1. Chapter Ten:
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
Liabilities are debts owed from past transactions. Liabilities can be separated into two categories: Current and Noncurrent.
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.
Current Liabilities
Noncurrent Liabilities
I.O.U.

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. Liabilities – Question
Devon Mfg. borrows $100,000 from First Bank. The loan will be repaid in 20 years and has an annual interest rate of 8%.
Is this a current liability or a noncurrent liability?
Part I
Review this information for Devon Manufacturing. Is this a current or noncurrent liability?
Part II
Because the debt has a maturity term of twenty years, it is noncurrent.
The obligation will not be paid within one year or one operating cycle, so it is a noncurrent liability.

5. Evaluating Liquidity
An important indicator of a company’s ability to meet its current obligations.
Two commonly used measures:
There are two common ways to evaluate a company’s ability to pay its current obligations. Working Capital is the difference between Current Assets and Current Liabilities. If this difference is positive, it indicates that a company has enough Current Assets on hand to pay debts that are due in the short term.
The Current Ratio is another common measure of liquidity. This ratio is calculated as Current Assets divided by Current Liabilities. If this ratio is one to one or higher, it indicates that a company has enough Current Assets to pay its Current Liabilities.
Working Capital = Current Assets – Current Liabilities
Current Ratio = Current Assets ÷ Current Liabilities

6. Liabilities – Question
Devon Mfg. has current liabilities of $230,000 and current assets of $322,000.
What is Devon’s current ratio?
Part I
Here is some information for Devon Manufacturing. What is Devon’s current ratio?
Part II
It is one point four to one. This means that Devon has enough Current Assets to pay its Current Liabilities one point four times.

7. Accounts Payable
Short-term obligations to suppliers for purchases of merchandise and to others for goods and services.
Office supplies invoices
Merchandise inventory 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.
Utility and phone bills
Shipping charges

8. Notes Payable Current Portion of 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

9. Security National Bank
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.
signed
title
Miami, Fl
Nov. 1, 2005
Porter Company
Six months
Security National Bank
$10,000.00
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 ten thousand dollars, has an interest rate of twelve percent, and is due six months from the date of the note.
Let’s look at the entry Porter Company will make on November 1st.
12.0%
John Caldwell
treasurer

10. Interest Payable
Interest expense is the compensation to the lender for giving up the use of money for a period of time.
The liability is called interest payable.
To the lender, interest is a revenue.
To the borrower, interest is an expense.
Most notes have an interest rate associated with them. For borrowers, this is the interest expense they will incur and for lenders, this is the interest revenue they will receive.
Interest Rate Up!

11. Interest = Principal × Interest Rate × Time
Interest Payable
The interest formula includes three variables that must be considered when computing interest:
Interest = Principal × Interest Rate × Time
When computing interest for one year, “Time” equals 1. When the computation period is less than one year, then “Time” is a fraction.
Interest is calculated as Principal times the Interest Rate times the Time the note was outstanding.
For example, if we needed to compute interest for 3 months, “Time” would be 3/12.

12. Interest Payable – Example
What entry would Porter Company make on December 31, the fiscal year-end?
Part I
On December thirty-first, Porter Company needs an adjusting entry to record the interest expense. Let’s look at that entry.
Part II
On December thirty-first, Porter debits Interest Expense and credits Interest Payable for two hundred dollars.
The two hundred dollars in interest is calculated as the original note amount of ten thousand dollars times the interest rate of twelve percent times the outstanding time of the note. At December thirty-first, the outstanding time for this note is two months.
$10,00012% 2/12 = $200

13. 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 ten thousand dollars to hold their spot on the schedule. The client agrees and give the accounting firm ten thousand dollars.
When it is time to do the audit, how happy would the client be if the accounting firm just gave them back the ten thousand dollars 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 ten thousand dollars.
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.

14. 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.

15. 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.

16. Installment Notes Payable
Long-term notes that call for a series of installment payments.
Each payment covers interest for the period AND a portion of the principal.
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.
With each payment, the interest portion gets smaller and the principal portion gets larger.

17. 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 one thousand dollars.

18. Interest = Principal × Stated Rate × Time
Bonds Payable
Bonds usually carry a stated rate of interest, also called a contract rate.
Interest is normally paid semiannually.
Interest is computed as:
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.
Interest = Principal × Stated Rate × Time

19. 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.

20. 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

21. Accounting for Bonds Payable
On January 1, 2005, Rocket Corp. issues $1,500,000 of 12%, 10-year bonds payable. Interest is payable semiannually, each July 1 and January 1.
Assume the bonds are issued at face value. Record the issuance of the bonds.
Part I
Review this information for Rocket Corporation. Assume the bonds are issued at face value. Let’s see how to record this bond issue.
Part II
To record this bond issue, Rocket debits Cash and credits Bonds Payable for one million five hundred thousand dollars.

22. Accounting for Bonds Payable
Record the interest payment on July 1, 2005.
Part I
Let’s record the interest payment.
Part II
On July first, the interest payment is recorded as a debit to Interest Expense and a credit to Cash for ninety thousand dollars.
Interest is calculated as principal of one million five hundred thousand dollars times the interest rate of twelve percent times the time period of half a year.

23. Lease Payment Obligations
Operating Leases
Capital Leases
Lease agreement transfers risks and benefits associated with ownership to lessee.
Lessee records a leased asset and lease liability.
Lessor retains risks and benefits associated with ownership.
Lessee records rent expense as incurred.
If you rent an apartment, you probably have an operating lease. You have the right to use the property, within certain limits, but the landlord still owns the property. You probably make monthly rent payments and at the end of your rental period, you will move out of the apartment. This typical rental agreement involves the lessee recording rent expense as rent payments are made.
However, there are situations that may look like a rental agreement but that are more like a purchase of the assets being rented. These are called capital leases, and in these situations the lease agreement transfers risks and benefits associated with ownership to the lessee. Because the lessee basically becomes the owner of the property, the lessee must record an asset and a liability.
Let’s look in more detail at the characteristics of a capital lease.

24. Capital Lease Criteria
To qualify as a capital lease, a lease contract must have one of the following criteria:
The lease transfers ownership to the lessee at the end of the lease.
The lease contains a bargain purchase option to buy the asset for a small amount.
The lease term is equal to or greater than seventy-five percent of the life of the asset under lease.
The present value of the minimum lease payments is equal to or greater than ninety percent of the fair market value of the asset under lease.
If any one of these criteria is met, the lease must be recorded as a capital lease.