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Chapter 11: Liabilities, on and off balance sheet

General issuesLong-term debt, contingent liabilities

Leasing

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Liabilities, definition and classification

present obligations based on past transactions or events thatrequire either future payment or future performance of services

recognized when incurred; end-of-period adjustments may benecessaryvalued at the amount due or at fair market value

classified as current or long-term; determinable or contingent

A liability is a present obligation of the enterprise arising from pastevents, the settlement of which is expected to result in an outflow fromthe enterprise of resources embodying economic benefits. [IASC Framework, paragraph 49]

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Long-term / current

Long-term Liabilitydue beyond the current period or the normal operatingcycle, whichever is longerused to cover long-term financing needs

Current Liabilitydue within one year or within the normal operating cycle, whichever is longerincurred in connection with operating processlong-term liabilities may contain a current portion accordingto the lapse of time• to be shown separately

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Part I: Current Liabilities

Accounts Payablesometimes called trade accounts payablebalances owed to others for goods and services purchasedon open accounttime lag between resource inflow and payment

Short-Term Bank Loans„line of credit“ – short-term borrowing when neededpromissory note over the full amount uses to be signedinterest rate may vary over time

? Current liabilities as a percent of total liabilities for the Bank of New York and AT&T are approximately 80 percent and 40 percent, respectively. Explain why thesetwo companies carry such different levels of current liabilities.

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Notes Payable, accounting treatment whengranted

written promises to pay a certain sum on a specified futuredateused to secure loans or to pay suppliers for goods

money received equalto face value of note

money received equal to present value of note

Case 1 - Interest stated separately

Sep 30 Cash 10.000 Notes Payable 10.000 (To record issuance of 9%, 90-day note to Commerzbank)

Case 2 - Interest in face amount

Sep 30 Cash 9.779Discount on Notes Payable _221 Notes Payable 10.000 (To record issuance of zero-interest-bearing 90-day note to Commerzbank)

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Accounting treatment of payment

interest expense

= 10.000 x 9% x 90/360

interest expense is lower in case 2 than in case 1 since the effective amount borrowedwas lower, too.

Case 1 - Interest stated separately

Dec 30 Notes Payable 10.000Interest Expense _225 Cash 10.225 (To record payment of Commerzbank interest-bearing note and accrued interest at maturity)

Case 2 - Interest in face amount

Dec 30 Notes Payable 10.000 Cash 10.000 (To record payment of note with interest included in face amount)

Dec 30 Interest Expense ____221 Discount on Note Payable 221 (To record interest expense on note payable)

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other current debt

Current Maturities of Long-Term Debtportions of long-term debt maturing within the next year areclassified as current liabilitiese.g. installment due on a long-term liability, i.e. a loanno journal entry necessary

Short-Term Obligations Expected to Be Refinanceddon‘t require use of working capital within the next yearenterprise needs to demonstrate intent and ability to refinance the obligation

Dividends Payableliability is incurred after the board‘s decision to pay out dividendsliability exists until dividends are paid

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Unearned Revenuesexamples:

sale of season tickets for a sports clubsubscription of magazinesgift certificatesmeal tickets

accounting treatmentwhen payment is received: debit cash, and credit unearnedrevenue accountwhen revenue is earned: debit unearned revenue, and creditan earned revenue account

Type of Account TitleBusiness Unearned Revenue Earned Revenue

Airline Unearned Passenger Ticket Revenue Passenger RevenueRestaurant Unearned Meal Revenue Meal RevenueMagazine Publisher Unearned Subscription Revenue Subscription RevenueSports Club Unearned Ticket Revenue Ticket Revenue

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Economic function of unearned revenue

recognize unearned revenue when customers areentitled to receive future service for their presentpayment with certainty

to be distinguished from warranty reserves

Example – Microsoftunearned revenue increased year after yearu.r. arise from sale of Windows and Office

you do not buy just the current version but future improvements as well

if sales are growing so is unearned revenue

Increases in unearned revenues may signal favorable futuredevelopment!

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Sales and Excise Taxes Payable

federal and state authorities levy taxes on retailtransactions or rendering of services

tax collected by seller and then remitted to tax authorityto record a (gross) sale of € 232 given a sales tax of 16%, the following entries are required:

similar entries to record collection of excise tax excisetax payable

Cash Sale

Apr 19 Cash 232 Sales 200 Sales Taxes Payable 32

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Taxes

Income Taxes Payableexpense in the year the income is earnedestimated because tax files are subject to review and approvaldebit income taxes expense, credit income taxes payable

Property Taxes Payablefiscal year of tax authority often differs from the firm‘s fiscalyeardepending on period chosen to charge the taxes, estimatesmay be necessaryprovision for property taxes usually by a monthly accrual in the company‘s books during the fiscal period of the taxingauthority for which the taxes are paid

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Contingencies

Definition„ ... an existing condition, situation, or set of circumstances involving uncertainty as to possiblegain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved whenone or more future events occur or fail to occur.“[FASB] Statement of Financial Accounting Standards No.5, par.1 (1975)

Gain contingencies are not recorded.Loss contingencies are not existing liabilities, but potential liabilitiesliabilities contingent on occurence or nonoccurence of a future event

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Example

Dream Cars Inc., a car dealer, offers variousspecialties to its customers:

Free repair of newly bought cars in case of defect within thenext two yearsFree inspection on request by new customers within thenext six months with purchase of 4 new tires beforechristmas (as a christmas customer appreciation special)

No definite liability incurred; Uncertain:payeedueamount.

Neverthelessit is probable, that a liability has been incurred, andthe liability can reasonably be estimated.

Record the estimated amount as a contingent liability!

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Accounting for contingencies under US-GAAP

Event

Contingent Loss Contingent Gain

Probability ofOccurence High Reasonable Remote High Reasonable Remote

Is it estimable?

Yes No

AccountingTreatment Accrue Disclose Disclose Ignore Disclose Ignore Ignore

Source: Pratt, p. 432.

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Common instances of losscontingencies/contingent liabilities:

Litigation, claims, and assessmentsthe cause for legal action occurred in the pastprobability of unfavorable outcome assessed accoding to pastexperienceestimate of expected loss: legal action is decided but number of claimants uncertainpending litigation vs. actual/possible claims and assessments: no exact amounts disclosed due to influence on position before thecourt

Guarantee and warranty costsguarantee for credit defaultproduct warranty

Premiums and coupons.Environmental liabilities.Pensions and other postemployment benefit obligations.

see

follo

win

g pa

ges

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Guarantee and warranty costs

Warranty: guarantee to repair or replace defectivegoods during a predetermined period following thesaleaccounting either

Cash Basis – warranty costs charged to period in whichcompany complies with the warrantyAccrual Basis – warranty costs charged to period of sale as operating expense• Example (accrual basis): Michael Drums sells music

instruments. Per 100 units sold, 2 require warranty service. Thecost per service is estimated at € 70. In 2002, he sold 800 units. Five warranty services have already been performed at coststotalling € 430. So there remain eleven warranty services as an estimated liability.

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1. Sale of 800 units at average price € 100

Cash or Accounts Receivable 80.000 Sales 80.000

2. Recognition of warranty expense

Warranty Expense 430 Cash,Inventory, or Accrued Payroll _ _430 (warranty costs incurred)

Warranty Expense 770Estimated Liability under Warranties _ _770 (to accrue estimated warranty costs)

3. Recognition of warranty costs incurred in 2003 (on 2002 sales)

Estimated Liability under Warranties 770 Cash, Inventory, or Accrued Payroll _ _770

Journal entries for the example:

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Premiums and coupons

Examplesfrequent-flyer programsbonus cards of department storestoys that come with McDonalds junior meals

Accounting problem again: estimation of the liabilityincurred with the sales

(to comply with the matching principle)

Journal entries – similar to „Drums example“

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Example: Frequent-flyer program

America West Airlines (Phoenix, Arizona), „Flightfund“ started in 1987, over 1 million active members

program is the company‘s single largest current liability(„Air traffic liability“)Air traffic liability, $ 240 million (34% of current liabilities)

EstimationHow many people are eligible for free air travel?How many will redeem mileage during the current period?Where are their destinations?cost estimate for possible „free“ travel: „incremental costmethod“

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*Totals (in billions) adjusted to reflect expiration of approximately 9-11% of airline miles. Note: Due to trends in award activity, we estimate that 16-34% of all awards will go unredeemed. This includes expirations.

Source: http://www.webflyer.com/company/press_room/facts_and_stats/liability_accumulation.php

Frequent-flyer milesNumber of miles Cumulative Number of miles Cumulative Cumulative un-

Year awarded by the awarded miles redeemed by redeemed miles redeemed miles/airlines* to date* members to date program liability

to date*

1981 4,1 4,1 1,9 1,9 2,21982 16,8 20,9 12,9 14,8 6,11983 38,5 59,2 28,6 43,4 15,8

:::2000 1.440,0 10.009,3 349,5 3.379,1 6.630,22001 1.600,0 11.609,3 341,6 3.720,7 7.888,62002 1.646,0 13.255,3 402,9 4.123,6 9.131,7

The World‘s Frequent Flyers...

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Environmental liabilitiesresult from obligation to clean up, say, toxic waste or to landscape sites no longer used for business

sometimes very hard to estimate the liabilityindemnity claims after environmental catastrophes

For example: Bayer AG“[28 ] Other provisionsOther provisions are valued in accordance with IAS 37 (Provisions, Contingent Liabilities and Contingent Assets) using the best estimate of the extent of the obligation. Interest-bearing provisions are discounted to present value. Personnel commitments mainly include annual bonus payments, long service awards and other personnel costs. The miscellaneous provisions include € 131 million for restructuring. Provisions for environmental protection relate to future relandscaping, landfill modernization and the remediation of land contaminated by past industrial operations. Sufficient provisions have been established for such commitments.”[Bayer AG, Annual Report 2000, notes to financial statements.]

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Part II: Long-term liabilities

BondsDefinition of a bondWhy issuing bondsTypes of bondsAccounting for bond issuesAccounting for bond retirements

Long-Term Notes PayableReporting and Analysis of Long-Term Debt

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Bonds

securities issued by, e.g. corporations orgovernmental agencies, to obtain large-sum long-term financingnormally due ten to fifty years after issuevarious covenants and restrictions for protection of both lenders and borrowerssmall denominations allows collection of large sums of moneyinterest payment

annually or semiannuallyzero bonds

„bond issue“ refers to total number of bonds issuedat one time

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Why issue bonds?

to obtain large sums of money for long time thatcannot be collected otherwise e.g. from banksdebt financing has some advantages over equityfinancing

stockholder controls remains unaffectedtax savings: interest expense is tax deductibleleverage effect: spread between return on assets and interest cost is usually positive and increases return on equity

Stock financing vs. bond financing – an example€ 2 million needed to fund a projectalternative I – issues 100.000 shares at current price of € 20 per sharealternative II – issuance of € 2 million, 9% bonds at face value

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Funds obtained by ... issuance of ... issuance ofadditional shares bonds(250.000 shares (150.000 shares

outstanding) outstanding)

Earnings before interest and income taxes € 700.000 € 180.000 € 700.000 € 180.000Interest 0 0 180.000 180.000

Earnings before income taxes € 700.000 € 180.000 € 520.000 € 0Income taxes at 35% 245.000 63.000 182.000 0

Net income € 455.000 € 117.000 € 338.000 0

Earnings per share € 1,82 € 0,47 € 2,25 0

Note: Net income under bond financing is lower than under stock financing, but return on equity may be higher.

Note that interest cost will increase with leverage because of an increasing default risk.

Volatility of earning increases.

RoE 9.1% 2.34% 11.27% 0%

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How to issue bonds ?

usually, approval by board of directors and general meeting of shareholders necessary; authorized:

number of bondstotal face value and nominal interest rate• face value: amount of principal the issuer must repay at maturity• nominal interest rate determines amount of cash interest the issuer

has to pay (also stated rate of interest)bonds are taken by investment banks („underwriters“) and sold to the publicunderwriters buy bonds for resale or on a commission basisbondholders are represented by a trustee, typically a large bankcontract between company and bank is called bond indenture

specifies terms of the bond, rights, privileges, and limitations of bondholders

bondholders receive bond certificates as evidence of thecompany‘s debt to the bondholder; bondholders are creditors !

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Types of Bonds

Secured and Unsecured Bondssecured bonds: bondholders have a claim to certain assetsof the company upon default, e.g. mortgage bondunsecured bonds: issued against general credit of borrower(debenture bonds)

Term and Serial Bondsterm bonds: all bonds of an issue mature on the same dateserial bonds: bonds mature over several maturity dates

Registered and Coupon Bondsregistered bonds: corporation maintains record of all bondholderscoupon bonds: bond not recorded in the name of the owner; transferable by delivery

cont‘d next page

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Types of Bonds, cont‘d

Convertible and Callable Bondsconvertible bonds: bonds that can be converted intocommon stock at the option of the holder• bonds furnished with a stock option to reduce coupon

callable bonds: bonds that can be retired before maturity at the issuer‘s option

Income and Revenue Bondsincome bonds: interest payment only if company isprofitablerevenue bonds: interest on the bonds is paid from specificrevenue sources

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Bond Ratings

Moody‘s Investors Service, Standard & Poor‘s Corp. and Fitch are the dominating rating agencies

(Historical) Original Rating Default Rate*

AAA 0.52%AA 1.31%A 2.32%BBB 6.64%BB 19.52%B 35.76%CCC 53.38%

*Percentage of defaults by issuers rated by Standard & Poor‘s over the past 15 years, based on rating they were initially assigned. /// Data: Standard & Poor‘s

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Accounting for Bonds Payable

bonds are traded in the capital marketmarket rate (effective yield) of interest and (current) bondprices are inversely related• yield rate: the virtual interest rate r a bond purchased at the

current price in the market yields to the owner• Let c denote the coupon, B the bond price, T the maturity

(time to repayment), face value = F.• Then r is the solution to the following equation:

• The yield for longer term debt uses to be higher than forshorter term debt (normal term structure of interest rates)

• yield rate (bond price) depend on credit rating

( ) ( )B

rF

rc

T

T

tt =

++⎟⎟

⎠

⎞⎜⎜⎝

⎛

+∑= 111

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Accounting for Bonds Payable

face value € 300.000 stated rate of interest 7% market rate of interest 10% 12%

schedule of payments year 1 year 2 year 3 year 4 year 1 year 2 year 3 year 4

interest € 21.000 € 21.000 € 21.000 € 21.000 € 21.000 € 21.000 € 21.000 € 21.000principal € 300.000 € 300.000

present value of interest € 66.567 € 63.784present value of principal € 204.904 € 190.655

present value (selling price) of the bond € 271.471 € 254.440

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Inverse relation between interest rates and bond prices

bond #1 – statedrate of interest of c1= 5% and term to maturity of T1= 10

bond #2 - statedrate of interest of c2 > c1 and term to maturity of T2=T1

bond #3 - statedrate of interest of c3=c1 and time to maturity T3 = 5 < T1

assumption: bonds 1-3 have the same face value = 100

0

20

40

60

80

100

120

140

160

180

200

2 4 6 8 10 12 14 16 18 20 % r

B

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Stated rate of interest, market rate of interest, effective rate of interest, and bond issue prices:

The stated rate of interest i = c/F may differ from themarket rate of interest

since the yield must be equal to the market rate the issueprice must be adapted accordingly:

If the stated rate islower than the market rate: issue price lower than face value, bond sells at a discounthigher than the market rate: issue price exceeds face value, bond sells at a premium

at the date of issue

must hold with a given market rate r

( ) ( )B

rF

rc

T

T

tt =

++⎟⎟

⎠

⎞⎜⎜⎝

⎛

+∑= 111

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Issuing Bonds At Face Value (“at par”)stated rate of interest i = r market rate of interestaccounting entry: cash proceeds = face value of the bonds

Example: 5-year term bonds, face value of € 900.000, datedJanuary 1, 2004, interest rate 8%, annual interest payments on January 1.

To record issuance of bonds on January 1

Cash 900.000

Bonds Payable 900.000

To record accrued interest expense at year end (December 31)

Bond interest expense 72.000

Bond interest payable 72.000

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Issuing Bonds at Discount

stated rate of interest i < r market rate of interestExample: as before, but market rate of interest now 10% (stated rate of interest 8%).

discount is 68.234has to be amortized over the time to maturity• usually: straight line method: 68.234 / 5 = 13.647

766.8311,1000.900

1,1000.72

5

5

1=+∑

=tt

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Issuing Bonds at Discount

Long-term liabilities Bonds Payable € 900.000 Less: Discount on Bonds Payable 112.159 € 787.841

Balance sheet presentation:€ 900 000

68.234 € 831.766

To record issuance of bonds on January 1

Cash 831.766

Discount on Bonds Payable 68.234

Bonds payable 900.000

To record accrued interest expense and accrued amortization at year-end(December 31)

Bond interest expense 85.647

Discount on Bonds Payable 13.647

Interest Payable 72.000

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Long-term liabilities Bonds Payable € 900.000 Add: Premium on Bonds Payable 133.901 € 1.033.901

Balance sheet presentation

Issuing bonds at a premiumstated rate of interest i > r market rate of interest

Example: as before, but market rate of interest now 6%

€ 900 00075.823 € 975.823

To record issuance of bonds on January 1

Cash 975.823

Premium on Bonds Payable 75.823

Bonds payable 900.000

To record accrued interest expense and accrued amortization at year-end(December 31)

Bond interest expense 56.835

Premium on Bonds Payable 15.165

Interest Payable 72.000

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Amortizing Bond Premium / Bond Discount

the bond premium (discount) is amortized over thelife of the bonds

straight-line methodeffective interest method

Straight-line methodequal amounts of the premium (discount) are amortized in each period, equal interest expense recorded in each period

interest expense = interest to be paid + amortized discountamortized discount = (face value – issue price) / number of interest periodsinterest expense = interest to be paid – amortized premiumamortized premium = (issue price – face value) / number of interest periods

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Effective interest method

interest expense = bond carrying value ×effective rate of interest

discount amortization = interest expense –interest to be paidpremium amortization = interest to be paid –interest expense

increasing amounts are amortized in each period• interest expense is equal to a constant percentage

of the carrying value of the bonds• interest expense recorded is, thus, increasing

under discountand decreasing under premium amortization

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Annual interest paid interest discount unamortized bond carryingperiod expense amortization discount value

issue date 68.234 831.7661 72.000 83.177 11.177 57.057 842.9432 72.000 84.294 12.294 44.763 855.2373 72.000 85.524 13.524 31.239 868.7614 72.000 86.876 14.876 16.363 883.6375 72.000 88.364 16.364 0 900.000

Effective interest discount amortization schedule foran 8% bond sold to yield 10%

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The journal entry to record accrued interest at December 31, 2004, is

... and bond interest expenses will keep rising as the carrying value of thebonds increases.

Bond interest expense 83.177Discount on bonds payable 11.177Bond interest payable 72.000

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Effective interest premium amortization schedule for8% bonds sold to yield 6%

Annual interest paid interest premium unamortized bond carryingperiod expense amortization premium value

issue date 75.823 975.8231 72.000 58.549 13.451 62.372 962.3722 72.000 57.742 14.258 48.115 948.1153 72.000 56.887 15.113 33.002 933.0024 72.000 55.980 16.020 16.982 916.9825 72.000 55.019 16.981 1 900.001

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The journal entry to record accrued interest on December 31, 2004, is

... and bond interest expenses will keep falling as thecarrying value of the bonds decreases.

Bond interest expense 58.549Premium on bonds payable 13.451Bond interest payable 72.000

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Zero Bonds

bonds that bear no interest (explicitly) and are issued solely forcashalso called deep discount bonds

Example: An 8-year zero bond with face value of € 10 million(10.000 x € 1.000 each) is issued and sold at a price of € 3.270.000.

What is the implicit interest rate ?

The implicit interest rate is 15%. It is the interest rate thatequates (in present value terms) the cash received with theamounts to be paid in the future.

8)1(000.000.10€000.270.3€ −+⋅= i

14999,01000.270.3000.000.10

8 =−=i

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The journal entry to record the issuance of this zerobond is

The schedule for bond discount amortization underthe effective interest method of one bond (to keepthe numbers small) is

Cash 3.270.000Discount on Bonds Payable 6.730.000 Bond Payable 10.000.000

cash interest expense discount unamortized bond carrying paid amortization discount value

issue date 673 3271 0 49 49 624 3762 0 56 56 568 4323 0 65 65 503 4974 0 75 75 428 5725 0 86 86 342 6586 0 99 99 244 7567 0 113 113 130 8708 0 130 130 0 1.000

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Accounting for Bond Retirements

Redeeming bonds at maturity

... at maturity, the book value (carrying value) of the bond is equalto its face value.Redeeming bonds before maturity

... here is the journal entry for retiring the 8% bond sold to yield 10% at the end of the 3rd period given the market interestrate now has declined to 8%.

Bonds Payable 900.000 Cash 900.000

Bonds payable 900.000Discount on Bonds payable 31.239Loss on bond redemption 103.239Cash 972.000

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Disclosure Requirements for Long-Term Debt

composition of long-term debtlong-term debt maturing within one year should bereported as a current liabilitymaturities of long-term debt during each of the nextfive yearsany special arrangements, e.g. refinancing, conversion into stock, „off-balance-sheet financing“

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Off-Balance-Sheet Financing

imprecise definition of liabilities allows off-balance-sheet financingcredit agreements usually contain covenants, i.e. limitations to issuing further debtcompanies try to find ways to get money withouthaving to diclose debt on the balance sheetWays to do that

form a new entity together with some other company so thatit does not have to be consolidated. The entity then borrowsmoney The two companies guarantee debt repayment and disclose this fact as a contingent liability.sell assets at a high price to such an entityforward sales of products: a bank buys oil or natural gas forwardmezzanine capital

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Leasing

Finance Lease: the lessor makes a fixed asset (e.g. a piece of equipment) available to the lessee keeping legal ownership but transferring the economic risk and rewards to the lessee.lessee pays prespecified installmentsAccounting treatmentLessee‘s balance sheet shows

asset and accumulated depreciation as if owned; a lease liability: long term liability: total of payments owed

Lessor‘s balance sheet showsLease receivable; asset is taken out of balance sheet as ifsold

Operating lease: lessor keeps asset, lessee showsneither asset nor liability

this treatment is controversial

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Example

Autolease offers a car leasing contract under thefollowing rules:

Initial payment € 10000monthly installments: € 200duration: 3 years, maximum kilometers: 15 000 per yearcurrent operating costs are borne by the lesseethe lessee has no purchase option at the end of thecontract, car has to be returned to lessorthe car is leased „full coverage insured“ by the lessor whogets the insurance benefits

this is an operating leaseinitial payment is prepaid rent.