Cash, Short-term Investments and Accounts Receivable Chapter 4 Cash, Short-term Investments and Accounts Receivable Chapter 4

Chapter 7 Liabilities

Chapter 7 Learning Objectives Account for the major types of transactions and events affecting current liabilities. Define the key characteristics of, and account for, contingent liabilities. Account for the major types of transactions and events affecting bonds payable. Distinguish between operating leases and capital leases. Discuss accounting issues for long-term liabilities stemming from pension and other postretirement employee benefit plans. Define the key information needs of decision makers regarding liabilities. Compute and interpret the current, long-term debt to equity, and times interest earned ratios as well as the amount of working capital. (Appendix) Compute the issue price of bonds and prepare journal entries related to discount and premium amortization. Chapter 7 Chapter 7 3

Definition The Financial Accounting Standards Board defines liabilities as "probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events." * *Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 6, “Elements of Financial Statements” (Stamford, Conn.: FASB, 1985), paragraph 35. Chapter 7

Current Liabilities Accounts Payable Notes Payable Salaries Payable Current Portion of Long-term Debt Chapter 7

Notes Payable Interest = Principal x Rate x Time Common Terms: Maker Payee Principal Term of Note Maturity Date/Value Interest = Principal x Rate x Time *Use a 360 day year Chapter 7

Entries for Notes Payable Suppose that Bonney’s Dress Shop borrows $5,000 from a local bank on October 2, 2009, and signs a 120-day, 12% note payable. The note’s maturity date is January 30, 2010. Bonney’s Dress Shop would prepare the following entries on Oct. 2 and Dec. 31, 2009. Chapter 7

Entries for Notes Payable Continued Chapter 7

Entries for Notes Payable Continued On Jan. 30, 2010, Bonney’s Dress Shop repays the bank the $5,000 principal amount plus 12% interest for the note’s 120-day term. Bonney’s Dress Shop prepares the following entry. Chapter 7

Review John Company issued a 6%, 60-day, $2,000 note on November 16, 2010, to purchase equipment. The accrued interest on December 31, 2010, is $20. $120. $15. $10. Chapter 7 Chapter 7 10

Review John Company issued a 6%, 60-day, $2,000 note on November 16, 2010, to purchase equipment. The accrued interest on December 31, 2010, is $20. $120. $15. $10. Chapter 7 Chapter 7 11

Review John Company issued a 6%, 60-day, $5,000 note on December 1, 2010, to purchase equipment. The entry on maturity date will include a debit to interest expense for $50. $30. $25. $45. Chapter 7 Chapter 7 12

Review John Company issued a 6%, 60-day, $5,000 note on December 1, 2010, to purchase equipment. The entry on maturity date will include a debit to interest expense for $50. $30. $25. $45. Chapter 7 Chapter 7 13

Entries for Installment Notes Payable Assume that Ryan Company purchases a $25,000 truck on January 31, 2009. The company signs a five-year note payable, and payments of $483 are to be made at the end of each month at an annual interest rate of 6%. The next slide shows the computations for the first six months of principal and interest payments. Chapter 7

Installment Notes Payable Chapter 7

Entries for Installment Notes Payable The following entries reflect the first two installment payments for Ryan Co. Chapter 7

Other Accrued Liabilities Product Warranty Vacation Pay Accrued Payroll Chapter 7

Entries for Product Warranty Liabilities Suppose a ball point pen manufacturer expects that 2% of its pens sold will need to be replaced or repaired at a cost of $15 per pen. If 200,000 pens are sold in 2009, the firm expects to eventually repair or replace 4,000 pens at a cost of $60,000. During 2010, the company incurs $15,100 of warranty costs ($10,000 for parts, and $5,100 for labor). The following entries are prepared in 2009 and 2010 respectively. Chapter 7

Entries for Product Warranty Liability 2009 2010 Chapter 7

Review debit to Warranty Expense for $30,000. Gilbert Company provides a warranty on its primary product sold. Gilbert estimates the warranty will run $2 per unit and in 2010 sold 15,000 products. The adjusting entry will include a debit to Warranty Expense for $30,000. credit to Warranty Expense for $30,000. debit to Warranty Liability for $30,000. debit to Cash for $30,000. Chapter 7 Chapter 7 20

Review debit to Warranty Expense for $30,000. Gilbert Company provides a warranty on its primary product sold. Gilbert estimates the warranty will run $2 per unit and in 2010 sold 15,000. The adjusting entry will include a debit to Warranty Expense for $30,000. credit to Warranty Expense for $30,000. debit to Warranty Liability for $30,000. debit to Cash for $30,000. Chapter 7 Chapter 7 21

Vacation Pay Liability Assume that Linton & Co. provides each employee an annual two-week paid vacation and employees work 50 weeks per year. Each payroll period, vacation pay accumulated by Linton employees equals 4% (2/50) of that week’s payroll. If the two-week payroll is $350,000 vacation pay earned by employees is $14,000. In a typical year, 10% of all vacation pay accumulated by Linton employees is forfeited. Chapter 7

Entry for Vacation Pay Liability Chapter 7

Contingent Liabilities The two factors to consider in determining the accounting treatment for a loss contingency are whether (1) it is likely that an actual loss will result from the contingency and (2) the amount of the potential loss can be reasonably estimated. Probable Reasonably Possible Remote Chapter 7

Contingent Losses and Related Contingent Liabilities Chapter 7

Long-term Liabilities Bonds Payable Mortgage Payable Long-Term Notes Payable Lease Obligations Chapter 7

Bonds Payable Callable Convertible Stated/Contract Rate Effective/Market Rate Maturity Value Maturity Value= PV(Principal) + PVA(Interest Payments) Effective Rate > Stated Rate = Discount Effective Rate < Stated Rate = Premium Chapter 7

Determining the Issue Price of Bonds The relationship of a bond’s stated interest rate to interest rates being paid in the market is a primary determinant of issue price. Assume Hardin Manufacturing sells 100 five-year bonds with a face value of $1,000 and a stated interest rate of 10% for $1,000 each. The market rate of interest on similar bonds is also 10%. Hardin Manufacturing would prepare the following journal entry. Chapter 7

Journal Entry to Sell Bonds at Face Value Chapter 7

Determining the Issue Price of Bonds The relationship of a bond’s stated interest rate to interest rates being paid n the market is a primary determinant of issue price. Assume Hardin Manufacturing sells 100 five-year bonds with a face value of $1,000 and a stated interest rate of 10% for $1,000 each. Investors are also considering other bonds paying 11%. If Hardin wants to attract buyers for its bonds, it will have to sell the bonds at 95 (or $950 per bond). Hardin Manufacturing would prepare the following journal entry. Chapter 7

Journal Entry to Sell Bonds at Less than Face Value Chapter 7

Determining the Issue Price of Bonds The relationship of a bond’s stated interest rate to interest rates being paid n the market is a primary determinant of issue price. Assume Hardin Manufacturing sells 100 five-year bonds with a face value of $1,000 and a stated interest rate of 10% for $1,000 each. Investors are also considering other bonds paying 9%. Investors are willing to pay Hardin 104% of face, since Hardin’s bonds have a better interest rate. Hardin Manufacturing would prepare the following journal entry. Chapter 7

Journal Entry to Sell Bonds at More than Face Value Chapter 7

Accounting for Bonds Issued at a Discount On April 1, 2009, Hardin Manufacturing issues $100,000, 10%, five-year bonds when the market rate of interest is 12%. Using present value tables, the issuance price of the bonds is determined to be $93,641. Using the straight-line method, Hardin would prepare the following journal entries to issue the bonds, record the adjusting entry, make interest payments and amortize the discount. Chapter 7

Entries for Bonds Issued at a Discount Chapter 7

Accounting for Bonds Issued at a Premium On April 1, 2009, Hardin Manufacturing issues $100,000, 10%, five-year bonds when the market rate of interest is 8%. Using present value tables, the issuance price of the bonds is determined to be $108,115. Using the straight-line method, Hardin would prepare the following journal entries to issue the bonds, record the adjusting entry, make interest payments and amortize the premium. Chapter 7

Entries for Bonds Issued at a Premium Chapter 7

Review a premium. face value. a discount. par. Gilbert Company sold $200,000 8%, 10-year bonds at 95. The bonds were sold at a premium. face value. a discount. par. Chapter 7 Chapter 7 38

Review a premium. face value. a discount. par. Gilbert Company sold $200,000 8%, 10-year bonds at 95. The bonds were sold at a premium. face value. a discount. par. Chapter 7 Chapter 7 39

Review Heedy Company sold $200,000 8%, 10-year bonds at 102. Cash proceeds from the sale of the bonds amounted to $216,000. $204,000. $206,000. $202,000. Chapter 7 Chapter 7 40

Review Heedy Company sold $200,000 8%, 10-year bonds at 102. Cash proceeds from the sale of the bonds amounted to $216,000. $204,000. $206,000. $202,000. Chapter 7 Chapter 7 41

Effect of Market Interest Rate on Bond Accounting Chapter 7

Problem Review Heedy Company issued $500,000, 10%, 10-year bonds at 102 on January 1, 2010. The bonds pay interest semiannually on June 30 and Dec. 31. The discount or premium is amortized using the straight-line method. Prepare entries needed for 2010. Chapter 7 Chapter 7 43

Problem Review Solution Date Description Debit Credit Jan. 1 Cash 510,000 Bonds Payable 500,000 Premium on Bonds Payable 10,000 June 30 Interest Expense 24,500 500 25,000 Dec. 31 Chapter 7 Chapter 7 44

Problem Review Heedy Company issued $600,000, 10%, 10-year bonds at 96 on January 1, 2010. The bonds pay interest semiannually on June 30 and Dec. 31. The discount or premium is amortized using the straight-line method. Prepare entries needed for 2010. Chapter 7 Chapter 7 45

Problem Review Solution Date Description Debit Credit Jan. 1 Cash 576,000 Discount on Bonds Payable 24,000 Bonds Payable 600,000 June 30 Interest Expense 31,200 1,200 30,000 Dec. 31 Chapter 7 Chapter 7 46

Leases RULES Capitalize a Lease if: Present Value of Minimum Lease payments>90% FMV Lease Term > 75% of Estimated Useful Life Title Transfer Bargain Purchase Option Chapter 7

Capitalized Leases: Record and depreciate Asset Record Liability Recognize Interest Expense Chapter 7

Postretirement Benefit Liabilities Defined Contribution Plan Defined Benefit Plan 401(k), IRA Other non-financial benefits Chapter 7

Ratios Current Ratio = Current Assets Current Liabilities Working Capital = Current Assets – Current Liabilities Net Interest Income Taxes Times Interest Income + Expense + Expense Earned Ratio = Interest Expense Chapter 7

THE END! Chapter 7 Chapter 7 51