Liabilities

Learning Objectives

1. Describe the recording and reporting of various current liabilities.

2. Describe the reporting of long-term liabilities and the cash flows associated with those liabilities.

3. Understand the nature of bonds and record a bond’s issuance, interest payments, and maturity.

Learning Objectives

4. Account for a bond that is redeemed prior to maturity.

5. Understand additional liabilities such as leases and contingent liabilities.

6. Evaluate liabilities through the calculation and interpretation of horizontal, vertical, and ratio analyses.

Learning Objectives

7. Appendix: Determine a bond’s issuance price.

8. Appendix: Record bond interest payments under the effective interest method.

Current LiabilitiesA current liability is an obligation of a business that is

expected to be satisfied or paid within one year.

LOI

Taxes as Current Liabilities

Businesses have a number of current tax obligations.

Income Taxes

Sales Taxes

Taxes Withheld

from Employee

Wages

Payroll Taxes

Income Taxes PayableCorporations, like individuals, are subject to federal taxation of income, which are typically current liabilities. Assume a company has $25,000 of annual income tax expense and plans to pay it in the next period. The company records:

Sales Taxes PayableAnother current liability example is sales taxes. Each time a company makes a retail sale, it collects sales tax according to state and/or local regulations. Assume on August 1, a $1,000 item is sold and the company collects 8% sales tax.

GENERAL J OURNAL

Date Description Debit Credit 2010 Aug.

1

Cash

1,080

Sales 1,000 Sales Tax Payable 80

Withheld Taxes PayableOther current liabilities include taxes withheld from employees’ pay checks. Assume an employee earns a monthly salary of $10,000. Based on the employee’s filing status, the company must withhold 15% of the salary for federal income taxes, 12% for state income taxes, and 7.65% for Social Security taxes.

GENERAL J OURNAL

Date Description Debit Credit 2010 Aug.

31

Salaries Expense

10,000

Fed. Income Taxes Payable 1,500 State Income Taxes Payable 1,200 FICA Taxes Payable 765 Cash 6,535

Payroll Taxes PayableIn addition to withholding taxes on behalf of employees, employers must also pay Social Security taxes of 7.65% on employee wages. These additional taxes are an expense for the company, as well as a current liability.

GENERAL J OURNAL

Date Description Debit Credit 2010 Aug.

31

Payroll Tax Expense

765

FICA Taxes Payable 765

Recording a Notes PayableAssume that on March 1, Brown Company borrows $30,000 by signing an 8%, 6-month note with Miller Street Bank. The note calls for interest to be paid when the note is repaid on August 31. The entry to record the note on March 1 is as follows:

GENERAL J OURNAL

Date Description Debit Credit 2010 Mar.

1

Cash

30,000

Note Payable 30,000

Calculation of InterestOn August 31, Brown must pay Miller Street Bank the original $30,000 borrowed plus the interest on the note. Interest over the six months is calculated as shown:

Payment of a Notes PayableBrown would pay $31,200 to the bank and

make the following entry on August 31, which increases Interest Expense to reflect the cost of

borrowing the $30,000, decreases the Note Payable account because the note is paid back, and decreases

Cash for the principal and interest payment.

GENERAL J OURNAL

Date Description Debit Credit 2010 Aug.

31

Note Payable

30,000

Interest Expense 1,200 Cash 31,200

Current Portion on Long-Term Debt

From Note 10 in the financial statements

Long-Term LiabilitiesLO2

A long-term liability is any obligation of a business that is expected to be satisfied or paid in more than one

year.

Like current liabilities, the type and size of long-termliabilities can vary across companies.

However, the most common and largest long-term liabilities often arise from borrowing money.

Balance Sheet Example

Detail in financial statement note

Revolving credit is a type of loan that does not require fixed principal

payments.

A term loan is simply an interest-bearing loan with principal due at

maturity.

Advanced Auto has two types of long-

term debt.

Statement of Cash Flows Example

Cash Inflows - BORROWING

Cash Outflows – REPAYING DEBT

BondsLO3

A bond is a financial instrument in which aborrower promises to pay future interest and

principal to a creditor in exchange for the creditor’s cash today.

The borrower “sells” or “issues” the bond and records a liability.

The creditor “buys” the bond and records aninvestment.

Bond TermsA number of terms and features are associated

with bonds, including:

Face Value: The amount that is repaid at maturity

of a bond.

Market (or effective) rate of interest: The rate of

return that investors in the bond markets demand for

a bond of similar risk.

Stated Interest Rate: The contractual rate at which

interest is paid to the creditor.

Maturity Date: The date on which the face value must be repaid to the

creditor.

1 2

3 4

Bond Rate Relationships

Bond Issuance at Face ValueAssume on January 1, 2010, York Products sells bonds with a face value of $100,000. The bonds carry a 6% interest rate and a January 1, 2025, maturity date. Interest is to be paid semiannually on July 1 and January 1. The market rate of interest is also 6%.

GENERAL J OURNAL

Date Description Debit Credit 2010 Jan.

1

Cash

100,000

Bonds Payable 100,000

Recording Interest PaymentsYork Products pays interest on July 1 and January 1 of each year.

GENERAL J OURNAL

Date Description Debit Credit 2010 July

1

Interest Expense

3,000

Cash 3,000

Recording Accrued Interest PaymentsYork Products pays interest on July 1 and January 1 of each year.

GENERAL J OURNAL

Date Description Debit Credit 2010 Dec

31

Interest Expense

3,000

Interest Payable 3,000

2011 Jan

1

Interest Payable

3,000

Cash 3,000

Bond Repayment at Maturity On January 1, 2025, York would record the

repayment of the bonds in addition to the last interest payment.

GENERAL J OURNAL

Date Description Debit Credit 2025 Jan.

1

Bonds Payable

100,000

Cash 100,000

Bond Issuance at a DiscountAssume on January 1, 2010, Agnew Company issues bonds with a face value of $200,000, a stated rate of 7%, and a maturity date of December 31, 2014. Interest is payable semiannually on June 30 and Dec. 31. The bonds sell at 98% of the face or $196,000.

GENERAL J OURNAL

Date Description Debit Credit 2010 Jan.

1

Cash

196,000

Discount on Bonds Payable 4,000 Bonds Payable 200,000

Reporting Discounted Bonds on the Balance Sheet

Recording Interest PaymentsAgnew Company pays interest on June 30 and December 31 .

GENERAL J OURNAL

Date Description Debit Credit 2010 June

30

Interest Expense

7,400

Discount on Bonds Payable 400 Cash 7,000

Two Methods of AmortizationStraight-line method: Equal amount of interest is amortized each time interest is paid. Easy to compute.

Effective Interest Rate: Amortizes the bond discount or premium so that interest expense each period is a constant percentage of the bond’s carrying value.

Bond Repayment at Maturity On Dec. 31, 2014, Agnew would record the

repayment of the bonds in addition to the last interest payment.

GENERAL J OURNAL

Date Description Debit Credit 2014 Dec.

31

Bonds Payable

200,000

Cash 200,000

Bond Issuance at a PremiumAssume on January 1, 2010, McCarthy Company issues bonds with a face value of $50,000, a stated interest rate of 8%, and a maturity date of December 31, 2012. Interest is payable semiannually on June 30 and December 31. The bonds were sold at a premium of 101.2 or ($50,000 x 101.2% = $50,600).

GENERAL J OURNAL

Date Description Debit Credit 2010 Jan.

1

Cash

50,600

Premium on Bonds Payable 600 Bonds Payable 50,000

Recording Interest PaymentsMcCarthy pays interest on June 30 and December 31 of each year.

GENERAL J OURNAL

Date Description Debit Credit 2010 June

30

Interest Expense

1,900

Premium on Bonds Payable 100 Cash 2,000

Bond Repayment at Maturity On Dec. 31, 2012, McCarthy

would record the repayment of the bonds in addition to the last interest payment.

GENERAL J OURNAL

Date Description Debit Credit 2014 Dec.

31

Bonds Payable

50,000

Cash 50,000

Redeeming a Bond Before Maturity

LO4

Bonds are retired for a number of reasons:•A company may want to reduce future interest expense; or•A company may want to take advantage of falling interest rates and replace existing bonds with less costly bonds.

Accounting for the early retirement bond consists of three steps:

Recording the Gain or Loss on the Redemption

Example of a RedemptionAssume Doyle Township issues a $20,000 eight-year bond on January 1, 2010, to fund the conversion of a warehouse to a youth activity center. The bond has a stated interest rate of 5% and is callable at 103 any time after 2014. The bond pays interest semiannually on June 30 and December 31. The bond sells for $19,200, or an $800 discount. Doyle decides to retire the bond early on December 31, 2016.

GENERAL J OURNAL

Date Description Debit Credit 2010 Jan.

1

Bonds Payable

20,000

Loss on Redemption 700 Discount on Bonds Payable 100 Cash 20,600

Additional LiabilitiesLO5

Two additional types of liabilities that are common to many organizations:lease liabilities and contingent liabilities.

A lease is a contractual agreement in which the lessee obtains the right to use an asset by making periodic payments to the lessor.

A contingent liability is an obligation that arises from an existing condition whose outcome is uncertain and whose resolution depends on a future event.

Types of Leases

Operating leases are popular off-balance sheet

financing tools.

Contingent Liabilities

Evaluating a Company’s Management of Liabilities

LO6

Ratio Analyses

Capital Structure: The mix of debt and equity that a company uses to generate its assets.

Appendix: Determining A Bond’s Issuance Price

LO7

The bond’s issuance price will always be the present value of those future cash flows discounted

backat the current market rate of interest.

Assume that the market rate of interest is 8% when Bowman Corporation issues a $100,000 4-year bond that

pays interest annually at a rate of 10%.

Bowman Example

$100,000 X 0.7350

$10,000 X 3.3121

Bond Interest Relationship

Ethics and Decision Making

In today’s business environment, companies have to be aware not only of the economic impact of their decisions,

but also of their ethical impact.

Information being used

for?

To falsify records??

To ignore product

safety??

To exceed

government

limits??

Appendix: Effective Interest

Method of AmortizationUnder this method, interest expense is calculated

by multiplying the bond’s carrying value by the market rate of interest at issuance by the time

outstanding.

Amortization CalculationOnce interest expense is known, the amount of discount or premium amortized is the difference

between interest expense and interest paid.

Bowman Example – Recording the Issuance

GENERAL J OURNAL

Date Description Debit Credit 2010 June

30

Cash

106,621

Premium on Bonds Payable 6,621 Bonds Payable 100,000

Recording the First Interest Payment

At the end of the first year, interest expense would be recorded as follows:

GENERAL J OURNAL

Date Description Debit Credit 2010 June

30

Interest Expense

8,530

Premium on Bonds Payable 1,470 Cash 10,000

Amortization Schedule

End of Chapter 9