Acct 500--Dealing with Liabilities

To record a liability for accounting purposes there must exist a transaction that can be recorded. For example, promises of future sales or provision of services do not represent recordable commitments for accounting purposes. Once payment has been received, even though no performance has occurred the transaction should be recorded.

Contingency:
A circumstance involving uncertainty as to a possible gain or loss. A gain contingency is generally not recorded because it violates the conservatism principle. A loss contingency is recorded if: a) information is available prior to issuance of financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred and b) the amount of the loss or impairment can be reasonably estimated.

If either condition is not met, the contingency must be disclosed if there is a reasonable possibility that a loss may have been incurred (FASB No. 5).

Example:
A lawsuit claiming damages is filed against a corporation. If the corporation concludes that there is a reasonable possibility of losing the lawsuit and if the amount can be reasonably estimated a liability is recognized. When recording the liability use the lower bound of the estimated range.

FASB Statement No. 5--Degrees of Uncertainty
Probable--Likely to Occur
Reasonably Probable--Less than likely more than remote
Remote--slight chance

Current Liabilities: Liabilities expected to be satisfied during the current accounting period with current assets. Current liabilities often provide interest free loans to the firm. For example, accts payable with a 30 day grace period provides a 30 day interest free loan in the amount of the receivable.

Term Loan:
Business Loan with specified repayment schedule usually the creditor is a bank or large insurance company.

Bond:
A certificate promising payment of a lump sum at maturity plus a stated rate of interest over the period the bond is outstanding.

Most bonds are fixed rate but some bonds "variable rate" bonds, are tied to some index plus a stated percentage (e.g, prime plus 2 percent). Bonds have a face value of $1,000 but are generally quoted as a percentage of face value. Therefore a bond selling at 98 is selling at 98 percent of $1,000 or $980. A bond selling at 105 is selling at 105 percent of $1,000 or $1050. Bondholders may require that firms maintain minimum standards for financial position. To insure that some standard is set bondholders may outline requirements in Bond (Debt) Covenants that issuers must abide by before purchasers are willing to acquire the bonds. Bonds may be categorized as mortgage or debentures. A mortgage bond is tied to a specific asset set and in default the bondholders will receive those assets to satisfy their claims. Debentures are just promises of the firm to repay principal plus interest. These bondholders have a general claim against the firms assets in the event of default and are not assured of satisfying claims at default.

Firms can redeem bond issues, but if it is before the maturity date the issuer may be requried to pay a premium to re-acquire the bond issue.

Bonds can also be callable or convertible. Callable bonds contain a provision that allows the issuer to call (buy back) the bond issue when the issuer deems it appropriate. The bond may specify a price and time period at which the bond may be called but bondholders must comply with the bond and accept the redemption. A convertible bond is one that can be converted to ownership (stock) in the corporation when the bondholder deems it appropriate.

In the example provide above the recorded transaction assumes that the bond was issued when the market interest rate was the same as the state rate on the bond. When that is not true investors are not willing to pay face value for a bond that pays less than the going market interest rate and they are more than willing to pay more for a bond that has a stated rate higher than the market rate. When either case is true the market value of the bond will be different that the face value. When market rates of interest are higher than the stated rate the bond will sell at a "discount". If the market rate is less than the stated rate the bond will sell for a "premium."

Bonds Payable are shown as long-term liabilities until the year before maturity. If the bonds are expected to be retired during the accounting period they are listed as a current liability. If portions of a bond issue are retired installments the current portion should be listed as a current liability. If a new bond issue is expected to replace the old bond issue the bonds should not be listed as current liabilities. Bond discounts are a contra liability and therefore are shown as offsets to the Bonds Payable account. Bond premiums are considered adjunct accounts and are considered additions to the Bonds Payable account. Principal minus bond discount (or plus premium) is referred to as the book value (or net book value) of the issue. Book value minus the unamortized cost of issuing the bonds is considered the net carrying value.

From the perspective of the bondholder a payment of the interest by the issuer represents interest revenue and would be recorded as a debit to cash and a credit to interest revenues. From the perspective of the bond issuer the payment of the stated interest rate is only part of the determination of the actual interest expense for the period. If the bonds sold at a discount, the amount of the discount represents the additional interest the firm had to pay to sell their bonds. Thus, for firms that sold their bonds at a discount the interest expense recorded each period will be higher than the amount of the check written to bond holders. If the bonds originally sold at a premium, the bondholders have provided a portion of their future interest payments to the bond issuer. Thus, the bond issuer will record lower interest expense than the amount of the check issued to bond holders. Examples of these transactions are provided below.

The dollar amount associated with the amortization of the bond discount and bond premium in the previous examples is determined using the effective interest method. There is an alternative method called straight-line but the use of straight-line to amortize discounts and premiums is not allowed unless no material difference exists using either method. Thus, the effective interest method becomes the method of choice. The effective interest method requires that the market interest on the date of bond issue be applied to the carrying amount that represents the amount that interest expense should be determined from. In the bond discount case the interest rate is applied to the net book value of the bond issue, or principal minus the discount. In the bond premium case the interest rate is also applied to the net book value but net book value is the sum of the principal amount and the unamortized premium amount.

The final point of discussion is bond retirement. If firms retired bonds at bond maturity the transaction recorded would be the payment of bond holders their principal amount and removal of the bond issue from the books of the firm. For example,

Bond Payable               $1,000
              Cash                      $1,000

However, bond retirement doesn't always occur at bond maturity. When the bonds are retired early the retirement may require the firm to pay more or less than the book value to retire the bonds. When the firm pays more than book value the bonds are retired at a loss. When the firm pays less than book value the bonds are retired at a gain. In both cases the gain or loss must be recognized and any remaining discount or premium must be removed from the books as well as the bond issue itself. The following examples will provide an indication of how this might be recorded.
Retirement of Bonds Issued at Discount
Retirement of Bonds Issued at Premium