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Chapter 10 Liabilities PowerPoint Authors: Brandy Mackintosh

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1 Chapter 10 Liabilities PowerPoint Authors: Brandy Mackintosh
Lindsay Heiser Chapter 10: Reporting and Interpreting Liabilities.

2 Explain the role of liabilities in financing a business.
Learning Objective 10-1 Explain the role of liabilities in financing a business. Learning objective 10-1 is to explain the role of liabilities in financing a business.

3 The Role of Liabilities
Liabilities are created when a company: Buys goods and services on credit Obtains short-term loans Issues long-term debt Current liabilities are short-term obligations that will be paid with current assets within the company’s current operating cycle or within one year of the balance sheet date, whichever is longer. Part I Liabilities play a significant role in financing most business activities. Liabilities are created when a company buys goods and services on credit, obtains short-term loans to cover gaps in cash flows, and issues long-term debt to obtain money for expanding into new regions and markets. Part II To help financial statement users know when liabilities must be repaid, companies prepare a classified balance sheet. Current liabilities are defined as short-term obligations that will be paid with current assets within the company’s current operating cycle or within one year of the balance sheet date, whichever is longer.

4 The Role of Liabilities
The liability section of the General Mills 2010 and 2011 comparative balance sheets. On this screen we show the liability section of the comparative balance sheets for General Mills for 2010 and All amounts are expressed in millions of dollars. As you can see, General Mills owed various types of liabilities at the end of each of these fiscal years. To help financial statement users know when liabilities must be repaid, companies prepare a classified balance sheet where current liabilities are reported separately from other liabilities. The excerpt of the classified balance sheets shown on this slide indicate that General Mills will have to pay nearly $3.7 billion in the year following its 2011 fiscal year. An additional $8.4 billion will need to be paid in the longer term. Although these long-term obligations rarely get a separate subheading of their own, people often refer to them as noncurrent or long-term liabilities.

5 Explain how to account for common types of current liabilities.
Learning Objective 10-2 Explain how to account for common types of current liabilities. Learning objective 10-2 is to explain how to account for common types of current liabilities.

6 Measuring Liabilities
Initial Amount of the Liability Cash Equivalent Additional Liability Amounts Increase Liability Part I In general, the amount reported for each liability is the result of three factors, the first factor is recording the initial amount of the liability. Part II The company records each liability at its cash equivalent, which is the amount of cash a creditor would accept to settle the liability immediately after a transaction or event creates the liability. The second factor is how to handle any additional amounts owed to the creditor. Part III The company increases liabilities whenever additional obligations arise, by purchasing goods and services or incurring interest charges over time. The third factor is the handling of payments or services provided to the creditor. Part IV The company decreases liabilities whenever the company makes a payment or provides services to the creditor. Notice that a liability is first recorded at a cash-equivalent amount, which excludes interest charges. Interest arises only when time passes, so no interest is recorded on the day the company purchases an item on account or the day the company receives a loan. Payments Made Decrease Liability

7 Current Liabilities Accounts Payable Accrued Liabilities
Increases (Credited) Decreases (Debited) when a company receives goods or services on credit when a company pays on its account Part I Accounts Payable is increased (credited) when a company receives goods or services on credit, and it is decreased (debited) when the company pays on its account. Accounts Payable is interest free unless it becomes overdue. Part II Accrued liabilities are liabilities that have been incurred but not yet paid. Examples include: Accrued Advertising Accrued Payroll Accrued Taxes Accrued Interest Other Accrued Liabilities. Accrued Liabilities Liabilities that have been incurred but not yet paid.

8 Accrued Payroll Payroll Liabilities Payroll Deductions
Payroll deductions are either required by law or voluntarily requested by employees and create a current liability for the company. Examples include: Income tax FICA tax Other deductions (charitable donations, union dues, etc.) Payroll Liabilities Payroll Deductions Employer Payroll Taxes Part I All employers must account for payroll. Many companies have a staff devoted totally to preparing payroll. In addition to Wages Payable, companies record liabilities for other aspects of payroll. Two significant payroll liabilities relate to payroll deductions and employer payroll taxes. Part II A paycheck from General Mills may look like the one shown on this slide. Notice the columns in blue on this paycheck that represent payroll deductions for this employee. Payroll deductions are either required by law or voluntarily requested by employees. The law requires that employers deduct federal income tax (and possibly state, county, and city income tax) from each employee’s gross earnings. The law also requires, through the Federal Insurance Contributions Act (FICA), that each employee supports Medicare and Social Security through employee payroll deductions called FICA taxes. In addition to these required deductions, employees may also choose to voluntarily have payroll deductions for charitable donations, parking, union dues, retirement savings, etc. Payroll deductions are subtracted from the employee’s gross pay to arrive at the employees’ net pay, which is the dollar amount of the payroll check. Employers are obligated to remit the deductions withheld from the employee’s payroll check to another organization or government agency on the employee’s behalf. The employer classifies payroll deductions as current liabilities because they must be paid to another entity no more than one month after the payroll date.

9 Accrued Payroll Gross Pay Payroll Deductions: Federal Income Taxes
FICA Taxes Other Total Payroll Deductions Net Pay $ 48.80 10.00 $ 116.80 $ General Mills’ will record the payroll check for Adam Palmer that is based on gross pay of $600 (40 hours worked times Adam’s pay rate of $15 per hour). General Mills’ withheld Income Taxes of $58, FICA taxes of $48.80, and United Way contribution of $10. The net pay received by Adam Palmer is $

10 Accrued Payroll Adam Palmer earned gross pay of $600 in the current payroll period. General Mills withheld $58 in Federal income taxes, $48.80 for FICA, and $10 for United Way, resulting in net pay of $ Let’s assume that General Mills has 1,000 workers just like Adam. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -$483,200 FIT Withheld (+L) +$58,000 FICA Payable (+L)+$48,800 United Way (+L) +$10,000 Payroll Expense(+E, -SE) -$600,000 Part I Adam Palmer earned gross pay of $600 in the current payroll period. General Mills withheld $58 in Federal income taxes, $48.80 for FICA, and $10 for United Way, resulting in net pay of $ Let’s assume (for simplicity) that General Mills has 1,000 workers just like Adam. Part II As we analyze this transactions, we find that the expense account, Wages and Salaries Expense (Payroll Expense) increases by $600,000, the liability account, Federal Income Taxes Withheld, increases by $58,000, the liability account, Federal Insurance Contributions Act Payable (FICA), increases by $48,800, and the liability account, United Way Payable, increases by $10,000, and the asset account, Cash, decreases by $483,200, the amount of all of the employee’s net pay. Part III General Mills records this transaction with a journal entry that begins with a debit, or increase, the expense account Wages and Salaries Expense for $600,000. Next, we credit, or increase, the liability accounts Withheld Income Taxes Payable for $58,000, FICA Payable for $48,800, and United Way Payable for $10,000. Finally, we credit, or decrease, the asset account Cash for $483,200. 2 Record dr Wages and Salaries Expense (+E, -SE) cr Withheld Income Taxes Payable (+L) cr FICA Payable (+L) cr United Way Payable (+L) cr Cash (-A) 58,000 48,800 10,000 483,200 600,000

11 Employer Payroll Taxes
Accrued Payroll Employer Payroll Taxes Employers have other liabilities related to payroll. FICA tax (a “matching” contribution) Federal unemployment tax State unemployment tax Assume General Mills was required to contribute $48,800 for FICA, $750 for federal unemployment tax, and $4,000 for state unemployment tax. 1 Analyze Liabilities Assets = Stockholders’ Equity + FICA Payable (+L) +48,800 FUTA Payable (+L) +750 SUTA Payable (+L) +4,000 Payroll Tax Expense (+E, -SE) -53,550 Part I Beyond paying employees and remitting payroll deductions, employers have other responsibilities that lead to substantial additional labor costs. Like their employees, all employers are required to pay FICA taxes. The required contribution is 100% of total employee contributions (called a “matching” contribution). In addition, employers are required by the Federal Unemployment Tax Act (FUTA) and State Unemployment Tax Act (SUTA) to pay unemployment taxes. The rates for these taxes vary by industry, state, and employer history but can be substantial. Part II Assume General Mills was required to contribute $48,800 for FICA, $750 for federal unemployment tax, and $4,000 for state unemployment tax. Let’s analyze this transaction. Part III Liabilities are increased for $48,800 (FICA Payable); $750 (Federal Unemployment Tax); $4,000 (State Unemployment Tax). Payroll Tax Expense is increased by $53,550. We know that an increase in an expense account reduces stockholders’ equity. Part IV The proper journal entry is to debit, or increase, the expense account, Payroll Tax Expense for $53,550. We will credit, or increase each liability for the appropriate amount. Let’s credit FICA Payable for $48,800, Federal Unemployment Tax Payable for $750, and State Unemployment Tax Payable for $4,000. 2 Record dr Payroll Tax Expense (+E, -SE) cr FICA Tax Payable (+L) cr Federal Unemployment Tax Payable (+L) cr State Unemployment Tax Payable (+L) 48,800 750 4,000 53,550

12 Accrued Income Taxes Corporations calculate taxable income by subtracting tax-allowed expenses from revenues. This taxable income is then multiplied by a tax rate, which for most large corporations is about 35 percent. Let’s assume General Mills calculated taxable income to be $1,000,000, and is subject to a 35% tax rate, so income taxes owed are $350,000 ($1,000,000 × 35%) 1 Analyze Liabilities Assets = Stockholders’ Equity + Income Tax Payable (+L) ,000 Expense (+E, -SE) -350,000 Part I Corporations pay taxes not only on payroll but also on income they earn. Corporations calculate taxable income by subtracting tax-allowed expenses from revenues. This taxable income is then multiplied by a tax rate, which for most large corporations is about 35 percent. Corporate income taxes are due two and a half months after year-end. Part II Let’s assume General Mills calculated taxable income to be $1,000,000, and is subject to a 35% tax rate, so income taxes owed are $350,000 ($1,000,000 × 35%). Part III The liability Income Tax Payable is increased by $350,000, and the expense account, Income Tax Expense is also increased by $350,000. Part IV The proper journal entry is to debit, or increase, the expense account Income Tax Expense for $350,000, and credit, or increase, the liability account Income Tax Payable for the same amount. 2 Record dr Income Tax Expense (+E, -SE) cr Income Tax Payable (+L) 350,000

13 Notes Payable Four key events occur with any note payable:
establishing the note, accruing interest incurred but not paid, recording interest paid, and recording principal paid. Part I Notes payable represents the amount the company owes to others as a result of issuing promissory notes. Four key events occur with any note payable. Part II Establishing the note. In this example the note is established on November 1, 2012. Part III Next, we must accrue interest incurred but not paid. This takes place on December 31, 2012. Part IV Next we need to record interest paid. In our example, the note matures on October 31, 2013, and 12-months of interest must be paid. Part V Last, we must record principal paid at maturity. This note matures on October 31, 2013, and we must pay the principal amount of $100,000. 3 1 4 2

14 Notes Payable 1. Establish the note on November 1, 2012.
Assume that on November 1, 2012, General Mills borrowed $100,000 cash on a one-year note that required General Mills to pay 6 percent interest and $100,000 principal, both on October 31, 2013. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (+A) +100,000 Notes Payable (+L) ,000 Part I The first key event relating to a note payable is the establishment of the note. Assume that on November 1, 2012, General Mills borrowed $100,000 cash on a one-year note that required General Mills to pay 6 percent interest and $100,000 principal, both on October 31, 2013. Part II Cash, an asset, increases by $100,000 and Notes Payable, a liability, increases by $100,000. Part III The journal entry to record this transaction is to debit, or increase, the asset account Cash for $100,000, and credit, or increase, the liability account Notes Payable for $100,000. 2 Record dr Cash (+A) cr Notes Payable (+L) 100,000

15 Notes Payable 2. Accrue interest owed but not paid on December 31, 2012. 1 Analyze Liabilities Assets = Stockholders’ Equity + Interest Payable (+L) +1,000 Expense (+E, -SE) -1,000 Part I The second key event in accounting for a note payable is to accrue interest that incurred by not yet paid. Now, let’s calculate the accrued interest for two-months from November 1, 2012 through December 31, 2012, the company’s year-end. We multiply the amount of the note, $100,000, by the stated interest rate of 6 percent and adjust for the time period outstanding, 2 divided by 12. We determine that interest for the two-months is $1,000. Part II When we analyze the accrual we learn that the liability account Interest Payable increases by $1,000. The Interest Expense account increases by $1,000. We know from previous work that an increase in an expense account reduces stockholders’ equity’ Part III The journal entry to record the transaction is to debit, or increase, the expense account Interest Expense for $1,000, and credit, or increase the liability account, Interest Payable for $1,000. 2 Record dr Interest Expense (+E, -SE) cr Interest Payable (+L) 1,000

16 Notes Payable 3. Record interest paid on October 31, 2013. 1 Analyze 2
Liabilities Assets = Stockholders’ Equity + Cash (-A) -6,000 Interest Payable (-L) -1,000 Expense (+E, -SE) -5,000 Part I The third key event in accounting for a note payable is to pay the interest when due. As shown in this timeline, this $6,000 interest payment includes the $1,000 that was accrued as Interest Payable at December 31, 2012, plus $5,000 interest expense incurred during the 10 months between January 1 and October 31, 2013. Part II When analyzing this transaction General Mills finds that the asset account Cash is decreased by $6,000, the liability account Interest Payable is reduced by $1,000. Remember that this is the interest accrued at year-end that is now being paid. Finally, the expense account, Interest Expense will increase by $5,000, which will cause a decrease in stockholders’ equity. Part III The next step in the process is to record interest paid on October, 31,2013. Remember, we accrued interest on December 31, the year-end for General Mills. The proper journal entry is to debit, or increase, the expense account Interest Expense for $5,000 (10-months interest), debit, or decrease the liability account Interest Payable for $1,000, and finally credit, or decrease the asset account, Cash for $6,000, the total interest owed for one year. 2 Record dr Interest Expense (+E, -SE) dr Interest Payable (-L) cr Cash (-A) 6,000 5,000 1,000

17 Notes Payable 4. Record principal paid of $100,000 on October 31, 2013. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -100,000 Note Payable (-L) ,000 2 Record dr Note Payable (-L) cr Cash (-A) 100,000 Part I The final step in accounting for a note payable is to pay the principal amount when due. In our example, General Mills owes $100,000, on October 31, 2013. Part II In analyzing this transaction General Mills finds that the asset account Cash is decreased by $100,000, the amount of the repayment, and the liability account, Notes Payable decreases by the same amount. Part III The journal entry to record this transaction is to debit, or decrease the liability account, Notes Payable for $100,000, and credit, or decrease the asset account, Cash for $100,000. We have now seen the four steps in accounting for a note payable.

18 Current Portion of Long-Term Debt
Noncurrent Portion of Long-term Debt If a company borrows money with the promise to repay it in two years, the loan is classified as a long-term debt. The company reports only the accrued interest on the loan as a current liability in that year’s balance sheet. After a year has passed, however, the loan becomes a current liability. When this happens, the borrower must report the loan in the Current Liabilities section of the balance sheet. Rather than create a different account for this, accountants simply remove the amount of principal to be repaid in the upcoming year from the total long-term debt and report it as a current liability, Current Portion of Long-term Debt. Borrowers must report in Current Liabilities the portion of long-term debt that is due to be paid within one year.

19 Additional Current Liabilities
Sales Tax Payable Payments collected from customers at time of sale create a liability that is due to the state government. Unearned Revenue Cash received in advance of providing services creates a liability of services due to the customer . Part I Retail companies are required to charge a sales tax in all but five states (Alaska, Delaware, Montana, New Hampshire, and Oregon). Retailers collect sales tax from consumers at the time of sale and forward it to the state government. Just like payroll taxes, the tax collected by the company is reported as a current liability until it is forwarded to the government. Sales tax is not an expense to the retailer because it is simply collected and passed on to the government. Part II Some companies receive cash before they provide goods or services to customers. Airlines are paid in advance of providing flights, retailers receive cash for gift cards that can be used for future purchases of goods and services, and other companies receive money for subscriptions before the subscriptions begin. In these cases, accountants initially debit cash and credit a liability account called Unearned Revenue. As the services are provided, the company reduces the liability and reports the earned revenue.

20 Additional Current Liabilities
Best Buy sells a television for $1,000 cash plus 5 percent sales tax. $1,000 × 5% = $50 sales tax collected 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (+A) +1,050 Sales Tax Payable (+L) +50 Sales Revenue (+R, +SE) +1,000 2 Record dr Cash (+A) cr Sales Tax Payable (+L) cr Sales Revenue (+R, +SE) 50 1,000 1,050 Part I Best Buy sells a television for $1,000 cash plus 5 percent sales tax. The sales tax collected by Best Buy is $50 (multiply $1,000 times 5 percent). So the total amount collected by Best Buy is $1,050. Let’s analyze this transaction. Part II The asset account, Cash is increased by $1,050, the liability Sales Tax Payable is increased by $50, and the Sales Revenue account is increased by $1,000, the sales price of the television. Part III To record the transaction we debit, or increase the asset account Cash for $1,050, credit, or increase the liability account Sales Tax Payable for $50, and credit, or increase, the Sales Revenue account for $1,000. When Best Buy pays the sales tax to the state government, its accountants will reduce Sales Tax Payable (with a debit) and reduce Cash (with a credit). When Best Buy pays the sales tax to the state government, its accountants will reduce Sales Tax Payable (with a debit) and reduce Cash (with a credit).

21 Additional Liabilities
On May 14th 2010, Live Nation Entertainment (the owner of Ticketmaster), received $8 million cash for advance ticket sales for two Lady Gaga concerts to be held on February 21 and 22, 2011. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (+A) +8 Unearned Revenue (+L) +8 2 Record dr Cash (+A) cr Unearned Revenue (+L) 8 Part I On May 14th 2010, Live Nation Entertainment (the owner of Ticketmaster), received $8 million cash for advance ticket sales for two Lady Gaga concerts to be held on February 21 and 22, 2011. Part II In analyzing this transaction we learn that the asset account Cash increased by $8 million, and the liability account Unearned Revenue increased by $8 million. As Live Nation Entertainment delivers the two concerts, the company will reduce the liability and recognize revenue earned. Part III The journal entry to record this transaction is to debit, or increase, the asset account Cash for $8 million, and credit, or increase, the liability account Unearned Revenue for $8 million.

22 Additional Liabilities
When the February 21st concert is held, Live Nation Entertainment can recognize one half of the unearned revenue as earned revenue, as they have fulfilled part of the liability. 1 Analyze Liabilities Assets = Stockholders’ Equity + Unearned Revenue (-L) -4 Concert Revenue (+R, +SE) +4 2 Record dr Unearned Revenue (-L) cr Concert Revenue (+R, +SE) 4 Part I When the February 21st concert is held, Live Nation Entertainment can recognize one half of the unearned revenue as earned revenue, as they have fulfilled part of the liability. Part II Unearned Revenue decreases by $4 million, and the revenue account Concert Revenue is increased by $4 million. Any revenue account increases stockholders’ equity. Part III The journal entry to record the transaction is a debit, or decrease, to the liability account, Unearned Revenue for $4 million, and a credit, or increase, in the revenue account Concert Revenue for $4 million. When the February 22 concert is held, Live Nation Entertainment will make another adjustment like the one in step 2 to show that it fulfilled its remaining obligation and earned $4 million more in concert revenue.

23 Analyze and record bond liability transactions.
Learning Objective 10-3 Analyze and record bond liability transactions. Learning objective 10-3 is to analyze and record bond liability transactions.

24 Long-Term Liabilities
Common Long-Term Liabilities Long-term notes payable Deferred income taxes Bonds payable Bonds are financial instruments that outline the future payments a company promises to make in exchange for receiving a sum of money now. Part I Common long-term liabilities include long-term notes payable, deferred income taxes, and bonds payable. Liabilities for deferred income taxes represent the amount of tax put off (or deferred) by taking larger tax deductions on the corporation’s income tax return than on its income statement. Part II Occasionally, governments and very large companies such as General Mills need to borrow more money than any single lender can provide. In 2008, for example, General Mills needed to borrow $750 million. Because issuing a promissory note for such a large amount of money was impractical, the company instead issued bonds. Bonds are financial instruments that outline the future payments a company promises to make in exchange for receiving a sum of money now. From the company’s perspective, the bond is a long-term liability. From the bondholder’s perspective, the bond is an investment. After a company issues the bonds, they can be traded on established exchanges such as the New York Bond Exchange.

25 Bonds Key Elements of a Bond Maturity date Face value
Stated interest rate 12 $1,000 × 6% = $60 Interest Computation Part I Three key elements of a bond are (1) the maturity date, (2) the amount payable on the maturity date (called the face value ), and (3) the stated interest rate. The face value of most bonds is $1,000. The stated interest rate is always expressed as an annual rate. Some bonds require interest payments every six months (semiannually). Each interest payment is computed by multiplying the face value times the stated interest rate (times the fraction of the year if payments are made semiannually). Bonds may be priced at amounts above or below their face value. Part II A bond’s price does not affect the amount of each interest payment. For example, a 6 percent bond with a face value of $1,000 will always pay interest of $60 cash each year ($1,000 times 6% times 12/12). Part III Investors in the market establish the issue price. The bond issue price is the amount that investors are willing to pay on the issue date in exchange for the cash payments that the company promises to make over the life of the bond. Bond pricing usually involves a present value computation. Bonds may be issued above face amount, at face amount, or below face amount, depending upon market conditions on the date of issue. Bond Pricing The bond price involves present value computations and is the amount that investors are willing to pay on the issue date for the bonds.

26 Bonds Balance Sheet Reporting of Bond Liability
Relationships between Interest Rates and Bond Pricing Part I In reporting bonds, the total face value of a bond plus any related premium or minus any related discount is reported in the liabilities section of the balance sheet. The amount of the bond liability, after taking into account any premium or discount, is referred to as the bond’s carrying value. Part II To determine whether a bond will be issued at a premium, at face value, or at a discount, you need consider only the relationship between the stated interest rate on the bond (what the bond pays in cash) and the market interest rate (the return that bondholders require).

27 Bonds Issued at Face Value
General Mills receives $100,000 cash in exchange for issuing 100 bonds at their $1,000 face value, so the bonds are issued at total face value (100 × $1,000 = $100,000). Bonds Issued at Face Value 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (+A) +100,000 Bonds Payable (+L)+100,000 Part I The price received from the issue of bonds may be equal to the face value, above the face value (premium), or below the face value (discount). General Mills receives $100,000 cash in exchange for issuing 100 bonds at their $1,000 face value, so the bonds are issued at total face value (100 times $1,000 equals $100,000). Part II Let’s look at the issuance of bonds at face value. General Mills receives $100,000 cash in exchange for issuing 100 bonds at their $1,000 face value, so the bonds are issued at total face value (100 times $1,000 equals $100,000). Part III In analyzing this transaction we learn that the asset account, Cash, increases by $100,000, and the liability account, Bonds Payable, increases by $100,000. Part IV The journal entry to record the transaction is a debit, or increase, to asset account, Cash for $100,000, and a credit, or increase, in the liability account, Bonds Payable, for $100,000. 2 Record dr Cash (+A) cr Bonds Payable (+L) 100,000

28 Bonds Issued at a Premium
General Mills issues 100 of its $1,000 bonds at a price of percent of face value, the company will receive $107,260 (100 × $1,000 × ). 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (+A) +107,260 Bonds Payable (+L) +100,000 Premium on Bonds Payable (+L) +7,260 Part I Let’s look at bonds issued at a premium. General Mills issues 100 of its $1,000 bonds at a price of percent of face value, the company will receive $107,260 (100 times $1,000 times ). These bonds were issued at a premium because the cash received is more than the face value of the bond. Part II In analyzing this transaction General Mills finds that the asset account, Cash, increases by $107,260, the liability account, Bonds Payable, increases by $100,000, and the liability account, Premium on Bonds Payable, increases by $7,260. The Premium on Bonds Payable is added to the Bonds Payable account when preparing a balance sheet. Part III The journal entry to record the transaction is a debit, or increase, to asset account, Cash for $107,260, credit, or increase, in the liability account, Bonds Payable, for $100,000, and credit, or increase, the liability account Premium on Bonds Payable for $7,260. 2 Record dr Cash (+A) cr Bonds Payable (+L) cr Premium on Bonds Payable (+L) 100,000 7,260 107,260

29 Bonds Issued at a Discount
General Mills receives $93,376 for bonds with a total face value of $100,000, the cash-equivalent amount is $93,376, which represents the liability on that date. These bonds are issued at a discount because the cash received is less than the face value of the bonds. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (+A) +93,376 Bonds Payable (+L) +100,000 Discount on Bonds Payable (+xL,-L)-6,624 $100, $93,376 = $6,624 discount Part I Let’s look at the issuance for bonds at a discount. General Mills receives $93,376 for bonds with a total face value of $100,000, the cash-equivalent amount is $93,376, which represents the liability on that date. These bonds are issued at a discount because the cash received is less than the face value of the bonds. The amount of the discount is $6,624 ($100,000 minus $93,376). Part II In analyzing this transaction General Mills finds that the asset account, Cash, increases by $93,376, the liability account, Bonds Payable, increases by $100,000, and the contra-liability account, Discount on Bonds Payable, increases by $6,624. The Discount on Bonds Payable is a contra-liability account that is subtracted from the face amount of the bonds when preparing a balance sheet. Part III The journal entry to record the transaction is a debit, or increase, to asset account, Cash, for $93,376, credit, or increase, in the liability account, Bonds Payable, for $100,000, and debit, or increase, the contra-liability account ,Discount on Bonds Payable for $6,624. 2 Record dr Cash (+A) dr Discount on Bonds Payable (+xL, -L) cr Bonds Payable (+L) 100,000 93,376 6,624

30 Interest on Bonds Issued at Face Value
General Mills issues bonds on January 1, 2013, at their total face value of $100,000. The bonds have an annual stated interest rate of 6 percent payable in cash on December 31 of each year, General Mills will need to accrue an expense and liability for interest at the end of each accounting period. The end of the first accounting period is January 31, 2013. 1 Analyze Liabilities Assets = Stockholders’ Equity + Interest Payable (+L) +500 Interest Expense (+E, -SE) $100,000 × 6% × 1/12 = $500 interest Part I Let’s take a look at analyzing and recording interest on bonds issued at face amount. General Mills issues bonds on January 1, 2013, at their total face value of $100,000. The bonds have an annual stated interest rate of 6 percent payable in cash on December 31 of each year, General Mills will need to accrue an expense and liability for interest at the end of each accounting period. The Interest Expense for the month ended January 31, 2013 is $500 ($100,000 times 6% times 1 over 12). Part II In analyzing this transaction General Mills finds that the liability account, Interest Payable, increases by $500, and the expense account, Interest Expense, increases by $500. Part III The journal entry to record the transaction is a debit, or increase, the expense account, Interest Expense, for $500, and credit, or increase, in the liability account, Interest Payable, for $500. General Mills would continue to calculate and record interest this way for each period until the interest is paid. When interest is paid, Interest Payable will be decreased (with a debit) and Cash will be decreased (with a credit). 2 Record dr Interest Expense (+E, -SE) cr Interest Payable (+L) 500

31 Interest on Bonds Issued at a Premium
Cash proceeds > Face value Cash proceeds – Face value = Premium Interest expense < Cash interest paid Interest expense = Cash interest paid – Premium amortization Part I Let’s take a look at bonds issued at a premium. When bonds issue at a premium, the bond issuer receives more cash on the issue date than the total face amount that will be repaid at maturity. The cash proceeds received on the issue date are equal to the carrying value of the bonds on that date. Part II We determine the premium amount by subtracting the face value from the cash proceeds received from the issuance of the bonds. General Mills received $107,260 for bonds with a face value of $100,000, so the premium is $7,260. The $7,260 isn’t exactly “free money,” but rather is a reduction in the company’s cost of borrowing. For accounting purposes, we match the reduced borrowing cost to the periods in which the bond remains unpaid. This process, called bond amortization, makes the Interest Expense smaller than the actual interest payment and, at the same time, causes the balance in Premium on Bonds Payable to decline each period, as shown in this graphic. Part III Because the premium amortization each period reduces the company’s cost of borrowing, the Interest Expense recorded each period will be less than the cash interest paid when bonds are issued at a premium. Part IV The interest expense each period is determined by subtracting the amount of the premium amortization from the cash interest paid. Part V As you can see from the graphic, the carrying value of the bonds is defined as the face amount plus any unamortized premium. As we amortize the premium, the carrying value gets closer to the face value. At maturity, you can see that the carrying value and face value are the same because the premium on bonds payable account has been fully amortized.

32 Interest on Bonds Issued at a Discount
Cash proceeds < Face value Face value – Cash proceeds = Discount Interest expense > Cash interest paid Interest expense = Cash interest paid+ Discount amortization Part I Let’s take a look at bonds issued at a discount. When bonds issue at a discount, the bond issuer receives less cash than the face value. The cash proceeds received on the issue date are equal to the carrying value of the bonds on that date. Part II The amount of the discount is equal to the total face value less the proceeds from the issuance. General Mills received $93,376 on the issue date for bonds with a face value of $100,000 at maturity. The amount of the discount at the date of issuance is $6,624. The $6,624 discount represents an extra cost of borrowing, over and above each interest payment. For accounting purposes, we match the extra borrowing cost to the periods in which the bond liability is owed. This amortization causes the Interest Expense to be more than the interest payment and, at the same time, causes Discount on Bonds Payable to decrease each period. As the Discount on Bonds Payable decreases, the carrying value of the liability increases until it reaches $100,000 on the maturity date, as illustrated in this graphic. Part III Because the discount represents an additional interest factor, the discount amortization each period increases the company’s cost of borrowing. Therefore, the Interest Expense recorded each period will be more than the cash interest paid when bonds are issued at a discount. Part IV Interest expense each period is determined by adding cash interest paid and the discount amortization amount for the current period. Part V As you can see from the graphic, the carrying value of the bonds is defined as the face amount minus any unamortized discount. As we amortize the discount, the carrying value gets closer to the face value. At maturity, you can see that the carrying value and face value are the same because the discount on bonds payable account has been fully amortized.

33 Bond Retirement General Mills’ bonds were retired with a payment equal to their $100,000 face value. Let’s analyze and record this transaction. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -100,000 Bonds Payable (-L) -100,000 Part I Most bonds are retired (paid off) at maturity. If interest has been fully paid at the time of maturity, the only remaining account to settle will be Bonds Payable. Assume that General Mills’ bonds were retired with a payment equal to their $100,000 face value. Part II In analyzing this transaction General Mills finds that the liability account, Bonds Payable, decreases by $100,000, and the asset account, Cash, decreases by $100,000. Part III The journal entry to record the transaction is a debit, or decrease, in the liability account, Bonds Payable, for $100,000, and credit, or decrease, in the asset account, Cash, for $100,000. 2 Record dr Bonds Payable (-L) cr Cash (-A) 100,000

34 Bond Retirement The early retirement of bonds has three financial effects. The company pays cash, eliminates the bond liability, and reports either a gain or a loss. Assume that in 2003, General Mills issued $100,000 of bonds at face value. Ten years later, in 2013, the company retired the bonds early. At the time, the bond price was 102, so General Mills made a payment of $102,000. Cash Payment $103,000 Carrying Value ,000 Loss on Retirement $3,000 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -102,000 Bonds Payable (-L) -100,000 Loss on Bond Retirement(+E,-SE) -2,000 Part I Rather than wait until the maturity date to retire the bonds, however, the company may retire them early. Companies with a lot of cash often retire their bonds early to reduce future interest expense and increase net income. The early retirement of bonds has three financial effects. The company (1) pays cash, (2) eliminates the bond liability, and (3) reports either a gain or a loss. A gain is recorded if the repurchase price is less than the carrying value of the bonds, and a loss is recognized if the repurchase price is more than the carrying value of the bonds. Part II Assume that in 2003, General Mills issued $100,000 of bonds at face value. Ten years later, in 2013, the company retired the bonds early. At the time, the bond price was 102, so General Mills made a payment of $102,000 (= $100,000 x 1.02) to retire the bonds. You can see that we have a loss because the cash paid exceeds the carrying value of the bond. If the cash paid for the bonds was less than the carrying value of the bonds, we would report a gain. Part III In analyzing this transaction General Mills finds that the liability account, Bonds Payable, decreases by $100,000, the Loss on Bond Retirement, an expense account increases by $2,000, and the asset account, Cash, decreases by $102,000. Part IV The journal entry to record the transaction is a debit to the liability account, Bonds Payable, for $100,000, a debit to the expense account, Loss on Bond Payable, for $2,000, and a credit to the asset account, Cash, for $102,000. 2 Record dr Bonds Payable (-L) dr Loss on Bond Retirement (+E, -SE) cr Cash (-A) 102,000 100,000 2,000

35 Describe how to account for contingent liabilities.
Learning Objective 10-4 Describe how to account for contingent liabilities. Learning objective 10-4 is to describe how to account for contingent liabilities.

36 Contingent Liabilities
Contingent liabilities are potential liabilities that arise from past transactions or events, but their ultimate resolution depends (is contingent) on a future event. Part I Contingent liabilities are potential liabilities that arise as a result of past transactions or events, but their ultimate resolution depends (is contingent) on a future event. Contingent liabilities differ from other liabilities because their dependence on a future event introduces a great deal of uncertainty. Accounting rules require the company to evaluate how likely it is to have a real liability and, if so, whether the amount of the liability can be reasonably estimated. Part II If we have a contingency, we must assess whether the contingency will likely lead to a liability. There are three possible outcomes; first, it is probable that we will incur a liability, second, it is possible that we may have a liability, and third, there is a remote chance of a liability being incurred. If it is probable that we will have a liability, and the amount of the liability can be reasonably estimated, we record the estimated liability and estimated loss in our books. If we cannot estimate the liability or if it is only possible that we will have a liability, we are required to describe the contingency in the notes to the financial statements. If it is only remote that a liability will be incurred, we do not record the contingency, nor do we describe it in the financial statement. Rather we do not mention the contingency at all.

37 Learning Objective 10-5 Calculate and interpret the quick ratio and the times interest earned ratio. Learning objective 10-5 is to calculate and interpret the quick ratio and the times interest earned ratio.

38 Evaluate the Results Two financial ratios are commonly used to assess a company’s ability to generate resources to pay future amounts owed: Quick ratio Times interest earned ratio Quick Ratio = (Cash + Short-term Investments + Accounts Receivable, Net) Current Liabilities Part I In evaluating a company’s ability to pay its liabilities, a good place to start is with the reports credit-rating agencies issue. We need to know how to analyze a set of financial statements in the same way that a credit rater would. Two financial ratios are commonly used to make an assessments of the company to generate resources to pay future amounts owed: the quick ratio and the times interest earned ratio. Part II We calculate the quick ratio by dividing “quick assets” by current liabilities. Quick assets generally include cash, short-term investments, and accounts receivable, net. The ratio tells us whether quick assets are sufficient to pay current liabilities. The higher the number the better able to quickly pay. Part III The numerator of the times interest earned ratio contains net income plus interest expense plus income tax expense. We divide the numerator by interest expense. The times interest earned ratio tells us whether sufficient resources are generated to cover interest costs. The higher the number the better the interest coverage. Times Interest Earned Ratio = (Net Income + Interest Expense + Income Tax Expense) Interest Expense

39 Evaluate the Results $620 + 0 + 1,162 3,659
At the end of its 2011 fiscal year, General Mills reported $620 million of cash and cash equivalents, no short-term investments, and $1,162 million of net accounts receivable. The company reported $3,659 million in total current liabilities. Quick Ratio = (Cash + Short-term Investments + Accounts Receivable, Net) Current Liabilities $ ,162 3,659 = Part I At the end of its 2011 fiscal year, General Mills reported $620 million of cash and cash equivalents, no short-term investments, and $1,162 million of net accounts receivable. The company reported $3,659 million in total current liabilities. Let’s calculate the quick ratio for We have placed the equation for the Quick Ratio on the screen to help you through the process. Part II The Quick Ratio for General Mills for the year 2011 is A quick ratio of implies that General Mills would be able to pay only 48.7 percent of its current liabilities, if forced to pay them immediately. However, not all current liabilities are to be paid immediately. A quick ratio of implies that General Mills would be able to pay only 48.7 percent of its current liabilities, if forced to pay them immediately. However, not all current liabilities are to be paid immediately.

40 Evaluate the Results $1,798 + $346 + $721 $346
In 2011, General Mills reported net income of $1,798 million and interest expense of $346 million, and income tax expense of $721 million. Let’s calculate the times interest earned for 2011. Times Interest Earned Ratio = (Net Income + Interest Expense + Income Tax Expense) Interest Expense $1, $ $721 $346 = times Part I One way to judge a company’s ability to pay interest is to ask whether it has generated enough income to cover its interest expense. The measure that most analysts use for this purpose is the times interest earned ratio. In 2011, General Mills reported net income of $1,798 million and interest expense of $346 million, and income tax expense of $721 million. Let’s calculate the times interest earned for On your screen is the equation for calculating times interest earned that we have previously discussed. Part II For 2011, General Mills had a Times Interest Earned Ratio of 8.28 times. The ratio means that General Mills generates $8.28 of income (before the costs of financing and taxes) for each dollar of interest expense. Reaching this level of interest coverage was important to General Mills because its long-term debt note reported that loan covenants required a minimum ratio of 2.5. The ratio means that General Mills generates $8.28 of income (before the costs of financing and taxes) for each dollar of interest expense. Reaching this level of interest coverage was important to General Mills because its long-term debt note reported that loan covenants required a minimum ratio of 2.5.

41 Straight-Line Method of Amortization
Chapter 10 Supplement 10A Straight-Line Method of Amortization Chapter 10: Supplement 10A: Straight-Line Method of Amortization

42 Bond Premium Bond premium or discount decreases each year, until it is completely eliminated on the bond’s maturity date. This process is called amortizing the bond premium or discount. The straight-line method of amortization reduces the premium or discount by an equal amount each period. Recall our example when General Mills received $107,260 on the issue date (January 1, 2013) but repays only $100,000 at maturity (December 31, 2016). Under the straight-line method, this $7,260 is spread evenly as a reduction in interest expense over the four years ($7,260 ÷ 4 = $1,815 per year). 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -6,000 Premium on Bonds Payable (-L) -1,815 Interest Expense (+E, -SE) -4,185 Cash Interest $6,000 Amortization of Premium (1,815) Interest Expense $4,185 Part I Bond premium or discount decreases each year, until it is completely eliminated on the bond’s maturity date. This process is called amortizing the bond premium or discount. The straight-line method of amortization reduces the premium or discount by an equal amount each period. Part II Recall our example when General Mills received $107,260 on the issue date (January 1, 2013) but repays only $100,000 at maturity (December 31, 2016). Under the straight-line method, this $7,260 is spread evenly as a reduction in interest expense over the four years ($7,260 ÷ 4 = $1,815 per year). So periodic interest expense will be $4,185 ($6,000 cash interest less premium amortization of $1,815). Part III In analyzing this transaction General Mills finds that the asset account, Cash, decreases by $6,000, the liability account, Premium on Bonds Payable decreases by $1,815, and the expense account, Interest Expense, increases by $4,185. Part IV The journal entry to record the transaction is to debit, or increase, the expense account, Interest Expense, for $4,185, debit or decrease the liability account, Premium on Bond Payable, for $1,815, and credit, or decrease, in the asset account, Cash, for $6,000. 2 Record dr Interest Expense (+E, -SE) dr Premium on Bonds Payable (-L) cr Cash (-A) 6,000 4,185 1,815

43 Amortization Schedule of Bonds Issued at a Premium
Bond Premium Amortization Schedule of Bonds Issued at a Premium Notice that each of these amounts would plot as a straight-line! $7,260 - $1,815 = $5,445 $107,260 – $1,815 = $105,445 $7,260 ÷ 4 = $1,815 $6,000 - $1,815 = $4,185 $100,000 × 6% × 12/12 = $6,000 Part I Here is a completed amortization schedule for the bonds sold at a premium. Let’s go through the calculation of each value. Part II Cash Paid each period is calculated by multiplying the face value of the bonds, $100,000, by the stated annual interest rate of 6 percent, and adjusting for the time period. In our cash the time period is one year, so we multiply the total annual interest by 1, or 12 divided by 12. Part III The total amount of the premium is $7,260, and we are using straight line amortization, so we divide $7,260 by the number of years, 4, to get an annual amortization of $1,815. Part IV The interest expense each period is determined by subtracting the periodic premium amortization, $1,815 from the cash interest paid of $6,000 to get $4,185. Part V The balance in the Premium on Bonds Payable is determined each period by subtracting the periodic amortization amount, $1,815, from the previous balance in the Premium on Bonds Payable, $7,260. In the next period, we subtract $1,815 from $5,445 to get the balance of $3,630. Part VI The carrying value of the bonds, $107,260, is updated by subtracting the premium amortization, $1,815, from the previous carrying value of the bonds to get $105,445.

44 Bond Discount Recall our example where General Mills received $93,376 for four-year bonds with a total face value of $100,000, implying a discount of $6,624. The annual amortization of the discount is $1,656 ($6,624 ÷ 4). 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -6,000 Discount on Bonds Payable(-xL,+L)+1,656 Interest Expense (+E, -SE) -7,656 Cash Interest $6,000 Amortization of Discount 1,656 Interest Expense $7,656 Part I Recall our example where General Mills received $93,376 for four-year bonds with a total face value of $100,000, implying a discount of $6,624. The annual amortization of the discount is $1,656 ($6,624 ÷ 4). Interest expense for the period is determined by adding cash interest paid and the amortization of the discount, for a total of $7,656. Let’s analyze and record the transaction for interest payment and discount amortization. Part II In analyzing this transaction General Mills finds that the asset account, Cash, decreases by $6,000, the contra-liability account, Discount on Bonds Payable decreases by $1,656, and the expense account, Interest Expense, increases by $7,656. Part III The journal entry to record the transaction is to debit, or increase, the expense account, Interest Expense, for $7,656, credit or decrease the contra-liability account, Discount on Bond Payable, for $1,656, and credit, or decrease, in the asset account, Cash, for $6,000. 2 Record dr Interest Expense (+E, -SE) cr Discount on Bonds Payable (-xL, +L) cr Cash (-A) 1,656 6,000 7,656

45 Amortization Schedule of Bonds Issued at a Discount
Bond Discount Amortization Schedule of Bonds Issued at a Discount $6,624 - $1,656 = $4,968 $93,376 + $1,656 = $95,032 $6,624 ÷ 4 = $1,656 $6,000 + $1,656 = $7,656 $100,000 × 6% × 12/12 = $6,000 Part I Here is a completed amortization schedule for the bonds sold at a discount. Let’s go through the calculation of each value. Part II Cash Paid each period is calculated by multiplying the face value of the bonds, $100,000, by the stated annual interest rate of 6 percent, and adjusting for the time period. In our cash the time period is one year, so we multiply the total annual interest by 1, or 12 divided by 12. Part III The total amount of the discount is $6,624, and we are using straight line amortization, so we divide $6,624 by the number of years, 4, to get an annual amortization of $1,656. Part IV The interest expense each period is determined by adding the periodic discount amortization, $1,656 to the cash interest paid of $6,000 to get $7,656. Part V The balance in the Discount on Bonds Payable is determined each period by subtracting the periodic amortization amount, $1,656, from the previous balance in the Discount on Bonds Payable, $4,968. In the next period, we subtract $1,656 from $4,968 to get the balance of $3,312. Part VI The carrying value of the bonds, $93,376, is updated by adding the discount amortization, $1,656, from the previous carrying value of the bonds to get $95,032.

46 Effective-Interest Method of Amortization
Chapter 10 Supplement 10B Effective-Interest Method of Amortization Chapter 10, Supplement 10B: Effective-Interest Method of Amortization

47 Effective Interest Amortization
The effective-interest method of amortization is considered a conceptually superior method of accounting for bonds because it correctly calculates interest expense by multiplying the market interest rate times the carrying value of the bonds. Interest (I) = Principal (P) × Rate (R) × Time (T) Interest Expense = Carrying Value × Market Rate × n/12 $4,290 = $107,260 × 4% × 12/12 When General Mills adds this $7,260 premium to the $100,000 face value, it reports a carrying value of $107,260 ($100,000 + $7,260) on January 1, The proceeds indicates that the market interest rte was 4 percent. Part I The effective-interest method of amortization is considered a conceptually superior method of accounting for bonds because it correctly calculates interest expense by multiplying the market interest rate times the carrying value of the bonds. Part II When General Mills adds this $7,260 premium to the $100,000 face value, it reports a carrying value of $107,260 ($100,000 plus $7,260) on January 1, The proceeds indicates that the market interest rate was 4 percent. So effective interest in the first year will be determined by multiplying the carrying value of the bonds ($107,260) times the market rate of interest of 4 percent time 12 divided by 12, or 1. First year effective interest is $4,290, while the cash interest paid is $6,000, as we have seen. Part III Here is a table showing the present value computation for bonds issued at a premium ($107,260), bonds sold at face value ($100,000), and bonds sold at a discount ($93,376). Notice that bonds are issued at a discount when the market rate of interest demanded by investors exceeds the stated rate of interest printed on the bonds. Bonds are issued at a premium when the market rate of interest demanded by investors is less that the stated rate on the bonds.

48 Effective Interest Amortization
General Mills issued 6% stated rate bonds for $107,260. The market rate of interest on these bonds is 4%. The face amount of the bonds, $100,000, results in cash interest is $6,000 ($100,000 × 6%). Let’s amortize the premium on the bonds at the first interest payment date. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -6,000 Premium on Bonds Payable (-L) -1,710 Interest Expense (+E, -SE) -4,290 Interest (I) = Principal (P) × Rate (R) × Time (T) Interest Expense = Carrying Value × Market Rate × n/12 $4,290 = $107,260 × 4% × 12/12 Part I General Mills issued 6% stated rate bonds for $107,260. The market rate of interest on these bonds is 4%. The face amount of the bonds is $100,000, so the cash interest is $6,000 ($100,000 × 6%). Let’s amortize the premium on the bonds at the first interest payment date. The premium amortization is the difference between the cash interest, $6,000 and effective interest, $4,290, or $1,710. The interest expense and amortization will differ in each period. The cash interest paid will not change from one period to the next. Part II In analyzing this transaction General Mills finds that the asset account, Cash, decreases by $6,000, the liability account, Premium on Bonds Payable decreases by $1,710, and the expense account, Interest Expense, increases by $4,290. Part III The journal entry to record the transaction is a debit, or increase, the expense account, Interest Expense, for $4,290, debit or decrease the liability account, Premium on Bonds Payable for $1,710, and credit or decrease the asset account, Cash, for $6,000. 2 Record dr Interest Expense (+E, -SE) dr Premium on Bonds Payable (-L) cr Cash (-A) 6,000 4,290 1,710 Cash Interest $ 6,000 Effective Interest ,290 Amortization of Premium $1,710

49 Effective Interest Amortization
$6,000 - $4,290 = $1,710 $7,260 - $1,710 = $5,550 Effective Interest Amortization of Bonds Issued at a Premium $107,260 × 4% × 12/12 = $4,290 $107,260 - $1,710 = $105,550 $100,000 × 6% × 12/12 = $6,000 Part I Here is a completed amortization schedule for the bonds sold at a premium. Let’s go through the calculation of each value. Part II Cash paid each period is calculated by multiplying the face value of the bonds, $100,000, by the stated annual interest rate of 6 percent, and adjusting for the time period. In our cash the time period is one year, so we multiply the total annual interest by 1, or 12 divided by 12. Part III The interest expense is determined by multiplying the carrying value of the bonds $107,260 time the market rate of interest demanded by investors of 4% times the period 12 divided by 12, or 1, to get $4,290. Part IV The amortization of the premium is determined by subtracting the interest expense ($4,290) from the cash interest of $6,000, to get $1,710. Part V The balance in the Premium on Bonds Payable is determined each period by subtracting the periodic amortization amount, $1,710, from the previous balance in the Premium on Bonds Payable, $7,260. In the next period, we subtract $1,778 from $5,550 to get the balance of $3,772. Part VI The carrying value of the bonds, $107,260, is updated by subtracting the premium amortization, $1,710, from the previous carrying value of the bonds to get $105,550. VII Notice that once again, cash interest paid remains the same over the life of the bonds at $6,000. However, Interest Expense decreases each period and Premium Amortization increases each period. Interest Expense decreases and Premium Amortization increases each period. Cash interest is unchanged.

50 Effective Interest Amortization
General Mills issued $100,000 face value, 6%, 4-year bonds at a market price to yield investors 8%. The bonds were issued at a discount of $6,624. Let’s determine the effective interest for the first interest payment period. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -6,000 Discount on Bonds Payable(-xL,+L)+1,470 Interest Expense (+E, -SE) -7,470 Interest (I) = Principal (P) × Rate (R) × Time (T) Interest Expense = Carrying Value × Market Rate × n/12 $7,470 = $93,376 × 8% × 12/12 2 Record dr Interest Expense (+E, -SE) cr Discount on Bonds Payable (-L) cr Cash (-A) 1,470 6,000 7,470 Part I General Mills issued $100,000 face value, 6%, 4-year bonds at a market price to yield investors 8%. The bonds were issued at a discount of $6,624. Let’s determine the effective interest for the first interest payment period. Before we can determine the interest expense for the period, we need to know the carrying value of the bonds. The carrying value of the bonds is $93,376, which is the face value of $100,000 minus the discount of $6,624. Interest expense is calculated by multiplying the carrying value of the bonds, $93,376 times 8% times 12 divided by 12, or 1. So, interest expense for the first period is $7,470. Part II In analyzing this transaction General Mills finds that the asset account, Cash, decreases by $6,000, and the expense account, Interest Expense, increases by $7,470. The difference between the $7,470 of interest expense and the $6,000 of cash paid in interest is the amortization of the discount. So, the third part of this transaction is a decrease in the contra-liability account, Discount on Bonds Payable, for $1,470 ($7,470 less $6,000). Part III The journal entry to record the transaction is a debit, or increase, the expense account, Interest Expense, for $7,470, credit or decrease the contra-liability account, Discount on Bond Payable, for $1,470, and credit, or decrease, in the asset account, Cash, for $6,000. Cash Interest $ 6,000 Effective Interest ,470 Amortization of Discount $ 1,470

51 Effective Interest Amortization
$7,470 - $6,000 = $1,470 $6,624 - $1,470 = $5,154 Effective Interest Amortization of Bonds Issued at a Discount $93,376 × 8% × 12/12 = $7,470 $93,376 + $1,470 = $94,846 $100,000 × 6% × 12/12 = $6,000 Part I Here is a completed amortization schedule for the bonds sold at a discount. Let’s go through the calculation of each value. Part II Cash Paid each period is calculated by multiplying the face value of the bonds, $100,000, by the stated annual interest rate of 6 percent, and adjusting for the time period. In our cash the time period is one year, so we multiply the total annual interest by 1, or 12 divided by 12. Part III The total amount of interest expense is $7,470. We determine this amount by multiplying the bond carrying value of $93,376 time the effective interest rate of 8 percent and multiply by 12 over 12 to get $7,470. Part IV The amortization of the bond discount is determined by subtracting the cash interest of $6,000, from the effective interest of $7,470, to get the amortization of $1,470. Part V The balance in the Discount on Bonds Payable is determined each period by subtracting the amortization amount from the previous balance in the Discount on Bonds Payable. Part VI At the end of 2013, the carrying value of the bonds, $94,846, is updated by adding the discount amortization, $1,470, to the previous carrying value of $93,376. Part VII Notice that once again, cash interest paid remains the same over the life of the bonds at $6,000. However, Interest Expense increases each period, and so does the amount of the Discount Amortization. Both Interest Expense and Discount Amortization increase each period. Cash interest is unchanged.

52 Simplified Effective-Interest Amortization
Chapter 10 Supplement 10C Simplified Effective-Interest Amortization Chapter 10, Supplement 10C: Simplified Effective-Interest Amortization

53 Accounting for Bond Issue.
The shortcut method records the bonds at issuance at Bonds Payable, Net. That is face amount less discount or face amount plus premium. The following journal entries demonstrate how the shortcut is applied to bonds issued at a premium, at face value, and at a discount. Part I The shortcut method shown in this section involves simplifying only one aspect of accounting for the Premium or Discount on Bonds Payable. Rather than record a discount or premium in a separate account, we combine the discount or premium with the bond’s face value in a single account that we will call Bonds Payable, Net. Part II The following journal entries demonstrate how the shortcut is applied to bonds issued at a premium, at face value, and at a discount. Notice that the bonds issued at a premium recorded both the asset and liability at $107,260, the face value plus the premium, or the proceeds received upon issuance. The liability is referred to as Bonds Payable, Net. When bonds are issued at a discount, both the asset and liability are recorded for $93,376. Once again, this is the proceeds from the issuance of the bonds. There are no separate accounts for Premium on Bonds Payable or Discount on Bonds Payable.

54 Bond Premium Interest (I) = Principal (P) × Rate (R) × Time (T)
Interest Expense = Bonds Payable, Net × Market Rate × n/12 Interest Expense $4,290 = $107,260 × 4% × 12/12 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -6,000 Bonds Payable, Net (-L) -1,710 Interest Expense (+E, -SE) -4,290 Part I The calculation of interest expense is determine by multiplying the balance in the Bonds Payable, Net account by the market rate of interest demanded by investors. The total interest is adjusted for the appropriate time period. In our case we will multiply $107,260 times 4 percent time 12 divided by 12, or 1, to get interest expense of $4,290. Part II These bonds were sold at a premium. In analyzing this transaction General Mills finds that the asset account, Cash, decreases by $6,000, the liability account, Bonds Payable, Net decreases by $1,710, and the expense account, Interest Expense, increases by $4,290. Part III The journal entry to record the transaction is a debit, or increase, the expense account, Interest Expense, for $4,290, debit or decrease the liability account, Bonds Payable, Net, for $1,710, and credit, or decrease, in the asset account, Cash, for $6,000. 2 Record dr Interest Expense (+E, -SE) dr Bonds Payable, Net (-L) cr Cash (-A) 6,000 4,290 1,710

55 Bond Discount Interest (I) = Principal (P) × Rate (R) × Time (T)
Interest Expense = Bonds Payable, Net × Market Rate × n/12 Interest Expense $7,470 = $93,376 × 8% × 12/12 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -6,000 Bonds Payable, Net (+L) -1,470 Interest Expense (+E, -SE) -7,470 Part I Here we have an example of bonds issued at a discount. The effective interest is determined by multiplying $93,376 (carrying value) times the market rate of interest demanded by investors (8 percent) and adjusted for the time period, 12 divided by 12, or 1. We see that interest expense is $7,470. Part II In analyzing this transaction General Mills finds that the asset account, Cash, decreases by $6,000, the liability account, Bonds Payable, Net, increases by $1,470, and the expense account, Interest Expense, increases by $7,470. Part III The journal entry to record the transaction is a debit, or increase, the expense account, Interest Expense, for $7,470, credit or increase the liability account, Bond Payable, Net, for $1,470, and credit, or decrease, in the asset account, Cash, for $6,000. 2 Record dr Interest Expense (+E, -SE) cr Bonds Payable, Net (+L) cr Cash (-A) 1,470 6,000 7,470

56 Chapter 10 Solved Exercises
M10-5, E10-2, E10-3, E10-8, E10-10, PA10-3 Chapter 10 Solved Exercises: M10-5, E10-2, E10-3, E10-8, E10-10, PA10-3

57 M10-5 Reporting Current and Noncurrent Portions of Long-Term Debt
Assume that on December 1, 2013, your company borrowed $15,000, a portion of which is to be repaid each year on November 30. Specifically, your company will make the following principal payments: 2014, $2,000; 2015, $3,000; 2016, $4,000; and 2017, $6,000. Show how this loan will be reported in the December 31, 2014 and 2013 balance sheets, assuming that principal payments will be made when required. As of December 31, Current Liabilities: Current Portion of Long-term Debt Long-term Debt Total Liabilities 2014 $ 3,000 10,000 $ 13,000 2013 $ 2,000 13,000 $ 15,000 Part I M10-5 Reporting Current and Noncurrent Portions of Long-Term Debt Assume that on December 1, 2013, your company borrowed $15,000, a portion of which is to be repaid each year on November 30. Specifically, your company will make the following principal payments: 2014, $2,000; 2015, $3,000; 2016, $4,000; and 2017, $6,000. Show how this loan will be reported in the December 31, 2014 and 2013 balance sheets, assuming that principal payments will be made when required. Part II We will report Current Portion of Long-Term Debt of $3,000, in 2014, and $2,000 in The remainder of the Long-Term Debt will be shown as a long-term liability.

58 E10-2 Recording a Note Payable through Its Time to Maturity
Many businesses borrow money during periods of increased business activity to finance inventory and accounts receivable. Target Corporation is one of America’s largest general merchandise retailers. Each Christmas, Target builds up its inventory to meet the needs of Christmas shoppers. A large portion of Christmas sales are on credit. As a result, Target often collects cash from the sales several months after Christmas. Assume that on November 1, 2013, Target borrowed $6 million cash from Metropolitan Bank and signed a promissory note that matures in six months. The interest rate was 8.0 percent payable at maturity. The accounting period ends December 31. Required: Give the journal entry to record the note on November 1, 2013. Give any adjusting entry required on December 31, 2013. Give the journal entry to record payment of the note and interest on the maturity date, April 30, 2014, assuming that interest has not been recorded since December 31, 2013. E10-2 Recording a Note Payable through Its Time to Maturity Many businesses borrow money during periods of increased business activity to finance inventory and accounts receivable. Target Corporation is one of America’s largest general merchandise retailers. Each Christmas, Target builds up its inventory to meet the needs of Christmas shoppers. A large portion of Christmas sales are on credit. As a result, Target often collects cash from the sales several months after Christmas. Assume that on November 1, 2013, Target borrowed $6 million cash from Metropolitan Bank and signed a promissory note that matures in six months. The interest rate was 8.0 percent payable at maturity. The accounting period ends December 31. Required: Give the journal entry to record the note on November 1, 2013. Give any adjusting entry required on December 31, 2013. Give the journal entry to record payment of the note and interest on the maturity date, April 30, 2014, assuming that interest has not been recorded since December 31, 2013.

59 E10-2 Recording a Note Payable through Its Time to Maturity
November 1, 2013: dr Cash (+A) cr Note Payable (+L) 6,000,000 Borrowed on 6-month, 8.0%, note payable. December 31, 2013 (end of the accounting period): dr Interest Expense (+E, -SE) cr Interest Payable (+L) 80,000 Adjusting entry for 2 months’ accrued interest ($6,000,000 x 8.0% x 2/12 = $80,000). Part I Let’s prepare the journal entry required at November 1, 2013, in connection with the Note Payable. Part II The proper entry is to debit, or increase, the asset account, Cash, for $6,000,000, and credit, or increase, the liability account, Note Payable for the same amount. Part III Now, prepare the entry at December 31, 2013 to accrue interest at the end of the year. Part IV The proper entry is to debit, or increase, the expense account, Interest Expense for $80,000, and credit, or increase, the liability account, Interest Payable for $80,000. This represents 2 months interest on $6,000,000 at annual interest of 8 percent interest. Part V Finally, prepare the journal entry at the maturity of the note, April 30, 2014. VI The entry should be a debit, or decrease, to the liability account, Note Payable for $6,000,000, a debit or decrease, to the liability account, Interest Payable, for $80,000 – the amount we accrued on December 31, 2013, a debit, or increase, to the expense account, Interest Expense for $160,000, representing four-months interest, and a credit, or decrease, to the asset account, Cash, for $6,240,000. The note has now been liquidated. April 30, 2014 (maturity date): dr Note Payable (-L) dr Interest Payable (per above) (-L) dr Interest Expense ($6,000,000 x 8.0% x 4/12) (+E, -SE) cr Cash (-A) 6,240,000 6,000,000 80,000 160,000 Paid note plus interest at maturity.

60 E10-3 Recording Payroll Costs
McLoyd Company completed the salary and wage payroll for March The payroll provided the following details: Required: Considering both employee and employer payroll taxes, use the preceding information to calculate the total labor cost for the company. Prepare the journal entry to record the payroll for March, including employee deductions (but excluding employer payroll taxes). Employees were paid in March but amounts withheld were not yet remitted. Prepare the journal entry to record the employer’s FICA taxes and unemployment taxes. E10-3 Recording Payroll Costs with Discussion McLoyd Company completed the salary and wage payroll for March The payroll provided the following details: Salaries and wages earned, $400,000, Employee income taxes withheld, $37,000, FICA taxes withheld, $28,600, Unemployment taxes, $2,780. Required: Considering both employee and employer payroll taxes, use the preceding information to calculate the total labor cost for the company. Prepare the journal entry to record the payroll for March, including employee deductions (but excluding employer payroll taxes). Employees were paid in March but amounts withheld were not yet remitted. Prepare the journal entry to record the employer’s FICA taxes and unemployment taxes.

61 E10-3 Recording Payroll Costs with Discussion
Req. 1 The total labor cost was $431,380, made up of the $400,000 in gross salaries and wages plus the $28,600 for Employer FICA taxes and $2,780 for unemployment taxes. Req. 2 March 31, 2013 dr Salaries and Wages Expense (+E, -SE) 400,000  cr Withheld Income Taxes Payable (+L) 37,000  cr FICA Taxes Payable—Employees (+L) 28,600  cr Cash (-A) ,400 Payroll for March including employee deductions. Part I Requirement number 1 – The total labor cost was $431,380, made up of the $400,000 in gross salaries and wages plus the $28,600 for employer FICA taxes and $2,780 for unemployment taxes. Part II Requirement number 2 – Let’s prepare the journal entry required on March 31, 2013, to record the Salaries and Wages Expense? Part III The journal entry is to debit, or increase, the expense account, Salaries and Wages Expense for $400,000, credit, or increase, the liability account, Withheld Income Taxes Payable for $37,000, credit, or increase, the liability account, FICA Taxes Payable – Employees for $28,600, and credit, or decrease, the asset account, Cash, for $334,400. Part IV Let’s record the employer payroll tax expense as a result of the March 31 payroll. Part V We will debit, or increase, the expense account, Payroll Tax Expense for $31,380, credit, or increase the liability account, FICA Taxes Payable – Employer for $28,600 (the matching FICA taxes paid by the employer), and credit, or increase, the liability account, Unemployment Taxes Payable for $2,780. Req. 3 March 31, 2013 dr Payroll Tax Expense (+E,-SE) 31,380  cr FICA Taxes Payable—Employer (+L) 28,600  cr Unemployment Taxes Payable (+L) 2,780 Employer payroll taxes on March payroll.

62 Prepare the journal entry to record the bond issuance.
E10-8 Preparing Journal Entries to Record Issuance of Bonds at Face Value, Payment of Interest, and Early Retirement On January 1, 2013, Innovative Solutions, Inc., issued $200,000 in bonds at face value. The bonds have a stated interest rate of 6 percent. The bonds mature in 10 years and pay interest once per year on December 31. Required: Prepare the journal entry to record the bond issuance. Prepare the journal entry to record the interest payment on December 31, Assume no interest has been accrued earlier in the year. Assume the bonds were retired immediately after the first interest payment at a quoted price of 101. Prepare the journal entry to record the early retirement of the bonds. E10-8 Preparing Journal Entries to Record Issuance of Bonds at Face Value, Payment of Interest, and Early Retirement On January 1, 2013, Innovative Solutions, Inc., issued $200,000 in bonds at face value. The bonds have a stated interest rate of 6 percent. The bonds mature in 10 years and pay interest once per year on December 31. Required: Prepare the journal entry to record the bond issuance. Prepare the journal entry to record the interest payment on December 31, Assume no interest has been accrued earlier in the year. Assume the bonds were retired immediately after the first interest payment at a quoted price of 101. Prepare the journal entry to record the early retirement of the bonds.

63 E10-8 Preparing Journal Entries to Record Issuance of Bonds at Face Value, Payment of Interest, and Early Retirement Req. 1 dr Cash (+A) 200,000  cr Bonds Payable (+L) 200,000 Req. 2  dr Interest Expense (+E, -SE) 12,000 cr Cash (-A) 12,000 ($200,000 x 6% x 12/12) = $12,000 Part I Requirement number 1 – the proper journal entry is to debit, or increase, the asset account, Cash for $200,000, and credit, or increase, the liability account, Bonds Payable for the same amount. Part II Requirement number 2 – the journal entry starts with a debit, or increase, to the expense account, Interest Expense for $12,000, and a credit, or decrease, to the asset account, Cash, for $12,000. This represents one year of interest on the $200,000 face amount of the bonds at 6 percent interest. Requirement number 3 – The journal entry should start with a debit, or decrease, in the liability account, Bonds Payable for $200,000, a debit, or increase, to the expense account, Loss on Bonds Retired, for $2,000, and a credit, or decrease, to the asset account Cash for $202,000. Req. 3 dr Bonds Payable (-L) 200,000 dr Loss on Bonds Retired (+E, -SE) 2,000   cr Cash (-A) ,000 ($200,000 x 101%) = $202,000

64 E10-10 Calculating and Interpreting the Quick Ratio and Times Interest Earned Ratio
At December 31, 2010, Kraft Foods Inc. reported no short-term investments but did report the following amounts (in millions) in its financial statements: Required: Compute the quick ratio and times interest earned ratio (to two decimal places) for 2010 and 2009. Did Kraft appear to have increased or decreased its ability to pay current liabilities and future interest obligations as they become due? E10-10 Calculating and Interpreting the Quick Ratio and Times Interest Earned Ratio At December 31, 2010, Kraft Foods Inc. reported no short-term investments but did report the following amounts (in millions) in its financial statements shown in the table on your screen. Required: Compute the quick ratio and times interest earned ratio (to two decimal places) for 2010 and 2009. Did Kraft appear to have increased or decreased its ability to pay current liabilities and future interest obligations as they become due?

65 E10-10 Calculating and Interpreting the Quick Ratio and Times Interest Earned Ratio
Req. 1 = = $2,481 + $6,539 $15,660 = = $2,101 + $5,197 $11,491 Req. 2 Part I Recall the equation for calculating the Quick Ratio – We divide the company’s quick assets by current liabilities. Part II In 2010, the quick ratio was 0.58, which means the company had 58 cents in liquid assets for each one dollar in current liabilities. Part III In 2009, the quick ratio was higher at 0.64, which means the company had 64 cents in liquid assets for each one dollar in current liabilities. Requirement number 2 – Requires us to calculate the Times Interest Earned Ratio. As you can see on the screen, we have shown the equation for calculating the Times Interest Earned Ratio to help you with the exercise. Part IV In 2010, the Times Interest Earned was 3.60, which means the company was able to earn $3.60 dollars for every one dollar in interest expense. Part V In 2009, the company shows a Times Interest Earned Ratio of 4.36, which means it was able to earn $4.36 for each one dollar in interest expense. The times interest earned weakened from 2009 to 2010). This is not a good trend from the viewpoint of the debt holders. = ($4, $ 2, $1,147) ÷ $2,024 = 3.60 = ($3, $ 1, $1,136) ÷ $1,237 = 4.36

66 PA10-3 Recording and Reporting Current Liabilities
During 2013, Lakeview Company completed the following two transactions. The annual accounting period ends December 31. On December 31, 2013, calculated the payroll, which indicates gross earnings for wages ($80,000), payroll deductions for income tax ($8,000), payroll deductions for FICA ($6,000), payroll deductions for American Cancer Society ($3,000), employer contributions for FICA (matching), state unemployment taxes ($500), and federal unemployment taxes ($100). Employees were paid in cash, but these payments and the corresponding payroll deductions and employer taxes have not yet been recorded. Collected rent revenue of $6,000 on December 10, 2013, for office space that Lakeview rented to another business. The rent collected was for 30 days from December 11, 2013, to January 10, 2014, and was credited in full to Unearned Rent Revenue. Required: Give the journal entries to record payroll on December 31, 2013. Give ( a ) the journal entry for the collection of rent on December 10, 2013, and ( b ) the adjusting journal entry on December 31, 2013. Show how any liabilities related to these items should be reported on the company’s balance sheet at December 31, 2013. PA10-3 Recording and Reporting Current Liabilities During 2013, Lakeview Company completed the following two transactions. The annual accounting period ends December 31. On December 31, 2013, calculated the payroll, which indicates gross earnings for wages ($80,000), payroll deductions for income tax ($8,000), payroll deductions for FICA ($6,000), payroll deductions for American Cancer Society ($3,000), employer contributions for FICA (matching), state unemployment taxes ($500), and federal unemployment taxes ($100). Employees were paid in cash, but these payments and the corresponding payroll deductions and employer taxes have not yet been recorded. Collected rent revenue of $3,600 on December 10, 2013, for office space that Lakeview rented to another business. The rent collected was for 30 days from December 11, 2013, to January 10, 2014, and was credited in full to Unearned Rent Revenue. Required: Give the journal entries to record payroll on December 31, 2013. Give ( a ) the journal entry for the collection of rent on December 10, 2013, and ( b ) the adjusting journal entry on December 31, 2013. Show how any liabilities related to these items should be reported on the company’s balance sheet at December 31, 2013. Explain why the accrual basis of accounting provides more relevant information to financial analysts than the cash basis.

67 dr Wage Expense (+E, -SE) 80,000
PA10-3 Recording and Reporting Current Liabilities Req. 1 dr Wage Expense (+E, -SE) 80,000  cr Withheld Income Tax Payable (+L) 8,000  cr FICA Payable (+L) ,000  cr American Cancer Society Payable (+L) 3,000  cr Cash (-A) ,000 dr Payroll Tax Expense (+E, -SE) 6,600  cr FICA Payable (+L) ,000  cr State Unemployment Tax Payable (+L)  cr Federal Unemployment Tax Payable (+L) Req. 2 (a) December 10, 2013: dr Cash (+A) 6,000   cr Unearned Rent Revenue (+L) 6,000 Part I Requirement number 1 – Requires us to prepare the journal entries for the wages expense owed to employees and the payroll tax expense paid by the employer. Part II The entry to record payroll to pay employees begins with a debit, or increase, to the expense account, Wages Expense for $80,000, next, credit, or increase, the liability account Withheld Income Tax Payable for $8,000, credit the liability account, FICA Payable for $8,000, credit, or increase, the liability account, American Cancer Society Payable for $3,000, and credit the asset account Cash for $63,000. Part III Next, we record the journal entry for the employer’s payroll tax expense. We begin with a debit, or increase, to the expense account, Payroll Tax Expense for $6,600, we credit, or increase, the liability account FICA Payable for the employer’s matching amount for what the employees had withheld from their paychecks, credit the liability account State Unemployment Tax Payable for $500, and credit the liability account, Federal Unemployment Tax Payable for $100. Part IV Requirement number 2 – requires us to record the unearned revenue on December 10, 2013 and then record the earned portion as of December 31, 2013 Part V The journal entry is to debit, or increase, the asset account Cash for $6,000 and credit, or increase, Unearned Rent Revenue by the same amount. At the end of the month the company must adjust the Unearned Rent Revenue account to record rent earned. Part VI The adjusting entry at the end of December is to debit, or reduce the Unearned Rent Revenue account for $4,000, and credit, or increase, the Rent Revenue account for $4,000. Collection of rent revenue for one month. (b) December 31, 2013: dr Unearned Rent Revenue (-L) 4,000   cr Rent Revenue (+R, +SE) 4,000 Earned 20 days of rent and initially recorded all as unearned. Need to reduce unearned revenue for the 20 days and record it as earned revenue (20/30 x $6,000 = $4,000).

68 Balance sheet at December 31, 2013: Current Liabilities:
PA10-3 Recording and Reporting Current Liabilities Req. 3 Balance sheet at December 31, 2013: Current Liabilities:   Withheld Income Taxes Payable 8,000  FICA Payable 12,000  American Cancer Society Payable 3,000  State Unemployment Tax Payable  Federal Unemployment Tax Payable  Unearned Rent Revenue 2,000 Part I Requirement number 3 – Requires us to show the presentation of the current liability accounts at year-end. As you can see, the balance of $12,000 in the FICA Payable account represents $6,000 withheld from the employee’s paycheck, and $6,000 as the employer’s matching amount of $6,000. The rest of the balances were taken straight from our journal entries.

69 End of Chapter 10 End of chapter 10.


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