©2008 Pearson Prentice Hall. All rights reserved. 8-1 Liabilities Chapter 8

©2008 Pearson Prentice Hall. All rights reserved. 8-2 Learning Objective 1 Account for current liabilities and contingent liabilities

©2008 Pearson Prentice Hall. All rights reserved. 8-3 Categories of Current Liabilities Known amounts Unknown amounts Current liabilities are obligations due with one year of balance sheet date

©2008 Pearson Prentice Hall. All rights reserved. 8-4 Current Liabilities of Known Amount Accounts Payable Amounts owed for products and services purchased on account Short-Term Notes Payable Common form of financing; company incurs interest expense Accrued Liabilities Expense incurred, but not yet paid; often an adjusting entry includes salaries & interest payable Sales Tax Payable Tax levied by state on retail sales; company collects from customer and remits to gov’t Payroll Liabilities Salaries & wages paid to employees; also includes income taxes and FICA taxes withheld Unearned revenues Customers makes payment before receiving product or service

©2008 Pearson Prentice Hall. All rights reserved. 8-5 Entries for Short-Term Notes Payable DateAccountsDebitCredit 1-DecInventory$10,000 Notes Payable, Short-Term $10,000 Purchased inventory by issuing a $10,000, 12%, 90-day note payable 31-DecInterest Expense$100 Interest Payable $100 Accrual of interest at year-end (10,000 x 12% x 30/360) Suppose a company purchases inventory by signing a $10,000, 12% 90-day note payable on December 1

©2008 Pearson Prentice Hall. All rights reserved. 8-6 Entries for Short-Term Notes Payable 1-MarNotes Payable, Short-Term$10,000 Interest Payable ________ Interest Expense$200 Cash $10,300 Payment of the note and interest at maturity The maturity date of the note would be March 1 of the following year What amount would “zero it out” ?

©2008 Pearson Prentice Hall. All rights reserved. 8-7 Recording Payroll Each pay period salary expense and withholdings are recorded Salary Expense$$$$ Employee Income Tax Payable $$$$ FICA Tax Payable $$$$ Salary Payable $$$$ Gross Pay Net Pay

©2008 Pearson Prentice Hall. All rights reserved. 8-8 Current Portion of Long-Term Debt Some long-term debt is paid in installments Any amount due in the upcoming year is reclassified as a current liability

©2008 Pearson Prentice Hall. All rights reserved. 8-9 Current Liabilities That Are Estimated (Amounts Unknown) Estimated Warranty Payable Contingent Liabilities

©2008 Pearson Prentice Hall. All rights reserved Estimated Warranty Payable Companies guarantee products through warranty agreements Warranty expense is estimated in same period as sale of product  Matching principle JOURNAL DateAccountsDebitCredit Warranty Expense$$$$ Estimated Warranty Payable $$$$

©2008 Pearson Prentice Hall. All rights reserved Contingent Liabilities Potential liability that depends on a future event arising out of past events Likelihood of future event is assessed as:  Probable  Reasonably possible  Unlikely

©2008 Pearson Prentice Hall. All rights reserved LikelihoodAccounting Probable Record liability if amount can be estimated Reasonably Possible Include in notes to financial statements UnlikelyDo not report Accounting for Contingent Liabilities

©2008 Pearson Prentice Hall. All rights reserved Long-Term Liabilities: Bonds To raise capital, companies sell bonds to the public Bonds payable are groups of notes payable issued to multiple lenders, called bondholders

©2008 Pearson Prentice Hall. All rights reserved Bond Terms Amount borrowed; usually in $1000 units Also called face value, or par value Maturity Date Date bond is due; 5, 10 or 20 year terms are common Interest Company must pay bondholders interest in regular intervals over the term of the bond Underwriter A securities firm that purchases the bond issue and resells to clients Principal

©2008 Pearson Prentice Hall. All rights reserved Types of Bonds Term bonds  All bonds in an issue mature at one specific date Serial bonds  Bonds in the issue mature installments Secured (mortgage) bonds  Bondholders have right to company assets if interest and principal is not paid Unsecured (debenture) bonds  Backed only by the good faith of the issuing company

©2008 Pearson Prentice Hall. All rights reserved Bond Premium and Discount Premium Issue price above face value Market rate of interest is greater than stated rate of interest Discount Issue price below face value Market rate of interest is less than stated rate of interest Market interest rate = rate investors demand for loaning money; changes frequently Stated interest rate = printed on the bond certificate; determines amount of cash interest; remains constant

©2008 Pearson Prentice Hall. All rights reserved Learning Objective 2 Account for bonds payable

©2008 Pearson Prentice Hall. All rights reserved Issuing Bonds Payable at Face Value Suppose a company issues $100,000 of 8% bonds payable that mature in ten years; the bonds pay interest semi-annually DateAccountsDebitCredit 1-JanCash$100,000 Bond payable $100,000 Issued $100,000, 8%, 10-year bonds at face value 1-JulInterest Expense _________ Cash ___________ ___ Paid semi-annual interest on bonds Face value x interest rate x 1/2

©2008 Pearson Prentice Hall. All rights reserved Issuing Bonds at a Discount If stated interest rate of bonds is less than market interest rate, bondholders will not pay face value for bond Market price of bond drops below face value Cash received from bond issue is less than face value

©2008 Pearson Prentice Hall. All rights reserved Issuing Bonds at a Discount Suppose a company issues $100,000 of 9%, five-year bonds when the market interest rate is 10% The market price of the bonds is $96,149 DateAccountsDebitCredit 1-JanCash$96,149 Discount on Bonds Payable$3,851 Bonds payable $100,000 Issued $100,000, 9%, 10-year bonds at a discount

©2008 Pearson Prentice Hall. All rights reserved Carrying Amount: Bonds Issued at a Discount Bonds are shown at their carrying amount on the balance sheet Carrying amount = Face value Less Discount Balance Balance Sheet January 1 Long-Term Liabilities: Bonds Payable$100,000 Less: Discount($3,851)$96,149

©2008 Pearson Prentice Hall. All rights reserved ©2009 Prentice Hall 5-22 Learning Objective 3 Measure interest expense

©2008 Pearson Prentice Hall. All rights reserved Interest Expense on Bonds Issued at a Discount Interest Expense > Cash Payment Interest Expense = Carrying Amount of Bond x Market Interest Rate Discount Amortization = Interest Expense - Cash Payment The company must pay interest based on the face value even though it received less than face value Discount is amortized (reduced) over the bond term.

©2008 Pearson Prentice Hall. All rights reserved Recording Interest on Bonds Issued at a Discount Referring to the previous example, interest expense on July 1 would be recorded as follows: DateAccountsDebitCredit 1-JulyInterest Expense (96,149 x 5%)$4,807 Discount on Bonds Payable$307 Cash ($100,000 x____) _________ To pay semiannual interest and amortize bond discount Interest expense is debited for the carrying amount x market rate x 1/2 Cash is credited for the face value x stated rate x 1/2 Discount is credited for the difference between the expense and payment Stated rate x 1/2

©2008 Pearson Prentice Hall. All rights reserved Discount on Bonds Payable Issue Date, Jan. 1 $3,851 1 st Int. Pmt, July 1 $307 $3,544 Balance, July. 1 Balance Sheet July 1 Long-Term Liabilities: Bonds Payable$100,000 Less: Discount($3,544)$96,456

©2008 Pearson Prentice Hall. All rights reserved Issuing Bonds at a Premium If stated interest rate of bonds is greater than market interest rate, bondholders will pay more than face value for bond Market price of bond increases above face value Cash received from bond issue is greater than face value

©2008 Pearson Prentice Hall. All rights reserved Issuing Bonds at a Premium Suppose a company issues $100,000 of 9%, five-year bonds when the market interest rate is 8% The market price of the bonds is $104,100 DateAccountsDebitCredit 1-JanCash$104,100 Premium on Bonds Payable_______ Bonds payable $100,000 Issued $100,000, 9%, 10-year bonds at a premium Cash price – face value

©2008 Pearson Prentice Hall. All rights reserved Carrying Amount: Bonds Issued at a Premium Bonds are shown at their carrying amount on the balance sheet Carrying amount = Face value Plus Premium Balance Balance Sheet January 1 Long-Term Liabilities: Bonds Payable$100,000 Plus: Premium $ 4,100$104,100

©2008 Pearson Prentice Hall. All rights reserved Interest Expense on Bonds Issued at a Premium Interest Expense < Cash Payment Interest Expense = Carrying Amount of Bond x Market Interest Rate Premium Amortization = Cash Payment – Interest Expense The company pays interest based on only the face value even though it received more than face value. Premium is amortized (reduced) over the bond term.

©2008 Pearson Prentice Hall. All rights reserved Recording Interest on Bonds Issued at a Premium Referring to the previous example, interest expense on July 1 would be recorded as follows: DateAccountsDebitCredit 1-JulyInterest Expense (104,100 x 4%)$4,164 Premium on Bonds Payable$336 Cash ($100,000 x 4.5%) $4,500 Issued $100,000, 9%, 10-year bonds at a discount Interest expense is debited for the carrying amount x market rate x 1/2 Cash is credited for the face value x stated rate x 1/2 Premium is debited for the difference between the expense and payment

©2008 Pearson Prentice Hall. All rights reserved Premium on Bonds Payable Issue Date, Jan. 1 $336 1 st Int. Pmt, July 1 $4,100 $3,764 Balance, July. 1 Balance Sheet July 1 Long-Term Liabilities: Bonds Payable$100,000 Plus: Premium$3,764$103,764

©2008 Pearson Prentice Hall. All rights reserved Retiring Bonds Before Maturity Interest rates may change causing companies to retire bonds early  Borrowing rates may become less than interest rate on bonds Some bonds are callable  Company can pay off bonds a specific price

©2008 Pearson Prentice Hall. All rights reserved Convertible bonds Bondholders may exchange bonds for company’s stock Offers investor:  Assured receipt of interest and principal on bonds  Opportunity for gains on stock Investors will accept a lower interest rate on bonds because of the attractiveness of this feature.

©2008 Pearson Prentice Hall. All rights reserved Learning Objective 4 Understand the advantages and disadvantages of borrowing

©2008 Pearson Prentice Hall. All rights reserved Financing Operations with Bonds or Stock When a company needs funds, they can raise money by:  Issuing stock No liabilities or interest expense Less risky More costly  Issuing bonds or notes Does not dilute control of company Results in higher earnings per share More debt increases risk

©2008 Pearson Prentice Hall. All rights reserved E8-31 Plan A—Borrow at 8% Net Income before expansion $500,000 Additional income 420,000 Less interest expense (500K x 8%) (40,000) 380,000 Less income tax expense (114,000) Expected additional income 266,000 Total company net income $766,000 Earnings per share $________ Net income divided by shares of stock

©2008 Pearson Prentice Hall. All rights reserved E8-31 Plan B—Issue Stock Net Income before expansion $ 500,000 Additional income 420,000 Less interest expense ,000 Less income tax expense (126,000) Expected additional income 294,000 Total company net income $ 794,000 Earnings per share: $ 3.97

©2008 Pearson Prentice Hall. All rights reserved Times-Interest-Earned Also called interest-coverage ratio Relates income to interest expense Operating income Interest expense

©2008 Pearson Prentice Hall. All rights reserved Leases Lease–rental agreement in which the tenant (lessee) agrees to make rent payments to the property owner (lessor) Two categories:  Operating  Capital

©2008 Pearson Prentice Hall. All rights reserved Operating Leases Usually short-term or cancelable Lessor retains risks and rewards of owning asset Lessee records “rent expense” when payments are made

©2008 Pearson Prentice Hall. All rights reserved Capital Leases Long-term noncancelable debt Four criteria  Title transfers to lessee at end of lease  Lease contains a bargain purchase option  Lease term is 75% or more of asset’s life  Present value of lease payments is 90% or more than fair value of leased asset If lease meets one of the above criteria, it is considered a capital lease

©2008 Pearson Prentice Hall. All rights reserved Learning Objective 5 Report liabilities on the balance sheet

©2008 Pearson Prentice Hall. All rights reserved Liabilities on the Balance Sheet Current liabilities are listed and include the current portion of long-term debt Long-term debt is often reported as one amount on the balance sheet A disclosure note provides the detail of long-term debt

©2008 Pearson Prentice Hall. All rights reserved Long-Term Liabilities on the Cash Flow Statement Issuing bonds and long-term borrowing are reported as financing inflows Payments of bond and loan principal are reported as financing inflows Interest expense is reported in the operating section

©2008 Pearson Prentice Hall. All rights reserved End of Chapter 8