1 Financial Accounting: Tools for Business Decision Making, 2nd Ed. Kimmel, Weygandt, Kieso ELS

Chapter 10

3 Chapter 10 Reporting and Analyzing Liabilities After studying Chapter 10, you should be able to: zExplain a current liability and identify the major types of current liabilities. zDescribe the accounting for notes payable. zExplain the accounting for other current liabilities. zIdentify the requirements for the financial statement presentation and analysis of current liabilities.

4 After studying Chapter 10, you should be able to: zExplain why bonds are issued and identify the types of bonds. zPrepare the entries for the issuance of bonds and their interest expense. zDescribe the entries when bonds are redeemed. zIdentify the requirements for the financial statement presentation and analysis of long- term liabilities. Chapter 10 Reporting and Analyzing Liabilities

5 Liabilities are.. zCreditors claims on total assets zExisting debts and obligations Liabilities must be settled in the future by transfer of assets or services.

6 Current Liabilities Can reasonably be expected to paid zFrom existing current assets or through the creation of other current liabilities. zWithin 1 year or the operating cycle, whichever is longer. Debts that do not meet both criteria are Long-Term Liabilities.

7 Current Liability Types zNotes Payable zAccounts Payable zUnearned Revenues zAccrued Liabilities

8 Notes Payable are... zObligations in the form of written notes. zOften used instead of accounts payable - they give written documentation if needed for legal remedies. zUsed for short-term and long-term financing needs.

Notes Payable Illustration

Remember - Interest accrues over life of the note and must be recorded periodically. Journal Mar 1Cash100,000 Notes Payable100,000 (To record issuance of 12%, 4-month note to bank) June 30Interest Expense 4,000 Interest Payable 4,000 (To accrue interest for 4 months on note) $100,000 x.12 x 4/12 months

11 Sales Taxes Payable... zAre collected from customers. zAre expressed as a % of sales price. zAre required by law. zMust be sent to state often. zAre often rung separately from sales on the cash register.

Journal Mar 25Cash10,600 Sales10,000 Sales Taxes Payable 600 (To record daily sales and sales taxes)

13 Sales Taxes... When sales taxes are not rung up separately, total receipts are divided by 100% plus the sales taxes percentage. Total Receipts 100% + 6% 10,600 = $10,000 Sales 1.06

14 Sales Taxes... $10,000 x.06 = $ 600 Sales Taxes 10,600 = $10,000 Sales 1.06 Mar 25Cash10,600 Sales10,000 Sales Taxes Payable 600 (To record daily sales and sales taxes) Journal

15 Payroll Taxes... Amount required by law to be withheld from employees’ gross pay. ySocial Security taxes withheld (FICA) yFederal Income Taxes yState Income Taxes (if applicable)

Journal Mar 7 Salaries and Wages Expense 100,000 FICA Taxes Payable7,250 Federal Income Taxes Payable 21,864 States Income Taxes Payable2,922 Salaries and Wages Payable 67,964 Cash 67,964

Payroll Deductions Illustration 10-1

18 Unearned Revenues... Cash received before revenues are earned and recorded as liabilities until they are earned.

19 Unearned Revenues... zMagazine subscriptions zRent received in advance zCustomer deposits for future service zSale of airline tickets for future travel zSale to season sporting events

20 Current Maturities of Long-Term Debt The portion of the long-term debt that is due within the current year or operating cycle should be classified as a current liability.

FICTICTIOUS COMPANY Balance Sheet December 31, 2001 Assets Current Assets Cash $ 272 Marketable securities (current) 609 Receivables 74 Other current assets 83 Total current assets 1,038 Property and equipment (net) 317 Marketable securities (long-term) 322 Other long-term assets 280 Total Assets $1,957 Liabilities and Stockholders’ Equity Liabilities Current Liabilities Accounts payable$527 Notes payable133 Current maturities of long term debt100 Accrued liabilities and expenses 56 Total current liabilities816 Long-term debt 83 Total liabilities899 Stockholders’ equity Common stock 830 Retained earnings228 Total Liabilities and stockholders’ equity $1,957

22 Liquidity Ratios... Measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash. zWorking capital zCurrent ratio zAcid-test ratio

23 Working Capital Measures short- term ability to pay liabilities Current Assets - Current Liabilities = Working Capital

24 Current Ratio Measure of short-term ability to pay obligations Current Ratio = Current Assets Current Liabilities

25 Acid-Test Ratio Measure of company’s immediate short-term ability to pay obligations Acid-Test Ratio = Securities, Net Receivables Current Liabilities Cash,Marketable

26 Line of Credit... Is a prearranged agreement between a company and a lender to allow the company to borrow up to an agreed- upon amount.

27 Long-Term Liabilities... Are obligations that are expected to be paid after 1 year.

28 Bonds... zAre a form of interest-bearing notes payable issued by corporations, universities and governmental agencies. zAre sold in small denominations, which makes them attractive to investors.

Advantages of Bond Financing Over Common Stock Illustration 10-6

30 Secured Bonds... Have specific assets of the issuer pledged as collateral for bonds. yMortgage Bond - a bond secured by real estate. ySinking Fund Bond - a bond secured by specific assets to retire the bonds.

31 Unsecured or Debenture Bonds... Are issued against the general credit of the borrower. Page 463 in book

32 Term Bonds... Are due for payment (mature) at a single specified future date. Page 463 in book

33 mature in installments. Serial Bonds... Page 463 in book

34 Convertible Bonds... Can be changed into common stock at the bondholder’s option. Callable Bonds… Are subject to retirement prior at a stated dollar amount prior to maturity at the option of the issuer.

35 Issuing Bonds... zRequires formal approval by board of directors and stockholders. zBoard of Directors must stipulate yTotal number of bonds to be authorized yTotal face value yContractual Interest Rate

36 Bond Indenture... zThe terms of a bond issue set forth in a legal document. zSummarizes the rights and privileges of bondholders and trustees. zSummarizes obligations and commitments of issuing company.

37 Face Value... The amount of principle due at maturity date. Contractual Interest Rate... Is the rate used to determine the amount of cash interest the borrower pays and investor receives.

38 Present Value... The value today of an amount to be received at some date in the future after taking into account current interest rates.

39 Market Interest Rate... The rate that investors demand for loaning funds. Not the same as contractual or stated rate.

Cash Flow of Bonds Illustration 10-9

41 Accounting for Bond Issues Bonds may be issued at: zFace value zBelow face value (discount) or zAbove face value (premium).

42 Issuing Bonds at Face Value Assume that Devour Corporation issued 1,000, 10-year 10%, $1,000 bonds dated January 1, 2001 at 100 (100% of face value) with interest payable on July 1 and January 1. 1/1Cash1,000,000 Bonds Payable 1,000,00 (To record sale of bonds at face value)

43 Issuing Bonds at Face Value The bonds are reported in the long-term liability section of the balance sheet because the maturity date is more than 1 year away. The entry to record the semiannual interest on July 1 is: 7/1Bond Interest Expense 50,000 Cash 50,000 (To record the payment of bond interest)

44 Issuing Bonds at Face Value On December 31 the following adjusting entry is required to record the $ 50,000 of interest accrued since July 1: 12/31Bond Interest Expense 50,000 Bond Interest Payable 50,000 (To accrue bond interest)

45 Discount or Premiums on Bonds Often the contractual (stated) interest rate and the market (effective) interest rate differ… therefore bonds sell above or below face value.

46 Bond Discount... When the investor pays less than the face value of the bond. WHY? To adjust the contractual interest to the market interest rate.

47 Bond Premium... When the investor pays more than the face value of the bond. WHY? To adjust the contractual interest to the market interest rate.

Bond Prices Vary Inversely With Changes in Market Interest Rates Illustration 10-11

49 Selling Bonds at Discount January 1, 2001, Candlestick, Inc., sells $1 million, 5- year, 10% bonds at 98 with interest payable on July 1 and January 1. 1/1Cash 980,000 Discount on Bonds Payable 20,000 Bonds Payable1,000,000 (To record sale of bonds at a discount)

50 Carrying (Book) Value of Bonds Long-term liabilities Bonds payable $1,000,000 Less: Discount on bonds 20,000 $980,000 payable Carrying Value Illustration 10-12

51 Selling Bonds at Premium Assume that on January 1, 2001, Candlestick, Inc., sells $1 million, 5-year, 10% bonds at 102 with interest payable on July 1 and January 1. 1/1Cash1,020,000 Bonds Payable1,000,000 Premium Bonds Payable 20,000 (To record sale of bonds at a premium)

Could you show me how to present a premium?

53 Carrying (Book) Value of Bonds Long-term liabilities Bonds payable $1,000,000 Add : Premium on bonds 20,000 $1,020,000 payable Carrying Value Illustration 10-17

54 Straight-line Method of Allocation Is Used to Comply with Matching Principle Amortizing Bond Discount Amortizing Bond Premium Page 471 in Book Page 469 in Book

55 Amortizing Bond Discount/Premium Candlelight would amortize the $20,000 discount/premium as follows: $20,000 ÷ 10 Interest Periods = $2,000 Semiannually

56 Bond Retirement Bonds may be redeemed at maturity or before maturity.

57 Redeeming Bonds Before Maturity zA company may decide to retire bonds before maturity to: yreduce interest cost yremove debt from its balance sheet. zA company should retire debt early only if it has sufficient cash resources.

58 Redeeming Bonds Before Maturity zWhen bonds are retired before maturity, it is necessary to: yEliminate the carrying value of the bonds at the redemption date yRecord the cash paid yRecognize the gain or loss on redemption.

Partial Balance Sheet Long-term liabilities Bonds payable 10% due in 2009 $1,000,000 Less: Discount on bonds payable 80,000 $ 920,000 Notes payable, 11%, due in 2015 and secured by plant assets 500,000 Lease liability 540,000 Total long-term liabilities $1,960,000 Illustration 10-22

60 Debt to Total Assets Ratio... Indicates the extent to which a company’s debt could be repaid by liquidating assets. Debt to Total Assets Ratio= Total Liabilities Total Assets Illustration 10-23

61 Times Interest Earned Ratio... Provides an indication of company’s ability to meet interest payments as they come due. Times Interest Earned Ratio= Income Before Interest Expense & Income Tax Interest Expense Illustration 10-23

62 Contingent Liabilities... zAre events with uncertain outcomes. zMust be recorded in the financial statements: yif the company can determine a reasonable estimate of the expected loss and yif it is probable it will lose the suit.

63 Lease Liabilities zIn some instances the lease contract transfers substantially all the benefits and risks of ownership to the lessee, so that the lease is in effect a purchase of the property. zThe type of lease described above is called a capital lease because the fair value of the leased asset is capitalized by the lessee recording it on its balance sheet.

64 Capital Lease zIs it likely that the lessee will end up with the assets at the end of the lease? zWill the lessee use the asset for most of its useful life? zWill the payments made by the lessee be approximately the same as the payments it would have made if it had purchased the asset?

65 Capital Lease zLessee must record the asset and a related liability for the lease payments. zMost lessees do not like to report leases on their balance sheets because the lease liability increases the company's total liabilities. zThe procedure of keeping liabilities off the balance sheet is often referred to as off- balance sheet financing.

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