Reporting and Analyzing Liabilities

1
Chapter 10

• Reporting and Analyzing Liabilities
• (Including Appendix 10A, 10B and Appendix C)

2
Liabilities

• Creditors claims on total assets
• Existing debts and obligations
• Liabilities must be settled in the future by
  transfer of assets or services

3
Current Liabilities

• Criterion 1 Can reasonably be expected to paid
  from existing current assets or through the
  creation of other current liabilities
• Criterion 2 Paid within 1 year or the operating
  cycle, whichever is longer.
• Notes Payable, Accounts Payable, Unearned
  Revenues, Accrued Liabilities
• Debts that do not meet both criteria are
  Long-Term Liabilities

4
Notes Payable

• Obligations in the form of written notes
• Often used instead of accounts payable
• They give written documentation if needed for
  legal remedies
• Used for short-term and long-term financing needs

5
Journal
Mar 1 Cash 100,000 Notes
Payable 100,000 (To record issuance of 12,
4-month note to bank)

• Remember - Interest accrues over life of the note
  and must be recorded periodically.

April 30 Interest Expense
2,000 Interest Payable
2,000 (To accrue interest for 2 months on
note) 100,000 x .12 x 2/12
months July 1 Notes payable 100,000 Interest
payable 2,000 Interest expense
2,000 Cash
104,000 (To record payment of
interest and principal)
6
Sales Taxes Payable

• Are collected from customers
• Are expressed as a of sales price
• Are required by law
• Mar 25 Cash 10,600
• Sales 10,000
• Sales Taxes Payable 600
• (To record daily sales and sales taxes)

7
Payroll Taxes

• Amount required by law to be withheld from
  employees gross pay
• Social Security taxes withheld (FICA)
• Federal Income Taxes
• State Income Taxes (if applicable)
• Mar 7 Salaries and Wages Expense 100,000
• FICA Taxes Payable 7,250
• Federal Income Taxes Payable 21,864
• States Income Taxes Payable 2,922
• Salaries and Wages Payable 67,964
• Salaries and Wages Payable 67,964
• Cash
  67,964

8
Unearned Revenues

• Cash received before revenues are earned and
  recorded as liabilities until they are earned.
• Magazine subscriptions, rent received in advance,
  customer deposits for future service, sale of
  airline tickets for future travel
• Cash
• Unearned revenue
• Unearned revenue
• Revenue

9
Current Maturities of Long-Term Debt

• The portion of the long-term debt that is due
  within the current year or operating cycle should
  be classified as a current liability

10
Liquidity Ratios

• Measure the short-term ability of a company to
  pay its maturing obligations and to meet
  unexpected needs for cash

Working capital Current assets Current
liabilities Current ratio Current
assets Current liabilities Acid-test
ratio Cash, Marketable securities, Net A/R
Current liabilities
11
Long-Term Liabilities

• Are obligations that are expected to be paid
  after 1 year
• Bonds
• a form of interest-bearing notes payable issued
  by corporations, universities and governmental
  agencies.
• are sold in small denominations (1,000), which
  makes them attractive to investors.
• Bond financing v. stock financing
  Illustrations 10-6 and 10-7

12
Advantages of Bond Financing

• Stockholder control is not affected bondholders
  do not receive voting rights
• Tax savings bond interest is deductible,
  dividends are not deductible
• Earnings per share may be higher since no
  additional stock is issued (EPS Income
  available to common stockholders/Number of
  outstanding shares)

13
Bonds

• Mortgage Bond - a bond secured by real estate
  
  
• Sinking Fund Bond - a bond secured by specific
  assets to retire the bonds
• Unsecured or debenture bond - issued against the
  general credit of the borrower
• Term bond - Are due for payment (mature) at a
  single specified future date
• Serial bond matures in installments
• Convertible bond can be converted to common
  stock
• Callable bond can be retired before maturity

14
Terms

• Face value principal amount paid at maturity
• Contractual rate (stated rate, coupon rate)
  rate at which interest is paid semiannually or
  annually
• (Interest paid Face value stated rate)
• Market rate the rate investors demand
• (present value calculations use market rate)
• Present value value today of amount(s) that
  will be paid/received in the future, calculated
  using market rate

15
Accounting for Bond Issues

• Bonds may be issued at
• Face value
• Contractual rate Market rate
• Cash proceeds/Present value of future cash flows
  Face value
• Below face value (discount)
• Contractual rate lt Market rate
• Cash proceeds/Present value of future cash flows
  lt Face value
• Above face value (premium)
• Contractual rate gt Market rate
• Cash proceeds/Present value of future cash flows
  gt Face value

16
Bonds issued at Face value

• A company issues 100,000 of 5-year bonds at 10
  interest payments are made semiannually the
  market rate is 10
• PV of 100,000 100,000 0.61391 61,391
• PV of annuity 5,000 7.72173 38,609
  (rounded)
• Total PV Cash proceeds received at issuance
• 61,391 38,609 100,000
• Semiannual interest payment 100,000 .05

17
Bonds issued at Discount

• A company issues 100,000 of 5-year bonds at 10
  interest payments are made semiannually the
  market rate is 12
• PV of 100,000 100,000 0.55839 55,839
• PV of annuity 5,000 7.36009 36,800
  (rounded)
• Total PV Cash proceeds received at issuance
• 55,839 36,800 92,639
• Semiannual interest payment 100,000 .05

18
Bonds issued at Premium

• A company issues 100,000 of 5-year bonds at 10
  interest payments are made semiannually the
  market rate is 8
• PV of 100,000 100,000 0.67556 67,556
• PV of annuity 5,000 8.11090 40,555
  (rounded)
• Total PV Cash proceeds received at issuance
• 67,55640,555 108,111
• Semiannual interest payment 100,000 .05

19
Issuing Bonds at Face Value

• Assume that Devour Corporation issued 1,000,
  10-year 10, 1,000 bonds dated January 1, 2001
  at 100 (100 of face value) with interest payable
  on July 1 and January 1.
• 1/1 Cash
  1,000,000 Bonds Payable
  1,000,000
• (To record sale of bonds at face value)

20
Issuing Bonds at Face Value

• The bonds are reported in the long-term liability
  section of the balance sheet because the maturity
  date is more than 1 year away
• The entry to record the semiannual interest on
  July 1 is
• 7/1 Bond Interest Expense 50,000
  Cash 50,000
• (To record the payment of bond interest
  every 6 months
• 1,000,000 0.05)
• Remember to accrue interest if the accounting
  period ends between bond interest payment dates

21
Selling Bonds at Discount

• On January 1, 2001, Candlestick, Inc., sells
  100,000, 5-year, 10 bonds at 92.639 of face
  value with interest payable on July 1 and
  January 1. The effective/market rate of interest
  is 12.
• 1/1 Cash
  92,639 Discount on Bonds Payable
  7,361
  Bonds Payable 100,000
• (To record sale of bonds at a discount)
• Carrying value of the bonds on the balance sheet
• Long-term liabilities
• Bonds payable 100,000
• Less Discount on bonds 7,361 92,639
  (Carrying value)
• payable

22
Amortizing Bond Discount effective interest
method
23
Amortizing Bond Discount effective interest
method

• Interest paid every 6 months is constant
• 100,000 .05
• Interest expense Carrying value .06
  (semiannual market rate)
• Discount amortized every period Interest
  expense Interest paid
• Carrying value Face value Unamortized
  discount
• At maturity Carrying value Face value
• Discount bonds interest expense gt interest paid
• Discount additional cost of borrowing
• Interest expense Interest paid in cash
  discount amortized

24
Selling bonds at Premium

• Assume that on January 1, 2001, Candlestick,
  Inc., sells 100,000 5-year, 10 bonds at
  108,111 with interest payable on July 1 and
  January 1. The market rate of interest is 8.
• 1/1 Cash 108,111
  Bonds Payable 100,000
• Premium Bonds Payable
  8,111
• Carrying value of the bonds on the balance sheet
  
• Long-term liabilities
• Bonds payable 100,000
• Add Premium on bonds 8,111
  108,111 (Carrying value)
• payable

25
Amortizing Bond Premium effective interest
method
26
Amortizing Bond Premium effective interest
method

• Interest paid every 6 months is constant
• 100,000 .05
• Interest expense Carrying value .04
  (semiannual market rate)
• Premium amortized every period Interest paid
  Interest expense
• Carrying value Face value Unamortized Premium
• At maturity Carrying value Face value
• Premium bonds Interest paid gt Interest expense
• Premium lowers the cost of borrowing
• Interest expense Interest paid premium
  amortized

27
Bond Retirement

• At maturity, carrying value of bonds face value
• Redemption at maturity time
• Bonds payable 1,000,000
• Cash 1,000,000
• Redemption before maturity
• Step 1Eliminate carrying value of bonds
• Face value unamortized discount (for discount
  bonds)
• Face value unamortized premium (for premium
  bonds)
• Step 2 Record cash received
• Step 3 Recognize gain or loss for difference
  between cash received and carrying value
• Illustration

28
Accounting for long-term notes payable Appendix
10B

• To obtain financing, company issues 500,000, 12
  , 20-year mortgage note on January 1, 2000
  semiannual installment payment amounts to
  33,231.

29
Ratios
Debt to total assets Total debts/Total
assets Times interest earned ratio Income
Before Interest Expense Income Tax
Interest Expense
30
Contingent Liabilities

• Events with uncertain outcomes
• Example lawsuit
• Must be recorded in the financial statements
• if the company can determine a reasonable
  estimate of the expected loss and
• if it is probable it will lose the suit

31
Capital v. Operating Lease

• Operating lease asset owned by the lessor
  temporary use by the lessee apartment and car
  rentals
• Capital lease - the lease contract transfers
  substantially all the benefits and risks of
  ownership to the lessee
• Capital lease criteria
• Is it likely that the lessee will end up with
  the asset at the end of the lease?
• Will the lessee use the asset for most of its
  useful life?
• Will the payments made by the lessee be
  approximately the same as the payments it would
  have made if it had purchased the asset?

32
Capital Lease

• Lessee books a leased asset (records depreciation
  expense) and a lease liability (records interest
  expense) at the present value of the minimum
  lease payments
• Most lessees do not like to report leases on
  their balance sheets because the lease liability
  increases the company's total liabilities
• The procedure of keeping liabilities off the
  balance sheet is often referred to as off-balance
  sheet financing