1. McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. Liabilities Chapter 10

2. 10-2 The Nature of Liabilities Defined as present obligations arising from past events. Their settlement is expected to result in an outflow of resources. Maturity = 1 year or lessMaturity > 1 year Current Liabilities Noncurrent Liabilities

3. 10-3 Distinction Between Debt and Equity The acquisition of assets is financed from two sources: Funds from creditors, with a definite due date, and sometimes bearing interest. Funds from owners.

4. 10-4 Provisions Provisions have two basic characteristics: 1.The liability is known to exist, 2.The precise dollar amount cannot be determined until a later date. Provisions have two basic characteristics: 1.The liability is known to exist, 2.The precise dollar amount cannot be determined until a later date. Example: An automobile warranty obligation.

5. 10-5 Short-term obligations to suppliers for purchases of goods and to others for goods and services. inventory invoices Shipping charges Utility and phone bills Office supplies invoices Current Liabilities: Accounts Payable Examples

6. 10-6 Total Notes Payable Current Notes Payable Noncurrent Notes Payable When a company borrows money, a note payable is created. Current Portion of Notes Payable The portion of a note payable that is due within one year, or one operating cycle, whichever is longer. When a company borrows money, a note payable is created. Current Portion of Notes Payable The portion of a note payable that is due within one year, or one operating cycle, whichever is longer. Current Liabilities: Notes Payable

7. 10-7 Current Liabilities: Notes Payable PROMISSORY NOTE Location Date after this date promises to pay to the order of the sum of with interest at the rate of per annum. Hong Kong1 Nov. 2010 Six monthsPorter Company John Caldwell Security National Bank $100,000.00 12.0% Treasurer and Senior VP Signed: Title:

8. 10-8 Accrued Liabilities Accrued liabilities arise from the recognition of expenses for which payment will be made in the future. Accrued liabilities are often referred to as accrued expenses. Examples include: 1.Interest payable, 2.Taxes payable, and 3.Accrued payroll liabilities.

9. 10-9 Net Pay Payroll Liabilities Medical care Taxes Unemployment Taxes Social Security Taxes Income Tax Voluntary Deductions Gross Pay

10. 10-10 a liability account. Cash is received in advance. Cash is sometimes collected from the customer before the revenue is actually earned. Unearned Revenue As the earnings process is completed

11. 10-11 Relatively small debt needs can be filled from single sources. Banks Insurance CompaniesPension Plans oror Noncurrent Liabilities

12. 10-12 Large debt needs are often filled by issuing bonds. Noncurrent Liabilities

13. 10-13 Maturing Obligations Intended to be Refinanced One special type of noncurrent liability is an obligation that will mature in the current period but that is expected to be refinanced on a noncurrent basis. If management has both the intend and ability to refinance soon-to-mature obligations on a noncurrent basis, these obligations are classified as noncurrent liabilities.

14. 10-14 With each payment, the interest portion gets smaller and the principal portion gets larger. Installment Notes Payable Each payment covers interest for the period AND a portion of the principal. Long-term notes that call for a series of installment payments.

15. 10-15 Allocating Installment Payments Between Interest and Principal 1. Identify the unpaid principal balance. 2. Interest expense = Unpaid Principal × Interest rate. 3. Reduction in unpaid principal balance = Installment payment – Interest expense. 4. Compute new unpaid principal balance. On 1 January, Year 1, King’s Inn purchased furnishings at a cost of $75,815.7. The loan was a five-year loan and had an interest rate of 10%. The annual payment is $20,000. Let’s prepare an amortization table for King’s Inn. On 1 January, Year 1, King’s Inn purchased furnishings at a cost of $75,815.7. The loan was a five-year loan and had an interest rate of 10%. The annual payment is $20,000. Let’s prepare an amortization table for King’s Inn.

16. 10-16 Allocating Installment Payments Between Interest and Principal DatePayment Interest Expense Reduction in Unpaid Balance Unpaid Balance 1 Jan. Year 1. $ 75,815.7 31 Dec. Year 1 $ 20,000.00 $ 7,581.6 $ 12,418.4 63,397.3 31 Dec. Year 2 20,000.00 6,339.7 13,660.3 49,737.0 31 Dec. Year 3 20,000.00 4,973.7 15,026.3 34,710.7 31 Dec. Year 4 20,000.00 3,471.1 16,528.9 18,181.8 31 Dec. Year 5 20,000.00 1,818.2 18,181.8 0.00 $75,815.7 × 10% = $7,581.6 $20,000 - $7,581.6 = $12,418.4 $75,815.7 - $12,418.4 = $63,3973

17. 10-17 Using the Amortization Table DateDescriptionDebitCredit 31Dec.Interest Expense7,581.6 Interest Payable 7,581.6 The information needed for the journal entry can be found on the amortization table. The cash payment amount, the interest expense, and the principal reduction amount are all in the table.

18. 10-18 Using the Amortization Table DateDescriptionDebitCredit 1 Jan.Interest Payable7,581.6 Note Payable12,418.4 Cash 20,000.00 On 1 January, Year 2, the first annual payment will be made on the installment note. Refer to the previous entry and amortization for the amounts shown.

19. 10-19 Bonds Payable principal Bonds usually involve the borrowing of a large sum of money, called principal. lump sum The principal is usually paid back as a lump sum at the end of the bond period. face value Individual bonds are often denominated with a par value, or face value, of $10,000 or some multiple of $10,000. principal Bonds usually involve the borrowing of a large sum of money, called principal. lump sum The principal is usually paid back as a lump sum at the end of the bond period. face value Individual bonds are often denominated with a par value, or face value, of $10,000 or some multiple of $10,000.

20. 10-20 Bonds Payable contract rate Bonds usually carry a stated rate of interest, also called a contract rate. Interest is normally paid semiannually. Interest is computed as: Principal × Stated Rate × Time = Interest

21. 10-21 Bonds Payable underwriter Bonds are issued through an intermediary called an underwriter. Bonds can be sold on organized securities exchanges. percentage Bond prices are usually quoted as a percentage of the face amount. For example, a $10,000 bond priced at 102 would sell for $10,200.

22. 10-22 Mortgage Bonds Convertible Bonds Junk Bonds Debenture Bonds Types of Bonds

23. 10-23 On 1 March 2010, Wells Corporation issues $15,000,000 of 12%, 10-year bonds payable. Interest is payable semiannually, each 1 March and 1 September. Assume the bonds are issued at face value. Record the issuance of the bonds. On 1 March 2010, Wells Corporation issues $15,000,000 of 12%, 10-year bonds payable. Interest is payable semiannually, each 1 March and 1 September. Assume the bonds are issued at face value. Record the issuance of the bonds. Accounting for Bonds Payable DateDescriptionDebitCredit 1 Mar.Cash 15,000,000 Bonds Payable 15,000,000

24. 10-24 Record the interest payment on 1 September 2010. Accounting for Bonds Payable $15,000,000 × 12% × ½ = $900,000

25. 10-25 Bonds Issued Between Interest Dates Bonds are often sold between interest dates. Bonds are often sold between interest dates. The selling price of the bond is computed as: The selling price of the bond is computed as:

26. 10-26 Bonds Issued at a Discount or Premium The selling price of the bond is determined by the market based on the time value of money.

27. 10-27 Bonds Issued at a Discount Wells, Corp. issues bonds on 1 January 2010. Principal = $10,000,000 Issue price = $9,500,000 Stated Interest Rate = 9% Interest Dates = 30/6 and 31/12 Maturity Date = 31 Dec., 2029 (20 years) Wells, Corp. issues bonds on 1 January 2010. Principal = $10,000,000 Issue price = $9,500,000 Stated Interest Rate = 9% Interest Dates = 30/6 and 31/12 Maturity Date = 31 Dec., 2029 (20 years)

28. 10-28 Bonds Issued at a Discount To record the bond issue, Wells Corporation would make the following entry on 1 January, 2010:

29. 10-29 Maturity Value Carrying Amount Bonds Issued at a Discount

30. 10-30 Amortizing the discount over the term of the bond increases Interest Expense each interest payment period. Bonds Issued at a Discount Using the straight-line method, the discount amortization will be $12,500 every six months. $500,000 ÷ 40 periods = $12,500 Using the straight-line method, the discount amortization will be $12,500 every six months. $500,000 ÷ 40 periods = $12,500

31. 10-31 Amortization of the Discount We prepare the following journal entry to record the first interest payment. $450,000 $10,000,000 × 9% × ½ = $450,000 Interest paid every six months is calculated as follows:

32. 10-32 Maturity Value Carrying Amount $500,000 – $12,500 – $12,500 The carrying amount will increase to exactly $10,000,000 on the maturity date. Bonds Issued at a Discount

33. 10-33 Wells Corporation will repay the principal amount on 31 December 2029 with the following entry: Bonds Issued at a Discount

34. 10-34 The Concept of Present Value How much is a future amount worth today? Present Value Future Value Interest compounding periods Today

35. 10-35 Two types of cash flows are involved with bonds: Today  Principal payment at maturity is a lump sum payment.  Periodic interest payments called annuities. Maturity The Concept of Present Value

36. 10-36 Early Retirement of Debt Gains or losses incurred as a result of retiring bonds should be reported as other income or other expense on the income statement.

37. 10-37 Contingent Liabilities A contingent liability is a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity Two factors affect whether a contingent loss must be accrued and reported as a liability: 1.The likelihood that the confirming event will occur. 2.Whether the loss amount can be reasonably estimated. Two factors affect whether a contingent loss must be accrued and reported as a liability: 1.The likelihood that the confirming event will occur. 2.Whether the loss amount can be reasonably estimated.

38. 10-38 Evaluating the Safety of Creditors’ Claims This ratio indicates a margin of protection for creditors. From the creditor’s point of view, the higher this ratio, the better. Operating Profit Interest Expense Interest Coverage Ratio =

39. 10-39 End of Chapter 10