209.21 is 10%.


Example (contd.)

The following entries would be recorded for 20x5 and 20x6:1/1/x5

Equipment 6,209.21Discount on N/P 3,790.89

N/P 10,00012/31/x5

Int. Exp. (6,209.21 x 10%) 621Discount on N/P 621

12/31/x6 Int. Exp. (6,209.21 + 621) x 10% 683

Discount on N/P 683


Example (contd.)

Regardless of the effective interest rate on the long-term note payable, the total expense (interest expense on the unpaid portion of the note plus the depreciation expense of the acquired asset) charged by the company is the same (i.e., $10,000).


Installment Notes – Example D

Notes could be paid by installments (a constant amount paid periodically) rather than by a single amount at maturity.

Using Example B (on p95), assuming an installment payment at the end of each year for the following 5 years, ( starting 12/31/x5), the annual installment payment for the note (loan) equals: $6,209.21/ 3.79079=$1,638


Installment Notes: (Contd.)

Journal Entries:1/1/x5 Equipment 6,209.21

Note Payable 6,209.21

12/31/x5 Interest Exp. * 621N/P 1,017

Cash1,638 *6,209.21 x 10% = 621

12/31/x6 Interest Exp. * 519N/P 1,119

Cash1,638 *(6,209.21 - 1,017) x 10% = 519.2


Installment Notes: (Contd.) Journal Entries:12/31/x7 Interest Exp. * 407 N/P

1,231 Cash1,638 *(6,209-1,017-1,119) x 10% =

40712/31/x8 Interest Exp. * 284 N/P

1,354 Cash1,638 *(6,209-1,017-1,119-1,231) x

10% = 28412/31/x9 Interest Exp. * 149 N/P

1,489 Cash1,638

*(6,209-1,017-1,119-1,231- 1,354) x10% = 149



N/P1017 62091119123113541489 0*rounding error = $1


Mortgage Payable

If the note of Example C was issued for cash, it becomes a mortgage payable example. The journal entries are as follows:

Cash 6,209.21 Mortgage Payable

6,209.21


Mortgage Payable (contd.)

12/31/x5 Interest Exp. * 621Mortgage Pay.1,017

Cash1,638 *6,209.21 x 10% = 621

12/31/x6 Interest Exp. * 519M/P 1,119

Cash1,638 *(6,209.21 - 1,017) x 10% =

519.2



An installment note typically is recorded at its carrying amount (i.e., the face amount - the unamortized discount).

This is because the outstanding balance of an installment does not become its face amount as in the case for notes with a single payment at maturity.

Liabilities: Introduction

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