7 Liability Recognition and Nonowner Financing

MODULE 7
Liability
Recognition and
Nonowner
Financing
© Cambridge Business Publishers, 2021

Learning Objective 1
LO1
Evaluate accounting
for accrued liabilities.
© Cambridge Business Publishers, 2021 2

Current Liabilities
 Current section of the balance sheet reports liabilities that

will mature with a year

Accrued Liabilities
 AKA: Accrued expenses & Accruals

 Accrued liabilities are adjustments made to the balance sheet:
 After all transactions have been recorded
 Prior to the issuance of the financial statements
 So that the financial statements fairly present the financial condition of
the company
 These adjustments recognize liabilities (and the related expense
on the income statement) that are not the result of external
transactions
 Accrued liabilities are incurred in the current period and,
therefore, must be recognized in the current period.

Types of Accrued Liabilities
Two broad categories of accruals:

1. Routine contractual liabilities
 Wages to employees for work performed, but not yet paid
 Unpaid interest that is due in the current period
 Income taxes owed, but not yet paid, on profit earned in the period
 Other expense items like rent and utilities, incurred but not yet paid
2. Contingent liabilities – Depend on the occurrence of a
future uncertain event in order to determine whether a
liability exists and in what amount
 Litigation brought against the company – the outcome and amount
depend upon adjudication
 Warranty liabilities for products sold – the amount depends on future
claims for product repair or replacement

Accruals for Contractual Liabilities—
Wages Payable Example
 If the liability for unpaid wages is not reflected on balance sheet:

 Liabilities will be understated
 Wage expense will not be reflected in the income statement
 Profit for the period will be overstated
 To correct for this, accountants make an accounting adjustment
 When the wages are paid, cash and wages payable both decrease

Accruals for Contractual Liabilities—
Deferred Revenue Example
 AKA: Unearned Revenue
 Deferred revenue represents deposits or other prepayments
from customers that the company has not yet earned.
 Deferred revenue is an accrued liability until the company provides the
goods or performs the service according to the contract
 Once the company satisfies the performance obligations, the liability is
reduced and (earned) revenue is recognized

Accruals for Contingent Liabilities
 Some liabilities are less certain because the ultimate settlement

of the liability is contingent on the outcome of a future event
 Examples include
 Guarantees on the debt of another entity
 Lawsuits
 Product warranties and recalls
 Environmental disasters and remediation
 Companies record an a contingent liability when two conditions
are met
1. It is probable that one or more future events will confirm that a
liability existed at the financial statement date
2. The amount required to settle the liability in the future can be
reasonably determined at the financial statement date

Accruals for Contingent Liabilities—
Warranties Example
 Warranty liabilities are commitments that manufacturers make
to repair or replace defective products within a specified period
of time
 If the obligation is probable and the amount estimable with
reasonable certainty, GAAP requires that companies
 Record the expected cost of warranties as a liability
 Record the related expected warranty expense in the income
statement in the same period that the sales revenue is reported
 When the defective product is later replaced (or repaired), the
liability is reduced and the company records the cost of
necessary to satisfy the claim

Harley’s Warranty Footnote Disclosure
$116,840
Expense
 At the beginning of 2018, Harley-Davidson reported a warranty

and recall liability (reserve) of $94,250
 During 2018 Harley-Davidson:
 Added $53,367 for warranties issued on products sold in 2018
 Added $63,473 for product recalls and changes to pre-existing warranty
liabilities
 Paid out $79,300 to settle warranty claims. The settlements include cash
paid to customers for refunds, wages paid for repairs, and the cost of
parts used in repairs
Analysis of Warranty
Footnote Disclosures
 GAAP requires that warranty liabilities reflect estimated cost the
company expects to incur as a result of warranty claims
 Companies might intentionally
 underestimate warranty liability to report higher current income
 overestimate warranty liability to depress current income and create an
liability (cookie jar reserve) to absorb future warranty costs
 This would shift income from the current period to the future
 We must closely examine warranty liabilities and scrutinize
deviations from the historical relation to sales levels or from
peer company levels

Analyst Adjustments 7.1 (1)
 Warranty expenses are rife with estimates: product failure rates,

likelihood customers will make claims if products fail, the cost of
repairs, etc.
 Firms can deliberately manage warranty expense to achieve desired
financial reporting outcomes
 Analysts can “undo” potential earnings management by adjusting
warranty numbers
Analyst Adjustments 7.1 (2)
 As one approach to adjusting warranty numbers, analysts determine
an historical average as follows:
 We use the 1.83505% average to compute expected expense and

reformulate the income statement and balance sheet

LO2
Analyze short-term debt.

Accounting for Short-Term Debt
 When the company borrows short-term funds, it reports the

cash received on the balance sheet together with an increase
in liabilities (notes payable)
 The note is reported as a current liability because the company
expects to repay it within a year
 The borrower incurs (and the lender earns) interest on the
note as time passes
 GAAP requires the borrower to accrue the interest liability
and the related interest expense each time financial
statements are issued

Accounting for Short-Term Debt
 Assume that Verizon borrows $1,000 cash on January 1st
 The note bears 12% interest, payable quarterly
 Assume that Verizon prepared financial statements March 31st

 Verizon calculates interest as follows on March 31st

Current Maturities of Long-Term Debt
 Principal payments on long-term debt, that must be made

during the upcoming 12 months are reported as current liabilities
called current maturities of long-term debt
 Note that the current maturity is the principal portion only of
the payments that will be made in the upcoming year
 Consider a typical loan amortization schedule

LO3
Analyze long-term debt pricing.

Long-Term Debt – Pricing
 When companies require a large amount of financing, the

issuing bonds in capital markets is a cost-efficient way to raise
funds
 Bonds are structured like any other borrowing
 The borrower receives cash and agrees to pay it back with interest
 Generally, the entire face amount (principal) of the bond is repaid at
maturity (at the end of the bond’s life)
 Interest payments are made in the interim (usually semiannually)

Issuance of Bonds
 Companies that raise funds in the bond market normally

work with an underwriter (like Goldman Sachs) to set the
terms of the bond issue
 The underwriter
 Sells individual bonds (usually in $1,000 denominations) to its retail
clients and professional portfolio managers (like The Vanguard Group)
 Receives a fee for underwriting the bond issue
 These bonds are investments for individual investors, other

companies, retirement plans and insurance companies

Interest Rates and Bond Prices
 Issued bonds can trade in the secondary market just like stocks
 Bond prices fluctuate even though the company’s obligation to
repay principal and interest remains fixed throughout the life of
the bond
 The bond’s fixed rate of interest can be higher or lower than the
interest rates offered on other securities of similar risk
 Because bonds compete with other possible investments, bond
prices are set relative to the prices of other investments
 Just like in any competitive market―the laws of supply and
demand will cause bond prices to rise and fall

Two Types of Interest Rates
 Coupon (contract or stated) rate

 AKA: Contract rate, Stated rate
 The coupon rate of interest is stated in the bond contract
 We use coupon rate to compute the dollar amount of interest payments
that are paid (in cash) to bondholders during the life of the bond issue
 Market (yield or effective) rate
 AKA: Yield, Effective Rate
 This is the interest rate that investors expect to earn on the investment in
this debt security
 This rate is used to price the bond

Cash Flows to Bondholders
 Bondholders normally expect to receive two types of cash flow

1. Periodic interest payments (usually semiannual) during the bond’s life
 Interest payments are called an annuity because they are equal in amount
and made at regular intervals
2. Single payment of the face (principal) amount of the bond at maturity
 Repayment of principal is called a lump-sum because it occurs only once
 The bond price equals the present value of the annuity
payments plus the present value of the lump-sum payment.

Pricing of Bonds Issued at Par
 Assume a company issues the following bond:

 Face amount of $10 million
 A 6% annual coupon rate (which is a 3% semiannual rate)
 Matures in 10 years (in 20 semiannual periods)
 If the market demands 3% semiannually, the bond price

is $10 million and the bond is issued at par:

Pricing of Bonds Issued at a Discount
 If instead, investors demand a 4% semiannual return for the

3% semiannual coupon bond
 Because the bond carries a coupon rate lower than what investors
demand, the bond is less desirable and sells at a discount
 The bond now sells for $8,640,999, computed as follows:
 Because the bond carries a coupon rate lower than what investors
demand, the bond is less desirable and sells at a discount.
 In general, bonds sell at a discount whenever the coupon
rate is less than the market rate
Pricing of Bonds Issued at a Premium
 If instead, investors demand a 2% semiannual return for the

3% semiannual coupon bond
 Because the bond carries a coupon rate that is higher than
what investors demand, the bond is more desirable and sells
at a premium
 The bond now sells for $11,635,129, computed as follows:
 In general, bonds sell at a premium whenever the coupon rate

is greater than the market rate

Effective Cost of Debt
 Bonds are priced to yield the return (market rate) demanded

by investors
 Thus, the effective rate of a bond always equals the yield
demanded by investors, regardless of the bond’s coupon rate
 This means that companies cannot influence the effective
cost of debt by raising or lowering the coupon rate
 Doing so will only result in a bond premium or discount

Interest Expense vs. Interest Payments
 The effective cost of debt is used to determine interest expense

reported in the issuer’s income statement
 Because of bond discounts and premiums, interest expense is
usually different from the cash interest paid
Bonds sold at a discount:

99.631% - 0.3% = 99.331%
of face value

Verizon’s Coupon vs. Effective Rate
 We can use Excel to calculate the effective cost of debt
 Assume the notes were sold

on April 8, 2019
 Bonds mature in 8 years
 Assume interest paid
annually
 Verizon received proceeds of
99.331% of face value
= €1,241,637,500
 Effective rate was 0.9623%

LO4
Analyze long-term debt.

Balance Sheet Reporting (1)
 Companies report debt NET of discounts (or including premium)
 Details are reported in the debt footnote. For Verizon:

Balance Sheet Reporting (2)
 Footnotes provide a schedule of the maturities of long-term

debt
 Verizon's footnotes report the following in 2018:

Income Statement Reporting
 Interest expense reported on the income statement represents

the effective cost of debt, including
 The cash interest paid (the coupon rate)
 PLUS a portion of the additional borrowing costs associated with the
discount (or less a portion of the benefit associated with the premium)
 The process of recognizing additional interest expense
associated with a non-par bond is called amortization
See Appendix 7B for details

about bond amortization.

Financial Statement Effects of
Bond Repurchase
 AKA: Bond redemption or extinguishment
 Companies can and sometimes do repurchase their bonds prior
to maturity.
 Verizon reports a “loss on the early extinguishment of debt” of
$700 million in 2018 as described in the financial statement
footnotes as follows:
 When a bond repurchase occurs, a gain or loss usually results,

and is computed as follows:

Gains and Losses on Bond Retirements
 When a bond repurchase occurs, a gain or loss usually results,

and is computed as follows.
 The net bonds payable, also referred to as the book value or

carrying value, is the net amount reported on the balance sheet.
 If the issuer pays more to retire the bonds than the amount
carried on its balance sheet, it reports a loss on its income
statement.
 The issuer reports a gain on bond retirement if the repurchase
price is less than the net bonds payable.

Fair Value Disclosures
 GAAP requires companies to report current fair values of their

debt in footnotes (but not on the balance sheet)
 Changes in fair values are not included in net income because
 Gains and losses reverse with subsequent fluctuations in interest rates
 The bonds are repaid at par at maturity
 Verizon discloses the following in its footnotes:

LO5
Evaluate credit quality
and interpret credit ratings.

Credit Analysis
 While equity investors are focused on upside potential, lenders

are primarily concerned with credit risk: the risk that they will
not recoup the amount loaned or the interest
 Borrowers with higher credit risk have lower quality of debt
 Lenders’ focus on the company’s ability to repay the borrowed
amounts, which is largely determined by two factors
1. Level of indebtedness—amount of principal and interest
that must be repaid
2. Excess cash that the company is able to generate—this
provides the cash needed to repay the debt
 The term “excess cash” means the cash the company is able to
generate over and above what is needed for ongoing operating
and investing activities
Market Rate of Interest (1)
 Lenders require a higher interest rate as the borrower’s credit

risk increases (and the quality of its debt declines)
 The market rate of interest (yield) is defined as:
 The risk-free rate is the yield on U.S. Government borrowings

such as treasury bills, notes, and bonds
 The risk premium depends on the level of credit risk
associated with the borrower

Market Rate of Interest (2)
 Consider the risk-free rate and the rate for the lowest risk
corporate bonds (AAA) and for riskier corporate bonds (BAA)

What Are Credit Ratings?
 Companies that want to issue public debt normally seek a credit rating
on their proposed debt issue
 Major credit rating agencies include
 S&P Global Ratings
 Moody’s Investors Service
 Fitch Ratings
 The aim of rating agencies is to rate
debt so that its credit risk is more
accurately conveyed to, and
priced by, the market.
 Each rating agency has its own
rating system

Credit Ratings Agencies
 Credit rating agencies take a two-step approach to evaluate the

riskiness of a company’s debt
 The first step is to assess the likelihood of default
 The relative likelihood of default can be gauged by analyzing
 Historical and forecasted levels of debt
 Excess cash flow available to repay the debt
 The second step is to assess the potential loss that the lender
will suffer in the event of default
 The potential loss given default is generally a function of the structure of
the debt
 To quantify loss given default, rating agencies consider collateral, loan
terms, and covenants

What Determines Credit Ratings?
 Each rating agency uses its own rating system

 S&P Global Ratings’ process is depicted in the following
graphic:

Verizon Credit Rating Example (1)
 S&P assesses Verizon as STRONG when

it comes to business risk
 S&P determines that the company’s
financial risk is INTERMEDIATE
 This yields an anchor of a-
 Most of the modifiers are neutral
 Management and governance are
perceived as strong
 But a comparable rating analysis results
in a negative modifier
 S&P assigned Verizon a stand-alone
credit rating of BBB+

Verizon Credit Rating Example (2)
 S&P concludes its analysis by emphasizing its expectation that

Verizon will continue in its stated objective to reduce debt

Credit Ratings and Financial Ratios
 Rating agencies use several financial ratios to assess default risk
 A partial list of ratios used by Moody’s is in the table below
 In examining the ratios, recall that debt is increasingly more risky
as we move from the first row, Aaa, to the last row Caa-C

Why Credit Ratings Matter
 So, how good are credit ratings at predicting defaults?

 Moody’s provides the following graphic that illustrates the
default rates for each ratings category 5 years into the future.

LO6
Apply time value of money concepts.
(Appendix 7A)

Present Value Concepts
 Would you rather receive a dollar now or a dollar one year

from now?
 Most people would answer, a dollar now.
 Intuition tells us that a dollar received now is more valuable
than the same amount received sometime in the future.
 The dollar received now could be invested and one year from
now, we would have the dollar and the interest earned on
that dollar.

Present Value of a Single Amount
Risk and interest factors yield the following generalizations:
1. The right to receive an amount of money now (present
value) is worth more than the right to receive the same
amount later (future value)
2. The longer we must wait to receive an amount, the less
attractive the receipt is
3. The greater the interest rate the greater the amount we
will receive in the future
 Putting 2 and 3 together we see that the difference between
the present value of an amount and its future value is a
function of Principal × Interest Rate × Time
4. The more risk associated with any situation, the higher
the interest rate

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%, we can also calculate the
present value by discounting the future value as follows:

Using Present Value Tables

Present value tables are in Appendix A of the book―to use them:
 Determine the number of interest compounding periods (three years compounded
semiannually are 6 periods)
 The extreme left-hand column indicates the number of periods
 It is important to distinguish between years and compounding periods
 The table is for compounding periods (years × number of compounding periods
per year)
 Determine the interest rate per compounding period
 Interest rates are usually quoted on a per year (annual) basis
 The rate per compounding period is the annual rate divided by the number of compounding
periods per year. For example, an interest rate of 10% per year
would be 10% per period if compounded annually, and 5% per period if compounded
semiannually.
 Locate the present value factor, which is at the intersection of the row
of the appropriate number of compounding periods and the column
of the appropriate interest rate per compounding period
 Multiply
© Cambridge this factor
Business Publishers, 2021 by the dollars that will be paid or received in the future.
53
Examples

Present Value of an Annuity
 Often, future cash flows involve the same amount being paid
or received each period
 Examples of annuities include:
 Semiannual interest payments on bonds
 Quarterly dividend receipts
 Monthly insurance premiums
 If the payment or the receipt (the cash flow) is equally spaced

over time and each cash flow is the same dollar amount, we
have an annuity.

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 receipt separately and summing them (assume a 5%
annual rate)


Using Table 2
 Table 2 (Appendix A) provides a single multiplier for
computing the present value of an ordinary annuity
 Referring to Table 2 in the row for three periods and the
column for 5%, we see that the multiplier is 2.72325
 When applied to the $100 annuity amount, the multiplier

gives a present value of $272.33, the same present value we
derived by summing the three separate multipliers from
Table 1.
 Using annuity tables is simpler.
Bond Valuation
 A bond agreement specifies a pattern of future cash flows

 A series of interest payments (cash outflow)
 A single payment of the face amount at maturity (cash outflow)
 The market rate on the date of the sale is the rate we use to
determine the bond’s market value (its price).
 The selling price of a bond is determined as follows:
1. Use Table 1 to compute the present value of the future principal
payment at the prevailing market rate
2. Use Table 2 to compute the present value of the future series of
interest payments (the annuity) at the prevailing market rate
3. Add the present values from steps 1 and 2

Example – Par Bond
 Determine the price of a $100,000, 8%, four-year bond paying
interest semiannually
 The bond is sold when the prevailing market rate was 8%
(4% semi-annual rate).

Example – Discount Bond

Example – Premium Bond

Time Value of Money Computations
Using a Calculator
 We can use a financial calculator for time value of money
computations
 There are five function keys for these calculations
 If we know values for four of those five, the calculator will
compute the fifth
 Those function keys are:

Pricing Bonds Using
A Financial Calculator

Time Value of Money Using Excel
 We can use Excel or other spreadsheet software, to perform time
value of money calculations.
 There are a number of time value of money functions that involve
the same six variables:
 The Excel functions for present value and future value are:
 = pv(rate,nper,pmt,fv,type)
 = fv(rate,nper,pmt,pv,type)
Pricing a Bond Using Excel

Future Value Concepts
 The future value of a single sum is the amount that a specific
investment is worth at a future date if invested at a given rate of
compound interest
 To illustrate:
 We put $6,000 in a savings account that pays 6% annual interest
 We intend to leave the principal and interest in the account for five years
 We assume that interest is credited to the account at the end of each
year
 The balance in the account at the end of five years is determined
using Table 3 in Appendix A. The factor 1.33823 is at the
intersection of the row for five periods and the column for 6%.

Future Value of an Annuity
 If, instead of investing a single amount, we invest a specified

amount each period, then we have an annuity
 To illustrate: suppose we invest $2,000 at the end of each year
for five years at an 8% annual rate of return
 To determine the accumulated amount of principal and interest
at the end of five years, we use Table 4 in Appendix A, which
furnishes the future value of a dollar invested at the end of each
period
 The factor 5.86660 is in the row for five periods and the column
for 8%, and the calculation is as follows:

Cambridge Business Publishers
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7 Liability Recognition and Nonowner Financing

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MODULE 7

© Cambridge Business Publishers, 2021

© Cambridge Business Publishers, 2021 2

 Current section of the balance sheet reports liabilities that

© Cambridge Business Publishers, 2021 3

 AKA: Accrued expenses & Accruals

© Cambridge Business Publishers, 2021 4

Two broad categories of accruals:

© Cambridge Business Publishers, 2021 5

 If the liability for unpaid wages is not reflected on balance sheet:

© Cambridge Business Publishers, 2021 6

© Cambridge Business Publishers, 2021 7

 Some liabilities are less certain because the ultimate settlement

© Cambridge Business Publishers, 2021 8

© Cambridge Business Publishers, 2021 9

 At the beginning of 2018, Harley-Davidson reported a warranty

© Cambridge Business Publishers, 2021 11

 Warranty expenses are rife with estimates: product failure rates,

 We use the 1.83505% average to compute expected expense and

© Cambridge Business Publishers, 2021 13

Analyze short-term debt.

© Cambridge Business Publishers, 2021 14

 When the company borrows short-term funds, it reports the

© Cambridge Business Publishers, 2021 15

 Assume that Verizon prepared financial statements March 31st

© Cambridge Business Publishers, 2021 16

 Principal payments on long-term debt, that must be made

© Cambridge Business Publishers, 2021 17

Analyze long-term debt pricing.

© Cambridge Business Publishers, 2021 18

 When companies require a large amount of financing, the

© Cambridge Business Publishers, 2021 19

 Companies that raise funds in the bond market normally

 These bonds are investments for individual investors, other

© Cambridge Business Publishers, 2021 20

© Cambridge Business Publishers, 2021 21

 Coupon (contract or stated) rate

© Cambridge Business Publishers, 2021 22

 Bondholders normally expect to receive two types of cash flow

© Cambridge Business Publishers, 2021 23

 Assume a company issues the following bond:

 If the market demands 3% semiannually, the bond price

© Cambridge Business Publishers, 2021 24

 If instead, investors demand a 4% semiannual return for the

 If instead, investors demand a 2% semiannual return for the

 In general, bonds sell at a premium whenever the coupon rate

© Cambridge Business Publishers, 2021 26

 Bonds are priced to yield the return (market rate) demanded

© Cambridge Business Publishers, 2021 27

 The effective cost of debt is used to determine interest expense

Bonds sold at a discount:

© Cambridge Business Publishers, 2021 28

 Assume the notes were sold

© Cambridge Business Publishers, 2021 29

Analyze long-term debt.

© Cambridge Business Publishers, 2021 30

© Cambridge Business Publishers, 2021 31

 Footnotes provide a schedule of the maturities of long-term

© Cambridge Business Publishers, 2021 32

 Interest expense reported on the income statement represents

See Appendix 7B for details

© Cambridge Business Publishers, 2021 33

 When a bond repurchase occurs, a gain or loss usually results,

© Cambridge Business Publishers, 2021 34