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© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
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LIABILITIES
Chapter
10

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I.O.U.
Defined as debts or obligations
arising from past transactions or
events.
Defined as debts or obligations
arising from past transactions or
events.
Maturity = 1 year or less Maturity > 1 year
Current
Liabilities
Noncurrent
Liabilities
The Nature of LiabilitiesThe Nature of Liabilities

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The acquisition of assets is financed from two
sources:
Funds from creditors, with
a definite due date, and
sometimes bearing
interest.
Funds from
owners
DEBTDEBT EQUITYEQUITY
Distinction Between
Debt and Equity
Distinction Between
Debt and Equity

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Devon Mfg. borrows $100,000 from First
Bank. The loan will be repaid in 20 years and
has an annual interest rate of 8%.
Is this a current liability or a
noncurrent liability?
Devon Mfg. borrows $100,000 from First
Bank. The loan will be repaid in 20 years and
has an annual interest rate of 8%.
Is this a current liability or a
noncurrent liability?
Liabilities – QuestionLiabilities – Question
The obligation will not be paid
within one year or one operating
cycle, so it is a noncurrent liability.
The obligation will not be paid
within one year or one operating
cycle, so it is a noncurrent liability.

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Current Ratio = Current Assets ÷ Current Liabilities
Working Capital = Current Assets - Current Liabilities
An important indicator of a company’s ability
to meet its current obligations.
Two commonly used measures:
An important indicator of a company’s ability
to meet its current obligations.
Two commonly used measures:
Evaluating LiquidityEvaluating Liquidity

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Devon Mfg. has current liabilities of
$230,000 and current assets of $322,000.
What is Devon’s current ratio?What is Devon’s current ratio?
Devon Mfg. has current liabilities of
$230,000 and current assets of $322,000.
What is Devon’s current ratio?What is Devon’s current ratio?
Liabilities – QuestionLiabilities – Question

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Short-term obligations to suppliers for purchases of
merchandise and to others for goods and services.
Short-term obligations to suppliers for purchases of
merchandise and to others for goods and services.
Merchandise
inventory
invoices
Merchandise
inventory
invoices
Shipping
charges
Shipping
charges
Utility and
phone bills
Utility and
phone bills
Office
supplies
invoices
Office
supplies
invoices
Accounts PayableAccounts Payable

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Total Notes
Payable
Current Notes Payable
Noncurrent Notes Payable
When a company borrows money, a note payable is
created.
Current Portion of Notes Payable
The portion of a note payable that is due within one
year, or one operating cycle, whichever is longer.
When a company borrows money, a note payable is
created.
Current Portion of Notes Payable
The portion of a note payable that is due within one
year, or one operating cycle, whichever is longer.
Notes PayableNotes Payable

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PROMISSORY NOTE
Location Date
after this date
promises to pay to the order of
the sum of with interest at the rate
of per annum.
signed
title
Miami, Fl Nov. 1, 2003
Six months Porter Company
John Caldwell
Security National Bank
$10,000.00
12.0%
treasurer

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On November 1, 2003, Porter Company
would make the following entry.

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Interest expense is the
compensation to the lender for
giving up the use of money for a
period of time.
The liability is called interest
payable.
To the lender, interest is a
revenue.
To the borrower, interest is an
expense..
Interest expense is the
compensation to the lender for
giving up the use of money for a
period of time.
The liability is called interest
payable.
To the lender, interest is a
revenue.
To the borrower, interest is an
expense..
Interest
Rate
Up!
Interest PayableInterest Payable

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The interest formula includes three variables
that must be considered when computing
interest:
The interest formula includes three variables
that must be considered when computing
interest:
Interest = Principal × Interest Rate × Time
When computing interest for one year, “Time”
equals 1. When the computation period is less
than one year, then “Time” is a fraction.
When computing interest for one year, “Time”
equals 1. When the computation period is less
than one year, then “Time” is a fraction.
Interest PayableInterest Payable
For example, if we needed to compute interest for
3 months, “Time” would be 3/12.
For example, if we needed to compute interest for
3 months, “Time” would be 3/12.

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What entry would Porter Company make
on December 31, the fiscal year-end?
What entry would Porter Company make
on December 31, the fiscal year-end?
Interest Payable – ExampleInterest Payable – Example
$10,000 × 12% × 2
/12 = $200$10,000 × 12% × 2
/12 = $200

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Net Pay
Payroll LiabilitiesPayroll Liabilities
Medicare
Taxes
State and
Local Income
Taxes
FICA Taxes
Federal
Income Tax
Voluntary
Deductions
Gross Pay

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Deferred
revenue is
recorded.
a liability account.a liability account.
Cash is
received
in
advance.
Cash is sometimes collected from the
customer before the revenue is
actually earned.
Cash is sometimes collected from the
customer before the revenue is
actually earned.
Unearned RevenueUnearned Revenue
Earned
revenue is
recorded.
As the earnings
process is
completed . .

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Relatively small debt
needs can be filled from
single sources.
Relatively small debt
needs can be filled from
single sources.
Banks
Insurance
Companies
Pension
Plans
oror oror
Long-Term DebtLong-Term Debt

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Large debt needs are often
filled by issuing bonds.
Large debt needs are often
filled by issuing bonds.
Long-Term DebtLong-Term Debt

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Long-term notes that call for a series of
installment payments.
Long-term notes that call for a series of
installment payments.
Each payment covers
interest for the period
AND a portion of the
principal.
Each payment covers
interest for the period
AND a portion of the
principal.
With each payment, the
interest portion gets
smaller and the principal
portion gets larger.
With each payment, the
interest portion gets
smaller and the principal
portion gets larger.
Installment Notes PayableInstallment Notes Payable

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Identify the unpaid principal
balance.
Unpaid Principal × Interest rate =
Interest expense.
Installment payment - Interest
expense = Reduction in unpaid
principal balance.
Compute new unpaid principal
balance.
Identify the unpaid principal
balance.
Unpaid Principal × Interest rate =
Interest expense.
Installment payment - Interest
expense = Reduction in unpaid
principal balance.
Compute new unpaid principal
balance.
Allocating Installment Payments
Between Interest and Principal

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On January 1, 2003, Rocket
Corp. borrowed $7,581.57 from
First Bank of River City. The
loan was a five-year loan and
had an interest rate of 10%. The
annual payment is $2,000.
Prepare an amortization table for
Rocket Corp.’s loan.
On January 1, 2003, Rocket
Corp. borrowed $7,581.57 from
First Bank of River City. The
loan was a five-year loan and
had an interest rate of 10%. The
annual payment is $2,000.
Prepare an amortization table for
Rocket Corp.’s loan.

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Now, prepare the entry for the first payment on
December 31, 2003.
Now, prepare the entry for the first payment on
December 31, 2003.

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The information needed for the journal entry can be
found on the amortization table. The payment
amount, the interest expense, and the amount to
credit to principal are all on the table.
The information needed for the journal entry can be
found on the amortization table. The payment
amount, the interest expense, and the amount to
credit to principal are all on the table.

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Bonds usually involve the
borrowing of a large sum of
money, called principal.
The principal is usually paid
back as a lump sum at the end
of the bond period.
Individual bonds are often
denominated with a par value,
or face value, of $1,000.
Bonds usually involve the
borrowing of a large sum of
money, called principal.
The principal is usually paid
back as a lump sum at the end
of the bond period.
Individual bonds are often
denominated with a par value,
or face value, of $1,000.
Bonds PayableBonds Payable

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Bonds usually carry a stated
rate of interest, also called a
contract rate.
Interest is normally paid
semiannually.
Interest is computed as:
Interest = Principal × Stated Rate × TimeInterest = Principal × Stated Rate × Time

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Bonds are issued through an
intermediary called an
underwriter.
Bonds can be sold on organized
securities exchanges.
Bond prices are usually quoted
as a percentage of the face
amount.
 For example, a $1,000 bond
priced at 102 would sell for
$1,020.
Bonds are issued through an
intermediary called an
underwriter.
Bonds can be sold on organized
securities exchanges.
Bond prices are usually quoted
as a percentage of the face
amount.
 For example, a $1,000 bond
priced at 102 would sell for
$1,020.

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Mortgage
Bonds
Mortgage
Bonds
Convertible
Bonds
Convertible
Bonds Junk BondsJunk Bonds
Debenture
Bonds
Debenture
Bonds
Types of BondsTypes of Bonds

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On January 1, 2003, Rocket Corp. issues $1,500,000 of
12%, 10-year bonds payable. Interest is payable
semiannually, each July 1 and January 1.
Assume the bonds are issued at face value.
Record the issuance of the bonds.
On January 1, 2003, Rocket Corp. issues $1,500,000 of
12%, 10-year bonds payable. Interest is payable
semiannually, each July 1 and January 1.
Assume the bonds are issued at face value.
Record the issuance of the bonds.
Accounting for Bonds PayableAccounting for Bonds Payable

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Record the interest payment
on July 1, 2003.
Record the interest payment
on July 1, 2003.
Accounting for Bonds PayableAccounting for Bonds Payable

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Bonds Sold Between Interest DatesBonds Sold Between Interest Dates
Bonds are often sold between interest dates.
The selling price of the bond is computed as:
Bonds are often sold between interest dates.
The selling price of the bond is computed as:

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Present
Value
Present
Value
The Concept of Present ValueThe Concept of Present Value
Future
Value
Future
Value
$1,000
invested
today at 10%.
In 5 years it
will be worth
$1,610.51.
In 25 years it
will be worth
$10,834.71!
Money can grow over time,
because it can earn interest.

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How much is a future amount worth today?How much is a future amount worth today?
Present
Value
Future
Value
Interest compounding periods
Today
How much is a future amount worth today?
Three pieces of information must be known to
solve a present value problem:
The future amount.
The interest rate (i).
The number of periods (n) the amount will be
invested.
How much is a future amount worth today?
Three pieces of information must be known to
solve a present value problem:
The future amount.
The interest rate (i).
The number of periods (n) the amount will be
invested.

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Two types of cash flows are involved
with bonds:
Today
Principal payment
at maturity.
Periodic interest payments called annuities.
Maturity

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The Present Value Concept and
Bond Prices
The Present Value Concept and
Bond Prices
The selling price of the bond is determined by
the market based
on the time value of money.
=
>
<
>
<
=

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Gains or losses incurred as a result of retiring bonds
should be reported as extraordinary items on the
income statement.
Gains or losses incurred as a result of retiring bonds
should be reported as extraordinary items on the
income statement.
E x e r c i s i n g a c a l l
p r o v i s i o n .
P u r c h a s i n g t h e
b o n d s o n t h e
o p e n m a r k e t .
B o n d s c a n b e r e t i r e d b y . . .
Early Retirement of DebtEarly Retirement of Debt

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Lease agreement transfers
risks and benefits
associated with ownership
to lessee.
Lease agreement transfers
risks and benefits
associated with ownership
to lessee.
Lessee records a leased
asset and lease liability.
Lessee records a leased
asset and lease liability.
Lessor retains risks and
benefits associated with
ownership.
Lessor retains risks and
benefits associated with
ownership.
Lessee records rent
expense as incurred.
Lessee records rent
expense as incurred.
Lease Payment ObligationsLease Payment Obligations
Operating LeasesOperating Leases Capital LeasesCapital Leases

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T h e l e a s e t r a n s f e r s
o w n e r s h i p t o t h e
l e s s e e .
T h e l e a s e c o n t a i n s
a b a r g a i n p u r c h a s e
o p t i o n .
T h e l e a s e t e r m i s e q u a l t o
o r > 7 5 % o f t h e e c o n o m i c
l i f e o f t h e p r o p e r t y .
T h e P V o f t h e m i n i m u m
l e a s e p a y m e n t s = 9 0 % o f
t h e F M V o f t h e p r o p e r t y .
A l e a s e m u s t b e r e c o r d e d a s
a C a p i t a l L e a s e i f i t m e e t s
a n y o f t h e f o l l o w i n g c r i t e r i a .
Capital Lease CriteriaCapital Lease Criteria

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Employers offer pension
plans to employees.
Employers offer pension
plans to employees.
Retirees receive
pension
payments from
the pension
fund.
Retirees receive
pension
payments from
the pension
fund.
The employer makes
payments to a pension
fund. Usually, this is an
independent entity
managed by a
professional fund
manager.
The employer makes
payments to a pension
fund. Usually, this is an
independent entity
managed by a
professional fund
manager.
PensionsPensions

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Actuaries make the pension expense
computations, based on:
Average age, retirement age, life expectancy.
Employee turnover rates.
Compensation levels.
Expected rate of return for the fund.
Actuaries make the pension expense
computations, based on:
Average age, retirement age, life expectancy.
Employee turnover rates.
Compensation levels.
Expected rate of return for the fund.
The accountant then posts the entry to
record pension expense and pension
liability.
The accountant then posts the entry to
record pension expense and pension
liability.
PensionsPensions

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Many companies offer benefits
to retirees other than pensions,
such as health coverage or
fitness club memberships.
Many companies offer benefits
to retirees other than pensions,
such as health coverage or
fitness club memberships.
Other Postretirement BenefitsOther Postretirement Benefits
Unfunded liability
for nonpension
postretirement
benefits
Current
liability
Long-term
liability
Amount to
be funded
next year
Remainder
of unfunded
amount

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Corporations
pay income
taxes quarterly.
Deferred Income TaxesDeferred Income Taxes

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The difference between tax expense and tax
payable is recorded in an account called
deferred taxes.
The difference between tax expense and tax
payable is recorded in an account called
deferred taxes.
The Internal Revenue
Code is the set of
rules for preparing tax
returns.
The Internal Revenue
Code is the set of
rules for preparing tax
returns.
Financial statement
income tax expense.
Financial statement
income tax expense.
IRS income taxes
payable.
IRS income taxes
payable.
GAAP is the set of
rules for preparing
financial statements.
GAAP is the set of
rules for preparing
financial statements.
Results in . . . Results in . . .Usually. . .
Deferred Income TaxesDeferred Income Taxes

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Examine the December 31, 2003, information
for X-Off Inc.
X-Off uses straight-line depreciation for financial
reporting and accelerated depreciation for
income tax reporting. X-Off’s tax rate is 30%.
Deferred Income Taxes – ExampleDeferred Income Taxes – Example

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Income Tax
Statement Return Difference
Revenues 1,000,000$
Less:
Depreciation 200,000
Other expenses 650,000
Income before taxes 150,000$
× Tax rate 30%
Income taxes 45,000$
The income tax
amount computed
based on financial
statement income
is income tax
expense for the
period.
The income tax
amount computed
based on financial
statement income
is income tax
expense for the
period.
Compute X-Off’s income tax expense
and income tax payable.

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Compute X-Off’s income tax expense
and income tax payable.
Income Tax
Revenues 1,000,000$ 1,000,000$
Less:
Depreciation 200,000 320,000
Other expenses 650,000 650,000
Income before taxes 150,000$ 30,000$
× Tax rate 30% 30%
Income taxes 45,000$ 9,000$
Income taxes
based on tax
return
income are
the taxes
payable for
the period.
Income taxes
based on tax
return
income are
the taxes
payable for
the period.

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Income Tax
Revenues 1,000,000$ 1,000,000$ -$
Less:
Depreciation 200,000 320,000 (120,000)
Other expenses 650,000 650,000 -
Income before taxes 150,000$ 30,000$ 120,000$
× Tax rate 30% 30% 30%
Income taxes 45,000$ 9,000$ 36,000$
The deferred tax for the period of $36,000 is the
difference between income tax expense of $45,000 and
income tax payable of $9,000.
The deferred tax for the period of $36,000 is the
difference between income tax expense of $45,000 and
income tax payable of $9,000.

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Borrowing at one
rate and investing
at a higher rate.
If we borrow
$1,000,000 at 8% and
invest it at 10%, we
will clear $20,000
profit!
Financial LeverageFinancial Leverage

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Are we
having fun
yet?
End of Chapter 10End of Chapter 10

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