1. Liabilities
Chapter 10
Chapter 10: Liabilities

2. The Nature of Liabilities
Defined as debts or obligations arising from past transactions or events.
Maturity = 1 year or less
Maturity > 1 year
Current Liabilities
Noncurrent Liabilities
Liabilities are debts owed from past transactions. Liabilities can be separated into two categories: Current and Non-current.
Current liabilities are due to be paid within one year or the normal operating cycle of the business, whichever is longer. For most businesses, one year is longer than the operating cycle.
Noncurrent liabilities are due to be paid sometime after one year.

3. Distinction Between Debt and Equity
The acquisition of assets is financed from two sources:
DEBT
EQUITY
Funds from creditors, with a definite due date, and sometimes bearing interest.
A company can finance its operations from two sources. One is debt. Debt is a borrowing from a creditor, such as a bank. It has a definite due date and in most cases bears an interest rate.
Another way a company can finance its operations is through equity. This requires companies to sell additional stock in the company to new or existing shareholders.
Funds from owners.

4. Estimated Liabilities
Estimated liabilities have two basic characteristics:
The liability is known to exist,
The precise dollar amount cannot be determined until a later date.
An estimated liability has two basic characteristics: (1) the liability is known to exist, and (2) the precise dollar amount cannot be determined until a later date.
An example of an estimated liability is the warranty associated with a new car provided by the manufacturer. The warranty usually extends for a number of years. As each car is sold, the automaker incurs a liability to perform any work that may be required under the warranty. The dollar amount of the liability, however, can only be estimated at the date of sale.
Example: An automobile warranty obligation.

5. Current Liabilities: Accounts Payable
Short-term obligations to suppliers for purchases of merchandise and to others for goods and services.
Merchandise inventory invoices
Office supplies invoices
Accounts Payable are short-term obligations for purchases of merchandise and other goods and services that are used in the normal operations of a business.
Examples
Utility and phone bills
Shipping charges

6. Current Liabilities: Notes Payable
When a company borrows money, a note payable is created.
Current Portion of Notes Payable
The portion of a note payable that is due within one year, or one operating cycle, whichever is longer.
Many Notes Payable require payments on a regular basis during the life of the note. For example, many home mortgages are for fifteen or thirty years. But homeowners do not wait until the end of the fifteen or thirty years to make a payment. They usually make monthly payments during the loan term.
Remember that any debt due within one year is classified as current. The portion of a note payable that is due within one year would be classified as a current liability. The remainder of the note that is due outside of one year is classified as noncurrent.
Total Notes Payable
Current Notes Payable
Noncurrent Notes Payable

7. Current Liabilities: Notes Payable
PROMISSORY NOTE
Location Date
after this date
promises to pay to the order of
the sum of with interest at the rate of per annum.
Miami, Fl
Nov. 1, 2009
Six months
Porter Company
John Caldwell
Security National Bank
$10,000.00
12.0%
Treasurer and Senior VP
Signed:
Title:
A note is a written promise to pay a specific amount at a specific future date.
A note includes the following necessary information about the agreement. The payee on the note is the recipient of the cash at maturity. In this example, the payee is Security National Bank. The maker on the note is the debtor who owes the money. In this example, the maker is Porter Company. Notes also include information about the principal, interest rate, and due date. This note is for $10,000, has an interest rate of 12%. The note amount plus interest is due six-months from November 1st, the date of the note.

8. Accrued Liabilities
Accrued liabilities arise from the recognition of expenses for which payment will be made in the future. Accrued liabilities are often referred to as accrued expenses.
Examples include:
Interest payable,
Income taxes payable, and
Accrued payroll liabilities.
Accrued liabilities arise from the recognition of expenses for which payment will be made in the future. Accrued liabilities are often referred to as accrued expenses. Examples of accrued liabilities include interest payable and income taxes payable. As accrued liabilities stem from the recording of expenses, the matching principle governs the timing of their recognition. All companies incur accrued liabilities. In most cases, however, these liabilities are paid at frequent intervals.

9. State and Local Income Taxes
Payroll Liabilities
Gross Pay
Net Pay
Ever wondered what happens to the money deducted from your paycheck? Employers do not keep this money; instead it’s remitted to the appropriate entity. For example, money withheld for taxes is remitted to the proper taxing authority. Money voluntarily taken out of your paycheck for retirement funds and insurance is also remitted to the proper place.
All of these withholdings are liabilities for employers. They are due and payable to the appropriate entity within certain time periods.
Medicare Taxes
State and Local Income Taxes
FICA Taxes
Federal Income Tax
Voluntary Deductions

10. As the earnings process is completed
Unearned Revenue
Cash is sometimes collected from the customer before the revenue is actually earned.
As the earnings process is completed
Most of the time people in debt owe money, but sometimes a business can be in debt for services. For example, assume a new client asks his accounting firm to perform next year’s audit. After checking, the firm sees that it has just enough time to add one client to the schedule next year. The firm tells the client it would be glad to perform the audit but needs $10,000 to hold their spot on the schedule. The client agrees and gives the accounting firm $10,000.
When it is time to do the audit, how happy would the client be if the accounting firm just gave them back the $10,000 instead of performing the audit? Not too happy. They do not want money; they want auditing services. The accounting firm is not in debt for money but for auditing services valued at $10,000.
When the client paid in advance for the audit services, the firm debited Cash and credited a liability called Unearned Revenue.
Cash is received in advance.
Deferred revenue is recorded.
Earned revenue is recorded.
a liability account.

11. Long-Term Liabilities
Relatively small debt needs can be filled from single sources.
Banks
Insurance Companies
Pension Plans or
When a company has a relatively small need for cash, the need can usually be met by a single lender, such as a bank.

12. Long-Term Liabilities
Large debt needs are often filled by issuing bonds.
However, when a company needs large amounts of cash, one creditor may not be willing to take on all the risk of repayment. In this case, many companies issue bonds to lots of different people and entities to spread out the risk.

13. Maturing Obligations Intended to be Refinanced
One special type of long-term liability is an obligation that will mature in the current period but that is expected to be refinanced on a long-term basis.
If management has both the intend and ability to refinance soon-to-mature obligations on a long-term basis, these obligations are classified as long-term liabilities.
One special type of long-term liability is an obligation that will mature in the current period but that is expected to be refinanced on a long-term basis. If management has both the intend and ability to refinance soon-to-mature obligations on a long-term basis, these obligations are classified as long-term liabilities.

14. Installment Notes Payable
Long-term notes that call for a series of installment payments.
Installment notes call for a series of payments. Each payment includes some payment on the principal and some payment for interest. Most car loans and home loans are set up on installment payments. Often, the required payments are the same each month. For each payment made, the amount of the principal payment increases and the amount of the interest payment decreases.
Each payment covers interest for the period AND a portion of the principal.
With each payment, the interest portion gets smaller and the principal portion gets larger.

15. Allocating Installment Payments Between Interest and Principal
Identify the unpaid principal balance.
Interest expense = Unpaid Principal × Interest rate.
Reduction in unpaid principal balance = Installment payment – Interest expense.
Compute new unpaid principal balance.
On January 1, Year 1, King’s Inn purchased furnishings at a cost of $7, The loan was a five-year loan and had an interest rate of 10%. The annual payment is $2,000.
Let’s prepare an amortization table for King’s Inn.
Part I
When allocating a payment between interest and principal, follow these four steps.
First, identify the unpaid principal balance.
Second, calculate the interest expense.
Third, determine the reduction in the principal balance.
Fourth, compute the new unpaid principal balance.
Part II
Review the information for King’s Inn. On January 1, Year 1, King’s Inn purchased furnishings at a cost of $7, The loan was a five-year loan and had an interest rate of 10%. The annual payment is $2,000. Let’s prepare an amortization table for King’s Inn.

16. Allocating Installment Payments Between Interest and Principal
Date
Payment
Interest Expense
Reduction in Unpaid Balance
Unpaid Balance
Jan 1, Year 1
$ 7,581.57
Dec. 31, Year 1
$ 2,000.00 $
$ ,241.84
6,339.73
Dec. 31, Year 2
2,000.00
633.97
1,366.03
4,973.70
Dec. 31, Year 3
497.37
1,502.63
3,471.07
Dec. 31, Year 4
347.11
1,652.89
1,818.18
Dec. 31, Year 5
181.82
0.00
$7, × 10% = $758.16
$2,000 - $ = $1,241.84
$7, $1, = $6,339.73
Notice the annual payment is always $2,000. Also notice that for each payment the interest portion decreases and the principal portion increases. Let’s review how to get the interest expense and the principal payment amounts for the first installment payment on the note.
Interest is calculated by taking the unpaid balance at the beginning of the period of $7, and multiplying it by the 10% interest rate.
The principal is calculated by taking the annual payment and subtracting the interest.
The new unpaid balance is the previous balance less the amount of the principal reduction. Make sure you can calculate the other amounts on the table. Let’s look at the entry for the first payment.

17. Using the Amortization Table
The information needed for the journal entry can be found on the amortization table. The cash payment amount, the interest expense, and the principal reduction amount are all in the table.
Date
Description
Debit
Credit
Dec. 31
Interest Expense
758.16
Interest Payable
The first annual payment will be made on January 1, Year 2. At December 31, Year 1, King’s Inn must accrue interest for the year. We can use the amortization table to find the interest expense for Year 1. The proper journal entry is to debit Interest Expense and credit Interest Payable for $ A similar process of accrual and payment will be made in Years 2 and beyond.

18. Using the Amortization Table
On January 1, Year 2, the first annual payment will be made on the installment note. Refer to the previous entry and amortization for the amounts shown.
Date
Description
Debit
Credit
Jan. 1
Interest Payable
758.16
Note Payable
1,241.84
Cash
On January 1, Year 2, King’s Inn will make its first annual payment on the installment note. The accountant for King’s Inn will debit Interest Payable for $ to clear out that account. In addition, the accountant will debit Note Payable for $1,241.84, the amount of the principal reduction, and credit Cash for $2,000, the payment amount.

19. Bonds Payable
Bonds usually involve the borrowing of a large sum of money, called principal.
The principal is usually paid back as a lump sum at the end of the bond period.
Individual bonds are often denominated with a par value, or face value, of $1,000.
As mentioned earlier, when companies need large amounts of cash, they often issue bonds. The principal on bonds is typically paid at the end of the bond period. Bonds are often denominated with a face value, or par value, of $1,000.

20. Principal × Stated Rate × Time = Interest
Bonds Payable
Bonds usually carry a stated rate of interest, also called a contract rate.
Interest is normally paid semiannually.
Interest is computed as:
Principal × Stated Rate × Time = Interest
Bonds normally have an interest rate called a stated or contract rate. Interest is normally paid semiannually and is computed as Principal times Rate times Time. This computation should look familiar to you.

21. For example, a $1,000 bond priced at 102 would sell for $1,020.
Bonds Payable
Bonds are issued through an intermediary called an underwriter.
Bonds can be sold on organized securities exchanges.
Bond prices are usually quoted as a percentage of the face amount.
For example, a $1,000 bond priced at 102 would sell for $1,020.
Bonds are issued through an underwriter. A large number of bonds are traded on the New York Exchange and the American Exchange. Since bonds are bought and sold in the market, they have a market value, or price. For convenience, bond market values are expressed as a percent of their face or par value.

22. Types of Bonds Mortgage Bonds Debenture Bonds Convertible Bonds
There are several types of bonds. For Mortgage bonds, the issuer pledges specific assets as collateral. Debenture bonds are backed by the issuer’s general credit standing. Convertible bonds can be exchanged for a fixed number of common shares of the issuing corporation. Junk bonds have very high risk associated with them.
Convertible Bonds
Junk Bonds

23. Accounting for Bonds Payable
On March 1, 2009, Wells Corporation issues $1,500,000 of 12%, 10-year bonds payable. Interest is payable semiannually, each March 1 and September 1.
Assume the bonds are issued at face value. Record the issuance of the bonds.
Review this information for Wells Corporation. Assume the bonds are issued at face value. Let’s see how to record this bond issue. To record this bond issuance, the accountants at Wells will debit Cash and credit Bonds Payable for $1,500,000.
Date
Description
Debit
Credit
Mar. 1
Cash
1,500,000
Bonds Payable

24. Accounting for Bonds Payable
Record the interest payment on September 1, 2009.
$1,500,000 × 12% × ½ = $90,000
Let’s record the interest payment. On September 1st, the interest payment is recorded as a debit to Interest Expense and a credit to Cash for $90,000. Interest is calculated as principal of $1,500,000 times the interest rate of 12% times the time period of one-half year.

25. Bonds Issued Between Interest Dates
Bonds are often sold between interest dates.
The selling price of the bond is computed as:
One complicating factor that can occur is when a company issues bonds between interest dates. This is a common occurrence because bonds are sold when there is a willing buyer and seller, and that can take place on any date, not just an interest payment date.
When bonds are issued between interest payment dates, the investor pays for the bond PLUS the accrued interest since the last interest payment date. This allows the issuing company to pay all the investors the same interest amount on the interest payment date.
On the interest payment date, the investor receives the full interest payment for the period even though the bond was only outstanding for a portion of the period. The interest payment actually represents two factors: One is a mere repayment of the accrued interest that the investor paid on the purchase date of the bond; the other is interest earned since the bond was purchased.

26. Bonds Issued at a Discount or Premium
The selling price of the bond is determined by the market based on the time value of money.
The selling price of a bond is determined by comparing the market interest rate with the stated interest rate on the bond.
If the stated interest rate on the bond is equal to the market interest rate, then the bond sells at par value. That is, the selling price of the bond is equal to its par value.
In most cases, the stated rate and the market rate of interest will not agree. When these two interest rates differ, it seems to make sense to just change the stated rate to equal the market rate. However, this cannot be done because the bond certificate that lists all of the specifics about the bond, including the interest rate, was printed in advance of the issue date. Thus, we must pay the interest printed on the bond certificate.
The only thing not printed on the bond certificate is the selling price. The issuing company and the bond investors come to an agreement on a selling price that incorporates the difference in the stated interest rate and the market interest rate.
If a bond is paying 10 percent and the market is paying 12 percent, how many investors will want to buy bonds? None! Bonds must be made more attractive by reducing the selling price to make up the difference in the interest rates. In this case, the bond will sell at a discount, or below par value. This discount raises the effective interest rate investors will earn to 12 percent.
Now, if a bond is paying 10 percent and the market is paying 8 percent, how many investors will want to buy bonds? All of them! The selling price can be increased and still be attractive to bond investors. In this case, the bond sells at a premium, or above par value. This premium reduces the effective interest rate that investors will earn to 8 percent.

27. Bonds Issued at a Discount
Wells, Corp. issues bonds on January 1, 2009.
Principal = $1,000,000
Issue price = $950,000
Stated Interest Rate = 9%
Interest Dates = 6/30 and 12/31
Maturity Date = Dec. 31, 2028 (20 years)
In almost all cases, the stated rate and the market rate of interest will not agree. When these two interest rates are different, it might make sense to you for us to just change our stated rate to equal the market rate and then everything would be fine. Well, we can’t do that. The bond certificate lists all of the specifics about the bond including the stated interest rate. Because we have to print the bond certificates in advance, we are stuck having to pay the interest printed on the bond certificate. The only thing that is not printed on the bond certificate is the selling price. So, the issuing company and the bond investors come to an agreement on the selling price that incorporates the difference in the stated interest rate and the market interest rate at the time of issue.
On January 1, 2009, Wells Corporation sells $1,000,000 face amount, 9% stated rate bonds for $950,000. The bonds mature in 20 years and pay interest on June 30 and December 31 or each year. Wells was forced to reduce the selling price of the bonds to $950,000, because investors in the market place demanded an interest rate higher than the stated 9% rate. The difference between the $1,000,000 face value of the bonds and the cash issue price of $950,000 is the $50,000 discount that Wells offers to the bond investors.

28. Bonds Issued at a Discount
To record the bond issue, Well, Inc. would make the following entry on January 1, 2009:
On the issue date, Wells will debit Cash for the $950,000 of cash received, credit Bonds Payable for the face amount of $1,000,000, and debit Discount on Bonds Payable for the $50,000 difference. Discount on Bonds Payable is a contra-liability account and has a normal debit balance.

29. Bonds Issued at a Discount
Maturity Value
On the balance sheet, the discount account is subtracted from the face value of the bonds to arrive at the net carrying value of the bonds.
Carrying Value

30. Bonds Issued at a Discount
Amortizing the discount over the term of the bond increases Interest Expense each interest payment period.
Using the straight-line method, the discount amortization will be $1,250 every six months.
$50,000 ÷ 40 periods = $1,250
The discount represents an additional interest factor that will be amortized to Interest Expense over the life of the bond. Amortizing the discount will increase the total Interest Expense recorded for the bond each interest payment period. Using the straight-line method to amortize the discount, the accountants at Wells will divide the total discount by the number of interest payment periods to get the amount of the discount amortized each interest payment period. Since this is a 20-year bond and it pays interest semiannually, there are 40 interest payment periods. We calculate the amortization amount by dividing the amount of the discount, $50,000, by the total number of amortization periods in the life of the bond, 40, to get amortization of $1,250 each interest payment date.

31. Amortization of the Discount
$1,000,000 × 9% × ½ = $45,000
Interest paid every six months is calculated as follows:
We prepare the following journal entry to record the first interest payment.
Part I
Interest is paid semiannually, so Matrix will pay $45,000 every six months to the bond investors.
Part II
At each interest payment date Wells Corporation will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. The credit to Discount on Bonds Payable is determined using the straight-line method we discussed on the previous screen. The debit to Bond Interest Expense is the total of the two amounts in this entry. Notice that the amortization of the discount increases the company’s effective interest cost on the bonds.

32. Bonds Issued at a Discount
$50,000 – $1,250 – $1,250
On the balance sheet at the end of 2009, the discount account is subtracted from the principal amount of the bonds to arrive at the net carrying value of the bonds. As the discount is amortized, the carrying value will increase to exactly $1,000,000 on the maturity date.
Maturity Value
Carrying Value
The carrying value will increase to exactly $1,000,000 on the maturity date.

33. Bonds Issued at a Discount
Wells Corporation will repay the principal amount on December 31, 2028 with the following entry:
On the maturity date, Wells Corporation will record the payment of the face amount of the bonds by debiting Bonds Payable and crediting Cash for $1,000,000. The bonds have now been retired.

34. The Concept of Present Value
How much is a future amount worth today?
Present Value
Future Value
Interest compounding periods
In many transactions the future amount to be received is known, and the present value of this amount can be determined. This is typically the case with bonds. The concept of present value is based on the time value of money – the idea that receiving money today is preferable to receiving money at some later date. Receiving $1,000 at the end of four years is not as valuable as receiving $1,000 today. If you have the $1,000 today, you can invest the money and earn a return. Present value is the computation of the value of receiving monies in the future, given some desired rate of return on our investments.
Today

35. The Concept of Present Value
Two types of cash flows are involved with bonds:
Periodic interest payments called annuities.
As mentioned, there are two types of future cash flows involved with bonds. First, periodic interest payments made to bondholders. The bond contract specifies how frequently interest payments will be made—in most cases, either annually or semiannually. Interest payment amounts are called annuities and are calculated as the Bond Principal times the Stated Interest Rate on the bond times the Outstanding Time Period in the year.
The second cash flow for a bond is a principal payment at maturity. This is a lump sum payment at the end of a bond term to repay principal borrowed at the beginning.
Today
Maturity
Principal payment at maturity is a lump sum payment.

36. Early Retirement of Debt
Bonds can be retired by exercising a call provision or purchasing the bonds on the open market.
If bonds are retired before the maturity date, a gain or loss is recorded. The gain or loss is determined by comparing the carrying value of the bond on the retirement date with the cash price paid to retire the bond. Gains or losses due to bond retirement should be reported as other income or other expense on the income statement.
Gains or losses incurred as a result of retiring bonds should be reported as other income or other expense on the income statement.

37. Loss Contingencies
An existing uncertain situation involving potential loss depending on whether some future event occurs.
Two factors affect whether a loss contingency must be accrued and reported as a liability:
The likelihood that the confirming event will occur.
Whether the loss amount can be reasonably estimated.
Loss contingencies result from an existing situation that involves a potential loss, depending on whether a future event occurs. An example of a loss contingency is a lawsuit. In this example, the potential loss depends on whether the lawsuit is successful or not.
There are two factors that affect whether a loss contingency must be accrued and reported as a liability: One is the likelihood that the confirming event will occur, and the other is whether the loss amount can be reasonably estimated.
If it is probable that a loss contingency will occur and if the loss amount can be reasonably estimated, then a loss is accrued and reported as a liability.

38. Evaluating the Safety of Creditors’ Claims
Operating Income Interest Expense
Interest Coverage Ratio =
This ratio indicates a margin of protection for creditors. From the creditor’s point of view, the higher this ratio, the better.
The Interest Coverage ratio indicates a margin of protection for creditors. It is calculated as Operating Income divided by Interest Expense. From the creditor’s point of view, the higher this ratio, the better.

39. End of Chapter 10
End of chapter 10.