Learning Objectives Describe the recording and reporting of various current liabilities. Describe the reporting of long-term liabilities and the cash flows associated with those liabilities. Understand the nature of bonds and record a bond’s issuance, interest payments, and maturity.
Learning Objectives Account for a bond that is redeemed prior to maturity. Understand additional liabilities such as leases and contingent liabilities. Evaluate liabilities through the calculation and interpretation of horizontal, vertical, and ratio analyses.
Learning Objectives Appendix: Determine a bond’s issuance price. Appendix: Record bond interest payments under the effective interest method.
LOI Current Liabilities A current liability is an obligation of a business that is expected to be satisfied or paid within one year.
Taxes as Current Liabilities Income Taxes Sales Taxes Businesses have a number of current tax obligations. Payroll Taxes Taxes Withheld from Employee Wages
Income Taxes Payable Corporations, like individuals, are subject to federal taxation of income, which are typically current liabilities. Assume a company has $25,000 of annual income tax expense and plans to pay it in the next period. The company records:
Sales Taxes Payable Another current liability example is sales taxes. Each time a company makes a retail sale, it collects sales tax according to state and/or local regulations. Assume on August 1, a $1,000 item is sold and the company collects 8% sales tax.
Withheld Taxes Payable Other current liabilities include taxes withheld from employees’ pay checks. Assume an employee earns a monthly salary of $10,000. Based on the employee’s filing status, the company must withhold 15% of the salary for federal income taxes, 12% for state income taxes, and 7.65% for Social Security taxes.
Payroll Taxes Payable In addition to withholding taxes on behalf of employees, employers must also pay Social Security taxes of 7.65% on employee wages. These additional taxes are an expense for the company, as well as a current liability.
Recording a Notes Payable Assume that on March 1, Brown Company borrows $30,000 by signing an 8%, 6-month note with Miller Street Bank. The note calls for interest to be paid when the note is repaid on August 31. The entry to record the note on March 1 is as follows:
Calculation of Interest On August 31, Brown must pay Miller Street Bank the original $30,000 borrowed plus the interest on the note. Interest over the six months is calculated as shown:
Payment of a Notes Payable Brown would pay $31,200 to the bank and make the following entry on August 31, which increases Interest Expense to reflect the cost of borrowing the $30,000, decreases the Note Payable account because the note is paid back, and decreases Cash for the principal and interest payment.
Current Portion on Long-Term Debt From Note 10 in the financial statements
LO2 Long-Term Liabilities A long-term liability is any obligation of a business that is expected to be satisfied or paid in more than one year. Like current liabilities, the type and size of long-term liabilities can vary across companies. However, the most common and largest long-term liabilities often arise from borrowing money.
Balance Sheet Example Advanced Auto has two types of long-term debt. Detail in financial statement note Revolving credit is a type of loan that does not require fixed principal payments. A term loan is simply an interest-bearing loan with principal due at maturity.
Statement of Cash Flows Example Cash Inflows - BORROWING Cash Outflows – REPAYING DEBT
LO3 Bonds A bond is a financial instrument in which a borrower promises to pay future interest and principal to a creditor in exchange for the creditor’s cash today. The borrower “sells” or “issues” the bond and records a liability. The creditor “buys” the bond and records an investment.
Bond Terms A number of terms and features are associated with bonds, including: 1 2 Face Value: The amount that is repaid at maturity of a bond. Stated Interest Rate: The contractual rate at which interest is paid to the creditor. 3 4 Maturity Date: The date on which the face value must be repaid to the creditor. Market (or effective) rate of interest: The rate of return that investors in the bond markets demand for a bond of similar risk.
Bond Issuance at Face Value Assume on January 1, 2010, York Products sells bonds with a face value of $100,000. The bonds carry a 6% interest rate and a January 1, 2025, maturity date. Interest is to be paid semiannually on July 1 and January 1. The market rate of interest is also 6%.
Recording Interest Payments York Products pays interest on July 1 and January 1 of each year.
Recording Accrued Interest Payments York Products pays interest on July 1 and January 1 of each year.
Bond Repayment at Maturity On January 1, 2025, York would record the repayment of the bonds in addition to the last interest payment.
Bond Issuance at a Discount Assume on January 1, 2010, Agnew Company issues bonds with a face value of $200,000, a stated rate of 7%, and a maturity date of December 31, 2014. Interest is payable semiannually on June 30 and Dec. 31. The bonds sell at 98% of the face or $196,000.
Recording Interest Payments Agnew Company pays interest on June 30 and December 31 .
Two Methods of Amortization Straight-line method: Equal amount of interest is amortized each time interest is paid. Easy to compute. Effective Interest Rate: Amortizes the bond discount or premium so that interest expense each period is a constant percentage of the bond’s carrying value.
Bond Repayment at Maturity On Dec. 31, 2014, Agnew would record the repayment of the bonds in addition to the last interest payment.
Bond Issuance at a Premium Assume on January 1, 2010, McCarthy Company issues bonds with a face value of $50,000, a stated interest rate of 8%, and a maturity date of December 31, 2012. Interest is payable semiannually on June 30 and December 31. The bonds were sold at a premium of 101.2 or ($50,000 x 101.2% = $50,600).
Recording Interest Payments McCarthy pays interest on June 30 and December 31 of each year.
Bond Repayment at Maturity On Dec. 31, 2012, McCarthy would record the repayment of the bonds in addition to the last interest payment.
LO4 Redeeming a Bond Before Maturity • Bonds are retired for a number of reasons: • A company may want to reduce future interest expense; or • A company may want to take advantage of falling interest rates and replace existing bonds with less costly bonds. Accounting for the early retirement bond consists of three steps:
Example of a Redemption Assume Doyle Township issues a $20,000 eight-year bond on January 1, 2010, to fund the conversion of a warehouse to a youth activity center. The bond has a stated interest rate of 5% and is callable at 103 any time after 2014. The bond pays interest semiannually on June 30 and December 31. The bond sells for $19,200, or an $800 discount. Doyle decides to retire the bond early on December 31, 2016.
LO5 Additional Liabilities Two additional types of liabilities that are common to many organizations: lease liabilities and contingent liabilities. A lease is a contractual agreement in which the lessee obtains the right to use an asset by making periodic payments to the lessor. A contingent liability is an obligation that arises from an existing condition whose outcome is uncertain and whose resolution depends on a future event.
Types of Leases Operating leases are popular off-balance sheet financing tools.
LO6 Evaluating a Company’s Management of Liabilities
Ratio Analyses Capital Structure: The mix of debt and equity that a company uses to generate its assets.
LO7 Appendix: Determining A Bond’s Issuance Price The bond’s issuance price will always be the present value of those future cash flows discounted back at the current market rate of interest. Assume that the market rate of interest is 8% when Bowman Corporation issues a $100,000 4-year bond that pays interest annually at a rate of 10%.
Bowman Example $100,000 X 0.7350 $10,000 X 3.3121
Ethics and Decision Making Appendix: Effective Interest Method of Amortization In today’s business environment, companies have to be aware not only of the economic impact of their decisions, but also of their ethical impact. Under this method, interest expense is calculated by multiplying the bond’s carrying value by the market rate of interest at issuance by the time outstanding. Information being used for? To ignore product safety?? To exceed government limits?? To falsify records??
Amortization Calculation Once interest expense is known, the amount of discount or premium amortized is the difference between interest expense and interest paid.
Recording the First Interest Payment At the end of the first year, interest expense would be recorded as follows: