10-1

Chapter

10
LIABILITIES

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 10-2

Learning Objective

To define liabilities an
distinguish between
current and long-term
liabilities.

LO1
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 10-3

The Nature of Liabilities

Defined as debts or obligations

arising from past transactions or
events.

Maturity = 1 year or less Maturity > 1 year

Current Noncurrent
Liabilities Liabilities
I.O.U.

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 10-4
Distinction Between
Debt and Equity
The acquisition of assets is financed
from two sources:
DEBT EQUITY

Funds from creditors, with Funds from

a definite due date, and owners
sometimes bearing
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 10-5

Current Liabilities

Obligations that must be paid within one

year or within the operating cycle,
whichever is longer.

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 10-6

Liabilities – Question

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?
The obligation will not be paid
within one year or one operating
cycle, so it is a noncurrent liability.

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 10-7

Accounts Payable

Short-term obligations to suppliers for purchases of

merchandise and to others for goods and services.

Office
Merchandise supplies
inventory invoices
invoices
Utility and
Shipping phone bills
charges

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 10-8

Learning Objective

To account for notes

payable and interest
expense.

LO2
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 10-9

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.

Current Notes Payable

Total Notes
Payable Noncurrent Notes Payable

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 10-10

Notes Payable

PROMISSORY NOTE
Miami, Fl Nov. 1, 2007
Location Date
Six months after this date Porter Company
promises to pay to the order of Security National Bank
the sum of $10,000.00 with interest at the rate
of 12.0% per annum.
signed John Caldwell
title treasurer

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 10-11

Notes Payable

On November 1, 2007, Porter Company

would make the following entry.
Date Description Debit Credit
Nov. 1 Cash 10,000
Note Payable 10,000

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 10-12

Interest Payable
• 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.
Interest
• To the lender, interest is a revenue. Rate
Up!

• To the borrower, interest is an

expense.
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 10-13

Interest Payable

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.
For example, if we needed to compute interest for
3 months, “Time” would be 3/12.

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 10-14

Interest Payable – Example

What entry would Porter Company make

on December 31, the fiscal year-end?

Date Description Debit Credit

Dec. 31 Interest Expense 200
Interest Payable 200

$10,00012% 2/12 = $200

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 10-15

Interest Payable – Example

Porter will pay the note on January 31,

2008. Let’s look at the entry.

Date Description Debit Credit

Jan. 31 Interest Expense 100
Interest Payable 200
Notes Payable 10,000
Cash 10,300

$10,00012% 1/12 = $100

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 10-16

Learning Objective

To describe the costs

and basic accounting
activities related to
payrolls.

LO3
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 10-17

Payroll Liabilities
Gross Pay

Net Pay

State and Voluntary

Medicare Federal Local Income Deductions
FICA Taxes
Taxes Income Tax Taxes
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 10-18

Unearned Revenue

Cash is sometimes collected from the

customer before the revenue is
actually earned.
As the earnings
process is
completed . .
Cash is
Deferred Earned
received
revenue is revenue is
in
recorded. recorded.
advance.

a liability account. © The McGraw-Hill Companies, Inc., 2008

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 10-19

Long-Term Liabilities

Relatively small debt

needs can be filled from
single sources.

or Insurance
or Pension
Banks Companies Plans
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 10-20

Long-Term Liabilities

Large debt needs are often

filled by issuing bonds.

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 10-21

Installment Notes Payable

Long-term notes that call for a series of

installment payments.

Each payment covers With each payment, the

interest for the period interest portion gets
AND a portion of the smaller and the principal
principal. portion gets larger.

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 10-22
Allocating Installment Payments
Between Interest and Principal

• Identify the unpaid principal balance.

• Interest expense = Unpaid Principal ×
Interest rate.
• Reduction in unpaid principal balance =
Installment payment – Interest expense.
• Compute new unpaid principal balance.

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 10-23

Learning Objective

To prepare an
amortization table
allocating payments
between interest and
principal.

LO4
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 10-24
Allocating Installment Payments
Between Interest and Principal

On January 1, 2007, 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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 10-25
Allocating Installment Payments
Between Interest and Principal

Reduction in
Interest Unpaid Unpaid
Date Payment Expense Balance Balance
Jan. 1, 2007 $ 7,581.57
Dec. 31, 2007 $ 2,000.00 $ 758.16 $ 1,241.84 6,339.73
Dec. 31, 2008 2,000.00 633.97 1,366.03 4,973.70
Dec. 31, 2009 2,000.00 497.37 1,502.63 3,471.07
Dec. 31, 2010 2,000.00 347.11 1,652.89 1,818.18
Dec. 31, 2011 2,000.00 181.82 1,818.18 (0.00)

Now, prepare the entry for the first payment on

December 31, 2007.
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 10-26
Allocating Installment Payments
Between Interest and Principal
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.

Date Description Debit Credit

Dec. 31 Interest Expense 758.16
Note Payable 1,241.84
Cash 2,000.00

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 10-27

Learning Objective

To describe corporate
bonds and explain the
tax advantage of debt
financing.

LO5
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 10-28

Bonds Payable

 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.
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 10-29

Bonds Payable
 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

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 10-30

Bonds Payable
 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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 10-31

Types of Bonds

Mortgage Debenture
Bonds Bonds

Convertibl Junk
e Bonds Bonds

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 10-32

Accounting for Bonds Payable

On January 1, 2007, 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.

Date Description Debit Credit

Jan. 1 Cash 1,500,000
Bonds Payable 1,500,000

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 10-33

Accounting for Bonds Payable

Record the interest payment

on July 1, 2007.

Date Description Debit Credit

July 1 Interest Expense 90,000
Cash 90,000

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 10-34

Bonds Sold Between Interest Dates

• Bonds are often sold between interest dates.

• The selling price of the bond is computed as:

Present value of the bond

+ Accrued interest since the
last interest payment
= Selling price of the bond

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 10-35

Learning Objective

To account for bonds

issued at a discount or
premium.

LO6
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 10-36
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.

Interest Bond Accounting for

Present
Rates Value of the Principal (a single
Price payment)
the Difference
+ Present
Stated Value
Market of the Interest
Bond Par Value Payments
There is(an annuity)
no difference
=Rate = Rate
Selling Price Price = Bond
of the of the Bond to account for.
Stated Market Bond Par Value The difference is accounted
Rate < Rate Price < of the Bond for as a bond discount.
Stated Market Bond Par Value The difference is accounted
Rate > Rate Price > of the Bond for as a bond premium.

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 10-37

Bonds Issued at a Discount

Matrix, Inc. is attempting to issue $1,000,000
principal amount of 9% bonds. The bonds pay
interest on June 30 and December 31 each year
and mature in 20 years. Investors are unwilling to
pay the full face amount for Matrix’s bonds because
they believe the interest rate is too low. To entice
investors, Matrix must lower the price of the bonds.
The difference between the new lower issue price
and the principal of $1,000,000 is called a discount.
Let’s see how we account for these bonds.
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 10-38

Bonds Issued at a Discount

Matrix, Inc. issues bonds on January 1, 2007.

Principal = $1,000,000
Issue price = $950,000
Stated Interest Rate = 9%
Interest Dates = 6/30 and 12/31
Maturity Date = Dec. 31, 2026 (20 years)

Cash
Principal Proceeds Discount
$1,000,000 - $ 950,000 = $ 50,000
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Bonds Issued at a Discount

To record the bond issue, Matrix, Inc. would
make the following entry on January 1, 2007:

Date Description Debit Credit

Jan. 1 Cash 950,000
Discount on Bonds Payable 50,000
Bonds Payable 1,000,000

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Bonds Issued at a Discount

Partial Balance Sheet as of January 1, 2007

Long-term Liabilities:
Bonds Payable $ 1,000,000
Less: Discount on Bonds Payable 50,000 $ 950,000

Maturity Value
Carrying Value

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Bonds Issued at a Discount

Amortizing the discount over the term of the

bond increases Interest Expense each
interest payment period.

Using the straight-line method, the

discount amortization will be $1,250
every six months.
$50,000 ÷ 40 periods = $1,250
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Amortization of the Discount

Interest paid every six months is calculated as follows:

$1,000,000 × 9% = $90,000 ÷ 2 = $45,000

We prepare the following journal entry to record

the first interest payment.
Date Description Debit Credit
Jun. 30 Interest Expense 46,250
Discount on Bonds Payable 1,250
Cash 45,000

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Bonds Issued at a Discount

$50,000 – $1,250 – $1,250

Partial Balance Sheet as of December 31, 2007

Long-term Liabilities:
Bonds Payable $ 1,000,000
Less: Discount on Bonds Payable 47,500 $ 952,500

Maturity Value

The carrying value will Carrying Value

increase to exactly $1,000,000
on the maturity date.
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 10-44

Bonds Issued at a Discount

To record an the principal repayment, Matrix, Inc

would make the following entry on December 31, 2026:

Date Description Debit Credit

Dec. 31 Bonds Payable 1,000,000
Cash 1,000,000

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Bonds Issued at a Premium

If bonds of other companies are yielding less than

9 percent, investors will be willing to pay more than
the face amount for Matrix’s 9% bonds. The issue
price of Matrix’s 9% bonds will rise because of
investor demand for the 9% bonds. The
difference between the higher issue price and the
principal of $1,000,000 is called a premium.

Let’s look at accounting for a premium.

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Bonds Issued at a Premium

Matrix, Inc. issues bonds on January 1, 2007.

Principal = $1,000,000
The only change from
Issue price = $1,050,000
previous Matrix example.
Stated Interest Rate = 9%
Interest Dates = 6/30 and 12/31
Maturity Date = Dec. 31, 2026 (20 years)

Cash
Proceeds Principal Premium
$1,050,000 - $ 1,000,000 = $ 50,000
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Bonds Issued at a Premium

To record the bond issue, Matrix, Inc. would

make the following entry on January 1, 2007:

Date Description Debit Credit

Jan. 1 Cash 1,050,000
Premium on Bonds Payable 50,000
Bonds Payable 1,000,000

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Bonds Issued at a Premium

Partial Balance Sheet as of January 1, 2007

Long-term Liabilities:
Bonds Payable $ 1,000,000
Add: Premium on Bonds Payable 50,000 $ 1,050,000

Maturity Value
Carrying Value

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 10-49

Bonds Issued at a Premium

Amortizing the premium over the term of the

bond decreases Interest Expense each
interest payment period.

Using the straight-line method, the

premium amortization will be
$1,250 every six months.
$50,000 ÷ 40 periods = $1,250
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 10-50

Bonds Issued at a Premium

To record an interest payment, Matrix, Inc. would make

the following entry on each June 30 and December 31:

Date Description Debit Credit

Jun. 30 Interest Expense 43,750
Premium on Bonds Payable 1,250
Cash 45,000

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 10-51

Bonds Issued at a Premium

$50,000 – $1,250 – $1,250

Partial Balance Sheet as of December 31, 2007

Long-term Liabilities:
Bonds Payable $ 1,000,000
Add: Premium on Bonds Payable 47,500 $ 1,047,500

Maturity Value

The carrying value will Carrying Value

decrease to exactly $1,000,000
on the maturity date.
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 10-52

Bonds Issued at a Premium

To record an the principal repayment, Matrix would make

the following entry on December 31, 2026:

Date Description Debit Credit

Dec. 31 Bonds Payable 1,000,000
Cash 1,000,000

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 10-53

Learning Objective

To explain the concept

of present value as it
relates to bond prices.

LO7
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 10-54

The Concept of Present Value

$1,000 In 5 years it In 25 years it

invested will be worth will be worth
today at 10%. $1,610.51. $10,834.71!

Present Future
Value Money can grow over time, Value
because it can earn interest.
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 10-55

The Concept of Present Value

How much is a future amount worth today?

Present Interest compounding periods Future

Value Value

Today

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 10-56

The Concept of Present Value

How much is a future amount worth today?

Three pieces of information must be known
to solve a present value problem:
o The future amount.
o The interest rate (i).
o The number of periods (n) the
amount will be invested.

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The Concept of Present Value

Two types of cash flows are involved

with bonds:
Periodic interest payments called annuities.

Today Maturity

 Principal payment
at maturity.
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 10-58

Early Retirement of Debt

Gains or losses incurred as a result of retiring

bonds should be reported as other income or
other expense on the income statement.
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 10-59

Learning Objective

To explain how estimated

liabilities, loss
contingencies, and
commitments are
disclosed in financial
statements.

LO8
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 10-60

Loss Contingencies

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.

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Estimated Liabilities

1. Liabilities that are known to exist.

2. Uncertain as to dollar amount.
3. Reasonable estimate of dollar
amount is available.

Example:
Product warranties

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 10-62

Learning Objective

To evaluate the safety

of creditor’s claims.

LO9
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 10-63
Evaluating the Safety
of Creditors’ Claims

Interest
Coverage Operating Income
=
Ratio Interest Expense

This ratio indicates a margin of

protection for creditors.

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 10-64

Liabilities – Question
Devon Mfg. reports annual operating income of
$100,000 and annual interest expense of
$10,000.
What is Devon’s interest coverage ratio?

Interest Operating Interest

= ÷
Coverage Income Expense
= $ 100,000 ÷ $ 10,000
= 10

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 10-65

Financial Leverage

Borrowing at one If we borrow

$1,000,000 at 8%
rate and and invest it at 10%,
investing at a we will clear
higher rate. $20,000 profit!

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 10-66

Learning Objective

To describe reporting
issues related to
leases, postretirement
benefits, and deferred
taxes.

LO10
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 10-67

Lease Payment Obligations

Operating Leases Capital Leases

Lease agreement transfers

Lessor retains risks and
risks and benefits
benefits associated with
associated with ownership
ownership.
to lessee.

Lessee records rent Lessee records a leased

expense as incurred. asset and lease liability.

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Capital Lease Criteria

A lease must be recorded as

a Capital Lease if it meets
any of the following criteria.

The lease transfers The lease contains

ownership to the a bargain purchase
lessee. option.

The lease term is equal to The PV of the minimum

or > 75% of the economic lease payments = 90% of
life of the property. the FMV of the property.

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Pensions
Employers offer pension
plans to employees.

The employer makes

payments to a pension
fund. Usually, this is an
Retirees receive independent entity
pension managed by a
payments from professional fund
the pension manager.
fund.

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Pensions
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.
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 10-71

Other Postretirement Benefits

Many companies offer benefits

to retirees other than pensions,
such as health coverage or
fitness club memberships.

Amount to
Current
be funded
liability
Unfunded liability next year
for nonpension
postretirement
benefits Remainder
Long-term
of unfunded
liability
amount
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Deferred Income Taxes

Corporations
pay income
taxes
quarterly.

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Deferred Income Taxes

The Internal Revenue
GAAP is the set of
Code is the set of
rules for preparing
rules for preparing tax
financial statements.
returns.

Results in . . . Usually. . . Results in . . .

Financial statement IRS income taxes

income tax expense. payable.

The difference between tax expense and tax

payable is recorded in an account called
deferred taxes.
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 10-74

Deferred Income Taxes – Example

Examine the December 31, 2007, information

for Matrix, Inc.
Revenues $ 1,000,000
Depreciation Expense:
Straight-line 200,000
Accelerated 320,000
Other Expenses 650,000

Matrix uses straight-line depreciation for financial

reporting and accelerated depreciation for income
tax reporting. Matrix’s tax rate is 30%.

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Deferred Income Taxes – Example

Compute Matrix’s income tax expense
and income tax payable.

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

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Deferred Income Taxes – Example

Compute Matrix’s income tax expense
and income tax payable.

Income Tax
Statement Return Income taxes
Difference
Revenues $ 1,000,000 $ 1,000,000 based on tax
Less:
return
Depreciation 200,000 320,000
Other expenses 650,000 650,000 income are
Income before taxes $ 150,000 $ 30,000 the taxes
payable for
× Tax rate 30% 30%
the period.
Income taxes $ 45,000 $ 9,000

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Deferred Income Taxes – Example

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.

Income Tax
Statement Return Difference
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

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End of Chapter 1O

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