Financial Accounting and Accounting Standards · PDF fileBonds payable 100,000 Issuing Bonds...

10-2

Chapter 10 Liabilities

Learning Objectives

After studying this chapter, you should be able to:

1. Explain a current liability, and identify the major types of current

liabilities.

2. Describe the accounting for notes payable.

3. Explain the accounting for other current liabilities.

4. Explain why bonds are issued, and identify the types of bonds.

5. Prepare the entries for the issuance of bonds and interest expense.

6. Describe the entries when bonds are redeemed.

7. Describe the accounting for long-term notes payable.

8. Identify the methods for the presentation and analysis of non-current

liabilities.

10-3

Preview of Chapter 10

Financial Accounting

IFRS Second Edition

Weygandt Kimmel Kieso

10-4

Current liability

A debt that the company expects to pay within one

year or the operating cycle, whichever is longer.

Most companies pay current liabilities by using current

assets.

LO 1 Explain a current liability, and identify the

major types of current liabilities.

Current liabilities include notes payable, accounts payable, unearned

revenues, and accrued liabilities such as taxes, salaries and wages, and

interest payable.

Current Liabilities

10-5 LO 2 Describe the accounting for notes payable.

Notes Payable

Recorded obligation in the form of written notes.

Usually require the borrower to pay interest.

Issued for varying periods of time.

Those due for payment within one year of the statement

of financial position date are usually classified as current

liabilities.

Current Liabilities

10-6

Illustration: Hong Kong National Bank agrees to lend

HK$100,000 on September 1, 2014, if C.W. Co. signs a

HK$100,000, 12%, four-month note maturing on January 1.

Instructions

a) Prepare the journal entry on September 1.

b) Prepare the adjusting journal entry on December 31,

assuming monthly adjusting entries have not been made.

c) Prepare the journal entry at maturity (January 1, 2015).

LO 2 Describe the accounting for notes payable.

Current Liabilities

10-7

Notes payable 100,000

Cash 100,000

Interest payable 4,000

Interest expense 4,000

HK$100,000 x 12% x 4/12 = HK$4,000

b) Prepare the adjusting journal entry on Dec. 31.


Current Liabilities




a) Prepare the journal entry on September 1.

10-8


Notes payable 100,000

Cash 104,000


Current Liabilities




c) Prepare the journal entry at maturity (January 1, 2015).

10-9 LO 3 Explain the accounting for other current liabilities.

Sales Tax Payable

Sales taxes are expressed as a stated percentage of

the sales price.

Either rung up separately or included in total receipts.

Retailer collects tax from the customer.

Retailer remits the collections to the government’s

department of revenue.

Current Liabilities

10-10

Illustration: The March 25 cash register reading for Cooley

Grocery shows sales of NT$10,000 and sales taxes of NT$600

(sales tax rate of 6%), the journal entry is:

Sales revenue 10,000

Cash 10,600

Sales tax payable 600

LO 3 Explain the accounting for other current liabilities.

Current Liabilities

10-11 LO 3 Explain the accounting for other current liabilities.

Unearned Revenue

Revenues that are received before the company delivers goods

or provides services.

1. Company debits Cash, and credits

a current liability account

(Unearned Revenue).

2. When the company earns the

revenue, it debits the

Unearned Revenue account, and

credits a Revenue account.

Current Liabilities

10-12

Illustration: Busan IPark (KOR) sells 10,000 season football

tickets at W 50,000 each for its five-game home schedule. The

club makes the following entry for the sale of season tickets (in

thousands of W):


Unearned ticket revenue 500,000

Cash 500,000 Aug. 6

Ticket revenue 100,000

Unearned ticket revenue 100,000 Sept. 7

As each game is completed, Busan IPark records the revenue

earned.

Current Liabilities

10-13

Current Maturities of Long-Term Debt

Portion of long-term debt that comes due in the

current year.

Considered a current liability.

No adjusting journal entry required.


Current Liabilities

10-14

Current liabilities are presented after non-current

liabilities on the statement of financial position.

A common method of presenting current liabilities is to

list them by order of magnitude, with the largest ones

first.

Presentation

Statement Presentation and Analysis


10-15


Illustration 10-3


10-16

Liquidity refers to the

ability to pay maturing

obligations and meet

unexpected needs for

cash.

The current ratio

permits us to compare

the liquidity of different-

sized companies and of

a single company at

different times.

Illustration 10-5

Illustration 10-4


Analysis


10-17

The Missing Control

Human Resource Controls. Thorough background checks should be

performed. No employees should begin work until they have been approved by

the Board of Education and entered into the payroll system. No employees

should be entered into the payroll system until they have been approved by a

supervisor. All paychecks should be distributed directly to employees at the

official school locations by designated employees.

Independent internal verification. Budgets should be reviewed monthly to

identify situations where actual costs significantly exceed budgeted amounts.

Total take: $150,000

ANATOMY OF A FRAUD

Art was a custodial supervisor for a large school district. The district was

supposed to employ between 35 and 40 regular custodians, as well as 3 or 4

substitute custodians to fill in when regular custodians were missing. Instead, in

addition to the regular custodians, Art “hired” 77 substitutes. In fact, almost

none of these people worked for the district. Instead, Art submitted time cards

for these people, collected their checks at the district office, and personally

distributed the checks to the “employees.” If a substitute’s check was for

$1,200, that person would cash the check, keep $200, and pay Art $1,000.

10-18

A form of interest-bearing notes payable.

To obtain large amounts of long-term capital.

Three advantages over ordinary shares:

1. Shareholder control is not affected.

2. Tax savings result.

3. Earnings per share may be higher.

LO 4 Explain why bonds are issued, and identify the types of bonds.

Non-Current Liabilities

Bond Basics

Obligations that are expected to be paid after one year.

10-19

Effects on earnings per share—equity vs. debt.

Illustration 10-7


Bond Basics

10-20

Types of Bonds

LO 4

Bond Basics

10-21

Government laws grant corporations power to issue

bonds.

Board of directors and shareholders must approve bond

issues.

Board of directors must stipulate number of bonds to be

authorized, total face value, and contractual interest rate.

Terms of the bond are set forth in a legal document called

a bond indenture.

Issuing company arranges for printing of bond

certificates.

Bond Basics

Issuing Procedures


10-22

Represents a promise to pay:

► face value at designated maturity date, plus

► periodic interest at a contractual (stated) interest

rate on the maturity amount (face value).

Interest payments usually made semiannually.

Generally issued when the amount of capital needed is

too large for one lender to supply.

Bond Basics

Issuing Procedures


10-23

Maturity

Date

Illustration 10-8

Contractual

Interest

Rate

Face or

Par Value

DUE 2017 DUE 2017

2017

LO 4

Issuer of

Bonds

Bond Basics

10-24

Bond Trading

Bond Basics

Bondholders can sell their bonds, at any time, at the

current market price on national securities exchanges.

Bond prices are quoted as a percentage of the face value.


Application

$952.50 $1,018.75

(2) What is the price of a $1,000 bond trading at 101 7/8?

Application

(1) What is the price of a $1,000 bond trading at 95 1/4?

10-25

Bond Trading

Bond Basics




Newspapers and the financial press publish bond prices

and trading activity daily.


Illustration 10-9

10-26

Bond Trading

Bond Basics




Newspapers and the financial press publish bond prices

and trading activity daily.

A corporation makes journal entries only when it issues

or buys back bonds, or when bondholders exchange

convertible bonds into ordinary shares.


10-27

Determining the Market Value of Bonds

The features of a bond (callable, convertible, and so on) affect the

market rate of the bond.

Bond Basics

Market value is a function of the three factors that determine

present value:

1. amounts to be received,

2. length of time until the amounts are received, and

3. market rate of interest.


10-29

Corporation records bond transactions when it

issues (sells),

retires (buys back) bonds and

when bondholders convert bonds into ordinary shares.

NOTE: If bondholders sell their bond investments to other investors,

the issuing firm receives no further money on the transaction, nor

does the issuing corporation journalize the transaction.

Accounting for Bond Issues

LO 5 Prepare the entries for the issuance of bonds and interest expense.

10-30

Issue at Par, Discount, or Premium?



Illustration 10-10

Bond

Contractual

Interest Rate

of 10%

10-31

Illustration: On January 1, 2014, Candlestick Inc. issues

€100,000, five-year, 10% bonds at 100 (100% of face value).

The entry to record the sale is:


Jan. 1 Cash 100,000

Bonds payable 100,000

Issuing Bonds at Face Value


10-32

Illustration: On January 1, 2014, Candlestick Inc. issues

€100,000, five-year, 10% bonds at 100 (100% of face value).

Assume that interest is payable semiannually on January 1 and

July 1. Prepare the entry to record the payment of interest on

July 1, 2014, assume no previous accrual.


July 1 Interest expense 5,000

Cash 5,000


(€100,000 x 10% x 6/12)

10-33

Illustration: On January 1, 2014, Candlestick Corporation

issues €100,000, five-year, 10% bonds at 100 (100% of face

value). Assume that interest is payable semiannually on

January 1 and July 1. Prepare the entry to record the accrual

of interest on December 31, 2014, assume no previous

accrual.


Dec. 31 Interest expense 5,000



10-34 LO 5 Prepare the entries for the issuance of bonds and interest expense.

Illustration: On January 1, 2014, Candlestick, Inc. sells

€100,000, five-year, 10% bonds for €92,639 (92.639% of face

value). Interest is payable on July 1 and January 1. The entry

to record the issuance is:

Jan. 1 Cash 92,639



Issuing Bonds at a Discount

10-35

The issuance of bonds below face value—at a discount—causes the

total cost of borrowing to differ from the bond interest paid.

The reason: Borrower is required to pay the difference between the

issuance price and face value—the discount—at the maturity date.

Thus, the discount is considered to be an additional cost of

borrowing.

Statement Presentation


Illustration 10-11


Carrying value or

book value


Total Cost of Borrowing

Illustration 10-12

Illustration 10-13



Jan. 1 Cash 108,111


Illustration: On January 1, 2014, Candlestick, Inc. sells

€100,000, five-year, 10% bonds for €108,111 (108.111% of

face value). Interest is payable on July 1 and January 1. The

entry to record the issuance is:


Issuing Bonds at a Premium

10-38

Statement Presentation


The sale of bonds above face value causes the total cost of borrowing

to be less than the bond interest paid.

The reason: The borrower is not required to pay the bond premium at

the maturity date of the bonds. Thus, the bond premium is considered

to be a reduction in the cost of borrowing.

Illustration 10-14



Total Cost of Borrowing

Illustration 10-15

Illustration 10-16


10-40 LO 6 Describe the entries when bonds are redeemed.

Assuming that the company pays and records separately the

interest for the last interest period, Candlestick records the

redemption of its bonds at maturity as follows:

Bond payable 100,000

Cash 100,000

Accounting for Bond Retirements

Redeeming Bonds at Maturity

10-41

When bonds are retired before maturity, it is necessary to:

1. eliminate carrying value of bonds at redemption date;

2. record cash paid; and

3. recognize gain or loss on redemption.

The carrying value of the bonds is the face value of the bonds

adjusted for the bond discount or bond premium amortized up to the

redemption date.

LO 6 Describe the entries when bonds are redeemed.


Redeeming Bonds before Maturity

10-42

Illustration: Candlestick, Inc. has sold its bonds at a premium.

At the end of the eighth period, Candlestick retires these bonds

at 103 after paying the semiannual interest. The carrying value

of the bonds at the redemption date is €101,623. Candlestick

makes the following entry to record the redemption at the end

of the eighth interest period (January 1, 2018):


Loss on bond redemption 1,377

Cash 103,000

LO 6 Describe the entries when bonds are redeemed.


10-43

May be secured by a mortgage that pledges title to specific

assets as security for a loan.

Typically, terms require borrower to make installment

payments over the term of the loan. Each payment consists of

interest on the unpaid balance of the loan and

a reduction of loan principal.

Companies initially record mortgage notes payable at face

value.

LO 7 Describe the accounting for long-term notes payable.

Accounting for Long-Term Notes Payable

10-44

Illustration: Mongkok Technology Inc. issues a HK$500,000,

12%, 20-year mortgage note on December 31, 2014. The terms

provide for semiannual installment payments of HK$33,231. The

installment payment schedule for the first two years is as follows.

LO 7 Describe the accounting for long-term notes payable.

Illustration 10-17

Accounting for Other Long-Term Liabilities

10-45 LO 7 Describe the accounting for long-term notes payable.

Dec. 31 Cash 500,000

Mortgage payable 500,000

Jun. 30 Interest expense 30,000

Mortgage payable 3,231

Cash 33,231

Accounting for Other Long-Term Liabilities

Illustration: Mongkok Technology Inc. issues a HK$500,000,

12%, 20-year mortgage note on December 31, 2014. The terms

provide for semiannual installment payments of HK$33,231. The

installment payment schedule for the first two years is as follows.

10-47 LO 8 Identify the methods for the presentation

and analysis of non-current liabilities.

Illustration 10-18


Presentation

10-48

Two ratios that provide information about debt-paying

ability and long-run solvency are:

Debt to Total Assets Ratio

Times Interest Earned Ratio

LO 8 Identify the methods for the presentation

and analysis of non-current liabilities.


Analysis

10-49

Illustration: LG’s (KOR) had total liabilities of 39,048 billion, total

assets of 64,782 billion, interest expense of 778 billion, income

taxes of 1,092 billion, and net income of 2,967 billion.

LG has a relatively high debt to total assets percentage of 60.3%. Its

interest coverage of 6.22 times is considered safe.

LO 8


Analysis

Illustration 10-19

10-51

Illustration: Assume that you are willing to invest a sum of

money that will yield HK$1,000 at the end of one year, and you

can earn 10% on your money. What is the HK$1,000 worth

today?

To compute the answer,

1. divide the future amount by 1 plus the interest rate

(HK$1,000/1.10 = HK$909.09 OR

2. use a Present Value of 1 table. (HK$1,000 X .90909) =

HK$909.09 (10% per period, one period from now).

LO 9 Compute the market price of a bond.

Present Value of Face Value

APPENDIX 10A PRESENT VALUE CONCEPTS RELATED TO BOND PRICING

10-52


1. divide the future amount by 1 plus the interest rate

(HK$1,000/1.10 = HK$909.09.

Illustration 10A-1



10-53 LO 9 Compute the market price of a bond.



2. use a Present Value of 1 table. (HK$1,000 X .90909)

= HK$909.09 (10% per period, one period from now).

10-54

The future amount (HK$1,000), the interest rate (10%), and

the number of periods (1) are known


Illustration 10A-2


10-55

If you are to receive the single future amount of HK$1,000 in

two years, discounted at 10%, its present value is

HK$826.45 [($1,000 1.10) 1.10].



Illustration 10A-3

10-56

To compute the answer using a Present Value of 1 table.

(HK$1,000 X .82645) = HK$826.45 (10% per period, two

periods from now).



10-57

In addition to receiving the face value of a bond at maturity,

an investor also receives periodic interest payments

(annuities) over the life of the bonds.

To compute the present value of an annuity, we need to

know:

1) interest rate,

2) number of interest periods, and

3) amount of the periodic receipts or payments.


Present Value of Interest Payments (Annuities)

10-58

Assume that you will receive HK$1,000 cash annually for

three years and the interest rate is 10%.


Illustration 10A-5



Illustration 10A-6





HK$1,000 annual payment x 2.48685 = HK$2,486.85




10-61

Selling price of a bond is equal to the sum of:

Present value of the face value of the bond discounted

at the investor’s required rate of return

PLUS

Present value of the periodic interest payments

discounted at the investor’s required rate of return


Computing the Present Value of a Bond

10-62

Assume a bond issue of 10%, five-year bonds with a face value

of €100,000 with interest payable semiannually on January 1

and July 1. Illustration 10A-8


Computing the Market Price of a Bond

10-63

Illustration 10A-9





and July 1.

10-66

Under the effective-interest method, the amortization of

bond discount or bond premium results in period interest

expense equal to a constant percentage of the carrying value

of the bonds.

Required steps under the effective-interest method:

LO 10 Apply the effective-interest method of amortizing

bond discount and bond premium.

APPENDIX 10B EFFECTIVE-INTEREST METHOD OF BOND AMORTIZATION

Illustration 10B-1

10-67

Illustration: Candlestick, Inc. issues €100,000 of 10%, five-year

bonds on January 1, 2014, for €92,639, with interest payable each

July 1 and January 1. This results in a discount of €7,361.

Illustration 10B-2

LO 10

Effective-Interest Method of Bond Amortization

Amortizing Bond Discount

10-68



July 1 and January 1. This results in a discount of €7,361.

Journal entry on July 1, 2014, to record the interest payment and

amortization of discount is as follows:

Interest Expense 5,558

Bonds Payable 558

Cash 5,000

July 1




10-69

Illustration 10B-4



July 1 and January 1. This results in a premium of €8,111.

Amortizing Bond Premium



10-70


Cash 5,000

Bonds Payable 676

July 1



July 1 and January 1. This results in a premium of €8,111.


amortization of premium is as follows:




10-71

The effective-interest method is the method required by IFRS to

determine amortized cost. Under U.S. GAAP, companies are

allowed to use straight-line amortization when the results do

not differ materially from the effective-interest method.


LO 11

APPENDIX 10C STRAIGHT-LINE AMORTIZATION

Illustration 10C-1

10-72

Illustration: Candlestick, Inc., sold €100,000, five-year, 10%

bonds on January 1, 2014, for €92,639 (discount of €7,361).

Interest is payable on July 1 and January 1.


LO 11

APPENDIX 10C STRAIGHT-LINE AMORTIZATION

Illustration 10C-2

10-73


bonds on January 1, 2014, for €92,639 (discount of €7,361).

Interest is payable on July 1 and January 1. The bond discount

amortization for each interest period is €736 (€7,361÷10).


amortization of discount is as follows:


Cash 5,000

Bonds Payable 736

July 1


LO 11 Apply the straight-line method of amortizing


10-74


bonds on January 1, 2014, for €108,111 (premium of €8,111).

Interest is payable on July 1 and January 1.

Illustration 10C-4




10-75


bonds on January 1, 2014, for €108,111 (premium of €8,111).

Interest is payable on July 1 and January 1. The bond premium

amortization for each interest period is €811 (€8,111÷10).


amortization of premium is as follows:


Cash 5,000

Bonds Payable 811

July 1




10-76

Every employer incurs liabilities relating to employees’

salaries and wages.

Salaries and Wages Payable — amounts owed to

employees.

Withholding taxes (U.S. federal and state income

taxes, and Social Security taxes) — amounts owed to

the governmental taxing authorities.

Determining the payroll involves computing three amounts: (1)

gross earnings, (2) payroll deductions, and (3) net pay.

LO 12 Prepare entries for payroll and payroll taxes under U.S. law.

APPENDIX 10D PAYROLL-RELATED LIABILITIES

10-77

Illustration: Assume a corporation records its payroll for the

week of March 7 as follows:

Salaries and wages expense 100,000

Federal income tax payable 21,864

FICA tax payable 7,650

State income tax payable 2,922

Salaries and wages payable 67,564

LO 12

Cash 67,564

Salaries and wages payable 67,564 Mar. 11

Record the payment of this payroll on March 11.

Mar. 7

Payroll-Related Liabilities

10-78

Payroll tax expense results from three taxes that

governmental agencies levy on employers.

These taxes are:

FICA tax

Federal unemployment tax

State unemployment tax



10-79

Illustration: Based on the corporation’s $100,000 payroll, the

company would record the employer’s expense and liability

for these payroll taxes as follows.

Payroll tax expense 13,850

Federal unemployment tax payable 800

FICA tax payable 7,650

State unemployment tax payable 5,400



10-80

Key Points

The basic definition of a liability under GAAP and IFRS is very

similar. Liabilities may be legally enforceable via a contract or law

but need not be; that is, they can arise due to normal business

practice or customs.

Both GAAP and IFRS classify liabilities as current or non-current on

the face of the statement of financial position. IFRS specifically

states, however, that industries where a presentation based on

liquidity would be considered to provide more useful information

(such as financial institutions) can use that format instead.

Another Perspective

10-81

Key Points

Under IFRS, companies sometimes show liabilities before assets.

Also, they will sometimes show non-current liabilities before current

liabilities. Neither of these presentations is used under GAAP.

Under IFRS, companies sometimes will net current liabilities against

current assets to show working capital on the face of the statement

of financial position. This practice is not used under GAAP.

The basic calculation for bond valuation is the same under GAAP

and IFRS. In addition, the accounting for bond liability transactions is

essentially the same between GAAP and IFRS.

Another Perspective

10-82

Key Points

IFRS requires use of the effective-interest method for amortization of

bond discounts and premiums. GAAP allows use of the straight-line

method where the difference is not material.

GAAP often uses a separate discount or premium account to

account for bonds payable. IFRS records discounts or premiums as

direct increases or decreases to Bonds Payable.

The accounting for convertible bonds differs between IFRS and

GAAP. GAAP requires that the proceeds from the issuance of

convertible debt be shown solely as debt. Unlike GAAP, IFRS splits

the proceeds from the convertible bond between an equity

component and a debt component. The equity conversion rights are

reported in equity.

Another Perspective

10-83

Key Points

IFRS reserves the use of the term contingent liability to refer only to

possible obligations that are not recognized in the financial

statements but may be disclosed if certain criteria are met. Under

GAAP, contingent liabilities are recorded in the financial statements

if they are both probable and can be reasonably estimated. If only

one of these criteria is met, then the item is disclosed in the notes.

IFRS uses the term provisions to refer to liabilities of uncertain

timing or amount. Examples of provisions would be provisions for

warranties, employee vacation pay, or anticipated losses. Under

GAAP, these are considered recordable contingent liabilities.

Another Perspective

10-84

Looking to the Future

The FASB and IASB are currently involved in two projects, each of

which has implications for the accounting for liabilities. One project is

investigating approaches to differentiate between debt and equity

instruments. The other project, the elements phase of the conceptual

framework project, will evaluate the definitions of the fundamental

building blocks of accounting. The results of these projects could

change the classification of many debt and equity securities.

Another Perspective

10-85

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