Liabilities in Perspective

1
Liabilities in Perspective

• Liabilities are a companys obligations to pay
  cash or to provide goods and services to other
  companies or individuals.
• Accrual accounting recognizes expenses when they
  occur rather than when they are paid.
• When an expense is recognized before it is paid,
  a liability is created.

2
Liabilities in Perspective

• Liabilities are classified as either current or
  long term to help readers interpret the immediacy
  of a companys obligations.
• Current liabilities - obligations that fall due
  within the coming year or within the companys
  normal operating cycle
• Long-term liabilities - obligations that fall due
  beyond one year from the balance sheet date
• If long-term liabilities are paid gradually, the
  portion that comes due within the year becomes a
  current liability.

3
Liabilities in Perspective

• In the general ledger, each liability (wages,
  salaries, interest, etc.) is kept in a different
  account.
• However, in the financial statements, liabilities
  may be combined and shown as a single amount.
• The terms accrued or payable may sometimes be
  used to denote liabilities.

4
Accounting for Current Liabilities

• Not all current liabilities are recorded the same
  way.
• Some are the result of a transaction with a third
  party, such as a supplier or a lender.
• Some are the result of an adjusting
  journal entry made to acknowledge
  an obligation arising over
  time, such as interest
  or wages.

5
Accounts Payable

• Accounts payable (or trade accounts payable) are
  amounts owed to suppliers.
• Large sums of money flow through accounts payable
  systems, so data-processing and internal control
  systems are carefully designed for accounts
  payable.
• The company must ensure that checks are written
  only for legitimate obligations of the company.

6
Notes Payable

• Promissory note (note payable) - a written
  promise to repay principal plus interest at
  specific future dates
• Notes payable can be classified as current or
  long term depending on when they are payable.

7
Notes Payable

• Rather than having to apply for many small loans
  at different times, companies obtain lines of
  credit with lenders.
• Line of credit - an agreement with a bank to
  automatically provide short-term loans up to some
  preestablished maximum
• The lender does not have to do extensive
  paperwork or credit checks every time a borrower
  needs money.
• The borrower has a preset amount of borrowing
  available.

8
Notes Payable

• Companies sometimes borrow directly from
  investors in the form of commercial paper.
• Commercial paper - a short-term debt contract
  issued by prominent companies that borrow
  directly from investors
• These liabilities usually fall due within 9
  months, often within 60 days.

9
Income Taxes Payable

• Corporations make periodic installment payments
  based on their estimated tax for the year.
  Therefore, the accrued tax liability at year end
  is generally much smaller than the actual income
  tax expense.
• Corporations must adjust their periodic payments
  to reflect changes in the estimates in earnings
  for the year.

10
Current Portion ofLong-Term Debt

• If long-term liabilities are paid gradually, the
  portion that comes due within the year becomes a
  current liability.
• The journal entry to reclassify a liability is
• Long-term debt xxxx
• Current portion of long-term debt xxxx

11
Sales Tax

• When companies collect sales taxes, they are
  collecting on behalf of a state or local
  government.
• Sales taxes do not affect the income
  statement.
• They are recorded in a liability account
  called Sales Tax Payable until they are remitted
  to the governmental unit.

12
Product Warranties

• A sales warranty creates a liability, but
  warranty claims will arise in the future and
  cannot be estimated precisely.
• If warranty obligations are material, they
  must be accrued when the products are sold.
• Warranty obligations are usually based on
  past experience for replacing or
  fixing defective products.

13
Product Warranties

• The entries related to product warranties are as
  follows
• To record the estimated liability
• Warranty expense 30,000
• Liability for warranties 30,000
• To record a claim against the warranty
• Liability for warranties 500
• Cash, accounts payable, etc. 500

14
Unearned Revenue

• Revenues that are collected before services or
  goods are delivered are called unearned revenues.
• Examples include lease rentals, magazine
  subscriptions, insurance premiums, advance ticket
  sales, etc.
• These amounts are recorded as current liabilities
  and are converted to revenues as the services or
  goods are delivered, i.e., when a month passes or
  when an issue of a magazine is delivered to a
  subscriber.

15
Long-Term Liabilities

• Some long-term liabilities are much like some
  short-term liabilities except for the time frame.
• Car loans or mortgage loans are much like notes
  payable, but they are for a longer term.
• As time passes, payments of interest and
  principal eliminate the loan obligation.

16
Long-Term Liabilities

• Illustration and analysis of a loan
• Assume that 10,000 is borrowed at 10 interest.
  The yearly payment is to be 3,154.71 for four
  years on December 31 of each year.
• The total repayment amount is 12,618.83, which
  consists of the 10,000 principal plus 2,618.83
  in interest.

17
Bonds and Notes

• Both bonds and notes are legal contracts that
  specify how much is to be borrowed and the dates
  and amounts for repayment by the borrower.
• Notes and bonds are called negotiable financial
  instruments because they can be transferred from
  one lender to another.
• Some bonds and notes are private placements,
  which means that only a few sources of borrowing
  are used rather than the general public.

18
Bonds and Notes

• Bond - a formal certificate of indebtedness that
  is typically accompanied by (1) a promise to pay
  interest in cash at a specified annual rate plus
  (2) a promise to pay the principal at a specific
  maturity date
• The interest rate is often called the nominal
  interest rate, contractual rate, coupon rate, or
  stated rate.
• The principal amount is also known as the face
  amount.

19
Bonds and Notes

• Interest rate - the percentage applied to a
  principal amount to calculate the amount of
  interest that must be paid on the loan
• Interest represents the return the lender can
  earn for loaning money.
• In general, riskier loans demand higher interest
  rates.

20
Bond Accounting

• On December 31, 2000, a company issued
  10,000,000 in 2-year, 10 bonds. Interest is to
  be paid semiannually on June 30 and December 31.
  Assuming that the bonds are held to maturity, the
  journal entries are
• To record the issuance of the bonds
• Cash 10,000,000
• Bonds payable 10,000,000
• To record the payments of the semiannual
  interest
• Interest expense 500,000
• Cash ((10,000,000 x 10) / 2)
  500,000
• To record the repayment of principal at maturity
• Bonds payable 10,000,000
• Cash 10,000,000

21
Deferred Taxes

• As discussed before, delays in payment of taxes
  between the time that income is earned and taxes
  are due leads to short-term taxes payable.
• However, another reason for taxes payable arises
  because of differences between U.S. income tax
  rules and GAAP.
• Sometimes tax rules can cause income tax expense
  to be recorded long before it is actually paid
  and creates a deferred tax liability.

22
Deferred Taxes

• Differences arise because GAAP is designed to
  provide useful information to investors, while
  the tax code is written to generate revenues for
  the government.
• Managers try to pay the least amount of taxes at
  the latest time possible.
• They try to delay reporting taxable revenue as
  long as possible while deducting expenses as
  quickly as possible.

23
Deferred Taxes

• Differences may be created because
• Rules for financial reporting and tax rules
  differ.
• Managers make different choices of accounting
  treatment for financial reporting than for tax
  reporting.
• Managers have an incentive to keep taxable income
  low, but they have an incentive to make financial
  income high.

24
Contingent Liabilities

• Contingent liabilities - a potential liability
  that depends on a future event arising out of a
  past transaction
• Some contingent liabilities are certain in
  amount.
• Smith Company may guarantee a loan for Parker
  Company. Smith Company will pay if, and only if,
  Parker Company does not pay.
• This is a liability of Parker Company and a
  contingent liability of Smith Company.

25
Contingent Liabilities

• More often, contingent liabilities are of an
  indefinite amount.
• Lawsuits are common examples. These are
  possible obligations of uncertain amounts.
• Some companies show contingent liabilities on the
  balance sheet, but most disclose such amounts in
  the footnotes to the financial statements.

26
Debt Ratios andInterest-Coverage Ratios

• Debt ratios are used to measure the extent to
  which a company has used borrowing to finance its
  activities.
• The more borrowing, and the less equity, the
  riskier it is to lend money to a firm.

27
Debt Ratios andInterest-Coverage Ratios

Debt-to- equity ratio
Long-term- debt-to-total- capital ratio
Total long-term debt

Total shareholders equity long-term debt
28
Debt Ratios andInterest-Coverage Ratios
Debt-to- total-assets ratio

Interest- coverage ratio