Lecture 17-19 Post-Class - ACCT 101 UPENN

Lecture
17-19
Liabilities
Part A
Current Liabilities
Current Liabilities
Liability - A present responsibility to sacrifice assets in
the future due to a transaction or other event that
happened in the past.
Current liabilities are usually, but not always, due within

one year. Notes payable, accounts payable, and payroll
liabilities are the three main categories.
Note: If a company has an operating cycle longer than
one year, its current liabilities are defined by the
operating cycle rather than by the length of a year.
Current liabilities are also sometimes called short-term
liabilities.
3
Current v. Long-Term Liabilities

LIABILITIES
CURRENT
Payable within one
year
LONG-TERM
With in the
Payable
more
company
than
one year
4
Reporting Current
Liabilities
Distinguishing between current and long-term
liabilities helps investors and creditors assess
risk.
Companies often prefer to report a liability as
long-term--it may cause the firm to appear
less risky.
Many companies list notes payable first,
followed by accounts payable, and then other
current liabilities from largest to smallest.
5
Examples of Current Liabilities
Accrued expenses
Accounts/Notes payables
Unearned revenues
Sales taxes payable
The current portion of long-term debt
Sales Taxes
Payable
Company selling products subject to sales
taxes is responsible for collecting the sales
tax directly from customers and periodically
sending the sales taxes collected to the
state and local governments.
When the company collects the sales taxes,
it increases cash (a debit) and increases
sales taxes payable (a credit).
7
Current Portion of Long-Term

Debt
Currently maturing portion of a long-term debt is reported as a

current liability on the balance sheet.
Assume Southwest Airlines had total borrowings of $3,515 million
at December 31, 2009, of which $190 million was payable in 2010
and the remaining $3,325 million is due after 2010. In its 2009
balance sheet, the company records the $3,515 million in current
and long-term debt, as shown below
SOUTHWEST AIRLINES
Balance Sheet (partial)
December 31, 2009
($ in millions)
Current liabilities:
Current portion of long-term debt
Long-term debt
Long-term liabilities:
Total borrowings
$190
3,325
$3,515
8
Contingencies
Apply the appropriate accounting

treatment for contingencies
Contingent liability:
An existing, uncertain situation that
might result in a loss.
Examples: Lawsuits, product
warranties, environmental
problems, and premium offers
10
Contingent Liabilities
Whether we report a loss contingent liability depends
on two criteria:
The likelihood of payment can be:
Probablelikely to occur
Reasonably possiblemore than remote but
less than probable; or
Remotethe chance is slight
The ability to estimate the payment amount is
either:
Known or reasonably estimable; or
Not reasonably estimable.
We record a liability if the loss is probable and the
amount is at least reasonably estimable.
The journal entry to record a contingent liability
requires a debit to a loss (or expense) account and a
credit to a liability.
11
Contingent
Liabilities
If the likelihood of payment is probable and if one
amount within a range appears more likely, we
record that amount.
When no amount within the range appears more
likely than others, we record the minimum amount
and disclose the potential additional loss.
If the likelihood of loss is reasonably possible
rather than probable, we record no entry but make
full disclosure in a footnote to the financial
statements to describe the contingency.
If the likelihood of payment is remote, disclosure
usually is not required.
12
Warranties
When you buy a new Dell notebook, it comes with a warranty

covering the hardware from defect for either a 90-day, oneyear, or two-year period depending on the product.
Why does Dell offer a warranty?
To increase sales, of course.
Based on the matching principle, the company needs to
record warranty expense in the same accounting period as
the sale.
A warranty represents an expense and a liability at the time of
the sale, because it meets the criteria for recording a
contingent liability.
Even though Dell doesnt know exactly at the time of the sale
what that warranty expense will be, it can, based on
experience, reasonably estimate the amount.
13
Recording
Contingent Liabilities
Example:
Dell Computer sells a computer product for $5,000 with a

one-year warranty. In 2010, 100 computers were sold for a
total sales revenue of $500,000.
Analyzing past records, Dell estimates that repairs will
average 2% of total sales.
Warranty expenses
Warranty liability
10,000
10,000
Contingent Gains
Is an existing uncertain situation that might result in
a gain, which often is the flip side of contingent
liabilities.
In a pending lawsuit, one sidethe defendant
faces a contingent liability, while the other sidethe
plaintiffhas a contingent gain.
We record contingent liabilities when the loss is
probable and the amount is reasonably estimable.
We do not record contingent gains
Though firms do not record contingent gains in the
accounts, they sometimes disclose them in notes to
the financial statements
15
Assess liquidity
Liquidity Analysis
Liquidity refers to having sufficient cash to pay currently maturing
debts.
Working Capital:
It is the difference between current assets and current liabilities.
Current ratio:
We calculate it by dividing current assets by current liabilities.
Acid-test ratio/Quick ratio:

We calculate it by dividing quick assets by current liabilities.
Quick assets include cash, short-term investments, and accounts
receivable.
16
Lets
Review
Selected financial data regarding current assets and current liabilities for
United and Southwest Airlines are as follows
($ in millions)
Current assets
Cash and cash equivalents
Current investments
Net receivables
Inventory
Other current assets
Total current assets
Current liabilities
Accounts payable
Short/current long-term debt
Other current liabilities
Total current liabilities
United
$3,046
977
237
601
$4,861
$3,231
1,808
2,242
$7,281
Southwest
$1,368
435
574
203
313
$2,893
$2,643
163
$2,806
1. Calculate working capital for United Airlines and Southwest Airlines.

2. Calculate the current ratio for United Airlines and Southwest Airlines.
3. Calculate the acid-test (quick) ratio for United Airlines and Southwest Airlines.
17
Lets
Review
Solution:
1. ($ in
Total
Current
Assets
United
$4,861
$7,281
$(2,420)
Southwest
$2,893
$2,806
$ 87
($ in
millions)
Total
Current
Assets
United
$4,861
$7,281
0.67
Southwest
$2,893
$2,806
1.03
($ in
millions)
Quick
Assets
Total Current
Liabilities
Acid-Test
Ratio
United
$4,023
$7,281
0.55
Southwest
$2,377
$2,806
0.85
millions)
2.
Total Current
Liabilities
Working
Capital
=
Total Current
Liabilities
Current
Ratio
=
3.
18
Part B
Long Term
Debt
Explain financing alternatives

Financing Options
Debt Financing - borrowing
money (liabilities)
Equity Financing - obtaining
additional investment from
stockholders (stockholders
equity)
Capital Structure - is the mixture
of liabilities and stockholders
equity used by a business
20
What is a Bond?
A formal debt instrument that obligates

the borrower to repay a stated amount,
referred to as the principal or face
amount, at a specified maturity date.
In return, the borrower agrees to pay
interest over the life of the bond.
Similar to notes payable, except bonds
are usually issued to many lenders at
the same time.
Traditionally, interest on bonds is paid
twice a year (semi-annually).
Bonds are sold or underwritten by
investment houses like JPMorgan,
Citibank and Bank of America.
21
Bonds - Example
Note that the bond terms simply communicate a flow of cash payments
$10,000 face value

5.25% interest
15 year life
Pays $525 of interest each period plus $10,000 at the end
Pricing a Bond
Valuing Bonds
We are issuing bonds of $1,000 face value, 10% coupon rate, due in 2 years. Interest
is paid semiannually.
Period 0
Cash flow
$50
$50
$50
4
$50
+ 1,000
principal
What will be the price of the bonds when they are issued (i.e., how much cash
proceeds will we get?)
It depends on the market interest rate on the day the bonds are issued!
Bondholders are willing to give the company an amount equal to the present
value of future cash flows discounted at the market rate of interest. So Proceeds at
issuance depend on:
issued)
Face value of the Bonds ($1,000)

Coupon interest rate (5% semi-annually)
Effective Interest Rate at Issuance (i.e., market interest rate when
24
Determine the price of

a bond issue
Issue price is calculated as the present value of the face

amount plus the present value of the periodic interest
payments.
Bonds can be issued at:
Face amount
Below face amount (discount)
Above face amount (premium)
Ways to determine the issue price of bonds:
Financial calculator
Excel Spreadsheet
Calculate the price of the bonds using present
value tables
25
Determine the price of a

bond issue (Cont.)
Market Interest Rate true interest rate used
by investors to value a companys bond issue.
The higher the market interest rate, the
lower will be the bond issue price.
Stated Interest Rate (coupon rate) rate
quoted in the bond contract used to calculate
the cash payments for interest.
Periods to Maturity number of years to
maturity multiplied by the number of interest
payments per year.
26
Bonds Issued at Face Amount
Pricing Bonds Issued at Face Amount Using a Financial

Calculator
Illustration of RC Enterprises:
The face amount equals $100,000. The interest payment every

six months is $3,500 (= $100,000 x 7% x year).
The market rate can be equal to, less than, or greater than the
stated 7% interest rate paid to investors. Lets first assume the
market interest rate is 7%. RCs bonds pay interest semi-annually
for 10 years .
27
Bonds Issued at Face Amount

An alternative to using a financial calculator is to
calculate the issue price of the bonds using
present value tables.
Present value of face amount
= $100,000 x 0.50257*
Present value of interest payments
= $3,5001
Issue price of the bonds

1
x14.21240**
$ 50,257
49,743
$100,000
$100,000 x 7% x year = $3,500
* Table 2, i = 3.5% , n = 20
** Table 4, i = 3.5% , n = 20
28
Bonds Issued at a Discount
RC Enterprises issues the same $100,000 of 7% bonds when

other bonds of similar risk and maturity are paying 8%.
RCs bonds are less attractive to investors because they can
purchase bonds of similar risk that are paying the higher 8% rate.
RC will have to issue its 7% bonds below its $100,000 face
amount.
Bonds issued below face amount are said to be issued at a
discount.
Pricing Bonds Issued at a Discount Using a Financial Calculator
29
Bonds Issued at a Discount

Pricing bonds issued at a discount using present
value tables.
Present value of principal
= $100,000 x 0.45639*
Present value of interest payments = $3,5001

1
x 13.59033**
$45,639
47,566
$93,205
$100,000 x 7% x year = $3,500
* Table 2, i = 4% , n = 20
** Table 4, i = 4% , n = 20
The bond issue price is below the face amount of $100,000.

The issuing company receives only $93,205 from investors,
but will pay back $100,000 when the bonds mature in 10
years.
30
Bonds issued at a Premium
RC Enterprises issues $100,000 of 7% bonds when other bonds

of similar risk and maturity are paying only 6%.
Investors will pay more than $100,000 for 7% bonds since they
look relatively attractive compared with bonds paying only 6%.
These bonds will sell for a premium. A premium occurs when the
issue price of a bond is above its face amount. In this case, RCs
bonds will sell for more than $100,000.
Pricing of Bonds Issued at a Premium using a Financial
Calculator shown below
31
Bonds issued at a Premium

Pricing bonds issued at a premium
using present value tables.
Present value of principal
= $100,000 x 0.55368*
Present value of interest payments = $3,5001

1
$ 55,368
x 14.87747**
52,071
$107,439
$100,000 x 7% x year = $3,500
* Table 2, i = 3% , n = 20
** Table 4, i = 3% , n = 20
The bond issue price is above the face amount of $100,000.

RC Enterprises receives $107,439 from investors, but will
need to pay back only $100,000 when the bonds mature in
10 years.
32
Determine the price of a bond issue
33
Recording Bonds Payable
Account for the issuance of bonds
On January 1, 2012, RC Enterprises issues $100,000 of 7% bonds, due

in 10 years, with interest payable semi-annually on June 30 and
December 31 each year.
The bonds issue for exactly $100,000, assuming a 7% market interest
rate. RC Enterprises records the bond issue as:
January 1, 2012
Cash
Bonds Payable
(Issued bonds at face amount)
Debit
100,000
Credit
100,000
On June 30, 2012, RC Enterprises records the first semiannual interest payment:
June 30, 2012
Interest Expense
Cash
(Record semiannual interest
payment)
($100,000 x 7% x 1/2 = $3,500)
Debit
3,500
Credit
3,500
35
Recording Bonds Issued at a Discount
In the preceding example we assumed the stated interest rate (7%) and the
market interest rate (7%) were the same.
If the market interest rate is 8%, the bonds will issue at only $93,205.
This is less than $100,000. The bonds are paying only 7%, while investors
can purchase bonds of similar risk paying 8%.
The entry RC Enterprises makes to record the bond issue at a discount is:
Cash
Discount on Bonds Payable
Bonds Payable
93,205
6,795
100,000
The balance in the bonds payable account is (100,0006,792) and is called the net carrying value. The
carrying value will increase from the amount originally
borrowed ($93,205) to the amount due at maturity
($100,000) over the 10-year life of the bonds.
36
Recording Bonds Issued at a Discount

We calculate interest expense as the carrying value (the amount
actually owed during that period) times the market rate (4% semiannually or 8% annually, in our example)
Interest
expense
Carrying
value of
bond
$3,728
$93,205
Market
interest rate
per period
8% x
Cash paid for interest is equal to the face amount times the stated
rate (3.5% semi-annually or 7% annually, in our example).
Cash paid
for
Interest
Face
amount of
bond
$3,500
$100,000
Stated
interest rate
per period
7% x
37
RC Enterprises records the following journal entries:
June 30, 2012
Debit
Interest Expense ($93,205 x 8% x )
3,728
Discount Bonds Payable (difference)
Credit
228
Cash ($100,000 x 7% x )
3,500
(Record semiannual interest payment)
Dec 31, 2012
Debit
Interest Expense ([$93,205 +228]x 8% x )
3,737
Discount on Bonds Payable (difference)

Cash ($100,000 x 7% x )
Credit
237
3,500
(Record semiannual interest payment)
38
Amortization Schedule for Bond Discount
An amortization schedule provides a nice

summary of the cash interest payments,
interest expense, and changes in carrying
value for each semi-annual interest period.
The amounts for the June 30, 2012 and the
December 31, 2012 semi-annual interest
payment entries can be taken directly from the
amortization schedule.
39
(1)
Date
(2)
Cash Paid
for interest
(3)
Interest
Expense
(4)
Discount
Amortization
(5)
Carrying
Value
(6)
Ending
Unamortized
Discount
Face Amount x
Stated Rate
Carrying
Value x
Market
Rate
(3) (2)
Prior Carrying
Value + (4)
Face Amount
- (5)
$93,205
$6,795
1/1/2012
6/30/2012
$3,500
$3,728
$228
93,433
6,567
12/31/2012
3,500
3,737
237
93,670
6,330
99,057
943
481
6/30/2021
3,500
3,962
462
99,519
12/31/2021
3,500
3,981
481
$100,000
0
40
Recording Bonds Issued at a Premium
RC Enterprises issues $100,000 of 7% bonds when other

bonds of similar risk are paying only 6%.
The bonds will issue at $107,439. Investors will pay more than
$100,000 for these 7% bonds because bonds of similar risk are
paying only 6% interest.
The entry to record the bond issue at a premium is:
Cash
107,439
Premium on Bonds Payable
Bonds Payable
7,439
100,000
The carrying value of bond is $107,439.
41
RC Enterprises records the following journal entries:
June 30, 2012
Debit
Interest Expense ($107,439 x 6% x )
3,223
Premium on Bonds Payable (difference)
Credit
277
Cash ($100,000 x 7% x )
3,500
(Semi-annual interest payment)
Dec. 31, 2012
Debit
Interest Expense ([$107,439 -227]x 6% x )
3,215
Premium on Bonds Payable (difference)

Cash ($100,000 x 7% x )
Credit
285
3,500
(Semi-annual interest payment)
42
Amortization Schedule for Bond Premium
An amortization schedule provides a nice summary

of the cash interest payments, interest expense,
and changes in carrying value for each semiannual interest period.
The amounts for the June 30, 2012 and the
December 31, 2012 semi-annual interest payment
entries can be taken directly from the amortization
schedule.
43
(1)
Date
(2)
Cash Paid
for interest
(3)
Interest
Expense
(4)
Premium
Amortization
(5)
Carrying
Value
(6)
Ending
Unamortized
Premium
Face Amount x
Stated Rate
Carrying
Value x
Market
Rate
(2) (3)
Prior Carrying
Value - (4)
(5)Face Amount
$107,439
$7,439
1/1/2012
6/30/2012
$3,500
$3,223
$277
107,162
7,162
12/31/2012
3,500
3,215
285
106,877
6,877
100,956
956
6/30/2021
3,500
3,029
471
100,485
485
12/31/2021
3,500
3,015
485
$100,000
0
44
Changes in Carrying Value

Over Time
45
Record the retirement of

bonds
When the issuing corporation buys back its bonds from the
investors, it is said that the company has retired those bonds.
It can wait until the bonds mature to retire them, or in most
cases, the issuer will choose to buy the bonds back early
BOND RETIREMENTS AT MATURITY
Regardless of whether bonds are issued at face amount, a
discount, or a premium, their carrying value at maturity will equal
their face amount.
RC Enterprises records the retirement of its bond at maturity as:
December 31, 2021
Bonds Payable
Cash
(Retire bonds at maturity)
Debit
Credit
100,000
100,000
46
Bond Retirements Before

Maturity
Firms need not necessarily wait until the maturity date
before retiring an obligation. Particularly, in the case of
publicly traded bonds, firms may choose to retire all or a
part of the issue prior to maturity.
Purchase on open market
Redeem callable bonds
When the issuer retires debt before its scheduled maturity

date, the transaction is called an early extinguishment
If the amount paid to retire a bond is different from its
carrying value, the firm recognizes a gain or loss from the
transaction.
Amount paid>carrying value => Loss
Amount paid<carrying value => Gain
47
Early Retirement of Bond

From bonds issued at discount example:
(1)
Date
(2)
Cash Paid
for interest
(3)
Interest
Expense
(4)
Discount
Amortization
1/1/2012
(5)
Carrying
Value
(6)
Ending
Unamortized
Discount
$93,205
$6,795
6/30/2012
$3,500
$3,728
$228
93,433
6,567
12/31/2012
3,500
3,737
237
93,670
6,330
Suppose the company purchases the bond on the open

market on Jan. 1, 2013. The market price (purchase
price) of the bonds was $93,000.
Bond Payable
100,000
Gain on Bond Retirement
670
Discount on Bond Payable
6,330
Cash
93,000
Early Retirement of Bond

From bonds issued at premium example:
(1)
Date
(2)
Cash Paid
for interest
(3)
Interest
Expense
(4)
Premium
Amortization
1/1/2012
(5)
Carrying
Value
(6)
Ending
Unamortized
Premium
$107,439
$7,439
6/30/2012
$3,500
$3,223
$277
107,162
7,162
12/31/2012
3,500
3,215
285
106,877
6,877
Suppose the company purchases the bond on the open

market on Jan. 1, 2013. The market price (purchase
price) of the bonds was $107,000.
Bond Payable
100,000
Loss on Bond Retirement
123
Premium on Bond Payable
6,877
Cash
107,000
Summary of Bonds Payable

Par/Face value
Discount
Premium
Interest Rate
Coupon = Market
Coupon < Market
Coupon > Market
Cash Interest
Pymts
Use coupon rate
Use coupon rate
Use coupon rate
= Cash Interest
Pymts
> Cash Interest

Pymts
< Cash Interest Pymts
Face Value
Face Value
Discount
Face Value +
Premium
Interest
Expense*
Balance Sheet
Carrying Value
* In all three cases, Interest expense=Carrying value*Market interest

rate
50
Group Exercise
On Jan. 1, 2010. XL Corp issued bonds of $1,000 face value, 10%
coupon rate, due in 2 years, interest paid semiannually. Record the
journal entries of bond issuance, all interest payments, and
repayment at maturity.
Assume following three scenarios:
1) The market interest rate is 10%.
Suppose XL Corp purchased the bonds back on Jan. 1, 2011 at a
price of $960. Record the journal entries for each scenario.
51
1) Bonds Issued at Face Value

Issuing bonds of $1,000 face value, 10% coupon, due in 2 years,
interest paid semiannually. The market interest rate is 10%.
When the market rate equals the coupon rate, bonds are
issued at par.
Cash
1,000
Bonds Payable
1,000
Journal entry for payments (made every 6 months):
Interest Expense
Cash
50
50
Journal entry at maturity on 12/31/2011:
Bonds Payable
Cash
1,000
1,000
52
2) Bonds Issued at Discount

Cash Proceeds = PV Principal + PVAnnuity Coupon
= ( $1,000 * 0.7921 ) + ( $50 * 3.4651 )
= $792.10 + 173.25
= $965.35
PV factor of
6% @ 4 periods
PVA factor of
6% @ 4 periods
When the market rate is greater than the coupon rate,

bonds are issued at a discount.
Cash
Discount on Bonds Payable
Bonds Payable
965.35
34.65
1,000.00
53
2) Amortization of Bond Discount

Beginning
Carrying
Interest
Cash
Date
Value
Expense(6%) Payment
6/30/2010
965.35
57.92
50.00
12/31/2010
973.27
58.40
50.00
6/30/2011
981.67
58.90
50.00
12/31/2011
990.57
59.43
50.00
Discount
Amortization
7.92
8.40
8.90
9.43
Ending
Ending
Unamortized Carrying
Discount
Value
26.73
973.27
18.33
981.67
9.43
990.57
0
1000.00
Journal entry for first interest payment on 6/30/2010:

Interest Expense
57.92
Cash
7.92
50.00

Bonds Payable
1,000
Cash
1,000
Journal entry of early retirement on Jan. 1, 2011 with purchase
price of $960.
Bond Payable
1000.00
21.67
18.33
Cash
960.00
54
3) Bonds Issued at Premium

Cash Proceeds = PV Principal + PVA Coupon
= ( $1,000 * 0.8548 ) + ( $50 * 3.6299 )
= $854.80 + 181.50
= $1,036.30
PV factor of
4% @ 4 periods
PVA factor of
4% @ 4 periods
When the market rate is less than the coupon rate, bonds
are issued at a premium.
Cash
1,036.30
Premium on Bonds Payable
36.30
Bonds Payable
1,000.00
55
3) Amortization of Bond Premium

Period:
6/30/2010
12/31/2010
6/30/2011
12/31/2011
Beginning
Carrying
Interest
Cash
Value
Expense(4%) Payment
1,036.30
41.45
50.00
1,027.75
41.11
50.00
1,018.86
40.75
50.00
1,009.61
40.39
50.00
Premium
Amortization
8.55
8.89
9.25
9.61
Ending
Unamortized
Premium
27.75
18.86
9.61
0
Journal entry for first interest payment on 6/30/2010:

Interest Expense
41.45
8.55
Cash
Ending
Carrying
Value
1,027.75
1,018.86
1,009.61
1,000.00
50.00

Bonds Payable
1,000
Cash
1,000
Journal entry of early retirement on Jan. 1, 2011 with purchase
price of $960.
Bond Payable
Cash
1000.00
18.86
58.86
960.00
56
Leases
Accounting for Leases

Lease: Contract whereby an owner grants
the use of property to a second party in
exchange for regular rental payments
Lessor: Owner of property who grants usage
rights to the lessee
Lessee: Party that has the right to use leased
property and makes lease payments to the
lessor
Legal title to property remains with lessor
Types of Leases
Capital (finance) leases: Transfers most
risks and benefits of ownership to the lessee
Property accounted for as an asset and obligation
to pay as liability
Operating leases: Should not be recognized

as liabilities on the balance sheet
Should be accounted for by the lessee as
ordinary rent expenses
Criteria for a Capital Lease

If any one of the following criteria are met, the lease is accounted for
as a capital lease:
1) Ownership of the asset is transferred to the lessee at the end
of the lease term.
2) A "bargain purchase" option exists. A bargain purchase
option exists if the lessee can purchase the asset for a price that
seems sufficiently less than the estimated fair market value on
the exercise date that the option is likely to be exercised.
3) The lease term is 75% or more of the estimated useful life of
the asset.
4) The present value of the minimum lease payments is 90% or
more of the estimated fair market value of the equipment.
If none of these four criteria are met, the lease is treated as an
operating lease.
Criteria for a Capital Lease

The determination of whether a lease qualifies as a
capital lease or as an operating lease is highly subjective
and discretionary.
When is a purchase option a "bargain purchase" option?
What is the "useful life" of the asset?
What is the "fair market value" of a (customized) asset?
If the lease qualifies as a capital lease, the answers to

these questions will influence the recorded value of the
lease assets and liabilities.
Lease Example
RalphCo decides to lease a truck from Jerry's Truck Mart. The truck is
estimated to have a cash purchase price of $16,000, a useful life of four years,
and an estimated salvage value of $0.
On January 1, 2006, RalphCo signs a two-year lease, with annual payments of
$5,000 to be made at the end of each year. At the end of the lease term,
RalphCo must return the truck to Jerrys. If RalphCo were to get a bank loan to
purchase the truck directly, the interest rate would be 10% per year.
True or False? This is an Capital Lease.
False (operating lease):
1. Ownership transfer at end of lease? No.
2. Bargain purchase option? No.
3. Term 75% of useful life? 2/4 = 50% 75%? No.
4. PV of payments 90% of Fair Value?
$5,000 x 1.7355 = $8,678 90% of Fair Value (=90%*16,000= $14,400 )? No.
Prepare the journal entries for RalphCo resulting from the lease.
Lease Example
On January 1, 2006, RalphCo signs a two-year lease, with annual payments of
$5,000 to be made at the end of each year. At the end of the lease term,
RalphCo must return the truck to Jerrys. If RalphCo were to get a bank loan to
purchase the truck directly, the interest rate would be 10% per year.
Each year, the journal entry for RalphCo is:
Rent Expense
Cash
5,000
5,000
The lease payment is expensed in the year it is incurred

No recognition of any asset or liability associated with the lease
Lease Example
Now suppose January 1, 2006, RalphCo signs a four-year lease, with annual
payments of $5,000 to be made at the end of each year. At the end of the
lease term, RalphCo must return the truck to Jerrys. If RalphCo were to get a
bank loan to purchase the truck directly, the interest rate would be 10% per
year.
True:
3. Term 75% of useful life? 4/4 = 100% 75%? YES.
$5,000 x 3.1699 = 15,850 14,400 = 90% of Fair Value? YES.
Lease Example
The lease is accounted for as if the truck had been purchased via a
financing agreement. The initial asset and liability amounts are
recorded at the present value of the lease payments.
1/1/06 (record the lease):
Leased Asset Truck
15,850
Capital Lease Liab., current
3,415
Capital Lease Liab., long-term
12,435
PV of payments = annuity of $5,000 for 4 years at 10% = $15,850
Current portion = First years payment First years interest
= $5,000 - $15,850 * 10%
= $5,000 - $1,585
= $3,415
Lease Example Schedule of Payments

(1)
CapitalLease
Liabilityat
BeginningofYear
15,850
12,435
8,679
4,546
(2)
InterestExpense
at10%perYear
1,585
1,244
868
454
(3)
CashforCapital
LeasePayment
5,000
5,000
5,000
5,000
(4)
(5)
(3)(2)
Reductionin
LeaseLiability
3,415
3,757
4,132
4,546
(1)(4)
CapitalLease
LiabilityatEndof
Year
12,435
8,679
4,546
(0)
Lease Example End of Year Entries: 2006
Depreciate Leased Asset (assuming straight line, 4 years)

Leased Asset Truck Amort. Exp.
3,963
Acc. Amort. of Leased Asset Truck
3,963
Record Lease Payment
Interest Exp. (carrying value*interest rate)
1,585
3,415
Cash
5,000
Reclassify Lease Obligation
3,757*
3,757
*Current portion=Next periods payment - Next periods interest
=5,000-12,435*10%=3,757
Depreciate Leased Asset

3,963
Interest Exp.
1,244
3,757
Cash
4,132
3,963
5,000
4,132

3,962
3,962
Interest Exp.
868
4,132
Cash
5,000
4,546
4,546

3,962
3,962
Interest Exp.
454
4,546
Cash
5,000
Lease Example Schedule of Payments

(1)
Endof
Year
2006
2007
2008
2009
CapitalLease
Liabilityat
BeginningofYear
15,850
12,435
8,679
4,546
TotalInterestExp
TotalAmort.Exp
TotalInt.&Amort.
(2)
InterestExpense
at10%perYear
1,585
1,244
868
454
4,150
15,850
20,000
(3)
CashforCapital
LeasePayment
5,000
5,000
5,000
5,000
(4)
(5)
(3)(2)
Reductionin
LeaseLiability
3,415
3,757
4,132
4,546
(1)(4)
CapitalLease
LiabilityatEndof
Year
12,435
8,679
4,546
(0)
20,000 TotalCashPayments
Make financial decisions using

long-term liability ratios
73
Debt to equity ratio
Debt requires payment on specific dates. Failure to repay a debt or

the interest on the debt on a timely basis may result in default or in
some cases bankruptcy.
A companys risk increases as it accumulates more debt.
Debt can also be an advantage. This occurs when a company earns
a return that is greater than the cost of borrowing those funds,
thereby increasing the return to stockholders.
We calculate the debt to equity ratio as:
Debt to
equity
ratio
Total liabilities
=
Stockholders equity
74
Times interest earned

ratio
Lenders require interest payments in return for the use of their

money. Failure to pay interest when it is due may invoke
penalties, possibly leading to bankruptcy.
The times interest earned ratio compares interest expense with
income available to pay those charges.
To measure the amount available to pay interest we need to add
interest expense back to net income. Similarly, because interest
expense is deductible for income tax purposes, we need to add
back tax expense as well.
Times interest
earned ratio
Net income + Interest expense + Tax

expense
=
Interest expense
75
Group Exercise-Leases
SmithCo decides to lease a jet from DaveCo. The jet is estimated to
have a cash purchase price of $16,000, a useful life of four years,
and an estimated salvage value of $0. On January 1, 2006, SmithCo
signs a four year non-cancellable lease, with annual payments of
$5,000 to be made at the end of each year. At the end of the lease
term, SmithCo must return the jet to DaveCo. If SmithCo were to get
a bank loan to purchase the jet directly, the interest rate would be
11% per year.
1) How much interest expense related to this lease was recognized
by SmithCo during the first year of the lease term?
2) How much was the balance in the lease obligation (liability) at the
end of year 2006?
76
True:
3. Term 75% of useful life? 4/4 = 100% 75%? YES.
$5,000 x 3.1024 (annuity factor at 11% discount rate) = 15,512
14,400 = 90% of Fair Value? YES.
Prepare the journal entries for SmithCo resulting from the capital lease.
1/1/06 (record the lease):
Leased Asset Jet
15,512
3,294
12,218
PV of payments = annuity of $5,000 for 4 years at 11% = $15,512
Current portion = First years payment First years interest
= $5,000 - $15,512 * 11%
= $5,000 - $1,706
= $3,294
End of Year Entries: 2006
Depreciate Leased Asset (assuming straight line, 4 years)

Leased Asset Jet Amort. Exp. 3,878
Acc. Amort. of Leased Asset Jet
3,878
Interest Exp. (carrying value*interest rate)
1,706
3,294
Cash
5,000
So outstanding lease obligation at end of 2006 is: 1,5512-3,294=12,218

Lecture 17-19 Post-Class - ACCT 101 UPENN

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Lecture 17-19 Post-Class - ACCT 101 UPENN

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Lecture

Current liabilities are usually, but not always, due within

Current v. Long-Term Liabilities

Examples of Current Liabilities

Current Portion of Long-Term

Currently maturing portion of a long-term debt is reported as a

Apply the appropriate accounting

When you buy a new Dell notebook, it comes with a warranty

Dell Computer sells a computer product for $5,000 with a

Acid-test ratio/Quick ratio:

1. Calculate working capital for United Airlines and Southwest Airlines.

Explain financing alternatives

A formal debt instrument that obligates

$10,000 face value

Pays $525 of interest each period plus $10,000 at the end

Face value of the Bonds ($1,000)

Determine the price of

Issue price is calculated as the present value of the face

Determine the price of a

Bonds Issued at Face Amount

Pricing Bonds Issued at Face Amount Using a Financial

The face amount equals $100,000. The interest payment every

Bonds Issued at Face Amount

Present value of interest payments

Issue price of the bonds

$100,000 x 7% x year = $3,500

Bonds Issued at a Discount

RC Enterprises issues the same $100,000 of 7% bonds when

Bonds Issued at a Discount

Present value of interest payments = $3,5001

$100,000 x 7% x year = $3,500

The bond issue price is below the face amount of $100,000.

Bonds issued at a Premium

RC Enterprises issues $100,000 of 7% bonds when other bonds

Bonds issued at a Premium

Present value of interest payments = $3,5001

$100,000 x 7% x year = $3,500

The bond issue price is above the face amount of $100,000.

Determine the price of a bond issue

Recording Bonds Payable

Account for the issuance of bonds

On January 1, 2012, RC Enterprises issues $100,000 of 7% bonds, due

Recording Bonds Issued at a Discount

Recording Bonds Issued at a Discount

RC Enterprises records the following journal entries:

June 30, 2012

Interest Expense ($93,205 x 8% x )

Discount Bonds Payable (difference)

(Record semiannual interest payment)

Dec 31, 2012

Interest Expense ([$93,205 +228]x 8% x )

Discount on Bonds Payable (difference)

(Record semiannual interest payment)

Amortization Schedule for Bond Discount

An amortization schedule provides a nice

Recording Bonds Issued at a Premium

RC Enterprises issues $100,000 of 7% bonds when other

The carrying value of bond is $107,439.

RC Enterprises records the following journal entries:

June 30, 2012

Interest Expense ($107,439 x 6% x )

Premium on Bonds Payable (difference)

(Semi-annual interest payment)