Chapter 07- Accounting for Liabilities

Contingent Liability

a potential obligation arising from a past event

• The amount/existence depends on some future event, such as a pending lawsuit

• GAAP requires that companies classify contingent liabilities into three different categories depending on the likelihood of their becoming actual liabilities

Warranty

Promises to correct deficiencies or dissatisfactions in quality, quantity, or performance of products or services sold.

• Many companies guarantee their products or services to attract customers

• Usually represent liabilities that must be reported in the financial statements

Long-term Liabilities

Liabilities with maturity dates beyond one year or the company’s operating cycle, whichever is longer; noncurrent liabilities

Long-term debt

agreements vary with respect to requirements for paying interest charges and repaying principal

Fixed interest rate

Interest rate (charge for the use of money) that does not change over the life of the loan

Variable interest rate

Interest rate that fluctuates (may change) from period to period over the life of the loan

Amortization

Method of systematically allocating the costs of intangible assets to expense over their useful lives; also term for converting the discount on a note or a bond to interest expense over a designated period

Installment Notes

Obligation that requires regular payments of principal and interest over the life of the loan

Line of credit

Preapproved credit arrangement with a lending institution in which a business can borrow money by simply writing a check up to the approved limit.

• Enables a company to borrow or repay funds as needed

• Usually specify a limit on the amount that can be borrowed

• Interest rates on lines of credit normally vary with fluctuations in some designated interest rate benchmark, such as the rate paid on US Treasury bills

• Typically have one-year terms but are frequently extended indefinitely by simply renewing the credit agreement

Bond Certificates

Debt security used to obtain long-term financing in which a company borrows funds from a number of lenders, called bondholders; usually issued in denominations of $1,000.

• Companies borrow money directly from the public

• Describe a company’s obligation to pay interest and repay the principal

Issuer

the seller and borrower of the bond

Bondholder

the lender of the bond

Face Value

the amount due at maturity

Stated Interest Rate

Rate of interest specified in the bond contract that will be paid at specified intervals over the life of the bond

Bond Discount

Difference between the selling price and the face amount of a bond sold for less than the face amount.

Effective Interest Rate

Yield rate of bonds, equal to the market rate of interest on the day the bonds are sold.

• the actual rate of interest the borrower must pay the actual rate

• Deeper discounts raise the effective rate, and shallower discounts would reduce the effective rate of interest

Carrying Value

Face amount of a bond liability less any unamortized bond discount or plus any unamortized bond premium.

Bond Premium

Difference between the selling price and the face amount of a bond that is sold for more than the face amount

• Reduce the effective interest rate

Premium on Bonds Payable

Difference between the selling price and the face amount of a bond that is sold for more than the face amount

Market rate of interest

Interest rate currently available on a wide range of alternative investments with similar levels of risk

• The effective rate of interest investors are willing to accept for a particular bond equals the market rate of interest for other investments with similar levels of risk at the time the bond is issued

• When the market rate of interest is higher than the stated rate of interest, bonds will sell at a discount to increase the effective of interest to the market rate

• When the market rate is lower than the stated rate, bonds will sell at a premium to reduce the effective rate to the market rate

Collateral

Assets pledged as security for a loan.

• Large loans with long terms to maturity pose more risk to lenders than small loans with short terms

Restrictiv covenants

Special provisions specified in the loan contract that are designed to prohibit management from taking certain actions that place creditors at risk

Current asset

Asset that will be converted to cash or consumed within one year or an operating cycle, whichever is longer.

• Expected to be converted to cash or consumed within one year at an operating cycle

Operating Cycle

Time required to turn cash into inventory, inventory into receivables, and receivables back to cash.

Refinancing short-term debt on a long-term basis

in general, if a business does not plan to use any of its current assets to repay a debt, that debt is listed as long-term even if it is due within one year

Classified balance sheets

Balance sheet that distinguishes between current and noncurrent items.