CHAPTER 11 LIABILITIES CHAPTER 11 LIABILITIES STUDY OBJECTIVES After studying this chapter, you should understand: Major types of current liabilities Entries for bond issuance and interest expense Accounting for notes payable Entries for bond redemption Accounting for other current liabilities Accounting for long-term notes payable The purpose of bonds, and major types of bonds Presentation and analysis of long-term liabilities

Key features of a current liability: It is expected to be paid from existing current assets or through the creation of other current liabilities It will be paid within one year or the operating cycle, whichever is longer. STUDY OBJECTIVE 1 TYPES OF CURRENT LIABILITIES STUDY OBJECTIVE 1 TYPES OF CURRENT LIABILITIES Notes Payable Accounts Payable Unearned Revenues Accrued Liabilities

STUDY OBJECTIVE 2 NOTES PAYABLE STUDY OBJECTIVE 2 NOTES PAYABLE Key features of a note payable : Promissory note Interest Notes due within a year are current liabilities

Assume First National Bank agrees to lend $100,000 on March 1, 2006, if Cole Williams Co. 12%, 4-month note. DateAccount TitlesDebitCredit General Journal March 1 Cash 100,000 Notes Payable 100,000 NOTES PAYABLE ISSUANCE DATE NOTES PAYABLE ISSUANCE DATE Assets received = face value of note

$100,000 x 12% x 4/12 = $4,000 Face Value of Note Annual Interest Rate Time in Terms of One Year Interest Using the Cole Williams Co. data: INTEREST FORMULA If the loan term is expressed in days, use the number of days divided by 365. If loan term is expressed in months, use the number of months divided by 12.

If Cole Williams Co. prepares financial statements semiannually, an adjusting entry is required to recognize interest expense and interest payable of $4,000 at June 30. DateAccount TitlesDebitCredit General Journal June 30 Interest Expense 4,000 Interest Payable 4,000 NOTES PAYABLE INTEREST ACCRUAL NOTES PAYABLE INTEREST ACCRUAL

DateAccount TitlesDebitCredit General Journal July 1 Notes Payable 100,000 Interest Payable 4,000 Cash 104,000 NOTES PAYABLE MATURITY DATE NOTES PAYABLE MATURITY DATE When the loan is paid, the FACE VALUE is debited, any interest accrued is removed, and cash is decreased by this combined amount.

REVIEW QUESTION INTEREST ACCRUAL REVIEW QUESTION INTEREST ACCRUAL Shari Uecker Company borrows $88,500 on September 1, 2006 From Egg Harbor State Bank by signing a one year, 12% note. What is the accrued interest at December 31, 2006? Answer: $88,500 x 12% x 4/12 = $3,540 Answer: $88,500 x 12% x 4/12 = $3,540

Sales tax is expressed as a stated percentage of the sales price on goods sold to customers by a retailer. The retailer collects the tax from the customer when the sale occurs. Retailer periodically remits the collections to the state’s department of revenue. STUDY OBJECTIVE 3 OTHER CURRENT LIABILITIES SALES TAXES PAYABLE STUDY OBJECTIVE 3 OTHER CURRENT LIABILITIES SALES TAXES PAYABLE Retailer is a collection agent for the tax authority.

On March 25th cash register readings for Cooley Grocery show sales of $10,000 and sales taxes of $600. DateAccount TitlesDebitCredit General Journal Mar. 25 Cash10,600 Sales 10,000 Sales Tax Payable 600 SALES TAXES PAYABLE SALE DATE SALES TAXES PAYABLE SALE DATE Sales tax rate = 6%

If Cooley Grocery “rings up” total receipts of $10,600, and the sales tax percentage is 6%, we can figure sales as follows: $10,600 / 1.06 = $10,000 Total receipts – Sales = Tax collected $10,600 - $10,000 = $600 EXTRACTING SALES TAX FROM TOTAL RECEIPTS EXTRACTING SALES TAX FROM TOTAL RECEIPTS

PAYROLL AND PAYROLL TAXES PAYABLE Liabilities relating to employee wages and salaries include: Wages and salaries payable Withholding taxes (to record payment of March 7 payroll) 67,564 Cash 67,564Salaries & Wages PayableMarch 11 (record payroll & w/h taxes for week of March 7) 67,564 Salaries & Wages Payable 2,922 State Income Taxes Payable 21,864 Federal Income Taxes Payable 7,650 FICA Taxes Payable 100,000Salaries & Wages ExpenseMarch 7 CreditDebitAccountDate

PAYROLL DEDUCTIONS

(record employer’s payroll taxes for week of March 7) 5,400 SUTA Taxes Payable 800 FUTA Taxes Payable 7,650 FICA Taxes Payable 13,850Payroll Tax ExpenseMarch 7 CreditDebitAccountDate PAYROLL AND PAYROLL TAXES PAYABLE Various payroll taxes are levied upon the employer: Matching FICA taxes Federal unemployment taxes State unemployment taxes

EMPLOYER PAYROLL TAXES

Unearned Revenues occur when a company receives cash before a service is rendered. Examples: Airline sells a ticket for future flights Attorney receives legal fees before work is done. UNEARNED REVENUES

Superior University sells 10,000 season football tickets at $50 each for its five-game home schedule. DateAccount TitlesDebitCredit General Journal Aug. 6 Cash 500,000 Unearned Football Ticket Revenue 500,000 UNEARNED REVENUES CASH RECEIPT UNEARNED REVENUES CASH RECEIPT

As each game is completed, Unearned Football Ticket Revenue is debited for 1/5 of the unearned revenue. The earned revenue, Football Ticket Revenue, is credited. DateAccount TitlesDebitCredit General Journal Sept. 7 Unearned Football Ticket Revenue 100,000 Football Ticket Revenue 100,000 UNEARNED REVENUES EARNINGS DATE UNEARNED REVENUES EARNINGS DATE

Shown below are specific unearned and earned revenue accounts in selected types of businesses. Type of BusinessUnearned RevenueEarned Revenue Airline Unearned passenger Ticket Revenue Passenger Revenue Magazine Publisher Unearned Subscription Revenue Subscription Revenue Hotel Unearned Rental RevenueRental Revenue Insurance Company Unearned Premium RevenuePremium Revenue Account Title UNEARNED AND EARNED REVENUE ACCOUNTS UNEARNED AND EARNED REVENUE ACCOUNTS

That portion of long-term debt due within 1 year. Classified as a current liability on the balance sheet CURRENT MATURITIES OF LONG-TERM DEBT CURRENT MATURITIES OF LONG-TERM DEBT

FINANCIAL STATEMENT PRESENTATION

$ 16,791 - $ 12,621 = $ 4,170 Current Assets Current Liabilities Working Capital - = WORKING CAPITAL FORMULA Working Capital The excess of current assets over current liabilities. A measure of short-term liquidity.

$16,791 / $12,621 = 1.33 : 1 Current Assets Current Liabilities Current Ratio / = CURRENT RATIO FORMULA Current Ratio The ratio of current assets to current liabilities. A measure of short-term liquidity.

A form of interest-bearing notes payable issued by corporations, universities, & governmental agencies. Can be sold in small denominations to attract many investors. Sold to obtain long term capital. An alternative to issuing stock. STUDY OBJECTIVE 4 BONDS PAYABLE STUDY OBJECTIVE 4 BONDS PAYABLE

ADVANTAGES OF BOND FINANCING OVER STOCK ADVANTAGES OF BOND FINANCING OVER STOCK

EFFECTS ON EPS BONDS VS. STOCK EFFECTS ON EPS BONDS VS. STOCK

TYPES OF BONDS Bond TypeDistinguishing characteristics SecuredBacked by specific assets UnsecuredBacked by credit of issuer (debentures) TermPaid at end of specified term SerialPaid in installments RegisteredIssued in name of specific holder BearerNot registered. (Coupon bonds) ConvertibleCan be converted to common stock CallableCan be retired before maturity

Corporate bonds are traded on securities exchanges. Bond prices are quoted as a percentage of the face value of the bond (usually $1,000). Transactions between a bondholder and other investors are not journalized by the issuing corporation. A corporation records entries when it issues/buys back bonds, and when bondholders convert bonds into stock. STUDY OBJECTIVE 5 BOND ISSUANCE PROCEDURES STUDY OBJECTIVE 5 BOND ISSUANCE PROCEDURES

The present value (PV) of a bond is a function of three factors: 1. Dollar amount 2. Time 3. Market rate of interest The process of determining the PV is discounting. DETERMINING MARKET VALUE OF BONDS DETERMINING MARKET VALUE OF BONDS

ISSUING BONDS AT FACE VALUE ISSUING BONDS AT FACE VALUE Assume that Devor Corporation issues year, 9% $1,000 bonds dated January 1, 2006, at 100 (100% of face value). The entry to record the sale is: (record sale of bonds at face value) 1,000,000 Bonds payable 1,000,000CashJan 1 CreditDebitAccountDate 1000 bonds x $1000 = $1,000,000

BOND INTEREST PAYMENT Assume that interest is payable semi-annually on January 1 and July 1. Next payment Is due July 1, The entry is: (record semi-annual bond interest payment) 45,000 Cash 45,000Bond Interest ExpenseJuly 1 CreditDebitAccountDate $1,000,000 x 9% x 6/12 = $45,000

BOND INTEREST ACCRUAL Assume that interest is payable semi-annually on January 1 and July 1. Next payment Is due January 1, At December 31, 2005 the entry to accrue interest is: Record bond interest accrual at year end 45,000 Bond Interest Payable 45,000Bond Interest ExpenseDec 31 CreditDebitAccountDate $1,000,000 x 9% x 6/12 = $45,000

INTEREST RATES AND BOND PRICES BOND CONTRACTUAL INTEREST RATE 10% Issued when: 8% 10% 12% Premium Face Value Discount Market Rates Bonds Sell at:

ISSUING BONDS AT A DISCOUNT On January 1, 2006, Candlestick, Inc. sells $100,000, 5-year, 10% bonds for $92,639 with interest payable on payable on July 1 & January 1. The entry to record the issuance is: 100,000 Bonds Payable (record issuance of bonds at a discount) 7,361Discount on Bonds Payable 92,639CashJan 1 CreditDebitAccountDate Market value of bonds = $92,639

FINANCIAL STATEMENT PRESENTATION--DISCOUNT CANDLESTICK, INC. Balance Sheet (partial) Long-term liabilities Bonds payable $100,000 Less: Discount on Bond Payable $7,361 $92,639 Discount on Bonds Payable is a contra account, which is deducted from bonds payable on the balance sheet: Carrying value of bonds = $92,639

TOTAL COST OF BORROWING BONDS ISSUED AT A DISCOUNT The the discount is an additional cost of borrowing that is recorded as bond interest expense over the life of the bonds. The total cost of borrowing for Candlestick, Inc., is computed as follows: Semiannual Interest Payments ($100,000*10%*.5=$5,000; $5,000*10)$50,000 Add: Bond Discount ($100,000-$92,639)$7,361 Total Cost of Borrowing$57,361 Bonds Issued at a Discount

ISSUING BONDS AT A PREMIUM On January 1, 2006, Candlestick, Inc. sells $100,000, 5-year, 10% bonds for $108,111 with interest payable on payable on July 1 & January 1. The entry to record the issuance is: 100,000 Bonds Payable (record issuance of bonds at a premium) 8,111 Premium on Bonds Payable 108,111CashJan 1 CreditDebitAccountDate Market value of bonds = $108,111

FINANCIAL STATEMENT PRESENTATION—PREMIUM CANDLESTICK, INC. Balance Sheet (partial) Long-term liabilities Bonds payable $100,000 Add: Premium on Bonds Payable $8,111 $108,111 Premium on Bonds Payable is added to bonds payable on the balance sheet: Carrying value of bonds = $108,111

The premium is considered to be a reduction in the cost of borrowing that should be credited to Bond Interest Expense over the life of the bonds. Semiannual Interest Payments ($100,000*10%*.5=$5,000; $5,000*10)$50,000 Less: Bond Premium ($108,111-$100,000)$8,111 Total Cost of Borrowing$41,889 Bonds Issued at a Premium TOTAL COST OF BORROWING BONDS ISSUED AT A PREMIUM

Book value of the bonds at maturity will equal their face value. The entry to record the redemption of the Candlestick bonds at maturity is: STUDY OBJECTIVE 6 REDEEMING BONDS AT MATURITY (record payment of bonds at maturity) 100,000 Cash 100,000Bonds PayableMaturity date CreditDebitAccountDate This assumes all interest has been paid to maturity. The entry will be the same regardless of whether The bonds were issued at face value, discount, or premium

STUDY OBJECTIVE 7 LONG-TERM NOTES PAYABLE Terms exceed one year. May be secured by a specific assets (mortgage). Mortgage N/P are recorded initially at face value. Subsequent entries required for installment payments. (B)(C)(D) Semiannual Interest Period (A) Cash Payment Interest Expense (D) x 6% Reduction Of Principal (A) – (B) Principal Balance (D) –(C) Issue date $500, ,231 $30,000 $3, ,769 2 $33,231 29,806 3, ,344 Porter Technology Inc. issues a $500,000, 12%, 20-year mortgage note on December 31, 2006, to build a research lab. The terms provide for semiannual installment payment of $33,231. The installment payment schedule for the first year is shown below:

The entries to record the issuance and first interest payment are: LONG-TERM NOTES PAYABLE JOURNAL ENTRIES 33,231 Cash 30,000Interest ExpenseJune 30 3,231Mortgage Notes Payable (record mortgage loan) (record first installment payment) 500,000 Mortgage Notes Payable 500,000CashDec 31 CreditDebitAccountDate

STUDY OBJECTIVE 8 PRESENTATION & ANALYSIS The long-term liabilities for LAX Corporation are shown below: LAX Corporation Balance Sheet (partial) Long-term liabilities Bonds payable 10% due in 2012 $1,000,000 Less: Discount on bonds payable 80,000$920,000 Mortgage notes payable, 11%, due in 2018 and secured by plant assets 500,000 Lease liability 540,000 Total long-term liabilities $1,960,000

DEBT TO TOTAL ASSETS RATIO 44.3% = $21,394 / $48,263 TOTAL DEBT DEBT TO TOTAL ASSETS = ———————— TOTAL ASSETS Measures the percentage of total assets provided by creditors, indicating the degree of leverage. Data from Johnson & Johnson’s 2003 annual report appears below:

TIMES INTEREST EARNED RATIO 50.8 times = ($ $ $207) $207 TIMES INT INCOME BEFORE INC. TAXES & INTEREST EXPENSE EARNED = ——————————————————————————— INTEREST EXPENSE Indicates the company’s ability to meet interest payments as they come due. Johnson & Johnson’s 2003 annual report data is used below: