john wiley & sons, inc. financial a ccounting, 5e prepared by kurt m. hull, mba cpa california...

John Wiley & Sons, Inc.

Financial Accounting, 5e

Prepared byKurt M. Hull, MBA CPA

California State University, Los Angeles

Weygandt, Kieso, & Kimmel

CHAPTER 11LIABILITIESCHAPTER 11LIABILITIES

STUDY OBJECTIVES

After studying this chapter, you should understand:

Major types of

current liabilities

Entries for bond issuance

and interest expense

Accounting for

notes payable

Entries for

bond redemption

Accounting for

other current liabilities

Accounting for

long-term notes payable

The purpose of bonds,

and major types of bonds

Presentation and analysis

of long-term liabilities

Key features of a current liability: It is expected to be paid from existing current assets or

through the creation of other current liabilities

It will be paid within one year or the operating cycle, whichever is longer.

STUDY OBJECTIVE 1TYPES OF CURRENT LIABILITIES

STUDY OBJECTIVE 1TYPES OF CURRENT LIABILITIES

Notes PayableAccounts Payable

Unearned RevenuesAccrued Liabilities

STUDY OBJECTIVE 2

NOTES PAYABLESTUDY OBJECTIVE 2

NOTES PAYABLE

Key features of a note payable:

Promissory noteInterest

Notes due within a year are current liabilities

Assume First National Bank agrees to lend $100,000 on March 1, 2006, if

Cole Williams Co. 12%, 4-month note.

Date Account Titles Debit Credit

General Journal

March 1 Cash 100,000 Notes Payable 100,000

NOTES PAYABLEISSUANCE DATENOTES PAYABLE

ISSUANCE DATE

Assets received = face value of note

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

Face Valueof Note

Annual Interest

Rate

Time in Terms

of One Year

Interest

Using the Cole Williams Co. data:

INTEREST FORMULAINTEREST FORMULA

If the loan term is expressed in days, use the number of days divided by 365.

If loan term is expressed in months,

use the number of months divided by 12.

If Cole Williams Co. prepares financial statements semiannually, an adjusting entry is required to recognize

interest expense and interest payable of $4,000 at June 30.


General Journal

June 30 Interest Expense 4,000 Interest Payable 4,000

NOTES PAYABLEINTEREST ACCRUAL

NOTES PAYABLEINTEREST ACCRUAL


General Journal

July 1 Notes Payable 100,000 Interest Payable 4,000 Cash 104,000

NOTES PAYABLEMATURITY DATENOTES PAYABLE

MATURITY DATE

When the loan is paid, the FACE VALUE is

debited, any interest accrued is removed,

and cash is decreased by this combined amount.

REVIEW QUESTIONINTEREST ACCRUAL

REVIEW QUESTIONINTEREST ACCRUAL

Shari Uecker Company borrows $88,500 on September 1, 2006From Egg Harbor State Bank by signing a one year, 12% note.

What is the accrued interest at December 31, 2006?

Answer:

$88,500 x 12% x 4/12 = $3,540

Answer:

$88,500 x 12% x 4/12 = $3,540

• Sales tax is expressed as a stated percentage of the sales price on goods sold to customers by a retailer.

• The retailer collects the tax from the customer when the sale occurs. Retailer periodically remits the collections to the state’s department of revenue.

STUDY OBJECTIVE 3OTHER CURRENT LIABILITIES

SALES TAXES PAYABLE

STUDY OBJECTIVE 3OTHER CURRENT LIABILITIES

SALES TAXES PAYABLE

Retailer is a collection agent for the tax authority.

On March 25th cash register readings for Cooley Grocery show sales of $10,000 and sales taxes of $600.


General Journal

Mar. 25 Cash 10,600 Sales 10,000

Sales Tax Payable 600

SALES TAXES PAYABLESALE DATE

SALES TAXES PAYABLESALE DATE

Sales tax rate = 6%

If Cooley Grocery “rings up” total receipts

of $10,600, and the sales tax percentage

is 6%, we can figure sales as follows:

$10,600 / 1.06 = $10,000

Total receipts – Sales = Tax collected

$10,600 - $10,000 = $600

EXTRACTING SALES TAX FROM TOTAL RECEIPTS

EXTRACTING SALES TAX FROM TOTAL RECEIPTS

PAYROLL AND PAYROLL TAXES PAYABLE


Liabilities relating to employee wages and salaries include: Wages and salaries payable

Withholding taxes

(to record payment of March 7 payroll)

67,564 Cash

67,564Salaries & Wages PayableMarch 11

(record payroll & w/h taxes for week of March 7)

67,564 Salaries & Wages Payable

2,922 State Income Taxes Payable

21,864 Federal Income Taxes Payable

7,650 FICA Taxes Payable

100,000Salaries & Wages ExpenseMarch 7

CreditDebitAccountDate

PAYROLL DEDUCTIONSPAYROLL DEDUCTIONS

(record employer’s payroll taxes for week of March 7)

5,400 SUTA Taxes Payable

800 FUTA Taxes Payable

7,650 FICA Taxes Payable

13,850Payroll Tax ExpenseMarch 7




Various payroll taxes are levied upon the employer: Matching FICA taxes

Federal unemployment taxesState unemployment taxes

EMPLOYER PAYROLL TAXESEMPLOYER PAYROLL TAXES

Unearned Revenues occur when a company receives cash before a service is rendered.

Examples: Airline sells a ticket for future flights

Attorney receives legal fees before work is done.

UNEARNED REVENUESUNEARNED REVENUES

Superior University sells 10,000 season football tickets at $50 each for its five-game home schedule.


General Journal

Aug. 6 Cash 500,000 Unearned Football Ticket Revenue 500,000

UNEARNED REVENUESCASH RECEIPT

UNEARNED REVENUESCASH RECEIPT

As each game is completed, Unearned Football Ticket Revenue is debited for 1/5 of the unearned revenue. The

earned revenue, Football Ticket Revenue, is credited.


General Journal

Sept. 7 Unearned Football Ticket Revenue 100,000 Football Ticket Revenue 100,000

UNEARNED REVENUESEARNINGS DATE

UNEARNED REVENUESEARNINGS DATE

Shown below are specific unearned and earned

revenue accounts in selected types of businesses.

Type of Business Unearned Revenue Earned Revenue

AirlineUnearned passenger

Ticket RevenuePassenger Revenue

Magazine Publisher

Unearned Subscription Revenue

Subscription Revenue

HotelUnearned Rental

Revenue Rental RevenueInsurance Company

Unearned Premium Revenue Premium Revenue

Account Title

UNEARNED AND EARNEDREVENUE ACCOUNTS

UNEARNED AND EARNEDREVENUE ACCOUNTS

That portion of long-term debt due within 1 year.

Classified as a current liabilityon the balance sheet

CURRENT MATURITIESOF LONG-TERM DEBT

CURRENT MATURITIESOF LONG-TERM DEBT

FINANCIAL STATEMENTPRESENTATION

FINANCIAL STATEMENTPRESENTATION

$ 16,791 - $ 12,621 = $ 4,170

CurrentAssets

CurrentLiabilities

WorkingCapital- =

WORKING CAPITAL FORMULAWORKING CAPITAL FORMULA

Working Capital

The excess of current assets over current liabilities.A measure of short-term liquidity.

$16,791 / $12,621 = 1.33 : 1

CurrentAssets

CurrentLiabilities

CurrentRatio/ =

CURRENT RATIO FORMULACURRENT RATIO FORMULA

Current Ratio

The ratio of current assets to current liabilities.A measure of short-term liquidity.

A form of interest-bearing notes payable issued by corporations,

universities, & governmental agencies.

Can be sold in small denominations to attract many investors.

Sold to obtain long term capital.

An alternative to issuing stock.

STUDY OBJECTIVE 4

BONDS PAYABLESTUDY OBJECTIVE 4

BONDS PAYABLE

ADVANTAGES OF BOND FINANCING OVER STOCKADVANTAGES OF BOND

FINANCING OVER STOCK

EFFECTS ON EPSBONDS VS. STOCKEFFECTS ON EPS

BONDS VS. STOCK

TYPES OF BONDS TYPES OF BONDS

Bond Type Distinguishing characteristicsSecured Backed by specific assets

Unsecured Backed by credit of issuer (debentures)

Term Paid at end of specified term

Serial Paid in installments

Registered Issued in name of specific holder

Bearer Not registered. (Coupon bonds)

Convertible Can be converted to common stock

Callable Can be retired before maturity

• Corporate bonds are traded on securities exchanges.

• Bond prices are quoted as a percentage of the face value of the bond (usually $1,000).

• Transactions between a bondholder and other investors are not journalized by the issuing corporation.

• A corporation records entries when it issues/buys back bonds, and when bondholders convert bonds into stock.

STUDY OBJECTIVE 5BOND ISSUANCE PROCEDURES

STUDY OBJECTIVE 5BOND ISSUANCE PROCEDURES

The present value (PV) of a bond is a function of three factors:

1. Dollar amount2. Time 3. Market rate of interest The process of determining the PV is discounting.

DETERMINING MARKETVALUE OF BONDS

DETERMINING MARKETVALUE OF BONDS

ISSUING BONDSAT FACE VALUEISSUING BONDSAT FACE VALUE

Assume that Devor Corporation issues 1000 10-year, 9% $1,000 bonds dated

January 1, 2006, at 100 (100% of face value). The entry to record the sale is:

(record sale of bonds at face value)

1,000,000 Bonds payable

1,000,000CashJan 1


1000 bonds x $1000 = $1,000,000

BOND INTEREST PAYMENTBOND INTEREST PAYMENT

Assume that interest is payable semi-annuallyon January 1 and July 1. Next payment

Is due July 1, 2006. The entry is:

(record semi-annual bond interest payment)

45,000 Cash

45,000Bond Interest ExpenseJuly 1


$1,000,000 x 9% x 6/12 = $45,000

BOND INTEREST ACCRUALBOND INTEREST ACCRUAL

Assume that interest is payable semi-annuallyon January 1 and July 1. Next payment

Is due July 1, 2006. At December 31, 2005the entry to accrue interest is:

(record sale of bonds at face value)

45,000 Bond Interest Payable

45,000Bond Interest ExpenseDec 31


$1,000,000 x 9% x 6/12 = $45,000

INTEREST RATES AND BOND PRICESINTEREST RATES AND BOND PRICES

BONDCONTRACTUAL

INTERESTRATE 10%

Issuedwhen:

8%

10%

12%

Premium

Face Value

Discount

Market Rates Bonds Sell at:

ISSUING BONDS AT A DISCOUNTISSUING BONDS AT A DISCOUNT

On January 1, 2006, Candlestick, Inc. sells$100,000, 5-year, 10% bonds for $92,639 with

interest payable on payable on July 1 & January 1. The entry to record the issuance is:

100,000 Bonds Payable

(record issuance of bonds at a discount)

7,361Discount on Bonds Payable

92,639CashJan 1


Market value of bonds = $92,639

FINANCIAL STATEMENT PRESENTATION--DISCOUNT

FINANCIAL STATEMENT PRESENTATION--DISCOUNT

CANDLESTICK, INC. Balance Sheet (partial)

Long-term liabilities Bonds payable $100,000 Less: Discount on Bond Payable $7,361 $92,639

Discount on Bonds Payable is a contra account, whichis deducted from bonds payable on the balance sheet:

Carrying value of bonds = $92,639

TOTAL COST OF BORROWINGBONDS ISSUED AT A DISCOUNTTOTAL COST OF BORROWING

BONDS ISSUED AT A DISCOUNT

• The the discount is an additional cost of borrowing that is recorded as bond interest expense over the life of the bonds.

• The total cost of borrowing for Candlestick, Inc., is computed as follows:

Semiannual Interest Payments ($100,000*10%*.5=$5,000; $5,000*10) $50,000Add: Bond Discount ($100,000-$92,639) $7,361 Total Cost of Borrowing $57,361

Bonds Issued at a Discount

ISSUING BONDS AT A PREMIUMISSUING BONDS AT A PREMIUM

On January 1, 2006, Candlestick, Inc. sells$100,000, 5-year, 10% bonds for $108,111 with

interest payable on payable on July 1 & January 1. The entry to record the issuance is:

100,000 Bonds Payable

(record issuance of bonds at a premium)

8,111 Premium on Bonds Payable

108,111CashJan 1


Market value of bonds = $108,111

FINANCIAL STATEMENT PRESENTATION—PREMIUM

FINANCIAL STATEMENT PRESENTATION—PREMIUM

CANDLESTICK, INC. Balance Sheet (partial)

Long-term liabilities Bonds payable $100,000 Add: Premium on Bonds Payable $8,111 $108,111

Premium on Bonds Payable is added to bonds payable on the balance sheet:

Carrying value of bonds = $108,111

The premium is considered to be a reduction in the cost of borrowing that should

be credited to Bond Interest Expense over the life of the bonds.

Semiannual Interest Payments ($100,000*10%*.5=$5,000; $5,000*10) $50,000Less: Bond Premium ($108,111-$100,000) $8,111 Total Cost of Borrowing $41,889

Bonds Issued at a Premium

TOTAL COST OF BORROWINGBONDS ISSUED AT A PREMIUMTOTAL COST OF BORROWINGBONDS ISSUED AT A PREMIUM

REVIEW QUESTIONBONDS SOLD AT A PREMIUM

REVIEW QUESTIONBONDS SOLD AT A PREMIUM

On January 1, Dias Corporation issued $1,000,000, 14%, 5-year bonds with interest payable on July 1 and January 1.

the bonds sold for $1,098,540. The market rate of interestwas 12%. On the first interest date, using the effective

interest method, what is the debit to bond interest expense?

Answer: $1,098,540 x 6% = $65,192

Book value of the bonds at maturity will equal their face value.

The entry to record the redemption of the Candlestick bonds at maturity is:

STUDY OBJECTIVE 6REDEEMING BONDS AT MATURITY

STUDY OBJECTIVE 6REDEEMING BONDS AT MATURITY

(record payment of bonds at maturity)

100,000 Cash

100,000Bonds PayableMaturity date


This assumes all interest has been paid to maturity. The entry will be the same regardless of whether

The bonds were issued at face value, discount, or premium

Assume the bonds were sold at a premium. At the end of the eight interest period,

Candlestick retires the bonds for $103,000.Carrying value on date of redemption is $106,123

The entry to retire the bonds is:

REDEEMING BONDS BEFORE MATURITYREDEEMING BONDS BEFORE MATURITY

1,377Loss on Bond Redemption

103,000 Cash

(record redemption and loss prior to maturity)

1,623Premium on Bonds Payable

100,000Bonds PayableJan 1


Loss calculation: Cash paid – carrying value

$103,000 - $106,123

CONVERTING BONDS TO COMMON STOCK

CONVERTING BONDS TO COMMON STOCK

Market prices of the bonds and the stock are ignored. The carrying value of the bonds is transferred to capital.

No gain or loss is recognized.

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.

The entry to record the conversion is:

80,000 Paid in capital in excess of par

(record bond conversion)

20,000 Common Stock

100,000Bonds PayableJuly 1


STUDY OBJECTIVE 7LONG-TERM NOTES PAYABLE

STUDY OBJECTIVE 7LONG-TERM NOTES PAYABLE

• Terms exceed one year.• May be secured by a specific assets (mortgage).• Mortgage N/P are recorded initially at face value. • Subsequent entries required for installment payments.

(B) (C) (D)Semiannual

InterestPeriod

(A)Cash

Payment

InterestExpense(D) x 6%

ReductionOf Principal

(A) – (B)

PrincipalBalance(D) –(C)

Issue date $500,000

1 33,231 $30,000 $3,231 496,769

2 $33,231 29,806 3,425 493,344

Porter Technology Inc. issues a $500,000, 12%, 20-year mortgage note on December 31, 2006, to build a research lab.

The terms provide for semiannual installment payment of $33,231. The installment payment schedule for the first year is shown below:

The entries to record the issuance and first interest payment are:

LONG-TERM NOTES PAYABLEJOURNAL ENTRIES

LONG-TERM NOTES PAYABLEJOURNAL ENTRIES

33,231 Cash

30,000Interest ExpenseJune 30

3,231Mortgage Notes Payable

(record mortgage loan)

(record first installment payment)

500,000 Mortgage Notes Payable

500,000CashDec 31


STUDY OBJECTIVE 8PRESENTATION & ANALYSIS

STUDY OBJECTIVE 8PRESENTATION & ANALYSIS

The long-term liabilities for LAX Corporation are shown below:

LAX CorporationBalance Sheet (partial)

Long-term liabilities Bonds payable 10% due in 2012 $1,000,000

Less: Discount on bonds payable 80,000 $920,000

Mortgage notes payable, 11%, due in 2018 and secured by plant assets 500,000

Lease liability 540,000

Total long-term liabilities $1,960,000

DEBT TO TOTAL ASSETS RATIODEBT TO TOTAL ASSETS RATIO

44.3% = $21,394 / $48,263

TOTAL DEBT DEBT TO TOTAL ASSETS = ————————

TOTAL ASSETS

Measures the percentage of total assets provided by creditors, indicating the degree of leverage.

Data from Johnson & Johnson’s 2003 annual report appears below:

TIMES INTEREST EARNED RATIOTIMES INTEREST EARNED RATIO

50.8 times = ($7197 + $3111 + $207)

$207

TIMES INT INCOME BEFORE INC. TAXES & INTEREST EXPENSE EARNED = ———————————————————————————

INTEREST EXPENSE

Indicates the company’s ability to meet

interest payments as they come due.

Johnson & Johnson’s 2003

annual report data is used below:

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john wiley & sons, inc. financial a ccounting, 5e prepared by kurt m. hull, mba cpa california...

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