chap010 notes (1)

© The McGraw-Hill Companies, Inc., 2005McGraw-Hill/Irwin

10-1

LIABILITIESChapter

10


10-2

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


10-3

The acquisition of assets is financedfrom two sources:

Funds from creditors, with a definite due date, and

sometimes bearing interest.

Funds from owners

DEBTDEBT EQUITYEQUITY

Distinction BetweenDebt and Equity

Distinction BetweenDebt and Equity


10-4

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.


10-5

Current RatioCurrent Ratio = Current Assets = Current Assets ÷ Current Liabilities÷ Current LiabilitiesCurrent RatioCurrent Ratio = Current Assets = Current Assets ÷ Current Liabilities÷ Current Liabilities

Working Capital Working Capital = Current Assets= Current Assets - Current Liabilities- Current LiabilitiesWorking Capital Working Capital = Current Assets= Current Assets - Current Liabilities- 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


10-6

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


10-7

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


10-8

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


10-9

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, 2005

Six months Porter Company

John Caldwell

Security National Bank

$10,000.00

12.0%

treasurer



10-10

On November 1, 2005, Porter Company would make the following entry.



10-11

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


10-12

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.


10-13

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

$10,00012% 2/12 = $200$10,00012% 2/12 = $200


10-14

Net Pay

Payroll LiabilitiesPayroll Liabilities

Medicare Taxes

State and Local Income

TaxesFICA Taxes

Federal Income Tax

Voluntary Deductions

Gross Pay


10-15

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 . .


10-16

Relatively small debt needs can be filled from

single sources.

Relatively small debt needs can be filled from

single sources.

BanksInsurance

CompaniesPension

Plans

oror oror

Long-Term LiabilitiesLong-Term Liabilities


10-17

Large debt needs are often filled by issuing bonds.

Large debt needs are often filled by issuing bonds.

Long-Term LiabilitiesLong-Term Liabilities


10-18

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


10-19

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



10-20

On January 1, 2005, 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, 2005, 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.




10-21

Now, prepare the entry for the first payment on December 31, 2005.

Now, prepare the entry for the first payment on December 31, 2005.




10-22

The information needed for the journal entry can be found on the amortization table. The payment

amount, the interest expense, and the amount to debit 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 debit to principal are all on the table.




10-23

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


10-24

Bonds usually carry a stated rate of interest, also called a contract rate.

Interest is normally paid semiannually.

Interest is computed as:

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 × Time Interest = Principal × Stated Rate × Time



10-25

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.



10-26

Mortgage Bonds

Mortgage Bonds

Convertible Bonds

Convertible Bonds Junk BondsJunk Bonds

Debenture Bonds

Debenture Bonds

Types of BondsTypes of Bonds


10-27

On January 1, 2005, 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, 2005, 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


10-28

Record the interest paymenton July 1, 2005.

Record the interest paymenton July 1, 2005.

Accounting for Bonds PayableAccounting for Bonds Payable


10-29

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:


10-30

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.


10-31

How much is a future amount worth today?How much is a future amount worth today?

Present Value

FutureValue

Interest compounding periods

Today



10-32


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.


10-33

Two types of cash flows are involved with bonds:

Today

Principal payment at maturity.

Periodic interest payments called annuities.

Maturity



10-34

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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=


10-35

Gains or losses incurred as a result of retiring bonds should be reported as other income or other

expense on the income statement.

Gains or losses incurred as a result of retiring bonds should be reported as other income or other

expense on the income statement.

Exercising a callprovision.

Purchasing thebonds on theopen market.

B o n ds can b e re tired by . . .

Early Retirement of DebtEarly Retirement of Debt


10-36

Loss ContingenciesLoss Contingencies

An existing uncertain situation involving potential loss depending on whether some future event occurs.

An existing uncertain situation involving potential loss depending on whether some future event occurs.

Two factors affect whether a loss contingency must be accrued and reported as a liability:

1. The likelihood that the confirming event will occur.

2. Whether the loss amount can be reasonably estimated.

Two factors affect whether a loss contingency must be accrued and reported as a liability:

1. The likelihood that the confirming event will occur.

2. Whether the loss amount can be reasonably estimated.


10-37

Estimated LiabilitiesEstimated Liabilities

Liabilities that are known to exist. Uncertain as to dollar amount. Reasonable estimate of dollar amount is

available.

Liabilities that are known to exist. Uncertain as to dollar amount. Reasonable estimate of dollar amount is

available.

Example: Product warranties


10-38

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


10-39

The lease transfersow nership to the

lessee.

The lease containsa bargain purchase

option.

The lease term is equal toor > 75% of the econom ic

life of the property.

The PV of the m inim umlease paym ents = 90% ofthe FM V of the property.

A lease must be recorded asa Capital Lease if it meets

any of the follow ing criteria.

Capital Lease CriteriaCapital Lease Criteria


10-40

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


10-41

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


10-42

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 liabilityfor nonpensionpostretirement

benefits

Currentliability

Long-termliability

Amount tobe fundednext year

Remainderof unfunded

amount


10-43

Corporations pay income

taxes quarterly.

Deferred Income TaxesDeferred Income Taxes


10-44

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


10-45

Examine the December 31, 2005, 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


10-46

Income TaxStatement 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.



10-47

Compute X-Off’s income tax expense and income tax payable.


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.



10-48


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.



10-49

Evaluating the Safetyof Creditors’ Claims

Evaluating the Safetyof Creditors’ Claims

This ratio indicates a margin of protection for creditors.

This ratio indicates a margin of protection for creditors.

Operating Income

Interest Expense

Interest

Coverage

Ratio=


10-50

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


10-51

End of Chapter 10End of Chapter 10

chap010 notes (1)

Economy & Finance