Learning objective number 1 is to define liabilities and distinguish between current and long-term liabilities.
Liabilities are debts owed from past transactions. Liabilities can be separated into two categories: Current and Non-current. Current liabilities are due to be paid within one year or the normal operating cycle of the business, whichever is longer. For most businesses, one year is longer than the operating cycle. Noncurrent liabilities are due to be paid sometime after one year.
A company can finance its operations from two sources. One is debt. Debt is a borrowing from a creditor, such as a bank. It has a definite due date and in most cases bears an interest rate. Another way a company can finance its operations is through equity. This requires companies to sell additional stock in the company to new or existing shareholders.
Current liabilities are defined as those liabilities that must be paid within one year or within the normal operating cycle, whichever is longer. Working capital is defined as current assets minus current liabilities.
Part I Review this information for Devon Manufacturing. Is this a current or non-current liability? Part II Because the debt has a maturity term of 20 years, it is non-current.
Accounts Payable are short-term obligations for purchases of merchandise and other goods and services that are used in the normal operations of a business.
Learning objective number 2 is to account for notes payable and interest expense.
Many Notes Payable require payments on a regular basis during the life of the note. For example, many home mortgages are for fifteen or thirty years. But homeowners do not wait until the end of the fifteen or thirty years to make a payment. They usually make monthly payments during the loan term. Remember that any debt due within one year is classified as current. The portion of a note payable that is due within one year would be classified as a current liability. The remainder of the note that is due outside of one year is classified as noncurrent.
A note is a written promise to pay a specific amount at a specific future date. A note includes the following necessary information about the agreement. The payee on the note is the recipient of the cash at maturity. In this example, the payee is Security National Bank. The maker on the note is the debtor who owes the money. In this example, the maker is Porter Company. Notes also include information about the principal, interest rate, and due date. This note is for $10,000, has an interest rate of 12%, and is due six months from the date of the note. Let’s look at the entry Porter Company will make on November 1 st .
Porter debits Cash and credits Note Payable for $10,000.
Most notes have an interest rate associated with them. For borrowers, this is the interest expense they will incur and for lenders, this is the interest revenue they will receive.
Interest is calculated as Principal times the Interest Rate times the Time the note was outstanding.
Part I On December 31 st , Porter Company needs an adjusting entry to record the interest expense. Let’s look at that entry. Part II On December 31 st , Porter debits Interest Expense and credits Interest Payable for $200. The two hundred dollars in interest is calculated as the original note amount of ten thousand dollars times the interest rate of twelve percent times the outstanding time of the note. At December 31 st , the outstanding time for this note is two months.
Part I On January 31 st , Porter Company will pay back the principal amount of the note plus the interest for three months. Let’s look at that entry. Part II Porter eliminates the note payable for $10,000 and the interest payable for $200. The company must recognize the interest expense for the month of January of $100. Cash will be credited for the principal plus interest of $10,300. The two hundred dollars in interest is calculated as the original note amount of ten thousand dollars times the interest rate of twelve percent times the outstanding time of the note. At December 31 st , the outstanding time for this note is two months.
Learning objective number 3 is to describe the costs and basic accounting activities related to payrolls.
Ever wondered what happens to the money deducted from your paycheck? Employers do not keep this money; instead it’s remitted to the appropriate entity. For example, money withheld for taxes is remitted to the proper taxing authority. Money voluntarily taken out of your paycheck for retirement funds and insurance is also remitted to the proper place. All of these withholdings are liabilities for employers. They are due and payable to the appropriate entity within certain time periods.
Most of the time people in debt owe money, but sometimes a business can be in debt for services. For example, assume a new client asks his accounting firm to perform next year’s audit. After checking, the firm sees that it has just enough time to add one client to the schedule next year. The firm tells the client it would be glad to perform the audit but needs $10,000 to hold their spot on the schedule. The client agrees and gives the accounting firm $10,000. When it is time to do the audit, how happy would the client be if the accounting firm just gave them back the $10,000 instead of performing the audit? Not too happy. They do not want money; they want auditing services. The accounting firm is not in debt for money but for auditing services valued at $10,000. When the client paid in advance for the audit services, the firm debited Cash and credited a liability called Unearned Revenue.
When a company has a relatively small need for cash, the need can usually be met by a single lender, such as a bank.
However, when a company needs large amounts of cash, one creditor may not be willing to take on all the risk of repayment. In this case, many companies issue bonds to lots of different people and entities to spread out the risk.
Installment notes call for a series of payments. Each payment includes some payment on the principal and some payment for interest. Most car loans and home loans are set up on installment payments. Often, the required payments are the same each month. For each payment made, the amount of the principal payment increases and the amount of the interest payment decreases.
When allocating a payment between interest and principal, follow these four steps. First, identify the unpaid principal balance. Second, calculate the interest expense. Third, determine the reduction in the principal balance. Fourth, compute the new unpaid principal balance. Let’s look at an example.
Learning objective number 4 is to prepare an amortization table allocating payments between interest and principal.
Review the information for Rocket Corporation. On January 1 st , Rocket Corporation borrowed money from First Bank. The annual payment is $2,000. Let’s look at the amortization table for this loan.
Notice the annual payment is always $2,000. Also notice that for each payment the interest portion decreases and the principal portion increases. Let’s review how to get the interest expense and the principal payment amounts for the first installment payment on the note. Interest is calculated by taking the unpaid balance at the beginning of the period of $7,581.57 and multiplying it by the 10% interest rate. The principal is calculated by taking the annual payment and subtracting the interest. Let’s look at the entry for the first payment.
The entry includes a debit to Interest Expense and Note Payable and a credit to Cash.
Learning objective number 5 is to describe corporate bonds and explain the tax advantage of debt financing.
As mentioned earlier, when companies need large amounts of cash, they often issue bonds. The principal on bonds is typically paid at the end of the bond period. Bonds are often denominated with a face value, or par value, of $1,000.
Bonds normally have an interest rate called a stated or contract rate. Interest is normally paid semiannually and is computed as Principal times Rate times Time. This computation should look familiar to you.
Bonds are issued through an underwriter. A large number of bonds are traded on the New York Exchange and the American Exchange. Since bonds are bought and sold in the market, they have a market value, or price. For convenience, bond market values are expressed as a percent of their face or par value.
There are several types of bonds. For Mortgage bonds, the issuer pledges specific assets as collateral. Debenture bonds are backed by the issuer’s general credit standing. Convertible bonds can be exchanged for a fixed number of common shares of the issuing corporation. Junk bonds have very high risk associated with them.
Part I Review this information for Rocket Corporation. Assume the bonds are issued at face value. Let’s see how to record this bond issue. Part II To record this bond issue, Rocket debits Cash and credits Bonds Payable for $1,500,000.
Part I Let’s record the interest payment. Part II On July 1 st , the interest payment is recorded as a debit to Interest Expense and a credit to Cash for $90,000. Interest is calculated as principal of one million five hundred thousand dollars times the interest rate of twelve percent times the time period of half a year.
One complicating factor that can occur is when a company issues bonds between interest dates. This is a common occurrence because bonds are sold when there is a willing buyer and seller, and that can take place on any date, not just an interest payment date. When bonds are issued between interest payment dates, the investor pays for the bond PLUS the accrued interest since the last interest payment date. This allows the issuing company to pay all the investors the same interest amount on the interest payment date. On the interest payment date, the investor receives the full interest payment for the period even though the bond was only outstanding for a portion of the period. The interest payment actually represents two factors: One is a mere repayment of the accrued interest that the investor paid on the purchase date of the bond; the other is interest earned since the bond was purchased.
Learning objective number 6 is to account for bonds issued at a discount or premium.
The selling price of a bond is determined by comparing the market interest rate with the stated interest rate on the bond. If the stated interest rate on the bond is equal to the market interest rate, then the bond sells at par value. That is, the selling price of the bond is equal to its par value. In most cases, the stated rate and the market rate of interest will not agree. When these two interest rates differ, it seems to make sense to just change the stated rate to equal the market rate. However, this cannot be done because the bond certificate that lists all of the specifics about the bond, including the interest rate, was printed in advance of the issue date. Thus, we must pay the interest printed on the bond certificate. The only thing not printed on the bond certificate is the selling price. The issuing company and the bond investors come to an agreement on a selling price that incorporates the difference in the stated interest rate and the market interest rate. If a bond is paying 10 percent and the market is paying 12 percent, how many investors will want to buy bonds? None! Bonds must be made more attractive by reducing the selling price to make up the difference in the interest rates. In this case, the bond will sell at a discount, or below par value. This discount raises the effective interest rate investors will earn to 12 percent. Now, if a bond is paying 10 percent and the market is paying 8 percent, how many investors will want to buy bonds? All of them! The selling price can be increased and still be attractive to bond investors. In this case, the bond sells at a premium, or above par value. This premium reduces the effective interest rate that investors will earn to 8 percent.
In almost all cases, the stated rate and the market rate of interest will not agree. When these two interest rates are different, it might make sense to you for us to just change our stated rate to equal the market rate and then everything would be fine. Well, we can’t do that. The bond certificate lists all of the specifics about the bond including the stated interest rate. Because we have to print the bond certificates in advance, we are stuck having to pay the interest printed on the bond certificate. The only thing that is not printed on the bond certificate is the selling price. So, the issuing company and the bond investors come to an agreement on the selling price that incorporates the difference in the stated interest rate and the market interest rate at the time of issue. For example, if the market rate of interest is more than 9%, investors will be unwilling to pay the full face amount of $1,000,000 for Matrix’s 9% bonds. The issue price of Matrix’s 9% bonds will have to be lower to entice investor interest. The difference between the lower issue price and the face amount of one million dollars is called a discount. Let’s see how we account for bonds issued at a discount.
Because the market rate of interest is more than 9%, Matrix must reduce the issue price of its 9% bonds from $100,000 to $950,000 to attract investors. The difference between the $1,000,000 face value of the bonds and the cash issue price of $950,000 is the $50,000 discount that Matrix offers to the bond investors.
On the issue date, Matrix will debit Cash for the $950,000 of cash received, credit Bonds Payable for the face amount of $1,000,000, and debit Discount on Bonds Payable for the $50,000 difference. Discount on Bonds Payable is a contra-liability account and has a normal debit balance.
On the balance sheet, the discount account is subtracted from the face value of the bonds to arrive at the net carrying value of the bonds.
The discount represents an additional interest factor that will be amortized to Interest Expense over the life of the bond. Amortizing the discount will increase the total Interest Expense recorded for the bond each interest payment period. Using the straight-line method to amortize the discount, Matrix will divide the total discount by the number of interest payment periods to get the the amount of the discount amortized each interest payment period. Since this is a 20-year bond and it pays interest semiannually, there are 40 interest payment periods. This calculation determines that the discount amortization will be $1,250 at each interest payment date.
Part I Interest is paid semiannually, so Matrix will pay $45,000 every six months to the bond investors. Part II At each interest payment date Matrix, Inc. will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. The credit to Discount on Bonds Payable is determined using the straight-line method we discussed on the previous screen. The debit to Bond Interest Expense is the total of the two amounts in this entry.
On the balance sheet at the end of 2007, the discount account is subtracted from the principal amount of the bonds to arrive at the net carrying value of the bonds. As the discount is amortized, the carrying value will increase to exactly $1,000,000 on the maturity date.
On the maturity date, Matrix, Inc. will record the payment of the face amount of the bonds by debiting Bonds Payable and crediting Cash for $1,000,000.
Remember that in almost all cases, the stated rate and the market rate of interest will not agree. When this happens, the issuing company and the bond investors come to an agreement on the selling price that incorporates the difference in the stated interest rate and the market interest rate at the time of issue. For example, if the market rate of interest is less than 9%, investors will be willing to pay more than the full face amount of $1,000,000 for Matrix’s 9% bonds. The issue price of Matrix’s 9% bonds will rise because of investor demand for the 9% bonds. The difference between the higher issue price and the face amount of $1,000,000 is called a premium. Let’s look at a premium on the bonds issued by Matrix.
Because the market rate of interest is less than 9%, Blair will increase the issue price of its 9% bonds from $1,000,000 to $1,050,000. The difference between the $1,000,000 face value of the bonds and the cash issue price of $1,050,000 is the $50,000 premium.
On the issue date, Matrix will debit Cash for the $1,050,000 of cash received, credit Bonds Payable for the face amount of $1,000,000, and credit Premium on Bonds Payable for the $50,000 difference. Premium on Bonds Payable is a adjunct-liability account and has a normal credit balance.
On the balance sheet, the premium is added to the face value of the bonds to arrive at the net carrying value of the bonds.
The premium represents a reduction in interest that will be amortized to Interest Expense over the life of the bond. Amortizing the premium will decrease the total Interest Expense recorded for the bond each interest payment period. Using the straight-line method to amortize the premium, Matrix, Inc. will divide the total premium by the number of interest payment periods to get the the amount of the premium amortized each interest payment period. Since this is a 20-year bond and it pays interest semiannually, there are 40 interest payment periods. This calculation determines that the premium amortization will be $1,250 at each interest payment date.
Every six months, Matrix will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. The debit to Premium on Bonds Payable is determined using the straight-line method we discussed on the previous screen. The debit to Interest Expense is the difference between the $45,000 of cash paid and the $1,250 of premium amortization.
On the balance sheet, the premium account is added to the face value of the bonds to arrive at the current carrying value of the bonds. As the premium is amortized, the carrying value will decrease to exactly $1,000,000 on the maturity date.
On the maturity date, Matrix will record the payment of the face amount of the bonds by debiting Bonds Payable and crediting Cash for $1,000,000.
Learning objective number 7 is to explain the concept of present value as it relates to bond prices.
Part I The basis of the present value concept is that money can grow over time because of the interest it can earn. Part II For example, $1,000 invested today at 10% will be worth $1,610.51 in five years and worth $10,834.71 in twenty-five years. The present value concept is used to price bonds. Bonds are priced at the present value of their future cash flows.
In many transactions the future amount to be received is known, and the present value of this amount can be determined. This is typically the case with bonds. The next slide will show how to determine the present value of future cash flows for a bond.
To determine the present value of a future amount, three things must be known: the future amount to be received, the interest rate, and the number of interest compounding periods. For a bond, the future amount may take two forms. First, a bond typically has a lump sum payment for principal due on a maturity date in the future. Second, bonds may also have periodic interest payments made during the life of the bond. For a bond, the calculated present value would be its selling price. Let’s take a closer look at the two types of future cash flows associated with bonds.
As mentioned, there are two types of future cash flows involved with bonds. First, periodic interest payments made to bondholders. The bond contract specifies how frequently interest payments will be made—in most cases, either annually or semiannually. Interest payment amounts are called annuities and are calculated as the Bond Principal times the Stated Interest Rate on the bond times the Outstanding Time Period in the year. The second cash flow for a bond is a principal payment at maturity. This is a lump sum payment at the end of a bond term to repay principal borrowed at the beginning.
Bonds can be retired by exercising a call provision or purchasing the bonds on the open market. If bonds are retired before the maturity date, a gain or loss is recorded. The gain or loss is determined by comparing the carrying value of the bond on the retirement date with the cash price paid to retire the bond. Gains or losses due to bond retirement should be reported as other income or other expense on the income statement.
Learning objective number 8 is to explain how estimated liabilities, loss contingencies, and commitments are disclosed in financial statements.
Loss contingencies result from an existing situation that involves a potential loss, depending on whether a future event occurs. An example of a loss contingency is a lawsuit. In this example, the potential loss depends on whether the lawsuit is successful or not. There are two factors that affect whether a loss contingency must be accrued and reported as a liability: One is the likelihood that the confirming event will occur, and the other is whether the loss amount can be reasonably estimated. If it is probable that a loss contingency will occur and if the loss amount can be reasonably estimated, then a loss is accrued and reported as a liability.
Some liabilities must be estimated when recorded. These liabilities are known to exist, but the exact dollar amount is uncertain. Product warranties are an example of this.
Learning objective number 9 is to evaluate the safety of creditor’s claims.
The Interest Coverage ratio indicates a margin of protection for creditors. It is calculated as Operating Income divided by Interest Expense.
Part I See if you can calculate Devon’s interest coverage ratio. Part II Devon has an interest coverage ratio of 10. This means that Devon was able to earn its annual interest expense payment 10 time during the year. This is a very comforting measure for creditors.
Many companies use financial leverage to increase investment earnings. By borrowing at a low rate and investing at a higher rate, the company will have a net increase in investment profits.
Learning objective number 10 is to describe reporting issues related to leases, postretirement benefits, and deferred taxes.
If you rent an apartment, you probably have an operating lease. You have the right to use the property, within certain limits, but the landlord still owns the property. You probably make monthly rent payments and at the end of your rental period, you will move out of the apartment. This typical rental agreement involves the lessee recording rent expense as rent payments are made. However, there are situations that may look like a rental agreement but that are more like a purchase of the assets being rented. These are called capital leases, and in these situations the lease agreement transfers risks and benefits associated with ownership to the lessee. Because the lessee basically becomes the owner of the property, the lessee must record an asset and a liability. Let’s look in more detail at the characteristics of a capital lease.
To qualify as a capital lease, a lease contract must have one of the following criteria: The lease transfers ownership to the lessee at the end of the lease. The lease contains a bargain purchase option to buy the asset for a small amount. The lease term is equal to or greater than seventy-five percent of the life of the asset under lease. The present value of the minimum lease payments is equal to or greater than ninety percent of the fair market value of the asset under lease. If any one of these criteria is met, the lease must be recorded as a capital lease.
Another liability companies record is related to pensions. Many companies offer pension plans to their employees as part of their benefit packages. During employment, the company invests specified amounts of money to be able to meet anticipated retirement payments in the future. These investments are usually made to an independent pension fund, managed by a professional fund manager. When employees retire, the company pays their pensions from these investments.
Actuaries determine the amount of payments required to be paid to the pension fund annually. These computations are based on employees’ average age, anticipated retirement dates, life expectancy, turnover rates, compensation levels, and the expected rate of return on the fund. Actuaries provide specified payment amounts to accountants, who then record the pension expense and pension liability for the period.
Companies also incur liabilities for other parts of their postretirement benefit package, such as continuing health coverage. Amounts expected to be paid within one year are reported as current liabilities. Amounts expected to be paid outside of one year are reported as long-term liabilities.
Corporations pay income taxes quarterly. Let’s see how income taxes affect the liabilities of a corporation.
Remember, generally accepted accounting principles, or GAAP, are used to prepare financial statements, and the Internal Revenue Code is used to prepare tax returns. Because there are two different sets of rules, the financial statement income tax expense determined using GAAP and the income taxes payable determined using the Internal Revenue Code will not agree. The difference between tax expense and tax payable is recorded as deferred taxes. Let’s look at an example.
Here is information for Matrix Incorporated. Notice that the depreciation method used for financial reporting is the straight-line method. For tax purposes, an accelerated depreciation method is used. For the year 2007, depreciation expense on the financial statements was $200,000 using straight-line depreciation. However, for tax purposes, the depreciation expense used to determine income taxes payable was $320,000 dollars. Let’s see how this difference is resolved.
This slide shows how Matrix determined its income tax expense of $45,000 for financial reporting purposes.
However, their taxes payable was determined using the Internal Revenue Code and resulted in income taxes payable for the period of $9,000.
The difference between the $45,000 in tax expense and the $9,000 in taxes payable is the deferred tax for the period. In this case, the deferred tax is $36,000 and is reported as a liability on Matrix’s financial statements.