ch10: liabilities kieso

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Chapter 10

Liabilities

Financial Accounting, IFRS EditionWeygandt Kimmel Kieso

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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.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

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Current LiabilitiesCurrent LiabilitiesCurrent LiabilitiesCurrent Liabilities

Notes payableNotes payable

Sales taxes payableSales taxes payable

Unearned revenuesUnearned revenues

Current maturities of long-Current maturities of long-

term debtterm debt

Statement presentation Statement presentation

and analysisand analysis

Bond basicsBond basics

Accounting for bond issuesAccounting for bond issues

Accounting for bond Accounting for bond

retirementsretirements

Accounting for long-term Accounting for long-term

notes payablenotes payable

Statement presentation and Statement presentation and

analysisanalysis

Non-Current LiabilitiesNon-Current LiabilitiesNon-Current LiabilitiesNon-Current Liabilities

LiabilitiesLiabilitiesLiabilitiesLiabilities

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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.

What is a Current Liability?What is a Current Liability?What is a Current Liability?What is a Current Liability?

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

Section 1 Section 1 Current LiabilitiesCurrent Liabilities

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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).

QuestionQuestion

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


7 SO 2 Describe the accounting for notes payable.SO 2 Describe the accounting for notes payable.

Notes Payable

Written promissory note.

Require the borrower to pay interest.

Issued for varying periods.


8

Illustration: On March 1, 2011, Cole Williams borrows

$100,000 from First National Bank on a 4-month, 12% note.

Instructions

a) Prepare the entry on March 1.

b) Prepare the adjusting entry on June 30, assuming

monthly adjusting entries have not been made.

c) Prepare the entry at maturity (July 1).

SO 2 Describe the accounting for notes payable.SO 2 Describe the accounting for notes payable.


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a) Prepare the entry on March 1.

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 June 30.



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c) Prepare the entry at maturity (July 1).

Interest payable 4,000

Notes payable 100,000

Cash

104,000



11 SO 3 Explain the accounting for other current liabilities.SO 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.


12

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

10,000

Cash 10,600

Sales tax payable

600

SO 3 Explain the accounting for other current liabilities.SO 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.

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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.




Illustration 10-2Unearned and earnedrevenue accounts

Unearned Revenue

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Current Maturities of Long-Term Debt

Portion of long-term debt that comes due in the current year.

No adjusting entry required.



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Illustration 10-3Statement of financial position presentation of current liabilities (in thousands)

Statement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and Analysis

Presentation


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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

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Working capital is calculated as:

a. current assets minus current liabilities.

b. total assets minus total liabilities.

c. non-current liabilities minus current liabilities.

d. both (b) and (c).

QuestionQuestion



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Bonds are a form of interest-bearing notes payable.

Three advantages over ordinary shares:

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

1. Stockholder control is not affected.

2. Tax savings result.

3. Earnings per share may be higher.

Section 2 Section 2 Non-Current LiabilitiesNon-Current Liabilities

Bond BasicsBond BasicsBond BasicsBond Basics

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Effects on earnings per share—equity vs. debt.

Illustration 10-7



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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



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Types of Bonds

Secured and Unsecured (debenture) bonds.

Term and Serial bonds.

Registered and Bearer (or coupon) bonds.

Convertible and Callable bonds.



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Issuing Procedures

Bond contract known as a bond indenture.

Represents a promise to pay:

(1) sum of money at designated maturity date, plus

(2) periodic interest at a contractual (stated) rate on the

maturity amount (face value).

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

Interest payments usually made semiannually.

Generally issued when the amount of capital needed is too

large for one lender to supply.



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Bond BasicsBond BasicsBond BasicsBond BasicsIssuer of

BondsIssuer of

Bonds

MaturityDate

MaturityDate

Illustration 10-8

Contractual Interest

Rate

Contractual Interest

Rate

Face or Par ValueFace or

Par Value

DUE 2013 DUE 2013

2013

SO 4 SO 4

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Bond Trading

Bonds traded on national securities exchanges.

Newspapers and the financial press publish bond prices and trading activity daily.

Read as: Outstanding 5.125%, $1,000 bonds that mature in 2014. Currently yield a 5.747% return. On this day, $33,965,000 of these bonds were traded. Closing price was 96.595% of face value, or $965.95.



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Determining the Market Value of Bonds

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.

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



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

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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

Accounting for Bond IssuesAccounting for Bond IssuesAccounting for Bond IssuesAccounting for Bond Issues


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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



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Illustration: On January 1, 2011, 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


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Illustration: On January 1, 2011, CandlestickCorporation issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest ispayable semiannually on January 1 and July 1. Prepare the entry to record the payment of interest on July 1, 2011, assume no previous accrual.

July 1 Bond interest expense 5,000

Cash 5,000

Issuing Bonds at Face ValueIssuing Bonds at Face ValueIssuing Bonds at Face ValueIssuing Bonds at Face Value


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Illustration: On January 1, 2011, CandlestickCorporation issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest ispayable semiannually on January 1 and July 1. Prepare the entry to record the accrual of interest on December 31, 2011, assume no previous accrual.

Dec. 31 Bond interest expense 5,000

Bond interest payable 5,000

Issuing Bonds at Face ValueIssuing Bonds at Face ValueIssuing Bonds at Face ValueIssuing Bonds at Face Value


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6%

8%

10%

Premium

Face Value

Discount

Assume Contractual Rate of 8%Assume Contractual Rate of 8%

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

Bonds Sold AtMarket Interest


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Illustration: On January 1, 2011, 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

Bond payable 92,639


Issuing Bonds at a Discount

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Statement Presentation


Issuing Bonds at a DiscountIssuing Bonds at a DiscountIssuing Bonds at a DiscountIssuing Bonds at a Discount

Illustration 10-11Statement presentation ofbonds issued at a discount

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Total Cost of Borrowing

Illustration 10-12

Illustration 10-13


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Discount on Bonds Payable:

a. has a credit balance.

b. is a contra account.

c. is added to bonds payable on the statement of

financial position.

d. increases over the term of the bonds.

Question


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Illustration: On January 1, 2011, 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:

Jan. 1 Cash 108,111



Issuing Bonds at a Premium

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Statement Presentation


Issuing bonds at an amount different from face value is quite

common. By the time a company prints the bond certificates and

markets the bonds, it will be a coincidence if the market rate and the

contractual rate are the same.

Issuing Bonds at a PremiumIssuing Bonds at a PremiumIssuing Bonds at a PremiumIssuing Bonds at a Premium

Illustration 10-14Statement presentation ofbonds issued at a premium

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Total Cost of Borrowing

Illustration 10-15

Illustration 10-16

Issuing Bonds at a PremiumIssuing Bonds at a PremiumIssuing Bonds at a PremiumIssuing Bonds at a Premium

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Redeeming Bonds at Maturity

SO 6 Describe the entries when bonds are redeemed.SO 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 RetirementsAccounting for Bond RetirementsAccounting for Bond RetirementsAccounting for Bond Retirements

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When retiring bonds before maturity, it is necessary to:

1. eliminate the carrying value of the bonds at the redemption

date;

2. record the cash paid; and

3. recognize the 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.



Redeeming Bonds before Maturity

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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



45

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, 2015):


Loss on redemption 1,377

Cash 103,000



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Long-Term Notes Payable

May be secured by a mortgage that pledges title to

specific assets as security for a loan.

Typically, terms require the borrower to make installment

payments over the term of the loan. Payment consists of

1. interest on the unpaid balance of the loan and

2. a reduction of loan principal.

Companies initially record mortgage notes payable at

face value.

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

Accounting for Long-Term Notes PayableAccounting for Long-Term Notes PayableAccounting for Long-Term Notes PayableAccounting for Long-Term Notes Payable

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

year mortgage note on December 31, 2011. 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 10-17


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

year mortgage note on December 31, 2011. 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.

Dec. 31 Cash 500,000

Mortgage notes payable 500,000

Jun. 30 Interest expense 30,000

Mortgage notes payable 3,231

Cash 33,231


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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



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Presentation

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


Illustration 10-18

52

Analysis

Two ratios that provide information about debt-paying ability and long-run solvency are:

Total debt

Total assets

Debt to total assets

=

The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations.

1.1.



53

Income before income taxes and interest expense

Interest expense =

Indicates the company’s ability to meet interest payments as they come due.

Analysis



Times Interest Earned

2.2.

54

Illustrate: LG’s (KOR) had total liabilities of W39,048

billion, total assets of W64,782 billion, interest expense of

W778 billion, income taxes of W1,092 billion, and net

income of W2,967 billion.

Analysis

Illustration 10-19



56

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.

Understanding U.S. GAAPUnderstanding U.S. GAAP

Key DifferencesKey Differences Liabilities

57

Both GAAP and IFRS classify liabilities industries where a

presentation based on liquidity would be considered to provide

more useful information (such as financial institutions) can use

that format instead.

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.



58

IFRS requires 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 GAAP accounting for leases is much more “rules-based,”

with specific bright-line criteria (such as the “90% of fair value”

test) to determine if a lease arrangement transfers the risks and

rewards of ownership; IFRS is more conceptual in its

provisions.



59

Looking to the FutureLooking to the Future


The FASB and IASB are currently involved in two projects that

have implications for the accounting for liabilities. The FASB

and IASB have identified leasing as one of the most

problematic areas of accounting. The joint project will initially

focus primarily on lessee accounting. One of the first areas to

be studied is, “What are the assets and liabilities to be

recognized related to a lease contract?” The main issue is

whether the focus should remain on the leased item or should

instead focus on the right to use the leased item. Finally, the

two standard-setting bodies are involved in a far-reaching

project to significantly change the approach used to account

for pensions.

Liabilities

60

To illustrate present value concepts, 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,

divide the future amount by 1 plus the interest rate

($1,000/1.10 = $909.09 OR

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

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

SO 9 Compute the market price of a bond.SO 9 Compute the market price of a bond.

Present Value Concepts Related to Bond PricingPresent Value Concepts Related to Bond PricingPresent Value Concepts Related to Bond PricingPresent Value Concepts Related to Bond Pricing

Appendix 10APresent Value of Face Value

61


divide the future amount by 1 plus the interest rate ($1,000/1.10 = $909.09.


Present Value of Face Value

Illustration 10A-1


62


use a Present Value of 1 table. ($1,000 X .90909) = $909.09 (10% per period, one period from now).




TABLE 10A-1

63

The future amount ($1,000), the interest rate (10%), and the number of periods (1) are known




Illustration 10A-2

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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

65

To compute the answer using a Present Value of 1 table. ($1,000 X .82645) = $826.45 (10% per period, two periods from now).




TABLE 10A-1

66

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)

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




Illustration 10A-5

68





Illustration 10A-6

69





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

TABLE 10A-2

70 SO 9 Compute the market price of a bond.SO 9 Compute the market price of a bond.


Computing the Present Value of a Bond

The selling price of a bond is equal to the sum of:

1) The present value of the face value of the bond discounted at the investor’s required rate of return

PLUS

2) The present value of the periodic interest payments discounted at the investor’s required rate of return

71

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



72


Illustration 10A-9



Contractual Rate = Discount Rate Issued at Face Value

73


Illustration 10A-10



Contractual Rate < Discount Rate Issued at a Discount

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Illustration 10A-11



Contractual Rate > Discount Rate Issued at a Premium

75

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:

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

1. Compute the bond interest expense.

2. Compute the bond interest paid or accrued.

3. Compute the amortization amount.

Effective-Interest Method of Bond AmortizationEffective-Interest Method of Bond AmortizationEffective-Interest Method of Bond AmortizationEffective-Interest Method of Bond Amortization

Appendix 10B

76

Assume Candlestick, Inc. issues $100,000 of 10%, five-year bonds

on January 1, 2011, for $92,639, with interest payable each July 1

and January 1. Illustration 10B-2

Amortizing Bond Discount

Effective-Interest Method of Bond AmortizationEffective-Interest Method of Bond AmortizationEffective-Interest Method of Bond AmortizationEffective-Interest Method of Bond Amortization

SO 10SO 10

77



and January 1.

Journal entry on July 1, 2011, to record the interest payment and

amortization of discount is as follows:

Effective-Interest Method of Bond AmortizationEffective-Interest Method of Bond Amortization


Interest Expense 5,558

Cash 5,000

Bonds Payable 558

July 1


78

Illustration 10B-4


SO 10SO 10

Amortizing Bond Premium



and January 1.

79




Cash 5,000

Bonds Payable 676

July 1




and January 1.


amortization of premium is as follows:

80

Candlestick, Inc., sold $100,000, five-year, 10% bonds on January

1, 2011, for $92,639 (discount of $7,361). Interest is payable on

July 1 and January 1. Illustration 10C-2


Straight-Line AmortizationStraight-Line Amortization

SO 11SO 11

Appendix 10C

81


1, 2011, 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).




Cash 5,000

Bonds Payable 736

July 1



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

82


1, 2011, for $108,111. Interest is payable on July 1 and January 1.

Illustration 10C-4



SO 11SO 11

83


1, 2011, for $108,111 (premium of $8,111). Interest is payable on

July 1 and January 1. The bond discount amortization for each

interest period is $811 ($8,111/10).




Cash 5,000

Bonds Payable 811

July 1



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

84

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

Payroll-Related LiabilitiesPayroll-Related LiabilitiesPayroll-Related LiabilitiesPayroll-Related Liabilities

Appendix 10D

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

85

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 payable 2,922Salaries and wages payable 67,564

Cash

67,564

Salaries and wages payable 67,564Mar. 11

Record the payment of this payroll on March 11.

Mar. 7



86

Payroll tax expense results from three taxes that

governmental agencies levy on employers.

These taxes are:

FICA tax

Federal unemployment tax

State unemployment tax



87

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



88

Employer payroll taxes do not include:

a. Federal unemployment taxes.

b. State unemployment taxes.

c. Federal income taxes.

d. FICA taxes.

Question



89

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