Chapter 10

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 10

Reporting and Interpreting Liabilities

McGraw-Hill/Irwin


Learning Objective 1

Explain how the reporting of liabilities

assists decision-makers.


Decisions Related To Liabilities

Before extending credit, a credit Before extending credit, a credit manager for a company must assess:manager for a company must assess:

1.1. How much does the borrower owe to How much does the borrower owe to others?others?

2.2.What was the reason for the past What was the reason for the past borrowings?borrowings?

3.3.Will the company be able to repay the Will the company be able to repay the amount borrowed on time?amount borrowed on time?

Before extending credit, a credit Before extending credit, a credit manager for a company must assess:manager for a company must assess:

1.1. How much does the borrower owe to How much does the borrower owe to others?others?

2.2.What was the reason for the past What was the reason for the past borrowings?borrowings?

3.3.Will the company be able to repay the Will the company be able to repay the amount borrowed on time?amount borrowed on time?


Current LiabilitiesCurrent

Liabilities

Due within one year or the company’s

operating cycle, whichever is

longer.

Due within one year or the company’s

operating cycle, whichever is

longer.

Long-Term Liabilities

Long-Term Liabilities

Due after one year or the company’s operating cycle,

whichever is longer.

Due after one year or the company’s operating cycle,

whichever is longer.

Reporting Liabilities



Explain how to account for common

types of current liabilities.


Exh.9.2

Current and Long-Term Liabilities

2006 LiabilitiesCurrent Liabilities

Accounts payable 1,151$ Other current liabilities 1,353 Notes payable 1,503 Current portion of long-term debt 2,131 Total Current Liabilities 6,138 Long-term Debt 4,237 Other Liabilities 924 Total Liabilities 11,299$

General Mills' Liabilities(In Millions)


Measurement of Liabilities

The dollar amount reported for liabilities results from:

1.1. The initial amount of the liabilitiesThe initial amount of the liabilities. A liability is recorded at its cash equivalent, which is the amount of cash that a creditor would accept to settle the liability immediately.

2.2. Additional amounts owed to the creditorAdditional amounts owed to the creditor. Liabilities are increased whenever additional obligations arise, including interest charges.

3.3. Payments or services provided to the creditorPayments or services provided to the creditor. Liabilities are reduced whenever the company makes payments or provides services to the creditor.

The dollar amount reported for liabilities results from:

1.1. The initial amount of the liabilitiesThe initial amount of the liabilities. A liability is recorded at its cash equivalent, which is the amount of cash that a creditor would accept to settle the liability immediately.

2.2. Additional amounts owed to the creditorAdditional amounts owed to the creditor. Liabilities are increased whenever additional obligations arise, including interest charges.

3.3. Payments or services provided to the creditorPayments or services provided to the creditor. Liabilities are reduced whenever the company makes payments or provides services to the creditor.


Accounts PayableAccounts Payable – – Purchase of goods or services Purchase of goods or services on credit.on credit.

Accrued LiabilitiesAccrued Liabilities – – An expense is incurred in one An expense is incurred in one accounting period, the cash payment in a later accounting period, the cash payment in a later period. period.

Sales Tax PayableSales Tax Payable – – Liability resulting when a Liability resulting when a company collects sales tax for the state.company collects sales tax for the state.

Notes PayableNotes Payable – – Occurs when one company Occurs when one company borrows money from another.borrows money from another.

Current Liabilities

Unearned RevenueUnearned Revenue – – The receipt of cash before The receipt of cash before goods or services are provided.goods or services are provided.


Accrued Payroll Taxes

Employers incur several

expenses and liabilities from

having employees.


Exh.9.5

Accrued Payroll Taxes

FICA TaxesMedicare

TaxesFederal

Income TaxState and Local Income Taxes

Voluntary Deductions

Gross PayGross Pay

Net PayNet Pay


FICA Taxes Medicare Taxes

2006: 6.2% of the first $94,200 earned in the

year.

2006: 1.45% of all wages earned in the

year.

Employers owe the FICA amount withheld from Employers owe the FICA amount withheld from employees’ gross pay to the IRS.employees’ gross pay to the IRS.

Employers owe the FICA amount withheld from Employers owe the FICA amount withheld from employees’ gross pay to the IRS.employees’ gross pay to the IRS.

FICA Taxes


Here is information about the payroll for General Mills:

Recording Payroll

Debit CreditCompensation expense (+E, -SE) 1,800,000

Liability for income taxes withheld (+L) 275,000 FICA taxes withheld (+L) 105,000 Cash (-A) 1,420,000

Compensation expense (+E, -SE) 105,000 FICA payable (+L) 105,000

Accounts

Salaries and wages earned by employees 1,800,000$ Less: Income taxes withheld from employees 275,000 Less: FICA taxes withheld from employees 105,000 Net pay to employees 1,420,000$

General Mills' Payroll


Exh.9.3

Notes Payable

PROMISSORY NOTE

Face Value Date

after date promise to pay to the order of

National Bank, Boston, MA

Dollars

plus interest at the annual rate of .

PROMISSORY NOTE

Face Value Date

after date promise to pay to the order of

National Bank, Boston, MA

Dollars

plus interest at the annual rate of .

$200,000 Sept. 30, 2007

One Year I

Two hundred thousand and no/100----------------------

12%

Janet Smith, CFOFor Matrix, Inc.

Matrix, Inc. borrows $200,000 from National Bank


On September 30, 2007, Matrix, Inc. would do the following:

Notes Payable

= +Stockholders'

Equity

CashNotes

Payable+200000 +200,000

Assets Liabilities

Debit CreditCash (+A) 200,000

Notes payable (+L) 200,000

Accounts

Leading to this journal entry:


Notes Payable

Interest = Principal Interest = Principal × Rate × Time× Rate × TimeInterest = Principal Interest = Principal × Rate × Time× Rate × Time

Interest = $200,000 × 12% × 3/12Interest = $200,000 × 12% × 3/12

9/30/079/30/07 12/31/0712/31/07 12/31/0812/31/08

NoteNoteIssuesIssues

YearYearEndEnd

NoteNoteDueDue

= +Stockholders'

Equity

Interest Payable

Interest Expense (+E)

+6,000 -6,000

Assets Liabilities


Notes Payable

Debit CreditInterest expense (+E, -SE) 6,000

Interest payable (+L) 6,000

Accounts

On December 31, 2007, Matrix, Inc. would prepare this journal entry . . .


On September 30, 2008, Matrix, Inc. must pay the interest and principal on the note.

Notes Payable

$24,000 = $200,000 × 12% × 12/12$24,000 = $200,000 × 12% × 12/12

= +Stockholders'

Equity

CashNotes

PayableInterest Payable

Interest Expense (+E)

-224,000 -200,000 -6,000 -18,000

Assets Liabilities


Notes PayableOn September 30, 2008, Matrix, Inc. would

prepare these journal entries . . .

Debit CreditInterest expense (+E, -SE) 18,000 Interest payable (-L) 6,000

Cash (-A) 24,000

Note payable (-L) 200,000 Cash (-A) 200,000

Accounts


Sales Tax PayableFrank’s Sporting Goods sells a raft for $750 and Frank’s Sporting Goods sells a raft for $750 and collects the required 6% sales tax for the state.collects the required 6% sales tax for the state.

Debit CreditCash (+A) 795

Sales tax payable (+L) 45 Sales revenue (+R, +SE) 750

Accounts

= +Stockholders'

Equity

Cash

Sales Tax

PayableSales

Revenue (+R)+795 +45 +750

Assets Liabilities


On 6/1/07, Excel Catering received $1,500 in advance for catering a party on 7/4/07.

Unearned Revenues

Debit CreditCash (+A) 1,500

Unearned revenue (+L) 1,500

Accounts

= +Stockholders'

Equity

CashUnearned Revenue

+1,500 +1,500

Assets Liabilities


Unearned Revenues

Excel finished catering the party on July 4th and does the following . . .

Debit CreditUnearned revenue (-L) 1,500

Catering revenue (+R, +SE) 1,500

Accounts

= +Stockholders'

Equity

Unearned Revenue

Catering Revenue (+R)

-1,500 +1,500

Assets Liabilities



Analyze and record bond liability transactions.


Long-term Liabilities

Private Loan Publicly Issued Debt

(1) Find a Lender (1) Set Loan Terms

(2) Set Loan Terms (2) Find Lenders

(3) Borrow Money (3) Borrow Money (Notes Payable) (Bonds Payable)

Two Ways to Obtain Corporate Financing


Prepare the entry for Jan. 1, 2008, to record the Prepare the entry for Jan. 1, 2008, to record the following bond issue by Matrix, Inc. following bond issue by Matrix, Inc.

Face Value = $10,000,000Face Value = $10,000,000

Stated Interest Rate = 10%Stated Interest Rate = 10%

Interest Date = December 31Interest Date = December 31

Bond Date = Jan. 1, 2008Bond Date = Jan. 1, 2008

Maturity Date = Dec. 31, 2010 (3 years)Maturity Date = Dec. 31, 2010 (3 years)

Prepare the entry for Jan. 1, 2008, to record the Prepare the entry for Jan. 1, 2008, to record the following bond issue by Matrix, Inc. following bond issue by Matrix, Inc.




Bond Date = Jan. 1, 2008Bond Date = Jan. 1, 2008

Maturity Date = Dec. 31, 2010 (3 years)Maturity Date = Dec. 31, 2010 (3 years)

Bonds Issued at Face Value



1/1/081/1/08BondsBondsIssuedIssued

$10,000,000$10,000,000ReceivedReceived

12/31/0812/31/08InterestInterest

PaidPaid


PaidPaid


PaidPaid

$10,000,000$10,000,000RepaidRepaidFace AmountFace Amount

InterestInterest

$10,000,000 $10,000,000 ×× 10% 10% ×× 12/12 = $1,000,000 12/12 = $1,000,000$10,000,000 $10,000,000 ×× 10% 10% ×× 12/12 = $1,000,000 12/12 = $1,000,000



Debit CreditCash (+A) 10,000,000

Bonds payable (+L) 10,000,000

Accounts

On January 1, 2008, the bonds are On January 1, 2008, the bonds are issued to the public.issued to the public.

= +Stockholders'

Equity

CashBonds

Payable+10,000,000 +10,000,000

Assets Liabilities



On 12/31/08 the first annual interest payment is On 12/31/08 the first annual interest payment is due to the bondholders.due to the bondholders.

Debit CreditInterest expense (+E, -SE) 1,000,000

Cash (-A) 1,000,000

Accounts

= +Stockholders'

Equity

CashInterest

Expense (+E)-1,000,000 -1,000,000

Assets Liabilities

$10,000,000 $10,000,000 × 10% = $1,000,000× 10% = $1,000,000$10,000,000 $10,000,000 × 10% = $1,000,000× 10% = $1,000,000


Bond Issued Below or Above Face Value

6%6%StatedStatedRateRate

6%6%StatedStatedRateRate

4% Market Rate4% Market Rate4% Market Rate4% Market Rate Wow, I’ll pay extraWow, I’ll pay extraWow, I’ll pay extraWow, I’ll pay extra PremiumPremiumPremiumPremiumWhat lenders expectWhat lenders expect What lenders thinkWhat lenders think What lenders payWhat lenders pay

6% Market Rate6% Market Rate6% Market Rate6% Market Rate It’s just enoughIt’s just enoughIt’s just enoughIt’s just enough Face ValueFace ValueFace ValueFace Value

What lenders expectWhat lenders expect What lenders thinkWhat lenders think What lenders payWhat lenders pay

8% Market Rate8% Market Rate8% Market Rate8% Market Rate I’m not attracted (yet)I’m not attracted (yet)I’m not attracted (yet)I’m not attracted (yet) DiscountDiscountDiscountDiscount

What lenders expectWhat lenders expect What lenders thinkWhat lenders think What lenders payWhat lenders pay


Bond Issued Below or Above Face Value

Face valueFace value

Stated interest rateStated interest rate

Face valueFace value

Stated interest rateStated interest rate

Issue priceIssue price

Market interest rateMarket interest rate

Issue priceIssue price

Market interest rateMarket interest rate

Used only to Used only to determine cash determine cash

interest paymentsinterest payments

Used to determine Used to determine the bond liability and the bond liability and

interest expenseinterest expense


On Jan. 1, 2008, Matrix, Inc. issues these bonds: On Jan. 1, 2008, Matrix, Inc. issues these bonds:


Issue Price = 95.19634% of par valueIssue Price = 95.19634% of par value


Market Interest Rate = 12%Market Interest Rate = 12%


Bond Date = January 1, 2008Bond Date = January 1, 2008

Maturity Date = December 31, 2010 (3 years)Maturity Date = December 31, 2010 (3 years)

On Jan. 1, 2008, Matrix, Inc. issues these bonds: On Jan. 1, 2008, Matrix, Inc. issues these bonds:








Bonds Issued at a Discount


Face Value

Cash Proceeds Discount

10,000,000$ - 9,519,634$ = 480,366$

$10,000,000 95.19634%$10,000,000 95.19634%

Issuing Bonds at a Discount

= +Stockholders'

Equity

CashBonds

PayableBond

Discount+9,519,634 +10,000,000 -480,366

Assets Liabilities



Debit CreditCash (+A) 9,519,634 Discount on bonds payable (+xL) 480,366

Bonds payable (+L) 10,000,000

Accounts

On January 1, 2008, Matrix will record the issuance of the bonds with the following journal entry.


$9,519,634 $9,519,634 × 12% = $1,142,356× 12% = $1,142,356$9,519,634 $9,519,634 × 12% = $1,142,356× 12% = $1,142,356$1,142,356 -$1,142,356 - $1,000,000 = $142,356 $1,000,000 = $142,356$1,142,356 -$1,142,356 - $1,000,000 = $142,356 $1,000,000 = $142,356



Partial Balance Sheet as of January 1, 2008

Long-term Liabilities: Bonds Payable 10,000,000$ Less: Discount on Bonds Payable 480,366 9,519,634$

Maturity ValueMaturity ValueMaturity ValueMaturity Value

Carrying ValueCarrying ValueCarrying ValueCarrying Value




Partial Balance Sheet as of December 31, 2008

Long-term Liabilities: Bonds Payable 10,000,000$ Less: Discount on Bonds Payable 338,010 9,661,990$

$480,366 -$480,366 - $142,356 = $338,010 $142,356 = $338,010$480,366 -$480,366 - $142,356 = $338,010 $142,356 = $338,010


On January 1, 2008, Matrix, Inc. issues these bonds: On January 1, 2008, Matrix, Inc. issues these bonds:

Par Value = $10,000,000Par Value = $10,000,000







On January 1, 2008, Matrix, Inc. issues these bonds: On January 1, 2008, Matrix, Inc. issues these bonds:

Par Value = $10,000,000Par Value = $10,000,000







Bonds Issued at a Premium



Cash Proceeds Face Value Premium

10,515,419$ - 10,000,000$ = 515,419$

$10,000,000 105.15419%$10,000,000

105.15419%

= +Stockholders'

Equity

CashBonds

PayableBond

Premium+10,515,419 +10,000,000 +515,419

Assets Liabilities



Debit CreditCash (+A) 10,515,419

Premium on bonds payable (+L) 515,419 Bonds payable (+L) 10,000,000

Accounts

On January 1, 2008, Matrix will record the issuance of the bonds with the following journal entry.



$10,515,419 $10,515,419 × 8% = $841,234× 8% = $841,234$10,515,419 $10,515,419 × 8% = $841,234× 8% = $841,234$1,000,000 -$1,000,000 - $841,234 = $158,766 $841,234 = $158,766$1,000,000 -$1,000,000 - $841,234 = $158,766 $841,234 = $158,766



Partial Balance Sheet as of January 1, 2008

Long-term Liabilities: Bonds Payable 10,000,000$ Add: Premium on Bonds Payable 515,419 10,515,419$

Maturity ValueMaturity ValueMaturity ValueMaturity Value

Carrying ValueCarrying ValueCarrying ValueCarrying Value



Partial Balance Sheet as of December 31, 2008

Long-term Liabilities: Bonds Payable 10,000,000$ Plus: Premium on Bonds Payable 356,653 10,356,653$

$515,419 -$515,419 - $158,766 = $356,653 $158,766 = $356,653$515,419 -$515,419 - $158,766 = $356,653 $158,766 = $356,653


Early Retirement of Debt

On January 1, 2009, Matrix retires the bonds issued On January 1, 2009, Matrix retires the bonds issued at a premium shown below. Matrix paid at a premium shown below. Matrix paid

$10,200,000 to retire the bonds.$10,200,000 to retire the bonds.


Early Retirement of Debt

= +Stockholders'

Equity

CashBonds

PayableBond

PremiumGain on

Retirement-10,200,000 -10,000,000 -356,653 +156,653

Assets Liabilities

The retirement will have the following impact on the balance sheet of Matrix, Inc:

Debit CreditBonds payable (-L) 10,000,000 Premium on bonds payable (-L) 356,653

Cash (-A) 10,200,000 Gain on bond retirement (+R, +SE) 156,653

Accounts



Interpret the current ratio and times

interest earned ratio.


Evaluate the Results

Name of Measure Formula What It Tells You

Current Ratio

Whether current assets are sufficient to pay current liabilities. Higher is better.J

Times Interest Earned Ratio

Whether sufficient resources are generated to cover interest costs. Higher is better. J

Current AssetsCurrent Liabilities

Net Income Before Interest and TaxesInterest Expense


Current Ratio

CurrentCurrentRatioRatio ==

Current AssetsCurrent AssetsCurrent LiabilitiesCurrent Liabilities

Measures whether the company has enough Measures whether the company has enough current assets to pay what it currently owes.current assets to pay what it currently owes.Measures whether the company has enough Measures whether the company has enough current assets to pay what it currently owes.current assets to pay what it currently owes.


Times Interest Earned Ratio

Times InterestTimes InterestEarned RatioEarned Ratio ==

Net Income + Interest Expense + Income Tax ExpenseNet Income + Interest Expense + Income Tax ExpenseInterest ExpenseInterest Expense

This ratio shows the amount of This ratio shows the amount of resources generated for each dollar resources generated for each dollar

of interest expense.of interest expense.

This ratio shows the amount of This ratio shows the amount of resources generated for each dollar resources generated for each dollar

of interest expense.of interest expense.


Understanding Common Features of Debt

Loan Terms What They Mean EffectsSecurity Guarantees that the borrower's assets will

be given to the creditor if the borrower doesn't pay.

Reduces risk to creditors, making them willing to accept a lower interest rate.

Loan Covenants Allows the creditor to force immediate repayment of the loan if the borrower violates these terms.

Reduces risk to creditors, making them willing to accept a lower interest rate.

Seniority Senior debt is paid first in the event of bankruptcy, followed by subordinated debt.

Reduces risk to senior creditors making them willing to accept a lower interest rate.

Convertibility Gives the creditor an option to accept the borrower's stock as payment for the outstanding loan.

Gives greater control to creditors, reducing their risk and making them willing to accept a lower interest rate.

Callability Gives the borrower control over the decision to fully repay the lender before the loan's maturity date.

Gives greater control to borrowers, increasing creditors' risk and causing them to demand a higher interest rate.



Describe the additional liabilities information reported in the notes

to the financial statements.


Contingent Liability

Possible Possible Possible Possible

Don’t mention it Don’t mention it Don’t mention it Don’t mention it Remote Remote Remote Remote

Record a liability Record a liability Record a liability Record a liability

ContingentContingentliabilityliability

ContingentContingentliabilityliability

ProbableProbableProbableProbable

YesYesYesYes

Describe in notesDescribe in notesDescribe in notesDescribe in notes

No No No No

How likely isthe liability?

Can weestimate the

amount?Accountingrequired.


End of Chapter 10

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