1. Accounting for Liabilities Chapter 7 Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 7-2 Learning Objective 1 Show how notes payable and related interest expense affect financial statements.

3. 7-3 Accounting for Notes Payable 09/01/12 Borrowing On September 1, 2012 Herrera Supply Company (HSC) borrowed $90,000 from the National Bank. HSC issued a note payable due in one year with an annual interest rate of 9%.

4. 7-4 Accrual of Interest Expense 12/31/12 Recognition of Interest Expense At the end of 2012, HSC must accrue interest on its note payable. $90,000 × 9% × 4/12 = $2,700 interest expense

5. 7-5 Paying principal & interest at maturity date 08/31/13 Recognition of interest expense. Payment of principal and interest on the maturity date, August 31, 2013. $90,000 × 9% × 8/12 = $5,400 interest expense Now, record payment of principal and interest payable.

6. 7-6 Learning Objective 2 Show how sales tax liabilities affect financial statements.

7. 7-7 Accounting for Sales Tax Most states require retail companies to collect sales tax on items sold to their customers. The retailer then remits the tax to the state at regular intervals. Sales tax is a liability to the retailer until paid to the state. HSC sells merchandise to a customer for $2,000 cash in a state where the sales tax rate is 6%.

8. 7-8 Accounting for Sales Tax Remitting the tax (paying cash to the state tax authority) is an asset use transaction.

9. 7-9 Learning Objective 3 Define contingent liabilities and explain how they are reported in financial statements.

10. 7-10 Reporting Contingent Liabilities

11. 7-11 Learning Objective 4 Explain how warranty obligations affect financial statements.

12. 7-12 Warranty Obligations To attract customers, many companies guarantee their products or services. Within the warranty period, the seller promises to replace or repair defective products without charge. Event 1 Sale of Merchandise HSC sells $7,000 of merchandise for cash. The merchandise had a cost of $4,000.

13. 7-13 Warranty Obligations Event 2 Recognition of Warranty Expense HSC estimates that warranty expense associated with the current sale will be $100.

14. 7-14 Warranty Obligations Event 3 Settlement of Warranty Obligation HSC pays $40 cash to repair defective merchandise returned by a customer.

15. 7-15 Financial Statements Sales Revenue7,000$ Cost of Goods Sold(4,000) Gross Margin3,000 Warranty Expense(100) Net Income2,900$ Income Statement

16. 7-16 Learning Objective 5 Show how installment notes affect financial statements.

17. 7-17 Long-term installment notes are liabilities that usually have terms from two to five years. Each payment covers interest for the period and a portion of the principal. As payments are made, the amount allocated to interest gets smaller and to principal gets larger. Principal CompanyLender Payments Installment Notes Payable

18. 7-18 Applying payments to principal and interest 1. Identify the unpaid principal balance. 2. Amount applied to interest = Unpaid principal balance (1) × Interest rate. 3. Amount applied to principal = Cash payment less the amount applied to interest (2). 4. New unpaid principal balance = Unpaid principal balance (1) less the amount applied to principal (3). Applying payments to principal and interest 1. Identify the unpaid principal balance. 2. Amount applied to interest = Unpaid principal balance (1) × Interest rate. 3. Amount applied to principal = Cash payment less the amount applied to interest (2). 4. New unpaid principal balance = Unpaid principal balance (1) less the amount applied to principal (3). Installment Notes Payable

19. 7-19 On January 1, 2012, Blair Company issued a $100,000 face value installment note to National Bank. The note had a 9 percent annual interest rate and a five year term. The loan agreement called for five equal payments of $25,709 to be made on December 31 of each year. Prepare an amortization table for Blair’s note. On January 1, 2012, Blair Company issued a $100,000 face value installment note to National Bank. The note had a 9 percent annual interest rate and a five year term. The loan agreement called for five equal payments of $25,709 to be made on December 31 of each year. Prepare an amortization table for Blair’s note. Installment Notes Payable

20. 7-20 Installment Notes Payable Cash payment determined using present value concepts presented in a later chapter. All computations rounded to the nearest dollar; after the 2016 payment the loan balance is 0. Accounting Period Unpaid Principal Balance on January 1 Cash Payment on December 31 Amount Applied to Interest Amount Applied to Principal 2012100,000$ 25,709$ 9,000$ 16,709$ 201383,291 25,709 7,496 18,213 201465,078 25,709 5,857 19,852 201545,226 25,709 4,070 21,639 201623,587 25,710 2,123 23,587

21. 7-21 With each payment the amount applied to the principal increases and the amount applied to interest decreases. Annual payments are constant. Installment Notes Payable

22. 7-22 Installment Notes Payable Issuing the note has the following effect on Blair’s 2012 financial statements: The December 2012 cash payment has the following effect on Blair’s 2012 financial statements:

23. 7-23 Learning Objective 6 Show how a line of credit affects financial statements.

24. 7-24 Line of Credit Lines of credit are pre-approved financing plans that allow companies to borrow and repay funds as needed up to the maximum credit line set by the creditor. Lines of credit are normally used for relatively short- term borrowing to finance seasonal business needs.

25. 7-25 Line of Credit Lagoon Company borrows money using a line of credit to finance building up its inventory. Lagoon repays the loan over the summer using cash generated from sales. ( Interest rates generally fluctuate based on a designated interest rate benchmark.) Each borrowing is an asset source transaction. Each repayment is an asset use transaction.

26. 7-26 Learning Objective 7 Explain how to account for bonds issued at face value and their related interest costs.

27. 7-27 Mason Company issues bonds on January 1, 2011. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Mason Company issues bonds on January 1, 2011. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Mason Company issues bonds on January 1, 2012. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2016 (5 years) Mason Company issues bonds on January 1, 2012. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2016 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Bonds Issued at Face Value

28. 7-28 Bonds Issued at Face Value Event 1 Issue Bonds for Cash Issuing the bonds has the following effect on Mason’s 2012 financial statements: Event 1 Issue Bonds for Cash Issuing the bonds has the following effect on Mason’s 2012 financial statements: Event 2 Investment in Land Paying $100,000 cash to purchase land is an asset exchange transaction. Event 2 Investment in Land Paying $100,000 cash to purchase land is an asset exchange transaction.

29. 7-29 Bonds Issued at Face Value Event 3 Revenue Recognition Recognizing $12,000 cash revenue from renting the property is an asset source transaction. Event 3 Revenue Recognition Recognizing $12,000 cash revenue from renting the property is an asset source transaction. Event 4 Expense Recognition Mason’s $9,000 ($100,000 x 0.09) cash payment in each of the 5 years represents interest expense. Event 4 Expense Recognition Mason’s $9,000 ($100,000 x 0.09) cash payment in each of the 5 years represents interest expense.

30. 7-30 Bonds Issued at Face Value Bond Interest Payments Mason Company Investors On each yearly interest payment date, Mason Company will pay $9,000 in interest. The amount is computed as follows: $100, 000 × 9% = $9,000

31. 7-31 Bonds Issued at Face Value Event 6 Payoff of Bond Liability The principal repayment on December 31, 2016 will have the following effect on Mason’s 2016 financial statements: Event 6 Payoff of Bond Liability The principal repayment on December 31, 2016 will have the following effect on Mason’s 2016 financial statements: Event 5 Sale of Investment in Land Selling the land for cash equal to its $100,000 book value is an asset exchange transaction. Event 5 Sale of Investment in Land Selling the land for cash equal to its $100,000 book value is an asset exchange transaction.

32. 7-32 Bonds Issued at Face Value Bond Principal at Maturity Date Mason Company Investors On December 31, 2016, Mason Company will return the $100,000 principal amount to the investors.

33. 7-33

34. 7-34 Learning Objective 8 Use the straight-line method to amortize bond discounts and premiums.

35. 7-35 Mason Company issues bonds on January 1, 2011. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Mason Company issues bonds on January 1, 2011. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Mason Company issues bonds on January 1, 2012. Principal = $100,000 Issued at 95 instead of face; cash proceeds of $95,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2016 (5 years) Mason Company issues bonds on January 1, 2012. Principal = $100,000 Issued at 95 instead of face; cash proceeds of $95,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2016 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Bonds Issued at a Discount

36. 7-36 Mason Company issues bonds on January 1, 2011. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Mason Company issues bonds on January 1, 2011. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors $100,000 face issued at 95: Bonds Payable$100,000 Less: Discount on Bonds Payable (5,000) Carrying Value$ 95,000 $100,000 face issued at 95: Bonds Payable$100,000 Less: Discount on Bonds Payable (5,000) Carrying Value$ 95,000 Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Bonds Issued at a Discount

37. 7-37 Bonds Issued at a Discount Expense Recognition for Bond issued at 95 Mason’s cash payment is $9,000 ($100,000 x 0.09) Amortization of the discount of $5,000 over 5 years is $1,000 per year. Interest expense recognized is $9,000 plus $1,000 = $10,000 Expense Recognition for Bond issued at 95 Mason’s cash payment is $9,000 ($100,000 x 0.09) Amortization of the discount of $5,000 over 5 years is $1,000 per year. Interest expense recognized is $9,000 plus $1,000 = $10,000

38. 7-38

39. 7-39 Mason Company issues bonds on January 1, 2011. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Mason Company issues bonds on January 1, 2011. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Mason Company issues bonds on January 1, 2012. Principal = $100,000 Issued at 105 instead of face, cash proceeds of $105,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2016 (5 years) Mason Company issues bonds on January 1, 2012. Principal = $100,000 Issued at 105 instead of face, cash proceeds of $105,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2016 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Bonds Issued at a Premium

40. 7-40 Mason Company issues bonds on January 1, 2011. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Mason Company issues bonds on January 1, 2011. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors $100,000 face issued at 105: Bonds Payable$100,000 Plus: Premium on Bonds Payable 5,000 Carrying Value$ 105,000 $100,000 face issued at 105: Bonds Payable$100,000 Plus: Premium on Bonds Payable 5,000 Carrying Value$ 105,000 Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Bonds Issued at a Premium

41. 7-41 Bonds Issued at a Premium Expense Recognition for Bond issued at 105 Mason’s cash payment is $9,000 ($100,000 x 0.09) Amortization of the premium of $5,000 over 5 years is $1,000 per year. Interest expense recognized is $9,000 less $1,000 = $8,000 Expense Recognition for Bond issued at 105 Mason’s cash payment is $9,000 ($100,000 x 0.09) Amortization of the premium of $5,000 over 5 years is $1,000 per year. Interest expense recognized is $9,000 less $1,000 = $8,000

42. 7-42 Learning Objective 9 Distinguish between current and noncurrent assets and liabilities.

43. 7-43 Current Versus Noncurrent Current assets are expected to be converted to cash or consumed within one year or an operating cycle, whichever is longer. Current assets include: Cash Marketable Securities Accounts Receivable Short-Term Notes Receivable Interest Receivable Inventory Supplies Prepaid Items Cash Marketable Securities Accounts Receivable Short-Term Notes Receivable Interest Receivable Inventory Supplies Prepaid Items

44. 7-44 Current Versus Noncurrent Current liabilities are due within one year or an operating cycle, whichever is longer. Current liabilities, also called short-term liabilities, include: Accounts PayableAccounts Payable Short-Term Notes PayableShort-Term Notes Payable Wages PayableWages Payable Taxes PayableTaxes Payable Interest PayableInterest Payable Accounts PayableAccounts Payable Short-Term Notes PayableShort-Term Notes Payable Wages PayableWages Payable Taxes PayableTaxes Payable Interest PayableInterest Payable

45. 7-45 Learning Objective 10 Prepare a classified balance sheet.

46. 7-46

47. 7-47 Learning Objective 11 Use the effective interest rate method to amortize bond discounts and premiums (Appendix).

48. 7-48 Mason Company issues bonds on January 1, 2011. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Mason Company issues bonds on January 1, 2011. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Mason Company issues bonds on January 1, 2012. Principal = $100,000 Issued at 95 instead of face; cash proceeds of $95,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2016 (5 years) Mason Company issues bonds on January 1, 2012. Principal = $100,000 Issued at 95 instead of face; cash proceeds of $95,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2016 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Bonds Issued at a Discount

49. 7-49 Bonds Issued At A Discount – Effective Interest Rate Method Interest paid in cash each year is $9,000. The effective interest rate method is based on the market rate of interest on the day of issue and results in: o varying amount of interest expense o related and varying addition to the carrying value of the bonds each year.

50. 7-50 Amortization Schedule for Bond Discount

51. 7-51 Mason Company issues bonds on January 1, 2011. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Mason Company issues bonds on January 1, 2011. Principal = $100,000 Stated Interest Rate = 9% Interest Date = 12/31 Maturity Date = Dec. 31, 2015 (5 years) Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors United Company issues bond with face value of $100,000 Issued price is $107,985 Stated Interest Rate = 10%; Effective rate of interest = 8% Interest Date = 12/31 Term of bond is 5 years United Company issues bond with face value of $100,000 Issued price is $107,985 Stated Interest Rate = 10%; Effective rate of interest = 8% Interest Date = 12/31 Term of bond is 5 years Bond Certificate at Face Value Bond Certificate at Face Value Bond Selling Price Mason Company Investors Bonds Issued at a Premium

52. 7-52 Amortization Schedule for Bond Premium

53. 7-53 Effective Interest Rate Method to Amortize the Premium. See Exhibit 7.14. Cash of $10,000 is paid for interest. Interest expense of $8,639 is recognized and $1,361 is subtracted from the carrying value of the bond liability

54. 7-54 End of Chapter Seven