Liabilities

• Current liabilities: due in one year or less– Types– Ratios

• Long-term liabilities: due in more than one year– Bonds– Capital leases versus operating leases

• Contingent liabilities: possible future liabilities

Current Liabilities

• Interest payable• Unearned revenue• Sales tax payable• Payroll taxes payable

Interest PayableAdjusting entry: accrued interest ($100 x 12% x 3/12)

Interest Expense 3

Interest Payable 3

N/P paid:

N/P 100

Interest Expense 9

Interest Payable 3

Cash 112

Interest payable is a

current liability

Unearned RevenueWhen cash is received:

Cash 100

Unearned Revenue 100

When revenue earned:

Unearned Revenue 100

Revenue 100

Unearned

Revenue is a

current liability

Sales Tax PayableSale: Coles County 6.25%

Cash 106.25

Sales (Revenue) 100

Sales Tax Payable 6.25

When sales tax paid to gov:

Sales Tax Payable 6.25

Cash 6.25

Sales tax not an expense for retailer

Why generally no sales tax on Internet purchases ???

Sales Tax payable is a

current liability

Payroll Taxes Payable$400 Employee Wages

Wage expense 400.00

Federal income tax payable (W-4 exemptions, refund?)

46.00

State income tax payable (IL 3%; others 0 – 10%) 12.00

City income tax payable (generally larger cities, none in IL)

4.00

Social security tax payable (employee, 6.25% of $87,000)

25.00

Employee Medicare tax payable (employee, 1.45% of all)

5.80

Pension contribution payable (retire before 80, put max in)

24.00

Health insurance payable (generally dependents) 40.00

Cash (not much….) 243.20

Social Security and Medicare Issues

• Depletion of social security funds– Social security payments

• 2 for 1– Live too long after retirement– Vote often

– Social security contributions• Not enough Gen X, Y, Z, etc.• Company matches your Social Security and Medicare

contributions– Self-employed and independent contractors

• Medicare funds– Health insurance for those collecting social

security

CURRENT LIABILITY RATIOSShort-Term Creditors

RATIOS

CURRENT QUICK (ACID-TEST) WORKING CAPITAL

CA / CL CA – INV / CL CA - CL

> 2?? > 1??? > 0???

Long-term liabilities

• Bonds• Capital leases

BOND BASICS

IBM

$1,000 LOAN

Interest each year at coupon rate$1,000 at maturity

Bond Values• Lend IBM $1,000 for 30 years @ 8%, two years

later rates on similar bonds decrease to 6%– Still receiving $80 per year for 28 more years

• PV of Annuity, 28 years, 6%– $80 x 13.4062 =$1,072.50

– Receiving $1,000 in 28 years• PV of $1, 28 years, 6%

– $1,000 x .1956 = $195.60

– Value of bond = PV of Int Annuity + PV of $1,000• $1,072.50 + $195.60 = $1,268.10

– 26.8% increase in bond value– If coupon rate > required rate of return, value of

bond will be > $1,000

Bond Values

• Discount bond cash flows at required rate of return (yield to maturity)– Don’t use coupon rate– If you do, you’ll find value is $1,000

• Interest rates increase, bond values decrease• Interest rates decrease, bond values increase• Bonds are priced at a percent of par value

– 104, 98, etc.

Bonds

• Advantages– Interest on bonds deducted as an expense

on tax return• Dividends on common stock: not an expense

– No dilution of stockholders’ interest

• Disadvantages– Failure to pay debt can result in bankruptcy– Dividends discretionary; interest is not

Bond Journal EntriesWhen bonds are issued:

Cash 1000

Bonds Payable 1000

When interest is paid:

Interest expense 40

Cash 40

($1000 x 8% x 6/12)

Leasing long-term assets

• Advantages of operating leases– No concern about residual value– Generally smaller down payment– Can deduct rent on tax return– Keeps liability off balance sheet

• However, should disclose lease commitments in footnotes

Leasing long-term assets

• Capital leases– Lease property for most of its useful life– Can purchase the property for nominal

amount at end of lease– Lease payments represent financing– Treat as an asset and long-term liability

Contingent liability

• Possible future liability– Either

• Amount of liability can not be reasonably determined

• Or not sure if liability exists

– Lawsuits, environmental issues, etc.– Generally disclose in footnotes