1. Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

2. Chapter 10 Reporting and Interpreting Liabilities PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Fred Phillips, Ph.D., CA

3. Learning Objective 1 Explain the role of liabilities in financing a business. 10-3

4. The Role of Liabilities Current liabilities are short-term obligations that will be paid with current assets within the company’s current operating cycle or within one year of the balance sheet date, whichever is longer. Buys goods and services on credit Obtains short-term loans Issues long-term debt Liabilities are created when a company: 10-4

5. The Role of Liabilities The liability section of the General Mills 2007 and 2008 comparative balance sheets. 10-5

6. Learning Objective 2 Explain how to account for common types of current liabilities. 10-6

7. Measuring Liabilities Initial Amount of the Liability Cash Value Additional Liability Amounts Increase Liability Cash Payments Made Decrease Liability 10-7

8. Current Liabilities Accounts Payable Accrued Liabilities Liabilities that have been incurred but not yet paid. Increases (Credited) Decreases (Debited) Decreases (Debited) when a company receives goods or services on credit when a company pays on its account 10-8

9. Calculating Payroll Payroll Liabilities 1.Payroll Deductions 2.Employer Payroll Taxes Payroll Deductions Payroll deductions are either required by law or voluntarily requested by employees and create a current liability for the company. Examples include: 1.Income tax 2.FICA tax 3.Other deductions (charitable donations, union dues, etc.) 10-9

10. Calculating Payroll 10-10

11. Recording Payroll 1 Analyze 2 Record Adam Palmer earned gross pay of $600 in the current payroll period. General Mills withheld $58 in Federal income taxes, $48.80 for FICA, and $10 for United Way, resulting in net pay of $483.20. 10-11

12. Payroll Taxes 1 Analyze 2 Record Employer Payroll Taxes Employers have other liabilities related to payroll. 1.FICA tax (a “matching” contribution) 2.Federal unemployment tax 3.State unemployment tax Assume General Mills was required to contribute $16,400 for FICA, $250 for federal unemployment tax, and $1,350 for state unemployment tax. 10-12

13. Accrued Income Taxes Corporations calculate taxable income by subtracting tax-allowed expenses from revenues. This taxable income is then multiplied by a tax rate, which for most large corporations is about 35 percent. General Mill calculated taxable income to be $1,000,000, and is subject to a 35% tax rate, so income taxes owed are $350,000 ($1,000,000 × 35%) 1 Analyze 2 Record 10-13

14. Notes Payable Four key events occur with any note payable: 1.establishing the note, 2.accruing interest incurred but not paid, 3.recording interest paid, and 4.recording principal paid. 10-14

15. Notes Payable 2 Record 1. Establish the note on November 1, 2009. Assume that on November 1, 2009, General Mills borrowed $100,000 cash on a one-year note that required General Mills to pay 6 percent interest and $100,000 principal, both on October 31, 2010. 1 Analyze 10-15

16. Notes Payable 2 Record 1 Analyze Accrue interest owed but not paid on December 31, 2009. $100,000 × 6% × 2/12 = $1,000 accrued interest P x I x T P x I x T $100,000 × 6% × 2/12 = $1,000 accrued interest P x I x T P x I x T 10-16

17. Notes Payable Record interest accrued in 2010 $100,000 × 6% × 10/12 = $5,000 interest P x I x T $100,000 × 6% × 10/12 = $5,000 interest P x I x T 2 Record 1 Analyze 10-17

18. Notes Payable 4. Record principal paid of $100,000 on October 31, 2010. 2 Record 1 Analyze 10-18

19. Current Portion of Long-Term Debt Long-Term Debt Current Portion of Long-term Debt Noncurrent Portion of Long-term Debt Borrowers must report in Current Liabilities the portion of long-term debt that is due to be paid within one year. 10-19

20. Additional Current Liabilities Sales Tax Payable Payments collected from customers at time of sale create a liability that is due to the state government. Unearned Revenue Cash received in advance of providing services creates a liability of services due to the customer. 10-20

21. Additional Current Liabilities Best Buy sells a television for $1,000 cash plus 5 percent sales tax. 2 Record 1 Analyze $1,000 × 5% = $50 sales tax collected When Best Buy pays the sales tax to the state government, its accountants will reduce Sales Tax Payable (with a debit) and reduce Cash (with a credit). 10-21

22. Additional Liabilities On October 1 IAC, an internet provider, received $30 cash for three- months of internet access, paid in advance. 2 Record 1 Analyze 10-22

23. Additional Liabilities At the end of October, IAC provided one month of internet service to its customer. 2 Record 1 Analyze $30 ÷ 3 months = $10 per month 10-23

24. Learning Objective 3 Analyze and record bond liability transactions. 10-24

25. Long-Term Liabilities Bonds are financial instruments that outline the future payments a company promises to make in exchange for receiving a sum of money now. Common Long-Term Liabilities 1.Long-term notes payable 2.Deferred income taxes 3.Bonds payable 10-25

26. Bonds Bond Pricing The bond price involves present value computations and is the amount that investors are willing to pay on the issue date for the bonds. Key Elements of a Bond 1.Maturity date 2.Face value 3.Stated interest rate 12 $1,000×6%×= $60 Interest Computation 10-26

27. Bonds Balance Sheet Reporting of Bond Liability Relationships between Interest Rates and Bond Pricing 10-27

28. Bonds 2 Record 1 Analyze General Mills receives $100,000 cash in exchange for issuing 100 bonds at their $1,000 face value, so the bonds are issued at total face value (1,000 × $1,000 = $100,000). Bonds Issued at Face Value 10-28

29. Bonds General Mills issues 100 of its $1,000 bonds at a price of 107.26 (percent) of face value, the company will receive $107,260 (100 × $1,000 × 1.0726). Bonds Issued at a Premium 2 Record 1 Analyze 10-29

30. $100,000 - $93,376 = $6,624 discount Bonds General Mills receives $93,376 for bonds with a total face value of $100,000,sold at 93.376 the cash-equivalent amount is $93,376, which represents the liability on that date. These bonds are issued at a discount because the cash received is less than the face value of the bonds. Bonds Issued at a Discount 2 Record 1 Analyze 10-30

31. Interest on Bonds Issued at Face Value General Mills issues bonds on January 1, 2010, at their total face value of $100,000. The bonds have an annual stated interest rate of 6 percent payable in cash on December 31 of each year, General Mills will need to accrue an expense and liability for interest at the end of each accounting period. The end of the first accounting period is January 31, 2010. $100,000 × 6% × 1/12 = $500 interest 2 Record 1 Analyze 10-31

32. Interest on Bonds Issued at a Premium Cash proceeds > Face value Cash proceeds – Face value = Premium Interest expense < Cash interest paid Interest expense = Cash interest paid – Premium amortization 10-32

33. Interest on Bonds Issued at a Discount Cash proceeds < Face value Face value – Cash proceeds = Discount Interest expense > Cash interest paid Interest expense = Cash interest paid+ Discount amortization 10-33

34. Assume that in 2000, General Mills issued $100,000 of bonds at face value. Ten years later, in 2010, the company retired the bonds early. At the time, the bond price was 103, so General Mills made a payment of $103,000. Cash Payment $103,000 Carrying Value 100,000 Loss on Retirement $3,000 Bond Retirement 2 Record 1 Analyze 10-34 The early retirement of bonds has three financial effects. The company 1. pays cash, 2. eliminates the bond liability, and 3. reports either a gain or a loss.

35. Learning Objective 4 Describe how to account for contingent liabilities. 10-35

36. Contingent Liabilities Contingent liabilities are potential liabilities that arise from past transactions or events, but their ultimate resolution depends (is contingent) on a future event. 10-36

37. Learning Objective 5 Calculate and interpret the quick ratio and the times interest earned ratio. 10-37

38. Evaluate the Results Two financial ratios are commonly used to assess a company’s ability to generate resources to pay future amounts owed: 1.Quick ratio 2.Times interest earned ratio Quick Ratio = (Cash + Short-term Investments + Accounts Receivable, Net) Current Liabilities Times Interest Earned Ratio = (Net Income + Interest Expense + Income Tax Expense) Interest Expense 10-38

39. Evaluate the Results In 2008, General Mills reported $661 million of cash and cash equivalents, no short-term investments, and $1,082 million of net accounts receivable. The company reported $4,856 million in total current liabilities. Quick Ratio = (Cash + Short-term Investments + Accounts Receivable, Net) Current Liabilities $661 + 0 + 1,082 4,856 = 0.359 A quick ratio of 0.359 implies that General Mills would be able to pay only 35.9 percent of its current liabilities, if forced to pay them immediately. However, not all current liabilities are to be paid immediately. 10-39

40. Evaluate the Results In 2008, General Mills reported net income of $290 million and interest expense of $100 million, and income tax expense of $230 million. Let’s calculate the times interest earned for 2008. $290 + $100 + $230 $100 = 6.20 times The ratio means that General Mills generates $6.20 of income (before the costs of financing and taxes) for each dollar of interest expense. No doubt this ratio is part of the reason that General Mills has earned a favorable credit rating of BBB+. Times Interest Earned Ratio = (Net Income + Interest Expense + Income Tax Expense) Interest Expense 10-40

41. Chapter 10 Supplement 10A Straight-Line Method of Amortization

42. Cash Interest$6,000 Amortization of Premium (1,815) Interest Expense$4,185 Cash Interest$6,000 Amortization of Premium (1,815) Interest Expense$4,185 Bond Premium Bond premium or discount decreases each year, until it is completely eliminated on the bond’s maturity date. This process is called amortizing the bond premium or discount. The straight-line method of amortization reduces the premium or discount by an equal amount each period. Bond premium or discount decreases each year, until it is completely eliminated on the bond’s maturity date. This process is called amortizing the bond premium or discount. The straight-line method of amortization reduces the premium or discount by an equal amount each period. Recall our example when General Mills received $107,260 on the issue date (January 1, 2010) but repays only $100,000 at maturity (December 31, 2013). Under the straight-line method, this $7,260 is spread evenly as a reduction in interest expense over the four years ($7,260 ÷ 4 = $1,815 per year). 2 Record 1 Analyze 10-42

43. Bond Premium Amortization Schedule of Bonds Issued at a Premium $7,260 ÷ 4 = $1,815 $100,000 × 6% × 12/12 = $6,000 face value x stated int x T $100,000 × 6% × 12/12 = $6,000 face value x stated int x T $6,000 - $1,815 = $4,185 $7,260 - $1,815 = $5,445 $107,260 – $1,815 = $105,445 Notice that each of these amounts would plot as a straight-line! 10-43

44. Cash Interest$6,000 Amortization of Discount 1,656 Interest Expense$7,656 Cash Interest$6,000 Amortization of Discount 1,656 Interest Expense$7,656 Bond Discount Recall our example where General Mills received $93,376 for four-year bonds with a total face value of $100,000, implying a discount of $6,624. The annual amortization of the discount is $1,656 ($6,624 ÷ 4). 2 Record 1 Analyze 10-44

45. Bond Discount Amortization Schedule of Bonds Issued at a Discount $6,624 ÷ 4 = $1,656 $100,000 × 6% × 12/12 = $6,000 Face value x stated int x T $100,000 × 6% × 12/12 = $6,000 Face value x stated int x T $6,000 + $1,656 = $7,656 $6,624 - $1,656 = $4,968 $93,376 + $1,656 = $95,032 10-45

46. Chapter 10 Supplement 10B Effective-Interest Method of Amortization

47. Effective Interest Amortization The effective-interest method of amortization is considered a conceptually superior method of accounting for bonds because it correctly calculates interest expense by multiplying the market interest rate times the carrying value of the bonds. Interest (I) = Principal (P) × Rate (R) × Time (T) Interest Expense = Carrying Value × Market Rate × n/12 $4,290 = $107,260 × 4% × 12/12 When General Mills adds this $7,260 premium to the $100,000 face value, it reports a carrying value of $107,260 ($100,000 + $7,260) on January 1, 2010. The proceeds indicates that the market interest rate was 4 percent. 10-47

48. Interest (I) = Principal (P) × Rate (R) × Time (T) Interest Expense = Carrying Value × Market Rate × n/12 $4,290 = $107,260 × 4% × 12/12 Cash Interest $ 6,000 Effective Interest 4,290 Amortization of Premium $1,710 Cash Interest $ 6,000 Effective Interest 4,290 Amortization of Premium $1,710 Effective Interest Amortization General Mills issued 6% stated rate bonds for $107,260. The market rate of interest on these bonds is 4%. The face amount of the bonds, $100,000, results in cash interest is $6,000 ($100,000 × 6%). Let’s amortize the premium on the bonds at the first interest payment date. 2 Record 1 Analyze 10-48

49. Effective Interest Amortization Effective Interest Amortization of Bonds Issued at a Premium $107,260 × 4% × 12/12 = $4,290 $100,000 × 6% × 12/12 = $6,000 Face value x stated int x time $100,000 × 6% × 12/12 = $6,000 Face value x stated int x time $107,260 - $1,710 = $105,550 $6,000 - $4,290 = $1,710 $7,290 - $1,710 = $5,550 Interest Expense decreases and Premium Amortization increases each period. Cash interest is unchanged. 10-49

50. Effective Interest Amortization Interest (I) = Principal (P) × Rate (R) × Time (T) Interest Expense = Carrying Value × Market Rate × n/12 $7,470 = $93,376 × 8% × 12/12 General Mills issued $100,000 face value, 6%, 4-year bonds at a market price to yield investors 8%. The bonds were issued at a discount of $6,624. Let’s determine the effective interest for the first interest payment period. Cash Interest $ 6,000 Effective Interest 7,470 Amortization of Discount $ 1,470 Cash Interest $ 6,000 Effective Interest 7,470 Amortization of Discount $ 1,470 2 Record 1 Analyze 10-50

51. Effective Interest Amortization $93,376 × 8% × 12/12 = $7,470 $100,000 × 6% × 12/12 = $6,000 Face value x stated int x time $100,000 × 6% × 12/12 = $6,000 Face value x stated int x time $93,376 + $1,470 = $94,846 $7,470 - $6,000 = $1,470 $7,470 - $1,470 = $5,154 Effective Interest Amortization of Bonds Issued at a Discount Both Interest Expense and Discount Amortization increase each period. Cash interest is unchanged. 10-51

52. Chapter 10 Solved Exercises M10-5, E10-2, E10-3, E10-8, E10-10, PA10-3

53. M10-5 Reporting Current and Noncurrent Portions of Long-Term Debt Assume that on December 1, 2010, your company borrowed $14,000, a portion of which is to be repaid each year on November 30. Specifically, your company will make the following principal payments: 2011, $2,000; 2012, $3,000; 2013, $4,000; and 2014, $5,000. Show how this loan will be reported in the December 31, 2011 and 2010 balance sheets, assuming that principal payments will be made when required. 10-53

54. E10-2 Recording a Note Payable through Its Time to Maturity Many businesses borrow money during periods of increased business activity to finance inventory and accounts receivable. Target Corporation is one of America’s largest general merchandise retailers. Each Christmas, Target builds up its inventory to meet the needs of Christmas shoppers. A large portion of Christmas sales are on credit. As a result, Target often collects cash from the sales several months after Christmas. Assume that on November 1, 2010, Target borrowed $6 million cash from Metropolitan Bank and signed a promissory note that matures in six months. The interest rate was 7.5 percent payable at maturity. The accounting period ends December 31. Required: 1.Give the journal entry to record the note on November 1, 2010. 2.Give any adjusting entry required on December 31, 2010. 3.Give the journal entry to record payment of the note and interest on the maturity date, April 30, 2011, assuming that interest has not been recorded since December 31, 2010. 10-54

55. E10-2 Recording a Note Payable through Its Time to Maturity November 1, 2010: Borrowed on 6-month, 7.5%, note payable. December 31, 2010 (end of the accounting period): Adjusting entry for 2 months’ accrued interest ($6,000,000 x 7.5% x 2/12 = $75,000). April 30, 2011 (maturity date): Paid note plus interest at maturity. 10-55

56. E10-3 Recording Payroll Costs with Discussion McLoyd Company completed the salary and wage payroll for March 2010. The payroll provided the following details: Required: 1.Considering both employee and employer payroll taxes, use the preceding information to calculate the total labor cost for the company. 2.Prepare the journal entry to record the payroll for March, including employee deductions (but excluding employer payroll taxes). 3.Prepare the journal entry to record the employer’s FICA taxes and unemployment taxes. 10-56

57. The total labor cost was $248,045, made up of the $230,000 in gross salaries and wages plus the $16,445 for employer FICA taxes and $1,600 for unemployment taxes. Req. 1 Req. 2 dr Salaries and Wages Expense (+E, -SE) 230,000 cr Withheld Income Taxes Payable (+L) 50,200 cr FICA Taxes Payable—employees (+L) 16,445 cr Cash (-A)163,355 Payroll for March including employee deductions. March 31, 2010 Req. 3 dr Payroll Tax Expense (+E,-SE)18,045 cr FICA Taxes Payable—employer (+L)16,445 cr Unemployment Taxes Payable (+L) 1,600 Employer payroll taxes on March payroll. March 31, 2010 E10-3 Recording Payroll Costs with Discussion 10-57

58. E10-8 Preparing Journal Entries to Record Issuance of Bonds at Face Value, Payment of Interest, and Early Retirement On January 1, 2010, Innovative Solutions, Inc., issued $200,000 in bonds at face value. The bonds have a stated interest rate of 6 percent. The bonds mature in 10 years and pay interest once per year on December 31. Required: 1.Prepare the journal entry to record the bond issuance. 2.Prepare the journal entry to record the interest payment on December 31, 2010. Assume no interest has been accrued earlier in the year. 3.Assume the bonds were retired immediately after the first interest payment at a quoted price of 102. Prepare the journal entry to record the early retirement of the bonds. 10-58

59. Req. 1 Req. 2 Req. 3 dr Cash (+A)200,000 cr Bonds Payable (+L)200,000 dr Interest Expense (+E, -SE) 12,000 cr Cash (-A)12,000 ($200,000 x 6% x 12/12) = $12,000 dr Bonds Payable (-L) 200,000 dr Loss on Bonds Retired (+E, -SE) 4,000 cr Cash (-A) 204,000 ($200,000 x 102%) = $204,000 E10-8 Preparing Journal Entries to Record Issuance of Bonds at Face Value, Payment of Interest, and Early Retirement 10-59

60. E10-10 Calculating and Interpreting the Quick Ratio and Times Interest Earned Ratio According to its Web site, Kraft Foods Inc. sells enough Kool-Aid® mix to make 1,000 gallons of the drink every minute during the summer and over 560 million gallons each year. At December 31, 2008, the company reported no short-term investments but did report the following amounts (in millions) in its financial statements: Required: 1.Compute the quick ratio and times interest earned ratio (to two decimal places) for 2008 and 2007. 2.Did Kraft appear to have increased or decreased its ability to pay current liabilities and future interest obligations as they become due? How can you explain the seemingly conflicting findings of your ratio analysis? 10-60

61. Req. 1 Req. 2 E10-10 Calculating and Interpreting the Quick Ratio and Times Interest Earned Ratio 10-61

62. Req. 3 The times interest earned ratio has decreased from 6.95 to 3.93, suggesting a decline in Kraft’s ability to cover its interest through profitable operations. The quick ratio has increased from 0.34 in 2007 to 0.54 in 2008, suggesting Kraft is in a better position to quickly pay its current liabilities at the end of 2008. These findings seem to conflict, but can be explained as follows. In 2008, when the economy was suffering, Kraft realized that it could no longer rely as much on obtaining short-term financing to cover cash needs. Consequently, Kraft borrowed more funds through long-term debt, which doubled the amount the company held in Cash and Cash Equivalents. Obtaining more long-term debt financing came at a cost, however, as indicated by the doubling of Interest Expense. The results of these shifts were an increase in the quick ratio (associated with the increase in Cash) and a decrease in the times interest earned ratio (associated with the increase in Interest Expense). E10-10 Calculating and Interpreting the Quick Ratio and Times Interest Earned Ratio 10-62

63. PA10-3 Recording and Reporting Current Liabilities During 2010, Lakeview Company completed the following two transactions. The annual accounting period ends December 31. a.On December 31, 2010, calculated the payroll, which indicates gross earnings for wages ($80,000), payroll deductions for income tax ($8,000), payroll deductions for FICA ($6,000), payroll deductions for American Cancer Society ($2,000), employer contributions for FICA (matching), state unemployment taxes ($500), and federal unemployment taxes ($100). Employees were paid in cash, but these payments and the corresponding payroll deductions and employer taxes have not yet been recorded. b.Collected rent revenue of $3,600 on December 10, 2010, for office space that Lakeview rented to another business. The rent collected was for 30 days from December 11, 2010, to January 10, 2011, and was credited in full to Rent Revenue. Required: 1.Give the journal entries to record payroll on December 31, 2010. 2.Give ( a ) the journal entry for the collection of rent on December 10, 2010, and ( b ) the adjusting journal entry on December 31, 2010. 3.Show how any liabilities related to these items should be reported on the company’s balance sheet at December 31, 2010. 4.Explain why the accrual basis of accounting provides more relevant information to financial analysts than the cash basis. 10-63

64. Req. 1 Req. 2 dr Wage Expense (+E, -SE)80,000 cr Withheld Income Tax Payable (+L) 8,000 cr FICA Payable (+L) 6,000 cr American Cancer Society Payable (+L) 2,000 cr Cash (-A)64,000 dr Payroll Tax Expense (+E, -SE) 6,600 cr FICA Payable (+L) 6,000 cr State Unemployment Tax Payable (+L) 500 cr Federal Unemployment Tax Payable (+L) 100 (a)December 10, 2010: dr Cash (+A)3,600 cr Rent Revenue (+R, +SE)3,600 Collection of rent revenue for one month. (b)December 31, 2010: dr Rent Revenue (-R, -SE)1,200 cr Unearned Rent Revenue (+L)1,200 Earned 20 days of rent but initially recorded as if all was earned. Need to reduce revenue for 10 days unearned (10/30 x $3,600 = $1,200). PA10-3 Recording and Reporting Current Liabilities 10-64

65. Req. 3 Req. 4 Balance sheet at December 31, 2010: Current Liabilities: Withheld Income Taxes Payable 8,000 FICA Payable12,000 American Cancer Society Payable 2,000 State Unemployment Tax Payable 500 Federal Unemployment Tax Payable 100 Unearned Rent Revenue 1,200 Accrual basis accounting is beneficial to financial analysts because it records revenues when they are earned and expenses when they are incurred, regardless of when the related cash is received or paid. Cash basis accounting only records revenues when they are received and expenses when they are paid. A financial analyst is looking towards the future of the company, so it is helpful to know how much cash will be coming into and out of the company at later dates. Cash basis accounting limits financial analysts to only what has happened in prior periods and tells them very little about future events and cash flows that will affect the financial health of the company. PA10-3 Recording and Reporting Current Liabilities 10-65

66. End of Chapter 10