Chapter Seven Accounting for Liabilities © 2015 McGraw-Hill Education.

Accounting for Notes Payable 09/01/14 Borrowing On September 1, 2014 Herrera Supply Company (HSC) borrowed $90,000 from the National Bank. HSC issued a note payable due in one year with an annual interest rate of 9%. 7-2

Accrual of Interest Expense 12/31/14 Recognition of Interest Expense At the end of 2014, HSC must accrue interest on its note payable. $90,000 × 9% × 4/12 = $2,700 interest expense 7-3

Paying principal & interest at maturity date 08/31/15 Recognition of interest expense. Payment of principal and interest on the maturity date, August 31. $90,000 × 9% × 8/12 = $5,400 interest expense Now, record payment of principal and interest payable. 7-4

Accounting for Sales Tax Most states require retail companies to collect sales tax on items sold to their customers. The retailer then remits the tax to the state at regular intervals. Sales tax is a liability to the retailer until paid to the state. HSC sells merchandise to a customer for $2,000 cash in a state where the sales tax rate is 6%. 7-5

Accounting for Sales Tax Remitting the tax (paying cash to the state tax authority) is an asset use transaction. 7-6

Reporting Contingent Liabilities 7-7

Warranty Obligations To attract customers, many companies guarantee their products or services. Within the warranty period, the seller promises to replace or repair defective products without charge. Event 1 Sale of Merchandise HSC sells $7,000 of merchandise for cash. The merchandise had a cost of $4,

Warranty Obligations Event 2 Recognition of Warranty Expense HSC estimates that warranty expense associated with the current sale will be $

Warranty Obligations Event 3 Settlement of Warranty Obligation HSC pays $40 cash to repair defective merchandise returned by a customer. 7-10

Financial Statements Sales Revenue7,000$ Cost of Goods Sold(4,000) Gross Margin3,000 Warranty Expense(100) Net Income2,900$ Income Statement 7-11

Installment Notes Payable Cash payment determined using present value concepts presented in a later chapter. All computations rounded to the nearest dollar; after the 2018 payment the loan balance is 0. Accounting Period Unpaid Principal Balance on January 1 Cash Payment on December 31 Amount Applied to Interest Amount Applied to Principal ,000$ 25,709$ 9,000$ 16,709$ ,291 25,709 7,496 18,213 65,078 25,709 5,857 19, ,226 25,709 4,070 21,639 23,587 25,710 2,123 23,

With each payment the amount applied to the principal increases and the amount applied to interest decreases. Annual payments are constant. Installment Notes Payable 7-13

Line of Credit Lagoon Company borrows money using a line of credit to finance building up its inventory. Lagoon repays the loan over the summer using cash generated from sales. ( Interest rates generally fluctuate based on a designated interest rate benchmark.) Each borrowing is an asset source transaction. Each repayment is an asset use transaction. 7-14

Mason Company issues bonds on January 1, Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Mason Company issues bonds on January 1, Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Mason Company issues bonds on January 1, Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2018 (5 years) Mason Company issues bonds on January 1, Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2018 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Bonds Issued at Face Value 7-15

Bonds Issued at Face Value Event 1 Issue Bonds for Cash Issuing the bonds has the following effect on Mason’s 2014 financial statements: Event 1 Issue Bonds for Cash Issuing the bonds has the following effect on Mason’s 2014 financial statements: Event 2 Investment in Land Paying $100,000 cash to purchase land is an asset exchange transaction. Event 2 Investment in Land Paying $100,000 cash to purchase land is an asset exchange transaction. 7-16

Bonds Issued at Face Value Event 3 Revenue Recognition Recognizing $12,000 cash revenue from renting the property is an asset source transaction. Event 3 Revenue Recognition Recognizing $12,000 cash revenue from renting the property is an asset source transaction. Event 4 Expense Recognition Mason’s $9,000 ($100,000 x 0.09) cash payment in each of the 5 years represents interest expense. Event 4 Expense Recognition Mason’s $9,000 ($100,000 x 0.09) cash payment in each of the 5 years represents interest expense. 7-17

Bonds Issued at Face Value Event 6 Payoff of Bond Liability The principal repayment on December 31, 2018 will have the following effect on Mason’s 2018 financial statements: Event 6 Payoff of Bond Liability The principal repayment on December 31, 2018 will have the following effect on Mason’s 2018 financial statements: Event 5 Sale of Investment in Land Selling the land for cash equal to its $100,000 book value is an asset exchange transaction. Event 5 Sale of Investment in Land Selling the land for cash equal to its $100,000 book value is an asset exchange transaction. 7-18

Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors $100,000 face issued at 95: Bonds Payable$100,000 Less: Discount on Bonds Payable (5,000) Carrying Value$ 95,000 $100,000 face issued at 95: Bonds Payable$100,000 Less: Discount on Bonds Payable (5,000) Carrying Value$ 95,000 Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Bonds Issued at a Discount 7-19

Mason Company issues bonds on January 1, Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Mason Company issues bonds on January 1, Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors $100,000 face issued at 105: Bonds Payable$100,000 Plus: Premium on Bonds Payable 5,000 Carrying Value$ 105,000 $100,000 face issued at 105: Bonds Payable$100,000 Plus: Premium on Bonds Payable 5,000 Carrying Value$ 105,000 Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Bonds Issued at a Premium 7-20

Current Versus Noncurrent Current assets are expected to be converted to cash or consumed within one year or an operating cycle, whichever is longer. Current assets include: Cash Marketable Securities Accounts Receivable Short-Term Notes Receivable Interest Receivable Inventory Supplies Prepaid Items Cash Marketable Securities Accounts Receivable Short-Term Notes Receivable Interest Receivable Inventory Supplies Prepaid Items 7-21

Current Versus Noncurrent Current liabilities are due within one year or an operating cycle, whichever is longer. Current liabilities, also called short-term liabilities, include: Accounts PayableAccounts Payable Short-Term Notes PayableShort-Term Notes Payable Wages PayableWages Payable Taxes PayableTaxes Payable Interest PayableInterest Payable Accounts PayableAccounts Payable Short-Term Notes PayableShort-Term Notes Payable Wages PayableWages Payable Taxes PayableTaxes Payable Interest PayableInterest Payable 7-22

End of Chapter Seven 7-23