Liabilities and Stockholders Equity Chapter 8 A200 Survey of Accounting University of Tennessee Fall 2015 Debt Financing and Equity Financing Debt Financing Creates a liability principal must be repaid Creates an additional cost Interest Equity Financing Stock issued Dilutes control of the business by creating new owners stockholders Stockholders expect to receive a return on their investment Increase in market price per share of stock Dividends share of business profit Equity Financing Retained Earnings Creates no liability or new owners Creates no additional costs Only earnings not distributed to owners as dividends are retained Leverage Using borrowed funds debt rather than owner funds equity to finance asset purchases and operations A high Debt to Equity ratio means high risk levels for stockholders slide 28 2 3 Current Liabilities Accounts Payable Wages Payable etc are recorded when a business purchases goods or services without paying for them Expense is incurred before cash is paid Transaction 1 Morton Corporation s employees worked through the end of the month which ended on Tuesday Morton will pay the 12 000 of wages on Friday Effect on Statement of Cash Flows Effect on Income Stmt and Stmt of Retained Earnings Balance Sheet Assets Liabilities Wages Payable 12 000 Equity Retained Earnings 12 000 12 000 Expense 4 Current Liabilities Accounts Payable Wages Payable etc are satisfied when the business pays them Transaction 2 Morton Corporation pays the amount owed to employees Effect on Statement of Cash Flows Balance Sheet Assets 12 000 Liabilities Wages Payable Cash 12 000 Operating Effect on Income Stmt and Stmt of Retained Earnings 12 000 Equity Retained Earnings 5 Current Liabilities Unearned Fees Unearned Rent etc are recorded when a business receives cash from a customer before rendering a service or providing goods Transaction 3 Morton Corporation received 300 000 from a customer for whom Morton performed services this year and 5 000 from a customer as an advance on work Morton will do next year Effect on Statement of Cash Flows Balance Sheet Assets 305 000 Liabilities Unearned Fees Cash 305 000 Operating Effect on Income Stmt and Stmt of Retained Earnings 5 000 Equity Retained Earnings 300 000 300 000 Revenue Notes Payable Current or Long term Liabilities 6 Notes Payable are amounts owed by the business under a written contract with a stated principal face amount with a stated rate of interest market rate with a stated term and due date maturity date Current Liability if the due date is within one year of the issue date Long term Liability if the due date is longer than one year The current portion of a long term note payable is usually recorded as a current liability Notes Payable generate a related expense Interest Expense and a related liability Interest Payable Interest Expense is computed as P x R x T using a 360 day year 7 Current Liabilities Note Payable Transaction 4 On 10 01 15 Morton Corporation purchased supplies for 40 000 giving a 90 day 6 note payable Effect on Statement of Cash Flows Effect on Income Stmt and Stmt of Retained Earnings Balance Sheet Assets Note Payable Supplies 40 000 Liabilities 40 000 Equity 8 Current Liabilities Note Payable Transaction 5 On 10 31 15 in an end of period adjustment Morton recognized that it owed 30 days of interest on the note Effect on Statement of Cash Flows Effect on Income Stmt and Stmt of Retained Earnings Balance Sheet Assets Liabilities Equity Interest Payable Retained Earnings 200 200 200 Expense 9 Current Liabilities Note Payable Transaction 6 On 11 30 15 in an end of period adjustment Morton recognized that it owed another 30 days of interest on the note Effect on Statement of Cash Flows Effect on Income Stmt and Stmt of Retained Earnings Balance Sheet Assets Liabilities Equity Interest Payable Retained Earnings 200 200 200 Expense 10 Current Liabilities Note Payable Transaction 7 On 12 29 15 the maturity date of the note Morton paid both principal and interest Effect on Statement of Cash Flows Balance Sheet Assets 40 000 Financing 600 Operating Effect on Income Stmt and Stmt of Retained Earnings Liabilities Cash Note Payable 40 600 40 000 Equity Interest Payable Retained Earnings 400 200 200 Expense 11 Contingent Liabilities Amounts the business may owe in the future GAAP says businesses should record contingent liabilities only if the future event is probable and the amount is estimable Transaction 8 In April Morton sold goods on account 200 000 with a warranty It is probable that some of these goods will need repair during the warranty period and Morton can estimate the cost of repairs historical repair costs are 3 of sales Effect on Statement of Cash Flows Effect on Income Stmt and Stmt of Retained Earnings Balance Sheet Assets Liabilities Equity Accounts Receivable Warranty Payable Retained Earnings 200 000 6 000 200 000 200 000 Revenue 6 000 6 000 Expense 12 Long Term Liabilities Bonds Payable Bond terms Par value 100 of the face value bonds often sell above or below par Face or Principal the amount of each bond the amounts borrowed Bonds are sold in 1 000 increments Term the length of the bond contract Maturity date redemption date the end of the term The borrowing business must repay both principal and any unpaid interest on the maturity date Interest amount the business must pay twice a year over the whole term principal x rate x time Contract rate coupon rate rate of interest promised to bondholders lenders Market rate rate of interest of comparable bonds offered This determines whether bonds sell at par above par or below par 13 Long Term Liabilities Bonds Payable Transaction 9 On 4 15 15 Morton Corporation issued at par 3 500 000 of 20 year 8 bonds for cash with interest payable semi annually Effect on Statement of Cash Flows Balance Sheet Assets Cash in from financing 3 500 000 Effect on Income Stmt and Stmt of Retained Earnings Cash 3 500 000 Liabilities Equity Bonds Payable Retained Earnings 3 500 000 14 Long Term Liabilities Bonds Payable Transaction 10 On 10 15 15 Morton pays 140 000 interest to the bondholders Effect on Statement of Cash Flows Balance Sheet Assets Cash 140 000 Operating Effect on Income Stmt and Stmt of Retained Earnings 140 000 Liabilities Bonds Payable Equity Retained Earnings 140 000 140 000 Expense 15 Long Term Liabilities Bonds Payable At the end of the term 4 15 35 20 years in the future Morton will pay the last semi annual interest payment and will also repay the