Financial Accounting, 5e California State University, Los Angeles Weygandt, Kieso, & Kimmel Prepared by Kurt M. Hull, MBA CPA California State University, Los Angeles John Wiley & Sons, Inc. 1

CHAPTER 11 LIABILITIES STUDY OBJECTIVES After studying this chapter, you should understand: Major types of current liabilities Entries for bond issuance and interest expense Accounting for notes payable Entries for bond redemption other current liabilities long-term notes payable The purpose of bonds, and major types of bonds Presentation and analysis of long-term liabilities

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

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

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

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

INTEREST ACCRUAL NOTES PAYABLE June 30 Interest Expense 4,000 General Journal Date Account Titles Debit Credit June 30 Interest Expense 4,000 Interest Payable 4,000 If Cole Williams Co. prepares financial statements semiannually, an adjusting entry is required to recognize interest expense and interest payable of $4,000 at June 30. 5

MATURITY DATE NOTES PAYABLE July 1 Notes Payable 100,000 General Journal Date Account Titles Debit Credit July 1 Notes Payable 100,000 Interest Payable 4,000 Cash 104,000 When the loan is paid, the FACE VALUE is debited, any interest accrued is removed, and cash is decreased by this combined amount. 6

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

OTHER CURRENT LIABILITIES STUDY OBJECTIVE 3 OTHER CURRENT LIABILITIES SALES TAXES PAYABLE Sales tax is expressed as a stated percentage of the sales price on goods sold to customers by a retailer. The retailer collects the tax from the customer when the sale occurs. Retailer periodically remits the collections to the state’s department of revenue. Retailer is a collection agent for the tax authority. 7

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

EXTRACTING SALES TAX FROM TOTAL RECEIPTS If Cooley Grocery “rings up” total receipts of $10,600, and the sales tax percentage is 6%, we can figure sales as follows: $10,600 / 1.06 = $10,000 Total receipts – Sales = Tax collected $10,600 - $10,000 = $600 9

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

PAYROLL DEDUCTIONS

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

EMPLOYER PAYROLL TAXES 21

UNEARNED REVENUES Unearned Revenues occur when a company receives cash before a service is rendered. Examples: Airline sells a ticket for future flights Attorney receives legal fees before work is done. 10

UNEARNED REVENUES CASH RECEIPT General Journal Date Account Titles Debit Credit Aug. 6 Cash 500,000 Unearned Football Ticket Revenue 500,000 Superior University sells 10,000 season football tickets at $50 each for its five-game home schedule.

UNEARNED REVENUES EARNINGS DATE General Journal Date Account Titles Debit Credit Sept. 7 Unearned Football Ticket Revenue 100,000 Football Ticket Revenue 100,000 As each game is completed, Unearned Football Ticket Revenue is debited for 1/5 of the unearned revenue. The earned revenue, Football Ticket Revenue, is credited. 12

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

That portion of long-term debt Classified as a current liability CURRENT MATURITIES OF LONG-TERM DEBT That portion of long-term debt due within 1 year. Classified as a current liability on the balance sheet 13

FINANCIAL STATEMENT PRESENTATION 14

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

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

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

ADVANTAGES OF BOND FINANCING OVER STOCK

EFFECTS ON EPS BONDS VS. STOCK

TYPES OF BONDS Bond Type Distinguishing characteristics Secured Backed by specific assets Unsecured Backed by credit of issuer (debentures) Term Paid at end of specified term Serial Paid in installments Registered Issued in name of specific holder Bearer Not registered. (Coupon bonds) Convertible Can be converted to common stock Callable Can be retired before maturity

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

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

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

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

BOND INTEREST ACCRUAL $1,000,000 x 9% x 6/12 = $45,000 Assume that interest is payable semi-annually on January 1 and July 1. Next payment Is due July 1, 2006. At December 31, 2005 the entry to accrue interest is: Date Account Debit Credit Dec 31 Bond Interest Expense 45,000 Bond Interest Payable 45,000 (record sale of bonds at face value) $1,000,000 x 9% x 6/12 = $45,000

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

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

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

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

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

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

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

REVIEW QUESTION BONDS SOLD AT A PREMIUM On January 1, Dias Corporation issued $1,000,000, 14%, 5-year bonds with interest payable on July 1 and January 1. the bonds sold for $1,098,540. The market rate of interest was 12%. On the first interest date, using the effective interest method, what is the debit to bond interest expense? Answer: $1,098,540 x 6% = $65,192

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

REDEEMING BONDS BEFORE MATURITY Assume the bonds were sold at a premium. At the end of the eight interest period, Candlestick retires the bonds for $103,000. Carrying value on date of redemption is $106,123 The entry to retire the bonds is: Date Account Debit Credit Jan 1 Bonds Payable 100,000 Premium on Bonds Payable 1,623 Loss on Bond Redemption 1,377 Cash 103,000 (record redemption and loss prior to maturity) Loss calculation: Cash paid – carrying value $103,000 - $106,123

CONVERTING BONDS TO COMMON STOCK Market prices of the bonds and the stock are ignored. The carrying value of the bonds is transferred to capital. No gain or loss is recognized. On July 1 Saunders Associates converts $100,000 bonds sold at face value into 2,000 shares of $10 par value common stock. Both the bonds and the common stock have a market value of $130,000. The entry to record the conversion is: Date Account Debit Credit July 1 Bonds Payable 100,000 Common Stock 20,000 Paid in capital in excess of par 80,000 (record bond conversion)

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

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

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

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

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

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