Module 7 - Current and Long-Term Liabilities

MBA 617: Managerial Accounting
Module 7: Current & Long-Term

Liabilities
Accruals
Agenda Short-Term Debt
Long-Term Debt
• Bond Issues
• At Par
• At a Discount
• At a Premium
Credit Quality
Time Value of Money

Accruals
• Accruals are Adjustments made to conform to GAAP to “fairly
present the financial condition of the entity”
• Accrual Basis of Accounting – recognize Revenues in the period in
which they are earned, and expenses matched to those Revenues
they are used to create
• Also need to Recognize Liabilities on the Balance Sheet, and the
corresponding Expenses on the Income Statement.
Type of Liabilities
• Short-Term (Current) & Long-Term
• Contractual
• Routine / Expected Expenditures
• Include Wages, Interest Expense, Income Taxes, and other expenses that have
been incurred (used up) but not paid yet (such as rent, utilities, etc.)
• Contingent
• Uncertain – depend (contingent) upon the occurrence of an event
• Amount is also uncertain
• Must recognize a liability if two conditions are met:
• Probable – the probability of the event is more likely than not
• Estimable – in the case the event does occur, the amount of the liability can be reasonably
estimated or determined.
Types of Contingent Liabilities
• Lawsuits
• Guarantees (guarantee of debt) of another entity
• Product Warranties and Recalls
• Environmental Disasters and Remediation
GAAP requires recording of expected costs of Liabilities, including

Contingent Liabilities. Liabilities must be estimated and recorded on
the Balance Sheet, and Expenses must be recorded on the Income
Statement.
Recording Liabilities
General Journals:
To record the liability
Warranty Expense $10,000
Warranty Liabilitiy $10,000
*Estimate at 10% of Sales, where Sales = $100,000
Note: The above entry is a “non-cash” entry.
To satisfy an actual claim
Warranty Liabilitiy $100
Cash $100
Note: When a claim comes in, no expense is recorded. The Expense is recognized when the Sale is
made, per GAAP. The satisfaction of the claim is offset against the reserve set aside in the Warranty
Liability Account. Each time a claim is satisfied, the liability account decreases. The Cash is paid out
when the claim is satisfied.
Footnotes
• Footnotes in Financial Statements include important
disclosures, which serve to expound upon and clarify
matters.
• Examination of these disclosures can provide more
information, regarding expectations of future cash flows,
and other trend analyses, with which investors can better
judge the financial health and future performance of an
entity.
Short-Term Debt
• Debt maturing within 1 year, or operating cycle, whichever is
shorter.
• Includes the Current Portion of Long-term Debt
• Principal amount only (Not Interest, because this would be on the Income
Statement, not the Balance Sheet)
• That portion of the Long-term Debt that will be maturing within 1 year
• Footnote disclosures are required to show the schedule of Long-
term Debt Maturities
Long-Term Debt
• Bank Loans are used for relatively smaller amounts of
Debt
• Bonds are common for larger entities
• To secure financing for larger projects and debt
amounts
• Are generally much more cost effective (lower
effective interest expense
Bonds
• Are structured much like a bank loan
• Requires payback of Principal
• Requires Interest Payment, periodically
• Most often, Interest is paid Semi-Annually (twice a year)
• Coupon Rate – (Contract, Face, or Stated Rate – used to
calculate the periodic payment to owner .
• Ex.: $1,000 Bond Coupon 10% /2 = $50/semi-annual pmt
• Market Rate – (Yield or Effective Rate) – rate demanded by
investors, used to calculate the initial sales price of the Bond,
using the NPV calculations.
Pricing of Bonds – At Par (100 (%))
• Market Rate and Coupon Rate are the same.
• $1,000 Bond
• Coupon Rate is 10%
• Market Rate is 10%
Bond Sells at $1,000 (company gets $1,000 cash)
Cash $1,000
Bonds Payable $1,000
Investor gets 10%/ per year – divided up into two payments of $50 semi-annually.
At the end of the Bond Term, the investor gets their $1,000 back.
Pricing Bonds – at Discount (97 (%))
Market Rate is Greater than the Coupon Rate
• Since the Underwriting of the Bonds, the demanded rate in the market has gone
up, yielding a better return for like Bonds in the Market.
• The Bond must be sold at an amount less than the Face value of $1,000, to
make the Bond yield the same as any other like Bond in the Market, otherwise,
nobody would ever buy it.
Cash $970
Discount 30
Investor gets SAME 10%/ per year – divided up into two payments of $50 semi-
annually, but only has to pay $970.
Pricing Bonds – at Discount (102 (%))
Market Rate is Less than the Coupon Rate
• Since the Underwriting of the Bonds, the demanded rate in the market has decreased,
yielding a lesser return for like Bonds in the Market.
• The Bond is worth more than those like Bonds in the Market, so it will sell for a
Premium, more than the Face Amount.
Cash $1,020
Premium 20
Investor gets SAME 10%/ per year – divided up into two payments of $50 semi-annually,
but has to pay more, $1,020.
Effective Cost of Bonds
• The Periodic Interest, based on the Coupon Rate, does not change,
regardless of the price the bonds were issued for (whether Par, Discount,
or Premium)
• The Effective Cost then, is the Interest payment as represented by the
Semi-Annual periodic payments, plus the discount (if issued at a
discount), or minus the premium (if issued for a premium)
• The cost would be the interest payments, and then the difference in the
Face Value ($1,000) and the actual cash received (the original price paid
by the investor)
• Bonds issued at Par would have a cost of the Interest Payments, as
represented by the Coupon Rate. Nothing more, nor less.
Amortization
A Bond is recorded on the Balance Sheet at the Issuance Price of the Proceeds
actually received, ($970 or $1,020, for example)
Over the term of the Bond, the Discount or Premium must be Amortized.
• For a Bond Issued at a discount, the discount must be allocated each semi-annual
period, to effectively increase the Interest Expense recognized. The payment
received by the investor is the same, but the amortization of the discount gets
added to the basis of the Bond Carrying Value. At the end of the Bond Term, the
Discount is fully Amortized, resulting in the Carrying Value being made whole up to
the Face Value of the Bond.
• For a Bond Issued at a premium, the premium would decrease the effective Interest
Expense being paid. The amortization of this Premium would decrease the
Carrying Value over time, so that it too would equal the Face Amount at Maturity.
Amortization of a Discount
The Difference in Market versus the Coupon Rate, results in the Amortization applied. .
Amortization of Premium
The Difference in Market versus the Coupon Rate, results in the Amortization applied. .
Quality of Debt
• The market rate of interest is usually defined as the yield on U.S.
Government borrowings such as treasury bills, notes, and bonds,
called the risk-free rate, plus a risk premium (also called a spread).
• The Risk-Free Rate is a Floating (changing) rate, based on Treasury

(highest quality) rate fluctuations.
• A Company’s Risk Premium is determined based on it’s Credit Quality.
• Companies with poorer Credit Quality must pay a higher Risk
Premium.
Credit Ratings
• Credit Ratings are published by Independent Ratings Agencies
• Based on a broad range of ratios and Analyses
• Focus on Business Risk
• Industry Characteristics
• Competitive Position
• Management
• Also Focus on Financial Risk
• Profitability Ratios
• Cash Flow Ratios (liquidity)
• Solvency (longer term perspective)
As Ratings Go Down, Risk Premium Goes Up, and Interest Cost Goes Up
Time Value of Money
A Dollar Today, is worth more than a Dollar sometime in the Future.
When determining the price of a Bond, there are two calculations:

• PV of a Single Amount - you have to discount the Future payment of
the Face Amount ($1,000) to Present Value Dollars. So, if you’re going
to get $1,000 in the Future, how much are you willing to pay today?
• PV of a Series of Equal Payments (Annuity) – If multiple payments are
to be received, then you much calculate the effects of Interest
Compounding (payment of Interest on Interest previously paid and
accumulated)
Present Value Computation
 If we have $90.91 today and can invest it at 10% for 1 year, our investment
will grow to $100:
 So, $90.91 is the present value of $100 to be received 1 year hence if the
investment rate is 10%:
© Cambridge Business Publishers, 2018 21

Simple Annuity Example
 Assume $100 is to be received at the end of each of the next three
years as an annuity.
 As shown below, the present value of this annuity can be computed
from Table 1 by computing the present value of each of the three
individual receipts and summing them (assume a 5% annual rate).

Pricing our
Bond
Using a
•Make Certain you change your signs to negative, as indicated.
Financial •In this Case, the -4,000 is equal to the Interest Rate (Coupon Rate). If you
were to change this to $-3,000,
Calculator •or $-5,000, the calculator would effectively calculate your new Bond
Price. So, effectively, the Interest Rate you put in is the Market Rate, then
the PMT you put in would be the Coupon, or Stated Payment (as
calculated).

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MBA 617: Managerial Accounting

Module 7: Current & Long-Term

Agenda Short-Term Debt

Time Value of Money

GAAP requires recording of expected costs of Liabilities, including

• The Risk-Free Rate is a Floating (changing) rate, based on Treasury

When determining the price of a Bond, there are two calculations:

© Cambridge Business Publishers, 2018 21

© Cambridge Business Publishers, 2018 22

© Cambridge Business Publishers, 2018 23

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