©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Current and Long-Term Liabilities Chapter 8

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Learning Objective 1 Account for current liabilities and contingent liabilities.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Current Liabilities Current liabilities are obligations due within one year or within the company’s normal operating cycle if it is longer than one year. Known amount Amount must be estimated

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Current Liabilities Accounts payable Short-term notes payable Sales tax payable Current portion of long-term debt Accrued expenses Payroll liabilities Unearned revenues

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Current Liabilities Accounts payable are amounts owed to suppliers for goods or services purchased on account. Short-term notes payable are notes payable due within one year.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Short-Term Notes Payable In addition to recording the note payable, the business must also pay interest expense. On January 30, a business purchased inventory for $8,000 by issuing a 1-year, 10% note payable. The fiscal year ends on April 30.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Short-Term Notes Payable January 30 Inventory8,000 Notes Payable8,000 Purchase of inventory by issuing a one-year, 10% note How much interest was accrued as of April 30? $8,000 × 10% × (3/12) = $200

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Short-Term Notes Payable How is the payment at maturity recorded? January 30 Note Payable8,000 Interest Payable 200 Interest Expense 600 Cash8,800 $8,000 × 10% × (9/12) = $600

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Sales Tax Payable Suppose one day’s sales at a Home Depot Store totaled $200,000. Suppose one day’s sales at a Home Depot Store totaled $200,000. How is the day’s sales recorded? The business collected an additional 5% in sales tax. The business collected an additional 5% in sales tax.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Sales Tax Payable Cash ($200,000 × 1.05)210,000 Sales Revenue200,000 Sales Tax Payable ($200,000 ×.05) 10,000 To record cash sales and the related sales tax Cash ($200,000 × 1.05)210,000 Sales Revenue200,000 Sales Tax Payable ($200,000 ×.05) 10,000 To record cash sales and the related sales tax

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Current Installment of Long-Term Debt It is the amount of the principal that is payable within one year. At the end of the year, a company reclassifies the amount of its long-term debt that must be paid during the upcoming year.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Accrued Expenses These are expenses that have been incurred but not recorded. These are expenses that have been incurred but not recorded. Salaries Taxes withheld Interest Utilities Salaries Taxes withheld Interest Utilities

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Payroll Liabilities Salary Expense10,000 Employee Income Tax Payable1,200 FICA Tax Payable 800 Salary Payable8,000 To record salary expense

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Unearned Revenues The Dun & Bradstreet (D&B) Corporation provides credit evaluation services to subscribers. The Dun & Bradstreet (D&B) Corporation provides credit evaluation services to subscribers. What are the entries? Assume that D&B charges a client $750 for a three-year subscription. Assume that D&B charges a client $750 for a three-year subscription.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Unearned Revenues January 1 Cash750 Unearned Revenue750 To receive cash for a three-year subscription December 31 Unearned Revenue250 Subscription Revenue250 To record revenue earned at the end of the year

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Unearned Revenues December 31, Balance SheetYear 1Year 2Year 3 Current liabilities: Unearned subscription revenue$250$250$-0- Long-term liabilities: Unearned subscription revenue$250$-0-$-0- Income StatementYear 1Year 2Year 3 Revenues: Subscription revenue$250$250$250

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Current Liabilities That Must Be Estimated Estimated Warranty Payable Assume that Black & Decker made sales of $200,000,000 subject to product warranties. What is the estimated warranty expense? Black & Decker estimates that 3% of the products it sells this year will require repair or replacement.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Estimated Warranty Payable $200,000,000 ×.03 = $6,000,000 Warranty Expense6,000,000 Estimated Warranty Payable6,000,000 To accrue warranty expense Warranty Expense6,000,000 Estimated Warranty Payable6,000,000 To accrue warranty expense

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Estimated Warranty Payable Assume that defective merchandise totals $5,800,000. Estimated Warranty Payable5,800,000 Inventory5,800,000 To replace defective products sold under warranty Black & Decker will replace it and record the following:

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Contingent Liabilities They are a potential liability that depends on a future event arising out of past events. They are a potential liability that depends on a future event arising out of past events. 1. Record an actual liability if it is probable that the loss will occur and the amount can be reasonably estimated. 1. Record an actual liability if it is probable that the loss will occur and the amount can be reasonably estimated.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Contingent Liabilities 2. Report a contingent liability in the notes to the financial statement if it is reasonably possible that a loss or expense will occur. 2. Report a contingent liability in the notes to the financial statement if it is reasonably possible that a loss or expense will occur. 3. There is no reason to report a contingent loss that is remote – unlikely to occur. 3. There is no reason to report a contingent loss that is remote – unlikely to occur.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Bonds: An Introduction A bond is an interest bearing long-term note payable. A bond is an interest bearing long-term note payable. Bonds are groups of notes payable issued to multiple lenders called bondholders. Bonds are groups of notes payable issued to multiple lenders called bondholders. Principal Interest rate Payment dates

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Types of Bonds Term bonds Serial bonds Secured, or mortgage, bonds Unsecured bonds (debentures)

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Bond Prices Bond prices are quoted at a percent of their maturity value. A quote of 101½ means that a $1,000 bond sells for $1,000 × = $1,015. A $1,000 bond quoted at 88 3 / 8 is priced at $1,000 × = $

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Bond Prices A bond issued at a price above its face (par) value is issued at a premium. A bond issued at a price below face (par) value has a discount. As a bond nears maturity, its market price moves toward par value.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Present Value The amount invested today receives a greater amount at a future date, which is called the present value of a future amount. the amount of the future receipt. the length of time to the future receipt. the interest rate for the period.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Bond Interest Rates Bonds are sold at market price, which is the amount that investors are willing to pay at any given time. present value of the principal to be received at maturity. present value of periodic interest payments.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Bond Interest Rates Contract rate (stated rate) Market rate (effective rate)

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Learning Objective 2 Account for bonds payable transactions.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Issuing Bonds Payable at Par Value On January 1, Chrysler Corporation issued $50,000,000 of 9%, 5-year bonds at par. On January 1, Chrysler Corporation issued $50,000,000 of 9%, 5-year bonds at par. January 1 Cash50,000,000 Bonds Payable50,000,000 To issue 9%, 5-year bonds at par January 1 Cash50,000,000 Bonds Payable50,000,000 To issue 9%, 5-year bonds at par

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Issuing Bonds Payable at Par Value What is the entry for the interest payment of July 1? $50,000,000 × 9% × 6/12 = $2,250,000 July 1 Interest Expense2,250,000 Cash2,250,000 To pay semiannual interest July 1 Interest Expense2,250,000 Cash2,250,000 To pay semiannual interest

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Issuing Bonds Payable at Par Value What is the entry to accrue interest on December 31? $50,000,000 × 9% × 6/12 = $2,250,000 December 1 Interest Expense2,250,000 Interest Payable 2,250,000 To accrue interest December 1 Interest Expense2,250,000 Interest Payable 2,250,000 To accrue interest

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Chrysler issues $100,000 of its 9%, five-year bonds when the market interest rate is 10%. Cash96,149 Discount on Bonds Payable 3,851 Bonds Payable100,000 To issue 9%, 5-year bonds at a discount Issuing Bonds Payable at a Discount Chrysler receives $96,149 at issuance.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Issuing Bonds Payable at a Discount Chrysler’s balance sheet immediately after issuance of the bonds: Total current liabilities$ XXX Long-term liabilities: Bonds payable, 9%, due 2009$100,000 Discount on bonds payable – 3,851$96,149 Discount on Bonds Payable is a contra account to Bonds Payable, a decrease in liabilities.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Learning Objective 3 Measure interest expense.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Amortization Table on Bonds Issued at a Discount 1/1/04 7/1/04 1/1/05 7/1/05 1/1/09 $4,500 4,500 $4,807 4,823 4,839 4,961 $ $3,851 3,544 3,221 2, $ 96,149 96,456 96,779 97, ,000 Interest Date Interest Payment Interest Expense Discount Amort. Discount Account Balance Bond Carrying Amount

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Interest Expense on Bonds Issued at a Discount On July 1, 2004, Chrysler makes the first $4,500 semiannual interest payment and also amortizes (decreases) the bond discount. July 1, 2004 Interest Expense4,807 Discount on Bonds Payable 307 Cash4,500 To pay semiannual interest and amortize bond discount

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Interest Expense on Bonds Issued at a Discount At December 31, 2004, Chrysler accrues interest and amortizes the bond discount for July through December. December 31, 2004 Interest Expense4,823 Discount on Bonds Payable 323 Interest Payable4,500 To accrue semiannual interest and amortize bond discount

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Interest Expense on Bonds Issued at a Discount Bonds Payable Discount on Bonds Payable 100,0003, July Dec. 31 3,221 Bond carrying amount: $100,000 – $3,221 = $96,779 Chrysler’s bond accounts as of December 31, 2004.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Chrysler Corporation issues $100,000 of 9%, five-year bonds when the market interest rate is 8%. Cash104,100 Bonds Payable100,000 Premium onBonds Payable 4,100 To issue 9% bonds at a premium Issuing Bonds Payable at a Premium Chrysler receives $104,100 at issuance.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Issuing Bonds Payable at a Premium Chrysler’s balance sheet immediately after issuance of the bonds: Total current liabilities$ XXX Long-term liabilities: Bonds payable$100,000 Premium on bonds payable 4,100 $104,100 Premium on Bonds Payable is added to the Balance of Bonds Payable to determine the carrying amount.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Amortization Table on Bonds Issued at a Premium 1/1/04 7/1/04 1/1/05 7/1/05 1/1/09 $4,500 4,500 $4,164 4,151 4,137 3,955 $ $4,100 3,764 3,415 3, $104, , , , ,000 Interest Date Interest Payment Interest Expense Premium Amort. Premium Account Balance Bond Carrying Amount

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Interest Expense on Bonds Issued at a Premium On July 1, 2004, Chrysler makes the first $4,500 semiannual interest payment and also amortizes (decreases) the bond premium. July 1, 2004 Interest Expense4,164 Premium on Bonds Payable 336 Cash4,500 To pay semiannual interest and amortize bond premium

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Straight-Line Amortization This method amortizes the bond discount or premium by dividing it into equal amounts for each interest period. Chrysler would amortize the $4,100 premium over 10 periods. $4,100 ÷ 10 = $410 per period

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Early Retirement of Bonds Payable Air Products and Chemicals, Inc., has $70 million of debenture bonds outstanding with unamortized discount of $350,000. The market price is 99¼. Par value of bonds being retired$70,000,000 Less: Unamortized discount – 350,000 Carrying amount of the bonds$69,650,000 Market price ($70,000,000 × ) 69,475,000 Extraordinary gain on retirement$ 175,000

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Convertible Bonds and Notes Texas Instruments has convertible notes payable of $250,000,000. Notes Payable125,000,000 Common Stock 4,000,000 Paid-in Capital121,000,000 To record conversion of notes payable Assume that noteholders convert half the notes into 4 million shares, $1 par common stock.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Learning Objective 4 Understand the advantages and disadvantages of borrowing.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Financing Operations With Bonds or Stocks Issuing Stock Issuing Notes or Bonds Creates no liabilities or interest expense Less risky to the issuing corporation Does not dilute stock ownership or control of the corporation Results in higher earnings per share because the earnings on borrowed money usually exceeds interest expense

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Financing Operations With Bonds or Stocks Suppose a corporation needs $500,000 for expansion. Plan 1 is to issue $500,000 of 10% bonds payable. Plan 2 is to issue 50,000 shares of common stock for $500,000. It has net income of $300,000 and 100,000 shares of common stock outstanding. Management is considering two financing plans:

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Financing Operations With Bonds or Stocks Net income before expansion$300,000 Project income before interest and taxes$200,000 Less interest expense ($500,000 × 0.10) – 50,000 Project income before income tax$150,000 Less income tax expense (40%) – 60,000 Expected project net income 90,000 Total company net income$390,000 Earnings per share after expansion: ($390,000/100,000 shares) $3.90 Plan 1: Borrow $500,000 at 10%

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Financing Operations With Bonds or Stocks Net income before expansion$300,000 Project income before interest and taxes$200,000 Less interest expense 0 Project income before income tax$200,000 Less income tax expense (40%) – 80,000 Expected project net income 120,000 Total company net income$420,000 Earnings per share after expansion: ($420,000/150,000 shares) $2.80 Plan 2: Issue 50,000 Shares of Common Stock for $500,000

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Long-Term Liabilities: Leases and Pensions A lease is a rental agreement in which the tenant (lessee) agrees to make rent payments to the property owner (lessor). Operating Capital

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Long-Term Liabilities: Leases and Pensions It transfers title at the end of the term. The present value of the lease payments is 90% or more of the market value of the leased asset. It contains a bargain purchase option. The lease terms cover 75% or more of the estimated useful life of the leased asset.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Long-Term Liabilities: Leases and Pensions Companies record pension and retirement benefit expenses while employees work for the company. Companies record pension and retirement benefit expenses while employees work for the company. At the end of each period, the company compares the fair market value of the assets in the pension plan – cash and investments – with the plan’s accumulated benefit obligation. At the end of each period, the company compares the fair market value of the assets in the pension plan – cash and investments – with the plan’s accumulated benefit obligation.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Long-Term Liabilities: Leases and Pensions If the accumulated benefit obligation exceeds plan assets, the plan is underfunded, and the company must report the excess liability amount as a long-term pension liability on the balance sheet. If the accumulated benefit obligation exceeds plan assets, the plan is underfunded, and the company must report the excess liability amount as a long-term pension liability on the balance sheet.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Learning Objective 5 Report liabilities on the balance sheet.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Reporting Liabilities Accounts payable$1,976 Accrued salaries and related expenses 627 Sales tax payable 298 Other accrued expenses 1,402 Income taxes payable 78 Current installments of long-term debt 4 Total current liabilities$4,385 Long-term debt 1,545 Other long-term liabilities 451 Amounts in millions

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Reporting Fair Market Value of Long-Term Debt FASB Statement No. 107 requires companies to report the fair market value of their financial instruments, which includes long-term debt.

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren Reporting Financing Activities on the Statement of Cash Flows Cash Flow from Financing Activities: Borrowing by using commercial paper$754 Proceeds from long-term borrowings 32 Payment of long-term debt (29) Proceeds from issuance of common stock 351 Payments of cash dividends (371) Other, net (4) Net cash provided by financing activities$733 Amounts in millions Year Ended December 31

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren End of Chapter 8