Chapter 10
Liabilities
PowerPoint Authors:
Brandy Mackintosh
Lindsay Heiser
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 10-1
Explain the role of liabilities in
financing a business.
10-2
The Role of Liabilities
Liabilities are created when a company:
Buys goods
and services
on credit
Obtains
short-term
loans
Issues
long-term
debt
Current liabilities are short-term obligations that will
be paid with current assets within the company’s
current operating cycle or within one year of the
balance sheet date, whichever is longer.
10-3
The Role of Liabilities
The liability section of the General Mills 2010 and 2011
comparative balance sheets.
10-4
Learning Objective 10-2
Explain how to account for
common types of current
liabilities.
10-5
Measuring Liabilities
Initial Amount of the Liability
Cash Equivalent
Additional Liability Amounts
Increase Liability
Payments Made
10-6
Decrease Liability
Current Liabilities
Accounts Payable
Increases
(Credited)
Decreases
(Debited)
when a company
receives goods or
services on credit
when a company
pays on its account
Accrued Liabilities
Liabilities that have been incurred but not yet paid.
10-7
Accrued Payroll
Payroll Deductions
Payroll Liabilities
Payroll deductions are either required by law or voluntarily
requested by employees and create a current liability for the
1.
Payroll Deductions
company. Examples include:
1. Income tax
2. Employer
FICA tax
2.
Payroll Taxes
3. Other deductions (charitable donations, union dues, etc.)
10-8
Accrued Payroll
Gross Pay
$ 600.00
Payroll Deductions:
Federal Income Taxes
FICA Taxes
48.80
Other
10.00
Total Payroll Deductions
Net Pay
10-9
$ 58.00
116.80
$ 483.20
Accrued Payroll
Adam Palmer earned gross pay of $600 in the current payroll period.
General Mills withheld $58 in Federal income taxes, $48.80 for FICA, and
$10 for United Way, resulting in net pay of $483.20. Let’s assume that
General Mills has 1,000 workers just like Adam.
1
Analyze
Assets
Cash (-A) -$483,200
2
Liabilities
FIT Withheld (+L) +$58,000
FICA Payable (+L)+$48,800
United Way (+L) +$10,000
+
Stockholders’ Equity
Payroll
Expense(+E, -SE) -$600,000
Record
dr
10-10
=
Wages and Salaries Expense (+E, -SE)
cr Withheld Income Taxes Payable (+L)
cr FICA Payable (+L)
cr United Way Payable (+L)
cr Cash (-A)
600,000
58,000
48,800
10,000
483,200
Accrued Payroll
Employer Payroll Taxes
Employers have other liabilities related to payroll.
1. FICA tax (a “matching” contribution)
2. Federal unemployment tax
3. State unemployment tax
Assume General Mills was required to contribute $48,800 for FICA, $750
for federal unemployment tax, and $4,000 for state unemployment tax.
1
Analyze
Assets
=
Liabilities
+
FICA Payable (+L) +48,800
FUTA Payable (+L) +750
SUTA Payable (+L) +4,000
2
Payroll Tax
Expense (+E, -SE) -53,550
Record
dr
10-11
Stockholders’ Equity
Payroll Tax Expense (+E, -SE)
cr FICA Tax Payable (+L)
cr Federal Unemployment Tax Payable (+L)
cr State Unemployment Tax Payable (+L)
53,550
48,800
750
4,000
Accrued Income Taxes
Corporations calculate taxable income by subtracting tax-allowed
expenses from revenues. This taxable income is then multiplied by a tax
rate, which for most large corporations is about 35 percent.
Let’s assume General Mills calculated taxable income to be $1,000,000,
and is subject to a 35% tax rate, so income taxes owed are $350,000
($1,000,000 × 35%)
1
Analyze
Assets
=
Liabilities
Income Tax
Payable (+L) +350,000
2
Stockholders’ Equity
Income Tax
Expense (+E, -SE) -350,000
Record
dr
10-12
+
Income Tax Expense (+E, -SE)
cr Income Tax Payable (+L)
350,000
350,000
Notes Payable
Four key events occur with any note payable:
1. establishing the note,
2. accruing interest incurred but not paid,
3. recording interest paid, and
4. recording principal paid.
10-13
Notes Payable
1. Establish the note on November 1, 2012.
Assume that on November 1, 2012, General Mills borrowed $100,000 cash
on a one-year note that required General Mills to pay 6 percent interest and
$100,000 principal, both on October 31, 2013.
1
Analyze
Assets
Cash (+A) +100,000
2
Notes
Payable (+L)
+
Stockholders’ Equity
+100,000
Record
dr
10-14
Liabilities
=
Cash (+A)
cr Notes Payable (+L)
100,000
100,000
Notes Payable
2. Accrue interest owed but not paid on December 31, 2012.
1
Analyze
Assets
Liabilities
=
Interest
Payable (+L)
2
Stockholders’ Equity
Interest
Expense (+E, -SE)
-1,000
Record
dr Interest Expense (+E, -SE)
cr Interest Payable (+L)
10-15
+1,000
+
1,000
1,000
Notes Payable
3. Record interest paid on October 31, 2013.
1
Analyze
Assets
Cash (-A) -6,000
2
Liabilities
Interest
Payable (-L) -1,000
+
Stockholders’ Equity
Interest
Expense (+E, -SE)
-5,000
Record
dr
dr
10-16
=
Interest Expense (+E, -SE)
Interest Payable (-L)
cr Cash (-A)
5,000
1,000
6,000
Notes Payable
4. Record principal paid of $100,000 on October 31, 2013.
1
Analyze
Assets
=
Cash (-A) -100,000
2
Note
Payable (-L)
+
Stockholders’ Equity
-100,000
Record
dr
10-17
Liabilities
Note Payable (-L)
cr Cash (-A)
100,000
100,000
Current Portion of Long-Term
Debt
Long-Term Debt
Current Portion of
Long-term Debt
Noncurrent Portion
of Long-term Debt
Borrowers must report in Current Liabilities the portion of
long-term debt that is due to be paid within one year.
10-18
Additional Current Liabilities
10-19
Sales Tax
Payable
Payments collected from
customers at time of sale create
a liability that is due to the state
government.
Unearned
Revenue
Cash received in advance of
providing services creates a
liability of services due to the
customer .
Additional Current Liabilities
Best Buy sells a television for $1,000 cash plus 5 percent sales tax.
$1,000 × 5% = $50 sales tax collected
1 Analyze
Assets
Cash (+A) +1,050
2
=
Liabilities
Sales Tax
Payable (+L) +50
+
Stockholders’ Equity
Sales
Revenue (+R, +SE)
Record
dr
Cash (+A)
cr Sales Tax Payable (+L)
cr Sales Revenue (+R, +SE)
1,050
50
1,000
When Best Buy pays the sales tax to the state government, its
accountants will reduce Sales Tax Payable (with a debit) and
reduce Cash (with a credit).
10-20
+1,000
Additional Liabilities
On May 14th 2010, Live Nation Entertainment (the owner of
Ticketmaster), received $8 million cash for advance ticket sales for
two Lady Gaga concerts to be held on February 21 and 22, 2011.
1 Analyze
Assets
Cash (+A) +8
2
Liabilities
+
Stockholders’ Equity
Unearned
Revenue (+L) +8
Record
dr
10-21
=
Cash (+A)
cr Unearned Revenue (+L)
8
8
Additional Liabilities
When the February 21st concert is held, Live Nation Entertainment
can recognize one half of the unearned revenue as earned
revenue, as they have fulfilled part of the liability.
1 Analyze
Assets
=
Liabilities
Unearned
Revenue (-L) -4
2
Stockholders’ Equity
Concert
Revenue
(+R, +SE) +4
Record
dr
10-22
+
Unearned Revenue (-L)
cr Concert Revenue (+R, +SE)
4
4
Learning Objective 10-3
Analyze and record bond liability
transactions.
10-23
Long-Term Liabilities
Common Long-Term Liabilities
1. Long-term notes payable
2. Deferred income taxes
3. Bonds payable
Bonds are financial instruments that outline the
future payments a company promises to make
in exchange for receiving a sum of money now.
10-24
Bonds
Key Elements of a Bond
1. Maturity date
2. Face value
3. Stated interest rate
Interest Computation
12
$1,000 × 6% × 12 = $60
Bond Pricing
The bond price involves present value computations and is the amount
that investors are willing to pay on the issue date for the bonds.
10-25
Bonds
Balance Sheet Reporting of Bond Liability
Relationships between Interest Rates and Bond Pricing
10-26
Bonds
Bonds Issued at Face Value
General Mills receives $100,000 cash in exchange for issuing
100 bonds at their $1,000 face value, so the bonds are issued at
total face value (100 × $1,000 = $100,000).
1 Analyze
Assets
Cash (+A) +100,000
2
+
Stockholders’ Equity
Bonds
Payable (+L)+100,000
Record
dr
10-27
Liabilities
=
Cash (+A)
cr Bonds Payable (+L)
100,000
100,000
Bonds
Bonds Issued at a Premium
General Mills issues 100 of its $1,000 bonds at a price of
107.26 percent of face value, the company will receive
$107,260 (100 × $1,000 × 1.0726).
1
Analyze
Assets
Cash (+A) +107,260
2
Liabilities
+
Stockholders’ Equity
Bonds Payable (+L) +100,000
Premium on
Bonds Payable (+L) +7,260
Record
dr
10-28
=
Cash (+A)
cr Bonds Payable (+L)
cr Premium on Bonds Payable (+L)
107,260
100,000
7,260
Bonds
Bonds Issued at a Discount
General Mills receives $93,376 for bonds with a total face value of
$100,000, the cash-equivalent amount is $93,376, which represents
the liability on that date. These bonds are issued at a discount
because the cash received is less than the face value of the bonds.
1
Analyze
Assets
Cash (+A) +93,376
2
Liabilities
+
Stockholders’ Equity
Bonds Payable (+L) +100,000
Discount on
Bonds Payable (+xL,-L)-6,624
Record
dr
dr
10-29
=
$100,000 - $93,376 = $6,624 discount
Cash (+A)
Discount on Bonds Payable (+xL, -L)
cr Bonds Payable (+L)
93,376
6,624
100,000
Interest on Bonds Issued at Face Value
General Mills issues bonds on January 1, 2013, at their total face
value of $100,000. The bonds have an annual stated interest rate of
6 percent payable in cash on December 31 of each year, General
Mills will need to accrue an expense and liability for interest at the
end of each accounting period. The end of the first accounting
period is January 31, 2013.
1
Analyze
Assets
$100,000 × 6% × 1/12 = $500 interest
=
Liabilities
Interest Payable (+L) +500
2
Stockholders’ Equity
Interest
Expense (+E, -SE)
-500
Record
dr
10-30
+
Interest Expense (+E, -SE)
cr Interest Payable (+L)
500
500
Interest on Bonds Issued at a Premium
Cash proceeds > Face value
Cash proceeds – Face value = Premium
Interest expense < Cash interest paid
Interest expense = Cash interest paid – Premium amortization
10-31
Interest on Bonds Issued at a Discount
Cash proceeds < Face value
Face value – Cash proceeds = Discount
Interest expense > Cash interest paid
Interest expense = Cash interest paid+ Discount amortization
10-32
Bond Retirement
General Mills’ bonds were retired with a payment
equal to their $100,000 face value. Let’s analyze and
record this transaction.
1
Analyze
Assets
=
Cash (-A) -100,000
2
+
Stockholders’ Equity
Bonds Payable (-L) -100,000
Record
dr
10-33
Liabilities
Bonds Payable (-L)
cr Cash (-A)
100,000
100,000
Bond Retirement
The early retirement of bonds has three financial effects. The company
1. pays cash,
2. eliminates the bond liability, and
3. reports either a gain or a loss.
Assume that in 2003, General Mills issued $100,000 of bonds at face value.
Ten years later, in 2013, the company retired the bonds early. At the time,
the bond price was 102, so General Mills made a payment of $102,000.
1
Analyze
Assets
Cash (-A) -102,000
2
+
Stockholders’ Equity
Loss on Bond
Retirement(+E,-SE) -2,000
Record
dr
dr
10-34
Cash Payment
$103,000
Liabilities
=
Carrying Value
100,000
Bonds
Payable (-L) -100,000
Loss on
Retirement
$3,000
Bonds Payable (-L)
Loss on Bond Retirement (+E, -SE)
cr Cash (-A)
100,000
2,000
102,000
Learning Objective 10-4
Describe how to account for
contingent liabilities.
10-35
Contingent Liabilities
Contingent liabilities are potential liabilities that arise from past
transactions or events, but their ultimate resolution depends
(is contingent) on a future event.
10-36
Learning Objective 10-5
Calculate and interpret the
quick ratio and the times
interest earned ratio.
10-37
Evaluate the Results
Two financial ratios are commonly used to assess a
company’s ability to generate resources to pay
future amounts owed:
1. Quick ratio
2. Times interest earned ratio
Quick Ratio =
(Cash + Short-term Investments + Accounts Receivable, Net)
Current Liabilities
Times Interest
=
Earned Ratio
10-38
(Net Income + Interest Expense + Income Tax Expense)
Interest Expense
Evaluate the Results
At the end of its 2011 fiscal year, General Mills reported $620 million of
cash and cash equivalents, no short-term investments, and $1,162 million
of net accounts receivable. The company reported $3,659 million in total
current liabilities.
Quick Ratio =
(Cash + Short-term Investments + Accounts Receivable, Net)
Current Liabilities
$620 + 0 + 1,162
3,659
=
0.487
A quick ratio of 0.487 implies that General Mills would
be able to pay only 48.7 percent of its current
liabilities, if forced to pay them immediately. However,
not all current liabilities are to be paid immediately.
10-39
Evaluate the Results
In 2011, General Mills reported net income of $1,798 million and interest
expense of $346 million, and income tax expense of $721 million. Let’s
calculate the times interest earned for 2011.
Times Interest
=
Earned Ratio
(Net Income + Interest Expense + Income Tax Expense)
Interest Expense
$1,798 + $346 + $721
$346
=
8.28 times
The ratio means that General Mills generates $8.28 of income (before the
costs of financing and taxes) for each dollar of interest expense. Reaching this
level of interest coverage was important to General Mills because its long-term
debt note reported that loan covenants required a minimum ratio of 2.5.
10-40
Chapter 10
Supplement 10A
Straight-Line Method of Amortization
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Bond Premium
Bond premium or discount decreases each year, until it is completely
eliminated on the bond’s maturity date. This process is called amortizing
the bond premium or discount. The straight-line method of amortization
reduces the premium or discount by an equal amount each period.
Recall our example when General Mills received $107,260 on the issue date
(January 1, 2013) but repays only $100,000 at maturity (December 31, 2016).
Under the straight-line method, this $7,260 is spread evenly as a reduction in
interest expense over the four years ($7,260 ÷ 4 = $1,815 per year).
1
Analyze
Assets
Cash (-A) -6,000
Cash Interest
Amortization
of
Premium
Liabilities
=
InterestPremium
Expense
on
Bonds Payable
2
(-L) -1,815
Expense (+E, -SE) -4,185
Record
dr
dr
10-42
$6,000
(1,815)
Stockholders’ Equity
+
$4,185 Interest
Interest Expense (+E, -SE)
Premium on Bonds Payable (-L)
cr Cash (-A)
4,185
1,815
6,000
Bond Premium
Amortization Schedule of Bonds Issued at a Premium
$7,260 - $1,815 = $5,445
$7,260 ÷ 4 = $1,815
$100,000 × 6% × 12/12 = $6,000
$107,260 – $1,815 = $105,445
$6,000 - $1,815 = $4,185
Notice that each of these amounts would plot as a straight-line!
10-43
Bond Discount
Recall our example where General Mills received $93,376 for four-year
bonds with a total face value of $100,000, implying a discount of $6,624.
The annual amortization of the discount is $1,656 ($6,624 ÷ 4).
1
Analyze
Assets
Cash (-A) -6,000
Cash Interest
Liabilities
=
Amortization
of
Discount
InterestDiscount
Expense
on
$6,000
+
1,656
$7,656
Bonds Payable(-xL,+L)+1,656
2
Interest
Expense (+E, -SE) -7,656
Record
dr
10-44
Stockholders’ Equity
Interest Expense (+E, -SE)
cr Discount on Bonds Payable (-xL, +L)
cr Cash (-A)
7,656
1,656
6,000
Bond Discount
Amortization Schedule of Bonds Issued at a Discount
$6,624 - $1,656 = $4,968
$6,624 ÷ 4 = $1,656
$100,000 × 6% × 12/12 = $6,000
$93,376 + $1,656 = $95,032
$6,000 + $1,656 = $7,656
10-45
Chapter 10
Supplement 10B
Effective-Interest Method of
Amortization
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Effective Interest Amortization
The effective-interest method of amortization is considered a conceptually superior
method of accounting for bonds because it correctly calculates interest expense by
multiplying the market interest rate times the carrying value of the bonds.
When General Mills adds this $7,260 premium to the $100,000 face value,
it reports a carrying value of $107,260 ($100,000 + $7,260) on January 1,
2013. The proceeds indicates that the market interest rte was 4 percent.
Interest (I) = Principal (P) × Rate (R) × Time (T)
Interest Expense = Carrying Value × Market Rate × n/12
$4,290 = $107,260 × 4% × 12/12
10-47
Effective Interest Amortization
General Mills issued 6% stated rate bonds for $107,260. The market
rate of interest on these bonds is 4%. The face amount of the bonds,
$100,000, results in cash interest is $6,000 ($100,000 × 6%). Let’s
amortize the premium on the bonds at the first interest payment date.
1
Analyze
Interest (I) = Principal (P) × Rate (R) × Time (T)
Liabilities
Stockholders’ Equity
=
+
Interest Expense = Carrying Value × Market Rate × n/12
-6,000
on
$4,290Premium
= $107,260
× 4% × 12/12 Interest
Assets
Cash (-A)
Bonds Payable (-L) -1,710
2
Record
dr
dr
10-48
Cash Interest
$ 6,000
Interest Expense
(+E, -SE)Interest
Effective
4,290
Premium on Bonds Payable (-L)
Amortization of Premium $1,710
cr Cash (-A)
Expense (+E, -SE) -4,290
4,290
1,710
6,000
Effective Interest Amortization
$6,000 - $4,290 = $1,710
$7,260 - $1,710 = $5,550
Effective Interest Amortization of Bonds Issued at a Premium
$107,260 × 4% × 12/12 = $4,290
$100,000 × 6% × 12/12 = $6,000
$107,260 - $1,710 = $105,550
Interest Expense decreases and Premium Amortization
increases each period. Cash interest is unchanged.
10-49
Effective Interest Amortization
General Mills issued $100,000 face value, 6%, 4-year bonds at a market
price to yield investors 8%. The bonds were issued at a discount of $6,624.
Let’s determine the effective interest for the first interest payment period.
1
Analyze
Interest (I)= = Principal
(P) × Rate (R) ×+ Time
(T)
Liabilities
Stockholders’
Equity
Interest ExpenseDiscount
= Carrying
Value × Market Rate
× n/12
-6,000
on
Interest
$7,470
= $93,376
× 8% × 12/12 Expense (+E, -SE) -7,470
Bonds
Payable(-xL,+L)+1,470
Assets
Cash (-A)
2
Record
dr
Cash Interest
$ 6,000
Interest ExpenseEffective
(+E, -SE)Interest
7,470
cr Discount on Bonds Payable (-L)
Amortization of Discount $ 1,470
cr
10-50
Cash (-A)
7,470
1,470
6,000
Effective Interest Amortization
$7,470 - $6,000 = $1,470
$6,624 - $1,470 = $5,154
Effective Interest Amortization of Bonds Issued at a Discount
$93,376 × 8% × 12/12 = $7,470
$100,000 × 6% × 12/12 = $6,000
$93,376 + $1,470 = $94,846
Both Interest Expense and Discount Amortization
increase each period. Cash interest is unchanged.
10-51
Chapter 10
Supplement 10C
Simplified Effective-Interest
Amortization
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Accounting for Bond Issue.
The shortcut method records the bonds at issuance at Bonds Payable,
Net. That is face amount less discount or face amount plus premium.
The following journal entries demonstrate how the shortcut is applied to
bonds issued at a premium, at face value, and at a discount.
10-53
Bond Premium
Interest (I) = Principal (P) × Rate (R) × Time (T)
Interest Expense = Bonds Payable, Net × Market Rate × n/12
Interest Expense $4,290 = $107,260 × 4% × 12/12
1
Analyze
Assets
Cash (-A) -6,000
2
Bonds
Payable, Net (-L)
-1,710
+
Stockholders’ Equity
Interest
Expense (+E, -SE) -4,290
Record
dr
dr
10-54
Liabilities
=
Interest Expense (+E, -SE)
Bonds Payable, Net (-L)
cr Cash (-A)
4,290
1,710
6,000
Bond Discount
Interest (I) = Principal (P) × Rate (R) × Time (T)
Interest Expense = Bonds Payable, Net × Market Rate × n/12
Interest Expense $7,470 = $93,376 × 8% × 12/12
1
Analyze
Assets
Cash (-A) -6,000
2
Bonds
Payable, Net (+L)
+
-1,470
Stockholders’ Equity
Interest
Expense (+E, -SE) -7,470
Record
dr
10-55
Liabilities
=
Interest Expense (+E, -SE)
cr Bonds Payable, Net (+L)
cr Cash (-A)
7,470
1,470
6,000
Chapter 10
Solved Exercises
M10-5, E10-2, E10-3, E10-8, E10-10,
PA10-3
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
M10-5 Reporting Current and Noncurrent Portions of Long-Term
Debt
Assume that on December 1, 2013, your company borrowed $15,000, a
portion of which is to be repaid each year on November 30.
Specifically, your company will make the following principal payments:
2014, $2,000; 2015, $3,000; 2016, $4,000; and 2017, $6,000. Show how
this loan will be reported in the December 31, 2014 and 2013 balance
sheets, assuming that principal payments will be made when required.
As of December 31,
2014
2013
Current Liabilities:
Current Portion of Long-term Debt
Long-term Debt
Total Liabilities
10-57
$
3,000
$
2,000
10,000
13,000
$ 13,000
$ 15,000
End of Chapter 10
10-58