Accounting Boot CampAccounting Boot CampModules 6 and 8Modules 6 and 8

Time Value of Money,Time Value of Money,Liabilities and EquityLiabilities and Equity

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LiabilitiesLiabilities

What is a liability?– “Probable future sacrifice of economic benefits

arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.”

– Future sacrifice of economic benefits.– Present obligations.– Past transactions or events.

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A. Current LiabilitiesA. Current Liabilities Classification

– expected to require the use of current assets (or the creation of other current liabilities) to settle the obligation.

Valuing current liabilities on the balance sheet– Ignore present value– Report at face value

Reporting current liabilities– Primary problem is ensuring that all existing

current liabilities are reported on the balance sheet.

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Current Operating LiabilitiesCurrent Operating Liabilities1.Accounts payable - for purchase of goods and

services (usually no interest). 2. Accrued liabilities - short-term payables usually

settled with cash in the near future. Ex: Wages, Interest, Income Tax, Utilities, Vacation Pay, Bonuses, Property Taxes.

3. Unearned revenues - usually settled with delivery of goods and services.

4. Estimated accruals - amounts not known at the end of the period and must be estimated. Ex: Warranties.

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WarrantiesWarranties5.Companies generate sales revenue when they sell

products; offering warranties is part of the cost of selling the product; the amount of the future warranty costs is not known, but may be estimated.

– Record estimated expense and liability when products are sold (matching concept):

Warranty Expense xx

Estimated Warranty Liability xx– As costs are incurred (usually in subsequent periods),

charge expenditure to warranty liability:

Estimated Warranty Liability xx

Cash, etc. xx

Note: warranties, like other estimates, may be subject to manipulation.

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LawsuitsLawsuits6. What about lawsuits where the company is the

defendant? Should we accrue for the possible future liability?

Only if the settlement is “probable” and “reasonably estimable”.

Since the criteria are vague, and legal staff can usually find sufficient evidence to indicate some level of probability that the defendant will prevail, estimated liabilities for lawsuits are rarely recorded.

However, most lawsuits meet the minimum requirement of “reasonably possible” and must be disclosed in the notes to the financials; these disclosures inform investors as to the potential exposure. Most companies have a section for “Contingencies” in their footnotes.

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Current Non-Operating LiabilitiesCurrent Non-Operating Liabilities7.Short-Term Interest-Bearing Debt -

borrowing from bank is a financing activity, and not part of operations.

8.Current Portion of Long-Term Debt - the portion of long-term liabilities, like bonds and mortgages, that will come due within the next 12 months (as of the financial statement date), will require the use of current assets (specifically cash) to settle the liabilities; these liabilities must be classified as current liabilities.

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B. Long-Term Liabilities: Bonds PayableB. Long-Term Liabilities: Bonds Payable

Long-term liabilities are initially recorded at the present value of the future cash flows.

Before discussing long-term liabilities, we must first introduce the concept of present value.

Future value applications are discussed in a later section.

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Time Value of MoneyTime Value of MoneyAppendix 8A (pages 8-27 through 8-32)Appendix 8A (pages 8-27 through 8-32)

The value of a dollar today will decrease over time. Why?

Two components determine the “time value” of money:– interest (discount) rate– number of periods of discounting

For financial reporting, we are concerned primarily with present value concepts.

Other investment decisions utilize future value concepts.

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Present Value ConceptsPresent Value Concepts

To record activities in the general ledger dealing with future cash flows, we should calculate the present value of the future cash flows using present value formulas or techniques.

Types of activities that require PV calculations:– long-term notes payable – bonds payable and bond investments– capital leases

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Types of Present Value CalculationsTypes of Present Value Calculations

PV of a single sum (PV1): discounting a future value of a single amount that is to be paid in the future (ex: face value of bonds payable).

PV of an ordinary annuity (PVOA): discounting a set of payments, equal in amount over equal periods of time, where the first payment is made at the end of each period (ex: interest on bonds payable).

Note: present value of an annuity due will also be discussed in ACCT 5301.

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Present Value of a Single SumPresent Value of a Single SumAll present value calculations presume a discount rate (i) and a number of periods of discounting (n).There are 4 different ways you can calculate the PV1:

1. Formula: PV1 = FV1 [1/(1+i)n]2. Tables: see page A2 (back of text), Table 1

PV1 Table

PV1 = FV1( ) i, n

3.Calculator (with time value functions)4.Spreadsheet

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Illustration 1: L.T. Notes PayableIllustration 1: L.T. Notes Payable Long-term, usually issued to financial institutions. May be interest bearing or non-interest bearing

(we will look at non-interest bearing). May be serial notes (periodic payments) or term

notes (balloon payments). We will look at balloon payments here.

Note: zero coupon bonds are similar in treatment to non-interest bearing notes.

Illustration 1: On January, 2, 2009, Pearson Company purchases a section of land for its new plant site. Pearson issues a 5 year non-interest bearing note, and promises to pay $50,000 at the end of the 5 year period. What is the cash equivalent price of the land today, if a 6 percent discount rate is assumed?

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Illustration 1 SolutionIllustration 1 Solution

See page A2 (back of the text), Table 1

PV1 Table

PV1 = FV1( ) i, n PV1 Table

i=6%, n=5 Journal entry Jan. 2, 2009:

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2. Present Value of an Ordinary Annuity 2. Present Value of an Ordinary Annuity (PVOA)(PVOA)

An annuity is defined as equal payments over equal periods of time. An ordinary annuity assumes that each payment occurs at the end of each period.PVOA calculations presume a discount rate (i), where (A) = the amount of each annuity, and (n) = the number of annuities (or rents), which is the same as the number of periods of discounting. There are 4 different ways you can calculate PVOA:1. Formula: PVOA = A [1-(1/(1+i)n)] / i 2. Tables: see page A-2 (back of text), Table 2

PVOA Table

PVOA = A( ) i, n

3.Calculator (with time value functions)4.Spreadsheet

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Illustration 2: Long Term Notes PayableIllustration 2: Long Term Notes Payable

Illustration 2: On January, 2, 2008, Pearson Company purchases a section of land for its new plant site. Pearson issues a 5 year non-interest bearing note, and promises to pay $10,000 per year at the end of each of the next 5 years. What is the cash equivalent price of the land, if a 6 percent discount rate is assumed?

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Illustration 2 SolutionIllustration 2 Solution

See Appendix A, Table 2

PVOA Table

PVOA = A ( ) i, n PVOA Table

= i=6%, n=5

Journal entry Jan. 2, 2008:

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Bonds PayableBonds PayableBonds payable are issued by a company

(usually to the marketplace) to generate cash flow.

The bonds represent a promise by the company to pay a stated interest each period (yearly, semiannually, quarterly), and pay the face amount of the bond at maturity.

The marketplace values bonds by discounting the cash flows using the market rate of interest. This is also called the yield rate, discount rate, or effective rate.

There are two types of cash flows with bonds: PVOA (for interest payments) and PV1(for payment of maturity value).

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Illustration 3: Bonds Payable (Discount)Illustration 3: Bonds Payable (Discount) On January 1, 2006, Corvette Corporation

issues $100,000 of its 5 year bonds which have an annual stated rate of 5%, and pay interest annually each December 31, starting December 31, 2006. The bonds were issued to yield 6% annually.

Calculate the issue price of the bond:What are the cash flows and factors?(1) Face value at maturity =(2) Stated Interest =

Face value x stated rate x time period

Number of periods = n = 5 yrsDiscount rate = 6% per year

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Illustration 3Illustration 3 : Present Value Calculations : Present Value CalculationsPV of interest annuity:

PVOA Table PVOA Table

PVOA = A( ) = i, n i = 6%, n=5

PV of face value:

PV1 Table PV1 Table

PV =FV1( ) = i, n I = 6%, n=5

Total issue price = Issued at a discount of $4,212 because the

company was offering an interest rate less than the market rate, and investors were not willing to pay as much for the lower interest rate.

Illustration 3: Journal EntryIllustration 3: Journal Entry

The journal entry to record the initial issue of the bond would be:

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Illustration 4: Bonds Payable(Premium)Illustration 4: Bonds Payable(Premium) On July 1, 2005, Mustang Corporation issues

$100,000 of its 5 year bonds which have an annual stated rate of 7%, and pay interest semiannually each June 30 and December 31, starting December 31, 2005. The bonds were issued to yield 6% annually.

Calculate the issue price of the bond:What are the cash flows and factors?(1) Face value at maturity = $100,000(2) Stated Interest =

Face value x stated rate x time period 100,000 x .07 x 1/2 = $3,500

Number of periods = n = 5 yrs x 2 = 10Discount rate = 6% / 2 = 3% per period

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Illustration 4 - SolutionIllustration 4 - SolutionPV of interest annuity:

PVOA Table PVOA Table

PVOA = A( ) = 3,500 (8.53020) = $29,856 i, n i = 3%, n = 10

PV of face value:

PV1 Table PV1 Table

PV =FV1( ) = 100,000(0.74409)=$74,409 i, n i=3%, n=10

Total issue price = $104,265Issued at a premium of $4,265 because the company was offering an interest rate greater than the market rate, and investors were willing to pay more for the higher interest rate.

Illustration 4: Journal EntryIllustration 4: Journal Entry

The journal entry to record the initial issue of the bond would be:

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Illustration 5: Annuity IncomeIllustration 5: Annuity Income

Other present value applications include financial decisions. For example:

Illustration 4: On January, 2, 2008, Donna Smith won the lottery. She was offered an annuity of $100,000 per year for the next 20 years, or $1,000,000 today as an alternative settlement. Which option should Donna choose? Assume that she can earn an average 4 percent return on her investments for the next 20 years.

Solution: calculate the present value of the annuity at a discount rate of 4%, then compare to the $1,000,000 settlement.

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Illustration 5 SolutionIllustration 5 Solution

PVOA Table

PVOA = A ( ) i, n PVOA Table

= i=4%, n=20

Which should she choose?

At approximately what interest (discount) rate would she choose differently? (based on whole percentage rate)

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Types of Future Value CalculationsTypes of Future Value Calculations FV of a single sum (FV1): compounding a

future value of a single amount that is to be accumulated in the future. Example: – projected future value of a savings bond.

FV of an ordinary annuity (FVOA): compounding the future value of a set of payments, equal in amount over equal periods of time, where the first payment is made at the end of the first period. Examples:– projected balance in a retirement account.– amount of payments into retirement fund.

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3. Future Value of a Single Sum (FV1)3. Future Value of a Single Sum (FV1)There are 4 different ways you can calculate the FV1:1. Formula: FV1 = PV1 [(1+i)n]2. Tables: see page A-3, Table 3

FV1 Table

FV1 = PV1( ) i, n

3.Calculator (with time value functions).4.Excel spreadsheet.

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Illustration 6: InvestmentIllustration 6: Investment

Holliman Company wants to invest $200,000 cash it received from the sale of land. What amount will it accumulate at the end of 10 years, assuming a 6% interest rate, compounded annually?

FV1 Table

FV1 = PV1 ( ) i=6%, n=10 FV1 Table

FV1 = = i=6%, n=10

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4.Future Value of an Ordinary Annuity 4.Future Value of an Ordinary Annuity (FVOA)(FVOA)FVOA calculations presume a compound rate (i), where (A) = the amount of each annuity, and (n) = the number of annuities (or rents), which is the same as the number of periods of compounding. There are 4 different ways you can calculate FVOA:1. Formula: FVOA = A [(1+i)n - 1] / i 2. Tables: see page A-3, Table 4

FVOA Table

FVOA = A( ) i, n

3.Calculator (with time value functions).4.Excel spreadsheets.

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Illustration 7: Future Value of InvestmentIllustration 7: Future Value of Investment

Jane Smith wants to invest $10,000 at the end of each year for the next 20 years, for her retirement. What balance will she have at the end of 20 years (after the last deposit), assuming a 6% interest rate, compounded annually?

FVOA Table

FVOA = A ( ) = i=6%, n=20

FVOA Table

FVOA = = i=6%, n=20

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Illustration 8: Future Value of InvestmentIllustration 8: Future Value of Investment

James Holliman wants to accumulate $200,000 at the end of 10 years, for his son’s education fund. What equal amount must he invest annually to achieve that balance, assuming a 6% interest rate, compounded annually?

FVOA Table

FVOA = A ( ) = i=6%, n=10

FVOA Table

= i=6%, n=10

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C. Stockholders’ EquityC. Stockholders’ Equity

1.Accounting for preferred and common2.Treasury stock3.Retained earnings4.Other comprehensive income5.Statement of stockholders’ equity

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1. Preferred Stock1. Preferred Stock Advantages

– Preference over common in liquidation– Stated dividend – Variety of features regarding dividends– Preference over common in dividend payout

Disadvantages– Subordinate to debt in liquidation– Stated dividend can be skipped– No voting rights (versus common)

Debt or equity?– components of both– usually (but not always) classified with equity

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1. Common Stock1. Common StockAdvantages

– Voting rights: election of board of directors vote on significant activities of management

– Rights to residual profits (after preferred)Disadvantages

– Last in liquidation– No guaranteed return

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1. Accounting for Common Stock 1. Accounting for Common Stock (CS) and Preferred Stock (PS) (CS) and Preferred Stock (PS)

Par value - initially established to create a “minimum legal capital”.– Ex: Minimum legal capital in some states is

$1,000 for new corporations, so issue: 1,000 shares at $1par, or 100 shares at $10 par, or other combination. . .

Par value is not market value. Credit CS or PS for par value. Excess over par credited to “Paid in Capital in

Excess of Par or Stated Value” or abbreviated: “Additional Paid-in Capital” (APIC).

Some newer stock issues (for common stock) are “no par” stock.

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1.1. Journal EntriesJournal EntriesIssue PS at greater than par value:

Cash xx mkt. valuePreferred Stock xx total parAPIC - PS xx excess(plug)

Issue CS at greater than par value:Cash xx mkt. value

Common Stock xx total parAPIC - CS xx excess(plug)

Note: most states do not allow companies to issue at less than par value.

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1.1. Journal Entries -continuedJournal Entries -continuedIssue no par common stock:

Cash xx mkt. valueCommon Stock xx mkt. value

Note: many companies have newer stock issues that are no par, but most companies still have older stock issues which contain a par value and APIC.

The Stockholders’ Equity section of the balance sheet of Sample Company illustrates many of the components of SE discussed in this chapter.

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Sample Co. Stockholders’ EquitySample Co. Stockholders’ EquityCommon stock, $1 par value, 500,000 shares

authorized, 80,000 shares issued, and75,000 shares outstanding $ 80,000

Preferred stock, $100 par value, 1,000 sharesauthorized, 100 shares issued and outstanding 10,000

Paid in capital on common $ 20,000Paid in capital on preferred 3,000Paid in capital on treasury stock 2,000 25,000Retained earnings:

Unappropriated $20,000Appropriated 4,000 24,000

Less: Treasury stock, 5,000 shares (at cost) (6,000)Less: Other comprehensive income (loss) (2,000)Total Stockholders’ Equity $131,000

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Journal Entries-Sample Co.Journal Entries-Sample Co.Now, using Sample Company information,

record the following additional issues of common and preferred stock:

Issued 100 shares of PS at $102 per share: Cash (100x $102) 10,200

PS (100x $100 par) 10,000APIC - PS (plug) 200

Issued 500 shares of CS at $5 per share:Cash (500 x $5) 2,500

CS (500 x $1 par) 500APIC - CS (plug) 2,000

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2. Treasury Stock2. Treasury Stock Created when a company buys back shares of

its own common stock. Reasons for buyback:

– reissue to employees for compensation.– hold in treasury (or retire) to increase market

price and earnings per share.– reduce total dividend payouts while

maintaining per share payouts.– thwart takeover attempts by reducing

proportion of shares available for purchase.– give cash back to existing shareholders.

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2.2. Treasury Stock - continuedTreasury Stock - continued The debit balance account called “Treasury

Stock” is reported in stockholders’ equity as a contra (reduces SE). Note: not an asset.

The stock remains issued, but is no longer outstanding.– does not have voting rights– cannot receive cash dividends

May be reissued (to the market or to employees) or retired.

No gains or losses are ever recognized from these equity transactions.

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2. Treasury Stock(TS) - Journal Entries2. Treasury Stock(TS) - Journal EntriesThere are two techniques for recording TS transactions (Par Value method and Cost method). We will use only the Cost method. This technique establishes a “cost” for TS equal to the amount paid to acquire the TS. Par value is not used for TS transactions.

To record purchase of TS from market:TS xx “cost”

Cash xx market(cost equals the cash paid)

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2. Treasury Stock(TS) - Journal Entries2. Treasury Stock(TS) - Journal EntriesTo reissue TS to market at greater than cost:

Cash xx marketAPIC - TS xx over costTS xx cost

To reissue TS to market at less than cost:Cash xx market

APIC - TS xx if availableRetained Earnings xx if needed*

TS xx cost*debit RE if no APIC-TS available to absorb the

remaining debit difference.

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TS - Example ProblemTS - Example ProblemTT Corporation has 100,000 shares of $1 par value

stock authorized, issued and outstanding at January 1, 2008. The stock had been issued at an average market price of $5 per share, and there have been no treasury stock transactions to this point.

Assume that, in February of 2008, TT Corp. repurchases 10,000 shares of its own stock at $7 per share. In July of 2008, TT Corp. reissues 2,000 shares of the treasury stock for $8 per share. In December of 2008, TT Corp. reissues the remaining 8,000 shares for $6 per share. Prepare the journal entries for 2008 regarding the treasury stock.

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TS Example -Journal EntriesTS Example -Journal EntriesFeb: repurchase 10,000 sh. @ $7 =

$70,000.

July: reissue 2,000 sh @ $ 8 = $16,000

(cost = 2,000 @ $7 = 14,000)

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TS Example -Journal EntriesTS Example -Journal EntriesDec: reissue 8,000 sh. @ $ 6 = $48,000

(cost = 8,000 sh.@ $7 = 56,000)

Now we need to debit one or more accounts to compensate for the difference.

(1) debit APIC-TS (but lower limit is to -0-).(2) debit RE if necessary for any remaining

balance (this is only necessary when we are decreasing equity).

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3. Retained Earnings 3. Retained Earnings We will be expanding the basic retained earnings

formula in this chapter. Now, the Retained Earnings Column of the Statement of Stockholders’ Equity may include the following:RE, beginning xxAdd: net income xxLess dividends:

Cash dividends-common xx Cash dividends - preferred xx Stock dividends xx Property dividends xx

Less: Adjustment for TS transactions xx Appropriation of RE xx

RE, ending xx

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4. Other Comprehensive Income4. Other Comprehensive IncomeComprehensive Income is a term that was

defined in the Statements of Financial Accounting Concepts (SFAC 6).

It consists of all non-owner changes in equity. This includes net income as we have been defining revenues and expenses throughout the semester, and it also includes “Other Comprehensive Income.”

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4. Other Comprehensive Income4. Other Comprehensive Income“Other Comprehensive Income” (OCI)

includes certain direct equity adjustments that are not part of the current income statement, but which may have eventual effect on income.

One of these adjustments that will not be discussed until the fall class is the Pension Adjustment.

The amount is recorded to reflect the full amount of the pension asset or liability in the balance sheet, with the offset to OCI, until the effect is eventually transferred to the income statement.

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4. Other Comprehensive Income4. Other Comprehensive IncomeAnother item in Other Comprehensive Income

is the Cumulative Translation Adjustment. This adjustment occurs when a company owns

a foreign subsidiary, and must translate the foreign subsidiary to U. S. dollars before consolidating.

The adjustment would only be realized as part of the income statement if the foreign subsidiary was sold or liquidated for U.S. dollars.

The adjustment can be an increase or decrease, depending on the cumulative direction of change in the exchange rate.

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4. Other Comprehensive Income4. Other Comprehensive IncomeOther items in Other Comprehensive Income

include:Unrealized Gain/Loss on Available-for-Sale

Investments. These long term investments are allowed to revalue each period up or down to market. The revaluation causes a gain or loss to be recognized (it is unrealized since the investment has not been sold).

However, since the investment is long-term, the gain or loss is NOT recognized in the income statement. Instead, it is recognized cumulatively in OCI, until the investment is finally sold.

Similar treatment is given to certain kinds of derivatives (a special form of investments).

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5. Statement of Stockholders’ Equity5. Statement of Stockholders’ EquityIn this chapter, we have discussed the

Statement of Retained Earnings as the link between the balance sheet and the income statement.

However, the Statement of Stockholders’ Equity has become the default statement for large companies in recent years.

The Statement of Stockholders’ Equity details the change in retained earnings, including all the changes discussed in this chapter, and it also shows the change during the year in all of the stockholders’ equity accounts.

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5. Example of St. of Stockholders’ Equity5. Example of St. of Stockholders’ Equity CS PS APIC RE OCI TS

Balance 1/1/09 $200 $100 $400 $400Net income 250Cash dividends (40)Stock dividends $200 (200)Purchase of TS $(40)Reissue of TS ( 1) 10Revalue AFS Invest. $12Balance, 12/31/09 $400 $100 $400 $409 $12 $(30)

Note: CS = common stock; PS = preferred stock; APIC = additional paid in capital on common and preferred stock; RE = retained earnings; OCI = Other Comprehensive Income and reflects the unrealized gain on Available-for-sale investment.