1. Current and Long-Term Liabilities
Chapter 7
Current and Long-Term Liabilities
This chapter introduces liabilities with known amounts due: notes payable, sales taxes payable, and contingent liabilities including warranties payable. We will discuss current liabilities, those that are payable within one year or the operating cycle, whichever is longer; and long-term liabilities. We will learn about two types of long-term debt: notes payable and bonds payable

2. Learning Objective 1
Show how notes payable and related interest expense affect financial statements.
Learning Objective 1:
Show how notes payable and related interest expense affect financial statements.

3. Accounting for Notes Payable
09/01/06 Loan of money
On September 1, 2006 Herrera Supply Company (HSC) borrowed $90,000 from the National Bank. HSC issues a note payable due in one year with an annual interest rate of 9%.
Part I Herrera Supply Company (HSC) borrowed ninety thousand dollars from the National Bank. HSC issues a note payable due in one year with an annual interest rate of 9%.
Part II The asset account, cash, increases by ninety thousand dollars, and the liability account, notes payable, increases by the same amount. There is no income statement impact of this transaction. However, the financing activities section of the Statement of Cash Flows shows an inflow of ninety thousand dollars.

4. Accrual of Interest Expense
12/31/06 Recognition of Interest Expense
At the end of 2006, HSC must accrue interest on its note payable.
$90,000 × 9% × 4/12 = $2700 interest expense
Part I
At the end of 2006, HSC must accrue interest expense on the loan it took out on September 1st.
Part II
To calculate the interest we multiply the principal amount of ninety thousand dollars times the annual interest rate of nine percent and adjust the total for the time the note has been outstanding. The note was signed on September 1st, so four months have passed to December 31st. The interest expense is two thousand seven hundred dollars.
Part III The liability account, interest payable, increases by two thousand seven hundred dollars and the equity account decreases by the same amount because net income decreases by two thousand seven hundred dollars. There is no cash flow impact of this accrual.

5. Paying principal & interest at maturity date
08/31/07 Recognition of interest expense. Payment of principal and interest on the maturity date, August 31, 2007.
$90,000 × 9% × 8/12 = $5,400 interest expense
Now, record payment of principal and interest payable.
Part I
August 31, is the Notes Payable’s maturity date. Principal and interest for the loan must be paid to the National Bank on this date.
Part II
First, calculate the amount of Interest Expense that has been earned from January 1, 2007 to August 31, To calculate the interest, we multiply the principal amount of ninety thousand dollars times the annual interest rate of nine percent and adjust the total for the time the note has been outstanding in Remember the note was signed on September 1st and four months of interest expense were already recorded as interest expense in The interest expense in 2007 is five thousand four hundred dollars.
Part III
HSC now records the payment of both principal and interest. Note that cash is decreases by eight thousand one hundred dollars, while interest payable decreases by eight thousand one hundred dollars. Also notice that cash decreases by ninety thousand dollars and notes payable decreases by ninety thousand dollars. There is no effect on the income statement. However, the statement of cash flows shows an eight thousand one hundred dollar cash outflow from operating activities and a ninety thousand dollar cash outflow from financing activities.

6. Learning Objective 2
Show how sales tax liabilities affect financial statements.
Learning Objective 2:
Show how sales tax liabilities affect financial statements.

7. Accounting for Sales Tax
Most states require retail companies to collect sales tax on items sold to their customers. The retailer then remits the tax to the state at regular intervals. Sales tax is a liability to the retailer until paid to the state.
HSC sells merchandise to a customer for $2,000 cash in a state where the sales tax rate is 6%.
Part I
Most states require retail companies to collect sales tax on items sold to their customers. The retailer then remits the tax to the state at regular intervals. Sales tax is a liability to the retailer until paid to the state.
HSC sells merchandise to a customer for two thousand dollars cash in a state where the sales tax rate is six percent.
Part II
Cash increases by two thousand one hundred twenty dollars. Sales Tax Payable increases by one hundred twenty dollars (the amount of sales tax that must be sent to the state). Equity increases by two thousand dollars which is the sales price of the items sold to customers. The statement of cash flows shows a two thousand one hundred twenty dollar inflow from operating activities.

8. Accounting for Sales Tax
Remitting the tax (paying cash to the state tax authority) is an asset use transaction.
Remitting the tax (paying cash to the state tax authority) is an asset use transaction. Cash decreases by one hundred twenty dollars and Sales Tax Payable decreases by one hundred twenty dollars. There is no effect on the income statement. The statement of cash flows shows one hundred twenty dollars outflow from operating activities.

9. Learning Objective 3
Define contingent liabilities and explain how they are reported in financial statements.
Learning Objective 3:
Define contingent liabilities and explain how they are reported in financial statements

10. Contingent Liabilities
A contingent liability is a potential obligation arising from a past event. The amount or existence of the obligation depends on some future event.
Generally accepted accounting principles require that companies classify contingent liabilities into three different categories depending on the likelihood of them becoming actual liabilities.
A contingent liability is a potential obligation arising from a past event. The amount or existence of the obligation depends on some future event.
Generally accepted accounting principles require that companies classify contingent liabilities into three different categories depending on the likelihood of them becoming actual liabilities: probable and reasonably estimated; possible or not estimable; or remote.
Probable and reasonably estimated
Possible or not estimable
Remote

11. Reporting Contingent Liabilities
If the likelihood of a future obligation arising is probably (likely) and its amount can be reasonably estimated, a liability is recognized in the financial statements. Examples: unearned revenue, warranties, vacation pay, sick leave.
If the likelihood of a future obligation arising is possible but not likely or if its amount cannot be reasonably estimated, no liability is reported on the balance sheet. However, the potential liability is disclosed in the footnotes to the financial statements. Examples: legal challenges, environmental damages, government investigations.
If the likelihood of a future obligation arising is remote, no liability is recognized in the financial statements or disclosed in the footnotes to the statements.

12. Learning Objective 4
Explain how warranty obligations affect financial statements.
Learning Objective 4:
Explain how warranty obligations affect financial statements.

13. Warranty Obligations
To attract customers, many companies guarantee their products or services. Within the warranty period, the seller promises to replace or repair defective products without charge.
Event Sale of Merchandise HSC sells $7,000 of merchandise for cash. The merchandise had a cost of $4,000.
Part I You have probably purchased merchandise with a product warranty. Most warranties agree to replace or repair defective merchandise within a specified period of time.
Part II HSC sells seven thousand dollars of merchandise that has a cost basis to the company of four thousand dollars. The merchandise is subject to a warranty.
Part III
The asset account, cash, increases by seven thousand dollars and income of seven thousand dollars increases equity. The operating activities section of the statement of cash flows shows an inflow of seven thousand dollars. In addition, the asset inventory decreases by four thousand dollars and cost of goods sold increases by the same amount.

14. Warranty Obligations
Event 2 Recognition of Warranty Expense HSC estimates that warranty expense associated with the current sale will be $100.
Part I HSC estimates that warranty expense associated with the seven thousand dollar sale will be one hundred dollars.
Part II The liability account, warranties payable, increases by one hundred dollars and an expense account, warranty expense, increases by the same amount. We are matching cost with the revenues generated in the accounting period.

15. Warranty Obligations
Event 3 Settlement of Warranty Obligation HSC pays $40 cash to repair defective merchandise returned by a customer.
Part I It cost HSC forty dollars cash to pay for repairs to defective merchandise included in the seven thousand dollar sale.
Part II The asset, cash, is reduced by forty dollars, and the liability, warranty payable, is reduced by the same amount. The income statement is not affected by the repairs payment. However, the forty dollars paid will appear in the operating activities section of the statement of cash flows as an outflow.

16. Financial Statements
Part I Revenue less cost of goods sold is equal to gross margin. We subtract the warranty expense to arrive at net income of two thousand nine hundred dollars. Now we can prepare the balance sheet.
Part II Notice the warranties payable in the liability section of the balance sheet.
Part III
In the statement of cash flows we have the seven thousand dollar inflow from customers and the forty dollar outflow for warranty payments.

17. Learning Objective 5
Show how the amortization of long-term notes affects financial statements.
Learning Objective 5:
Show how the amortization of long-term notes affects financial statements.

18. Installment Notes Payable
Long-term installment notes are liabilities that usually have terms from two to five years.
Principal
Payments
Company
Lender
Part I
Long-term installment notes are liabilities that usually have terms from two to five years.
Part II
The principal balance is repaid with a series of equal payments. Each payment includes some payment on the principal and some payment for interest. Most car loans and home loans are set up with installment payments.
Part III
For each payment that is made, the amount applied to the principal increases and the amount of the interest decreases.
Each payment covers interest for the period and a portion of the principal.
With each payment, the interest portion gets smaller and the principal portion gets larger.

19. Installment Notes Payable
Applying payments to principal and interest
Identify the unpaid principal balance.
Amount applied to interest = Unpaid principal balance × Interest rate.
Amount applied to principal = Cash payment – amount applied to interest in .
Unpaid principal balance = Unpaid principal balance in  – amount applied to principal in .
To determine the portion of each payment that is interest and the portion to apply to the principal, follow these four steps:
 Identify the unpaid principal balance.
 Multiply the unpaid principal balance times the interest rate to find the portion of the payment that is interest.
 Subtract the portion of the payment that is interest in  from the total cash payment to find the portion of the payment to apply to the principal.
 The updated unpaid principal balance equals the unpaid principal balance in  minus the portion of the payment applied to the principal in .
Let’s look at an example.

20. Prepare an amortization table for Blair’s note.
Installment Notes Payable
On January 1, 2005, Blair Company issued a $100,000 face value installment note to National Bank. The note had a 9 percent annual interest rate and a five year term. The loan agreement called for five equal payments of $25,709 to be made on December 31 of each year.
Prepare an amortization table for Blair’s note.
Take a minute and review this information for Blair Company. On January 1, 2005, Blair Company borrowed one hundred thousand dollars from National Bank. The loan has a nine percent interest rate and will be repaid with five annual payments of twenty-five thousand seven hundred nine dollars each.
Let’s look at the amortization table for this loan.

21. Installment Notes Payable
Cash payment determined using present value concepts presented in a later chapter.
Notice that the annual payment is always twenty-five thousand seven hundred nine dollars. Also notice that for each payment the interest portion decreases and the principal portion increases.
Let’s review how to get the amount applied to interest and the amount applied to principal for the first payment on this note.
The interest portion is calculated by multiplying the one hundred thousand dollar unpaid balance at the beginning of the period times nine percent to get nine thousand dollars.
The principal portion is calculated by subtracting nine thousand dollars from twenty-five thousand seven hundred nine dollars to get sixteen thousand seven hundred nine dollars.
You should verify the remain computations in the amortization table before advancing.
All computations rounded to the nearest dollar.

22. Annual payments are constant.
Installment Notes Payable
Annual payments are constant.
The graph on your screen shows that the amount of each payment applied to the principal increases each year, while the amount of interest decreases each year.
The amount applied to the principal increases each year. The amount of interest decreases each year.

23. Installment Notes Payable
Issuing the note has the following effect on Blair’s 2005 financial statements:
The December 2005 cash payment has the following effect on Blair’s 2005 financial statements:
Part I
Issuing the note payable increases both assets (Cash) and liabilities (Notes Payable). There is no effect on the Income Statement when the note is issued. The cash inflow is reported in the financing section of the Statement of Cash Flows.
Part II
Each payment decreases assets (Cash) by the amount of the payment. Liabilities (Notes Payable) decrease by the amount of the payment applied to principal. Equity (Retained Earnings) decreases by the amount of the payment that is interest. Net income decreases by the amount of interest. The portion of the payment that is interest is reported in the operating section of the Statement of Cash Flows. The portion of the payment applied to principal is reported in the financing section of the Statement of Cash Flows.

24. Installment Notes Payable
Although the amounts for interest expense and principal repayment differ each year, the effects of the annual payment on the financial statements are the same.
On the balance sheet, assets (cash) decrease by the total amount of the payment; liabilities (notes payable) decrease by the amount of the principal repayment; and stockholders’ equity (retained earnings) decreases by the amount of interest expense.
Net income decreases from recognizing interest expense. On the statement of cash flows, the portion of the cash payment applied to interest is reported in the operating activities section and the portion applied to principal is reported in the financing activities section.

25. Learning Objective 6
Show how a line of credit affects financial statements.
Learning Objective 6:
Show how a line of credit affects financial statements.

26. Line of Credit
Lines of credit are pre-approved financing plans that allow companies to borrow and repay funds as needed up to the maximum credit line set by the creditor.
Lines of credit are normally used for relatively short-term borrowing to finance seasonal business needs.
Lines of credit are pre-approved financing plans that allow companies to borrow and repay funds as needed up the maximum credit line set by the creditor. Lines of credit are normally used for relatively short-term borrowing to finance seasonal business needs.
For an individual, overdraft protection on a checking account is similar to a business line of credit.

27. Line of Credit
Lagoon Company borrows money using a line of credit to finance building up its inventory. Lagoon repays the loan over the summer using cash generated from sales.
Lagoon Company borrows money using a line of credit to finance building up its inventory. Lagoon repays the loan over the summer using cash generated from sales. Each borrowing is an asset source transaction (cash and the line of credit liability increase). Each repayment is an asset use transaction (cash and retained earnings decrease as does net income).
Each borrowing is an asset source transaction. Each repayment is an asset use transaction.

28. Effects on Financial Statements
Study the effects on the financial statements that result from each of the borrowings and repayments on the line of credit.

29. Learning Objective 7
Explain how to account for bonds and their related interest costs.
Learning Objective 7:
Explain how to account for bonds and their related interest costs.

30. Bonds Issued at Face Value
Mason Company issues bonds on January 1, 2001.
Principal = $100,000
Stated Interest Rate = 9%
Interest Date = 12/31
Maturity Date = Dec. 31, 2005 (5 years)
Mason Company issues bonds at face value. This means that the stated interest rate on the bond and the market interest rate on the bond are equal. Mason’s bonds have a face value of one hundred thousand dollars, a stated interest rate of nine percent with interest payable on December 31 of each year. The bonds are issued on January 1, 2001, and mature five years later on December 31, 2005.
On the issue date, the bondholders give Mason Company the selling price of the bond issue, and Mason Company gives the bondholders a bond certificate promising to pay periodic interest and to return the principal on the maturity date.
Bond Selling Price
Bond Certificate
at Face Value
Mason Company
Investors

31. Bonds Issued at Face Value
Event 1 Issue Bonds for Cash
Issuing the bonds has the following effect on Mason’s 2001 financial statements:
Issuing the bond payable increases both assets (Cash) and liabilities (Bonds Payable). There is no effect on the income statement when the note is issued. The cash inflow is reported in the financing section of the Statement of Cash Flows.

32. Bonds Issued at Face Value
Event 2 Investment in Land
Paying $100,000 cash to purchase land is an asset exchange transaction.
Event 3 Revenue Recognition
Recognizing $12,000 cash revenue from renting the property is an asset source transaction.
Part I
The asset cash decreases and the asset land increases by one hundred thousand dollars. There is no effect on the income statement. The cash outflow is reported in the investing section of the Statement of Cash Flows.
Part II
This event is repeated each year from 2001 through The asset cash increases by twelve thousand dollars as does the equity account, retained earnings. Recognizing revenue increases net income. The cash inflow is reported in the operating activities section of the statement of cash flows.

33. Bonds Issued at Face Value
On each interest payment date, Mason Company will pay $9,000 in interest. The amount is computed as follows:
$100, 000 × 9% = $9,000
On the each interest payment date for the five-year term of the bond issue, Mason will pay the bondholders a total of nine thousand dollars in interest. The interest is calculated by multiplying one hundred thousand dollars times the nine percent annual interest rate.
Bond Interest Payments
Mason Company
Investors

34. Bonds Issued at Face Value
Event 4 Expense Recognition
Mason’s $9,000 ($100,000 x 0.09) cash payments represents interest expense.
This event is also repeated each year from 2001 through Each interest payment decreases assets (Cash) and decreases Equity (Retained Earnings) by the amount of the interest payment. Net income also decreases by the amount of the interest payment. The interest payment is reported in the operating section of the Statement of Cash Flows.

35. Bonds Issued at Face Value
Event 5 Sale of Investment in Land
Selling the land for cash equal to its $100,000 book value is an asset exchange transaction.
Cash increases and land decreases. Since there is no gain or loss on the sale, the income statement is not affected. The cash inflow is reported in the investing activities section of the statement of cash flows.

36. Bonds Issued at Face Value
On December 31, 2005, Mason Company will return the $100,000 principal amount to the investors.
On the maturity date, Mason Company will pay the bondholders one hundred thousand dollars, the face amount of the bonds. At this time, the debt is extinguished.
Bond Principal
at Maturity Date
Mason Company
Investors

37. Bonds Issued at Face Value
Event 6 Payoff of Bond Liability
The principal repayment on December 31, 2005 will have the following effect on Mason’s 2005 financial statements:
The repayment at maturity decreases assets (Cash) and decreases liabilities (Bonds Payable) by one hundred thousand dollars. Net income is not effected by the repayment. The repayment is reported in the financing section of the Statement of Cash Flows.

38. Bonds Issued at Face Value
Compare Blair Company’s income statement in Exhibit 7-9 with Mason Company’s income statement in this exhibit.

39. Learning Objective 8
Distinguish between current and noncurrent assets and liabilities.
Learning Objectives 8:
Distinguish between current and noncurrent assets and liabilities.

40. Current Versus Noncurrent
Current assets are expected to be converted to cash or consumed within one year or an operating cycle, whichever is longer. Current assets include:
Cash
Marketable Securities
Accounts Receivable
Short-Term Notes Receivable
Interest Receivable
Inventory
Supplies
Prepaid Items
Current assets are expected to be converted to cash or consumed within one year of the normal operating cycle, whichever is longer. Do not confuse the operating cycle with the accounting cycle. The accounting cycle is usually monthly, and has nothing to do with the company’s operating cycle. Shown here is a list of common current assets.

41. Current Versus Noncurrent
Current liabilities are due within one year or an operating cycle, whichever is longer. Current liabilities include:
Accounts Payable
Short-Term Notes Payable
Wages Payable
Taxes Payable
Interest Payable
Current liabilities are due within one year or the normal operating cycle, whichever is longer. Current liabilities are normally paid with current assets. Shown here is a list of some current liabilities.

42. Learning Objective 9 Prepare a classified balance sheet.

43. Classified Balance Sheet
In a classified balance sheet we separate assets and liabilities by type. Property, plant, and equipment are usually considered long-lived assets much like long-term liabilities.

44. Learning Objective 10
Use the current ratio to assess the level of liquidity.
Learning Objective 10:
Use the current ratio to assess the level of liquidity.

45. Current Asset Current Liabilities
Current Ratio
Current Ratio =
Current Asset Current Liabilities
For Limbaugh Company the current ratio is:
Current Ratio =
$288,600 $193,800
= 1.49:1
Part I The current ratio is one of the most common ratios calculated in business. It measures the relationship between current assets and current liabilities.
Part II At Limbaugh Company the current ratio is one point four nine to one. This means that the company has one dollar and forty-nine cents in current assets for each dollar of current liabilities.
Part III
Current ratios can be too high or too low. A low ratio suggests the company may have difficulty paying its short-term obligations. A high ratio suggests the company is not maximizing its earnings potential because investments in liquid assets usually don’t earn as much as investments in other assets.
Current ratios can be too high or too low. A low ratio suggests the company may have difficulty paying its short-term obligations. A high ratio suggests the company is not maximizing its earnings potential because investments in liquid assets usually don’t earn as much as investments in other assets.

46. End of Chapter Seven
In this chapter we looked at some advanced transactions involving accounts and notes receivable. In addition, we examined obligations for product warranties. We also learned about two types of long-term debt: notes payable and bonds payable. We examined issuing bonds at face value.