10 1 10 REPORTING AND ANALYZING LIABILITIES 10

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10 REPORTING AND ANALYZING LIABILITIES 10 -2 Accounting, Fourth Edition

Study Objectives 10 -3 1. Explain a current liability and identify the major types of current liabilities. 2. Describe the accounting for notes payable. 3. Explain the accounting for other current liabilities. 4. Identify the types of bonds. 5. Prepare the entries for the issuance of bonds and interest expense. 6. Describe the entries when bonds are redeemed. 7. Identify the requirements for the financial statement presentation and analysis of liabilities.

Reporting and Analyzing Liabilities Current Liabilities What is a current liability? Notes payable Sales taxes payable Unearned revenues Current maturities of long-term debt Payroll and payroll taxes payable 10 -4 Bonds: Long. Term Liabilities Accounting for Bond Issues Accounting for Bond Retirements Types of bonds Issuing bonds at face value Issuing procedures Determining the market value of bonds Discount or premium on bonds Issuing bonds at a discount Issuing bonds at a premium Redeeming bonds at maturity Redeeming bonds before maturity Financial Statement Presentation and Analysis Balance sheet presentation Analysis Off-balancesheet financing

Current Liabilities What is a Current Liability? Two key features: 1. Company expects to pay the debt from existing current assets or through the creation of other current liabilities. 2. Company will pay the debt within one year or the operating cycle, whichever is longer. Current liabilities include notes payable, accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest payable. 10 -5 SO 1 Explain a current liability and identify the major types of current liabilities.

Current Liabilities Question To be classified as a current liability, a debt must be expected to be paid: a. out of existing current assets. b. by creating other current liabilities. c. within 2 years. d. both (a) and (b). 10 -6 SO 1 Explain a current liability, and identify the major types of current liabilities.

Current Liabilities Notes Payable 10 -7 u Written promissory note. u Require the borrower to pay interest. u Those due within one year of the balance sheet date are usually classified as current liabilities. SO 2 Describe the accounting for notes payable.

Current Liabilities Illustration: First National Bank agrees to lend $100, 000 on September 1, 2012, if Cole Williams Co. signs a $100, 000, 12%, four-month note maturing on January 1. When a company issues an interest-bearing note, the amount of assets it receives generally equals the note’s face value. Sept. 1 Cash 100, 000 Notes payable 10 -8 100, 000 SO 2 Describe the accounting for notes payable.

Current Liabilities Illustration: If Cole Williams Co. prepares financial statements annually, it makes an adjusting entry at December 31 to recognize interest. Dec. 31 Interest expense Interest payable 4, 000 * $100, 000 x 12% x 4/12 = 4, 000 10 -9 SO 2 Describe the accounting for notes payable.

Current Liabilities Illustration: At maturity (January 1), Cole Williams Co. must pay the face value of the note plus interest. It records payment as follows. Jan. 1 Notes payable Interest payable Cash 10 -10 100, 000 4, 000 104, 000 SO 2 Describe the accounting for notes payable.

Current Liabilities Sales Tax Payable 10 -11 u Sales taxes are expressed as a stated percentage of the sales price. u Retailer collects tax from the customer. u Retailer remits the collections to the state’s department of revenue. SO 3 Explain the accounting for other current liabilities.

Current Liabilities Illustration: The March 25 cash register readings for Cooley Grocery show sales of $10, 000 and sales taxes of $600 (sales tax rate of 6%), the journal entry is: Mar. 25 Cash 10, 600 Sales revenue Sales tax payable 10 -12 10, 000 600 SO 3 Explain the accounting for other current liabilities.

Current Liabilities Sometimes companies do not ring up sales taxes separately on the cash register. Illustration: Cooley Grocery rings up total receipts of $10, 600. Because the amount received from the sale is equal to the sales price 100% plus 6% of sales, (sales tax rate of 6%), the journal entry is: Mar. 25 Cash 10, 600 Sales revenue Sales tax payable 10, 000 * 600 * $10, 600 / 1. 06 = 10, 000 10 -13 SO 3 Explain the accounting for other current liabilities.

Current Liabilities Unearned Revenues that are received before the company delivers goods or provides services. 1. Company debits Cash, and credits a current liability account (unearned revenue). 2. When the company earns the revenue, it debits the Unearned Revenue account, and credits a revenue account. 10 -14 SO 3 Explain the accounting for other current liabilities.

Current Liabilities Illustration: Superior University sells 10, 000 season football tickets at $50 each for its five-game home schedule. The entry for the sales of season tickets is: Aug. 6 Cash 500, 000 Unearned ticket revenue 500, 000 As each game is completed, Superior records the earning of revenue. Sept. 7 Unearned ticket revenue Ticket revenue 10 -15 100, 000 SO 3 Explain the accounting for other current liabilities.

Current Liabilities Current Maturities of Long-Term Debt u Portion of long-term debt that comes due in the current year. u No adjusting entry required. Illustration: Wendy Construction issues a five-year, interest-bearing $25, 000 note on January 1, 2011. This note specifies that each January 1, starting January 1, 2012, Wendy should pay $5, 000 of the note. When the company prepares financial statements on December 31, 2011, $5, 000 1. What amount should be reported as a current liability? _____ $20, 000 2. What amount should be reported as a long-term liability? _______ 10 -16 SO 3 Explain the accounting for other current liabilities.

Current Liabilities Payroll and Payroll Taxes Payable The term “payroll” pertains to both: Salaries - managerial, administrative, and sales personnel (monthly or yearly rate). Wages - store clerks, factory employees, and manual laborers (rate per hour). Determining the payroll involves computing three amounts: (1) gross earnings, (2) payroll deductions, and (3) net pay. 10 -17 SO 3 Explain the accounting for other current liabilities.

Current Liabilities Illustration: Assume Cargo Corporation records its payroll for the week of March 7 as follows: Mar. 7 Salaries and wages expense 100, 000 FICA tax payable 7, 650 Federal tax payable 21, 864 State tax payable Salaries and wages payable 2, 922 67, 564 Record the payment of this payroll on March 7. Mar. 7 Salaries and wages payable Cash 10 -18 67, 564 SO 3

Current Liabilities Payroll tax expense results from three taxes that governmental agencies levy on employers. These taxes are: 10 -19 u FICA tax u Federal unemployment tax u State unemployment tax SO 3 Explain the accounting for other current liabilities.

Current Liabilities Illustration: Based on Cargo Corp. ’s $100, 000 payroll, the company would record the employer’s expense and liability for these payroll taxes as follows. Payroll tax expense 13, 850 FICA tax payable State unemployment tax payable Federal unemployment tax payable 10 -20 7, 650 800 5, 400 SO 3 Explain the accounting for other current liabilities.

Current Liabilities Question Employer payroll taxes do not include: a. Federal unemployment taxes. b. State unemployment taxes. c. Federal income taxes. d. FICA taxes. 10 -21 SO 3 Explain the accounting for other current liabilities.

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Bond: Long-Term Liabilities Bonds are a form of interest-bearing notes payable issued by corporations, universities, and governmental agencies. Sold in small denominations (usually $1, 000 or multiples of $1, 000). 10 -23 SO 4 Identify the types of bonds.

Bond: Long-Term Liabilities Types of Bonds 10 -24 u Secured u Unsecured u Convertible u Callable SO 4 Identify the types of bonds.

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Bond: Long-Term Liabilities Issuing Procedures u Bond certificate Ø Issued to the investor. Ø Provides name of the company issuing bonds, face value, maturity date, and contractual (stated) interest rate. 10 -26 u Face value - principal due at the maturity. u Maturity date - date final payment is due. u Contractual interest rate – rate to determine cash interest paid, generally semiannually. SO 4 Identify the types of bonds.

Bond: Long-Term Liabilities Illustration 10 -3 10 -27 SO 4

Bond: Long-Term Liabilities Determining the Market Value of Bonds Market value is a function of the three factors that determine present value: 1. the dollar amounts to be received, 2. the length of time until the amounts are received, and 3. the market rate of interest. The process of finding the present value is referred to as discounting the future amounts. 10 -28 SO 4 Identify the types of bonds.

Bond: Long-Term Liabilities Illustration: Assume that Acropolis Company on January 1, 2012, issues $100, 000 of 9% bonds, due in five years, with interest payable annually at year-end. Illustration 10 -4 Time diagram depicting cash flows Illustration 10 -5 Computing the market price of bonds 10 -29 SO 4 Identify the types of bonds.

Accounting for Bond Issues A corporation records bond transactions when it u issues or retires (buys back) bonds and u when bondholders convert bonds into common stock. Bonds may be issued at u face value, u below face value (discount), or u above face value (premium). Bond prices are quoted as a percentage of face value. 10 -30 SO 5 Prepare the entries for the issuance of bonds and interest expense.

Accounting for Bond Issues Question The rate of interest investors demand for loaning funds to a corporation is the: a. contractual interest rate. b. face value rate. c. market interest rate. d. stated interest rate. 10 -31 SO 5 Prepare the entries for the issuance of bonds and interest expense.

Issuing Bonds at Face Value Illustration: Devor Corporation issues 100, five-year, 10%, $1, 000 bonds dated January 1, 2012, at 100 (100% of face value). The entry to record the sale is: Jan. 1 Cash 100, 000 Bonds payable 100, 000 Prepare the entry Devor would make to accrue interest on December 31. Dec. 31 Interest expense Interest payable 10 -32 10, 000 SO 5 Prepare the entries for the issuance of bonds and interest expense.

Issuing Bonds at Face Value Prepare the entry Devor would make to pay the interest on Jan. 1, 2013. Jan. 1 Interest payable Cash 10 -33 10, 000 SO 5 Prepare the entries for the issuance of bonds and interest expense.

Accounting for Bond Issues Assume Contractual Rate of 10% 10 -34 Market Interest Bonds Sold At 8% Premium 10% Face Value 12% Discount SO 5 Prepare the entries for the issuance of bonds and interest expense.

Accounting for Bond Issues Question Karson Inc. issues 10 -year bonds with a maturity value of $200, 000. If the bonds are issued at a premium, this indicates that: a. the contractual interest rate exceeds the market interest rate. b. the market interest rate exceeds the contractual interest rate. c. the contractual interest rate and the market interest rate are the same. d. no relationship exists between the two rates. 10 -35 SO 5 Prepare the entries for the issuance of bonds and interest expense.

Issuing Bonds at a Discount Illustration: Assume that on January 1, 2012, Candlestick Inc. sells $100, 000, five-year, 10% bonds at 98 (98% of face value) with interest payable on January 1. The entry to record the issuance is: Jan. 1 Cash Discount on bonds payable Bonds payable 98, 000 2, 000 100, 000 Illustration 10 -8 Computation of total cost of borrowing—bonds issued at discount 10 -36 SO 5 Prepare the entries for the issuance of bonds and interest expense.

Issuing Bonds at a Discount Statement Presentation 10 -37 Illustration 10 -7 Statement presentation of discount on bonds payable SO 5 Prepare the entries for the issuance of bonds and interest expense.

Issuing Bonds at a Discount Question Discount on Bonds Payable: a. has a credit balance. b. is a contra account. c. is added to bonds payable on the balance sheet. d. increases over the term of the bonds. 10 -38 SO 5 Prepare the entries for the issuance of bonds and interest expense.

Issuing Bonds at a Premium Illustration: Assume that the Candlestick Inc. bonds previously described sell at 102 rather than at 98. The entry to record the sale is: Jan. 1 Cash Bonds payable Premium on bonds payable 102, 000 100, 000 2, 000 Illustration 10 -12 Computation of total cost of borrowing—bonds issued at premium 10 -39 SO 5 Prepare the entries for the issuance of bonds and interest expense.

Issuing Bonds at a Premium Statement Presentation Illustration 10 -11 Statement presentation of premium on bonds payable 10 -40 SO 5 Prepare the entries for the issuance of bonds and interest expense.

Accounting for Bond Retirements Redeeming Bonds at Maturity Candlestick records the redemption of its bonds at maturity as follows: Bonds payable Cash 10 -41 100, 000 SO 6 Describe the entries when bonds are redeemed.

Accounting for Bond Retirements Redeeming Bonds at Maturity When a company retires bonds before maturity, it is necessary to: 1. eliminate the carrying value of the bonds at the redemption date; 2. record the cash paid; and 3. recognize the gain or loss on redemption. The carrying value of the bonds is the face value of the bonds less unamortized bond discount or plus unamortized bond premium at the redemption date. 10 -42 SO 6 Describe the entries when bonds are redeemed.

Accounting for Bond Retirements Question When bonds are redeemed before maturity, the gain or loss on redemption is the difference between the cash paid and the: a. carrying value of the bonds. b. face value of the bonds. c. original selling price of the bonds. d. maturity value of the bonds. 10 -43 SO 6 Describe the entries when bonds are redeemed.

Accounting for Bond Retirements Illustration: Assume at the end of the fourth period, Candlestick Inc. , having sold its bonds at a premium, retires the bonds at 103 after paying the annual interest. Assume that the carrying value of the bonds at the redemption date is $100, 400 (principal $100, 000 and premium $400). Candlestick records the redemption at the end of the fourth interest period (January 1, 2016) as: Bonds payable 100, 000 Premium on bonds payable Loss on bond redemption Cash 10 -44 400 2, 600 103, 000 SO 6 Describe the entries when bonds are redeemed.

Accounting for Bond Retirements Question When bonds are converted into common stock: a. a gain or loss is recognized. b. the carrying value of the bonds is transferred to paid -in capital accounts. c. the market price of the stock is considered in the entry. d. the market price of the bonds is transferred to paidin capital. 10 -45 SO 6 Describe the entries when bonds are redeemed.

Financial Statement Analysis and Presentation Balance Sheet Presentation Illustration 10 -15 10 -46 SO 7

Financial Statement Analysis and Presentation Analysis Illustration 10 -16 10 -47 SO 7

Financial Statement Analysis and Presentation Liquidity Illustration 10 -17 Liquidity ratios measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash. 10 -48 SO 7 Identify the requirements for the financial statement presentation and analysis of liabilities.

Financial Statement Analysis and Presentation Solvency 10 -49 Solvency ratios measure the ability of a company to survive over a long period of time. SO 7

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Financial Statement Analysis and Presentation Off-Balance-Sheet Financing 10 -51 u Contingencies u Leasing ► Operating lease ► Capital lease SO 7 Identify the requirements for the financial statement presentation and analysis of liabilities.

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Straight-Line Amortization appendix 10 A Amortizing Bond Discount To follow the matching principle, companies allocate bond discount to expense in each period in which the bonds are outstanding. Illustration 10 A-1 10 -53 SO 8 Apply the straight-line method of amortizing bond discount and bond premium.

Straight-Line Amortization appendix 10 A Amortizing Bond Discount Illustration: Candlestick, Inc. , sold $100, 000, five-year, 10% bonds on January 1, 2012, for $98, 000 (discount of $2, 000). Interest is payable on January 1 of each year. Prepare the entry to accrue interest at Dec. 31, 2012. Dec. 31 Interest expense Discount on bonds payable Interest payable 10 -54 10, 400 10, 000 SO 8 Apply the straight-line method of amortizing bond discount and bond premium.

Straight-Line Amortization appendix 10 A Amortizing Bond Discount Illustration 10 A-2 10 -55 SO 8 Apply the straight-line method of amortizing bond discount and bond premium.

Straight-Line Amortization appendix 10 A Amortizing Bond Premium Illustration: Candlestick, Inc. , sold $100, 000, five-year, 10% bonds on January 1, 2012, for $102, 000 (premium of $2, 000). Interest is payable on January 1 of each year. Prepare the entry to accrue interest at Dec. 31, 2012. Dec. 31 Interest expense Premium on bonds payable Interest payable 10 -56 9, 600 400 10, 000 SO 8 Apply the straight-line method of amortizing bond discount and bond premium.

Straight-Line Amortization appendix 10 A Amortizing Bond Premium Illustration 10 A-4 10 -57 SO 8 Apply the straight-line method of amortizing bond discount and bond premium.

appendix 10 B Effective Interest Amortization Under the effective-interest method, the amortization of the discount or premium results in interest expense equal to a constant percentage of the carrying value. Required steps: 1. Compute the bond interest expense. 2. Compute the bond interest paid or accrued. 3. Compute the amortization amount. Illustration 10 B-1 10 -58

Effective Interest Amortization appendix 10 B Amortizing Bond Discount Illustration: Candlestick, Inc. , sold $100, 000, five-year, 10% bonds on January 1, 2012, for $98, 000. The effective-interest rate is 10. 53% and interest is payable on Jan. 1 of each year. Prepare the bond discount amortization schedule. 10 -59 SO 9 Apply the effective-interest method of amortizing bond discount and bond premium.

Effective Interest Amortization appendix 10 B Amortizing Bond Discount 10 -60 Illustration 10 B-2 SO 9 Apply the effective-interest method of amortizing bond discount and bond premium.

Effective Interest Amortization appendix 10 B Amortizing Bond Discount Illustration: Candlestick, Inc. records the accrual of interest and amortization of bond discount on Dec. 31, as follows: Dec. 31 Interest expense Discount on bonds payable Interest payable 10 -61 10, 319 10, 000 SO 9 Apply the effective-interest method of amortizing bond discount and bond premium.

Effective Interest Amortization appendix 10 B Amortizing Bond Premium Illustration: Candlestick, Inc. , sold $100, 000, five-year, 10% bonds on January 1, 2012, for $102, 000. The effective-interest rate is 9. 48% and interest is payable on Jan. 1 of each year. Prepare the bond premium amortization schedule. 10 -62 SO 9 Apply the effective-interest method of amortizing bond discount and bond premium.

Effective Interest Amortization appendix 10 B Amortizing Bond Premium Illustration 10 B-4 10 -63 SO 9 Apply the effective-interest method of amortizing bond discount and bond premium.

Effective Interest Amortization appendix 10 B Amortizing Bond Premium Illustration: Candlestick, Inc. records the accrual of interest and amortization of premium discount on Dec. 31, as follows: Dec. 31 Interest expense Premium on bonds payable Interest payable 10 -64 9, 670 330 10, 000 SO 9 Apply the effective-interest method of amortizing bond discount and bond premium.

appendix 10 C Long-Term Notes Payable u May be secured by a mortgage that pledges title to specific assets as security for a loan. u Typically, the terms require the borrower to make installment payments over the term of the loan. Each payment consists of 1. interest on the unpaid balance of the loan and 2. a reduction of loan principal. u 10 -65 Companies initially record mortgage notes payable at face value. SO 10 Describe the accounting for long-term notes payable.

appendix 10 C Long-Term Notes Payable Illustration: Porter Technology Inc. issues a $500, 000, 12%, 20 -year mortgage note on December 31, 2012. The terms provide for semiannual installment payments of $33, 231. Illustration 10 C-1 10 -66 SO 10 Describe the accounting for long-term notes payable.

appendix 10 C Long-Term Notes Payable Illustration: Porter Technology records the mortgage loan and first installment payment as follows: Dec. 31 Cash 500, 000 Mortgage payable Jun. 30 Interest expense Mortgage payable Cash 10 -67 500, 000 3, 231 33, 231 SO 10 Describe the accounting for long-term notes payable.

appendix 10 C Long-Term Notes Payable Question Each payment on a mortgage note payable consists of: a. interest on the original balance of the loan. b. reduction of loan principal only. c. interest on the original balance of the loan and reduction of loan principal. d. interest on the unpaid balance of the loan and reduction of loan principal. 10 -68 SO 10 Describe the accounting for long-term notes payable.

Key Points 10 -69 u The basic definition of a liability under GAAP and IFRS is very similar. In a more technical way, liabilities are defined by the IASB as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. u IFRS requires that companies classify liabilities as current or non-current on the face of the statement of financial position (balance sheet), except in industries where a presentation based on liquidity would be considered to provide more useful information (such as financial institutions).

Key Points 10 -70 u Under IFRS, liabilities are classified as current if they are expected to be paid within 12 months. u Similar to GAAP, items are normally reported in order of liquidity. Companies sometimes show liabilities before assets. Also, they will sometimes show non-current (long-term) liabilities before current liabilities. u Under both GAAP and IFRS, preferred stock that is required to be redeemed at a specific point in time in the future must be reported as debt, rather than being presented as either equity or in a “mezzanine” area between debt and equity.

Key Points 10 -71 u Under IFRS, companies sometimes will net current liabilities against current assets to show working capital on the face of the statement of financial position. u IFRS requires use of the effective-interest method for amortization of bond discounts and premiums. GAAP allows use of the straight-line method where the difference is not material. Under IFRS, companies do not use a premium or discount account but instead show the bond at its net amount. u Unlike GAAP, IFRS splits the proceeds from the convertible bond between an equity component and a debt component. The equity conversion rights are reported in equity.

Key Points u 10 -72 The IFRS leasing standard is IAS 17. Both Boards share the same objective of recording leases by lessees and lessors according to their economic substance—that is, according to the definitions of assets and liabilities. However, GAAP for leases is much more “rules-based, ” with specific bright-line criteria (such as the “ 90% of fair value” test) to determine if a lease arrangement transfers the risks and rewards of ownership; IFRS is more conceptual in its provisions. Rather than a 90% cut-off, it asks whether the agreement transfers substantially all of the risks and rewards associated with ownership.

Key Points 10 -73 u Under GAAP, some contingent liabilities are recorded in the financial statements, others are disclosed, and in some cases no disclosure is required. Unlike GAAP, IFRS reserves the use of the term contingent liability to refer only to possible obligations that are not recognized in the financial statements but may be disclosed if certain criteria are met. u For those items that GAAP would treat as recordable contingent liabilities, IFRS instead uses the term provisions. Provisions are defined as liabilities of uncertain timing or amount. Examples of provisions would be provisions for warranties, employee vacation pay, or anticipated losses.

Looking into the Future The FASB and IASB are currently involved in two projects. One project is investigating approaches to differentiate between debt and equity instruments. The other project, the elements phase of the conceptual framework project, will evaluate the definitions of the fundamental building blocks of accounting. The results of these projects could change the classification of many debt and equity securities. In addition to these projects, the FASB and IASB have also identified leasing as one of the most problematic areas of accounting. A joint project will initially focus primarily on lessee accounting. 10 -74

Which of the following is false? a) Under IFRS, current liabilities must always be presented before non-current liabilities. b) Under IFRS, an item is a current liability if it will be paid within the next 12 months. c) Under IFRS, current liabilities are shown in order of liquidity. d) Under IFRS, a liability is only recognized if it is a present obligation. 10 -75

Under IFRS, a contingent liability is: a) disclosed in the notes if certain criteria are met. b) reported on the face of the financial statements if certain criteria are met. c) the same as a provision. d) not covered by IFRS. 10 -76

The joint projects of the FASB and IASB could potentially: a) change the definition of liabilities. b) change the definition of equity. c) change the definition of assets. d) All of the above. 10 -77

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