Accounting for and Presentation of Liabilities CHAPTER 7 Accounting for and Presentation of Liabilities McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Nature of Liabilities L O 1 Current liabilities include: Accounts payable Short-term debt (Notes payable) Current maturities of long-term debt Unearned revenue or deferred credits Other accrued liabilities Liabilities are obligations that represent “probable future sacrifice of economic benefits.” The term accrued expenses is often used on the balance sheet to describe liabilities. Current liabilities are those liabilities that will be paid within one year of the current balance sheet date. Noncurrent liabilities include: Long-term debt (Bonds payable) Deferred tax liabilities Minority interest in subsidiaries

Nature of Liabilities L O 1 The recognition of a liability usually means an expense is recorded. Expenses reduce income. Lower net income means lower ROI.

Current Liabilities Short-Term Debt L O 1 Short-Term Debt On January 15, 2007Matrix, Inc. borrows $25,000 from 1st National Bank to provide working capital. The following entry is recorded: This transaction has the following effect on the financial statements of Matrix:

Current Liabilities Interest Expense L O 1 Interest Expense The $25,000 note bears interest at 9% per year. Interest is payable to the bank each December 31st. The following entry is recorded to accrue interest each month: This transaction has the following effect on the financial statements of Matrix:

Interest Calculation Methods L O 2 Straight Interest Interest = Principal × Rate × Time in years = $25,000 × 0.09 × 1 = $ 2,250 Annual Percentage Interest Rate (APR) APR = Interest Paid ÷ Money available × Time = $2,250 ÷ $25,000 × 1 = 9%

Interest Calculation Methods L O 2 Discount Basis Proceeds = Principal − Interest = $25,000 − $2,250 = $22,750 Annual Percentage Interest Rate (APR) APR = Interest Paid ÷ Money available × Time = $2,250 ÷ $22,750 × 1 = 9.89%

Current Liabilities Discount Basis L O 2 Discount Basis On January 15, 2007, Matrix, Inc. borrows $25,000 from 1st National Bank to provide working capital. The note was discounted by the bank and the net proceeds given to Matrix.

Current Liabilities L O 2 The $25,000 note bears interest at 9% per year. Interest is payable to the bank each December 31st. The following entry is recorded to accrue interest each month:

Current Maturities on Long-Term Debt Any portion of long-term debt that is to be repaid within a year of the balance sheet date is reclassified from the noncurrent liability section to the current liability section under the title, current maturities on long-term debt.

Otherwise, Net (or Total Invoice Amount) is Due . . . Accounts Payable Amounts owed to suppliers for goods and services that have been provided on credit. Purchase Discounts 2/10, n/30 . . . for this number of days. Otherwise, Net (or Total Invoice Amount) is Due . . . . . . in this Number of Days. Percentage Discount . . .

Accounts Payable and Discounts Matrix, Inc. purchased $62,000 of merchandise for resale. Gross Method Net Method

Accounts Payable and Discounts Matrix, Inc. paid for the merchandise within the discount period. Gross Method Net Method *A contra-expense account to COGS

Accounts Payable and Discounts Matrix, Inc. did not pay for the merchandise within the discount period. Gross Method Net Method

Unearned Revenue or Deferred Credits L O 3 Unearned Revenue or Deferred Credits Unearned revenue is created when customers pay for services or products before delivery. On January 1, 2007, Matrix, Inc. receives $2,400 cash as an advance payment for a one-year subscription to its monthly investment newsletter. Our goal is to recognize revenue as the subscription is fulfilled each month. 1/1/07 1/31/07 Month end 2/28/07 3/31/07 Cash received for one-year subscription < – – – – –12-month subscription – – – – – >

Unearned Revenue or Deferred Credits L O 3 Unearned Revenue or Deferred Credits On January 1, 2007, Matrix, Inc. receives $2,400 cash as an advance payment for a one-year subscription to its monthly investment newsletter.

Unearned Revenue or Deferred Credits L O 3 Unearned Revenue or Deferred Credits On January 31, 2007, Matrix would prepare the following adjusting entry to recognize revenue earned. $2,400 ÷ 12 = $200

State and Local Income Taxes Payroll Taxes L O 4 Gross Pay Net Pay State and Local Income Taxes Voluntary Deductions Medicare Taxes Federal Income Tax FICA Taxes

Liability for Warranties L O 5 It is appropriate to recognize the estimated warranty expense in the same period as the sale is recorded. Matrix, Inc. sells 1,000 DVD recorders for $500 each during 2007. Each DVD has a two-year warranty. Matrix estimates that warranty costs will be $30 per recorder.

Liability for Warranties L O 5 Matrix, Inc. sells 1,000 DVD recorders for $500 each during 2007. Each DVD has a two-year warranty. Matrix estimates that warranty costs will be $30 per recorder.

Liability for Warranties L O 5 During 2007, Matrix paid $3,500 in warranty costs.

Noncurrent Liabilities Long-Term Debt Interest on debt is tax deductible but dividends on stock are not. The after-tax cost of debt can be less than the cost of equities. Long-term debt can provide positive financial leverage. Leverage is the difference between the ROI and the ROE.

Financial Leverage Without Leverage With Leverage L O 6 Without Leverage ROI = $100,000 ÷ $500,000 = 20% ROE = $100,000 ÷ $500,000 = 20% With Leverage ROI = $100,000 ÷ $500,000 = 20% ROE = $88,000 ÷ $350,000 = 25.1%

Bond Terminology Bond Indenture Debenture Bonds Trustee of Bonds Mortgage Bonds Registered Bonds Term Bonds Coupon Bonds Serial Bonds Convertible Bonds

BOND PAYABLE Bonds Payable L O 7 Face Value $1,000 Interest 10% 6/30 & 12/31 Maturity Date 12/31/11 Bond Date 1/1/07 BOND PAYABLE 1. Face Value = Maturity or Par Value, Principal 2. Maturity Date 3. Stated Interest Rate 4. Interest Payment Dates 5. Bond Date Other Factors: 6. Market Interest Rate 7. Issue Date

Issuance of Bonds Payable At Par Value L O 7 Issuance of Bonds Payable At Par Value On 1/1/07 Matrix, Inc. issued the following bonds: Par Value = $1,500,000 (1,500 bonds @ $1,000 face) Stated Interest Rate = 10% Market Interest Rate = 10% Interest Dates = 6/30 & 12/31 of each year Bond Date = January 1, 2007 Maturity Date = Dec. 31, 2011 (5 years)

Issuance of Bonds Payable at a Discount or a Premium L O 8 Issuance of Bonds Payable at a Discount or a Premium On 1/1/07 Matrix, Inc. issued the following bonds: Par Value = $1,500,000 (1,500 bonds @ $1,000 face) Stated Interest Rate = 10% Market Interest Rate = 10% Interest Dates = 6/30 & 12/31 of each year Bond Date = January 1, 2007 Maturity Date = Dec. 31, 2011 (50 years)

Bonds Issued at a Discount L O 8 On 1/1/07 Matrix, Inc. issued the following bonds: Par Value = $1,000,000 (1,000 bonds) Stated Interest Rate = 10% Market Interest Rate = 12% Interest Dates = 6/30 and 12/31 Bond Date = January 1, 2007 Maturity Date = Dec. 31, 2011 (5 years)

Bonds Issued at a Discount L O 8 $1,000,000 × 10% × ½ = $50,000 1. Semiannual rate (i) = 6% (Market rate 12% ÷ 2) 2. Semiannual periods (n) = 10 (5 years × 2) Let’s look at the issuance of the bonds

Bonds Issued at a Discount L O 8 Bonds Issued at a Discount * A contra-liability account that will be amortized over the life of the bond as an adjustment to interest expense. A discount amortization increases periodic interest expense and a premium amortization decreases interest expense.

Retirement of Bonds Payable When Matrix retires the bonds at maturity the following entry will be made:

Early Retirement of Bonds On June 18, 2006, Matrix, Inc. retired $1,000,000 face amount bonds by paying bondholders $1,020,000. At the date of retirement the bonds had unamortized discount of $62,000.

Deferred Tax Liability L O 9 The Internal Revenue Code is the set of rules for preparing tax returns. GAAP is the set of rules for preparing financial statements. Results in . . . Usually. . . Results in . . . Financial statement income tax expense. IRS income taxes payable. The difference between tax expense and tax payable is referred to as deferred taxes.

Deferred Tax Liability L O 9 Here is income information at December 31, 2007, for Matrix, Inc. Matrix uses straight-line depreciation for financial reporting and MACRS depreciation for income tax reporting. Matrix is subject to a 30% tax rate.

Deferred Tax Liability L O 9 Here is the income tax return and income statement of Matrix for 2007.

Deferred Tax Liability L O 9 To recognize income taxes for 2007, Matrix would record the following entry:

Other Noncurrent Liabilities Obligations relating to pension plans and other employee benefit plans, including deferred compensation and bonus plans. Expenses relating to these plans are accrued and reflected in the income statement of the fiscal period in which the benefits are earned by the employees. Some companies pay postretirement benefits. Costs associated with these plans are usually expensed in the fiscal period in which payments are made to providers.

Other Noncurrent Liabilities L O 10 Minority Interest in Subsidiaries Financial statements of a parent company and its subsidiaries are usually combined or consolidated at the end of the accounting period. If a parent company owns more than 50% but less than 100% of a subsidiary, the minority shareholders’ interest in the subsidiary is shown on the balance sheet of the parent.

Other Noncurrent Liabilities Contingent Liabilities Potential claims on the resources of a company arising from pending litigation, environmental hazards, casualty losses to property, product warranties, or unsettled disputes with the Internal Revenue Service.

Gain/Loss Contingency Remote Reasonably Possible Probable Occurrence Probability is More Than Remote but Less Than Likely. Occurrence Probability is Likely. is Slight.

End of Chapter 7