1. McGraw-Hill/IrwinCopyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10 Liabilities PowerPoint Authors: Brandy Mackintosh Lindsay Heiser

2. 10-2 Learning Objective 10-1 Explain the role of liabilities in financing a business.

3. 10-3 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:

4. 10-4 The Role of Liabilities The liability section of the General Mills 2010 and 2011 comparative balance sheets.

5. 10-5 Learning Objective 10-2 Explain how to account for common types of current liabilities.

6. 10-6 Measuring Liabilities Initial Amount of the Liability Cash Equivalent Additional Liability Amounts Increase Liability Payments Made Decrease Liability

7. 10-7 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

8. 10-8 Accrued 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.)

9. 10-9 Accrued Payroll Gross Pay Payroll Deductions: Federal Income Taxes FICA Taxes Other Total Payroll Deductions Net Pay $ 58.00 48.80 10.00 $ 600.00 116.80 $ 483.20

10. 10-10 Accrued Payroll 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. Let’s assume that General Mills has 1,000 workers just like Adam. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -$483,200FIT Withheld (+L) +$58,000 FICA Payable (+L)+$48,800 United Way (+L) +$10,000 Payroll Expense(+E, -SE) -$600,000 2 Record dr Wages and Salaries Expense (+E, -SE) cr Withheld Income Taxes Payable (+L) cr FICA Payable (+L) cr United Way Payable (+L) cr Cash (-A) 58,000 48,800 10,000 483,200 600,000

11. 10-11 Accrued Payroll 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 $48,800 for FICA, $750 for federal unemployment tax, and $4,000 for state unemployment tax. 1 Analyze Liabilities Assets = Stockholders’ Equity + FICA Payable (+L) +48,800 FUTA Payable (+L) +750 SUTA Payable (+L) +4,000 Payroll Tax Expense (+E, -SE) -53,550 2 Record dr Payroll Tax Expense (+E, -SE) cr FICA Tax Payable (+L) cr Federal Unemployment Tax Payable (+L) cr State Unemployment Tax Payable (+L) 48,800 750 4,000 53,550

12. 10-12 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. Let’s assume General Mills 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 Liabilities Assets = Stockholders’ Equity + Income Tax Payable (+L) +350,000 Income Tax Expense (+E, -SE) -350,000 2 Record dr Income Tax Expense (+E, -SE) cr Income Tax Payable (+L) 350,000

13. 10-13 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.

14. 10-14 Notes Payable 1. Establish the note on November 1, 2012. Assume that on November 1, 2012, 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, 2013. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (+A) +100,000Notes Payable (+L) +100,000 2 Record dr Cash (+A) cr Notes Payable (+L) 100,000

15. 10-15 Notes Payable 2. Accrue interest owed but not paid on December 31, 2012. 1 Analyze Liabilities Assets = Stockholders’ Equity + Interest Payable (+L) +1,000 Interest Expense (+E, -SE) -1,000 2 Record dr Interest Expense (+E, -SE) cr Interest Payable (+L) 1,000

16. 10-16 Notes Payable 3. Record interest paid on October 31, 2013. 2 Record dr Interest Expense (+E, -SE) dr Interest Payable (-L) cr Cash (-A) 6,000 5,000 1,000 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -6,000Interest Payable (-L) -1,000 Interest Expense (+E, -SE) -5,000

17. 10-17 Notes Payable 4. Record principal paid of $100,000 on October 31, 2013. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -100,000Note Payable (-L) -100,000 2 Record dr Note Payable (-L) cr Cash (-A) 100,000

18. 10-18 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.

19. 10-19 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.

20. 10-20 Additional Current Liabilities Best Buy sells a television for $1,000 cash plus 5 percent sales tax. $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). 2 Record dr Cash (+A) cr Sales Tax Payable (+L) cr Sales Revenue (+R, +SE) 50 1,000 1,050 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (+A) +1,050Sales Tax Payable (+L) +50 Sales Revenue (+R, +SE) +1,000

21. 10-21 Additional Liabilities On May 14 th 2010, Live Nation Entertainment (the owner of Ticketmaster), received $8 million cash for advance ticket sales for two Lady Gaga concerts to be held on February 21 and 22, 2011. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (+A) +8Unearned Revenue (+L) +8 2 Record dr Cash (+A) cr Unearned Revenue (+L) 8 8

22. 10-22 Additional Liabilities When the February 21 st concert is held, Live Nation Entertainment can recognize one half of the unearned revenue as earned revenue, as they have fulfilled part of the liability. 1 Analyze Liabilities Assets = Stockholders’ Equity + Unearned Revenue (-L) -4 Concert Revenue (+R, +SE) +4 2 Record dr Unearned Revenue (-L) cr Concert Revenue (+R, +SE) 4 4

23. 10-23 Learning Objective 10-3 Analyze and record bond liability transactions.

24. 10-24 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

25. 10-25 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

26. 10-26 Bonds Balance Sheet Reporting of Bond Liability Relationships between Interest Rates and Bond Pricing

27. 10-27 Bonds 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 (100 × $1,000 = $100,000). Bonds Issued at Face Value 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (+A) +100,000 Bonds Payable (+L)+100,000 2 Record dr Cash (+A) cr Bonds Payable (+L) 100,000

28. 10-28 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 dr Cash (+A) cr Bonds Payable (+L) cr Premium on Bonds Payable (+L) 100,000 7,260 107,260 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (+A) +107,260Bonds Payable (+L) +100,000 Premium on Bonds Payable (+L) +7,260

29. 10-29 $100,000 - $93,376 = $6,624 discount Bonds General Mills receives $93,376 for bonds with a total face value of $100,000, 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 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (+A) +93,376Bonds Payable (+L) +100,000 Discount on Bonds Payable (+xL,-L)-6,624 2 Record dr Cash (+A) dr Discount on Bonds Payable (+xL, -L) cr Bonds Payable (+L) 100,000 93,376 6,624

30. 10-30 Interest on Bonds Issued at Face Value General Mills issues bonds on January 1, 2013, 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, 2013. $100,000 × 6% × 1/12 = $500 interest 2 Record dr Interest Expense (+E, -SE) cr Interest Payable (+L) 500 1 Analyze Liabilities Assets = Stockholders’ Equity + Interest Payable (+L) +500Interest Expense (+E, -SE) -500

31. 10-31 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

32. 10-32 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

33. 10-33 Bond Retirement General Mills’ bonds were retired with a payment equal to their $100,000 face value. Let’s analyze and record this transaction. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -100,000Bonds Payable (-L) -100,000 2 Record dr Bonds Payable (-L) cr Cash (-A) 100,000

34. 10-34 Assume that in 2003, General Mills issued $100,000 of bonds at face value. Ten years later, in 2013, the company retired the bonds early. At the time, the bond price was 102, so General Mills made a payment of $102,000. Cash Payment $103,000 Carrying Value 100,000 Loss on Retirement $3,000 Bond Retirement 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. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -102,000Bonds Payable (-L) -100,000Loss on Bond Retirement(+E,-SE) -2,000 2 Record dr Bonds Payable (-L) dr Loss on Bond Retirement (+E, -SE) cr Cash (-A) 102,000 100,000 2,000

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

36. 10-36 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.

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

38. 10-38 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

39. 10-39 Evaluate the Results At the end of its 2011 fiscal year, General Mills reported $620 million of cash and cash equivalents, no short-term investments, and $1,162 million of net accounts receivable. The company reported $3,659 million in total current liabilities. Quick Ratio = (Cash + Short-term Investments + Accounts Receivable, Net) Current Liabilities $620 + 0 + 1,162 3,659 = 0.487 A quick ratio of 0.487 implies that General Mills would be able to pay only 48.7 percent of its current liabilities, if forced to pay them immediately. However, not all current liabilities are to be paid immediately.

40. 10-40 Evaluate the Results In 2011, General Mills reported net income of $1,798 million and interest expense of $346 million, and income tax expense of $721 million. Let’s calculate the times interest earned for 2011. $1,798 + $346 + $721 $346 = 8.28 times The ratio means that General Mills generates $8.28 of income (before the costs of financing and taxes) for each dollar of interest expense. Reaching this level of interest coverage was important to General Mills because its long-term debt note reported that loan covenants required a minimum ratio of 2.5. Times Interest Earned Ratio = (Net Income + Interest Expense + Income Tax Expense) Interest Expense

41. McGraw-Hill/IrwinCopyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10 Supplement 10A Straight-Line Method of Amortization

42. 10-42 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. Recall our example when General Mills received $107,260 on the issue date (January 1, 2013) but repays only $100,000 at maturity (December 31, 2016). 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). 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -6,000Premium on Bonds Payable (-L) -1,815 Interest Expense (+E, -SE) -4,185 2 Record dr Interest Expense (+E, -SE) dr Premium on Bonds Payable (-L) cr Cash (-A) 6,000 4,185 1,815

43. 10-43 Bond Premium Amortization Schedule of Bonds Issued at a Premium $7,260 ÷ 4 = $1,815 $100,000 × 6% × 12/12 = $6,000 $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!

44. 10-44 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). 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -6,000Discount on Bonds Payable(-xL,+L)+1,656 Interest Expense (+E, -SE) -7,656 2 Record dr Interest Expense (+E, -SE) cr Discount on Bonds Payable (-xL, +L) cr Cash (-A) 1,656 6,000 7,656

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

46. McGraw-Hill/IrwinCopyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10 Supplement 10B Effective-Interest Method of Amortization

47. 10-47 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, 2013. The proceeds indicates that the market interest rte was 4 percent.

48. 10-48 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. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -6,000Premium on Bonds Payable (-L) -1,710 Interest Expense (+E, -SE) -4,290 2 Record dr Interest Expense (+E, -SE) dr Premium on Bonds Payable (-L) cr Cash (-A) 6,000 4,290 1,710

49. 10-49 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 $107,260 - $1,710 = $105,550 $6,000 - $4,290 = $1,710 $7,260 - $1,710 = $5,550 Interest Expense decreases and Premium Amortization increases each period. Cash interest is unchanged.

50. 10-50 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 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -6,000Discount on Bonds Payable(-xL,+L)+1,470 Interest Expense (+E, -SE) -7,470 2 Record dr Interest Expense (+E, -SE) cr Discount on Bonds Payable (-L) cr Cash (-A) 1,470 6,000 7,470

51. 10-51 Effective Interest Amortization $93,376 × 8% × 12/12 = $7,470 $100,000 × 6% × 12/12 = $6,000 $93,376 + $1,470 = $94,846 $7,470 - $6,000 = $1,470 $6,624 - $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.

52. McGraw-Hill/IrwinCopyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10 Supplement 10C Simplified Effective-Interest Amortization

53. 10-53 Accounting for Bond Issue. The shortcut method records the bonds at issuance at Bonds Payable, Net. That is face amount less discount or face amount plus premium. The following journal entries demonstrate how the shortcut is applied to bonds issued at a premium, at face value, and at a discount.

54. 10-54 Bond Premium Interest (I) = Principal (P) × Rate (R) × Time (T) Interest Expense = Bonds Payable, Net × Market Rate × n/12 Interest Expense $4,290 = $107,260 × 4% × 12/12 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -6,000Bonds Payable, Net (-L) -1,710 Interest Expense (+E, -SE) -4,290 2 Record dr Interest Expense (+E, -SE) dr Bonds Payable, Net (-L) cr Cash (-A) 6,000 4,290 1,710

55. 10-55 Bond Discount Interest (I) = Principal (P) × Rate (R) × Time (T) Interest Expense = Bonds Payable, Net × Market Rate × n/12 Interest Expense $7,470 = $93,376 × 8% × 12/12 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) -6,000Bonds Payable, Net (+L) -1,470 Interest Expense (+E, -SE) -7,470 2 Record dr Interest Expense (+E, -SE) cr Bonds Payable, Net (+L) cr Cash (-A) 1,470 6,000 7,470

56. McGraw-Hill/IrwinCopyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10 Solved Exercises M10-5, E10-2, E10-3, E10-8, E10-10, PA10-3

57. 10-57 As of December 31, Current Liabilities: Current Portion of Long-term Debt Long-term Debt Total Liabilities 2014 $ 3,000 10,000 $ 13,000 2013 $ 2,000 13,000 $ 15,000 M10-5 Reporting Current and Noncurrent Portions of Long-Term Debt Assume that on December 1, 2013, your company borrowed $15,000, a portion of which is to be repaid each year on November 30. Specifically, your company will make the following principal payments: 2014, $2,000; 2015, $3,000; 2016, $4,000; and 2017, $6,000. Show how this loan will be reported in the December 31, 2014 and 2013 balance sheets, assuming that principal payments will be made when required.

58. 10-58 End of Chapter 10