© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 10-1 LIABILITIES Chapter 10.

© The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin

10-1

LIABILITIES

Chapter

10


10-2

Defined as debts or obligations arising from past transactions or

events.

Defined as debts or obligations arising from past transactions or

events.

Maturity = 1 year or less Maturity > 1 year

Current Liabilities

(Accounts Payable)

Noncurrent Liabilities

The Nature of LiabilitiesThe Nature of Liabilities


10-3

Total Notes Payable

Current Notes Payable

Noncurrent Notes Payable

When a company borrows money, a note payable is created.

Current Portion of Notes Payable

The portion of a note payable that is due within one year, or one operating cycle, whichever is longer.

When a company borrows money, a note payable is created.

Current Portion of Notes Payable

The portion of a note payable that is due within one year, or one operating cycle, whichever is longer.

Notes PayableNotes Payable


10-4

PROMISSORY NOTE

Location Date

after this date

promises to pay to the order of

the sum of with interest at the rate

of per annum.

signed

title

Miami, Fl Nov. 1, 2007

Six months Porter Company

John Caldwell

Security National Bank

$10,000.00

12.0%

treasurer



10-5

On November 1, 2007, Porter Company would make the following entry after

issuing the note.



10-6

• Interest expenseInterest expense is the is the compensation to the lender for compensation to the lender for giving up the use of money for a giving up the use of money for a period of time.period of time.

• The liability is called The liability is called interest interest payablepayable..

• To the lender, interest is a To the lender, interest is a revenuerevenue..

• To the borrower, interest is an To the borrower, interest is an expenseexpense..

• Interest expenseInterest expense is the is the compensation to the lender for compensation to the lender for giving up the use of money for a giving up the use of money for a period of time.period of time.

• The liability is called The liability is called interest interest payablepayable..

• To the lender, interest is a To the lender, interest is a revenuerevenue..

• To the borrower, interest is an To the borrower, interest is an expenseexpense..

Interest Rate Up!

Interest PayableInterest Payable


10-7

The interest formula includes three variables that must be considered when

computing interest:

The interest formula includes three variables that must be considered when

computing interest:

Interest = Principal × Interest Rate × Time

When computing interest for one year, “Time” equals 1. When the computation period is less

than one year, then “Time” is a fraction.

When computing interest for one year, “Time” equals 1. When the computation period is less

than one year, then “Time” is a fraction.

Interest PayableInterest Payable

For example, if we needed to compute interest for 3 months, “Time” would be 3/12.

For example, if we needed to compute interest for 3 months, “Time” would be 3/12.


10-8

What entry would Porter Company make on December 31, the fiscal year-end?

What entry would Porter Company make on December 31, the fiscal year-end?

Interest Payable – ExampleInterest Payable – Example

$10,00012% 2/12 = $200$10,00012% 2/12 = $200


10-9

Porter will pay the note on January 31, 2008. Let’s look at the entry.

Porter will pay the note on January 31, 2008. Let’s look at the entry.

Interest Payable – ExampleInterest Payable – Example

$10,00012% 1/12 = $100$10,00012% 1/12 = $100


10-10

Net Pay

Payroll LiabilitiesPayroll Liabilities

Medicare Taxes

State and Local Income

TaxesFICA Taxes

Federal Income Tax

Voluntary Deductions

Gross Pay


10-11

Deferred revenue is recorded.

a liability account.a liability account.

Cash is received

in advance.

Cash is sometimes collected from the customer before the revenue is

actually earned.

Cash is sometimes collected from the customer before the revenue is

actually earned.

Unearned RevenueUnearned Revenue

Earned revenue is recorded.

As the earnings process is

completed . .


10-12

Relatively small debt needs can be filled from

single sources.

Relatively small debt needs can be filled from

single sources.

BanksInsurance

CompaniesPension

Plans

oror oror

Long-Term LiabilitiesLong-Term Liabilities


10-13

Large debt needs are often filled by issuing bonds.

Large debt needs are often filled by issuing bonds.

Long-Term LiabilitiesLong-Term Liabilities


10-14

With each payment, the interest portion gets

smaller and the principal portion gets larger.

With each payment, the interest portion gets

smaller and the principal portion gets larger.

Installment Notes PayableInstallment Notes Payable

Long-term notes that call for a series of installment payments.

Long-term notes that call for a series of installment payments.

Each payment covers interest for the period AND a portion of the

principal.

Each payment covers interest for the period AND a portion of the

principal.


10-15

• Identify the unpaid principal balance.

• Interest expense = Unpaid Principal × Interest rate.

• Reduction in unpaid principal balance = Installment payment – Interest expense.

• Compute new unpaid principal balance.

• Identify the unpaid principal balance.

• Interest expense = Unpaid Principal × Interest rate.

• Reduction in unpaid principal balance = Installment payment – Interest expense.

• Compute new unpaid principal balance.

Allocating Installment Payments Between Interest and Principal



10-16

On January 1, 2007, Rocket Corp. borrowed $7,581.57 from First Bank of River City. The loan was a five-year loan and

had an interest rate of 10%. The annual payment is $2,000.

Prepare an amortization table for Rocket Corp.’s loan.

On January 1, 2007, Rocket Corp. borrowed $7,581.57 from First Bank of River City. The loan was a five-year loan and

had an interest rate of 10%. The annual payment is $2,000.

Prepare an amortization table for Rocket Corp.’s loan.




10-17

Now, prepare the entry for the first payment on December 31, 2007.

Now, prepare the entry for the first payment on December 31, 2007.




10-18

The information needed for the journal entry can be found on the amortization table. The payment

amount, the interest expense, and the amount to debit to principal are all on the table.

The information needed for the journal entry can be found on the amortization table. The payment

amount, the interest expense, and the amount to debit to principal are all on the table.




10-19

Bonds usually involve the Bonds usually involve the borrowing of a large sum of borrowing of a large sum of money, called money, called principalprincipal..

The principal is usually paid The principal is usually paid back as a back as a lump sumlump sum at the end at the end of the bond period.of the bond period.

Individual bonds are often Individual bonds are often denominated with a par value, denominated with a par value, or or face valueface value, of $1,000., of $1,000.

Bonds usually involve the Bonds usually involve the borrowing of a large sum of borrowing of a large sum of money, called money, called principalprincipal..

The principal is usually paid The principal is usually paid back as a back as a lump sumlump sum at the end at the end of the bond period.of the bond period.

Individual bonds are often Individual bonds are often denominated with a par value, denominated with a par value, or or face valueface value, of $1,000., of $1,000.

Bonds PayableBonds Payable


10-20

Bonds usually carry a stated rate of interest, also called a contract rate.

Interest is normally paid semiannually.

Interest is computed as:

Bonds usually carry a stated rate of interest, also called a contract rate.

Interest is normally paid semiannually.

Interest is computed as:

Interest = Principal × Stated Rate × Time Interest = Principal × Stated Rate × Time



10-21

Bonds are issued through an intermediary called an underwriter.

Bonds can be sold on organized securities exchanges.

Bond prices are usually quoted as a percentage of the face amount.

For example, a $1,000 bond For example, a $1,000 bond priced at 102 would sell for priced at 102 would sell for $1,020$1,020..

Bonds are issued through an intermediary called an underwriter.

Bonds can be sold on organized securities exchanges.

Bond prices are usually quoted as a percentage of the face amount.

For example, a $1,000 bond For example, a $1,000 bond priced at 102 would sell for priced at 102 would sell for $1,020$1,020..



10-22

Mortgage Bonds

Mortgage Bonds

Convertible Bonds

Convertible Bonds

Junk BondsJunk

Bonds

Debenture Bonds

Debenture Bonds

Types of BondsTypes of Bonds


10-23

On January 1, 2007, Rocket Corp. issues $1,500,000 of 12%, 10-year bonds payable. Interest is payable

semiannually, each July 1 and January 1.

Assume the bonds are issued at face value.Record the issuance of the bonds.

On January 1, 2007, Rocket Corp. issues $1,500,000 of 12%, 10-year bonds payable. Interest is payable

semiannually, each July 1 and January 1.

Assume the bonds are issued at face value.Record the issuance of the bonds.

Accounting for Bonds PayableAccounting for Bonds Payable


10-24

Record the interest paymenton July 1, 2007.

Record the interest paymenton July 1, 2007.

Accounting for Bonds PayableAccounting for Bonds Payable


10-25

Bonds Sold Between Interest DatesBonds Sold Between Interest Dates

• Bonds are often sold between interest dates.Bonds are often sold between interest dates.• The selling price of the bond is computed as:The selling price of the bond is computed as:

• Bonds are often sold between interest dates.Bonds are often sold between interest dates.• The selling price of the bond is computed as:The selling price of the bond is computed as:


10-26

The Present Value Concept and Bond Prices

The Present Value Concept and Bond Prices

The selling price of the bond is determined by the market based

on the time value of money.

==

>>

<<

>>

<<

==


10-27

Bonds Issued at a DiscountBonds Issued at a Discount

Matrix, Inc. is attempting to issue $1,000,000 Matrix, Inc. is attempting to issue $1,000,000 principal amount of 9% bonds. The bonds pay principal amount of 9% bonds. The bonds pay

interest on June 30 and December 31 each year interest on June 30 and December 31 each year and mature in 20 years. Investors are unwilling to and mature in 20 years. Investors are unwilling to

pay the full face amount for Matrix’s bonds because pay the full face amount for Matrix’s bonds because they believe the interest rate is too low. To entice they believe the interest rate is too low. To entice

investors, Matrix must lower the price of the bonds. investors, Matrix must lower the price of the bonds. The difference between the new lower issue price The difference between the new lower issue price

and the principal of $1,000,000 is called a discount.and the principal of $1,000,000 is called a discount.

Let’s see how we account for these bonds.Let’s see how we account for these bonds.

Matrix, Inc. is attempting to issue $1,000,000 Matrix, Inc. is attempting to issue $1,000,000 principal amount of 9% bonds. The bonds pay principal amount of 9% bonds. The bonds pay

interest on June 30 and December 31 each year interest on June 30 and December 31 each year and mature in 20 years. Investors are unwilling to and mature in 20 years. Investors are unwilling to

pay the full face amount for Matrix’s bonds because pay the full face amount for Matrix’s bonds because they believe the interest rate is too low. To entice they believe the interest rate is too low. To entice

investors, Matrix must lower the price of the bonds. investors, Matrix must lower the price of the bonds. The difference between the new lower issue price The difference between the new lower issue price

and the principal of $1,000,000 is called a discount.and the principal of $1,000,000 is called a discount.

Let’s see how we account for these bonds.Let’s see how we account for these bonds.


10-28

Principal

Cash Proceeds Discount

1,000,000$ - 950,000$ = 50,000$


Matrix, Inc. issues bonds on January 1, 2007.Matrix, Inc. issues bonds on January 1, 2007.Principal = $1,000,000Principal = $1,000,000Issue price = $950,000Issue price = $950,000Stated Interest Rate = 9%Stated Interest Rate = 9%Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31Maturity Date = Dec. 31, 2026 (20 years)Maturity Date = Dec. 31, 2026 (20 years)

Matrix, Inc. issues bonds on January 1, 2007.Matrix, Inc. issues bonds on January 1, 2007.Principal = $1,000,000Principal = $1,000,000Issue price = $950,000Issue price = $950,000Stated Interest Rate = 9%Stated Interest Rate = 9%Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31Maturity Date = Dec. 31, 2026 (20 years)Maturity Date = Dec. 31, 2026 (20 years)


10-29


To record the bond issue, Matrix, Inc. wouldTo record the bond issue, Matrix, Inc. wouldmake the following entry on January 1, 2007:make the following entry on January 1, 2007:To record the bond issue, Matrix, Inc. wouldTo record the bond issue, Matrix, Inc. wouldmake the following entry on January 1, 2007:make the following entry on January 1, 2007:


10-30

Partial Balance Sheet as of January 1, 2007

Long-term Liabilities: Bonds Payable 1,000,000$ Less: Discount on Bonds Payable 50,000 950,000$



Maturity ValueMaturity ValueMaturity ValueMaturity Value

Carrying ValueCarrying ValueCarrying ValueCarrying Value



10-31

Amortizing the discount over the term of the Amortizing the discount over the term of the bond increases Interest Expense each bond increases Interest Expense each

interest payment period.interest payment period.

Amortizing the discount over the term of the Amortizing the discount over the term of the bond increases Interest Expense each bond increases Interest Expense each



Using the Using the straight-linestraight-line method, the method, the discount amortization will be $1,250 discount amortization will be $1,250

every six months. every six months.

$50,000 ÷ 40 periods = $1,250$50,000 ÷ 40 periods = $1,250

Using the Using the straight-linestraight-line method, the method, the discount amortization will be $1,250 discount amortization will be $1,250

every six months. every six months.

$50,000 ÷ 40 periods = $1,250$50,000 ÷ 40 periods = $1,250


10-32

Amortization of the DiscountAmortization of the Discount

We prepare the following journal entry to recordWe prepare the following journal entry to recordthe first interest payment.the first interest payment.We prepare the following journal entry to recordWe prepare the following journal entry to recordthe first interest payment.the first interest payment.

$1,000,000 × 9% = $90,000 ÷ 2 = $45,000$45,000

Interest paid every six months is calculated as follows:Interest paid every six months is calculated as follows:Interest paid every six months is calculated as follows:Interest paid every six months is calculated as follows:


10-33

Partial Balance Sheet as of December 31, 2007






$50,000 – $1,250 – $1,250$50,000 – $1,250 – $1,250$50,000 – $1,250 – $1,250$50,000 – $1,250 – $1,250

The carrying value willThe carrying value willincrease to exactly $1,000,000increase to exactly $1,000,000

on the maturity date.on the maturity date.

The carrying value willThe carrying value willincrease to exactly $1,000,000increase to exactly $1,000,000




10-34

To record the principal repayment, Matrix, IncTo record the principal repayment, Matrix, Incwould make the following entry on December 31, 2026:would make the following entry on December 31, 2026:To record the principal repayment, Matrix, IncTo record the principal repayment, Matrix, Incwould make the following entry on December 31, 2026:would make the following entry on December 31, 2026:



10-35

Bonds Issued at a PremiumBonds Issued at a Premium

If bonds of other companies are yielding less thanIf bonds of other companies are yielding less than9 percent, investors will be willing to pay more than9 percent, investors will be willing to pay more thanthe face amount for Matrix’s 9% bonds. The issuethe face amount for Matrix’s 9% bonds. The issue

price of Matrix’s 9% bonds will rise because ofprice of Matrix’s 9% bonds will rise because ofinvestor demand for the 9% bonds. Theinvestor demand for the 9% bonds. The

difference between the higher issue price and thedifference between the higher issue price and theprincipal of $1,000,000 is called a premium.principal of $1,000,000 is called a premium.

Let’s look at accounting for a premium.Let’s look at accounting for a premium.

If bonds of other companies are yielding less thanIf bonds of other companies are yielding less than9 percent, investors will be willing to pay more than9 percent, investors will be willing to pay more thanthe face amount for Matrix’s 9% bonds. The issuethe face amount for Matrix’s 9% bonds. The issue

price of Matrix’s 9% bonds will rise because ofprice of Matrix’s 9% bonds will rise because ofinvestor demand for the 9% bonds. Theinvestor demand for the 9% bonds. The

difference between the higher issue price and thedifference between the higher issue price and theprincipal of $1,000,000 is called a premium.principal of $1,000,000 is called a premium.

Let’s look at accounting for a premium.Let’s look at accounting for a premium.


10-36

Cash Proceeds Principal Premium

1,050,000$ - 1,000,000$ = 50,000$

Matrix, Inc. issues bonds on January 1, 2007.Matrix, Inc. issues bonds on January 1, 2007.Principal = $1,000,000Principal = $1,000,000Issue price = $1,050,000Issue price = $1,050,000Stated Interest Rate = 9%Stated Interest Rate = 9%Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31Maturity Date = Dec. 31, 2026 (20 years)Maturity Date = Dec. 31, 2026 (20 years)

Matrix, Inc. issues bonds on January 1, 2007.Matrix, Inc. issues bonds on January 1, 2007.Principal = $1,000,000Principal = $1,000,000Issue price = $1,050,000Issue price = $1,050,000Stated Interest Rate = 9%Stated Interest Rate = 9%Interest Dates = 6/30 and 12/31Interest Dates = 6/30 and 12/31Maturity Date = Dec. 31, 2026 (20 years)Maturity Date = Dec. 31, 2026 (20 years)

The only change fromprevious Matrix example.



10-37

To record the bond issue, Matrix, Inc. wouldTo record the bond issue, Matrix, Inc. wouldmake the following entry on January 1, 2007:make the following entry on January 1, 2007:To record the bond issue, Matrix, Inc. wouldTo record the bond issue, Matrix, Inc. wouldmake the following entry on January 1, 2007:make the following entry on January 1, 2007:



10-38


Long-term Liabilities: Bonds Payable 1,000,000$ Add: Premium on Bonds Payable 50,000 1,050,000$







10-39

Amortizing the premium over the term of the Amortizing the premium over the term of the bond decreases Interest Expense each bond decreases Interest Expense each


Amortizing the premium over the term of the Amortizing the premium over the term of the bond decreases Interest Expense each bond decreases Interest Expense each


Using the Using the straight-linestraight-line method, the method, the premium amortization will be premium amortization will be

$1,250 every six months. $1,250 every six months.

$50,000 ÷ 40 periods = $50,000 ÷ 40 periods = $1,250$1,250

Using the Using the straight-linestraight-line method, the method, the premium amortization will be premium amortization will be

$1,250 every six months. $1,250 every six months.

$50,000 ÷ 40 periods = $50,000 ÷ 40 periods = $1,250$1,250



10-40


To record an interest payment, Matrix, Inc. would makeTo record an interest payment, Matrix, Inc. would makethe following entry on each June 30 and December 31:the following entry on each June 30 and December 31:To record an interest payment, Matrix, Inc. would makeTo record an interest payment, Matrix, Inc. would makethe following entry on each June 30 and December 31:the following entry on each June 30 and December 31:


10-41








$50,000 – $1,250 – $1,250$50,000 – $1,250 – $1,250$50,000 – $1,250 – $1,250$50,000 – $1,250 – $1,250

The carrying value willThe carrying value willdecrease to exactly $1,000,000decrease to exactly $1,000,000


The carrying value willThe carrying value willdecrease to exactly $1,000,000decrease to exactly $1,000,000



10-42

To record an the principal repayment, Matrix would makeTo record an the principal repayment, Matrix would makethe following entry on December 31, 2026:the following entry on December 31, 2026:To record an the principal repayment, Matrix would makeTo record an the principal repayment, Matrix would makethe following entry on December 31, 2026:the following entry on December 31, 2026:



10-43

Present Value

Present Value

The Concept of Present ValueThe Concept of Present Value

Future Value

Future Value

$1,000 invested

today at 10%.

In 25 years it will be worth $10,834.71!

Money can grow over time, because it can earn interest.

In 5 years it will be worth

$1,610.51.


10-44

How much is a future amount worth today?How much is a future amount worth today?

Present Value

FutureValue

Interest compounding periods

Today



10-45


How much is a future amount worth today?

Three pieces of information must be known to solve a present value problem:

o The future amount.o The interest rate (i).o The number of periods (n) the

amount will be invested.

How much is a future amount worth today?

Three pieces of information must be known to solve a present value problem:

o The future amount.o The interest rate (i).o The number of periods (n) the

amount will be invested.


10-46

Two types of cash flows are involved with bonds:

Today

Principal payment at maturity.

Periodic interest payments called annuities.

Maturity



10-47

Gains or losses incurred as a result of retiring bonds should be reported as other income or

other expense on the income statement.

Gains or losses incurred as a result of retiring bonds should be reported as other income or

other expense on the income statement.

Early Retirement of DebtEarly Retirement of Debt


10-48

Evaluating the Safetyof Creditors’ Claims

Evaluating the Safetyof Creditors’ Claims

This ratio indicates a margin of protection for creditors.

This ratio indicates a margin of protection for creditors.

Operating Income

Interest Expense

Interest

Coverage

Ratio=


10-49

Devon Mfg. reports annual operating income of $100,000 and annual interest expense of

$10,000.

What is Devon’s interest coverage ratio?

Devon Mfg. reports annual operating income of $100,000 and annual interest expense of

$10,000.

What is Devon’s interest coverage ratio?

Liabilities – QuestionLiabilities – Question


10-50

Lease agreement transfers risks and benefits

associated with ownership to lessee.

Lease agreement transfers risks and benefits

associated with ownership to lessee.

Lessee records a leased asset and lease liability.

Lessee records a leased asset and lease liability.

Lessor retains risks and benefits associated with

ownership.

Lessor retains risks and benefits associated with

ownership.

Lessee records rent expense as incurred.

Lessee records rent expense as incurred.

Lease Payment ObligationsLease Payment Obligations

Operating LeasesOperating Leases Capital LeasesCapital Leases


10-51

The lease transfersow nership to the

lessee.

The lease containsa bargain purchase

option.

The lease term is equal toor > 75% of the econom ic

life of the property.

The PV of the m inim umlease paym ents = 90% ofthe FM V of the property.

A lease must be recorded asa Capital Lease if it meets

any of the follow ing criteria.

Capital Lease CriteriaCapital Lease Criteria

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 10-1 LIABILITIES Chapter 10.

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Transcript of © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 10-1 LIABILITIES Chapter 10.