1 © Copyright 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star Logo, and South-Western are trademarks used herein under license. FINANCIAL ACCOUNTING 2 ND EDITION BY DUCHAC, REEVE, & WARREN 10 Liabilities

2 LEARNING GOALS When you finish this chapter, you should be able to

3 1.Describe, illustrate current liabilities. 2.Describe characteristics of long-term liabilities; apply present value concepts to bonds payable. 3.Describe, illustrate deferred liabilities. LEARNING GOALS Continued

4 LEARNING GOALS 4. Identify characteristics of contingent liabilities. 5.Illustrate reporting of liabilities on balance sheet. 6.Analyze, interpret liquidity.

5 BARNES & NOBLE, INC. Barnes & Noble, Inc.  Debt can help business reach its objectives  B&N uses short-term credit to purchase books, music, DVDs  When merchandise is sold, debt is repaid  B&N uses long term debt to expand

6 LEARNING GOALS 1 Describe, illustrate current liabilities.

7 CURRENT LIABILITIES Current liabilities include –Accounts payable –Notes payable –Payroll liabilities LG 1

8 ACCOUNTS PAYABLE Accounts payable –Short term debt –Used for Buying goods, services for use in operations Buying merchandise for resale LG 1

9 NOTES PAYABLE Notes payable –Short term debt –Used for Buying goods, other assets Borrowing cash from bank Example: Issued 90-day, 12%, $1,000 interest bearing note to satisfy overdue account. Continued LG 1

10 8/1 ENTRY: Notes Payable 8/1 Acct Payable: MC Notes Payable 1,000 Replaced account payable to Murray Co. No effect cash flow No effect balance sheet No effect income statement LG 1 SCFBSIS

11 10/30 ENTRY: Payment 10/30 Notes Payable Interest Exp Cash 1, ,030 Paid note and interest Decreases operating cash flow Decreases assets, liabilities, equity on balance sheet Increases expenses on income statement LG 1 SCFBSIS E

12 EXERCISE 10-3a Press “Enter” or click left mouse button for answer. A borrower borrows $75,000 on a 90-day 7% note. LG 1 Click button to skip this exercise 1.The amount of interest is $ The proceeds received are $75,000

13 DISCOUNTED NOTES Discounted notes –Do not specify interest rate on note –Interest deducted from face of note Called “discount” “discount rate” used to compute discount –Creditor set rate of interest Example: Issued $20,000, 90-day, 15%, discounted note to purchase inventory. Continued LG 1

14 8/10 ENTRY: Discounted Note 8/10 Inventory Interest Exp Notes Payable 19, ,000 Bought inventory on discounted note No effect cash flow Increases assets, liabilities, decreases equity on balance sheet Increases expenses on income statement LG 1 SCFBSIS E

15 11/8 ENTRY: Payment 11/8 Notes Payable Cash 20,000 Paid discounted note. Decreases operating cash flow Decreases assets, liabilities on balance sheet No effect income statement LG 1 SCFBSIS

16 EXERCISE 10-3b Press “Enter” or click left mouse button for answer. A borrower borrows $75,000 on a 90-day note that is discounted at 7%. LG 1 Click button to skip this exercise 1.The amount of interest is $ The proceeds received are $73, The conditions in Exercise 3a are more favorable to the borrower.

17 PAYROLL LIABILITIES Payroll liabilities –Are short term liabilities –Include employee taxes withheld –Include employer taxes LG 1

18 PAYROLL TAXES Employee taxes withheld –FICA tax –Employees federal income tax –Employees state income tax Employer taxes include –FICA tax –State and federal unemployment taxes LG 1

19 4/11 ENTRY: Employee Payroll 4/11 Wages & Salaries Exp FICA Tax Payable Federal Tax Payable State Tax Payable Cash 13,800 1,035 1, ,830 Paid weekly payroll Decreases operating cash flow Decreases assets, equity, increases liabilities on balance sheet Increases expenses on income statement LG 1 SCFBSIS

20 4/11 ENTRY: Employer Taxes 4/11 Payroll Tax Expense FICA Payable SUTA Payable FUTA Payable 1,205 1, Employer’s weekly payroll tax expense No effect cash flow Increases liabilities,decreases equity on balance sheet Increases expenses on income statement LG 1 SCFBSIS

21 LEARNING GOALS 2 Describe characteristics of long-term liabilities; apply present value concepts to bonds payable.

22 BONDS Most common form of long term debt –Bond issue divided into individual bonds Most common face value (denomination): $1,000 –Interest paid annually, semi-annually, or quarterly LG 2

23 TYPES OF BONDS Term bonds –All bonds due at same time Serial bonds –Bond maturities spread over several dates Convertible bonds can be converted into equity Callable bonds can be redeemed early Debenture bonds issued on general credit LG 2

24 EXHIBIT 4 Time value of money: Comparing apples & oranges. $1 today does not equal $1 received in 10 years. LG 2

25 TIME VALUE of $1 If Apex Corp. deposited $55, in the bank at an annual interest rate of 6%, how much would they have in 10 years? LG 2

26 EXHIBIT 6 1 Deposit LG 2

27 TIME VALUE CALCULATION $1 Present value =Future amount *Present value $1 $55,840 =$100,000 * Over a 10 year period invested at 6%, $44,160 interest earned. LG 2 Present Value of $1 table on page 449.

28 TIME VALUE OF ANNUITY How much would Apex Corp. have to deposit in a bank today in order to withdraw $6,000 each year for 10 years with an annual interest rate of 6%? LG 2

29 TIME VALUE CALCULATION ANNUITY Present value annuity = Annuity payment *Present value annuity $44, = $6,000 * Payments of $6,000 over 10 6% are worth $44, TODAY. LG 2 Present Value of an Annuity table on page 451.

30 EXHIBIT 7 Annuity LG 2

31 CALCULATING BOND PRICE Bond price is function of –Face value of bond –Interest payments made –Bond market rate LG 2

32 EXHIBIT 10 + LG 2

33 LG 2 How does a firm record the sale of $100,000 of bonds at face value?

34 1/1 ENTRY: Bond Issuance 1/1 Cash Bonds Payable 100,000 Issued bonds at face value Increases financing cash flow Increases assets, liabilities on balance sheet No effect on income statement LG 2 SCFBSIS

35 LG 2 If the bonds pay 6% interest semiannually, how does the firm record the first interest payment?

36 6/30 ENTRY: Interest Payment 6/30 Interest Expense Cash 6,000 Paid semi-annual interest payment Decreases operating cash flow Decreases assets, equity on balance sheet Increases expenses on income statement LG 2 SCFBSIS E

37 BOND SOLD AT DISCOUNT Bonds sold below face value –Are sold at a discount –Contract rate is less than market interest rate Bonds sold below face value –Are sold at a discount –Contract rate is less than market interest rate LG 2

38 1/1 ENTRY: Bond Issuance 1/1 Cash Discount Bonds Payable 96,406 3, ,000 Issued bonds at discount Increases financing cash flow Increases assets, liabilities on balance sheet No effect on income statement LG 2 SCFBSIS

39 6/30 ENTRY: Interest Payment with Discount Amortization 6/30 Interest Expense Discount Cash 6, , Paid semi-annual interest payment Decreases operating cash flow Decreases assets, equity, increases liabilities on balance sheet Increases expenses on income statement LG 2 SCFBSIS E

40 BOND SOLD AT PREMIUM Bonds sold above face value –Are sold at a premium –Contract rate is more than market interest rate Bonds sold above face value –Are sold at a premium –Contract rate is more than market interest rate LG 2

41 1/1 ENTRY: Bond Issuance 1/1 Cash Bonds Payable Premium 103, ,000 3,769 Issued bonds at premium Increases financing cash flow Increases assets, liabilities on balance sheet No effect on income statement LG 2 SCFBSIS

42 6/30 ENTRY: Interest Payment with Premium Amortization 6/30 Interest Expense Premium Cash 5, ,000 Paid semi-annual interest payment Decreases operating cash flow Decreases assets, liabilities, equity on balance sheet Increases expenses on income statement LG 2 SCFBSIS E

43 BOND REDEMPTION When bonds redeemed –All related accounts removed –Gain or loss recognized When bonds redeemed –All related accounts removed –Gain or loss recognized LG 2

44 6/30 ENTRY: Bond Redemption 6/30 Bonds payable Premium Loss on B/P Cash 100,000 4,000 1, ,000 Called bonds Decreases operating cash flow Decreases assets, liabilities, equity on balance sheet Increases expenses on income statement LG 2 SCFBSIS E

45 LEARNING GOALS 3 Describe, illustrate deferred liabilities.

46 DEFERRED LIABILITIES Deferred revenue –Cash received before revenue earned –Ex.: unearned revenue Deferred expense –Expense recorded before cash payment –Ex.: tax expense LG 3

47 LEARNING GOALS 4 Identify characteristics of contingent liabilities.

48 CONTINGENT LIABILITIES Contingent liabilities –Arise from past transactions –Are often estimated –Must be paid if certain events occur in future –Ex.: warranty expense LG 4

49 EXHIBIT 15 How to account for different contingent liabilities On Balance Sheet In footnotes LG 4

50 LEARNING GOALS 5 Illustrate reporting of liabilities on balance sheet.

51 REPORTING LIABILITIES Liabilities segregated between –Current liabilities Due within the next year or operating cycle –Long term liabilities Due later than 1 year Liabilities listed in order of liquidity LG 5

52 LG 5 When are contingent liabilities reported on the face of the balance sheet? Contingent liabilities are reported on the balance sheet when they are probable & estimable.

53 LEARNING GOALS 6 Analyze, interpret liquidity.

54 CURRENT LIQUIDITY RATIOS Current liquidity analysis –Measures ability to pay current liabilities when they come due Current ratio Quick ratio LG 6 Current assets/ Current liabilities Quick assets/ Current liabilities

55 EXHIBIT 16 Partial balance sheet LG 6

56 CURRENT RATIO: Barnes & Noble Current assets/ Current liabilities $1,970.0/ 1,325.6 = 1.49 A higher ratio is better. LG 6

57 QUICK RATIO: Barnes & Noble Quick assets/ Current liabilities ($ $74.6)/ 1,325.6 = 0.46 A higher ratio is better. LG 6

58 ANALYZING CURRENT LIQUIDITY RATIOS If the standards for the current ratio and quick ratio are 2:1 & 1:1 respectively, what can you say about Barnes & Noble’s current liquidity position? LG 6

59 LONG TERM LIABILITY RATIOS Times Interest Earned indicates the ability to cover interest charges Leverage is a measure of relative debt financing LG 6 Total liabilities / Total Assets (Income before tax + Interest Exp) / Interest Exp.

60 TIMES INTEREST EARNED: Basic Information B&N, Inc (millions) Borders, Inc. (millions) Interest Exp$14.5$9.1 Income before tax LG 6

61 TIMES INTEREST EARNED: Calculations Barnes & Noble’s Times interest earned ratio is ($ $14.5) / $14.5 = 16.1 What is Border’s ratio? Which company is in a better position? A higher ratio is better. LG 6

62 DEBT-to-ASSETS: Basic Information B&N, Inc (millions) Borders, Inc. (millions) Total liabilities $2,135.6$1,538.5 Total Assets3,301.52,628.8 LG 6

63 LEVERAGE: Calculations Barnes & Noble’s leverage ratio is $2,135.6 / $3,301.5 = 0.65 What is Border’s ratio? Which company is in a better position? Higher leverage represents higher risk. LG 6

64 THE END CHAPTER 10