Accounting for Liabilities

1
Accounting for Liabilities

• Chapter 6

2
Classification of Liabilities

• directly matches the classification of assets
• Current liabilities
• Expected to be satisfied within one year or
  within the normal operating cycle, whichever is
  longer
• Paid out of current assets or with cash generated
  from operations
• Long-term liabilities
• Due beyond one year or beyond the normal
  operating cycle
• Used to finance long-term assets

It is important to distinguish between current
and long-term liabilities because of the effect
on liquidity
3
Common Categories of Current Liabilities

• Definitely determinable liabilities
• Set by contract or by statute and can be measured
  exactly Accounts payable
• Types
• - Bank loans and commercial paper
• - Notes payable
• Accrued liabilities
• Dividends payable
• Sales and excise taxes payable
• Current portions of long-term debt
• Payroll liabilities
• Unearned or deferred revenues

• Estimated liabilities
• Definite debts or obligations of which the exact
  dollar amount cannot be known until a later date
• Types
• Income taxes
• Property taxes
• Product warranties
• Vacation pay

4
Two Promissory Notes
5
Recording Notes Payable
Interest Stated Separately on Face of Note
Aug. 31 Issued a 60-day, 12 percent promissory
note with interest stated separately
Aug.31

Cash

5,000




Notes Payable


5,000




Issued 60
-
day, 12 percent


promissory note with interest
stated seperately







Oct. 30 Note is paid with interest

Oct
.3
0

Notes Payable

5,000



Interest Expense

100




Cash


5,100




Payment of note with interest


stated
separately








6
Recording Notes Payable
This is called discounting
Interest Deducted in Advance
Aug. 31 Issued a 60-day, 12 percent promissory
note with interest deducted in advance
Aug.31

Cash

4,9
00



Discount on Notes Payable

100




Notes Payable


5,000




Issued 60
-
day
promissory


note with
100
interest
included in face amount







Oct. 30 Note is paid

3
0

Interest
E
xpense

100




Discount on N
o
tes
Payable


100




Interest expense on notes payable









7
Recording Interest Payable
Sep. 30 Record interest expense for 30 days on
60-day, 12 percent promissory note issued August
31
Interest Stated Separately on Face of Note
Sep
.3
0

Interest Expense

50




Interest Payable


50




To record interest expense for 30 days

on note with interest stated separately








Interest Included in Face Amount
Sep
.3
0

Interest Expense

50




Discount on Notes Payable


50




To record interest expense for 30 days on

note with interest
included in face value








8
Current Portions of Long-Term Debt

• include the portions of long-term debt that are
  due within the next year and are to be paid from
  current assets
• Are classified as current liabilities
• No journal entry is required, Debt is
  reclassified when financial statements are
  prepared

For example a 500,000 debt is to be paid in
installments of 100,000 per year for the next
five years. When financial statements are
prepared, The total debt of 500,000 is
reclassified as follows
9
Illustration of Payroll Liabilities
10
Recording Payroll Liabilities
Feb 15 Record payroll, total employee wages,
32,500
Note that employees earned 32,500 but take home
pay was 21,214
Feb 15 Record payroll taxes
Payroll taxes and benefits increase the total
cost of payroll to 41,901 (32,500 9,401)
11
Types of Estimated Liabilities

• Income taxes
• The amount may not be known until after the end
  of the year -gt estimate tax liability
• Property taxes
• The company estimate the amount of property tax
  that applies to each month of the year
• Product warranties
• A company can estimate the future cost of the
  liability for defective goods sold
• Vacation pay
• Employees accrue vacation will estimated and
  allocated over the entire year so that
  month-to-month costs will not be distorted

12
Product Warranty Liability
During July, 350 mufflers were sold for 50 each.
In the past, 6 percent of mufflers were returned
for replacement under warranty
Dec 5 A customer returns, under warranty, a
defective muffler that cost 40 and pays a 20
service fee for the replacement
13
Long-Term Liabilities

• are obligations of the business that are due to
  be paid after one year or beyond the normal
  operating cycle, whichever is longer

Examples of long term debt Long-term bonds
(debentures) Long-term notes Mortgages Long-te
rm leases
14
Bonds

• are securities, usually long-term, representing
  money borrowed from the investing public by a
  corporation or some other entity
• Are promises to repay the amount borrowed
  (principal) and interest at a specified rate on
  specified future dates
• Must be repaid at a specified time and require
  periodic (usually semiannual) payments of interest

15
Prices of Bonds

• are stated in terms of a percentage of face
  value
• Bonds selling at 100, Sell at face or par value
• Bonds selling above 100, Sell at a premium
• Bonds selling below 100, Sell at a discount

A bond issue is quoted at 103 ½
What is the selling price of a 1,000 bond?
Discount Bonds sell for less than face
value Market interest rate gt face interest
rate Premium Bonds sell for more than face
value Face interest rate gt market interest rate
Market interest rate The rate of interest paid
in the market on bonds of similar risk, also
called effective interest rate
16
Issuing Bonds Payable
Premium on Bonds Payable
Cash
The discount or premium is amortized over the
life of the bonds using straight-line or
effective interest method
Differences
Bonds Payable
Discounts on Bonds Payable
17
Bonds Issued at Face Value
Vason Corporation has authorized the issuance of
100,000 of 9 percent, 5-year bonds on January 1,
20x4. Interest is to be paid on January 1 and
July 1 of each year. The bonds are sold for
their face value on January 1, 20x4
Record the issuance of the bonds
Record a semiannual interest payment
18
Bonds Issued at a Discount
Vason Corporation issues 100,000 of 9 percent,
5-year bonds at 96.149 on January 1, 20x4, when
the market rate is 10 percent
Record the issuance of the bonds at a discount
Unamortized Bond Discount is a contra-liability
account
Carrying Value of Bonds Face Value
Unamortized Bond Discount
100,000 3,851 96,149
19
Bond Discount Amortization Straight-Line Method




100,000
358.10
3,581
July 1, 20x4 First semiannual interest date.
Bond discount is amortized
The amount of unamortized bond discount is
declining while the carrying value of the bond is
increasing
Amortized discount per period
Bond discount Total interest
payment periods
20
Bond Discount Amortization Straight-Line Method




100,000
100,000
358.10
3,581
Jan. 1, 20x9 Bond due
358.10 358.10 358.10 358.10 358.10 358.10 358.10 3
58.10
Bal. -0-
358.10
Bal. -0-
The company will pay the bondholder 100,000 (the
face value of the bond), which is equal to the
cash received when the bond was issued plus the
bond discount
21
Bond Discount Amortization Effective Interest
Method
22
Bond Discount Amortization Effective Interest
Method
Record first semiannual interest payment and
amortization of bond discount
23
Bonds Issued at a Premium
Vason Corporation issues 100,000 of 9 percent,
5-year bonds for 104,100 on January 1, 20x4,
when the market rate is 8 percent
Record the issuance of the bonds at a premium
Carrying Value of Bonds Face Value
Unamortized Bond Premium
100,000 4,100 104,100
24
Bond Premium AmortizationStraight-Line Method

• assumes equal amortization of the bond premium
  for each interest period

Record first semiannual interest payment and
amortization of bond discount
25
Bond Premium AmortizationEffective Rate Method
26
Bond Premium AmortizationEffective Rate Method
Record first semiannual interest payment and
amortization of bond premium
27
Sale of Bonds Between Interest Dates
Vason Corporation sold 100,000 of 9 percent,
5-year bonds on May 1, 20x4 (after the January 1,
20x4 issue date)
28
Sale of Bonds Between Interest Dates
Record the sale of the bonds
Record the first semiannual interest payment
Bal. 0
May 1 3,000
July 1 4,500
Bal. 1,500
29
Year-End Accrual of Bond Interest Expense
Vason Corporation issues 100,000 of 9 percent,
5-year bonds at 104.1 on January 1, 20x4. The
companys fiscal year ends September 30, 20x4
Interest and amortization were recorded on July
1, 20x4 Three months of interest has accrued
since then
Bond Interest for 3 months 4,151 x 3/6
2,075.5 Amortized bond premium 349 x 3/6 174.5
30
Record the year-end accrual of bond interest
expense
Record second semiannual interest payment and
amortization of bond premium