Financial Accounting: Advanced Topics

Professor Oktay Urcan

Module 2: Liabilities

Table of Contents
Module 2: Liabilities ................................................................................................................ 1
Lesson 2-1: Overview and Liability Recognition Criteria .................................................................... 2
Lesson 1-1.1: Overview and Liability Recognition Criteria ................................................................................... 2

Lesson 2-2: Short-Term Liabilities ..................................................................................................... 6

Lesson 2-2.1: Short-Term Liabilities ..................................................................................................................... 6

Lesson 2-3: Long-Term Liabilities ...................................................................................................... 8

Lesson 2-3.1: Long-Term Liabilities ...................................................................................................................... 8

Lesson 2-4: Module 2 Appendix 0: Time Value of Money ................................................................ 17

Lesson 2-4.1: Appendix 0: Time Value of Money ............................................................................................... 17

Lesson 2-5: Module 2 Appendix 1: Special Liabilities ...................................................................... 31

Lesson 2-5.1: Appendix 1: Special Liabilities ...................................................................................................... 31

Lesson 2-6: Module 2 Appendix 2: Advanced Issues in Bonds ......................................................... 42

Lesson 2-6.1: Appendix 2: Advanced Issues in Bonds ........................................................................................ 42

Lesson 2-7: Module 2 Case Video ................................................................................................... 62

Lesson 2-7.1: Module 2 Case Video ................................................................................................................... 62

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Lesson 2-1: Overview and Liability Recognition Criteria

Lesson 1-1.1: Overview and Liability Recognition Criteria

In this module, we will cover accounting for liabilities. In particular, we will talk about
recognition of short and long term liabilities, liability valuation, and accounting for short
and long term liabilities.

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Liabilities are sacrifices to transfer economic values, and they are due to past
transactions.

In order for something to be a liability, it has to satisfy two criteria. First, it needs to be
measurable. It means that a value should be attributable to the liability. Second, it needs
to be due to an executive contract. It means that the liability should be due to an
agreement that has been approved by all parties.

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Some examples of liabilities are accounts payable, utility payable, annual revenue, bank
loan, bonds. We will spend some more time on these liabilities later in this course.

How are liabilities valued on the balance sheet?

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Short term liabilities are valued based on their face value. Face value is the amount of
liabilities without any consideration for interest rates and possible discounts. If a firm
gets $100 worth of inventory from a supplier to be paid next month, the firm shows $100
of accounts payable on the balance sheet. Since short term liabilities are expected to be
paid in a short time period, we value them based on their face value. On the other hand,
long term liabilities are presented on the balance sheet based on their present value of
future payments. If you are not familiar with the concept of present value, please watch
the video appendix zero time value of money in this module.

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Lesson 2-2: Short-Term Liabilities

Lesson 2-2.1: Short-Term Liabilities

In this video, we will talk about short-term liabilities. Their obligations to be fulfilled by
the firm within a year. Some examples are accounts payable, wage payable, and utility
payable. Short-term liabilities are valued based on their face value, which is the total
amount to pay in the future.

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Here is an example about short-term liabilities. A firm purchases inventory for $15,000
in payable in six months. This transaction increases assets by 15,000 due to increase in
inventory account. The other side of this transaction will be an increase in liabilities with
the same amount due to the increase in accounts payable. Please note that the liability
is valued based on its face value without any consideration for interest.

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Lesson 2-3: Long-Term Liabilities

Lesson 2-3.1: Long-Term Liabilities

In this video we will discuss long-term liabilities, their obligations to be fulfilled by the
firm in a time period more than a year. Some examples are bond payable and long-term
bank loan. Long-term liabilities are valued based on their present value of future
payments.

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A prominent example of long-term liabilities is bonds. Bonds are a type of a loan where
the borrower pays to the lender fixed periodic amounts, these are called coupon
payments. And the original amount of borrowed money, this is called the principal at the
bond maturity date. Bonds are traded in the market just like stocks.

Firms issue bond certificates to lenders in return of the amount borrowed. Bond
certificates include the following information. Maturity date, this is the principal

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repayment date. Face value, or principal, this is the amount to repay at maturity. And
coupon rate, this is the annual interest rate.

Since bonds are long-term liabilities, they are valued or priced according to their present
value of payments. Bond prices are calculated according to some of present values of
future coupon and principal payments. Our discussion in this video will just focus on par
bonds, where the price of the bond is equal to face value. Most of the bonds are issued
at par.

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For par bonds, bond payable, which is the amount of liability on the balance sheet, is
equal to bond face value. At the time of bond issuance, we increase the cash account,
which is an asset, on the balance sheet by the face value. And increase the bond
payable account, which is a liability, on the balance sheet by the face value to conduct
bond accounting.

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Here is an example of par bond issuance. Face value is 5,000, coupon rate is 10%,
which is paid semi-annually, issuance date is January 1st, 2025, and maturity is 5
years. At the time of bond issuance, we increase cash account by 5,000 and increase
bond payable account with the same amount as well. Please notice that 5,000 is the
face value of the bond.

What is the accounting for par bonds after issuance? We decrease cash account on the
balance sheet by bond interest payment. Bond interest payment can be calculated as
face value of the bond times coupon rate. Next we decrease the income statement by
bond interest expense. Bond interest expense is equal to beginning bond payable times
market interest rate. Market interest rate is the interest rate at the time the bond is
issued. Par bonds are very special because, for par bonds, beginning bond payable is
equal to face value. Market interest rate is equal to coupon rate, and bond interest
payment is equal to bond interest expense.

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Here is an example of par bond accounting after issuance. Face value is 5,000, coupon
rate is 10% paid semi-annually, issuance date is January 1st, 2025, and maturity is 5
years. The first line in the transaction worksheet shows accounting at the time of bond
issuance. The firm needs to make the first coupon payment after six months of issuance
because coupons are paid semi-annually. Annual coupon rate is 10%, therefore
semiannual coupon rate is 5%. Coupon payment amount can be calculated as face
value of the bond, which is 5,000, times semiannual coupon rate, which is 5%.
Therefore, semiannual coupon payment is equal to 250. When the firm makes the
coupon payment, cash decreases by 250. Please note that coupon payment also
means bond interest payments. For par bonds, bond interest payment is equal to bond
interest expense. Therefore, the firm also creates a bond interest expense of 250 on the
income statement.

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Since coupon payments are made semiannually, the firm needs to make another
coupon payment in December 2025. Coupon payment accounting is the same. Cash
decreases by 250, and the same number is recorded as bond interest expense on the
income statement. This process continues until the end of the maturity of the bond. A
firm needs to make two lines of transaction entry at the time of maturity. The first one is
to record the last coupon payment, and the second one is to record the payment of the
principal.

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In particular, a firm will make the following bond accounting entries at the time of
maturity. Decrease cash account on the balance sheet by bond interest payment, which
can be calculated as face value times coupon rate. Decrease income statement by
bond interest expense, which can be calculated as beginning bond payable times
market interest rate. Decrease cash account on the balance sheet by face value and
decrease bond payable on the balance sheet by face value.

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Here is an example of bond accounting at the time of maturity for a par bond. Face
value is 5,000, coupon rate is 10% paid semiannually, issuance date is January 1st,
2025, and maturity is 5 years. At the end of fifth year, after the bond is issued, the firm
makes two accounting entries. First, the firm records the last coupon payment. Cash
decreases by 250, and the same account is recorded as bond interest expense on the
income statement. Second, the firm pays the face value of the bond, cash decreases by
5,000, and -5,000 is recorded under bond payable to remove bond payable. Since bond
is paid back, bond payable account has an ending balance of zero.

Here is a summary of this module. In this module we learned liability recognition criteria,
liability valuation, and discuss accounting for short- and long-term liabilities. In the next
module, we will go over accounting for shareholders equity.

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Lesson 2-4: Module 2 Appendix 0: Time Value of Money

Lesson 2-4.1: Appendix 0: Time Value of Money

In this video, we will talk about the time value of money. Time value of money is a
finance topic. However, we need to know this topic to understand appendices in this
module. If you have taken a corporate finance class before, and if you're familiar with
the concepts of present value of an annuity, present value and future value, you do not
have to watch this video. On the other hand, if you have never taken a corporate
finance class, this video is for you. The first concept we will talk about is future value.
The idea here is that the value of one million dollar today is different than one million
dollar for example, 20 years later, due to mainly two reasons. One, inflation in prices.
One can buy less goods and services with one million dollar in the future, than she can
buy right now with one million dollars. We can see this in our lives too. Today, let's say a
car is 50,000, the car will not be 50,000, 20 years later because of increases in prices.
The second reason why purchasing power of the money changes across different times
is opportunity cost. One can invest one million dollar today and earn a return on this
investment, potentially ending up with more than one million dollars in the future.
Therefore, one million dollar in the future has a different purchasing power than one
million dollar today.

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Why do we need this concept or how we can apply this concept? We can apply this
concept to find the value of a certain amount of sum in the future.

For example, what is the value of 1,000 in three years from now on? Assume that the
interest rate or the discount rate is 9%. How do we approach this question? The value
of 1,000 will be 1,000*(1+9%) which is equal to 1,090 in Year 1. Why? We can invest
1,000 in a bank account and earn 1,000*9%, which is 90 in one year. Similarly, 1,000

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today will be worth 1,188 in Year 2, because we can invest 1,000 in a bank account,
earning 9% annual interest rate for two years. Please note that I have multiplied 1,000
with 1+9% twice. Similarly, the value of 1,000 today will be 1,295 in three years because
we multiply 1,000 with 1+9% three times. In other words, in terms of purchasing power,
today's 1,000 is equal to 1,295 in Year 3. This process is called compounding where we
calculate interest of the interest.

The process of calculating future value can be automated by the following formula, FV =
PV*(1+r)^n. In this formula, FV is future value, PV is present value, r is the interest or
discount rate, and n is the number of periods. If we apply this formula to the previous
question, today's 1,000 is equal to 1,295 in three years, which can be calculated as
1,000*(1+9%)^3.

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The second concept we will talk about in this video is present value. Present value is
the opposite concept of future value. What is the current value of a future amount?

Here's an example about present value. What is the present value of 5,000 three years
from now on? Assume that interest rate or the discount rate is 8%. We will follow the
opposite steps that we have taken to calculate present value. Year 3, 5,000 is
equivalent to 4,630 in Year 2. This can be calculated as 5000/(1+8%). In terms of

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purchasing power, 5,000 in Year 3 is equivalent to 4,630 in Year 2. Year 3, 5,000 is
equivalent to 4,287 in Year 1. This can be calculated as 5000/(1+8%) twice. If we follow
the same logic, we can calculate Year 3, 5,000, is equivalent to 3,969 in Year 0. This
process is called discounting where we discount a future amount to find its today's
value.

We can automate calculation of present value with the following formula, PV =

FV/(1+r)^n. In this formula, FV is future value, PV is present value, and r is the interest
or discount rate, and n is the number of periods. If we apply this formula to the previous
question, Year 3, 5,000 is equal to 3,969 today, which can be calculated as
5,000/(1+8%)^3.

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Next, we will talk about present value of an annuity. Annuity is a series of equal
payments in certain intervals. For example, $100 of interest payments in every month
over the next year. How do we calculate present value of an annuity? To answer, one
can calculate present value of each payment and then sum the discounted payments.

Here's an example to calculate present value of an annuity. What is the present value of
2,000 received in each of the next three years? Assume that interest or the discount

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rate is 5%. We can start by calculating present value of each payment to answer this
question. For example, present value of Year 3, 2,000 is equal to 2,000/(1+5%)^3,
which is equal to 1,728. Similarly, present value of Year 2, 2,000 is equal to 1,814, and
Year 1, 2,000 is equal to 1,905. If we sum all three present values, we can find that the
present value of 2,000 received in each of the next three years is equal to 5,447. In
terms of purchasing power, today's 5,447 is equivalent to 2,000 received in each of the
next three years when interest rate is 5%.

We can automate the calculation of present value of an annuity with the formula on the
screen. In this formula, PV is present value, PMT is periodic payment, r is interest rate,
and n is the number of years of discounting. If we apply this formula to the previous
question, we can again find the present value of 2,000 received in each of the next
three years is equal to 5,447.

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As we have discussed before, long-term liabilities are valued based on present value of
future payments they make. Since bonds make periodic payments, as well as final
payment at the time of maturity, we can use present value of annuity and present value
formulas to calculate the value of a bond. Here's an example. Face value is 5,000,
coupon rate is 10%, paid semi-annually, interest rate is 8%, issuance date is January
1st, 2025, and maturity is five years.

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Here is a picture showing all future payments of this bond. The bond makes semi-
annual coupon payments of 250, which is calculated as bond face value of 5,000 times
semi-annual coupon rate of 5% over the next five years, which is equal to 10 semi-
annual periods. The bond also pays the face value of 5,000 at the end of Year 5, which
is the semi-annual period 10. Since we are making semi-annual calculations, we need
to also use the semi-annual interest rate, which is 8%/2, which is equal to 4%. Please
notice that we must use present value of annuity formula to calculate the present value
of semi-annual coupon payments of 250. We can use the present value formula to find
the present value of the face value payment at the maturity, which is period 10.

Therefore, bond price is equal to sum of present values of future coupon and principal
payments. The present value of the principal is 5000/(1+4%)^10. Please note that we
use semi-annual interest rate of 4% in this question. Please also note that there are 10
periods in this question because we are using semi-annual calculations. This will give
us 3,377.82 as the present value of the principal payment at maturity. Next, we can
apply the present value of annuity formula to calculate the present value of 10 coupon
payments of 250 each. This will give us 2,027.72 as the present value of 10 coupon
payments. The price of the bond is then the summation of these two present values,
which is 5,406. What does this mean? In terms of purchasing power, today's 5,406 is
equivalent to 10 semi-annual payments of 250 over the next five years plus a payment
of 5,000 at the end of Year 5 when the semi-annual interest rate is 4%. In terms of bond
accounting, bond payable will be 5,406 in the transaction worksheet at the time of bond
issuance.

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Here's another example. Face value is 5,000, coupon rate is 10%, paid semi-annually,
interest rate is 12%, issuance date is January 1st, 2025, maturity is five years. The only
change with respect to the Example 1 is the change in interest rate from 8%-12%.

The amount of semi-annual coupon payments over the next five years, as well as the
amount of principal payment in Year 5 are the same as Example 1. Please note that the
new semi-annual interest rate is 6%.

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Bond price is equal to sum of present values of future coupon and principal payments.
The present value of the principal is 5000/(1+6%)^10. This will give us 2,791.97 as the
present value of the principal payment at maturity. Next, we can apply the present value
of annuity formula to calculate the present value of 10 coupon payments of 250 each.
This will give us 1,840.02 as the present value of 10 coupon payments. The price of the
bond is then the summation of these two present values, which is 4,632. What does this
mean? In terms of purchasing power, today's 4,632 is equivalent to 10 semi-annual
payments of 250 over the next five years plus a payment of 5,000 at the time of Year 5,
when the semi-annual interest rate is 6%. In terms of bond accounting, bond payable
will be 4,632 in the transaction worksheet at the time of bond issuance.

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The last concept we will discuss in this video is internal rate of return in short IRR.
Sometimes we are given present value of a stream of future cash payments, and we are
asked the interest rate or the discount rate which makes the present value of future
cash flows equal to our given present value. This special rate is called internal rate of
return, IRR.

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Here's an example about IRR. Suppose that today is December 31st, 2025. Firm A will
make the following payments on the following dates, December 2026, 100, December
2027, 150, December 2028, 500, and December 2029 50. If the present value of these
payments is 625, what must be the discount or interest rate?

The future cash flows do not have a pattern. Therefore, we cannot use the formulas
given in this lesson. Microsoft Excel has a function called IRR that can be used to
calculate the discount rate. In order to use IRR function of Excel, we set up an Excel
sheet as you see on the screen. Please note that cash flows are written in cells in their
correct order between cell C2 and cell F2. Please also note that cell B2 includes current
present value information. We put a minus sign before the present value so that Excel
understands that this is a present value. We then go to cell B3 and write the following
function, =IRR(B2:F2). This instructs Excel to calculate IRR of the values in cells
between C2 and F2 whose present value is B2. When we hit the enter button, we can
find that IRR is 10%. In other words, if we calculate the present value of payments
between 2026 and 2029 from 10% discount rate, it will be 625.

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We can check this by calculating present value of the payments between 2026 and
2029 by using 10% interest rate. The present value of 100 in year 2026 is 91. The
present value of 150 in year 2027 is 124. The present value of 500 in year 2028 is 376.
The present value of 50 in year 2029 is 34. Sum of present values is equal to 625, 625
is the present value amount given in the question.

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Lesson 2-5: Module 2 Appendix 1: Special Liabilities

Lesson 2-5.1: Appendix 1: Special Liabilities

In this video, we will talk about special liabilities. The first special liability is contingent
liability. Contingent liabilities are obligations that might be fulfilled by the firm in the
future. An example is lawsuit penalty. When a firm is sued, for example, for an
environmental issue, the firm may be liable. Its liability will depend on whether it will lose
the lawsuit. Therefore, this is a contingent liability. The valuation of contingent liability is
tricky. If the likelihood of occurrence is remote, we ignore the contingent liability. If the
likelihood of occurrence is possible, we disclose the contingent liability in a footnote. If
the likelihood of occurrence is probable, we create a contingent liability on the balance
sheet. There are no guidelines on what remote, possible, or probable means. It all
depends on firms and their auditors' interpretations.

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Here's a contingent liability example. A firm is sued for 10,000 due to environmental
damages. The firm estimates that it will probably lose the lawsuit. Since the likelihood of
losing the lawsuit is probable, the firm needs to create a contingent liability. Liability is
increased by 10,000 due to creating a contingent liability. The other side of the
transaction is a loss on income statement with the same amount. We can call this loss
as loss from contingent liability.

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The question continues and gives the following information. Suppose that the lawsuit
concludes with a 7,000 penalty for the firm. Here is how we record the actual lawsuit
penalty. Cash decreases by 7,000 and contingent liabilities removed by recording minus
10,000 under liabilities. The difference between cash and contingent liability is 3,000,
which we will record as a gain from contingent liability. In this question, the firm
overestimated the size of the loss due to the contingent liability. This is corrected when
the actual penalty is paid.

The second special liability we will to talk about is warranties. Warranties are promises
given by firms to buyers to fix or replace a product sold. They are usually given for a
certain period of time. If future warranty costs are large and could be reliably estimated,
warranties needs to be recognized in final statements.

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Here's an example about warranties. A firm sells five bicycles on January 1st, 2025 for
200 each. Each bicycle is sold with two-year warranty. The firm estimates that each
bicycle will have a warranty cost of 15 each over the two-year warranty period. The firm
spent $30 in 2025 for warranty claims. We start by recording bicycle sale. The firm sells
five bicycles from 200. Therefore, total revenue is 1,000. Both cash and revenues on
income statement increase by 1,000. For simplicity, we will not talk about cost of good
sold of bicycle sold. Please note that each bicycle comes with a two-year warranty and
the firm estimates a warranty cost of 15 per bicycle over the two-year period.

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Therefore, the firm needs to create a warranty-related liability at the time of bicycle sale.
We create a warranty provision of five bicycles times 15, which is the estimated
warranty cost per bicycle, which is equal to $75. Warranty provision is a liability. The
other side of the transaction will be a warranty expense of 75.

Next, we record 30 spent for warranty claims in 2025. Cash decreases by 30. The other
side of this transaction will be a reduction of 30 from warranty provision. Please note

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that when the firm actually spends on warranty claims, we reduce warranty provision,
rather than to record an expense on the income statement. Warranty provision is
created at the time of the sale of bicycles with a corresponding warranty expense on
income statement to absorb losses due to warranty claims in the future.

The question provides further information that suppose that the firm spends no money
on warranty claims in 2026. We start 2026 transaction worksheet with beginning
balances. Beginning balance of cash is 970, which is the difference between 1,000 due
to the sale of five bicycles and $30 spent on warranty claims. Beginning warranty
provision is 45, which is the difference between original warranty provision of 75 and 30
warranty provision used due to warranty claims. Finally, beginning retained earnings
has a balance of 925, which comes from bicycle revenue of 1,000 minus warranty
expense of 75.

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Since the firm spends no money on warranties in 2026 and warranty duration for each
bicycle is two years, the firm doesn't need any warranty provision at the end of 2026.
The firm closes warranty provision by recording minus 45 under warranty provision
account, and again, from warranties on the income statement with the same amount.

The third group of special liabilities we will talk about is third-party collections. They are
collections of money by firms from customers for other parties. An important example is

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sales tax collections for the government. Most of these third-party collections are short-
term liabilities.

Here's an example about third-party collections. A firm sells a car for 20,000, which
includes a sales tax of 1,000. Tax collections are transferred to the government at the
end of every month. We record a cash increase of 20,000, sales tax payable of 1,000,
and revenues of 19,000. Please note that out of 20,000 cash collected from the
customer, 1,000 belongs to the government as sales tax. Since sales taxes will be paid
to the government within a month, sales tax payable is valued based on face value.

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When the firm makes the sales tax payment to the government, both cash and sales tax
payable decrease by 1,000.

The last special liability we will discuss is bank loans. Bank loans are money borrowed
from a bank for a specific duration from a pre-specified interest rate. Loans can be
short-term or long-term liabilities depending on their duration.

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Here's an example about bank loans. Company A borrows 5,000 from Illini Bank for six
months for an annual interest rate of 10%. The bank loan increases cash account by
5,000. The other side of the transaction will be a creation of loan payable of 5,000.

Here are the entries when the loan is repaid six months later. Cash decreases by 5,250,
where the extra 250 is the six months' interest of the loan. It can be calculated as 5,000

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times semi-annual interest rate of 5%. Since the loan is paid, we deduct 5,000 from loan
payable. Finally, we record 250 interest expense on the income statement.

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Lesson 2-6: Module 2 Appendix 2: Advanced Issues in Bonds

Lesson 2-6.1: Appendix 2: Advanced Issues in Bonds

In this video, we will discuss advance issuance in bonds. Most bonds are issued at par
value. However, due to change in market conditions between coupon payment
determination date and the date the bond is issued to the market, bonds might be sold
more or less than the par value. Please remember that bond price is equal to sum of
present values of future coupon and principal payments. If the market effective interest
rate is lower than the coupon rate, the bond is issued at a premium. In other words, the
bond price is higher than the par value. If the market effective interest rate is higher than
the coupon rate, the bond is issued at a discount. In other words, the bond price is lower
than the par value.

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Just to be clear, bond price is determined by the interplay between market effective
interest rate and coupon rates. If the market rate is equal to coupon rate, then we have
a par bond. If the market rate is less than coupon rate, then we have a premium bond. If
the market rate is greater than coupon rate, then we have a discount bond. Premium
bonds bring more cash to the issuer than the par value. On the other hand, discount
bonds bring less cash to the issuer than the par value.

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There's an example about premium bond. Face value is 5,000. Coupon rate is 10%,
paid semi-annually, Market rate is 8%, issuance date is January 1st, 2025, and maturity
is five years. Since market rate is lower than the coupon rate, this is a premium bond.

How do we price a premium bond?

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Bond price is equal to the sum of present value of future coupon and principal
payments. If we use the present value formula, we can find that present value of the
principal which is 5,000 is 3,377.82. Please note that we use semi-annual discount rate
of 4% to calculate the present value. Similarly, we can use the present value of an
annuity formula to calculate the present value of coupon payments. Semi-annual
coupon payment is 5,000 times semi-annual coupon payment rate of 5%, which is equal
to 250. We can find that present value of the coupon payments from 4%, semi-annual
discount rate is 2,027.72. We can then find the price of the bond as 3,377 plus 2027,
which is equal to 5,406. Please note that the price of the bond is greater than the par
value. That is why this is the premium amount.

We will now discuss accounting for premium bonds.

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Cash increases by the price of the bond, which is 5,406. Bond payable increases by the
principal value of the bond which is 5,000. The premium, the extra price of the bond
over and above the principal value is recorded under a special account called bond
premium. The value of bond premium is 406.

What happens to a premium bond after issuance? We will decrease the cash account
on balance sheet by bond interest payment which is the coupon payments. Coupon

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payment is calculated as face value times coupon rate. We will also decrease the
income statement by bond interest expense which is going to be calculated as
beginning amount of bond payable times market interest rate. Then we will decrease
the bond premium account by the difference between bond interest payment which is
coupon payment and bond interest expense. Let's now apply premium bond accounting
after bond issuance.

We start with the transaction worksheet at the time of bond issuance. The first coupon is
paid after six months as we are doing semi-annual calculations. The amount of coupon
payment is 250 as we have calculated before. Coupon payment reduces cash account.
The amount of interest expense is beginning bond liability which is 5,406 times semi-
annual market interest rate of 4%. This will give us 216.2 as interest expense which will
be recorded as a reduction from income statement column. Please note that we use
total bond liability of 5,406 to calculate interest expense. The difference between bond
interest payment and bond interest expense is 33.8, which will be recorded as a bond
premium reduction.

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Let's apply this process one more time in December 2025. Cash is reduced by the
coupon payment of 250. Interest expenses differed in December 2025 because total
bond liability decreased. The new interest expenses 5,406-33.8*4%, which will be
214.9. The new difference between coupon payment and interest expense is 35.1 which
will be recorded as a reduction from bond premium account. We will repeat this process
until the end of maturity of this bond. Since bond premium account will decrease over
time, there will be a different interest expense in every period.

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In fact, we can use Microsoft Excel and create a bond amortization table for the
premium bond. We start Period 1 which is the end of first six months with net book
value, which is the net bond liability on the balance sheet at the time of bond issuance.
The second column is interest expense which is always equal to beginning net book
value of the bond multiplied by semi-annual interest rate of 4%. Coupon payment is
fixed and is always 250. The difference between coupon payment and interest expense
is bond premium amortization. We can then calculate ending premium as the difference
between beginning premium and premium amortization. Finally, we can calculate
ending net book value of the bond, which is beginning net book value minus bond
premium amortization. In Period 2, we start with Period 1 net book value and follow the
steps we have taken in Period 1.

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Please notice that if we successfully complete the amortization table, the balance of
bond premium decreases over time such that bond premium becomes zero at the time
of maturity. This makes a lot of sense because the firm just needs to pay the bond
investors face value which is 5,000. Bond accounting ensures that ending net book
value is the same as bond face value which is what the firm pays to bond investors.
What happens at the time of maturity for a premium bond? We decrease cash account
on the balance sheet by bond interest payment, which is always calculated as face
value times coupon rate. Decrease income statement by bond interest expense, which
is always calculated as beginning bond payable times market interest rate. Decrease
cash account on the balance sheet by face value, decrease bond payable on the
balance sheet by face value and close the bond premium account.

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Here's a transaction worksheet entries at the time of maturity. We reduce cash due to
two reasons. The last coupon payment of 250 and the payment of the face value of the
bond to the investors. We record the last bond interest expense of 201.3 on the income
statement. I have got the value of 201.3 from the bond amortization table we have
prepared. Similarly, I look at the bond amortization table and find that the last deduction
from the bond premium account is 48.7. This can also be calculated as coupon payment
of 250 minus bond interest expense of 201.3. Finally, we close the bond payable
account by recording -5,000 under this account.

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We will now give an example about discount bonds. As you will see soon, bond
accounting framework will be very similar to accounting for premium bonds. Face value
is 5,000, coupon rate is 10% paid semi-annually. Market rate is 12%, issuance date is
January 1st, 2025, and maturity is five years. Since market rate is higher than the
coupon rate, this is a discount bond. How do we price a discount bond?

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Bond price is equal to the sum of present value of future coupon and principal
payments. If we use the present value formula, we can find that the present value of the
principal which is 5,000 is equal to 2,791.97. Please note that we use semi-annual
discount rate of 6% to calculate the present value. Similarly, we can use the present
value of annuity formula to calculate the present value of coupon payments. Semi-
annual coupon payment is 250. We can find the present value of the coupon payments
from 6% semi-annual discount rate is 1,840.02. We can then find the price of the bond
as 2,791+1,840, which is equal to 4,632. Please note that the price of the bond is less
than the par value. That is why this is a discount bond.

We can now start recording the discount bond issuance in a transaction worksheet.

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Cash increases by the price of the bond, which is 4,632. Bond payable increases by the
principal value of the bond, which is 5,000. The discount, which is the difference
between the principal value and the bond price is recorded under a special account
called bond discount. The value of the bond discount account is -368.

What happens to discount bond after issuance? We will decrease the cash account on
the balance sheet by bond interest payment which is coupon payments. Coupon

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payment is calculated as face value times coupon rate. We will also decrease income
statement by bond interest expense which is going to be calculated as beginning
amount of bond payable times market interest rate. Then we will increase the bond
discount account by the difference between the bond interest payment which is coupon
payment and bond interest expense.

We will start discount bond accounting after bond issuance with a transaction worksheet
be completed at the time of initial bond issuance. The first coupon is paid after six
months as we are doing semi-annual calculations. The amount of coupon payment is
250 as we have calculated before. Coupon payment reduces cash account. The amount
of interest expense is beginning bond liability which is 4,632 times semi-annual market
interest rate which is 6%. This will give us 277.9 as interest expense which will be
recorded as a reduction from income statement column. Please note that we use total
bond liability of 4,632 to calculate interest expense. The difference between bond
interest payment and bond interest expense is 27.9 which we recorded under bond
discount column.

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Let's apply this process one more time in December 2025. Cash is reduced by coupon
payment of 250. The new interest expense is 4,632+27.9*6%, which will be 279.6. The
new difference between coupon payment and interest expense is 29.6, which will be
added to bond discount account. We will repeat this process until the end of maturity of
this bond. Since bond discount account will increase over time, there will be different
interest expense in every period.

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We can again use Microsoft Excel and create a bond amortization table for the discount
bond. We start Period 1 which is the end of the first six months with a net book value,
which is the net bond liability on the balance sheet at the time of bond issuance. The
second column is interest expense which is always equal to beginning net book value of
the bond multiply by semi-annual interest rate of 6%. Coupon payment is always 250.
The difference between coupon payment and interest expense is bond discount
amortization. We can then calculate ending discount as the difference between
beginning discount and discount amortization. Finally, we can calculate ending net book
value of the bond which is beginning net book value plus bond discount amortization. In
Period 2, we start with Period 1 net book value and follow the steps we have taken in
Period 1. Please note that if we successfully complete amortization table, the balance of
bond discount decrease over time such that bond discount become zero at the time of
maturity. This makes a lot of sense because the firm just needs to pay the bond
investors bond face value which is 5,000. Bond accounting ensures that ending net
book value is the same as bond face value, which is what the firm pays to bond
investors.

What happens at the time of maturity for a discount bond? We decrease cash account
on the balance sheet by bond interest payment which is always calculated as face value
times coupon rate. Decrease income statement by bond interest expense which is
always calculated as beginning bond payable times market rate. Decrease cash
account on the balance sheet by face value, decrease bond payable on the balance
sheet by face value, and close bond discount account.

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Here's the transaction worksheet entries at the time of maturity. We reduce cash due to
two reasons, the last coupon payment of 250 and the payment of the face value of the
bond to the investors. We record the last bond interest expense of 297.2 on the income
statement. I have got the value of 297.2 from the bond amortization table we prepared.
Similarly, I look at the bond amortization table and find that the last deduction from the
bond discount account is 47.2. This can be also calculated as the difference between
coupon payment of 250 and bond interest expense of 297.2. Finally, we close bond
payable account by recording -5,000 under this account.

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Firms sometimes repurchase their bonds from the market before the maturity date. This
may result in a gain or loss. This gain or loss is recorded as a component of continuing
operations. Gain or loss can be calculated as follows. First, calculate the market value
of the bond using the current market interest rates. This will be the bond repurchase
price. Second, calculate gain or loss as the current market value of the bond minus net
book value of the bond. Net book value of the bond is the total balance sheet value of
the bond at the time of repurchase.

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Here's an example about early bond repurchase. This is the discount bond we covered
in this video after the first coupon payment. Please note that the net book value of this
bond after the payment of first coupon is 5,000-368+27.9, which is equal to 4,659.9.

Suppose that the discount bond is repurchased from the market when the market
interest rate is 11%. What is the gain or loss from this repurchase? Please remember
that bond price is equal to some present value of future coupon and principal payments.

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Let's please start by calculating the price of this bond. We will use 5.5% as the semi-
annual discount rate. The present value of the principal is equal to 3,088. Please note
that there are nine periods left since we just made the first coupon payment. The
present value of the coupon payments is 1,738. Therefore, the market price of this bond
is 3,088+1,738, which is equal to 4,826. We can then calculate gain or loss from the
bond repurchase as market price which is 4,826 minus net book value which is 4,659.9.
This will result in a loss of 166.1.

We can then complete the early bond repurchase accounting in the transaction
worksheet. Cash decreases by 4,826. This is what the firm pays to repurchase the bond
from the market. We close both bond payable and bond discount accounts. We then
finally record the early bond repurchase loss of 166.1 on the income statement column.

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Lesson 2-7: Module 2 Case Video

Lesson 2-7.1: Module 2 Case Video

In this video, we will go through two case studies about liabilities. Here's case number 1.
Refer to the table in Johnson &Johnson's 2022 and you report for long term liabilities.
Recall that the company's fiscal year end is 1st January 2023. Using the information
provided, answer the following questions. Note, always use semi annual calculations.

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Part A of Case 1 asks, refer to the 6.73% debentures due to 2023, third instrument on
the table. Calculate interest expense on this note for fiscal year 2023, which is the year
ended January 1, 2024. Debentures are instruments similar to bonds in terms of
accounting.

If you look at Footnote 7 about borrowings, the third item is the 6.73% debentures due
to 2023 mentioned in the question.

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Since the book value of the instrument doesn't change between Year 2021 and 2022,
this is a par bond. For par bonds, interest expense is equal to coupon payment.
Therefore, interest expense is 6.73% * 250, which is equal to 16.825 in fiscal year 2023.

Part B of Case 1 asks, refer to the same note as in Part A. Provide entry, the company
will record at maturity. The firm will make two accounting entries at the time of maturity.

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First, the firm will record the final coupon payment. As we have discussed in Part A, this
is a par bond and its annual interest expenses 16.825. Since the question instructs to
use semi annual calculations, the last coupon payment is 16.825/2 = 8.41. Cash
decreases by 8.41 and the same amount is recorded under income statement as
interest expense. Next, the firm records the payment of the face value of the bond.
Cash and bond payable decreases by 250.

Part C of Case 1 asks, refer to the 0.55% notes due 2025, which is the nine instrument
on the table. Calculate interest expense on this note for fiscal year 2023, which is the
year ended January 1, 2024.

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Here is the Footnote 7 about borrowing. The 0.55% notes due 20 2025 has a book
value of 983 in 2021, and 918 in 2022. This is not a par bond. We will use the formula
for interest expense calculation for bonds.

Interest expense is equal to effective interest rate times the book value of the notes.
Therefore, interest expenses 0.57% * 918 = 5.233 in Year 2023. Just to be clear, the
interest rate we use is the effective interest rate information given in the table. You

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might ask, what is 0.55% mentioned in the title of the bond? That is annual coupon
rates.

Part D of Case 1 as refer to the 0.55% notes due 2025, which is the nine instrument on
the table. Assume the face value of the note is 950. Calculate interest payment on this
note for fiscal year 2023, which is the year ending January 2024. We need to carefully
read the question, the question is asking the interest payment, which is the same as
coupon payment. Interest payment is equal to stated interest rate, which is the coupon
rate times the face value of the notes. Therefore, interest payment is 0.55% * 950 =
5.225 in Year 2023.

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Here is Case 2. The following pages contain the balance sheet and part of Footnote 15
for Amgen from the 2022 annual report. Using this information, please answer the
following questions. The first question of Case 2 asks, what is the net book value of
Amgen's long term debt at December 31, 2022? Book value means balance sheet
value.

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If we look at liable section of the balance sheet, we will find that gains 2022 long term
debt amount is 37,354.

The second question of Case 2 gives the following information. The following questions
rate to the 2.20% notes due to 2027, which is the ninth item on the table. Assume that
the face value of these notes is 1600 and the interest is recorded annually. Part A of
Question 2 asks, what is your estimate of the total amount of interest expense that
Amgen recognized in fiscal year 2022 on these 2.20% notes?

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Here is Note 15 of Amgen tabulating financing arrangements. The 2.20% notes due to
2027 has a different book value amounts in 2021 and in 2022. Therefore, this is not a
par bond. We will use the power of the transaction worksheet to calculate the interest
expense of this bond in 2022.

2021 book value of this bond is 1750. This will be the beginning balance of bond
payable for year 2022. Ending book value of the bond is 1724, which we will record in

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the last nine in the transaction worksheet. Please notice that the book value of the bond
decreased by 26, which you can interpret as amortization of bond premium. If you
remember our lesson about premium bonds, bond premium is amortized over time,
resulting in lower net book value of the bond. This is a bond with a coupon rate of
2.20% as given in the title of the bond. Moreover, the question provides the information
that the face value of these notes is 1,600. Therefore, annual coupon amount is 1,600 *
2.20% = 35.2. We know the coupon payment amount and the amortization of the bond
premium, what is missing in the transaction worksheet is the interest expense of the
bond in 2022. Interest expense is the plug and can be calculated as.35.2-26 = 9.2.

Part B of Question 2 asks, what is the amount of unamortized discount or premium

related to 2.20% notes at December 31, 2022?

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We know that the face value of the notes is 1,600, and this information is provided in the
question. Book value of the note in 2022 is 1724, therefore, the amount of unamortized
premium is 1724 -1,600 =124 in 2022.

Part C of Question 2 asks, what is your best estimate of the historical interest rate on
the 2.20% note? To answer this question, we will use the formula, interest expense is
equal to interest rate times beginning net book value. In 2022, interest expense is 9.2 as

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we have calculated in Part A. Beginning net book value in 2022 is 1,750. We can then
apply the formula to calculate interest expense. After a little algebra, we can find that
historical interest rate is 0.53%.

Part D of Question 2 asks, what is your best estimate of the total amount of interest
expense that Amgen will record next year, which is fiscal year 2023 on these 2.20%
notes. Interest expense is equal to beginning note payable times interest rate.

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For 2023, beginning bond payable is 1724 and interest rate is 0.53% as we have
calculated Part C. Therefore, 2023 bond interest expense is 9.40.

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