Question

1. (1) Define liabilities. Identify several characteristics that distinguish liabilities from owners' equity. 2. (5) A friend of your just purchased a small tract of land and has taken out a $50,000, 11 percent mortgage, payable at $476.17 per month. After making first monthly payment he received a receipt from the bank stating that only $17.84 of the $476.17 had been applied to reducing the principal amount of the loan. Your friend computes that, at the rate of $17.84 per month, it will take over 233 years to pay off the $50,000 mortgage. Do you agree with your friend's analysis? Explain 3. (6) Briefly explain the income tax advantage of raising capital by issuing bonds rather than by selling capital stock. 4. (8) Why do bond prices vary inversely with interest rates? 5. (12) What is the meaning of the term loss contingency? Give several examples. How are loss contingencies presented in financial statements? Explain

Answer 1

Q 1 (5)

LIABILITY:

A liability is an obligation to or something that you owe somebody else. Liabilities are defined as a company's legal financial debts or obligations that arise during the course of business operations. Liabilities are settled over time through the transfer of economic benefits including money, goods, or services. Recorded on the right side of the balance sheet, liabilities include loans, accounts payable, mortgages, deferred revenues, and accrued expenses.

Difference between liability and owners equity

The important difference between stockholder's equity and liabilities is that stockholder equity is money owed to shareholders within the company while liabilities are owed to external parties. It is also important to note that in bankruptcy law, liabilities take precedence over stockholders' equity, meaning that a firm must pay its debts before its shareholders in the event of a bankruptcy

Q 3 (6)

There are several advantages of issuing bonds instead of stock for raising capital. One advantage is that the interest on bonds and other debt is deductible on the corporation's income tax return. Dividends on stock are not deductible on the income tax return.

Q 4 (8)

why do bonds price vary inversely with interest rates

Bond prices rise when interest rates fall, and bond prices fall when interest rates rise. Why is this?

Why Bond Prices Change When Interest Rates Change

A dollars and cents example offers the best explanation of the relationship between bond prices and interest rates. Let's look at a case study.

Case Study Facts

You buy a bond for $1,000.

It matu C-A11%)12 D-B-C Period 1 50,000.00 2 49.982.16 3 49.964.16 4 49,946.00 5 49,927.67 6 49,909.17 749,890.50 8 49.871.66 9 49,852.64 10 49,833.46 Loan Amount Monthly payment Monthly Intere: Principle payment Loan Amount remaining 49,982.16 49,964.16 49,946.00 49,927.67 49,909.17 49,890.50 49,871.66 49,852.64 49,833.46 457.84 457.67 457.16 1249,794.55 1349,774.83 14 49,754.93 15 49,734.85 16 49,714.58 49,694.13 18 49,673.49 19 49,652.66 20 49,631.64 21 49,610.42 22 49,589.02 23 49,567.41 49.794.55 49,774.83 49.754.93 49.734.85 49,714.58 49,694.13 49,673.49 49,652.66 49,631.64 456.45 455.72 17 454.76 49,589.02 49,567.41 49,545.61 49,523.61 49,501.40 49.479.00 49,456.38 49,433.57 21.60 454.37 454.17 453.97 25 49,523.61 26 49,501.40 27 49,479.00 28 49,456.38 29 49,433.57 22.82 30 452.93 452.72 452.50 452.28 452.07 451.85 451.62 451.40 31 49,387.30 32 49,363.84 33 49.340.17 49.387.30 49.363.84 49.340.17 35 49,292.19 36 49.267.86 37 49.243.31 8 49.218.54 49,292.19 49,267.86 49,243.31 49,218.54 39 49,168.31 450.71 450.48 450.24 1 49,142.85 49,091.23 49,065.06 49,038.65 49,091.23 4 49,065.06 45 49,038.65 46 49,012.00 48,985.11 48 48,957.97 49 48,930.58 50 48,902.94 51 48,875.05 48,985.11 48,957.97 48,930.58 48,902.94 48,875.05 48,846.90 47 C-A 119 112 Period Loan Amount Monthly payment Monthly Interest Principle payment Loan Amount remaining 48,846.90 48,818.49 48,789.83 48,760.90 48,731.70 48,702.24 48,672.51 48.642.50 48,612.22 48,581.66 48,550.82 48.519.70 48,488.30 48,456.60 48,424.62 48,392.34 48,359.77 48,326.90 48,293.72 48,260.24 48,226.46 48,192.37 447.50 447.24 48,789.83 48,760.90 48,731.70 48.702.24 48,672.51 48,642.50 48,612.22 445.89 61 48,550.82 48,488.30 48.456.60 48,424.62 48.392.34 48,359.77 443.89 48,293.72 48,260.24 48.226.46 48,192.37 48,157.96 48,123.24 48,088.20 48,052.84 48,017.15 47,981.14 47,944.79 47.908.12 47,871.11 47,833.75 47,796.06 47.758.02 442.69 72 441.76 48,123.24 48,088.20 48,052.84 48.017.15 47,981.14 47,944.79 47.908.12 47,871.11 47,833.75 47.796.08 47,758.02 47,719.63 47,680.89 75 440.48 78 79 81 439.16 438.48 437.78 437.43 437.07 436.72 436.35 435.99 47,680.89 47,641.80 47,602.34 47,562.53 47,522.35 47,481.80 47440.88 47,602.34 47,562.53 47,522.35 47,481.80 47,440.88 47,399.59 47.357.91 47.315.86 47,273.41 47,230.58 47.187.36 91 47,357.91 47,273.41 47.230.58 47.187.36 432.95 432.55 47,099.72 47,055.30 47,099.72 431.75 47,055.30 Period Loan Amount Monthly payment Monthly Interest Principle payment Loan Amount remaining 46,965.23 47,010.47 46,965.23 46,919.57 46,873.50 46,827.00 46,780.08 46,732.73 46,684.94 46,636.72 46,588.05 46,538.94 46,489.38 46,439.36 46,388.88 46,337.94 46,286.54 46,234.66 46,182.31 46,129.48 46,076.16 46,022.35 45,968.06 45.913.26 45,857.96 45,802.16 45,745.84 45,689.01 45,631.65 45,573.77 45,515.36 45,456.42 45,396.93 45,336.90 45,276.32 45,215.18 45,153.48 45,091.22 46,873.50 46,827.00 46,780.08 46,732.73 46,684.94 46,636.72 46,588.05 46,538.94 46,489.38 46,439.36 46,388.88 46,337.94 46,286.54 46,234.66 46,182.31 46,129.48 46,076.16 46,022.35 45,968.06 45.913.26 45,857.96 45,802.16 45,745.84 45,689.01 45,631.65 45,573.77 112 425.69 424.76 122 421.87 420.87 132 133 45,456.42 45,396.93 45,336.90 45,276.32 45,215.18 45,153.48 45,091.22 45,028.39 44,964.98 44,900.98 135 136 139 44,964.98 44,900.98 44,771.24 44,705.47 44.639.10 44,572.12 44,504.53 44,436.32 44,367.48 44.298.01 44.227.91 44,771.24 44,705.47 44,639.10 44,572.12 44,504.53 44,436.32 44,367.48 44.298.01 44,227.91 406.07 44,085.78 C-A 11%/12 Period Loan Amount Monthly payment Monthly Interest Principle payment Loan Amount remaining 44,085.78 44,013.71 43,941.00 43,867.63 43,793.58 403.46 43,941.00 43,867.63 43,793.58 43,718.85 43,643.43 43,567.33 43.490.52 43,413.02 43,334.80 43,255.87 401.44 43,643.43 43,567.33 43.490.52 43.413.02 43,334.80 43,255.87 399.37 398.66 397.24 395.78 80.39 43,095.82 43,014.70 42,932.83 42,850.21 42,766.83 42,682.69 42,597.78 42,512.09 42.425.61 42,338.34 42,250.27 42,161.40 42,071.71 41,981.20 41,889.85 41,797.67 41704.65 43,014.70 42,932.83 42,850.21 42.766.83 42,682.69 42,597.78 42,512.09 42,425.61 42.338.34 42.250.27 394.30 393.55 392.79 392.03 172 389.69 388.90 175 386.48 385.66 384.83 42,07171 41,981.20 41,889.85 41797.67 41704.65 380.56 41,516.03 41,420.43 41,323.94 41,420.43 41,323.94 476.17 476.17 41,128.32 41,029.16 40,929.09 40,828.10 40,726.19 40,623.34 40,519.55 41,029.16 40,929.09 40,828.10 40,726.19 40,623.34 40.519.55 40,414.81 40,309.11 40,202.44 40,094.79 39.986.16 39,876.53 476.17 476.17 371.43 40,309.11 40,202.44 40,094.79 39.986.16 39,876.53 39,765.89 39,654.25 39.541.57 108.63 201 39,654.25 g 87 2 3 4 5 51 41 2 9 5 8 7 3 2 8 9 111 3 3 9 2 9 9 6 2 2 2 5 8 6 8 3 4 3 31 3 9 5 7 9 6 3 9 5 2 3 2 2 2 21 77 39 38 39 29, 39 38 38 38 38 38 38 38 37 37 27, 37 37 37 37 37 36 35 35 35 36 36 36 35 35 35 35 35 35 35 34 34 24, 24, 24, 24, 33 33 33 33 33 32 32 32 32 32 nt 75 80 86 93 01 10 21 32 44 57 71 86 03 20 38 58 79 00 3 4 7 98 2 4 4 15 47 81 15 51 88 26 66 07 49 9 7 8 31 79 30 81 34 88 44 01 60 20 BI 44 st 46 42 37 31 24 07 96 85 73 60 46 31 4 9 9 9 38 7 9 7 5 19 91 3 3 2 70 36 2 6 9 91 51 10 8 25 80 34 86 38 87 36 83 29 73 16 57 97 36 73 ere #2 001 990 ase ssa EST 996 350 rsa %2 350 sag sag 36 35 ona 012 200 $25 3 3 3 3 3 3 3 3 22 22 33 31 31 013 12 31 30 30 30 30 003 201 220 200 28, er 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 nt 5 8 2 3 4 5 51 41 2 9 5 8 7 30 29 08 63 111 3 3 9 2 90 9 6 2 2 2 5 8 9 18 30 04 38 31 3 90 3 0 3 0 30 49 15 2 3 2 2 2 21 41 7 13 7 023 od 2 2 2 2 2 2 0 2 2 2 2 2 2 2 2 2 220 21 22 2 2 2 2 2 2 2 2 201 2 2 2 2 2 2 2 2 2 201 2 2 2 2 2 2 2 2 2 2 g 45 40 9 29 NB 30 6 2 00 92 96-11 33 SI 91 2 4 6 9 9 5 3 81 06 05 75 13 16 80 3 2 3 3 9 8 96 41 5 8 4 8 9 81 92 09 26 42 51 51 37 me 200 201 2 2 29 201 004 007 210 013 3 3 3 24 27 $30 ssa 996 ssa sag %2 996 bse 3 3 3 3 3 996 999 400 40 40 ATI 45 9 400 con st 7 2 6 6 05 31 5 5 93 08 21 2 4 4 4 4 4 3 9 7 3 5 5 2 16 87 55 20 81 40 96 8 9 3 86 5 6 9 2 5 3 9 7 2 2 3 35 2 273 160 15 15 tsi 48 195 14 13 13 125 130 125 iza 120 17 13 110 07 103 0 9 9 8 8 8 9 5 71 6 6 6 6 3 4 4 41 37 33 29 25 21 er 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 nt 85 45 40 9 2 16 30 67 24 00 92 96-33 61 31 2 4 6 9 9 5 3 81 06 05 75 13 16 80 3 8 3 9 79 88 96 41 18 5 5 4 88 79 81 92 09 26 42 51 51 4A 90 2345 od sub 30 30 31 3 3 3 3 3 3 3 3 3 220 21 2 3 4 5 $25 7 8 9 33 33 3 3 3 3 3 3 3 3 201 3 3 3 3 3 3 3 3 asi 350 350 - 2 res in four years (at which time you get back your $1,000 investment).

Its coupon rate (interest rate) is 4%, so it pays 4% a year, or $40 a year.

Suppose one year after you purchase the bond interest rates rise to 5% and you decide to sell your bond. When you enter an order to sell, the order goes to the market, and potential buyers now compare your bond to other bonds and offer you a price. This all happens very quickly over the internet.

How does your bond compare to other bonds on the market? Since interest rates went up, a newly issued $1,000 bond which matures in three years (the time left before your bond matures) is paying 5% interest or $50 a year. That means your bond must go through a market value adjustment to be fairly priced when compared to new issues.

Q 5 (12)

What is loss contingency

A loss contingency is a charge to expense for what is considered to be a probable future event, such as an adverse outcome of a lawsuit. A loss contingency gives the readers of an organization's financial statements early warning of an impending payment related to a likely obligation. If the amount of such a loss cannot be reliably estimated and is not considered probable, an entity may still choose to discuss the item in the footnotes that accompany its financial statements.

Example of a Disclosed Loss Contingency

A jury awarded $5.2 million to a former employee of the Company for an alleged breach of contract and wrongful termination of employment. The Company has appealed the judgment on the basis of errors in the judge’s instructions to the jury and insufficiency of evidence to support the amount of the jury’s award. The Company is vigorously pursuing the appeal. The Company and its subsidiaries are also involved in other litigation arising in the ordinary course of business. Since it presently is not possible to determine the outcome of these matters, no provision has been made in the financial statements for their ultimate resolution. The resolution of the appeal of the jury award could have a significant effect on the Company’s earnings in the year that a determination is made. However, in management ‘s opinion, the final resolution of all legal matters will not have a material adverse effect on the Company’s financial position.