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Liabilities
Chapter 8
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2. © 2007 McGraw-Hill Ryerson Ltd.
Liabilities
A future payment of assets or services that a company is presently obligated to make as a result of past transactions or events.
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Liabilities
Characteristics
The company has a present obligation.
Results from past transactions.
Payment to be made in the future.
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4. Current vs. Long-Term Liabilities
Current Liabilities
Are due within one year or within the next operating cycle, whichever is longer.
Are settled using current assets or by creating other current liabilities.
Long-Term Liabilities
Do not require payment within the longer of one year or an operating cycle.
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5. Current vs. Long-Term Liabilities
Current liability
Long-term liability
Balance sheet date
1 year or operating cycle
Examples:
Accounts payable
Unearned revenues
Wages payable
Current portion of
notes payable
Bonds payable
Lease obligations
Long-term portion of notes payable
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Accounts Payable
Are amounts owed to suppliers
Large sums of money flow through these accounts
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Notes Payable
A written promise to repay principal plus interest at specific future dates.(Promissory note)
Usually payable to banks
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Line of Credit
An agreement with a bank to provide automatically short-term loans up to some preestablished maximum
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Commercial Paper
A short-term debt contract issued by prominent companies that borrow directly from investors
The liability always falls due in 9 months or less, usually in 60 days after issuance.
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10. Accrued Employee Compensation
Compensation is not only monetary.
Benefits such as pension, medical, dental care are also forms of compensation
When accrue salary expenses at end of accounting period, must also accrue other forms of compensation
Withholding items – taxes, social security, pension.
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Income Taxes Payable
A corporation must pay income taxes as a percentage of earnings.
Periodic payments
Year end accrued liability is smaller as the result of periodic payments.
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12. Current Portion of Long-Term Debt
A company’s long-term debt often includes some payments due within a year
That portion must be reclassified as a current liability.
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Sales Tax
When taxes collected from customers, the company does not own the money
Must remit the taxes to the local or federal government.
Ex: Sales $100
Sales Tax 5%
Collect from customer 105
100 is Sales and the $5 is Sales Tax Payable
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Warranties
An agreement that obligates the seller to pay for replacing or repairing the product (or service) when it fails to perform as expected within a specified period.
Examples of products with warranties:
Automobiles
Appliances
Computers
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Warranties
The estimated liability and expense related to the warranty is recorded in the period when the revenue from the sale is recorded.
Example:
Warranty Expense 1,000
Estimated Warranty Liability ,000
To record estimated warranty expense and liability.
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Warranties
As the warranty work is done, the costs related to the warranty is applied to the liability account.
Example:
Warranty Liability*
Cash
Accounts Payable
To record costs of warranty repairs.
*The actual warranty costs may differ from the estimated expense. This is monitored by management and may require adjustments in future estimates.
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Unearned Revenue
Revenues collected by a company before it delivers services or goods
Ex. Lease rentals, magazine subscriptions, insurance premiums, advance airline tickets
Deferred credits -another name for unearned revenues
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Internal Controls
All payments to satisfy liabilities made with cheque
Supported by source documents
Purchase order (a document that specifies the items ordered and the price to be paid by the ordering company)
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Internal Control
Receiving report-A document that specifies the items received by the company and the condition of the items.
Invoice – A bill from the seller to a buyer indicating the number of items shipped, their price, and any additional cost along with payment terms.
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20. Long-Term Liabilities
Similar to short term liabilities except for the time frame
Ex. Mortgage loans, long term bank loans.
Report the liability on the balance sheet
Report expense (interest) on the income statement.
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21. Contingent Liabilities
Are potential future liabilities caused by past events.
Categories
Likely and the amount can be reasonably estimated.
Unlikely.
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22. Contingent Liabilities
Category
Accounting Treatment
Liability is likely and can be reasonably estimated.
Accrue estimated expense and liability.
Liability is not likely but may have a significant negative effect on the company.
Disclosure in the notes to the financial statements.
Gain contingencies.
Are not recorded until actually realized.
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Bond
A written promise to pay an amount identified as the par value of the bond along with interest at a stated annual amount.
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24. Bonds
The stated interest rate is also referred to as the contract rate, nominal rate, or coupon rate.
The rate is quoted as an annual rate.
Annual amount of interest paid
Par value Stated of the x rate of bond interest =
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Bonds
Advantages of Bonds
Bonds do not affect shareholder control.
Interest on bonds is tax deductible.
Bonds can increase return on equity.
Disadvantages of Bonds
Bonds require payment of both annual interest and par value at maturity.
Bonds can decrease return on equity.
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Bond Types
Secured Bonds
Assets are pledged as collateral by the issuing company. Example mortgage bond
Unsecured Bonds
Not backed by specific assets but only by earning capacity and credit reputation.
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Debenture Bonds
A debt security with a general claim against all assets instead of a specific claim against particular assets
Have a lower priority claim to recover their loan amount
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Bond Types
Registered Bonds
Bonds are issued in the names of the buyers.
Ownership records are kept up to date.
Bearer Bonds
Bonds are payable to whoever possesses them.
No records are kept for change in ownership.
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Bond Types
Convertible Bonds
Allow the buyer to exchange the bond for common shares at a fixed ratio.
Callable Bonds
May be called for early retirement at the option of the issuing corporation.
Convertible Bonds
May be exchanged for other securities, at the holder’s option.
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Restructuring
A significant makeover of part of the company typically involving the closing of plants, firing of employees and relocation of activities.
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Bond Pricing
The issue price of a bond is equal to the present value of the bond’s future cash payments.
Bonds may be exchanged in the market at a price equal to, below, or above the face value of the bond.
This occurs when the market rate of interest is different from the stated (contract) rate.
Bond market values are expressed as a percent of their par (face) value.
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Bond Pricing
Contract rate is:
Bond sells:
Above market rate
At a premium
(> 100% of face value)
Equal to market rate
At par value
(= 100% of face value)
Below market rate
At a discount
(< 100% of face value)
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33. © 2007 McGraw-Hill Ryerson Ltd.
Illustration: Issuing Bonds at Par
Barnes Corp. issues $800,000 of 9%, 20-year bonds. The bonds are dated January 1, 2011, and are due in 20 years on January 1, Interest is paid semi-annually each June 30 and December 31. All the bonds are sold at their par value.
On January 1, 2011, the date of issuance, the entry would be:
Cash ,000
Bonds Payable ,000
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34. © 2007 McGraw-Hill Ryerson Ltd.
Illustration: Issuing Bonds at Par
On June 30, 2011, the first interest payment date, the entry would be:
Bond Interest Expense ,000
Cash ,000
($800,000 x 9% x 6/12) = $36,000
On January 1, 2031, the maturity date, the entry would be:
Bonds Payable ,000
Cash ,000
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35. Issuing Bonds Between Interest Dates
When bonds are sold at a date other than the interest payment date, the purchaser pays the purchase price plus accrued interest.
The issuing company repays the interest on the next interest date.
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36. Illustration: Issuing Bonds Between Interest Dates
Canadian Tire has $100,000 of 9% bonds available for sale on January 1. Interest is payable on each June 30 and December 31. If the bonds are sold at par on March 1, two months after the original issue date of January 1, the issuer collects two months’ interest from the buyer at the time of sale.
Jan Mar June 30
Date of Sale
First Interest Date
Accrued interest
Stated Issue Date
($100,000 x 9% x 2/12) = $1,500
Purchaser pays face value plus accrued interest.
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37. On March 1, the date of issuance, the entry would be: Cash 101,500
Bonds Payable ,000
Interest Payable ,500
Jan Mar June 30
Stated Issue Date
Date of Sale
First Interest Date
Accrued interest
($100,000 x 9% x 2/12) = $1,500
Purchaser pays face value plus accrued interest.
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38. © 2007 McGraw-Hill Ryerson Ltd.
On June 30, the first interest payment, the entry would be:
Interest Payable ,500
Bond Interest Expense ,000
Cash ,500
Jan Mar June 30
Stated Issue Date
Date of Sale
First Interest Date
Accrued interest
Interest expense
($100,000 x 9% x 2/12) = $1,500
($100,000 x 9% x 4/12) = $3,000
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39. © 2007 McGraw-Hill Ryerson Ltd.
Mini-Quiz
Barnes Company issues $750,000, 9%, 20-year bonds. The current market rate is 8.5%. The total amount of interest owed to the bondholders for the semiannual interest payment is:
A)$67,500.  
B)$63,750.  
C)$37,500.
D)$33,750.  
E)$31,875.
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40. © 2007 McGraw-Hill Ryerson Ltd.
Mini-Quiz
Barnes Company issues $750,000, 9%, 20-year bonds. The current market rate is 8.5%. The total amount of interest owed to the bondholders for the semiannual interest payment is:
A)$67,500.  
B)$63,750.  
C)$37,500.
D)$33,750.  ($750,000 x 9% x 6/12)
E)$31,875.
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41. © 2007 McGraw-Hill Ryerson Ltd.
Bond Pricing
The issue price of the bond equals the present value of the future cash payments.
Per Per Per Per Per. 5 … .. .Maturity
Int.Pmt Int.Pmt Int.Pmt Int.Pmt Int.Pmt Int.Pmt.
Par Value
Bond Price =
Present Value of Maturity Payment +
Present Value of the Interest Payments
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42. © 2007 McGraw-Hill Ryerson Ltd.
Illustration: Present Value of a Discount Bond
Fila Corp. announces an offer to issue bonds with a $100,000 par value, an 8% annual contract rate with interest payable semi-annually, and with a three-year life.
The cash flows of the bond are:
mo mo mo mo mo mo.
$4,000* $4, $4, $4, $4, $4,000
$100,000
*Semi-annual interest payment = $100,000 x 8% x 6/12
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43. © 2007 McGraw-Hill Ryerson Ltd.
Illustration: Present Value of a Discount Bond
The issue price of the bond equals the present value of the future cash payments. The market rate for Fila’s bonds is 10%. Since the market rate is higher than the contract rate of 8%, the bonds will sell at a discount.
mo mo mo mo mo mo.
$4, $4, $4, $4, $4, $4,000
$100,000
The present value of these cash payments is $94,923.
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44. © 2007 McGraw-Hill Ryerson Ltd.
Illustration: Present Value of a Discount Bond
Assume the bonds were issued on December 31. The entry to record the issuance would be:
Cash ,923
Discount on Bonds Payable ,077
Bonds Payable ,000
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45. © 2007 McGraw-Hill Ryerson Ltd.
Illustration: Amortizing a Bond Discount
The discount of $5,077 is eventually paid to the bondholders and represents part of the cost of using the $94,923 for three years.
The discount is amortized over the life of the bonds using either the Straight-Line Method or the Effective Interest Method.
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46. Straight-Line Method
An equal portion of the discount is allocated to each period. This yields a constant dollar amount of interest expense each period.
Discount to be amortized each period
Bond Discount
Number of periods =
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47. Illustration: Straight-Line Method
Fila Corp.’s bond discount of $5,077 is amortized over the life of the bonds.
Periodic Amortization
Bond Discount
Number of periods =
$5,077
6 periods = =
$846/period
The entry to record each interest payment would be:
Bond Interest Expense ,846
Discount on Bonds Payable
Cash ,000
($100,000 x 8% x 6/12) = $4,000
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48. Effective Interest Method
This method allocates bond interest expense over the life of the bonds that yields a constant rate of interest. The interest expense increases each period since the balance in the liability account increases each period.
Periodic interest expense
Carrying Value of Bonds
Periodic Market Rate = x
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49. © 2007 McGraw-Hill Ryerson Ltd.
Illustration: Effective Interest Method
First period interest expense
Carrying Value of Bonds
Periodic Market Rate = x =
($100,000 - $5,077) x 5%* =
$4,746
*Semi-annual market rate
The entry to record the first interest payment would be:
Bond Interest Expense ,746
Discount on Bonds Payable
Cash ,000
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50. Issuing Bonds at a Premium
If the contract rate on a bond is greater than the market rate of interest, the bond will sell at a price above the bond’s par value.
The difference between par value and market value is known as a premium.
The premium is amortized over the life of the bond using either the Straight-Line Method or the Effective Interest Method.
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51. © 2007 McGraw-Hill Ryerson Ltd.
Mini-Quiz
The market value of a bond is equal to:
A)The present value of all future cash payments provided by a bond.  
B)The present value of all future interest payments provided by a bond.  
C)The present value of the principal of the bond.  
D)The future value of all future cash payments provided by a bond.  
E)The future value of all future interest payments provided by a bond.
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52. © 2007 McGraw-Hill Ryerson Ltd.
Mini-Quiz
The market value of a bond is equal to:
A)The present value of all future cash payments provided by a bond.  
B)The present value of all future interest payments provided by a bond.  
C)The present value of the principal of the bond.  
D)The future value of all future cash payments provided by a bond.  
E)The future value of all future interest payments provided by a bond.
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53. © 2007 McGraw-Hill Ryerson Ltd.
Bond Retirements
Bonds may be retired:
At maturity,
Before maturity, or
By converting them to shares.
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54. Retirement of Bonds at Maturity
The carrying value of bonds at maturity will always equal their par value.
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55. © 2007 McGraw-Hill Ryerson Ltd.
Illustration: Retiring Bonds at Maturity
Assume Hydro Quebec had $50,000 of bonds that matured on December 31, 2011, and that the final interest payment has already been made.
The entry to record the retirement of the bonds would be:
Bonds Payable ,000
Cash ,000
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56. Retirement of Bonds Before Maturity
Companies may wish to retire their bonds before maturity.
This may be accomplished by either:
Exercising a call option, or
Purchasing the bonds on the open market.
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57. © 2007 McGraw-Hill Ryerson Ltd.
Illustration: Retiring Bonds before Maturity
Assume a company issued callable bonds with a par value of $100,000. The call option requires the issuer to pay a call premium of $3,000 to bondholders in addition to the par value.
Assume all interest has been paid and the bonds have a carrying value of $104,500.
The entry to record the retirement of the bonds would be:
Bonds Payable ,000
Premium on Bonds Payable ,500
Gain on Retirement of Bonds ,500*
Cash ,000
($100,000 + $4,500) - $103,000 = $1500
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58. Bond Retirement by Conversion to Shares
Convertible bonds give bondholders the right to convert their bonds to a specified number of common shares.
When conversion occurs, the carrying value of the bonds is transferred from long-term liability accounts to contributed capital accounts.
No gain or loss on conversion is recorded.
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59. © 2007 McGraw-Hill Ryerson Ltd.
Illustration: Bond Retirement by Conversion to Shares
Assume a company has $100,000 par value bonds that have a $4,000 balance in the Discount on Bonds Payable account and these bonds are converted into 15,000 common shares.
The entry to record the conversion of the bonds would be:
Bonds Payable 100,000
Discount on Bonds Payable 4,000
Common Shares 96,000
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60. Long-Term Notes Payable
Notes payable are typically transactions with a single lender.
Interest expense is allocated to each period.
Interest expense for the period =
Interest rate on the note x
Beginning-of-period balance
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61. Long-Term Notes Payable
Payment options:
Interest and principal paid at maturity.
Installment notes:
Accrued interest plus equal principal payments.
Equal payments.
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Mortgage Notes
A legal agreement that helps protect the lender if the borrower fails to make the required payments.
Gives the lender the right to be paid out of the cash proceeds from the sale of the borrower’s assets specifically identified in the mortgage contract.
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63. © 2007 McGraw-Hill Ryerson Ltd.
Review
Compare the advantages and disadvantages of bond financing.
Advantages of bond financing include tax-deductible interest, no dilution of shareholders' equity, and the increased earnings on shareholders' equity due to financial leverage.
Disadvantages include repayment of principal, interest payments, and the risk of decreased earnings on shareholders' equity when operations are less profitable.
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64. © 2007 McGraw-Hill Ryerson Ltd.
Review
Explain the amortization of bond discount.
Bond discounts occur when bonds are sold for less than face or par value. The discount represents extra interest, since the full face value must be paid to bondholders at maturity. The amount of the bond discount is amortized over the life of the bond. The preferred method is the effective interest rate method. Bond interest expense is calculated by multiplying the bonds' beginning-of-the-period carrying value by the original market rate of the bonds.
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65. Lease Liabilities-Appendix 17B
Leases may be classified as:
Operating leases, or
Capital leases.
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66. Lease Liabilities-Appendix 17B
Operating Leases
Lessee has obligation to make future lease payments but is not required to report this on the balance sheet.
Note disclosure is required.
Lessor retains all the risks of ownership.
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67. Lease Liabilities-Appendix 17B
Capital Leases
A lease qualifies as a capital lease if the lease terms meet any of the following criteria:
The present value of the minimum lease payments is 90% or more of the fair value of the property at the inception of the lease.
The lease term is 75% or more of the asset’s economic life.
Ownership transfers to the lessee at the end of the lease term.
The lease has a bargain purchase option allowing the lessee to purchase the asset at less than the fair market value.
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68. Lease Liabilities-Appendix 17B
Capital Leases
A capital lease is the economic equivalent of a purchase with financing arrangements.
The lessee must report a leased asset and lease liability.
Interest expense and amortization are reported on the income statement of the lessee.
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69. © 2007 McGraw-Hill Ryerson Ltd.
End of Chapter
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