In this chapter, we will learn about current and long-term liabilities. Liabilities include accounts payable, notes payable, interest payable, bonds, capital leases, pensions, and deferred taxes.
Liabilities are debts we owe that arise from past transactions. We can separate liabilities into two categories: Current and Noncurrent. 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 their 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.
Part I Review this information for Devon Manufacturing. Is this a current or noncurrent liability? Part II Because the debt has a maturity term of twenty years, it is noncurrent.
There are two common ways to evaluate a company’s ability to pay its current obligations. Working Capital is the difference between Current Assets and Current Liabilities. If this difference is positive, it indicates that a company has enough Current Assets on hand to pay their debts that are due in the short term. The Current Ratio is another common measure of liquidity. This ratio is calculated as Current Assets divided by Current Liabilities. If this ratio is one to one or higher, it indicates that a company has enough Current Assets to pay its Current Liabilities.
Part I Here is some information for Devon Manufacturing. What is Devon’s current ratio? Part II It is one point four to one. This means that Devon has enough Current Assets to pay its Current Liabilities one point four times.
Accounts Payable are short-term obligations for purchases of merchandise and other goods and services that are used in the normal operations of the business.
Many Notes Payable have required 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. So, 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 would be 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 ten thousand dollars, has an interest rate of twelve percent, and is due six months from the date of the note. Let’s look at the entry Porter Company would make on November 1st.
Porter would debit Cash and credit Note Payable for ten thousand dollars.
Most notes have an interest rate associated with them. For the borrower, this is the interest expense they will incur and for the lender, 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 31st, Porter Company needs an adjusting entry to record the interest expense. Let’s look at that entry. Part II On December 31st, Porter would debit Interest Expense and credit Interest Payable for two hundred dollars. 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 31st, the outstanding time for this note is two months.
Have you ever wondered what happens to all the money that is deducted from your paycheck? Employers do not get to keep this money. They must remit the money withheld from your paycheck to the appropriate entity. For example, money withheld from your paycheck for taxes must be remitted to the proper taxing authority. Money you voluntarily take out of your paycheck, like for retirement funds and insurance, must be 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 when we think about being in debt, we are in debt for money. But sometimes a business can be in debt for services. For example, assume I own an accounting firm and a new client asks if my firm would do their audit next year. After checking my schedule, I see that I have just enough time to add one client to my schedule next year. I tell the client I would be glad to do their audit but I need ten thousand dollars now to hold their spot on the schedule. They agree and give me ten thousand dollars. Now, next year when it is time for their audit, how happy will this client be if I just turn around and give them ten thousand dollars and say let’s call it even? Not too happy. They do not want money; they want auditing services. So, I am in debt not for money but for auditing services valued at ten thousand dollars. When the client paid me in advance of performing these audit services, I would have 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. So, 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 that is 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.
Take a minute and review this information for Rocket Corporation. On January 1st, Rocket Corporation borrowed money from First Bank. The annual payment is two thousand dollars. Let’s look at the amortization table for this loan.
Notice that the annual payment is always two thousand dollars. 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 for the first installment payment for this note. The interest portion is calculated by taking the unpaid balance at the beginning of the period of seven thousand five hundred eighty one dollars and fifty seven cents and multiplying it by the interest rate of ten percent. The principal portion is calculated by taking the annual payment and subtracting the interest. Let’s look at the entry for the first payment.
The entry would include a debit to Interest Expense and Note Payable and a credit to Cash. On the previous slide, we went over how to arrive at the amounts used in this entry.
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 one thousand dollars.
Bonds normally have an interest rate that is 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. Mortgage bonds have specific assets of the issuer pledged as collateral. Debenture bonds are back 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 would debit Cash and credit Bonds Payable for one million five hundred thousand dollars.
Part I Let’s record the interest payment. Part II On July 1st, the interest payment would be recorded as a debit to Interest Expense and a credit to Cash for ninety thousand dollars. 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.
Part I We all know that money can grow over time because of the interest is can earn. This is the basis of the present value concept. Part II For example, a thousand dollars invested today at ten percent will be worth one thousand six hundred ten dollars and fifty one cents in five years and worth ten thousand eight hundred thirty four dollars and seventy one cents in twenty five years. We use the present value concept to price bonds. Bonds are priced at the present value of their future cash flows.
In many transactions, we know the future amount to be received and would like to determine the present value. This is typically the case with bonds. So now let’s see how to determine the present value of the future cash flows for a bond.
To determine the present value of a future amount, we need to know three things: 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 the principal that is due on the maturity date in the future. Second, bonds may also have periodic interest payments that are 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 we mentioned, there are two types of future cash flows involved with bonds. One is the periodic interest payments made to the bondholders. The bond contract specifies how frequently the interest payments will be made. In most cases, these interest payments are made either annually or semiannually. The interest payment amounts are called annuities. Interest payments 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 the principal payment at maturity. This is a lump sum payment at the end of the bond term to repay the principal borrowed at the beginning of the bond term.
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. In this case, the selling price of the bond is equal to its par value. 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 say just change our stated rate to equal the market rate and then everything would be fine. Well, we can’t do that. This can’t 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. So, 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. Now, if our bond is paying 10 percent and the market is paying 12 percent, how many investors will want to buy our bonds? None! So, we have to make our bonds 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 in the selling price raises the effective interest rate that the investors will earn to 12 percent. Now if our bond is paying 10 percent and the market is paying 8 percent, how many investors will want to buy our bonds? All of them! So, we can increase the price of our bonds and they will still be attractive to the bond investors. In this case, the bond sells at a premium, or above par value. This premium in the selling price reduces the effective interest rate that the investors will earn to 8 percent.
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 bonds. Gains or losses due to bond retirement should be reported as other income or other expense on the income statement.
Loss contingencies result from an existing situation that involves a potential loss that depends on whether some 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 the loss is accrued and reported as a liability.
Some liabilities must be estimated. These liabilities are known to exist, but we are uncertain as to the exact dollar amount. To record these liabilities, we estimate the liability amount. An example of an estimated liability is the liability recorded related to product warranties.
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, the you will leave the apartment and move out. This is a typical rental agreement and 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, in fact, more like a purchase of the assets being rented. These are called capital leases. In these situations, the lease agreement transfers the 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 that companies record is related to pensions. Many companies offer pension plans to their employees as part of their benefit packages. During the employment period, the company invests specified amounts of money to be able to meet the anticipated retirement payments in the future. These investments are usually made to a independent pension fund that is managed by a professional fund manager. When employees retire, the company pays their pension from these investments.
Annually, actuaries determine the amount of the payments required to the pension fund. These computations are based on the employees’ average age, anticipated retirement dates, life expectancy, turnover rates, compensation levels, and the expected rate of return on the fund. The actuaries provide their specified payment amounts to the accountants who record the pension expense and pension liability for the period.
Companies also incur liabilities for other parts of their benefit packages. These items include health insurance, vacation pay, and sick pay. Amounts expected to be paid within one year are reported as a current liability. Amounts expected to be paid outside of one year are reported as a long-term liability.
Corporations pay income taxes quarterly. Let’s see how income taxes can affect the liabilities of a corporation.
Remember that generally accepted accounting principles are used to prepare financial statements and that the Internal Revenue Code is used to prepare tax returns. Because we use 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 the tax expense and the tax payable is recorded as deferred taxes. Let’s look at an example.
Here is some information for X-Off Incorporated. Notice that the depreciation method used for financial reporting is the straight line method. For tax purposes, an accelerated depreciation method is used. So, for two thousand five, the depreciation expense on the financial statements was two hundred thousand dollars using straight line depreciation. However, for tax purposes, the depreciation expense used to determine income taxes payable was three hundred twenty thousand dollars. Let’s see how this difference is resolved.
Here is how X-Off determined its income tax expense of forty five thousand dollars 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 nine thousand dollars.
The difference between the forty five thousand dollars in tax expense and the nine thousand dollars in taxes payable is the deferred tax for the period. In this case, the deferred tax is thirty six thousand dollars. This would be reported as a liability on X-Off’s financial statements.
The Interest Coverage Ratio indicates a margin of protection for creditors. It is calculated as operating income divided by interest expense.
Many companies use financial leverage to increase their investment earnings. By borrowing at a low rate and investing the money at a higher rate, the company will have a net increase in investment profits.
In this chapter, we learned about current and long-term liabilities. Liabilities include accounts payable, notes payable, interest payable, bonds, capital leases, pensions, and deferred taxes.