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Chapter 10

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Chapter 10 Reporting and Analyzing LiabilitiesAfter studying Chapter 10, you should be able to:

Explain a current liability and identify the major types of current liabilities.

Describe the accounting for notes payable.Explain the accounting for other current

liabilities.Identify the types of bonds.

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After studying Chapter 10, you should be able to:

Prepare the entries for the issuance of bonds and their interest expense.

Describe the entries when bonds are redeemed.

Identify the requirements for the financial statement presentation and analysis of liabilities.

Chapter 10 Reporting and Analyzing Liabilities

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Liabilities are..

Creditors claims on total assetsExisting debts and obligations

Liabilities must be settled in the future by transfer of assets or services.

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Current Liabilities

Can reasonably be expected to be paidFrom 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.

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Types 0f Current Liability

Notes PayableAccounts PayableUnearned RevenuesAccrued Liabilities

Taxes Salaries and Wages Interest

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Notes Payable are...

Obligations in the form of written notes.Often used instead of accounts payable - they give

written documentation if needed for legal remedies.Used for short-term and long-term financing needs.

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Remember - Interest accrues over life of the note and must be recorded periodically.

Journal

Sept 1 Cash 100,000 Notes Payable 100,000

(To record issuance of 12%, 4-month note to bank)

Dec 31 Interest Expense 4,000Interest Payable 4,000

(To accrue interest for 4 months on note) $100,000 x .12 x 4\12 months

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JournalJan 1 Notes Payable 100,000

Interest Payable 4,000 Cash 104,000

(To record payment of 1st National Bank interest-bearing note and accrued interest at maturity)

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Sales Taxes Payable...Are collected from customers.Are expressed as a % of sales price.Are required by law.Must be sent to state often.Are often rung separately from sales on the cash

register.

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JournalMar 25 Cash 10,600

Sales 10,000Sales Taxes Payable 600

(To record daily sales and sales taxes)

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Payroll Deductions

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Payroll Taxes...

Amount required by law to be withheld from employees’ gross pay. Social Security taxes withheld (FICA- 7.65 for 2003) Federal income taxes State income taxes (if applicable)

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Journal

Mar 7 Salaries and Wages Expense 100,000FICA Taxes Payable 7,650Federal Income Taxes Payable 21,864States Income Taxes Payable 2,922Salaries and Wages Payable 67,564

Mar 7 Salaries and Wages Payable 67,564 Cash 67,564

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Journal

Mar 7 Payroll Tax Expense 13,850 FICA Taxes Payable 7,250

Federal Unemployment Taxes Payable 800State Unemployment Taxes Payable 5,400

Employers incur a second type of payroll-related activity.1) Employer’s share of FICA2) Federal unemployment3) State unemployment

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Unearned Revenues...

Cash received before revenues are earned and recorded as liabilities until they are earned.

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Unearned Revenues...

Magazine subscriptionsRent received in advanceCustomer deposits for

future serviceSale of airline tickets for

future travelSale to season sporting

events

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Journal

Aug 6 Cash 500,000 Unearned Ticket Revenue 500,000

(To record sale of 10,000 tickets)

Sept 7 Unearned Ticket Revenue 100,000

Ticket Revenue 100,000

(To record ticket revenue earned)

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Current Maturities of Long-Term Debt

The portion of the long-term debt that is due within the current year or operating cycle should be classified as a current liability.

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FICTICTIOUS COMPANYBalance Sheet

December 31, 2004AssetsCurrent Assets

Cash $ 272Marketable securities (current) 609Receivables 74Other current assets 83

Total current assets 1,038Property and equipment (net) 317

Marketable securities (long-term) 322 Other long-term assets 280 Total Assets $1,957 Liabilities and Stockholders’ Equity Liabilities

Current LiabilitiesAccounts payable $ 527

Notes payable 133Current maturities of long term debt 100Accrued liabilities and expenses 56 Total current liabilities 816

Long-term debt 83 Total liabilities 899

Stockholders’ equityCommon stock 830Retained earnings 228

Total Liabilities and stockholders’ equity $1,957

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Line of Credit...

Is a prearranged agreement between a company and a lender to allow the company to borrow up to an agreed-upon amount.

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Long-Term Liabilities...

Are obligations that are expected to be paid after 1 year.

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Bonds...

Are a form of interest-bearing notes payable issued by corporations, universities and governmental agencies.

Are sold in small denominations, (usually multiples of $1,000) which makes them attractive to investors.

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Bonds

A legal document that indicates:name of the issuerface value of the bondscontractual interest ratematurity dateother data

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Secured Bonds...

Have specific assets of the issuer pledged as collateral for bonds.

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Unsecured or Debenture Bonds...

Are issued against the general

credit of the borrower.

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Convertible Bonds... Can be changed into common

stock at the bondholder’s option.

Callable Bonds…subject to retirement at a stated dollar amount prior to maturity at the option of the issuer.

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Issuing Bonds...Requires formal approval by Board of

Directors and/or stockholders.Board of Directors must stipulate

Total number of bonds to be authorized Total face value Contractual

interest rate

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Accounting for Bond Issues

Bonds may be issued at:Face valueBelow face value (discount) or Above face value (premium).

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Bond Terms

Face Value - Amount of principal due at the maturity date of the bond.

Discount - The difference between the face value of a bond and its selling price, when a bond is sold for less than its face value.

Premium - The difference between the selling price and the face value of a bond when a bond is sold for more than its face value.

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Bond Terms

Present Value - value today of an amount to be received at some date in future after taking into account current interest rates

Contractual Interest Rate - rate used to determine the amount of interest the borrower pays and the investor receives

Market Interest Rate - rate investors demand for loaning money to the corporation

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Cash Flow of Bonds

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Issuing Bonds at Face Value

Devor Corporation issued 100, 5-year, 10%, $1,000 bonds dated January 1, 2004 at 100 (100% of face value) with interest payable annually January 1.

Jan 1 Cash 100,000 Bonds Payable 100,000

(To record sale of bonds at face value)

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Issuing Bonds at Face Value

The bonds are reported in the long-term liability section of the balance sheet because the maturity date is more than 1 year away.

The entry to record the annual interest on December 31 is:

Dec 31 Bond Interest Expense 10,000 Bond Interest Payable 10,000

(To accrue bond interest)

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Discount or Premiums on Bonds

Often the contractual (stated) interest rate and the market (effective) interest rate differ… therefore bonds sell above or below face value.

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Bond Discount...

When the investor pays less than the face value of the bond.

WHY? To adjust the contractual

interest to the market interest rate.

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Selling Bonds at Discount

On January 1, 2004, Candlestick, Inc., sells $100,000, 5-year, 10% bonds at 98 with interest payable on January 1.

Jan 1 Cash 98,000 Discount on Bonds Payable 2,000 Bonds Payable 100,000

(To record sale of bonds at a discount)

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Carrying (Book) Value of Bonds

Long-term liabilities

Bonds payable $ 100,000Less: Discount on bonds 2,000 $98,000 payable

Carrying Value

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Bond Premium...

When the investor pays more than the face value of the bond.

WHY? To adjust the contractual

interest to the market interest rate.

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Selling Bonds at Premium

On January 1, 2004, Candlestick, Inc., sells $100,000, 5-year, 10% bonds at 102 with interest payable on January 1.

Jan 1 Cash 102,000 Bonds Payable

100,000 Premium Bonds Payable

2,000(To record sale of bonds at a premium)

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Carrying (Book) Value of Bonds

Long-term liabilities

Bonds payable $ 100,000Add : Premium on bonds 2,000 $102,000

payable

Carrying Value

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Amortizing Bond Discount/Premium

Candlelight would amortize the $2,000 discount/premium as follows:

$2,000 ÷ 5 Interest Periods = $400 Annually

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Bond Retirement

Bonds may be redeemed at maturity or before maturity.

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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.

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Redeeming Bonds Before Maturity

When bonds are retired before maturity, it is necessary to: Eliminate the carrying value of the bonds at

the redemption date Record the cash paid Recognize the gain or loss on redemption.

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Partial Balance SheetLong-term liabilities Bonds payable 10% due in 2009 $1,000,000

Less: Discount on bonds payable 80,000 $ 920,000Notes payable, 11%, due in 2015

and secured by plant assets 500,000Lease liability 540,000Total long-term liabilities $1,960,000

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General Motors Corporation- Automotive Division Statement of Cash Flows (partial)

2001(in millions)

Cash flows from financing activitiesNet increase (decrease) in loans payable $ 194 Long-term debt - borrowings 5,850Long-term debt-repayments (2,620)Repurchases of common and preferred stocks (264)Proceeds from issuing common and preferred stocks 517Cash dividends paid to stockholders (1,201)Net cash (used in) provided by financing activities $2,476

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Debt to Total Assets Ratio...

Indicates the extent to which a company’s debt could be repaid by liquidating assets.

Debt to Total Assets Ratio =

Total LiabilitiesTotal Assets

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Liquidity Ratios

Measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash.

Working capitalCurrent ratioAcid-test ratio

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Working Capital

Measures short- term ability to pay liabilities

Current Assets - Current Liabilities = Working Capital

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Current Ratio

Measure of short-term ability to pay obligations

Current Ratio =Current Assets Current Liabilities

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Acid-Test Ratio

Measure of company’s immediate short-term ability to pay obligations

Acid-Test Ratio = Securities, Net Receivables

Current Liabilities

Cash,Marketable

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Leverage/Solvency Ratios

Measure the ability of a company to survive over a long-period of time.

Debt to Equity RatioDebt to Assets RatioTimes Interest Earned Ratio

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Debt to Equity Ratio

Indicates the extent to which a company has borrowed relative to its equity.

Debt to Equity =Ratio

Total Liabilities Total Equity

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Debt to Total Assets Ratio

Indicates the extent to which a company used debt to finance its assets.

Debt to Total Assets =Ratio

Total Liabilities Total Assets

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Times Interest Earned Ratio...

Provides an indication of company’s ability to meet interest payments as they come due.

Times Interest Earned Ratio=

Income Before Interest Expense & Tax Expense Interest Expense