F4 Liabilities: Final Review

PAYABLES AND ACCRUED LIABILITIES

 Liabilities = probable future sacrifices of economic benefits arising from
present obligations of an entity to transfer assets or provide services to other
entities in the future as a result of past transactions or events
 Current Liabilities: Operating
o Due within the longer of next year or the operating cycle
o Trade Accounts Payable – amounts owed for:
 Inventory
 Raw materials
 Recorded as purchases or inventory (periodic vs perpetual)
 Gross or net method
o Interest Payable – always look at dates
 Interest expense recorded in period incurred
 Non-Current Liabilities: Financing and Interesting Bearing
o Trade Notes Payable
o Taxes Payable
o Employee-Related
 Payroll Taxes (Employer Expense)
 Payroll Deductions (Employee Expense)
 Collected on behalf of employee and payable to
authorities
 Social Security, Medicare, Income Taxes
 Unemployment Taxes (Employer Expense)
 Bonuses (part of salary and wages expense – based company
profit)
 Accrued Vacation: SOCR
 Recorded in the year earned if all conditions are met:
o Services are already rendered (earned)
o Obligation relates to rights that vest or accumulate
o Compensation payment is probable
o Reasonably estimated amount
 If only SOC, not reasonably estimated = disclosure
 Deferred Compensation Agreement
 If all or a portion of expected future benefits are
attributed to period of service greater than one year =
the cost of benefits should be recognized over that
required period of service
 Current obligations expected to be refinanced with long-term liabilities =
included in non-current instead of current

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 Exit or Disposal Activities = book liability for associated exit or disposal
costs
o Recorded a present value = Total Costs * PV factor
o Costs incurred include:
 Involuntary employee termination benefits (severance pay)
 Terminate a contract that is not a lease (breach of contract)
 Consolidating facilities
 Relocating Employees
 Moving PPE
 Asset Retirement Obligations: legal obligation associated with the
retirement of a tangible long-lived asset that results from acquisition,
construction, development, or normal operation of long-lived assets
o Future obligation expensed during periods of benefit (closure or
removal costs)
o ARO = liability at PRESENT VALUE for future payment required to
clean up, close down, or restore the condition of an asset
 Accretion expense (interest) = increase in ARO liability to reach
future value amount (discounted amount of ARO)
 Beginning Carrying Value ARO * discount rate =
accretion expense
 DR Accretion Expense
o CR Asset Retirement Obligation
o ARC = amount capitalized at PRESENT VALUE (Asset)
 Depreciated STRAIGHT-LINE over remaining years to be
benefited (decreases asset down to $0)
o Initial Recognition: PV
 DR Asset Retirement Cost (Asset)
 CR Asset Retirement Obligation (Liability)
o At end of period, Accumulated Depreciation + Cumulative Accretion =
ARO
o TOTAL ARO EXPENSE = depreciation expense + accretion expense

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CONTINGENCIES AND COMMMITMENTS
 Loss Contingencies
o Probable = likely and reasonably estimated
 Accrue and record journal entry + disclose
 Highest probability = best estimate
 Equal probability = minimum accrued
o Reasonably Possible = less than likely more than remote
 Disclose in the footnotes
 Nature of contingency
 Estimate of possible loss
o Remote = slight chance of occurring
 Do nothing
 Exception = DOG Guarantee = disclose
 Debt of others guaranteed
 Obligation of commercial banks under standby letters of
credit
 Guarantees of repurchase receivables that have been sold
or assigned
 Gain Contingencies
o Apply the rule of conservatism – no accrual – no journal entry
o Claims or rights to receive cash or assets whose existence is uncertain
o Can be disclosed in the notes
 Do not disclose if remote
 Premiums = offers to customers to stimulate sales
o Cost of premium is charges to sales in periods that benefit from the
premium offer
 Number of outstanding premium offers must be estimated
accurately to reflect the current liability at the end of each
period
 Estimated redemption rate * number of coupons issued =
premium expense
o Journal Entry
 DR Premium Expense
 CR Premium Liability
 Warranties = seller’s promise to “Correct” any product defects
o Must create liability account if the cost can be reasonably estimated
 Entire liability should be accrued in the year to sale to match
cost with corresponding revenue
 Liability balance = total liability – actual expenditures
o Journal Entry
 DR Estimated Warranty Expenses
 CR Warranty Liability

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LONG-TERM LIABILITIES
 Long-term Liabilities = probable future sacrifices of economic benefits
associated with present obligations (not payable in the shorter of current
operating cycle or reported year)
 Lump Sum
o Present value of $1
 PV = FV / (1+r)^n (PV = Future Value * PV of $1)
 PV = FV / FV Factor
o Future value of $1
 FV = PV * (1+r)^n (FV = Present Value * FV of $1)
 FV = PV / PV Factor
 Annuities = multiple equal payments
o Ordinary Annuity = end of period
o Annuity Due = beginning of period
o PV = Payments * PV Factor
o FV = Payments * FV Factor
 Notes Payable = contractual rights to pay money at a fixed or determinable
rate
o Recorded at PRESENT VALUE
o Noninterest bearing or interest rate is unreasonable (below market =
value of note must be determined by imputing the market rate using
the effective interest method
 Discount is added to the note payable to determine the carrying
value to be reported on the balance sheet
o Imputing Interest: must be recorded over security life even if not
paid
 Gross note payable = payment * number of payments
 Gross note payable – present value of annuity = discount
(deferred interest expense)
 Discount = amortized over life of security
 Beginning carrying value * effective market rate =
interest expense
 Periodic payment – interest expense = reduction in
principal
 HIGH MARKET INTEREST RATE = LOWER PV OF NOTE
 = HIGHER DISCOUNT
o Journal Entries
 Imputed Interest: Purchase Asset
 DR Asset (PV)
 DR Discount on Note Payable
o CR Note Payable (gross)
 Periodic Payment

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  DR Interest Expense
 DR Note Payable (reduction in principal)
o CR Cash
 Amortize Discount on Note Payable
 DR Interest Expense (discount * rate)
o CR Discount on Note Payable
 Debt Covenants = used in lending agreements to protect their interest by
prohibiting actions of the debtors that might negatively affect the position of
creditors
o Concessions are negotiated and real default is avoided

BONDS
 Bonds = long-term liability recorded at face value
o Bonds payable is adjusted to PRESENT VALUE by subtracting
unamortized discount or adding unamortized premium
o Bond selling price = PV of future principal payment (lump sum) + PV of
the future periodic interest payments ((face * coupon) * PV of ordinary
annuity)
 Use market rate to determine PV factors (NEVER COUPON
RATE)
 Stated Interest Rate = Coupon Rate
o Face Value * Coupon Rate = Cash Payment
 Market (Effective) Interest Rate
o Carrying Value * Market Rate = Interest Expense
 INTEREST PAYABLE = FACE VALUE * CONTRACTUAL INTEREST RATE
o Also known as the coupon payment
 Market Rate = Coupon / Price
o Market Rate HIGHER than Coupon Rate = DISCOUNT
 Face Value – Selling Price = unamortized discount
 Bonds sell for less than face amount to make up for lower return
being provided
 Higher interest expense on income statement than coupon paid
o Market Rate LOWER than Coupon Rate = PREMIUM
 Selling price – Face Value = unamortized premium
 Investors will pay more than face value due to higher return
offered
 Lower interest expense on income statement than coupon paid
 Bonds Issuance Costs = deducted from carrying value of liability and
amortized using effective interest method
 Detachable Warrants = total issuance price must be allocated between
bonds and warrants (allocated proportionately on individual prices)
 Conversion to Common Stock
o Market Value Method: gain or loss is recorded equal to the
difference between the market value of the stock issued and the book
value of the bond before conversion
o Book Value Method: no gain or loss is recognized

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 Bond Amortization:
o Straight-line = constant dollar amount for coupon paid and interest
expense
 Even though not GAAP, it is allowed if results are not materially
different from the effective interest method
 (Unamortized discount/premium) / outstanding periods =
amortization
 Amortized discount = increases carrying value (ADD)
 Amortized premium = decreases carrying value
(SUBTRACT)
 CONSTANT INTEREST EXPENSE VALUE
o Effective Interest = Constant rate but dollar amount varies
 Coupon paid is constant
 Interest expense varies
 INCOME STATEMENT: Interest Expense = Carrying Value *
Market Rate
 BALANCE SHEET: Coupon = Face Amount * Coupon Rate
 EFFECTIVE INTEREST RATE METHOD:
 Amortization of discount = interest expense – interest
(coupon) payment
 Interest expense > coupon
 Increases carrying value -> higher interest expense
 Amortization of premium = interest (coupon) payment –
interest expense
 Interest expense < coupon paid
 Decreases carrying value -> lower interest expense
o Journal Entry – Discount (straight-line and effective interest
method)
 Borrower
 DR Bond Interest Expense
o CR Discount on Bond Payable
o CR Cash
 Investor
 DR Cash (Coupon paid)
 DR Investment in Bonds (Discount Amortization)
o CR Bonds Interest Revenue (market rate * carrying
value)
o Journal Entry – Premium
 Borrower
 DR Bond Interest Expense
 DR Premium on Bond Payable
o CR Cash
 Investor
 DR Cash
o CR Investment in Bonds (Premium Amortization)
o CR Bonds Interest Revenue

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  Bonds Issued Between Interest Dates
o Selling price must include the accrued interest to date; investor pays
interest and is reimbursed at the next payment date on receipt of a full
period’s interest
o Face value * coupon rate * (number of months since last
payment / 12)
o Journal Entry
 DR Cash
 DR Discount on Bonds Payable
 CR Bonds Payable
 CR Bonds Interest Expense (payable)
 Year-end Bond Interest Accrual
o If scheduled interest payment and issuer’s year-end do not agree =
must accrue interest by an adjusting entry on issuer’s books at year-
end
 Must take into account a prorated share of discount or premium
amortization
o Journal Entry – year end
 DR Interest Expense (carrying value * market rate)
 CR Interest Payable (face * coupon)
 CR Discount on Bonds Payable
TROUBLED DEBT RESTRUCTURING
 Creditor allows the debtor certain concessions to improve the likelihood of
collection that would not be considered under normal circumstances
 Debt Extinguishment Methods: DEBTOR
o Transfer of Assets
 Satisfy debt where carrying value of liability is > fair value
 Debtor recognizes gain on extinguishment of debt:
 Carrying amount of the payable (face amount + accrued
interest) - Fair value of assets given up
 When marking to FMV:
 Gain or loss on disposition of the asset (difference
between book value and fair value) reported in income of
the period
 Net gain = Carrying value of liability – net book value of
asset
 Journal Entry
 DR Payable (carrying value)
 DR Accumulated Depreciation
o CR PPE (cost)
o Gain (Extinguishment + FMV)
o Transfer of Equity Interest
 Carrying Value of Liability > FMV stock issued
 Difference between payable and equity interest fair value
= gain

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  Recognize Gain: no change to assets
 DR Payable
o CR Common stock (shares* par)
o CR Additional Paid-in Capital (shares * (FM – par))
o CR Gain
o Transfer of Equity Interest
 Carrying Value of Liability > FMV stock issued
 Difference between payable and equity interest fair value
= gain
 Recognize Gain: no change to assets
 DR Payable
o CR Common stock (shares* par)
o CR Additional Paid-in Capital (shares * (FM – par))
o CR Gain
 Modification of Terms: NOT EXTINGUISHED (DEBTOR SIDE)
o Debtor accounts for effects of restructuring prospectively
 Debtor does not change the carrying amount unless the carrying
amount exceeds the total future cash payment specified by the
new terms
 Creditor may record bad debt expense if it probable unable to
collect
o When total undiscounted future cash payments are less than
carrying amount, the debtor should:
 Reduce carrying amount accordingly
 Recognize difference as gain on debt restructuring
 DR Old Payable
o CR New Payable
o CR Gain on Restructuring
 Accounting and Reporting by CREDITORS
o Recognition of Impairment
 A loan is impaired if it is probable that the creditor will be unable
to collect all amounts due under the original contract when due
 Must estimate bad debts and record at year-end:
 DR Bad debt expense
o Allowance for losses
 Write-off or write down:
 CR Allowance for losses
o Receivable
o Receipt of Assets or Equity
 DR Asset (FMV)
 DR Allowance for losses
 CR Receivable
o Modification of Terms
 Measured based on the loan’s present value of expected future
cash flows discounted at the loan’s historical effective interest
rate

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  Step 1: Sum of PV of future cash flows = PV of principal +
PV of coupon payments
 Step 2: Carrying value of receivable – sum of PV of
discounted future cash flows = impairment
 DR Bad Debt Expense
o CR Allowance for credit losses
 Discounted cash flow approach = post-restructuring
effective interest rate must be used as the discount rate

EXTINGUISHMENT OF DEBT
 Corporations issuing bonds may recall or retire them prior to maturity
 Refundable bonds allow an existing issue to be retired and replaced with a
new issue at a lower interest rate
 A liability cannot be derecognized in the financial statements until it
has been extinguished by paying off debt or being legally released
 Debtor Pays Off Debt (at or before maturity)
o At Maturity = Debit Bonds Payable, CR Cash
o Before Maturity = recognize gain or loss in addition to regular entry at
maturity (carrying value – reacquisition price)
 Recognized as income from continuing operations
 Total loss = premium + unamortized discount and issuance
costs
 Total gain = unamortized premium and issuance + discount
o Journal Entry for loss
 DR Bonds Payable
 DR Loss on Extinguishment of Bonds
 CR Discount on Bonds Payable and issuance costs
 CR Cash (call price)
o Journal Entry for gain
 DR Bonds Payable
 DR Premium on Bonds Payable
 CR Gain on Extinguishment of Bonds
 CR Cash (call price
 Debtor is Legally Release (Transfer of Assets or Equity)

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 o FMV of transferred asset or equity LESS THAN Carrying Value of
Liability + Accrued Interest = GAIN
o Sum of Undiscounted Future Cash Flows LESS THAN Carrying Value of
Principal + Accrued Interest = GAIN and write-down debt

LESSEE ACCOUNTING
 Lease = used by public and private entities as a means of gaining access to
assets and reducing their exposure to the full risks of asset ownership
(CAPITALIZED)
 Requirements for a lease: decision made at contract inception
o Contract must depend on an identifiable asset in which the lessor
does not have a substantive substitution right (usually big stuff)
o Contract must convey the right to control the use of the asset over
the lease term to the lessee
o May be reassessed if the terms and conditions of the contract change
 Combining Contracts if all is met:
o One or more contracts contains or is a lease
o Contracts are entered into at approximately the same time
o Parties are the same or related
o One or more of the following:
 Performance or price of one contract affects the consideration
paid in other contracts
 Contracts have the same commercial objectives and were
negotiated as part of a package
 The right to use the underlying assets do not meet the
accounting criteria for separate lease components
 Finance Lease = if any one of the following criteria are met OWNES
o Ownership of asset will transfer from lessor to lessee by the end of
the term

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 o Written Option to purchase the asset and it is reasonably certain for
the lessee to exercise
o Net Present Value of all lease payments and any guaranteed residual
value is equal to or substantially exceeds the asset’s fair value (90%)
o Lease term represents a major part of the Economic Life remaining
for the asset (75%)
o Specialized asset that will not have an expected alternative use to
the lessor when the lease term ends
 Operating lease = none of the finance lease criteria are met
 Lease Term begins on commencement date and extends to noncancelable
period for which the lessee has the right to use the asset
o Options to extend lease term included if reasonably certain to be
exercised
o SHORT-TERM LEASES = expensed (12 months for less)
 Lease Payments: REPORT
o Required contractual fixed payments (includes variable payments
that are “in-substance” fixed payments) LESS any lease incentives
paid or payable to lessee
o Exercise option reasonably assured: exercise price of option to
purchase asst if reasonably certain
o Purchase Price at the end of the lease: stated purchase price
(required by lessor)
o Only Indexed or rate variable payments: no increase or decrease
to future lease payments should be assumed based on increases or
decreases in index or rate (any differences in payments are expensed
in period incurred)
o Residual Guarantees likely to be owed: full amount of residual value
guarantee at the end of the lease term in the present value test (do
not include unguaranteed)
o Termination Penalties: reasonably assured penalties due from
lessee upon lease termination
o Discount Rate: PV of minimum lease payments
 Rate implicit of the lease (if known, rare)
 If not readily available = use the incremental borrowing rate of
the lessee
 Operating Lease:
o Balance Sheet: ROU Asset and lease liability
 Amortized over the life of the lease using the effective interest
method
 Calculated using the PV of lease payments using appropriate
discount rate
 Periodic payment = annuity due (beginning of
period)
 Purchase option or guaranteed residual = PV of $1
o Income Statement

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  Lease expense = amortization expense (plug) + interest
expense (same every period)
o Commencement Date (lease starts) = SAME FOR BOTH TYPES
 DR Right-of-use asset (ROU)
 CR Lease Liability (PV of all payments)
o NET JOURNAL ENTRY:
 Dr Lease Expense (annual payment)
 DR Lease Liability (reduction in principal, lease expense –
interest expense)
 CR Cash (annual payment)
 CR Accumulated Amortization – ROU Asset (reduction in
principal)
 Reaches net book value of 0 after being fully amortized
 Lease expense (payment) – interest expense = reduction
in ROU carrying value
o Leasehold Improvements = amortized straight-line and expensed
o RENT EXPENSE SHOULD BE BASED ON TOTAL AMOUNT TO BE
PAID / TERM
 Important to recalculate if monthly rate changes (discount or
increase)
o OPERATING LEASE PAYMENT = CASH OUTFLOW FROM
OPERATIONS
 Financing Lease:
o Separate lease expense into amortization and interest expense:
income statement
 Amortization of asset = ROU Asset Value / Term (DOES NOT
INCLUDE INTEREST)
 Straight-line every year ACTUALLY CALCULATE
AMORTIZATION
o Interest Expense = Liability Carrying Value * effective rate
 Lease payment – interest expense = reduction in ROU
carrying value
 High in beginning, less over time (LEASE EXPENSE DIFF EVERY
YEAR)
o Lease expense = interest expense + annual amortization
o Commencement Date (lease starts) = SAME AS OPERATING
 DR Right-of-use asset (ROU)
 CR Lease Liability (PV of all payments)
o Interest Expense
 DR Interest Expense (carrying value * effective rate)
 DR Lease Liability (reduction of principal, payment - interest)
 CR Cash/Lease Payable (annual payment)
o Amortization
 DR Amortization Expense
 CR Accumulated Amortization – ROU Asset

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 o FINANCE PRINCIPAL PAYMENT = CASH OUTFLOW FROM
FINANCING
o FINANCE INTEREST PAYMENT = CASH OUTFLOW FROM
OPERATING
PRESENTATION AND DISCLOSURES
 Balance Sheet
o ROU Asset and Liability:
 Recognized separate line items
 Included with other assets/liabilities and disclosed separately in
the notes
 Portion of lease liability due within a year should be reported in
the current and remainder in long-term
o Financing and operating lease ROU assets and liabilities cannot be
presented together
o Finance Lease
 ROU amortized straight-line
 Ownership and Written Option: amortize over
asset’s useful life
 NPV, Economic Life, or Specialized Asset: amortize
over shorter of the lease term or useful life of the
asset
 Lease liability principal will be paid down over the life of the
lease
 Larger effect in early years – higher interest expense
 Income Statement
o Operating Leases
 Interest expense will be included in income from continuing
operations on the lessee’s income statement
o Finance Leases
 Amortization of ROU Asset
 Interest expense
 Statement of Cash Flows
o Operating
 Lease payments = operating cash flows
 Payments to bring asset to a condition and location in
preparation for intended use = investing activities
o Finance
 Principal portion of lease payment = financing cash flow
 Interest portion of lease payment = operating cash flow
 Variable lease payment not in lease liability = operating cash
flow

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