Financial Accounting, 3e Weygandt, Kieso, & Kimmel Prepared by Gregory K. Lowry Mercer University Marianne Bradford The University of Tennessee John Wiley & Sons, Inc.

CHAPTER 11 LIABILITIES After studying this chapter, you should be able to: 1 Explain a current liability and identify the major types of current liabilities. 2 Describe the accounting for notes payable. 3 Explain the accounting for other current liabilities. 4 Explain why bonds are issued and identify the types of bonds.

CHAPTER 11 LIABILITIES After studying this chapter, you should be able to: 5 Prepare the entries for the issuance of bonds and interest expense. 6 Describe the entries when bonds are redeemed or converted. 7 Describe the accounting for long-term notes payable. 8 Identify the methods for the financial statement presentation and analysis of long-term liabilities.

Long-Term Liabilities PREVIEW OF CHAPTER 11 Long-Term Liabilities Bond basics Accounting for bond issues Accounting for bond retirements Accounting for long-term note payable Statement presentation and analysis Current Liabilities Notes payable Sales taxes payable Payroll and payroll taxes Unearned revenues Current maturities of long-term debt LIABILITIES

CURRENT LIABILITIES A Current Liability is a debt that can reasonably be expected to be paid: 1 from existing current assets or in the creation of other current liabilities and 2 within one year or the operating cycle, whichever is longer. Current liabilities include: 1 Notes Payable 2 Accounts Payable 3 Unearned Revenues 4 Accrued Liabilities

NOTES PAYABLE Notes Payable are obligations in the form of written promissory notes that usually require the borrower to pay interest. Notes payable may be used instead of accounts payable because it supplies documentation of the obligation in case legal remedies are needed to collect the debt. Notes due for payment within one year of the balance sheet date are usually classified as current liabilities.

NOTES PAYABLE 100,000 100,000 When an interest-bearing note is issued, the assets received generally equal the face value of the note. Assume First National Bank agrees to lend $100,000 on March 1, 1999 if Cole Williams Co. signs a $100,000, 12%, 4-month note. Cash is debited and Notes Payable is credited.

NOTES PAYABLE 4,000 4,000 Interest accrues over the life of the note and must be recorded periodically. 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.

NOTES PAYABLE 100,000 4,000 104,000 At maturity, Notes Payable is debited for the face value of the note, Interest Payable is debited for the amount of accrued interest, and Cash is credited for the maturity value of the note.

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 (or selling company) collects the tax from the customer when the sale occurs, and periodically (usually monthly) remits the collections to the state’s department of revenue. Thus, the retailer serves as a collection agent for the taxing authority.

SALES TAXES PAYABLE 10,600 10,000 600 Cash register readings are used to credit Sales and Sales Taxes Payable. If on March 25th cash register readings for Cooley Grocery show sales of $10,000 and sales taxes of $600 (sales tax rate is 6%), the entry is a debit to Cash for the total, and a credit to Sales for the actual sales and Sales Taxes Payable for the amount of the sales tax.

SALES TAXES PAYABLE When sales taxes are not rung up separately on the cash register, total receipts are divided by 100% plus the sales tax percentage to determine the sales, and the difference is sales tax. If Cooley Grocery “rings up” total receipts, which are $10,600, and the sales tax percentage is 6%, we can figure sales as follows: $10,600 ÷ 1.06 = $10,000

PAYROLL AND PAYROLL TAXES PAYABLE The term payroll pertains to all wages and salaries payable owed to employees. Withholding taxes: 1 must be withheld from employees’ gross pay, 2 consist of social security (FICA) taxes and federal and state income taxes, and 3 are credited to appropriate liability accounts. 17

RECOGNIZING PAYROLL EXPENSES AND LIABILITIES 100,000 7,250 21,864 2,922 67,964 A corporation records its payroll for the pay period ending March 7 with the journal entry above. Salaries and Wages Expense is debited for $100,000 in gross earnings. Specific liability accounts are credited for the deductions made during the pay period. Salaries and Wages Payable is credited for $67,964 in net earnings.

RECORDING PAYMENT OF THE PAYROLL 67,964 67,964 The entry to record payment of the March 7 payroll is a debit to Salaries and Wages Payable and a credit to Cash. When currency is used in payment, one check is prepared for the amount of net earnings ($67,964).

ILLUSTRATION 11-2 PAYROLL DEDUCTIONS Net Pay FICA Taxes Federal Income Tax State & City Income Taxes Insurance, Pensions, &/or Union Dues Gross Pay Charity

EMPLOYER PAYROLL TAXES Payroll Tax Expense for businesses and educational institutions results from 3 taxes levied on employers by governmental agencies. 1 The employer must match each employee’s FICA contribution – resulting in payroll tax expense to the employer. 2 Federal unemployment taxes (FUTA) provide benefits for a limited time period to employees who lose their jobs through no fault of their own. FUTA is a tax borne entirely by the employer. 3 State unemployment taxes (SUTA) also provide benefits to employees who lose their jobs and are borne entirely by the employer.

RECORDING EMPLOYER PAYROLL TAXES The entry to record the payroll tax expense associated with the March 7 payroll results in a debit to Payroll Tax Expense for $13,450, a credit to FICA Taxes Payable for $7,250 ($100,000 X 7.25%), a credit to FUTA Payable for $800 ($100,000 X 0.8%), and a credit to SUTA Payable for $5,400 ($100,000 X 5.4%). 13,450 7,250 800 5,400

UNEARNED REVENUES Unearned Revenues (advances from customers) occur when a company receives cash before a service is rendered. Examples are when an airline sells a ticket for future flights or when an attorney receives legal fees before work is done.

UNEARNED REVENUES How do companies account for unearned revenues that are received before goods are delivered or services are rendered? 1 When the advance is received, Cash is debited, and a current liability account identifying the source of the unearned revenue is credited. 2 When the the revenue is earned, the unearned revenue account is debited, and an earned revenue account is credited.

UNEARNED REVENUES 500,000 500,000 If Superior University sells 10,000 season football tickets at $50 each for its five-game home schedule, the entry for the sale of the tickets is a debit to Cash for the advance received, and a credit to Unearned Football Ticket Revenue, a current liability.

UNEARNED REVENUES 100,000 100,000 As each game is completed, the Unearned Football Ticket Revenue account is debited for 1/5 of the unearned revenue, and the earned revenue, Football Ticket Revenue, is credited.

ILLUSTRATION 11-4 UNEARNED AND EARNED REVENUE ACCOUNTS Shown above are specific unearned and earned revenue accounts used in selected types of businesses.

CURRENT MATURITIES OF LONG-TERM DEBT Another item classified as a current liability is current maturities of long-term debt. Current maturities of long-term debt are often identified on the balance sheet as long-term debt due within one year.

FINANCIAL STATEMENT PRESENTATION Current liabilities is the first category under liabilities on the balance sheet. Each of the principal types of current liabilities is listed separately. Current liabilities are usually in order of magnitude with the largest obligations being listed first. However, many companies, as a matter of custom, show notes payable and accounts payable first regardless of amount. 14

ILLUSTRATION 11-5 BALANCE SHEET PRESENTATION OF CURRENT LIABILITIES

ILLUSTRATION 11-6 WORKING CAPITAL FORMULA AND COMPUTATION Current Liabilities Working Capital Current Assets $1,496.5 - $1,718.5 = $-222.0 The excess of current assets over current liabilities is working capital. The formula for the computation of Kellogg’s working capital is shown above.

ILLUSTRATION 11-7 CURRENT RATIO AND COMPUTATION Liabilities Current Ratio Current Assets $1,496.5 ÷ $1,718.5 = .87:1 The current ratio permits us to compare the liquidity of different sized companies and of a single company at different times. The current ratio is determined by dividing current assets by current liabilities. The formula for the computation of Kellogg’s current ratio is shown above.

LONG-TERM LIABILITIES Long-term liabilities are obligations that are expected to be paid after one year and are usually in the form of bonds or long-term notes. Bonds are a form of interest bearing notes payable issued by 1 corporations, 2 universities, and 3 governmental agencies.

BOND BASICS Why issue bonds? Other long-term financing – with notes payable and leasing – are rarely sufficient to furnish the funds needed for plant expansion and major projects. Corporate management usually decides whether to issue bonds (debt financing) or common stock (equity financing).

ILLUSTRATION 11-8 ADVANTAGES OF BOND FINANCING OVER COMMON STOCK From the standpoint of the corporation seeking long-term financing, bonds offer the following advantages over common stock. TAX BILL STOCK

ILLUSTRATION 11-9 EFFECTS ON EARNINGS PER SHARE – STOCKS VS. BONDS Microsystems, Inc. is considering 2 plans for financing the construction of a new $5 million plant: 1 Plan A involves the issuance of 200,000 shares of common stock at the current market price of $25 per share. 2 Plan B involves the issuance of $5 million, 12% bonds at face value. Microsystems currently has 100,000 shares of common stock outstanding. Income before interest and taxes will be $1.5 million on the new plant; income taxes are expected to be 30%.

TYPES OF BONDS Secured and Unsecured Bonds 1 Secured bonds have specific assets of the issuer pledged as collateral. 2 Unsecured bonds are issued against the general credit of the borrower. Term and Serial Bonds 1 Term bonds mature at a single specify future date. 2 Serial bonds mature in installments.

TYPES OF BONDS Registered and Bearer Bonds 1 Registered bonds are issued in the name of the owner. 2 Bearer (or coupon) bonds are not registered and require holders to send in coupons to receive interest payments. Convertible and Callable Bonds 1 Convertible bonds can be converted into common stock at the bondholder’s option. 2 Callable bonds are subject to retirement at a stated dollar amount prior to maturity at the option of the issuer.

ISSUING PROCEDURES In authorizing the bond issue – the board of directors must stipulate 1 the total number of bonds to be authorized, total face value, and 2 the contractual interest rate. The face value is the amount of principal due at the maturity date.

ISSUING PROCEDURES The contractual interest rate (or stated rate) is the rate used to determine the amount of cash interest the borrower pays and the investor receives. A bond indenture is a legal document that sets forth the terms of the bond issue. A bond certificate provides such information as: 1 name of the issuer, 2 face value of the bonds, 3 contractual interest rate, and 4 maturity date of the bonds.

ILLUSTRATION 11-11 MARKET INFORMATION FOR BONDS Corporate bonds are traded on national securities markets like capital stock. Bond prices are quoted as a percentage of the face value of the bond, which is usually $1,000. Bond prices and trading activity are published daily in newspapers and the financial press. The illustration below indicates that IBM has outstanding 83/8%, $1,000 bonds maturing in 2019 and currently yielding a 7.5% return. In addition, 50 bonds were traded on this day; and at the close of trading, the price was 112 1/8% of face value, or $1,121.25 in this case.

DETERMINING THE MARKET VALUE OF BONDS The market value (present value) of a bond is a function of 3 factors: 1 the dollar amounts to be received, 2 the length of time until the amounts are received, and 3 the market rate of interest. The market interest rate is the rate investors demand for loaning funds to the corporation. The process of finding the present value is referred to as discounting the future amounts.

ILLUSTRATION 11-13 COMPUTING THE MARKET PRICE OF BONDS On January 1, 2000, Kellogg Company issues $100,000 of 9% bonds, due in 5 years, with interest payable annually at year-end. Each purchaser of the bonds would receive the following 2 cash payments: 1 $100,000 principal to be paid at maturity and 2 Five $9,000 interest payments ($100,000 X 9%) over the term of the bonds. The present values of these amounts are shown below.

ACCOUNTING FOR BOND ISSUES ISSUING BONDS AT FACE VALUE Devor Corporation issues 1,000, 10 year, 9% bonds dated January 1, 2000, at 100 (100% of face value). The entry to record the sale is: 1,000,000 1,000,000

ACCOUNTING FOR BOND ISSUES ISSUING BONDS AT FACE VALUE Bonds payable are reported in the long-term liabilities section of the balance sheet since the maturity date is January 1, 2010 (more than 1 year away). The entry for the interest payment on July 1, 2000, assuming no previous accrual of interest, is: 45,000 45,000

ACCOUNTING FOR BOND ISSUES ISSUING BONDS AT FACE VALUE At December 31, an adjusting entry is required to recognize the $45,000 of interest expense incurred since July 1. Bond interest payable is classified as a current liability, since it is scheduled for payment within the next year. The entry is: 45,000 45,000

ILLUSTRATION 11-14 INTEREST RATES AND BOND PRICES Market Interest Rate 8% 10% 12% Bonds Sell at Discount Premium Face Value Bond Contractual Interest Rate 10% Issued when

ACCOUNTING FOR BOND ISSUES ISSUING BONDS AT A DISCOUNT If the market interest rate is greater than the contractual interest rate, the issuing corporation will sell the bonds at a price less than face value – at a discount. At January 1, 2000, Candlestick, Inc. sells $1,000,000, 5-year, 10% bonds at 98 (98% of face value) with interest payable on July 1 and January 1. The entry to record the issuance is: 980,000 20,000 1,000,000

ILLUSTRATION 11-15 STATEMENT PRESENTATION OF DISCOUNT ON BONDS PAYABLE 1 has a debit balance, 2 is a contra account, and 3 is deducted from Bonds Payable on the balance sheet, as shown below. The $980,000 represents the carrying value (or book value) of the bonds, which – on the date of issuance – is equal to the market value of the bonds.

ILLUSTRATION 11-16 TOTAL COST OF BORROWING – BONDS ISSUED AT A DISCOUNT The difference between the issuance price and the face value of the bonds – the discount – is an additional cost of borrowing that should be recorded as bond interest expense over the life of the bonds. The total cost of borrowing $980,000 for Candlestick, Inc. is $520,000, computed as follows:

ILLUSTRATION 11-17 ALTERNATIVE COMPUTATION OF TOTAL COST OF BORROWING – BONDS ISSUED AT A DISCOUNT Alternatively – the total cost of borrowing can be determined as follows:

Bond Discount Amortization ILLUSTRATION 11-18 FORMULA FOR STRAIGHT-LINE METHOD OF BOND DISCOUNT FORMULA FOR AMORTIZATION Bond discount should be allocated systematically to each accounting period benefiting from the use of the cash proceeds. The straight-line method of amortization allocates the same amount to interest expense in each interest period. The amount is determined as shown below: Number of Interest Periods Bond Discount Amortization Bond Discount

ACCOUNTING FOR BOND ISSUES ISSUING BONDS AT A DISCOUNT In this example, the bond discount amortization is $2,000 ($20,000 ÷ 10). The entry to record the payment of bond interest and the amortization of bond discount on July 1, 2000 is: 52,000 2,000 50,000

ACCOUNTING FOR BOND ISSUES ISSUING BONDS AT A DISCOUNT The December 31 adjusting entry is shown below. The effects of this entry are: 1 increase expenses (reduces net income and stockholders’ equity) by $52,000, 2 decrease assets by $50,000, and 3 increase liabilities by $2,000. 52,000 2,000 50,000

ACCOUNTING FOR BOND ISSUES ISSUING BONDS AT A PREMIUM If the market interest rate is less than the contractual interest rate, the issuing corporation will sell the bonds at a price greater than face value – at a premium. At January 1, 2000, Candlestick, Inc. sells $1,000,000, 5-year, 10% bonds at 102 (102% of face value) with interest payable on July 1 and January 1. The entry to record the issuance is: 1,020,000 1,000,000 20,000

ILLUSTRATION 11-20 STATEMENT PRESENTATION OF BOND PREMIUM Premium on Bonds Payable 1 has a credit balance and 2 is added to Bonds Payable on the balance sheet, as shown below. The $1,020,000 represents the carrying value (or book value) of the bonds, which – on the date of issuance – is equal to the market value of the bonds.

ILLUSTRATION 11-21 TOTAL COST OF BORROWING – BONDS ISSUED AT A PREMIUM The difference between the issuance price and the face value of the bonds – the premium – is a reduction in the cost of borrowing that should be recorded as a decrease in bond interest expense over the life of the bonds. The total cost of borrowing $1,020,000 for Candlestick, Inc. is $480,000, computed as follows:

ILLUSTRATION 11-22 ALTERNATIVE COMPUTATION OF TOTAL COST OF BORROWING – BONDS ISSUED AT A PREMIUM Alternatively – the total cost of borrowing can be determined as follows:

ACCOUNTING FOR BOND ISSUES ISSUING BONDS AT A PREMIUM In this example, the bond premium amortization is $2,000 ($20,000 ÷ 10). The entry to record the payment of bond interest and the amortization of bond premium on July 1 is: 48,000 2,000 50,000

ACCOUNTING FOR BOND ISSUES ISSUING BONDS AT A PREMIUM The December 31 adjusting entry is shown below. The effects of this entry are: 1 increase expenses (reduces net income and stockholders’ equity) by $48,000, 2 decrease assets by $50,000, and 3 decrease liabilities by $2,000. 48,000 2,000 50,000

ACCOUNTING FOR BOND ISSUES ISSUING BONDS BETWEEN INTEREST DATES When bonds are issued between interest payment dates, the issuer requires the investor to pay the market price for the bonds plus accrued interest since the last interest date. At the next interest date, the corporation will return the accrued interest to the investor by paying the full amount of interest due on the outstanding bonds.

ACCOUNTING FOR BOND ISSUES ISSUING BONDS BETWEEN INTEREST DATES Deer Corporation sells $1,000,000, 9% bonds at face value plus accrued interest on March 1. Interest is payable semiannually on July 1 and January 1. The accrued interest is $15,000 ($1,000,000 X 9% X 2/12). The proceeds on the sale of the bonds total $1,015,000, and the entry to record the issuance is: 1,015,000 1,000,000 15,000

ACCOUNTING FOR BOND ISSUES ISSUING BONDS BETWEEN INTEREST DATES At the first interest date, the bond interest payable balance must be eliminated and interest expense for 4 months (March 1 – June 30) must be recognized. Interest expense is $30,000 ($1,000,000 X 9% X 4/12). The entry on July 1 to record the $45,000 interest payment is: 15,000 30,000 45,000

ACCOUNTING FOR BOND RETIREMENTS REDEEMING BONDS AT MATURITY Regardless of the issuance price of the bonds, the book value of the bonds at maturity will equal their face value. The entry to record the redemption of the Candlestick bonds at maturity, assuming that the interest for the last interest period is paid and recorded separately, is: 1,000,000 1,000,000

ACCOUNTING FOR BOND RETIREMENTS REDEEMING BONDS BEFORE MATURITY A corporation may decide to retire bonds before maturity to lower interest expense and remove debt from its balance sheet. Debt should be retired early only if the corporation has sufficient cash resources. When bonds are retired before maturity, it is necessary to: 1 eliminate the carrying value of the bonds at the redemption date, 2 record the cash paid, and 3 recognize the gain or loss on redemption. The carrying value of the bonds is the face value of the bonds less (plus) unamortized bond discount (premium) at the redemption date.

ACCOUNTING FOR BOND RETIREMENTS REDEEMING BONDS BEFORE MATURITY Candlestick, Inc. – at the end of the eighth period (having sold its bonds at a premium) – retires its bonds at 103 after paying the semiannual interest. The carrying value of the bonds at the redemption date is $1,004,000. Gains or losses on early bond redemption are reported in the income statement as extraordinary items as required by GAAP: 1,000,000 4,000 26,000 1,030,000

ACCOUNTING FOR BOND RETIREMENTS CONVERTING BONDS INTO COMMON STOCK When the conversion of bonds into common stock is recorded, the current market values of the bonds and stock are ignored. On July 1, Saunders Associates converts $100,000 of bonds sold at face value into 10,000 shares of $10 par value common stock. Both the bonds and the stock have a market value of $130,000, which is not considered in making the entry. 100,000 100,000

ACCOUNTING FOR LONG-TERM NOTES PAYABLE Long-term notes payable are similar to short-term interest-bearing notes payable except that the terms of the notes exceed one year. A long-term note may be secured by a document called a mortgage that pledges title to specific assets as security (collateral) for a loan. Mortgage notes payable are widely used in: 1 the purchase of homes by individuals and 2 the acquisition of plant assets by many small and some large companies.

ILLUSTRATION 11-25 MORTGAGE INSTALLMENT PAYMENT SCHEDULE Each mortgage installment payment consists of: 1 interest on the unpaid balance of the loan and 2 a reduction of loan principal. Porter Technology Inc. issues a $500,000, 12%, 20-year mortgage note on December 31, 2000 to finance the construction of new research laboratory. The installment payment schedule for the first 2 years is:

ACCOUNTING FOR LONG-TERM NOTES PAYABLE The entries to record the mortgage loan and the first installment payment are as follows: 500,000 500,000 30,000 3,231 33,231 In the balance sheet, the reduction in principal for the next year is reported as a current liability, and the remaining unpaid principal balance is classified as a long-term liability.

ILLUSTRATION 11-26 BALANCE SHEET PRESENTATION OF LONG-TERM LIABILITIES Long-term liabilities are reported in a separate section of the balance sheet immediately following current liabilities, as shown above. Summary data may alternatively be presented in the balance sheet with detailed data shown in a supporting schedule. The current maturities of long-term debt should be reported under current liabilities if they are to be paid from current assets.

STATEMENT PRESENTATION AND ANALYSIS OF LONG-TERM LIABILITIES Long-term creditors and stockholders are interested in a company’s long-run solvency – particularly its ability to pay interest as it comes due and to repay the face value of the debt at maturity. Debt to total assets and times interest earned are 2 ratios that provide information about debt-paying ability and long-run solvency. The debt to total assets ratio measures the percentage of the total assets provided by creditors. The times interest earned ratio provides an indication of the company’s ability to meet interest payments as they come due.

Income before Income Taxes and Interest Expense ILLUSTRATION 11-27 DEBT TO TOTAL ASSETS AND TIMES INTEREST EARNED RATIOS WITH COMPUTATIONS Kellogg’s annual report disclosed total liabilities of $4,161.7 million, total assets of $5,051.5 million, interest expense of $119.5 million, income taxes of $279.9 million, and net income of $502.6 million. Kellogg’s debt to total assets ratio and times interest earned ratio are shown below: Total Debt Total Assets Debt to Total Assets $4,161.7 ÷ $5,051.5 = 82.4 % $502.6 + $279.9 + $119.5 ÷ $119.5 = 7.5 times Interest Expense Times Interest Earned Income before Income Taxes and Interest Expense

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CHAPTER 11 LIABILITIES