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CHAPTER 11 LIABILITIES

CHAPTER 11 LIABILITIES. STUDY OBJECTIVES After studying this chapter, you should understand:. STUDY OBJECTIVE 1 TYPES OF CURRENT LIABILITIES. Key features of a current liability: It is expected to be paid from existing current assets or through the creation of other current liabilities

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CHAPTER 11 LIABILITIES

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  1. CHAPTER 11 LIABILITIES STUDY OBJECTIVES After studying this chapter, you should understand:

  2. STUDY OBJECTIVE 1 TYPES OF CURRENT LIABILITIES Key features of a current liability: It is expected to be paid from existing current assets or through the creation of other current liabilities It will be paidwithin one year or the operating cycle, whichever is longer. Notes Payable Accounts Payable Unearned Revenues Accrued Liabilities

  3. STUDY OBJECTIVE 2 NOTES PAYABLE Key features of a note payable: Promissory note Interest Notes due within a year are current liabilities

  4. NOTES PAYABLE ISSUANCE DATE General Journal Date Account Titles Debit Credit March 1 Cash 100,000 Notes Payable 100,000 Assume First National Bank agrees to lend $100,000 on March 1, 2006, if Cole Williams Co. 12%, 4-month note. Assets received = face value of note

  5. INTEREST FORMULA If the loan term is expressed in days, use the number of days divided by 365. If loan term is expressed in months, use the number of months divided by 12. $100,000 x 12% x 4/12 = $4,000 Using the Cole Williams Co. data: Annual Interest Rate Time in Terms of One Year Face Value of Note Interest

  6. NOTES PAYABLE INTEREST ACCRUAL General Journal Date Account Titles Debit Credit June 30 Interest Expense 4,000 Interest Payable 4,000 If Cole Williams Co. prepares financial statements semiannually, an adjusting entry is required to recognize interest expense and interest payable of $4,000 at June 30.

  7. NOTES PAYABLE MATURITY DATE General Journal Date Account Titles Debit Credit July 1 Notes Payable 100,000 Interest Payable 4,000 Cash 104,000 When the loan is paid, the FACE VALUE is debited, any interest accrued is removed, and cash is decreased by this combined amount.

  8. REVIEW QUESTION INTEREST ACCRUAL Shari Uecker Company borrows $88,500 on September 1, 2006 From Egg Harbor State Bank by signing a one year, 12% note. What is the accrued interest at December 31, 2006? Answer: $88,500 x 12% x 4/12 = $3,540

  9. STUDY OBJECTIVE 3 OTHER CURRENT LIABILITIES SALES TAXES PAYABLE • Sales tax is expressed as a stated percentage of the sales price on goods sold to customers by a retailer. • The retailer collects the tax from the customer when the sale occurs. Retailer periodically remits the collections to the state’s department of revenue. Retailer is a collection agent for the tax authority.

  10. SALES TAXES PAYABLE SALE DATE General Journal Date Account Titles Debit Credit Mar. 25 Cash 10,600 Sales 10,000 Sales Tax Payable 600 On March 25th cash register readings for Cooley Grocery show sales of $10,000 and sales taxes of $600. Sales tax rate = 6%

  11. EXTRACTING SALES TAX FROM TOTAL RECEIPTS If Cooley Grocery “rings up” total receipts of $10,600, and the sales tax percentage is 6%, we can figure sales as follows: $10,600 / 1.06 = $10,000 Total receipts – Sales = Tax collected $10,600 - $10,000 = $600

  12. PAYROLL AND PAYROLL TAXES PAYABLE Liabilities relating to employee wages and salaries include: Wages and salaries payable Withholding taxes Date Account Debit Credit March 7 Salaries & Wages Expense 100,000 FICA Taxes Payable 7,650 Federal Income Taxes Payable 21,864 State Income Taxes Payable 2,922 Salaries & Wages Payable 67,564 (record payroll & w/h taxes for week of March 7) March 11 Salaries & Wages Payable 67,564 Cash 67,564 (to record payment of March 7 payroll)

  13. PAYROLL DEDUCTIONS

  14. PAYROLL AND PAYROLL TAXES PAYABLE Various payroll taxes are levied upon the employer: Matching FICA taxes Federal unemployment taxes State unemployment taxes Date Account Debit Credit March 7 Payroll Tax Expense 13,850 FICA Taxes Payable 7,650 FUTA Taxes Payable 800 SUTA Taxes Payable 5,400 (record employer’s payroll taxes for week of March 7)

  15. EMPLOYER PAYROLL TAXES

  16. UNEARNED REVENUES Unearned Revenues occur when a company receives cash before a service is rendered. Examples: Airline sells a ticket for future flights Attorney receives legal fees before work is done.

  17. UNEARNED REVENUES CASH RECEIPT General Journal Date Account Titles Debit Credit Aug. 6 Cash 500,000 Unearned Football Ticket Revenue 500,000 Superior University sells10,000season football tickets at$50each for itsfive-gamehome schedule.

  18. UNEARNED REVENUES EARNINGS DATE General Journal Date Account Titles Debit Credit Sept. 7 Unearned Football Ticket Revenue 100,000 Football Ticket Revenue 100,000 As each game is completed, Unearned Football Ticket Revenue is debited for 1/5 of the unearned revenue. The earned revenue, Football Ticket Revenue, is credited.

  19. UNEARNED AND EARNED REVENUE ACCOUNTS Shown below are specific unearned and earned revenue accounts in selected types of businesses. Account Title Type of Business Unearned Revenue Earned Revenue Unearned passenger Passenger Airline Ticket Revenue Revenue Unearned Magazine Subscription Subscription Publisher Revenue Revenue Unearned Rental Hotel Revenue Rental Revenue Insurance Unearned Premium Company Revenue Premium Revenue

  20. CURRENT MATURITIES OF LONG-TERM DEBT That portion of long-term debt due within 1 year. Classified as a current liability on the balance sheet

  21. FINANCIAL STATEMENTPRESENTATION

  22. WORKING CAPITAL FORMULA $ 16,791 - $ 12,621 = $ 4,170 Working Capital The excess of current assets over current liabilities. A measure of short-term liquidity. - Current Liabilities Current Assets = Working Capital

  23. CURRENT RATIO FORMULA $16,791 / $12,621 = 1.33 : 1 Current Ratio The ratio of current assets to current liabilities. A measure of short-term liquidity. Current Liabilities / Current Ratio = Current Assets

  24. STUDY OBJECTIVE 4 BONDS PAYABLE A form of interest-bearing notes payable issued by corporations, universities, & governmental agencies. Can be sold in small denominations to attract many investors. Sold to obtain long term capital. An alternative to issuing stock.

  25. ADVANTAGES OF BOND FINANCING OVER STOCK

  26. EFFECTS ON EPS BONDS VS. STOCK

  27. TYPES OF BONDS

  28. STUDY OBJECTIVE 5 BOND ISSUANCE PROCEDURES • Corporate bonds are traded on securities exchanges. • Bond prices are quoted as a percentage of the face value of the bond (usually $1,000). • Transactions between a bondholder and other investors are not journalized by the issuing corporation. • A corporation records entries when it issues/buys back bonds, and when bondholders convert bonds into stock.

  29. DETERMINING MARKET VALUE OF BONDS The present value (PV) of a bond is a function of three factors: 1. Dollar amount 2. Time 3. Market rate of interest The process of determining the PV is discounting.

  30. ISSUING BONDS AT FACE VALUE Assume that Devor Corporation issues 1000 10-year, 9% $1,000 bonds dated January 1, 2006, at 100 (100% of face value). The entry to record the sale is: Date Account Debit Credit Jan 1 Cash 1,000,000 Bonds payable 1,000,000 (record sale of bonds at face value) 1000 bonds x $1000 = $1,000,000

  31. BOND INTEREST PAYMENT Assume that interest is payable semi-annually on January 1 and July 1. Next payment Is due July 1, 2006. The entry is: Date Account Debit Credit July 1 Bond Interest Expense 45,000 Cash 45,000 (record semi-annual bond interest payment) $1,000,000 x 9% x 6/12 = $45,000

  32. BOND INTEREST ACCRUAL Assume that interest is payable semi-annually on January 1 and July 1. Next payment Is due January 1, 2006. At December 31, 2005 the entry to accrue interest is: Date Account Debit Credit Dec 31 Bond Interest Expense 45,000 Bond Interest Payable 45,000 Record bond interest accrual at year end $1,000,000 x 9% x 6/12 = $45,000

  33. INTEREST RATES AND BOND PRICES Market Rates Bonds Sell at: Issued when: 8% Premium BOND CONTRACTUAL INTEREST RATE 10% 10% Face Value Discount 12%

  34. ISSUING BONDS AT A DISCOUNT On January 1, 2006, Candlestick, Inc. sells $100,000, 5-year, 10% bonds for $92,639 with interest payable on payable on July 1 & January 1. The entry to record the issuance is: Date Account Debit Credit Jan 1 Cash 92,639 Discount on Bonds Payable 7,361 Bonds Payable 100,000 (record issuance of bonds at a discount) Market value of bonds = $92,639

  35. FINANCIAL STATEMENT PRESENTATION--DISCOUNT Discount on Bonds Payable is a contra account, which is deducted from bonds payable on the balance sheet: CANDLESTICK, INC. Balance Sheet (partial) Long - term liabilities Bonds payable $100,000 Less: Discount on Bond Payable $7,361 $92,639 Carrying value of bonds = $92,639

  36. TOTAL COST OF BORROWINGBONDS ISSUED AT A DISCOUNT • The the discount is an additional cost of borrowing that is recorded as bond interest expense over the life of the bonds. • The total cost of borrowing for Candlestick, Inc., is computed as follows: Bonds Issued at a Discount Semiannual Interest Payments ($100,000*10%*.5=$5,000; $5,000*10) $50,000 Add: Bond Discount ($100,000-$92,639) $7,361 Total Cost of Borrowing $57,361

  37. ISSUING BONDS AT A PREMIUM On January 1, 2006, Candlestick, Inc. sells $100,000, 5-year, 10% bonds for $108,111 with interest payable on payable on July 1 & January 1. The entry to record the issuance is: Date Account Debit Credit Jan 1 Cash 108,111 Premium on Bonds Payable 8,111 Bonds Payable 100,000 (record issuance of bonds at a premium) Market value of bonds = $108,111

  38. FINANCIAL STATEMENT PRESENTATION—PREMIUM Premium on Bonds Payable is added to bonds payable on the balance sheet: CANDLESTICK, INC. Balance Sheet (partial) Long - term liabilities Bonds payable $100,000 Add: Premium on Bonds Payable $ 8, 111 $ 108,111 Carrying value of bonds = $108,111

  39. TOTAL COST OF BORROWINGBONDS ISSUED AT A PREMIUM The premium is considered to be a reduction in the cost of borrowing that should be credited to Bond Interest Expense over the life of the bonds. Bonds Issued at a Premium Semiannual Interest Payments ($100,000*10%*.5=$5,000; $5,000*10) $50,000 Less: Bond Premium ($108,111-$100,000) $8,111 Total Cost of Borrowing $41,889

  40. STUDY OBJECTIVE 6REDEEMING BONDS AT MATURITY Book value of the bonds at maturity will equal their face value. The entry to record the redemption of the Candlestick bonds at maturity is: Date Account Debit Credit Maturity date Bonds Payable 100,000 Cash 100,000 (record payment of bonds at maturity) This assumes all interest has been paid to maturity. The entry will be the same regardless of whether The bonds were issued at face value, discount, or premium

  41. STUDY OBJECTIVE 7LONG-TERM NOTES PAYABLE • Terms exceed one year. • May be secured by a specific assets (mortgage). • Mortgage N/P are recorded initially at face value. • Subsequent entries required for installment payments. Porter Technology Inc. issues a $500,000, 12%, 20-year mortgage note on December 31, 2006, to build a research lab. The terms provide for semiannual installment payment of $33,231. The installment payment schedule for the first year is shown below: (B) (C) (D) Semiannual (A) Interest Reduction Principal Interest Cash Expense Of Principal Balance Period Payment (D) x 6% (A) – (B) (D) –(C) Issue date $500,000 1 33,231 $30,000 $3,231 496,769 2 $33,231 29,806 3,425 493,344

  42. LONG-TERM NOTES PAYABLEJOURNAL ENTRIES The entries to record the issuance and first interest payment are: Date Account Debit Credit Dec 31 Cash 500,000 Mortgage Notes Payable 500,000 (record mortgage loan) June 30 Interest Expense 30,000 Mortgage Notes Payable 3,231 Cash 33,231 (record first installment payment)

  43. STUDY OBJECTIVE 8PRESENTATION & ANALYSIS The long-term liabilities for LAX Corporation are shown below: LAX Corporation Balance Sheet (partial) Long-term liabilities $1,000,000 Bonds payable 10% due in 2012 80,000 $920,000 Less: Discount on bonds payable Mortgage notes payable, 11%, due in 2018 500,000 and secured by plant assets 540,000 Lease liability $1,960,000 Total long-term liabilities

  44. DEBT TO TOTAL ASSETS RATIO 44.3% = $21,394 / $48,263 Measures the percentage of total assets provided by creditors, indicating the degree of leverage. Data from Johnson & Johnson’s 2003 annual report appears below: TOTAL DEBT DEBT TO TOTAL ASSETS = ———————— TOTAL ASSETS

  45. TIMES INTEREST EARNEDRATIO Indicates the company’s ability to meet interest payments as they come due. Johnson & Johnson’s 2003 annual report data is used below: 50.8 times = ($7197 + $3111 + $207) $207 TIMES INT INCOME BEFORE INC. TAXES & INTEREST EXPENSE EARNED = ——————————————————————————— INTEREST EXPENSE

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