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LIABILITIES

Chapter

10

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I.O.U.

Defined as debts or obligationsarising from past transactions or

events.

Maturity = 1 year or less Maturity > 1 year

CurrentLiabilities NoncurrentLiabilities

The Nature of Liabilities

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The acquisition of assets is financedfrom two sources:

Funds from creditors, witha definite due date, and

sometimes bearinginterest.

Funds fromowners

DEBT EQUITY

Distinction BetweenDebt and Equity

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Devon Mfg. borrows $100,000 from FirstBank. The loan will be repaid in 20 years

and has an annual interest rate of 8%.

Is this a current liability or anoncurrent liability?

LiabilitiesQuestion

The obligation will not be paidwithin one year or one operating

cycle, so it is a noncurrent liability.

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Current Ratio = Current Assets Current Liabilities

Working Capital = Current Assets- Current Liabilities

An important indicator of a companys abilityto meet its current obligations.

Two commonly used measures:

Evaluating Liquidity

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Devon Mfg. has current liabilities of$230,000 and current assets of $322,000.

What is Devons current ratio?

LiabilitiesQuestion

Current

Ratio

=Current

Assets

Current

Liabilities= 322,000$ 230,000$

= 1.4

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Short-term obligations to suppliers for purchases ofmerchandise and to others for goods and services.

Merchandiseinventory

invoices

Shippingcharges

Utility andphone bills

Officesuppliesinvoices

Accounts Payable

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Total NotesPayable

Current Notes Payable

Noncurrent Notes Payable

When a company borrows money, a note payable iscreated.

Current Portion of Notes Payable

The portion of a note payable that is due within oneyear, or one operating cycle, whichever is longer.

Notes Payable

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PROMISSORY NOTE

Location Date

after this date

promises to pay to the order of

the sum of with interest at the rate

of per annum.signed

title

Miami, Fl Nov. 1, 2005

Six months Porter Company

John CaldwellSecurity National Bank

$10,000.00

12.0%

treasurer

Notes Payable

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On November 1, 2005, Porter Companywould make the following entry.

Date Description Debit CreditNov. 1 Cash 10,000

Note Payable 10,000

Notes Payable

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Interest expenseis thecompensation to the lender forgiving up the use of money for aperiod of time.

The liability is calledinterestpayable.

To the lender, interest is a

revenue.

To the borrower, interest is anexpense.

Interest

RateUp!

Interest Payable

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The interest formula includes three variablesthat must be considered when computing

interest:

Interest = Principal Interest Rate Time

When computing interest for one year, Time

equals 1. When the computation period is lessthan one year, then Time is a fraction.

Interest Payable

For example, if we needed to compute interest for3 months, Time would be 3/12.

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What entry would Porter Company makeon December 31, the fiscal year-end?

Date Description Debit Credit

Interest PayableExample

Date Description Debit Credit

Dec. 31 Interest Expense 200

Interest Payable 200

$10,00012% 2/12 = $200

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Net Pay

Payroll Liabilities

Medicare

Taxes

State andLocal Income

Taxes

FICA TaxesFederal

Income Tax

VoluntaryDeductions

Gross Pay

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Deferredrevenue isrecorded.

a liability account.

Cash isreceived

inadvance.

Cash is sometimes collected from thecustomer before the revenue is

actually earned.

Unearned Revenue

Earnedrevenue isrecorded.

As the earningsprocess is

completed . .

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Relatively small debtneeds can be filled from

single sources.

BanksInsurance

CompaniesPension

Plans

or or

Long-Term Liabilities

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Large debt needs are oftenfilled by issuing bonds.

Long-Term Liabilities

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Long-term notes that call for a series ofinstallment payments.

Each payment coversinterest for the periodAND a portion of the

principal.

With each payment, theinterest portion gets

smaller and the principalportion gets larger.

Installment Notes Payable

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Identify the unpaid principalbalance.

Unpaid Principal Interest rate

= Interest expense.Installment payment - Interest

expense = Reduction in unpaidprincipal balance.

Compute new unpaid principalbalance.

Allocating Installment PaymentsBetween Interest and Principal

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On January 1, 2005, RocketCorp. borrowed $7,581.57 from

First Bank of River City. Theloan was a five-year loan andhad an interest rate of 10%. The

annual payment is $2,000.

Prepare an amortization table forRocket Corp.s loan.

Allocating Installment PaymentsBetween Interest and Principal

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Date Payment

Interest

Expense

Reduction in

Unpaid

Balance

Unpaid

Balance

Jan. 1, 2005 7,581.57$

Dec. 31, 2005 2,000.00$ 758.16$ 1,241.84$ 6,339.73

Dec. 31, 2006 2,000.00 633.97 1,366.03 4,973.70

Dec. 31, 2007 2,000.00 497.37 1,502.63 3,471.07

Dec. 31, 2008 2,000.00 347.11 1,652.89 1,818.18

Dec. 31, 2009 2,000.00 181.82 1,818.18 (0.00)

Now, prepare the entry for the first payment onDecember 31, 2005.

Allocating Installment PaymentsBetween Interest and Principal

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The information needed for the journal entry can befound on the amortization table. The payment

amount, the interest expense, and the amount todebit to principal are all on the table.

Date Description Debit Credit

Dec. 31 Interest Expense 758.16

Note Payable 1,241.84

Cash 2,000.00

Allocating Installment PaymentsBetween Interest and Principal

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Bonds usually involve theborrowing of a large sum ofmoney, called principal.

The principal is usually paidback as a lump sum at theend of the bond period.

Individual bonds are oftendenominated with a par value,orface value, of $1,000.

Bonds Payable

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Bonds usually carry a statedrate of interest, also called acontract rate.

Interest is normally paidsemiannually.

Interest is computed as:

Interest = Principal Stated Rate Time

Bonds Payable

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Bonds are issued through anintermediary called an underwri ter.

Bonds can be sold on organized

securities exchanges. Bond prices are usually quoted as

a percentage of the face amount.

For example, a $1,000 bondpriced at 102 would sell for$1,020.

Bonds Payable

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MortgageBonds

ConvertibleBonds

Junk Bonds

DebentureBonds

Types of Bonds

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On January 1, 2005, Rocket Corp. issues $1,500,000 of12%, 10-year bonds payable. Interest is payable

semiannually, each July 1 and January 1.

Assume the bonds are issued at face value.Record the issuance of the bonds.

Accounting for Bonds Payable

Date Description Debit Credit

Jan. 1

Date Description Debit Credit

Jan. 1 Cash 1,500,000Bonds Payable 1,500,000

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Record the interest payment

on July 1, 2005.

Accounting for Bonds Payable

Date Description Debit Credit

July 1

Date Description Debit Credit

July 1 Interest Expense 90,000Cash 90,000

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Present value of the bond

+ Accrued interest since the

last interest payment= Selling price of the bond

Bonds Sold Between Interest Dates

Bonds are often sold between interest dates. The selling price of the bond is computed as:

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PresentValue

The Concept of Present Value

FutureValue

$1,000invested

today at 10%.

In 5 years itwill be worth

$1,610.51.

In 25 years itwill be worth$10,834.71!

Money can grow over time,because it can earn interest.

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How much is a future amount worth today?

PresentValue

FutureValue

Interest compounding periods

Today

The Concept of Present Value

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The Concept of Present Value

How much is a future amount worth today?

Three pieces of information must be knownto solve a present value problem:

The future amount.

The interest rate (i).

The number of periods (n) the amount will

be invested.

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Two types of cash flows are involvedwith bonds:

Today

Principal paymentat maturity.

Periodic interest payments called annuities.

Maturity

The Concept of Present Value

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The Present Value Concept and BondPrices

The selling price of the bond is determinedby the market based

on the time value of money.

Present Value of the Principal (a single payment)

+ Present Value of the Interest Payments (an annuity)

= Selling Price of the Bond

Interest Bond Accounting for Rates Price the Difference

Stated Market Bond Par Value There is no difference

Rate Rate Price of the Bond to account for.

Stated Market Bond Par Value The difference is accounted

Rate Rate Price of the Bond for as a bond discount.

Stated Market Bond Par Value The difference is accounted

Rate Rate Price of the Bond for as a bond premium.

=

>

75% of the economic

life of the property.

The PV of the minimumlease payments = 90% ofthe FMV of the property.

A lease must be recorded asa Capital Lease if it meets

any of the following criteria.

Capital Lease Criteria

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Employers offer pensionplans to employees.

Retirees receivepensionpayments from

the pensionfund.

The employer makespayments to a pensionfund. Usually, this is an

independent entity

managed by aprofessional fund

manager.

Pensions

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Actuaries make the pension expensecomputations, based on:

Average age, retirement age, lifeexpectancy.

Employee turnover rates.

Compensation levels.

Expected rate of return for the fund.

The accountant then posts the entry torecord pension expense and pension

liability.

Pensions

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Many companies offer benefitsto retirees other than pensions,

such as health coverage orfitness club memberships.

Other Postretirement Benefits

Unfunded liability

for nonpensionpostretirement

benefits

Currentliability

Long-termliability

Amount tobe fundednext year

Remainderof unfunded

amount

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Corporationspay incometaxes

quarterly.

Deferred Income Taxes

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The difference between tax expense and taxpayable is recorded in an account called

deferred taxes.

The Internal RevenueCode is the set of

rules for preparing taxreturns.

Financial statementincome tax expense.

IRS income taxespayable.

GAAP is the set ofrules for preparing

financial statements.

Results in . . . Results in . . .Usually. . .

Deferred Income Taxes

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Examine the December 31, 2005, informationfor X-Off Inc.

X-Off uses straight-line depreciation for financialreporting and accelerated depreciation for

income tax reporting. X-Offs tax rate is 30%.

Revenues 1,000,000$

Depreciation Expense:Straight-line 200,000

Accelerated 320,000

Other Expenses 650,000

Deferred Income TaxesExample

10-46

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Income TaxStatement Return Difference

Revenues 1,000,000$

Less:

Depreciation 200,000

Other expenses 650,000Income before taxes 150,000$

Tax rate 30%

Income taxes 45,000$

The income taxamount computedbased on financialstatement income

is income taxexpense for the

period.

Compute X-Offs income tax expenseand income tax payable.

Deferred Income TaxesExample

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Compute X-Offs income tax expenseand income tax payable.

Income TaxStatement Return Difference

Revenues 1,000,000$ 1,000,000$

Less:

Depreciation 200,000 320,000

Other expenses 650,000 650,000Income before taxes 150,000$ 30,000$

Tax rate 30% 30%

Income taxes 45,000$ 9,000$

Income taxesbased on tax

returnincome arethe taxes

payable forthe period.

Deferred Income TaxesExample

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Income TaxStatement Return Difference

Revenues 1,000,000$ 1,000,000$ -$

Less:

Depreciation 200,000 320,000 (120,000)

Other expenses 650,000 650,000 -Income before taxes 150,000$ 30,000$ 120,000$

Tax rate 30% 30% 30%

Income taxes 45,000$ 9,000$ 36,000$

The deferred tax for the period of $36,000 is thedifference between income tax expense of $45,000 and

income tax payable of $9,000.

Deferred Income TaxesExample

10-49

Evaluating the Safety

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Evaluating the Safetyof Creditors Claims

This ratio indicates a margin of

protection for creditors.

Operating Income

Interest Expense

Interest

Coverage

Ratio=

10-50

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Borrowing at one rateand investing at a

higher rate.

If we borrow$1,000,000 at 8% andinvest it at 10%, we

will clear $20,000profit!

Financial Leverage

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