Bonds

Chapter 11:
Liabilities, on and off balance sheet
General issues
Long-term debt, contingent liabilities
Leasing
1

Liabilities, definition and classification
• present obligations based on past transactions or events that
require either future payment or future performance of services
A liability is a present obligation of the enterprise arising from past
events, the settlement of which is expected to result in an outflow from
the enterprise of resources embodying economic benefits. [IASC
Framework, paragraph 49]
recognized when incurred; end-of-period adjustments may be
necessary
valued at the amount due or at fair market value
classified as current or long-term; determinable or contingent
2

Long-term / current
• Long-term Liability
due beyond the current period or the normal operating
cycle, whichever is longer
used to cover long-term financing needs
• Current Liability
due within one year or within the normal operating cycle,
whichever is longer
incurred in connection with operating process
long-term liabilities may contain a current portion according
to the lapse of time
• to be shown separately
3

Part I: Current Liabilities
• Accounts Payable
sometimes called trade accounts payable
balances owed to others for goods and services purchased
on open account
time lag between resource inflow and payment
• Short-Term Bank Loans
„line of credit“ – short-term borrowing when needed
promissory note over the full amount uses to be signed
interest 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 these
two companies carry such different levels of current liabilities.
4

Notes Payable, accounting treatment when
granted
written promises to pay a certain sum on a specified future
date
used to secure loans or to pay suppliers for goods
Case 1 - Interest stated separately
Sep 30 Cash 10.000
Notes Payable 10.000
(To record issuance of 9%,
90-day note to Commerzbank)
money received equal
to face value of note
Case 2 - Interest in face amount
money received equal to
present value of note
Sep 30 Cash 9.779
Discount on Notes Payable _221
Notes Payable 10.000
(To record issuance of zero-interest-bearing
90-day note to Commerzbank)
5

Accounting treatment of payment
Case 1 - Interest stated separately
Dec 30 Notes Payable 10.000
Interest Expense _225
Cash 10.225
(To record payment of
Commerzbank interest-bearing
note and accrued interest at
maturity)
interest expense
= 10.000 x 9% x 90/360
Case 2 - Interest in face amount
interest expense is lower in
case 2 than in case 1 since the
effective amount borrowed
was lower, too.
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)
6

other current debt
• Current Maturities of Long-Term Debt
portions of long-term debt maturing within the next year are
classified as current liabilities
e.g. installment due on a long-term liability, i.e. a loan
no journal entry necessary
• Short-Term Obligations Expected to Be Refinanced
don‘t require use of working capital within the next year
enterprise needs to demonstrate intent and ability to
refinance the obligation
• Dividends Payable
liability is incurred after the board‘s decision to pay out
dividends
liability exists until dividends are paid
7

Unearned Revenues
• examples:
sale of season tickets for a sports club
subscription of magazines
gift certificates
meal tickets
• accounting treatment
when payment is received: debit cash, and credit unearned
revenue account
when revenue is earned: debit unearned revenue, and credit
an earned revenue account
Type of Account Title
Business Unearned Revenue Earned Revenue
Airline Unearned Passenger Ticket Revenue Passenger Revenue
Restaurant Unearned Meal Revenue Meal Revenue
Magazine Publisher Unearned Subscription Revenue Subscription Revenue
Sports Club Unearned Ticket Revenue Ticket Revenue
8

Economic function of unearned revenue
• recognize unearned revenue when customers are
entitled to receive future service for their present
payment with certainty
to be distinguished from warranty reserves
Example – Microsoft
‣ unearned revenue increased year after year
‣ u.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 future
development!
9

Sales and Excise Taxes Payable
• federal and state authorities levy taxes on retail
transactions or rendering of services
tax collected by seller and then remitted to tax authority
to record a (gross) sale of € 232 given a sales tax of 16%,
the following entries are required:
Cash Sale
Apr 19 Cash 232
Sales 200
Sales Taxes Payable 32
similar entries to record collection of excise tax excise
tax payable
10

Taxes
• Income Taxes Payable
expense in the year the income is earned
estimated because tax files are subject to review and
approval
debit income taxes expense, credit income taxes payable
• Property Taxes Payable
fiscal year of tax authority often differs from the firm‘s fiscal
year
depending on period chosen to charge the taxes, estimates
may be necessary
provision for property taxes usually by a monthly accrual in
the company‘s books during the fiscal period of the taxing
authority for which the taxes are paid
11

Contingencies
• Definition
„ ... an existing condition, situation, or set of
circumstances involving uncertainty as to possible
gain (gain contingency) or loss (loss contingency) to
an enterprise that will ultimately be resolved when
one 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
liabilities
liabilities contingent on occurence or nonoccurence of a
future event
12

Example
• Dream Cars Inc., a car dealer, offers various
specialties to its customers:
Free repair of newly bought cars in case of defect within the
next two years
Free inspection on request by new customers within the
next six months with purchase of 4 new tires before
christmas (as a christmas customer appreciation special)
• No definite liability incurred; Uncertain:
payee
due
amount.
• Nevertheless
it is probable, that a liability has been incurred, and
the liability can reasonably be estimated.
Record the estimated amount as a contingent liability!
13

Accounting for contingencies under US-GAAP
Event
Contingent Loss
Contingent Gain
Probability of
Occurence High Reasonable Remote High Reasonable Remote
Is it estimable?
Yes No
Accounting
Treatment Accrue Disclose Disclose Ignore Disclose Ignore Ignore
Source: Pratt, p. 432.
14

Common instances of loss
contingencies/contingent liabilities:
• Litigation, claims, and assessments
the cause for legal action occurred in the past
probability of unfavorable outcome assessed accoding to past
experience
estimate of expected loss: legal action is decided but number of
claimants uncertain
pending litigation vs. actual/possible claims and assessments: no
exact amounts disclosed due to influence on position before the
court
• Guarantee and warranty costs
guarantee for credit default
product warranty
• Premiums and coupons.
• Environmental liabilities.
• Pensions and other postemployment benefit obligations.
see following pages
15

Guarantee and warranty costs
• Warranty: guarantee to repair or replace defective
goods during a predetermined period following the
sale
• accounting either
Cash Basis – warranty costs charged to period in which
company complies with the warranty
Accrual 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. The
cost per service is estimated at € 70. In 2002, he sold 800 units.
Five warranty services have already been performed at costs
totalling € 430. So there remain eleven warranty services as an
estimated liability.
16

Journal entries for the example:
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 770
Estimated 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
17

Premiums and coupons
• Examples
frequent-flyer programs
bonus cards of department stores
toys that come with McDonalds junior meals
• Accounting problem again: estimation of the liability
incurred with the sales
(to comply with the matching principle)
• Journal entries – similar to „Drums example“
18

Example: Frequent-flyer program
• America West Airlines (Phoenix, Arizona), „Flight
fund“ 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)
• Estimation
How 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 cost
method“
19

The World‘s Frequent Flyers...
Frequent-flyer miles
Number 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 2,2
1982 16,8 20,9 12,9 14,8 6,1
1983 38,5 59,2 28,6 43,4 15,8
:::
2000 1.440,0 10.009,3 349,5 3.379,1 6.630,2
2001 1.600,0 11.609,3 341,6 3.720,7 7.888,6
2002 1.646,0 13.255,3 402,9 4.123,6 9.131,7
*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
20

Environmental liabilities
• result from obligation to clean up, say, toxic waste or to
landscape sites no longer used for business
sometimes very hard to estimate the liability
indemnity claims after environmental catastrophes
• For example: Bayer AG
“[28 ] Other provisions
Other provisions are valued in accordance with IAS 37
(Provisions, Contingent Liabilities and Contingent Assets)
using the best estimate of the extent of the obligation. Interestbearing
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.]
21

Part II: Long-term liabilities
• Bonds
Definition of a bond
Why issuing bonds
Types of bonds
Accounting for bond issues
Accounting for bond retirements
• Long-Term Notes Payable
• Reporting and Analysis of Long-Term Debt
22

Bonds
• securities issued by, e.g. corporations or
governmental agencies, to obtain large-sum longterm
financing
• normally due ten to fifty years after issue
• various covenants and restrictions for protection of
both lenders and borrowers
• small denominations allows collection of large sums
of money
• interest payment
annually or semiannually
zero bonds
• „bond issue“ refers to total number of bonds issued
at one time
23

Why issue bonds?
• to obtain large sums of money for long time that
cannot be collected otherwise e.g. from banks
• debt financing has some advantages over equity
financing
stockholder controls remains unaffected
tax savings: interest expense is tax deductible
leverage 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 project
alternative I – issues 100.000 shares at current price of € 20
per share
alternative II – issuance of € 2 million, 9% bonds at face
value
24

Funds obtained by ... issuance of ... issuance of
additional shares
bonds
(250.000 shares (150.000 shares
outstanding)
outstanding)
Earnings before interest
and income taxes € 700.000 € 180.000 € 700.000 € 180.000
Interest 0 0 180.000 180.000
Earnings before income taxes € 700.000 € 180.000 € 520.000 € 0
Income 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
RoE 9.1% 2.34% 11.27% 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.
25

How to issue bonds ?
• usually, approval by board of directors and general meeting of
shareholders necessary; authorized:
number of bonds
total 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 public
underwriters buy bonds for resale or on a commission basis
bondholders are represented by a trustee, typically a large bank
contract 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 the
company‘s debt to the bondholder; bondholders are creditors !
26

Types of Bonds
• Secured and Unsecured Bonds
secured bonds: bondholders have a claim to certain assets
of the company upon default, e.g. mortgage bond
unsecured bonds: issued against general credit of borrower
(debenture bonds)
• Term and Serial Bonds
term bonds: all bonds of an issue mature on the same date
serial bonds: bonds mature over several maturity dates
• Registered and Coupon Bonds
registered bonds: corporation maintains record of all
bondholders
coupon bonds: bond not recorded in the name of the owner;
transferable by delivery
cont‘d next page
27

Types of Bonds, cont‘d
• Convertible and Callable Bonds
convertible bonds: bonds that can be converted into
common 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 Bonds
income bonds: interest payment only if company is
profitable
revenue bonds: interest on the bonds is paid from specific
revenue sources
28

Bond Ratings
• Moody‘s Investors Service, Standard & Poor‘s Corp.
and Fitch are the dominating rating agencies
Original Rating
(Historical)
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
29

Accounting for Bonds Payable
• bonds are traded in the capital market
market rate (effective yield) of interest and (current) bond
prices 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:
⎛
⎜
⎝
c
⎞
F
T
t ⎟ +
t= 1 1
T
=
∑
( 1 + r) ( + r)
⎠
• The yield for longer term debt uses to be higher than for
shorter term debt (normal term structure of interest rates)
• yield rate (bond price) depend on credit rating
B
30

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 € 21.000
principal € 300.000 € 300.000
present value of interest € 66.567 € 63.784
present value of principal € 204.904 € 190.655
present value (selling price) of the bond € 271.471 € 254.440
31

Inverse relation between interest rates and bond prices
B
200
180
160
140
120
100
80
60
40
20
0
2 4 6 8 10 12 14 16 18 20 % r
bond #1 – stated
rate of interest of c 1
= 5% and term to
maturity of T 1
= 10
bond #2 -stated
rate of interest of
c 2
> c 1
and term to
maturity of T 2
=T 1
bond #3 -stated
rate of interest of
c 3
=c 1
and time to
maturity T 3
= 5 < T 1
assumption: bonds 1-3 have the same face value = 100
32

Stated rate of interest, market rate of interest,
effective rate of interest, and bond issue prices:
• The stated rate of interest i = c/F maydifferfromthe
market rate of interest
since the yield must be equal to the market rate the issue
price must be adapted accordingly:
• If the stated rate is
lower than the market rate: issue price lower than face
value, bond sells at a discount
higher than the market rate: issue price exceeds face value,
bond sells at a premium
• at the date of issue
⎛
⎜
⎝
c
⎞
F
T
t ⎟ +
t= 1 1
T
=
∑
( 1 + r) ( + r)
⎠
B
must hold with a given market rate r
33

Issuing Bonds At Face Value (“at par”)
• stated rate of interest i = r market rate of interest
• accounting entry: cash proceeds = face value of the bonds
Example: 5-year term bonds, face value of € 900.000, dated
January 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
34

Issuing Bonds at Discount
• stated rate of interest i < r market rate of interest
Example: as before, but market rate of interest now 10%
(stated rate of interest 8%).
5
∑
t= 1
72.000
t
1,1
+
900.000
1,1
5
=
831.766
discount is 68.234
has to be amortized over the time to maturity
• usually: straight line method: 68.234 / 5 = 13.647
35

Issuing Bonds at Discount
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
Balance sheet presentation:
Long-term liabilities
Bonds Payable € € 900 900.000 000
Less: Discount on Bonds Payable 68.234 112.159 € 831.766 € 787.841
36

Issuing bonds at a premium
• stated rate of interest i > r market rate of interest
Example: as before, but market rate of interest now 6%
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
Balance sheet presentation
Long-term liabilities
Bonds Payable € 900 € 000 900.000
Add: Premium on Bonds Payable 75.823 133.901 € 975.823 € 1.033.901 37

Amortizing Bond Premium / Bond Discount
• the bond premium (discount) is amortized over the
life of the bonds
straight-line method
effective interest method
• Straight-line method
equal amounts of the premium (discount) are amortized in
each period, equal interest expense recorded in each period
interest expense = interest to be paid + amortized discount
amortized discount = (face value – issue price) / number of
interest periods
interest expense = interest to be paid – amortized premium
amortized premium = (issue price – face value) / number of
interest periods
38

Effective interest method
• interest expense = bond carrying value ×
effective rate of interest
discount amortization = interest expense –
interest to be paid
premium 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 discount
and decreasing under premium amortization
39

Effective interest discount amortization schedule for
an 8% bond sold to yield 10%
Annual interest paid interest discount unamortized bond carrying
period expense amortization discount value
issue date 68.234 831.766
1 72.000 83.177 11.177 57.057 842.943
2 72.000 84.294 12.294 44.763 855.237
3 72.000 85.524 13.524 31.239 868.761
4 72.000 86.876 14.876 16.363 883.637
5 72.000 88.364 16.364 0 900.000
40

The journal entry to record accrued interest at December 31, 2004, is
Bond interest expense 83.177
Discount on bonds payable 11.177
Bond interest payable 72.000
... and bond interest expenses will keep rising as the carrying value of the
bonds increases.
41

Effective interest premium amortization schedule for
8% bonds sold to yield 6%
Annual interest paid interest premium unamortized bond carrying
period expense amortization premium value
issue date 75.823 975.823
1 72.000 58.549 13.451 62.372 962.372
2 72.000 57.742 14.258 48.115 948.115
3 72.000 56.887 15.113 33.002 933.002
4 72.000 55.980 16.020 16.982 916.982
5 72.000 55.019 16.981 1 900.001
42

The journal entry to record accrued interest on
December 31, 2004, is
Bond interest expense 58.549
Premium on bonds payable 13.451
Bond interest payable 72.000
... and bond interest expenses will keep falling as the
carrying value of the bonds decreases.
43

Zero Bonds
• bonds that bear no interest (explicitly) and are issued solely for
cash
• also 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 ?
€3.270.000
= €10.000.000⋅(1
+ i)
−8
i =
10.000.000
8 −1
3.270.000
=
0,14999
• The implicit interest rate is 15%. It is the interest rate that
equates (in present value terms) the cash received with the
amounts to be paid in the future.
44

• The journal entry to record the issuance of this zero
bond is
Cash 3.270.000
Discount on Bonds Payable 6.730.000
Bond Payable 10.000.000
• The schedule for bond discount amortization under
the effective interest method of one bond (to keep
the numbers small) is
cash interest expense discount unamortized bond carrying
paid amortization discount value
issue date 673 327
1 0 49 49 624 376
2 0 56 56 568 432
3 0 65 65 503 497
4 0 75 75 428 572
5 0 86 86 342 658
6 0 99 99 244 756
7 0 113 113 130 870
8 0 130 130 0 1.000
45

Accounting for Bond Retirements
• Redeeming bonds at maturity
Bonds Payable 900.000
Cash 900.000
... at maturity, the book value (carrying value) of the bond is equal
to its face value.
• Redeeming bonds before maturity
Bonds payable 900.000
Discount on Bonds payable 31.239
Loss on bond redemption 103.239
Cash 972.000
• ... here is the journal entry for retiring the 8% bond sold to
yield 10% at the end of the 3rd period given the market interest
rate now has declined to 8%.
46

Disclosure Requirements for Long-Term Debt
• composition of long-term debt
• long-term debt maturing within one year should be
reported as a current liability
• maturities of long-term debt during each of the next
five years
• any special arrangements, e.g. refinancing,
conversion into stock, „off-balance-sheet financing“
47

Off-Balance-Sheet Financing
• imprecise definition of liabilities allows off-balancesheet
financing
• credit agreements usually contain covenants, i.e.
limitations to issuing further debt
• companies try to find ways to get money without
having to diclose debt on the balance sheet
• Ways to do that
form a new entity together with some other company so that
it does not have to be consolidated. The entity then borrows
money The two companies guarantee debt repayment and
disclose this fact as a contingent liability.
sell assets at a high price to such an entity
forward sales of products: a bank buys oil or natural gas
forward
mezzanine capital
48

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 installments
• Accounting treatment
• Lessee‘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 shows
Lease receivable; asset is taken out of balance sheet as if
sold
• Operating lease: lessor keeps asset, lessee shows
neither asset nor liability
this treatment is controversial
49

Example
• Autolease offers a car leasing contract under the
following rules:
Initial payment € 10000
monthly installments: € 200
duration: 3 years, maximum kilometers: 15 000 per year
current operating costs are borne by the lessee
the lessee has no purchase option at the end of the
contract, car has to be returned to lessor
the car is leased „full coverage insured“ by the lessor who
gets the insurance benefits
• this is an operating lease
initial payment is prepaid rent.
50