Lecture 12 Debt Flashcards
What are liabilities?
Liabilities are present obligations of the entity that arise from past events and whose settlement is expected to result in an outflow of resources from the entity. The outflow must be probable and reasonably estimable.
On the balance sheet, liabilities are arranged in order of maturity and grouped into current liabilities, which mature within one year or one operating cycle, and non-current (long-term) liabilities.
How to record a liability?
1) Determine whether events have occurred that require the recognition of a liability.
2) Estimate the expected future outflow required to settle the liability.
3)Record the journal entry to put the liability on the balance sheet:
DR (asset or expense account) xxx
CR liability xxx
4) When the liability is settled, record:
DR liability xxx
CR Cash xxx
What do we do about highly uncertain liabilities?
Some potential liabilities, called (loss) contingencies, are highly uncertain and depend on yet unknown future events that are at least partly beyond the entity’s control.
Examples include losses from pending lawsuits and environmental cleanup obligations.
Contingent losses are only recognized as liabilities if they are reasonably estimable and their occurrence is probable (US GAAP) or ‘more likely than not’ (IFRS).
Otherwise, they are disclosed in a footnote (if the contingency is reasonably possible) or not at all (if the probability is remote).
If recognized, the liability is referred to as a contingency (US GAAP) or a provision (IFRS).
Contingent gains are never recognized or disclosed.
What is the face value in long-term debt?
amount on which the interest payments are calculated; paid at maturity
What is the maturity date in long-term debt?
Time of the last interest payment and the payment of the face value
What is the coupon rate (nominal interest rate) in long-term debt?
Interest rate by which coupon (interest) payments are calculated
What is the coupon payment in long-term debt?
face value × coupon rate
What is the effective interest rate (market yield) in long-term debt?
discount rate that equates the present value of all future coupon and principal payments to the market value of the note
How to Find the Present Value of long-term debt?
𝑃𝑉=𝐹∙𝑐∙(1−1/(1+𝑟)^𝑇 )/𝑟+𝐹/(1+𝑟)^𝑇
How to record a note issuance?
When accounting for a note under the effective interest method, the note is initially (at the issuance date) recorded at its market value.
Face value and discount (or premium) are recorded in two separate accounts. In our example, the note issuance is thus recorded as:
DR cash xxx
DR note discount xxx
CR notes payable xxx
On the balance sheet, notes are shown net of any discount or premium. Notes maturing within the next year are shown as current liabilities.
How to record an interest expense?
The interest expense for the period is computed as
interest expense = net book value (beginning of period) × effective interest rate
The effective interest rate used in this calculation is always the effective rate as of the issuance date.
Changes in the market yield subsequent to the issuance date are ignored.
The interest expense almost always differs from the coupon payment.
The difference is booked against the discount (or premium) account and is called the note discount (or premium) amortization.
Why does book value equal present value under the effective interest method for long-term debt?
At the end of each subsequent year, the net amount of interest expense and coupon payment increases (or decreases) the carrying amount :
net carrying amount (ending) = net carrying amount (beginning) + discount (or premium) amortization
= net carrying amount (beginning) + interest expense – coupon payment
What are debt issuance costs and how are they recorded?
The difference between the expected carrying amount (based on the stated ‘issued at’ percentage) and the actual carrying amount is likely due to debt issuance costs (transaction costs).
Debt issuance costs are subtracted from the proceeds (i.e., the carrying amount of the note) and thus increase the effective rate of interest.
How is long-term debt treated in cash flow statements?
The discount or premium amortization is a non-cash component of interest expense.
If the cash flow statement is prepared under the indirect method, any discount or premium amortization becomes an adjusting item in the reconciliation between net income and net operating cash flow.
