Balance Sheet Classifications

1. Balance Sheet Classifications Current liabilities: Long-term liabilities: Due within one year of the balance sheet date Due beyond one year LO1

2. Long-Term Liabilities • Bonds payable • Notes payable • Leases • Deferred taxes

3. Bonds Borrower Investor • Long-term borrowing arrangement • Interest paid at stated rate and times • Principal repaid at maturity date LO2

4. Bonds Sold at Face Value Cash 10,000 Bonds Payable 10,000 To record the issuance of bonds at face value. Face value of bonds = Sales price

5. Face rate of interest the rate specified on the bond certificate also called: stated rate coupon rate nominal rate contract rate Market rate of interest the rate that investors could obtain by investing in other bonds similar to the issuing firm’s bonds also called: effective rate yield Bond Interest Rates LO3

6. Two sets of cash flows Calculating Bond Prices (1) Interest payments made each period PV = ? etc. $$ $$ $$ $$ (2) Principal due at maturity PV = ? $$$$$

7. Determining Bond Prices Example: On 1/1/12, Discount Firm issues: • $10,000, 8% bonds • Due December 31, 2015 • Interest payable annually • Market rate of interest = 10% Calculate the issue price of the bonds.

8. Compute interest payment at stated rate (i.e., 8%)... …but discount @ market rate Example of Price Calculation • Present value: • Interest payments: • $800 ×3.16987 = $2,536 • (PV; n = 4; i= 10%) • Principal payment: • $10,000 ×0.68301 = 6,830 • (PV; n = 4; i= 10%) • Bond issue price: $9,366

9. Recording Bond Discounts Cash 9,366 Discount on Bonds Payable 634 Bonds Payable 10,000 To record the issuance of bonds payable. Assets = Liabilities + Stockholders’ Equity +9,366 = –634 +10,000 LO4

10. Balance Sheet Presentation of Bond Discount Long-term liabilities: Bonds payable $10,000 Less: Discount on bonds payable 634 $ 9,366

11. Determining Bond Prices Assume Premium Firm sells the same $10,000, 8% bonds when the market rate on similar bonds is 6%.

12. Compute interest payment at stated rate (i.e., 8%)... …but discount @ market rate Example of Price Calculation • Present value: • Interest payments: • $800 ×3.46511 = $ 2,772 • (PV; n = 4; i= 6%) • Principal payment: • $10,000 ×0.79209 = 7,921 • (PV; n = 4; i= 6%) • Bond issue price: $10,693

13. Recording Bond Premiums Cash 10,693 Bonds Payable 10,000 Premium on Bonds Payable 693 To record the issuance of bonds payable. Assets = Liabilities + Stockholders’ Equity +10,693 = +10,000 + 693

14. Balance Sheet Presentation of Bond Premium Long-term liabilities: Bonds payable $10,000 Plus: Premium on bonds payable 693 $10,693

15. Interest Rates and Bond Prices BONDS ISSUED: IF STATED RATE: Above face value (at a premium) At face value Below face value (at a discount) > MARKET RATE = MARKET RATE < MARKET RATE

16. Amortization of Bond Premiums and Discounts Transferring an amount from the discount or premium account to interest expense over the life of the bond using the effective interest method Premium reduces interest expense Discount increases interest expense LO5

17. Amortization Schedule: Discount Cash Interest DiscountCarrying Date Interest Expense Amortized Value 1/ 1/12 ———$ 9,366 12/31/12 $800 $937 $137 9,503 12/31/13 800 950 150 9,653 12/31/14 800 965 165 9,818 12/31/15 800 982 182 10,000 (rounded)

18. Amortization Schedule: Premium Cash Interest Discount Carrying Date Interest Expense Amortized Value 1/1/12 ———$10,693 12/31/12 $800 $642 $158 10,535 12/31/13 800 632 168 10,367 12/31/14 800 622 178 10,189 12/31/15 800 611 189 10,000 (rounded)

19. Redemption of Bonds • Reasons for early redemption: • Excess cash • Changing interest rates Gain = Carrying Value – Redemption Price Loss = Redemption Price– Carrying Value LO6

20. Leases • Contractual arrangement • Grants right to use asset in exchange for payments • Form of financing Lessee Lessor LO7

21. OFFICE SPACE FOR LEASE Operating Leases • Record as rent (lease) expense each period • Disclose future lease obligations in financial statement notes

22. Capital Lease • Record as asset and corresponding liability (as if purchased through borrowings) • Depreciate asset over lease term • Separate payments into principal and interest components using the effective interest method

23. Criteria for Lease Capitalization Lease meets one or more: • Transfers ownership of property • Contains a bargain-purchase option • Term is >75% of property’s life • Present value of payments is >90% of property’s fair market value

24. IFRS and Leases • In U.S., if any of the previous criteria are present, the lease is considered a capital lease • IFRS considers these criteria as “guidelines” rather than rigid rules • Because of these differences , there is much more flexibility with international standards.

25. Debt-to-Equity Ratio How much have creditors contributed as compared to owners? Total Liabilities Total Stockholders’ Equity LO 8

26. Times Interest Earned Ratio Will they be able to pay the interest on their debt? Income Before Interest and Tax Interest Expense

27. Debt Service Coverage Ratio Will they be able to repay the principal on their loan? Cash Flow from Operations Before Interest and Tax Interest and Principal Payments

28. Long-Term Liabilities on the Statement of Cash Flows Operating Activities Net income xxx Increase in current liability + Decrease in current liability – Investing Activities Financing Activities Increase in long-term liability + Decrease in long-term liability – LO 9

29. Appendix Accounting Tools: Other Liabilities

30. Permanent difference – affects the tax records but not the accounting records, or vice versa Temporary difference – affects both book and tax records but not in the same period Deferred Tax • Used to reconcile the differences between the accounting for book purposes and for tax purposes • Should reflect temporary differences but not permanent differences LO 10

31. Sales Depreciation Expense Taxable Income × Tax Rate Tax Payable to IRS BookTax $6,000 $6,000 2,500 4,000 3,500 2,000 40% 40% $1,400 $ 800 Deferred Income Taxes Difference recorded as deferred tax $ 600

32. Income tax BookTax $1,400 $ 800 Deferred Income Taxes $ 600 Tax Expense 1,400 Tax Payable 800 Deferred Tax 600 To record income tax for the year.

33. End of Chapter 10