1 Financial Accounting: Tools for Business Decision Making Kimmel, Weygandt, Kieso, Trenholm KIMMEL

2 Chapter 10 Reporting and Analysing Liabilities After studying Chapter 10, 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.Identify the requirements for the financial statement presentation and analysis of current liabilities.

3 After studying Chapter 10, you should be able to: 5.Explain why bonds are issued and identify the types of bonds. 6.Prepare the entries for the issuance of bonds and their interest expense. 7.Describe the entries when bonds are redeemed. 8.Identify the requirements for the financial statement presentation and analysis of long- term liabilities. Chapter 10 Reporting and Analysing Liabilities

4 +Creditor claims on total assets +Existing debts and obligations +Current and long-term Liabilities must be settled in the future by transfer of assets or services Liabilities

5 Current Liabilities +Expected to be paid +From existing current assets or through the creation of other current liabilities +Within 1 year or the operating cycle, whichever is longer Debts that do not meet both criteria are long-term liabilities

6 +Notes payable +Accounts payable +Accrued liabilities +Sales taxes payable +Corporate income taxes payable +Payroll and employee benefits payable +Unearned revenues +Current maturities of long-term debt Current Liabilities

7 Notes Payable +Often used instead of accounts payable - they give written documentation if needed for legal remedies +Normally has interest attached +Used for short-term and long-term financing needs

8 +Federal goods and services tax (GST) +Provincial sales tax (PST) +Harmonized into one combined sales tax (HST) in some provinces +May be included in sales price, or excluded +Must be remitted periodically to respective governments Sales Taxes Payable

9 Corporate Income Taxes Payable +Calculated annually on corporate earnings +Estimated and remitted monthly; adjusted at year end

10 Payroll and Employee Benefits Payable +Employee payroll deductions +Canada pension plan (CPP) +Employment insurance (EI) +Federal and provincial income taxes +Other deductions at source +Employer payroll contributions +CPP +EI +Workers’ compensation +Other

11 +Cash received before revenues are earned. Recorded as liabilities until earned +Magazine subscriptions +Rent received in advance +Customer deposits for future service +Sale of airline tickets for future travel +Sale of season sporting events Unearned Revenues

12 Current Maturities of Long-Term Debt +Portion of the long-term debt that is due within the current year or operating cycle should be classified as a current liability

13 +Measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash +Current ratio (Chapter 2) +Acid-test ratio Liquidity Ratios

14 Current Ratio +Measure of short-term ability to pay obligations Current ratio = Current assets Current liabilities

15 Acid-Test Ratio +Measure of company’s immediate short-term ability to pay obligations Acid-test ratio = Cash + short-term investments + net receivables Current liabilities

16 Operating Line of Credit +Prearranged agreement between a company and a lender to allow the company to borrow up to an agreed- upon amount

17 Long-Term Liabilities +Obligations to be paid after 1 year +Include bonds, long-term notes, and lease obligations

18 Bonds +Form of interest-bearing notes payable issued by corporations, universities and governmental agencies +Sold in small denominations, which makes them attractive to investors

Illustration 10-6 Advantages of Bond Financing Over Common Shares

20 Types of Bonds +Secured (mortgage bond, sinking fund bond) vs. unsecured (debenture bond) +Term vs. serial +Convertible vs. redeemable/retractable

21 Terminology +Contractual interest rate +Stated rate which determines the amount of cash interest the borrower pays and investor receives +Market (effective) interest rate +Rate that investors demand for loaning funds

22 Terminology +Face value +Amount of principal due at maturity +Present value +Value today of bond (1) face value to be received at maturity, and (2) interest payments to be received periodically, after taking into account current interest rates

Cash Flow of Bonds Illustration 10-9

24 Accounting for Bond Issues +Bonds may be issued at +Face value +Below face value (discount) +Above face value (premium)

Illustration Interest Rates and Bond Prices

26 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) 1/1Cash1,000,000 Bonds Payable 1,000,000 (To record sale of bonds at face value)

27 +When the investor pays less than the face value of the bond WHY? +To adjust the contractual interest to the market interest rate Issuing Bonds at Discount

28 Issuing Bonds at Discount Assume that on January 1, 2001, Candlestick, Inc., sells $1 million, 5-year, 10% bonds at 98 1/1Cash 980,000 Discount on Bonds Payable 20,000 Bonds Payable1,000,000 (To record sale of bonds at a discount)

Could you show me how to present a discount on the balance sheet?

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

31 +When the investor pays more than the face value of the bond WHY? +To adjust the contractual interest to the market interest rate Issuing Bonds at Premium

32 Issuing Bonds at Premium Assume that on January 1, 2001, Candlestick, Inc., sells $1 million, 5-year, 10% bonds at 102 1/1Cash1, Bonds Payable1,000,000 Premium on Bonds Payable 20,000 (To record sale of bonds at a premium)

Could you show me how to present a premium on the balance sheet?

34 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

35 Amortizing Bond Discounts or Premiums +Straight-line method +Constant periodic expense, varying % +Simpler, widely used +Effective interest method +Varying periodic expense, constant % +Conceptually superior, better match +Both methods result in same total amount of interest expense over life of bonds

36 Amortizing Bond Discount Amortizing Bond Premium Straight-line Method of Amortization

37 Amortizing Bond Discounts or Premiums +Amortization spreads the cost of borrowing over the life of the bond +Discount amortization increases interest expense +Premium amortization reduces interest expense

38 Bond Retirements +Bonds may be redeemed at maturity or before maturity

39 Redeeming Bonds Before Maturity +A company may decide to retire bonds before maturity to: +Reduce interest cost +Remove debt from its balance sheet +A company should retire debt early only if it has sufficient cash resources

40 Redeeming Bonds Before Maturity +When bonds are retired before maturity: +Eliminate carrying value of the bonds at the redemption date +Record the cash paid +Recognize the gain or loss on redemption (gain if cost carrying value)

41 Presentation of Long-Term Liabilities +Report long-term debt separately in balance sheet and detail in notes +Report current maturities of long- term debt as current liabilities

42 Analysis of Long-Term Liabilities +Debt to total assets (Chapter 2) +Times interest earned +Cash interest coverage

43 Debt to Total Assets +Indicates the extent to which a company’s debt could be repaid by liquidating assets Debt to total assets ratio= Total liabilities Total assets

44 Times Interest Earned +Provides an indication of company’s ability to meet interest payments as they come due Times interest earned ratio= Earnings before interest expense and income tax expense (EBIT) Interest expense

45 Cash Interest Coverage +Provides an indication of company’s ability to meet interest payments as they come due on a cash basis Cash interest coverage ratio= Earnings before interest expense, income tax expense and amortization expense (EBITDA) Interest expense

46 Contingent Liabilities +Events with uncertain outcomes +Must be recorded in the financial statements +If the company can reasonably estimate the expected loss, and +If the loss is likely

47 Lease Liabilities +Operating lease +Capital lease

48 Operating Lease +Temporary use of the property by the lessee with continued ownership of the property by the lessor +Lease (rental) payments are recorded as an expense by the lessee and as revenue by the lessor Car rental is an example of an operating lease

49 Capital Lease +If lease contract transfers substantially all the benefits and risks of ownership to the lessee, the lease is in effect a purchase of the property +This type of lease is called a capital lease because the fair value of the leased asset is capitalized by the lessee recording it on its balance sheet

50 Decision Checkpoints +Can the company meet its current obligations? +Can the company obtain short-term financing when necessary? +Is the company generating sufficient earnings to cover annual interest payments? + Acid-test ratio + Liquidity ratios, lines of credit + Times interest earned ratio

51 Decision Checkpoints (continued) +Is the company generating sufficient cash to pay its interest? +Does the company have any contingent liabilities? +Does the company have significant unrecorded lease obligations? + Cash interest coverage ratio

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