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Chapter 10. LIABILITIES. Current Liabilities. Noncurrent Liabilities. I.O.U. The Nature of Liabilities. Defined as debts or obligations arising from past transactions or events. Maturity = 1 year or less. Maturity > 1 year. DEBT. EQUITY.

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Chapter10

LIABILITIES


The nature of liabilities

Current Liabilities

Noncurrent Liabilities

I.O.U.

The Nature of Liabilities

Defined as debts or obligations arising from past transactions or events.

Maturity = 1 year or less

Maturity > 1 year


Distinction between debt and equity

DEBT

EQUITY

Funds from creditors, with a definite due date, and sometimes bearing interest.

Distinction BetweenDebt and Equity

The acquisition of assets is financedfrom two sources:

Funds from owners


Current liabilities
Current Liabilities

Obligations that must be paid within one year or within the operating cycle, whichever is longer.


Liabilities question
Liabilities – Question

Devon Mfg. borrows $100,000 from First Bank. The loan will be repaid in 20 years and has an annual interest rate of 8%.

Is this acurrent liabilityor anoncurrent liability?

The obligation will not be paid within one year or one operating cycle, so it is anoncurrent liability.


Accounts payable
Accounts Payable

Short-term obligations to suppliers for purchases of merchandise and to others for goods and services.

Office supplies invoices

Merchandise inventory invoices

Utility and phone bills

Shipping charges


Notes payable

Current Notes Payable

Noncurrent Notes Payable

Notes Payable

When a company borrows money, a note payable is created.

Current Portion of Notes Payable

The portion of a note payable that is due within one year, or one operating cycle, whichever is longer.

Total Notes Payable


Notes payable1
Notes Payable

PROMISSORY NOTE

LocationDate

after this date

promises to pay to the order of

the sum of with interest at the rate

of per annum.

signed

title

Miami, Fl

Nov. 1, 2007

Porter Company

3 months

Security National Bank

$10,000.00

12.0%

John Caldwell

treasurer


Notes payable2
Notes Payable

On November 1, 2007, Porter Company would make the following entry.


Interest payable
Interest Payable

  • Interest expenseis the compensation to the lender for giving up the use of money for a period of time.

  • The liability is called interest payable.

  • To the lender, interest is a revenue.

  • To the borrower, interest is an expense.

Interest Rate Up!


Interest payable1

The interest formula includes three variables that must be considered when computing interest:

Interest Payable

Interest = Principal × Interest Rate × Time

When computing interest for one year, “Time” equals 1. When the computation period is less than one year, then “Time” is a fraction.

For example, if we needed to compute interest for 3 months, “Time” would be 3/12.


Interest payable example
Interest Payable – considered when computing interest:Example

What entry would Porter Company make on December 31, the fiscal year-end?

$10,00012% 2/12 = $200


Interest payable example1
Interest Payable – considered when computing interest:Example

Porter will pay the note on January 31, 2008. Let’s look at the entry.

$10,00012% 1/12 = $100


Payroll liabilities

Net Pay considered when computing interest:

State and Local Income Taxes

Voluntary Deductions

Medicare Taxes

Federal Income Tax

FICA Taxes

Payroll Liabilities

Gross Pay


Unearned revenue

Cash is received in advance. considered when computing interest:

Earned revenue is recorded.

Deferred revenue is recorded.

Unearned Revenue

Cash is sometimes collected from the customer before the revenue is actually earned.

As the earnings process is completed . .

a liability account.


Long term liabilities

Relatively small debt needs can be filled from single sources.

or

or

Insurance Companies

Pension Plans

Banks

Long-Term Liabilities


Long term liabilities1
Long-Term Liabilities sources.

Large debt needs are often filled by issuing bonds.


Installment notes payable

Each payment covers interest for the period sources.AND a portion of the principal.

With each payment, the interest portion gets smaller and the principal portion gets larger.

Installment Notes Payable

Long-term notes that call for a series of installment payments.


Allocating installment payments between interest and principal
Allocating Installment Payments Between Interest and Principal

  • Identify the unpaid principal balance.

  • Interest expense = Unpaid Principal × Interest rate.

  • Reduction in unpaid principal balance = Installment payment – Interest expense.

  • Compute new unpaid principal balance.


Allocating installment payments between interest and principal1
Allocating Installment Payments Between Interest and Principal

On January 1, 2007, Rocket Corp. borrowed $7,581.57 from First Bank of River City. The loan was a five-year loan and had an interest rate of 10%. The annual payment is $2,000.

Prepare an amortization table for Rocket Corp.’s loan.


Allocating installment payments between interest and principal2
Allocating Installment Payments Between Interest and Principal

Now, prepare the entry for the first payment on December 31, 2007.


Allocating installment payments between interest and principal3
Allocating Installment Payments Between Interest and Principal

The information needed for the journal entry can be found on the amortization table. The payment amount, the interest expense, and the amount to debit to principal are all on the table.


Bonds payable
Bonds Payable Principal

  • Bonds usually involve the borrowing of a large sum of money, called principal.

  • The principal is usually paid back as a lump sum at the end of the bond period.

  • Individual bonds are often denominated with a par value, or face value, of $1,000.


Bonds payable1
Bonds Payable Principal

  • Bonds usually carry a stated rate of interest, also called acontract rate.

  • Interest is normally paid semiannually.

  • Interest is computed as:

Interest = Principal × Stated Rate × Time


Bonds payable2
Bonds Payable Principal

  • Bonds are issued through an intermediary called an underwriter.

  • Bonds can be sold on organized securities exchanges.

  • Bond prices are usually quoted as a percentage of the face amount.

    For example, a $1,000 bond priced at 102 would sell for $1,020.


Types of bonds
Types of Bonds Principal

Mortgage Bonds

Debenture Bonds

Convertible Bonds

Junk Bonds


Accounting for bonds payable
Accounting for Bonds Payable Principal

On January 1, 2007, Rocket Corp. issues $1,500,000 of 12%, 10-year bonds payable. Interest is payable semiannually, each July 1 and January 1.

Assume the bonds are issued at face value.Record the issuance of the bonds.


Accounting for bonds payable1
Accounting for Bonds Payable Principal

Record the interest paymenton July 1, 2007.


Bonds sold between interest dates
Bonds Sold Between Interest Dates Principal

  • Bonds are often sold between interest dates.

  • The selling price of the bond is computed as:


The present value concept and bond prices

The selling price of the bond is determined by the market basedon the time value of money.

=

=

<

<

>

>

The Present Value Concept and Bond Prices


Bonds issued at a discount
Bonds Issued at a Discount based

Matrix, Inc. is attempting to issue $1,000,000 principal amount of 9% bonds. The bonds pay interest on June 30 and December 31 each year and mature in 20 years. Investors are unwilling to pay the full face amount for Matrix’s bonds because they believe the interest rate is too low. To entice investors, Matrix must lower the price of the bonds. The difference between the new lower issue price and the principal of $1,000,000 is called a discount.

Let’s see how we account for these bonds.


Bonds issued at a discount1
Bonds Issued at a Discount based

Matrix, Inc. issues bonds on January 1, 2007.

Principal = $1,000,000

Issue price = $950,000

Stated Interest Rate = 9%

Interest Dates = 6/30 and 12/31

Maturity Date = Dec. 31, 2026 (20 years)


Bonds issued at a discount2
Bonds Issued at a Discount based

To record the bond issue, Matrix, Inc. wouldmake the following entry on January 1, 2007:


Bonds issued at a discount3
Bonds Issued at a Discount based

Maturity Value

Carrying Value


Bonds issued at a discount4
Bonds Issued at a Discount based

Amortizing the discount over the term of the bond increases Interest Expense each interest payment period.

Using the straight-line method, the discount amortization will be $1,250 every six months.

$50,000 ÷ 40 periods = $1,250


Amortization of the discount

Interest paid every six months is calculated as follows: based

$1,000,000 × 9% = $90,000 ÷ 2 = $45,000

We prepare the following journal entry to recordthe first interest payment.

Amortization of the Discount


Bonds issued at a discount5
Bonds Issued at a Discount based

$50,000 – $1,250 – $1,250

Maturity Value

Carrying Value

The carrying value willincrease to exactly $1,000,000on the maturity date.


Bonds issued at a discount6
Bonds Issued at a Discount based

To record an the principal repayment, Matrix, Incwould make the following entry on December 31, 2026:


Bonds issued at a premium
Bonds Issued at a Premium based

If bonds of other companies are yielding less than9 percent, investors will be willing to pay more thanthe face amount for Matrix’s 9% bonds. The issueprice of Matrix’s 9% bonds will rise because ofinvestor demand for the 9% bonds. Thedifference between the higher issue price and theprincipal of $1,000,000 is called a premium.

Let’s look at accounting for a premium.


Bonds issued at a premium1

The only change from basedprevious Matrix example.

Bonds Issued at a Premium

Matrix, Inc. issues bonds on January 1, 2007.

Principal = $1,000,000

Issue price = $1,050,000

Stated Interest Rate = 9%

Interest Dates = 6/30 and 12/31

Maturity Date = Dec. 31, 2026 (20 years)


Bonds issued at a premium2
Bonds Issued at a Premium based

To record the bond issue, Matrix, Inc. wouldmake the following entry on January 1, 2007:


Bonds issued at a premium3
Bonds Issued at a Premium based

Maturity Value

Carrying Value


Bonds issued at a premium4
Bonds Issued at a Premium based

Amortizing the premium over the term of the bond decreases Interest Expense each interest payment period.

Using the straight-line method, the premium amortization will be $1,250 every six months.

$50,000 ÷ 40 periods = $1,250


Bonds issued at a premium5
Bonds Issued at a Premium based

To record an interest payment, Matrix, Inc. would makethe following entry on each June 30 and December 31:


Bonds issued at a premium6

$50,000 – $1,250 – $1,250 based

Bonds Issued at a Premium

Maturity Value

Carrying Value

The carrying value willdecrease to exactly $1,000,000on the maturity date.


Bonds issued at a premium7
Bonds Issued at a Premium based

To record an the principal repayment, Matrix would makethe following entry on December 31, 2026:


The concept of present value

$1,000 invested today at 10%. based

In 5 years it will be worth $1,610.51.

In 25 years it will be worth $10,834.71!

The Concept of Present Value

Present Value

Future Value

Money can grow over time, because it can earn interest.


The concept of present value1
The Concept of Present Value based

How much is a future amount worth today?

Present Value

FutureValue

Interest compounding periods

Today


The concept of present value2
The Concept of Present Value based

How much is a future amount worth today?

Three pieces of information must be known to solve a present value problem:

  • Thefutureamount.

  • The interest rate (i).

  • The number of periods (n) the amount will be invested.


The concept of present value3
The Concept of Present Value based

Two types of cash flows are involved with bonds:

Periodic interest payments called annuities.

Today

Maturity

  • Principal payment at maturity.


Early retirement of debt
Early Retirement of Debt based

Gains or losses incurred as a result of retiring bonds should be reported as other income or other expense on the income statement.


Loss contingencies

An existing uncertain situation involving potential loss depending on whether some future event occurs.

Loss Contingencies

Two factors affect whether a loss contingency must be accrued and reported as a liability:

  • The likelihood that the confirming event willoccur.

  • Whether the loss amount can be reasonablyestimated.


Estimated liabilities

Liabilities that are known to exist. depending on whether some future event occurs.

Uncertain as to dollar amount.

Reasonable estimate of dollar amount is available.

Estimated Liabilities

Example: Product warranties


Evaluating the safety of creditors claims

Interest Coverage Ratio depending on whether some future event occurs.

Operating IncomeInterest Expense

=

Evaluating the Safetyof Creditors’ Claims

This ratio indicates a margin of protection for creditors.


Liabilities question1
Liabilities – Question depending on whether some future event occurs.

Devon Mfg. reports annual operating income of $100,000 and annual interest expense of $10,000.

What is Devon’s interest coverage ratio?


Financial leverage
Financial Leverage depending on whether some future event occurs.

Borrowing at one rate and investing at a higher rate.

If we borrow $1,000,000 at 8% and invest it at 10%, we will clear $20,000 profit!


Lease payment obligations

Lease agreement transfers risks and benefits associated with ownership to lessee.

Lessor retains risks and benefits associated with ownership.

Lessee records rent expense as incurred.

Lessee records a leased asset and lease liability.

Lease Payment Obligations

Operating Leases

Capital Leases


Capital lease criteria
Capital Lease Criteria ownership to lessee.


Pensions
Pensions ownership to lessee.

Employers offer pension plans to employees.

The employer makes payments to a pension fund. Usually, this is an independent entity managed by a professional fund manager.

Retirees receive pension payments from the pension fund.


Pensions1
Pensions ownership to lessee.

Actuaries make the pension expense computations, based on:

  • Average age, retirement age, life expectancy.

  • Employee turnover rates.

  • Compensation levels.

  • Expected rate of return for the fund.

The accountant then posts the entry to record pension expense and pension liability.


Other postretirement benefits

Amount to ownership to lessee.be fundednext year

Currentliability

Remainderof unfundedamount

Long-termliability

Other Postretirement Benefits

Many companies offer benefits to retirees other than pensions, such as health coverage or fitness club memberships.

Unfunded liabilityfor nonpensionpostretirementbenefits


Deferred income taxes
Deferred Income Taxes ownership to lessee.

Corporations pay income taxes quarterly.


Deferred income taxes1
Deferred Income Taxes ownership to lessee.

The Internal Revenue Code is the set of rules for preparing tax returns.

GAAP is the set of rules for preparing financial statements.

Results in . . .

Usually. . .

Results in . . .

Financial statement income tax expense.

IRS income taxes payable.

The difference between tax expense and tax payable is recorded in an account calleddeferred taxes.


Deferred income taxes example
Deferred Income Taxes – Example ownership to lessee.

Examine the December 31, 2007, information for Matrix, Inc.

Matrix uses straight-line depreciation for financial reporting and accelerated depreciation for income tax reporting. Matrix’s tax rate is 30%.


Deferred income taxes example1
Deferred Income Taxes – Example ownership to lessee.

Compute Matrix’s income tax expense and income tax payable.

The income tax amount computed based on financial statement income is income tax expense for the period.


Deferred income taxes example2
Deferred Income Taxes – Example ownership to lessee.

Compute Matrix’s income tax expense and income tax payable.

Income taxes based on tax return income are thetaxes payablefor the period.


Deferred income taxes example3
Deferred Income Taxes – Example ownership to lessee.

Thedeferred taxfor the period of $36,000 is the difference between income tax expense of $45,000 and income tax payable of $9,000.


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