© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin LIABILITIES Chapter 10

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO1 To define liabilities an distinguish between current and long-term liabilities.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin I.O.U. Defined as debts or obligations arising from past transactions or events. Maturity = 1 year or lessMaturity > 1 year Current Liabilities Noncurrent Liabilities The Nature of Liabilities

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin The acquisition of assets is financed from two sources: Funds from creditors, with a definite due date, and sometimes bearing interest. Funds from owners DEBT EQUITY Distinction Between Debt and Equity

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Current Liabilities Obligations that must be paid within one year or within the operating cycle, whichever is longer.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Devon Mfg. borrows $100,000 from First Bank. The loan will be repaid in 20 years and has an annual interest rate of 8%. Is this a current liability or a noncurrent liability? Devon Mfg. borrows $100,000 from First Bank. The loan will be repaid in 20 years and has an annual interest rate of 8%. Is this a current liability or a noncurrent liability? Liabilities – Question The obligation will not be paid within one year or one operating cycle, so it is a noncurrent liability.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Short-term obligations to suppliers for purchases of merchandise and to others for goods and services. Merchandise inventory invoices Shipping charges Utility and phone bills Office supplies invoices Accounts Payable

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO2 To account for notes payable and interest expense.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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. Notes Payable

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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. signed title Miami, FlNov. 1, 2007 Six months Porter Company John Caldwell Security National Bank $10, % treasurer Notes Payable

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin On November 1, 2007, Porter Company would make the following entry. Notes Payable

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Interest expense is the compensation to the lender for giving up the use of money for a period of time. Interest expense is the compensation to the lender for giving up the use of money for a period of time. The liability is called interest payable. The liability is called interest payable. To the lender, interest is a revenue. To the lender, interest is a revenue. To the borrower, interest is an expense. To the borrower, interest is an expense. Interest expense is the compensation to the lender for giving up the use of money for a period of time. Interest expense is the compensation to the lender for giving up the use of money for a period of time. The liability is called interest payable. The liability is called interest payable. To the lender, interest is a revenue. To the lender, interest is a revenue. To the borrower, interest is an expense. To the borrower, interest is an expense. Interest Rate Up! Interest Payable

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin The interest formula includes three variables that must be considered when computing interest: Interest = Principal × Interest Rate × Time When computing interest for one year, “Time” equals 1. When the computation period is less than one year, then “Time” is a fraction. Interest Payable For example, if we needed to compute interest for 3 months, “Time” would be 3/12.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin What entry would Porter Company make on December 31, the fiscal year-end? Interest Payable – Example $10,000  12%  2 / 12 = $200

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Porter will pay the note on January 31, Let’s look at the entry. Interest Payable – Example $10,000  12%  1 / 12 = $100

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO3 To describe the costs and basic accounting activities related to payrolls.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Net Pay Payroll Liabilities Medicare Taxes State and Local Income Taxes FICA Taxes Federal Income Tax Voluntary Deductions Gross Pay

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Deferred revenue is recorded. a liability account. Cash is received in advance. Cash is sometimes collected from the customer before the revenue is actually earned. Unearned Revenue Earned revenue is recorded. As the earnings process is completed..

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Relatively small debt needs can be filled from single sources. Banks Insurance Companies Pension Plans oror Long-Term Liabilities

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Large debt needs are often filled by issuing bonds. Long-Term Liabilities

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin With each payment, the interest portion gets smaller and the principal portion gets larger. Installment Notes Payable Long-term notes that call for a series of installment payments. Each payment covers interest for the period AND a portion of the principal.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Identify the unpaid principal balance. Interest expense = Unpaid Principal × Interest rate. Reduction in unpaid principal balance = Installment payment – Interest expense. Compute new unpaid principal balance. Identify the unpaid principal balance. Interest expense = Unpaid Principal × Interest rate. Reduction in unpaid principal balance = Installment payment – Interest expense. Compute new unpaid principal balance. Allocating Installment Payments Between Interest and Principal

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO4 To prepare an amortization table allocating payments between interest and principal.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin On January 1, 2007, Rocket Corp. borrowed $7, from First Bank of River City. The loan was a five-year loan and had an interest rate of 10%. The annual payment is $2,000. Prepare an amortization table for Rocket Corp.’s loan. On January 1, 2007, Rocket Corp. borrowed $7, from First Bank of River City. The loan was a five-year loan and had an interest rate of 10%. The annual payment is $2,000. Prepare an amortization table for Rocket Corp.’s loan. Allocating Installment Payments Between Interest and Principal

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Now, prepare the entry for the first payment on December 31, Allocating Installment Payments Between Interest and Principal

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin The information needed for the journal entry can be found on the amortization table. The payment amount, the interest expense, and the amount to debit to principal are all on the table. Allocating Installment Payments Between Interest and Principal

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO5 To describe corporate bonds and explain the tax advantage of debt financing.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Bonds usually involve the borrowing of a large sum of money, called principal. Bonds usually involve the borrowing of a large sum of money, called principal. The principal is usually paid back as a lump sum at the end of the bond period. The principal is usually paid back as a lump sum at the end of the bond period. Individual bonds are often denominated with a par value, or face value, of $1,000. Individual bonds are often denominated with a par value, or face value, of $1,000. Bonds usually involve the borrowing of a large sum of money, called principal. Bonds usually involve the borrowing of a large sum of money, called principal. The principal is usually paid back as a lump sum at the end of the bond period. The principal is usually paid back as a lump sum at the end of the bond period. Individual bonds are often denominated with a par value, or face value, of $1,000. Individual bonds are often denominated with a par value, or face value, of $1,000. Bonds Payable

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Bonds usually carry a stated rate of interest, also called a contract rate. Interest is normally paid semiannually. Interest is computed as: Bonds usually carry a stated rate of interest, also called a contract rate. Interest is normally paid semiannually. Interest is computed as: Interest = Principal × Stated Rate × Time Bonds Payable

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Bonds are issued through an intermediary called an underwriter. Bonds can be sold on organized securities exchanges. Bond prices are usually quoted as a percentage of the face amount. For example, a $1,000 bond priced at 102 would sell for $1,020. Bonds are issued through an intermediary called an underwriter. Bonds can be sold on organized securities exchanges. Bond prices are usually quoted as a percentage of the face amount. For example, a $1,000 bond priced at 102 would sell for $1,020. Bonds Payable

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Mortgage Bonds Convertibl e Bonds Junk Bonds Debenture Bonds Types of Bonds

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin On January 1, 2007, Rocket Corp. issues $1,500,000 of 12%, 10-year bonds payable. Interest is payable semiannually, each July 1 and January 1. Assume the bonds are issued at face value. Record the issuance of the bonds. On January 1, 2007, Rocket Corp. issues $1,500,000 of 12%, 10-year bonds payable. Interest is payable semiannually, each July 1 and January 1. Assume the bonds are issued at face value. Record the issuance of the bonds. Accounting for Bonds Payable

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Record the interest payment on July 1, Accounting for Bonds Payable

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Bonds Sold 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: 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:

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO6 To account for bonds issued at a discount or premium.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin The Present Value Concept and Bond Prices The selling price of the bond is determined by the market based on the time value of money. = = > > < < > > < < = =

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Bonds Issued at a Discount Matrix, Inc. is attempting to issue $1,000,000 principal amount of 9% bonds. The bonds pay interest on June 30 and December 31 each year and mature in 20 years. Investors are unwilling to pay the full face amount for Matrix’s bonds because they believe the interest rate is too low. To entice investors, Matrix must lower the price of the bonds. The difference between the new lower issue price and the principal of $1,000,000 is called a discount. Let’s see how we account for these bonds. Matrix, Inc. is attempting to issue $1,000,000 principal amount of 9% bonds. The bonds pay interest on June 30 and December 31 each year and mature in 20 years. Investors are unwilling to pay the full face amount for Matrix’s bonds because they believe the interest rate is too low. To entice investors, Matrix must lower the price of the bonds. The difference between the new lower issue price and the principal of $1,000,000 is called a discount. Let’s see how we account for these bonds.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Bonds Issued at a Discount Matrix, Inc. issues bonds on January 1, Principal = $1,000,000 Issue price = $950,000 Stated Interest Rate = 9% Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2026 (20 years) Matrix, Inc. issues bonds on January 1, Principal = $1,000,000 Issue price = $950,000 Stated Interest Rate = 9% Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2026 (20 years)

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Bonds Issued at a Discount To record the bond issue, Matrix, Inc. would make the following entry on January 1, 2007:

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Maturity Value Carrying Value Bonds Issued at a Discount

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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 $1,250 every six months. $50,000 ÷ 40 periods = $1,250 Using the straight-line method, the discount amortization will be $1,250 every six months. $50,000 ÷ 40 periods = $1,250

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Amortization of the Discount We prepare the following journal entry to record the first interest payment. $45,000 $1,000,000 × 9% = $90,000 ÷ 2 = $45,000 Interest paid every six months is calculated as follows:

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Maturity Value Carrying Value $50,000 – $1,250 – $1,250 The carrying value will increase to exactly $1,000,000 on the maturity date. Bonds Issued at a Discount

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin To record an the principal repayment, Matrix, Inc would make the following entry on December 31, 2026: Bonds Issued at a Discount

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Bonds Issued at a Premium If bonds of other companies are yielding less than 9 percent, investors will be willing to pay more than the face amount for Matrix’s 9% bonds. The issue price of Matrix’s 9% bonds will rise because of investor demand for the 9% bonds. The difference between the higher issue price and the principal of $1,000,000 is called a premium. Let’s look at accounting for a premium. If bonds of other companies are yielding less than 9 percent, investors will be willing to pay more than the face amount for Matrix’s 9% bonds. The issue price of Matrix’s 9% bonds will rise because of investor demand for the 9% bonds. The difference between the higher issue price and the principal of $1,000,000 is called a premium. Let’s look at accounting for a premium.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Matrix, Inc. issues bonds on January 1, Principal = $1,000,000 Issue price = $1,050,000 Stated Interest Rate = 9% Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2026 (20 years) Matrix, Inc. issues bonds on January 1, Principal = $1,000,000 Issue price = $1,050,000 Stated Interest Rate = 9% Interest Dates = 6/30 and 12/31 Maturity Date = Dec. 31, 2026 (20 years) The only change from previous Matrix example. Bonds Issued at a Premium

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin To record the bond issue, Matrix, Inc. would make the following entry on January 1, 2007: Bonds Issued at a Premium

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Maturity Value Carrying Value Bonds Issued at a Premium

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Amortizing the premium over the term of the bond decreases Interest Expense each interest payment period. Using the straight-line method, the premium amortization will be $1,250 every six months. $50,000 ÷ 40 periods = $1,250 Using the straight-line method, the premium amortization will be $1,250 every six months. $50,000 ÷ 40 periods = $1,250 Bonds Issued at a Premium

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Bonds Issued at a Premium To record an interest payment, Matrix, Inc. would make the following entry on each June 30 and December 31:

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Bonds Issued at a Premium Maturity Value Carrying Value $50,000 – $1,250 – $1,250 The carrying value will decrease to exactly $1,000,000 on the maturity date.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin To record an the principal repayment, Matrix would make the following entry on December 31, 2026: Bonds Issued at a Premium

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO7 To explain the concept of present value as it relates to bond prices.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Present Value The Concept of Present Value Future Value $1,000 invested today at 10%. In 25 years it will be worth $10,834.71! Money can grow over time, because it can earn interest. In 5 years it will be worth $1,

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin How much is a future amount worth today? Present Value Future Value Interest compounding periods Today The Concept of Present Value

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin The Concept of Present Value How much is a future amount worth today? Three pieces of information must be known to solve a present value problem: o The future amount. o The interest rate (i). o The number of periods (n) the amount will be invested. How much is a future amount worth today? Three pieces of information must be known to solve a present value problem: o The future amount. o The interest rate (i). o The number of periods (n) the amount will be invested.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Two types of cash flows are involved with bonds: Today  Principal payment at maturity. Periodic interest payments called annuities. Maturity The Concept of Present Value

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Gains or losses incurred as a result of retiring bonds should be reported as other income or other expense on the income statement. Early Retirement of Debt

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO8 To explain how estimated liabilities, loss contingencies, and commitments are disclosed in financial statements.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Loss Contingencies An existing uncertain situation involving potential loss depending on whether some future event occurs. Two factors affect whether a loss contingency must be accrued and reported as a liability: Two factors affect whether a loss contingency 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 loss contingency must be accrued and reported as a liability: Two factors affect whether a loss contingency 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.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Estimated Liabilities 1. Liabilities that are known to exist. 2. Uncertain as to dollar amount. 3. Reasonable estimate of dollar amount is available. 1. Liabilities that are known to exist. 2. Uncertain as to dollar amount. 3. Reasonable estimate of dollar amount is available. Example: Product warranties

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO9 To evaluate the safety of creditor’s claims.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Evaluating the Safety of Creditors’ Claims This ratio indicates a margin of protection for creditors. Operating Income Interest Expense Interest Coverage Ratio =

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Devon Mfg. reports annual operating income of $100,000 and annual interest expense of $10,000. What is Devon’s interest coverage ratio? Devon Mfg. reports annual operating income of $100,000 and annual interest expense of $10,000. What is Devon’s interest coverage ratio? Liabilities – Question

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Borrowing at one rate and investing at a higher rate. If we borrow $1,000,000 at 8% and invest it at 10%, we will clear $20,000 profit! Financial Leverage

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO10 To describe reporting issues related to leases, postretirement benefits, and deferred taxes.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Lease agreement transfers risks and benefits associated with ownership to lessee. Lessee records a leased asset and lease liability. Lessor retains risks and benefits associated with ownership. Lessee records rent expense as incurred. Lease Payment Obligations Operating Leases Capital Leases

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Capital Lease Criteria

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Employers offer pension plans to employees. Retirees receive pension payments from the pension fund. The employer makes payments to a pension fund. Usually, this is an independent entity managed by a professional fund manager. Pensions

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Actuaries make the pension expense computations, based on: Average age, retirement age, life expectancy. Employee turnover rates. Compensation levels. Expected rate of return for the fund. Actuaries make the pension expense computations, based on: Average age, retirement age, life expectancy. Employee turnover rates. Compensation levels. Expected rate of return for the fund. The accountant then posts the entry to record pension expense and pension liability. Pensions

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Many companies offer benefits to retirees other than pensions, such as health coverage or fitness club memberships. Other Postretirement Benefits Unfunded liability for nonpension postretirement benefits Current liability Long-term liability Amount to be funded next year Remainder of unfunded amount

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Corporations pay income taxes quarterly. Deferred Income Taxes

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin The difference between tax expense and tax payable is recorded in an account called deferred taxes. The Internal Revenue Code is the set of rules for preparing tax returns. Financial statement income tax expense. IRS income taxes payable. GAAP is the set of rules for preparing financial statements. Results in... Usually... Deferred Income Taxes

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Examine the December 31, 2007, information for Matrix, Inc. Matrix uses straight-line depreciation for financial reporting and accelerated depreciation for income tax reporting. Matrix’s tax rate is 30%. Deferred Income Taxes – Example

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin The income tax amount computed based on financial statement income is income tax expense for the period. Compute Matrix’s income tax expense and income tax payable. Deferred Income Taxes – Example

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Compute Matrix’s income tax expense and income tax payable. Income taxes based on tax return income are the taxes payable for the period. Deferred Income Taxes – Example

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin The deferred tax for the period of $36,000 is the difference between income tax expense of $45,000 and income tax payable of $9,000. Deferred Income Taxes – Example

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin End of Chapter 1O