McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-1 CHAPTER 7 Accounting for and Presentation of Liabilities McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-2  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.  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. Nature of Liabilities L O 1

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-3 Nature of Liabilities Current liabilities include: Accounts payable Accounts payable Short-term debt (Notes payable) Short-term debt (Notes payable) Current maturities of long-term debt Current maturities of long-term debt Unearned revenue or deferred credits Unearned revenue or deferred credits Other accrued liabilities Other accrued liabilities Current liabilities include: Accounts payable Accounts payable Short-term debt (Notes payable) Short-term debt (Notes payable) Current maturities of long-term debt Current maturities of long-term debt Unearned revenue or deferred credits Unearned revenue or deferred credits Other accrued liabilities Other accrued liabilities Noncurrent liabilities include: Long-term debt (Bonds payable) Long-term debt (Bonds payable) Deferred tax liabilities Deferred tax liabilities Minority interest in subsidiaries Minority interest in subsidiaries Noncurrent liabilities include: Long-term debt (Bonds payable) Long-term debt (Bonds payable) Deferred tax liabilities Deferred tax liabilities Minority interest in subsidiaries Minority interest in subsidiaries L O 1

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-4 Nature of Liabilities  The recognition of a liability usually means that an expense has been recorded.  Expenses always reduce income.  Lower net income means lower ROI. L O 1 ROI = Return on Investment

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-5 Current Liabilities Short-Term Debt On January 1, 2008 Matrix, Inc. borrows $25,000 from 1 st National Bank to provide working capital. The following entry is recorded: L O 1 Financial Statement effect of this transaction

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-6 Current Liabilities Interest Expense The following entry is recorded to accrue interest each month: L O 1 Financial Statement effect of this transaction

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-7 Interest Calculation Methods Straight Interest Interest = Principal × Rate × Time in years = $25,000 × 0.09 × 1 = $ 2,250 per year or $ per month Annual Percentage Interest Rate (APR) APR = Interest Paid ÷ Money available × Time = $2,250 ÷ $25,000 × 1 = 9% L O 2

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-8 Interest Calculation Methods Discount Basis - Interest is Paid in Advance 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% L O 2

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-9 Current Liabilities Discount Basis On January 1, 2008, Matrix, Inc. borrows $25,000 from 1 st National Bank to provide working capital. The note was discounted by the bank and the net proceeds given to Matrix. L O 2 Financial Statement effect of this transaction

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Current Liabilities The Prepaid interest on the Note Payable will be reclassified as an expense each month using an adjusting entry L O 2 Financial Statement effect of this transaction

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved 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 of long-term debt. L O 2

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Accounts Payable Amounts owed to suppliers for goods and services that have been provided on credit.... in this Number of Days.... in this Number of Days. 2/10, n/30 Purchase Discounts Payment Terms Purchase Discounts Payment Terms... for this number of days. Otherwise, Net (or Total Invoice Amount) is Due... Percentage Discount... L O 2

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Accounts Payable and Discounts Matrix, Inc. purchased $62,000 of merchandise for resale on account. Terms = 2/10, n/30 Net Method Gross Method L O 2

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Accounts Payable and Discounts Matrix, Inc. paid for the merchandise within the discount period. Gross Method Net Method *A contra-expense account to COGS L O 2

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Accounts Payable and Discounts Matrix, Inc. did not pay for the merchandise within the discount period. Gross Method Net Method L O 2

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Unearned Revenue or Deferred Credits Unearned revenue is created when customers pay for services or products before delivery. Our goal is to recognize revenue as the subscription is fulfilled each month. Our goal is to recognize revenue as the subscription is fulfilled each month. 1/1/081/31/08 Month end 2/28/08 Month end 3/31/08 Month end Cash received for one-year subscription On January 1, 2008, Matrix, Inc. receives $2,400 cash as an advance payment for a one-year subscription to its monthly investment newsletter. L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Unearned Revenue or Deferred Credits On January 1, 2008, Matrix, Inc. receives $2,400 cash as an advance payment for a one-year subscription to its monthly investment newsletter. L O 3 Financial Statement effect of this transaction

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Unearned Revenue or Deferred Credits On January 31, 2008, Matrix would prepare the following adjusting entry to recognize revenue earned. L O 3 $2,400 ÷ 12 = $200 Financial Statement effect of this transaction

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Payroll Taxes FICA Taxes Medicare Taxes Federal Income Tax State and Local Income Taxes Voluntary Deductions Net Pay Gross Pay L O 4 - Deductions =

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Liability for Warranties Matrix, Inc. sells 1,000 DVD recorders for $500 each during Each DVD has a two-year warranty. Matrix estimates that warranty costs will be $30 per recorder. It is appropriate to recognize the estimated warranty expense in the same period as the sale is recorded. L O 5 Financial Statement effect of this transaction

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Liability for Warranties Adjusting Entry to reflect Warranty Liability for 2008 Sales L O 5 Financial Statement effect of this transaction

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Liability for Warranties During 2008, Matrix paid $3,500 in warranty costs. L O 5 Financial Statement effect of this transaction

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved 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. L O 6

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Financial Leverage 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% L O 6

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Bond Terminology Bond Indenture Trustee of Bonds Registered Bonds Coupon Bonds Term Bonds Mortgage Bonds Debenture Bonds Debenture Bonds Serial Bonds Convertible Bonds L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Bonds Payable - Terminology BOND PAYABLE L O 7 Face Value $1,000 Face Value is the amount an investor will receive at maturity. Bond Date 1/1/08 Bond Date is the date the bond was issued. Interest 10% Stated Interest Rate is typically an annual rate. 6/30 & 12/31 Interest Payment Dates are dates when investor is paid interest. Maturity Date 12/31/12 Maturity Date is date when face value of bond is repaid to investor.

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Issuance of Bonds Payable At Par Value On 1/1/08 Matrix, Inc. issued the following bonds: Par Value = $1,500,000 (1,500 $1,000 face) Stated Interest Rate = 10% Market Interest Rate = 10% Interest Dates = 6/30 & 12/31 of each year Bond Date = January 1, 2008 Maturity Date = Dec. 31, 2012 (5 years) L O 7 Financial Statement effect of this transaction

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Issuance of Bonds Payable at a Discount or a Premium L O 8 Market Rate Effect of Bond Selling Prices The prior example we looked at illustrated Stated Rate of Interest = to Market Rate

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Bonds Issued at a Discount On 1/1/08 Matrix, Inc. issued the following bonds: Par Value = $1,500,000 (1,500 bonds) Stated Interest Rate = 10% Market Interest Rate = 12% Interest Dates = 6/30 and 12/31 Bond Date = January 1, 2008 Maturity Date = Dec. 31, 2012 (5 years) L O 8

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Bonds Issued at a Discount 1. Semiannual rate (i) = 6% (Market rate 12% ÷ 2) 2. Semiannual periods (n) = 10 (5 years × 2) 1. Semiannual rate (i) = 6% (Market rate 12% ÷ 2) 2. Semiannual periods (n) = 10 (5 years × 2) $1,500,000 × 10% × ½ = $75,000 Let’s look at the issuance of the bonds L O 8

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Bonds Issued at a Discount L O 8 Financial Statement effect of this transaction * 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.

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Retirement of Bonds Payable When Matrix retires the bonds at maturity the following entry will be made: Financial Statement effect of this transaction L O 7 L O 8

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Early Retirement of Bonds On June 18, 2008, Matrix, Inc. retired $1,000,000 face amount of bonds by paying bondholders $1,020,000. At the date of retirement, the bonds had unamortized discount of $62,000. Financial Statement effect of this transaction L O 7 L O 8

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Deferred Tax Liability The Internal Revenue Code is the set of rules for preparing tax returns. Financial statement income tax expense. IRS income taxes payable. GAAP is the set of rules for preparing financial statements. Usually...Results in... The difference between tax expense and tax payable is referred to as deferred taxes. L O 9

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Deferred Tax Liability Here is income information at December 31, 2008, 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. L O 9

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Deferred Tax Liability Here is the income statement and income tax return of Matrix for L O 9 a deferred tax liability

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Deferred Tax Liability To recognize income taxes for 2008, Matrix would record the following entry: L O 9 Financial Statement effect of this transaction

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved 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. L O 10

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Other Noncurrent Liabilities 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. 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. L O 10

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved 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. L O 10

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Gain/Loss Contingency Remote Reasonably Possible Probable Occurrence Probability is More Than Remote but Less Than Likely. Occurrence Probability is More Than Remote but Less Than Likely. Occurrence Probability is Likely. Occurrence Probability is Likely. Occurrence Probability is Slight. Occurrence Probability is Slight. L O 10

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved End of Chapter 7