15-1. 15-2 Chapter 10 Liabilities Learning Objectives After studying this chapter, you should be able to: 1.Explain a current liability, and identify.

15-1

15-2

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 or converted.

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

8. Identify the methods for the presentation and analysis of long-term

liabilities.

15-3

Preview of Chapter 10

Financial and Managerial Accounting

Weygandt Kimmel Kieso

15-4

Current liability is debt with two key features:

1. Company expects to pay the debt from existing

current assets or through the creation of other current

liabilities.

2. Company will pay the debt within one year or the

operating cycle, whichever is longer.

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 payable, salaries payable, and interest payable.

Current Liabilities

15-5

To be classified as a current liability, a debt must be

expected to be paid:

a. out of existing current assets.

b. by creating other current liabilities.

c. within 2 years.

d. both (a) and (b).

Question

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

Current Liabilities

15-6 LO 2 Describe the accounting for notes payable.

Notes Payable

Written promissory note.

Require the borrower to pay interest.

Issued for varying periods.

Current Liabilities

15-7

Illustration: First National Bank agrees to lend $100,000 on

September 1, 2014, if Cole Williams Co. signs a $100,000,12%, four-month note maturing on January 1.

Instructions

a) Prepare the entry on September 1.

b) Prepare the adjusting entry on December 31, assuming

monthly adjusting entries have not been made.

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

LO 2 Describe the accounting for notes payable.

Current Liabilities

15-8

Notes payable

100,000

Cash 100,000

Interest payable

4,000

Interest expense 4,000

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

b) Prepare the adjusting entry on Dec. 31.


Current Liabilities



a) Prepare the entry on September 1.

15-9

Interest payable 4,000

Notes payable 100,000

Cash

104,000


Current Liabilities



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

15-10 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 state’s department

of revenue.

Current Liabilities

15-11

Illustration: The March 25 cash register reading for Cooley

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

15-12

The term “payroll” pertains to both:

Salaries - managerial, administrative, and sales

personnel (monthly or yearly rate).

Wages - store clerks, factory employees, and manual

laborers (rate per hour).

Determining the payroll involves computing three amounts: (1)

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


Payroll and Payroll Taxes Payable

Current Liabilities

15-13

Illustration: Assume a corporation records its payroll for the

week of March 7 as follows:

Salaries and wages expense 100,000

Federal income tax payable21,864

FICA tax payable7,650

State income tax payable2,922Salaries and wages payable

67,564

LO 3

Cash

67,564

Salaries and wages payable 67,564Mar. 11

Record the payment of this payroll on March 11.

Mar. 7

Current Liabilities

15-14

Payroll tax expense results from three taxes that

governmental agencies levy on employers.

These taxes are:

FICA tax

Federal unemployment tax

State unemployment tax


Current Liabilities

15-15

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 payable800

FICA tax payable7,650

State unemployment tax payable 5,400


Current Liabilities

15-16

Employer payroll taxes do not include:

a. Federal unemployment taxes.

b. State unemployment taxes.

c. Federal income taxes.

d. FICA taxes.

Question

Current Liabilities


15-17

15-18 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

15-19

Illustration: Assume that Superior University sells 10,000 season football tickets at $50 each for its five-game home schedule. The university makes the following entry for the sale of season tickets:


Unearned revenue

500,000

Cash 500,000Aug. 6

Ticket revenue

100,000

Unearned revenue 100,000Sept. 7

As the school completes each of the five home games, it would record the revenue earned.

Current Liabilities

15-20

Current Maturities of Long-Term Debt

Portion of long-term debt that comes due in the

current year.

No adjusting entry required.


Current Liabilities

15-21LO 3

Statement Presentation and Analysis

Illustration 10-5

15-22

Working capital is calculated as:

a. current assets minus current liabilities.

b. total assets minus total liabilities.

c. long-term liabilities minus current liabilities.

d. both (b) and (c).

Question

Current Liabilities


15-23

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 10-7

Illustration 10-6


Analysis


15-24

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.

15-25

A form of interest-bearing notes payable.

To obtain large amounts of long-term capital.

Three advantages over common stock:

1. Stockholder 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.

Long-Term Liabilities

Bond Basics

15-26

Effects on earnings per share—stocks vs. bonds.

Illustration 10-9


Bond Basics

15-27

The major disadvantages resulting from the use of bonds

are:

a. that interest is not tax deductible and the principal

must be repaid.

b. that the principal is tax deductible and interest must

be paid.

c. that neither interest nor principal is tax deductible.

d. that interest must be paid and principal repaid.

Question

Current Liabilities


15-28

Types of Bonds

LO 4

Bond Basics

15-29

State laws grant corporations the power to issue bonds.

Board of directors and stockholders must approve bond

issues.

Board of directors must stipulate number of bonds to be

authorized, total face value, and contractual interest rate.

Bond contract known as a bond indenture.

Paper certificate, typically a $1,000 face value.

Bond Basics

Issuing Procedures


15-30

Represents a promise to pay:

► sum of money at designated maturity date, plus

► periodic interest at a contractual (stated) 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


15-31

MaturityDate

MaturityDate

Illustration 10-10

Contractual Interest

Rate

Contractual Interest

Rate

Face or Par ValueFace or

Par Value

DUE 2017 DUE 2017

2017

LO 4

Issuer of Bonds

Issuer of Bonds

Bond Basics

15-32

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. dollar amounts to be received,

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

3. market rate of interest.


15-33

Corporation records bond transactions when it

issues (sells),

retires (buys back) bonds and

when bondholders convert bonds into common stock.

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.

15-34

Issue at Par, Discount, or Premium?



Illustration 10-12

Bond

Contractual

Interest Rate

of 10%

15-35 LO 5 Prepare the entries for the issuance of bonds and interest expense.

The rate of interest investors demand for loaning funds to

a corporation is the:

a. contractual interest rate.

b. face value rate.

c. market interest rate.

d. stated interest rate.


Question


Karson Inc. issues 10-year bonds with a maturity value of $200,000. If the bonds are issued at a premium, this indicates that:

a. the contractual interest rate exceeds the market interest rate.

b. the market interest rate exceeds the contractual interest rate.

c. the contractual interest rate and the market interest rate are the same.

d. no relationship exists between the two rates.

Question


15-37

Illustration: On January 1, 2014, Candlestick Corporation

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


15-38



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


15-39



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

Interest payable 5,000



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

Discount on bonds payable 7,361

Bond payable 100,000


Issuing Bonds at a Discount

15-41

Sale of bonds below face value causes the total cost of borrowing

to be more than the bond interest paid.

The reason: Borrower is required to pay the bond discount at the

maturity date. Thus, the bond discount is considered to be a

increase in the cost of borrowing.

Statement Presentation


Illustration 10-13


Carrying value or book value


Total Cost of Borrowing

Illustration 10-14

Illustration 10-15


15-43

Discount on Bonds Payable:

a. has a credit balance.

b. is a contra account.

c. is added to bonds payable on the balance sheet.

d. increases over the term of the bonds.



Question


Jan. 1 Cash 108,111


Premium on bond payable 8,111

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

15-45

Statement Presentation


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 10-16



Total Cost of Borrowing

Illustration 10-17

Illustration 10-18


15-47 LO 6 Describe the entries when bonds are redeemed or converted.

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

15-48

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 less unamortized bond discount or plus unamortized bond premium at the redemption date.

LO 6 Describe the entries when bonds are redeemed or converted.


Redeeming Bonds before Maturity

15-49 LO 6 Describe the entries when bonds are redeemed or converted.

When bonds are redeemed before maturity, the gain or

loss on redemption is the difference between the cash

paid and the:

a. carrying value of the bonds.

b. face value of the bonds.

c. original selling price of the bonds.

d. maturity value of the bonds.


Question

15-50

Illustration: Assume 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):Bonds payable 100,000

Premium on bonds payable 1,623

Loss on bond redemption 1,377

Cash 103,000



15-51

Until conversion, the bondholder receives interest on the

bond.

For the issuer, the bonds sell at a higher price and pay a

lower rate of interest than comparable debt securities without

the conversion option.

Upon conversion, the company transfers the carrying value of

the bonds to paid-in capital accounts. No gain or loss is

recognized.



Converting Bonds into Common Stock

15-52

Illustration: On July 1 Saunders Associates converts

$100,000 bonds sold at face value into 2,000 shares of $10 par

value common stock. Both the bonds and the common stock

have a market value of $130,000. Saunders makes the

following entry to record the conversion:


Common stock (2,000 x $10) 20,000

Paid-in capital in excess of par value 80,000



15-53

When bonds are converted into common stock:

a. a gain or loss is recognized.

b. the carrying value of the bonds is transferred to

paid-in capital accounts.

c. the market price of the stock is considered in the

entry.

d. the market price of the bonds is transferred to

paid-in capital.

Question



15-54

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

15-55

Illustration: Porter Technology Inc. issues a $500,000, 12%, 20-

year mortgage note on December 31, 2014. The terms provide for

semiannual installment payments of $33,231 (not including real

estate taxes and insurance). The installment payment schedule

for the first two years is as follows.


Illustration 10-19

Accounting for Other Long-Term Liabilities

15-56 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


Illustration: Porter Technology Inc. issues a $500,000, 12%, 20-

year mortgage note on December 31, 2014. The terms provide for

semiannual installment payments of $33,231 (not including real

estate taxes and insurance). The installment payment schedule

for the first two years is as follows.

15-57

Each payment on a mortgage note payable consists of:

a. interest on the original balance of the loan.

b. reduction of loan principal only.

c. interest on the original balance of the loan and

reduction of loan principal.

d. interest on the unpaid balance of the loan and

reduction of loan principal.



Question

15-58

15-59LO 8 Identify the methods for the presentation

and analysis of long-term liabilities.

Illustration 10-20


Presentation

15-60

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 long-term liabilities.


Analysis

15-61

Illustration: Kellogg had total liabilities of $8,925 million, total assets

of $11,200 million, interest expense of $295 million, income taxes of

$476 million, and net income of $1,208 million.

The higher the percentage of debt to total assets, the greater the risk

that the company may be unable to meet its maturing obligations.

LO 8


Analysis

15-62

Illustration: Kellogg had total liabilities of $8,925 million, total assets

of $11,200 million, interest expense of $295 million, income taxes of

$476 million, and net income of $1,208 million.

Times interest earned indicates the company’s ability to meet interest

payments as they come due.

LO 8


Analysis

15-63

15-64

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

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

earn 10% on your money. What is the $1,000 worth today?

To compute the answer,

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

($1,000/1.10 = $909.09 OR

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

15-65


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

($1,000/1.10 = $909.09.

Illustration 10A-1



15-66 LO 9 Compute the market price of a bond.



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

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

15-67

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

number of periods (1) are known


Illustration 10A-2


15-68

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

two years, discounted at 10%, its present value is $826.45

[($1,000 1.10) 1.10].


Illustration 10A-3


15-69

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

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

from now).



15-70

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)

15-71

Assume that you will receive $1,000 cash annually for three years and the interest rate is 10%.


Illustration 10A-5



Illustration 10A-6




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



15-74

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

15-75

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



15-76

Illustration 10A-9





and July 1.











15-79

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:

LO 10 Apply the effective-interest method of amortizing bond discount and bond premium.

1. Compute the bond interest expense.

2. Compute the bond interest paid or accrued.

3. Compute the amortization amount.

APPENDIX 10B EFFECTIVE-INTEREST METHOD OF BOND AMORTIZATION

15-80

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


Effective-Interest Method of Bond Amortization

Amortizing Bond Discount

15-81


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.

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

amortization of discount is as follows:

Interest Expense 5,558

Cash 5,000

Discount on Bonds Payable 558

July 1



15-82

Illustration 10B-4


bonds on January 1, 2014, for $108,111, with interest payable

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

Amortizing Bond Premium


15-83


Cash 5,000

Premium on Bonds Payable 676

July 1


bonds on January 1, 2014, for $108,111, with interest payable

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


amortization of premium is as follows:



15-84

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.

Illustration 10C-2


LO 11 Apply the straight-line method of amortizing bond discount and bond premium.

APPENDIX 10B STRAIGHT-LINE AMORTIZATION

15-85


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

Discount on Bonds Payable 736

July 1



15-86


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

Interest is payable on July 1 and January 1.

Illustration 10C-4



15-87


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

Premium on Bonds Payable 811

July 1



15-88

Liabilities are defined by the IASB as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. 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.

IFRS requires that companies classify liabilities as current or non-current on the face of the statement of financial position (balance sheet), except in industries where a presentation based on liquidity would be considered to provide more useful information (such as financial institutions). When current liabilities (also called short-term liabilities) are presented, they are generally presented in order of liquidity.

Key Points

15-89

Under IFRS, liabilities are classified as current if they are expected to be paid within 12 months.

Similar to GAAP, items are normally reported in order of liquidity. Companies sometimes show liabilities before assets. Also, they will sometimes show non-current (long-term) liabilities before current liabilities.

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 is evident in the Zetar financial statements in Appendix C.)

The basic calculation for bond valuation is the same under GAAP and IFRS.

Key Points

15-90

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. Under IFRS, companies do not use a premium or discount account but instead show the bond at its net amount. For example, if a $100,000 bond was issued at 97, under IFRS a company would record:

Cash 97,000


Key Points

15-91

The accounting for convertible bonds differs across IFRS and GAAP, 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.

Key Points

15-92

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.

Looking to the Future

15-93

Which of the following is false?

a) Under IFRS, current liabilities must always be presented

before noncurrent liabilities.

b) Under IFRS, an item is a current liability if it will be paid

within the next 12 months.

c) Under IFRS, current liabilities are shown in order of liquidity.

d) Under IFRS, a liability is only recognized if it is a present

obligation.

IFRS Self-Test Questions

15-94

The accounting for bonds payable is:

a) essentially the same under IFRS and GAAP.

b) differs in that GAAP requires use of the straight-line method

for amortization of bond premium and discount.

c) the same except that market prices may be different because

the present value calculations are different between IFRS and

GAAP.

d) not covered by IFRS.


15-95

The joint projects of the FASB and IASB could potentially:

a) change the definition of liabilities.

b) change the definition of equity.

c) change the definition of assets.

d) All of the above.


15-96

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15-1. 15-2 Chapter 10 Liabilities Learning Objectives After studying this chapter, you should be able to: 1.Explain a current liability, and identify.

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