Objectives 10 PDF

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CHAPTER 10 LIABILITIES LEARNING OBJECTIVES

1. EXPLAIN HOW TO ACCOUNT FOR CURRENT LIABILITIES. 2. DESCRIBE THE MAJOR CHARACTERISTICS OF BONDS. 3. EXPLAIN HOW TO ACCOUNT FOR BOND TRANSACTIONS. 4. EXPLAIN HOW TO ACCOUNT FOR LONG-TERM NOTES PAYABLE. 5. DISCUSS HOW LONG-TERM LIABILITIES ARE REPORTED AND ANALYZED. *6. APPLY THE STRAIGHT-LINE METHOD OF AMORTIZING BOND DISCOUNT AND BOND PREMIUM. *7. APPLY THE EFFECTIVE-INTEREST METHOD OF AMORTIZING BOND DISCOUNT AND BOND PREMIUM. *8 . COMPARE THE ACCOUNTING FOR LIABILITIES UNDER GAAP AND IFRS. Copyright © 2017 John Wiley & Sons, Inc.

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CHAPTER REVIEW

Current Liabilities 1.

(L.O. 1) A current liability is a debt that a company expects to pay within one year or the operating cycle, whichever is longer. Current liabilities include notes payable, accounts payable, unearned revenues, and accrued liabilities.

Notes Payable 2.

Notes payable are obligations in the form of written notes that usually require the borrower to pay interest. Notes due for payment within one year of the balance sheet date are usually classified as current liabilities.

3.

When an interest-bearing note is issued, the assets received generally equal the face value of the note: a. During the term of the note, it is necessary to accrue interest expense. b. At maturity, Notes Payable is debited for the face value of the note and Interest Payable is debited for accrued interest.

Sales Taxes Payable 4.

A sales tax is expressed as a percentage of the sales price on goods sold to customers. The entry by the selling company to record sales taxes is as follows: Cash ................................................................................................. Sales Revenue .......................................................................... Sales Taxes Payable .................................................................

XXXX XXXX XXXX

When sales taxes are not rung up separately on the cash register, total receipts are divided by 100% plus the sales tax percentage to determine the sales. Unearned Revenues 5.

Unearned Revenues (advances from customers) are recorded by a debit to Cash and a credit to a current liability account identifying the source of the unearned revenue. When the revenue is earned, an unearned revenue account is debited and an earned revenue account is credited.

Current Maturities of Long-Term Debt 6.

Another item classified as a current liability is current maturities of long-term debt. Current maturities of long-term debt are often identified on the balance sheet as long-term debt due within one year.

Payroll and Payroll Taxes Payable 7.

The amount of unpaid pay owed to employees is wages and salaries payable. Manadatory payroll deductions remitted to government authorities are withholding taxes, such as personal state and federal income taxes, social security taxes, and Medicare taxes. Also, with every payroll, the

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employer incurs liabilities to pay various payroll taxes, such as social security taxes, Medicare

taxes, and the state and federal unemployement taxes. 8.

The payroll and payroll tax liability accounts are classified as current liabilities.

Bonds 9.

(L.O. 2) Long-term liabilities are obligations that are expected to be paid after one year. Long-term liabilities include bonds, long-term notes, and lease obligations.

10. Bonds offer the following advantages over common stock: a. Stockholder control is not affected. b. Tax savings result. c. Earnings per share of common stock may be higher. 11. The major disadvantages resulting from the use of bonds are that interest must be paid on a periodic basis, and the principal (face value) of the bonds must be paid at maturity. Types of Bonds 12. Secured bonds have specific assets of the issuer pledged as collateral for the bonds. A mortgage bond is secured by real estate. 13. Unsecured bonds are issued against the general credit of the borrower; they are also called debenture bonds. 14. A bond secured by specific assets set aside to redeem (retire) the bonds is called a sinking fund bond. 15. Convertible bonds permit bondholders to convert the bonds into common stock at their option. Callable bonds are subject to call and retirement at a stated dollar amount prior to maturity at the option of the issuer. 16. State laws grant corporations the power to issue bonds. a. Within the corporation, formal approval by both the board of directors and stockholders is usually required before bonds can be issued. b. In authorizing a bond issue, the board of directors must stipulate the total number of bonds to be authorized, total face value, and the contractual interest rate (stated rate). c. The terms of the bond issue are set forth in a formal legal document called a bond indenture. Market Value of Bonds 17. The market value (present value) of a bond is a function of three factors: (a) the dollar amounts to be received, (b) the length of time until the amounts are received, and (c) the market rate of interest. The process of finding the present value is referred to as discounting the future amounts. Bond Transactions 18.

(L.O. 3) The issuance of bonds at face value results in a debit to Cash and a credit to Bonds Payable. a. Over the term of the bonds, entries are required for bond interest. b. At the maturity date, it is necessary to record the final payment of interest and payment of the face value of the bonds.

19.

Bonds may be issued below or above face value. a. If the market (effective) rate of interest is higher than the contractual (stated) rate, the bonds will sell at less than face value, or at a discount.

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b.

If the market rate of interest is less than the contractual rate on the bonds, the bonds will sell above face value, or at a premium.

Bond Issues at Discount 20.

When bonds are issued at a discount, a. The market rate of interest exceeds the stated rate. b. The discount is debited to a contra account, Discount on Bonds Payable, and it is deducted from Bonds Payable in the balance sheet to show the carrying (or book) value of the bonds. c. Bond discount is an additional cost of borrowing that should be recorded as interest expense over the life of the bonds.

Bond Issues at Premium 21.

When bonds are issued at a premium, a. The market rate of interest is less than the stated rate. b. The premium is credited to the account, Premium on Bonds Payable, and it is added to Bonds Payable in the balance sheet. c. Bond premium is a reduction in the cost of borrowing that should be credited to Interest Expense over the life of the bonds.

Bond Redemption and Conversion 22.

When bonds are redeemed at maturity and the last interest payment has been recorded, the Bonds Payable account debited and the Cash account credited for the face value of the bond.

23.

When bonds are redeemed before maturity it is necessary to (a) eliminate the carrying value of the bonds at the redemption date, (b) record the cash paid, and (c) recognize the gain or loss on redemption.

Long-term Notes Payable 24.

(L.O. 4) A long-term note payable may be secured by a document called a mortgage that pledges title to specific assets as security for a loan. a. Typically, the terms require the borrower to make installment payments consisting of (1) interest on the unpaid balance of the loan and (2) a reduction of loan principal. b. Mortgage notes payable are recorded initially at face value; each installment payment results in a debit to Interest Expense, a debit to Mortgage Payable, and a credit to Cash.

Statement Presentation and Analysis 25. (L.O. 5) Current liabilities are the first category of liabilities on the balance sheet. a. Usually notes payable are listed first and then accounts payable. b. The other current liabilities are listed in order of magnitude. 26. Long-term liabilities are reported in a separate section of the balance sheet immediately following current liabilities. 27. Debt financing has these advantages over equity financing. a. Stockholder control is not affected. b. Interest expense is deductible, while dividends are not. c. Return on stockholders’ equity may be higher. Copyright © 2017 John Wiley & Sons, Inc.

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28. Liquidity can be measured by comparing current assets to current liabilities in two ways. a. Working capital = Current assets – Current liabilities b. Current ratio = Current assets ÷ Current liabilities 29. Two measures of a company’s debt-paying ability and long-term solvency are: a. Debt to assets ratio = Total liabilities ÷ Total assets b. Times interest earned = (Net income + Interest expense + Tax expense ) ÷ Interest expense Straight-Line Method *30. (L.O. 6) When a bond sells at a discount, the straight-line method of amortization allocates the same amount of bond discount to each interest period. The formula is: Bond Discount ÷ Number of Interest Periods = Bond Discount Amortization *31. The entries to record the accrual and payment of periodic interest when the bond sells at a discount are: a. Interest Expense………………………......................... XXX Discount on Bonds Payable……………………. XXX Interest Payable………………………………….. XXX b. Interest Payable……………………………………….. XXX Cash……………………………………………….. XXX *32. When a bond sells at a premium, the straight-line method of amortization allocates the same amount of bond premium to each interest period. The formula is: Bond Premium ÷ Number of Interest Periods = Bond Premium Amortization *33. The entries to record the accrual and payment of periodic interest when a bond sells at a premium are: *34. a. b.

Interest Expense ......................................................... XXX Premium on Bonds Payable ....................................... XXX Interest Payable………………………………….. XXX Interest Payable .......................................................... XXX Cash……………………………………………….. XXX

Effective-Interest Method *35. (L.O. 7) The effective-interest method of amortization is an alternative to the straight-line method. Under this method, a. Interest Expense is computed first by multiplying the carrying value of the bonds at the beginning of the period by the effective interest rate. b. The credit to Cash (or Interest Payable) is computed by multiplying the face value of the bonds by the contractual interest rate. c. The bond discount or premium amortization amount is then determined by comparing bond interest expense with the interest paid or accrued. *36. The effective-interest method produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds. When the amounts of bond interest expense are materially different under the two methods, the effective-interest method is required under generally accepted accounting principles. Copyright © 2017 John Wiley & Sons, Inc.

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Compare the Accounting for Liabilities Under GAAP and IFRS *37. (L.O. 8) The following are the key similarities and differences between GAAP and IFRS as related to the recording process for liabilities. a. Similarities (1) The basic definition of a liability under GAAP and IFRS is very similar. (2) The accounting for current liabilities is similar between GAAP and IFRS. (3) IFRS requires liabilities be classified as current or noncurrent on the face of the statement of financial position, except in certain industries where a presentation based on liquidity would provide more useful information (like financial institutions). When current liabilities are presented, they are generally presented in order of liquidity. (4) Under IFRS if liabilities are expected to be paid within 12 months they are classified as current. (5) Under IFRS companies sometimes show liabilities before assets, and long-term liabilities before current liabilities. (6) The basic calculation of bond valuation and accounting for bond liability transaction is the same under GAAP and IFRS. (7) IFRS requires the effective-interest method for amortization of bond discounts and premiums. GAAP also requires this method unless the straight-line method does not produce a material difference. IFRS does not use a discount or premium account, instead it shows the bond at its net amount. b. Differences (1) Under IFRS current liabilities may be netted against current assets to show working capital on the face of the statement of financial position.

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LECTURE OUTLINE A.

Accounting for Current Liabilities. 1. A current liability is a debt that a company expects to pay within one year or the operating cycle, whichever is longer. The major types of current liabilities are notes payable, accounts payable, sales taxes payable, unearned revenues, and accrued liabilities. 2. Current liabilities include notes payable, accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest payable. a.

Companies record obligations in the form of written notes as notes payable. Companies frequently issue notes to payable to meet shortterm financing needs. Notes payable usually require the borrower to pay interest. Notes due for payment within one year of the balance sheet date are usually classified as current liabilities. When a company issues an interest-bearing note, the amount of assets it receives upon the issuance of the note generally equals the face value of the note. Interest accrues over the life of the note, and the company must periodically record that accrual.

b.

Sales taxes are expressed as a percentage of the sales price. The selling company collects the tax from the customer when the sale occurs, and periodically (monthly) remits the collections to the state’s department of revenue.

c.

Cash received from customers before goods are delivered or services are rendered is called unearned revenues. When a company receives the advance payment, it debits Cash, and credits a current liability account identifying the source of the unearned revenue. When the company earns the revenue, it debits an unearned revenue account, and credits an earned revenue account.

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d.

At the balance sheet date, all obligations due within one year are classified as current, and all other obligations are long-term. Companies often identify current maturities of long-term debt in the balance sheet as long-term debt due within one year.

e.

Several liabilities related to the payroll function are classified as current liabilities. (1) The liability incurred for unpaid employee earnings is called Salaries and Wages Payable. (2) Related liabilities include various amounts withheld from employees’ paychecks such as income tax, FICA (social security), and other voluntary deductions such as insurance, or union dues. (3) The employer also incurs liabilities for payroll taxes such as federal and state unemployment taxes and the employer’s share of FICA taxes.

B.

Why Issue Bonds? 1. Bonds are sold in small denominations (usually $1,000), and as a result, they attract many investors. 2. From the standpoint of the corporation seeking long-term financing, bonds offer the following advantages over common stock: a.

Stockholder control is not affected.

b.

Tax savings result.

c.

Earnings per share may be higher.

3. One disadvantage in using bonds is that the company must pay interest on a periodic basis. Also, the company must repay the principal at the due date. Copyright © 2017 John Wiley & Sons, Inc.

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C.

Types of Bonds. 1. Bonds may be classified by certain features. Some types of bonds commonly issued include: a.

Secured bonds have specific assets of the issuer pledged as collateral for the bonds. Unsecured bonds are issued against the general credit of the borrower.

b.

Bonds secured by specific assets set aside to redeem (retire) the bonds are called sinking fund bonds.

c.

Bonds that can be converted into common stock at the bondholder’s option are convertible bonds. Bonds that the issuing company can retire at a stated dollar amount prior to maturity are callable bonds.

2. Issuing procedures. a.

In authorizing the bond issue, the board of directors must stipulate the number of bonds to be authorized, total face value, and contractual interest rate.

b.

The terms of the bond issue are set forth in a legal document called a bond indenture. The indenture shows the terms and summarizes the rights of the bondholders and their trustees, and the obligations of the issuing company.

3. Determining the market value of bonds. a.

Present value is the amount that must be invested today at a given interest rate to have a specified sum of money at a specified date.

b.

The present value of a bond is the value at which it should sell in the marketplace. Market value is a function of the three factors that determine present value: (1) The dollar amounts to be received.

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(2) The length of time until the amounts are received. (3) The market rate of interest. D.

Issuing Bonds at Face Value. 1. When bonds are issued, Cash is debited for the cash proceeds and Bonds Payable is credited for the face value of the bonds. 2. The entry for payment of interest includes a debit to Interest Expense and a credit to Cash. 3. The entry to accrue bond interest includes a debit to Interest Expense and a credit to Interest Payable.

E.

Issuing Bonds at a Discount or Premium. 1. If the market interest rate is higher than the contractual (stated) rate, the bonds will sell at a discount (less than face value). 2. If the market interest rate is lower than the contractual (stated) rate on the bonds, the bonds will sell at a premium (more than face value). 3. The entry to record bonds issued at a discount includes a debit to Cash for the cash proceeds, a credit to Bonds Payable for the face value of the bonds, and a debit to Discount on Bonds Payable for the difference. a.

Discount on Bonds Payable is a contra liability account which is deducted from Bonds Payable on the balance sheet.

b.

The discount is an additional cost of borrowing and the company records this additional cost as interest expense over the life of the bonds.

4. The entry to record bonds issued at a premium includes a debit to Cash for the cash proceeds, a credit to Bonds Payable for the face value of the bonds, and a credit to Premium on Bonds Payable for the difference. Copyright © 2017 John Wiley & Sons, Inc.

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F.

a.

Companies add the premium on bonds payable to the bonds payable amount on the balance sheet.

b.

The bond premium is considered to be a reduction in the cost of borrowing and companies credit the premium to Interest Expense over the life of the bonds.

Redeeming Bonds Before Maturity. 1. Bonds may be redeemed before maturity ...