Slide
10-1
Chapter
10
McGraw-Hill/Irwin
LIABILITIES
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Slide
10-2
The Nature of Liabilities
Defined as debts or obligations
arising from past transactions or
events.
Maturity = 1 year or less
Maturity > 1 year
Current
Liabilities
Noncurrent
Liabilities
I.O.U.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-3
Distinction Between
Debt and Equity
The acquisition of assets is financed from two
sources:
DEBT
Funds from creditors, with
a definite due date, and
sometimes bearing
interest.
McGraw-Hill/Irwin
EQUITY
Funds from
owners
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Slide
10-4
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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-5
Evaluating Liquidity
An important indicator of a company’s ability
to meet its current obligations.
Two commonly used measures:
Working Capital = Current Assets - Current Liabilities
Current Ratio = Current Assets ÷ Current Liabilities
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-6
Liabilities – Question
Devon Mfg. has current liabilities of
$230,000 and current assets of $322,000.
What is Devon’s current ratio?
Current
Ratio
McGraw-Hill/Irwin
Current
Current
=
÷
Assets
Liabilities
= $ 322,000 ÷ $ 230,000
=
1.4
© The McGraw-Hill Companies, Inc., 2002
Slide
10-7
Accounts Payable
Short-term obligations to suppliers for purchases of
merchandise and to others for goods and services.
Office
supplies
invoices
Merchandise
inventory
invoices
Shipping
charges
McGraw-Hill/Irwin
Utility and
phone bills
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Slide
10-8
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
McGraw-Hill/Irwin
Noncurrent Notes Payable
© The McGraw-Hill Companies, Inc., 2002
Slide
10-9
Notes Payable
PROMISSORY NOTE
Miami, Fl
Location
Six months after this date
promises to pay to the order of
the sum of
$10,000.00
of
12.0% per annum.
Nov. 1, 2003
Date
Porter Company
Security National Bank
with interest at the rate
signed
title
McGraw-Hill/Irwin
John Caldwell
treasurer
© The McGraw-Hill Companies, Inc., 2002
Slide
10-10
Notes Payable
On November 1, 2003, Porter Company
would make the following entry.
Date
Description
Nov. 1 Cash
Note Payable
McGraw-Hill/Irwin
Debit
Credit
10,000
10,000
© The McGraw-Hill Companies, Inc., 2002
Slide
10-11
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.
To the lender, interest is a revenue.
To the borrower, interest is an
Interest
Rate
Up!
expense.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-12
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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-13
Interest Payable – Example
What entry would Porter Company make
on December 31, the fiscal year-end?
Date
Description
Dec. 31 Interest Expense
Interest Payable
Debit
Credit
200
200
$10,00012% 2/12 = $200
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-14
Payroll Liabilities
Gross Pay
Net Pay
FICA Taxes
McGraw-Hill/Irwin
Medicare
Taxes
Federal
Income Tax
State and
Voluntary
Local Income Deductions
Taxes
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Slide
10-15
Unearned Revenue
Cash is sometimes collected from the
customer before the revenue is
actually earned.
As the earnings
process is
completed .
Cash is
received
in
advance.
McGraw-Hill/Irwin
Deferred
revenue is
recorded.
a liability account.
.
Earned
revenue is
recorded.
© The McGraw-Hill Companies, Inc., 2002
Slide
10-16
Long-Term Debt
Relatively small debt
needs can be filled from
single sources.
or
Banks
McGraw-Hill/Irwin
Insurance
Companies
or
Pension
Plans
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Slide
10-17
Long-Term Debt
Large debt needs are often
filled by issuing bonds.
McGraw-Hill/Irwin
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Slide
10-18
Installment Notes Payable
Long-term notes that call for a series of
installment payments.
Each payment covers
interest for the period
AND a portion of the
principal.
McGraw-Hill/Irwin
With each payment, the
interest portion gets
smaller and the principal
portion gets larger.
© The McGraw-Hill Companies, Inc., 2002
Slide
10-19
Allocating Installment Payments
Between Interest and Principal
 Identify the unpaid principal
balance.
 Unpaid Principal × Interest rate =
Interest expense.
 Installment payment - Interest
expense = Reduction in unpaid
principal balance.
 Compute new unpaid principal
balance.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-20
Allocating Installment Payments
Between Interest and Principal
On January 1, 2003, 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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-21
Allocating Installment Payments
Between Interest and Principal
Reduction in
Interest
Unpaid
Expense
Balance
Date
Payment
Jan. 1, 2003
Dec. 31, 2003 $ 2,000.00 $ 758.16 $
Dec. 31, 2004
2,000.00
633.97
Dec. 31, 2005
2,000.00
497.37
Dec. 31, 2006
2,000.00
347.11
Dec. 31, 2007
2,000.00
181.82
1,241.84
1,366.03
1,502.63
1,652.89
1,818.18
Unpaid
Balance
$ 7,581.57
6,339.73
4,973.70
3,471.07
1,818.18
(0.00)
Now, prepare the entry for the first payment on
December 31, 2003.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-22
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
credit to principal are all on the table.
Date
Description
Dec. 31 Interest Expense
Note Payable
Cash
McGraw-Hill/Irwin
Debit
Credit
758.16
1,241.84
2,000.00
© The McGraw-Hill Companies, Inc., 2002
Slide
10-23
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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-24
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
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-25
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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-26
Types of Bonds
Mortgage
Bonds
Debenture
Bonds
Convertible
Bonds
Junk Bonds
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-27
Accounting for Bonds Payable
On January 1, 2003, 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
Jan. 1 Cash
Bonds Payable
McGraw-Hill/Irwin
Debit
Credit
1,500,000
1,500,000
© The McGraw-Hill Companies, Inc., 2002
Slide
10-28
Accounting for Bonds Payable
Record the interest payment
on July 1, 2003.
Date
Description
July 1 Interest Expense
Cash
McGraw-Hill/Irwin
Debit
Credit
90,000
90,000
© The McGraw-Hill Companies, Inc., 2002
Slide
10-29
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
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-30
The Concept of Present Value
$1,000
invested
today at 10%.
Present
Value
McGraw-Hill/Irwin
In 5 years it
will be worth
$1,610.51.
Money can grow over time,
because it can earn interest.
In 25 years it
will be worth
$10,834.71!
Future
Value
© The McGraw-Hill Companies, Inc., 2002
Slide
10-31
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:
Present
compounding periods
The futureInterest
amount.
Value
The interest rate (i).
The number of periods (n) the amount will be
Today
invested.
McGraw-Hill/Irwin
Future
Value
© The McGraw-Hill Companies, Inc., 2002
Slide
10-32
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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-33
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
Principal (a single
payment)
Rates Value of the
Price
the Difference
+ Present
Value
of the Interest
annuity)
Stated
Market
Bond
Par Value Payments
There is(an
no difference
= Rate
= Bond
of the Bond
to account for.
=Rate
Selling
Price Price
of the
Stated
Rate
Stated
Rate
<
Market Bond
Par Value The difference is accounted
Rate Price < of the Bond
for as a bond discount.
>
Market Bond
Par Value The difference is accounted
Rate Price > of the Bond
for as a bond premium.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-34
Early Retirement of Debt
Bonds can be retired by . . .
Exercising a call
provision.
Purchasing the
bonds on the
open market.
Gains or losses incurred as a result of retiring bonds
should be reported as extraordinary items on the
income statement.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-35
Lease Payment Obligations
Operating Leases
Capital Leases
Lessor retains risks and
benefits associated with
ownership.
Lease agreement transfers
risks and benefits
associated with ownership
to lessee.
Lessee records rent
expense as incurred.
Lessee records a leased
asset and lease liability.
McGraw-Hill/Irwin
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Slide
10-36
Capital Lease Criteria
A lease must be recorded as
a Capital Lease if it meets
any of the following criteria.
The lease transfers
ownership to the
lessee.
The lease contains
a bargain purchase
option.
The lease term is equal to
or > 75% of the economic
life of the property.
The PV of the minimum
lease payments = 90% of
the FMV of the property.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-37
Pensions
Employers offer pension
plans to employees.
Retirees receive
pension
payments from
the pension
fund.
McGraw-Hill/Irwin
The employer makes
payments to a pension
fund. Usually, this is an
independent entity
managed by a
professional fund
manager.
© The McGraw-Hill Companies, Inc., 2002
Slide
10-38
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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-39
Other Postretirement Benefits
Many companies offer benefits
to retirees other than pensions,
such as health coverage or
fitness club memberships.
Unfunded liability
for nonpension
postretirement
benefits
McGraw-Hill/Irwin
Amount to
be funded
next year
Current
liability
Remainder
of unfunded
amount
Long-term
liability
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Slide
10-40
Deferred Income Taxes
Corporations
pay income
taxes quarterly.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-41
Deferred Income Taxes
GAAP is the set of
rules for preparing
financial statements.
Results in . . .
Financial statement
income tax expense.
The Internal Revenue
Code is the set of
rules for preparing tax
returns.
Usually. . .
Results in . . .
IRS income taxes
payable.
The difference between tax expense and tax
payable is recorded in an account called
deferred taxes.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-42
Deferred Income Taxes – Example
Examine the December 31, 2003, information
for X-Off Inc.
Revenues
Depreciation Expense:
Straight-line
Accelerated
Other Expenses
$ 1,000,000
200,000
320,000
650,000
X-Off uses straight-line depreciation for financial
reporting and accelerated depreciation for
income tax reporting. X-Off’s tax rate is 30%.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
10-43
Deferred Income Taxes – Example
Compute X-Off’s income tax expense
and income tax payable.
Income
Statement
Revenues
$ 1,000,000
Less:
Depreciation
200,000
Other expenses
650,000
Income before taxes $
150,000
× Tax rate
Income taxes
McGraw-Hill/Irwin
$
30%
45,000
Tax
The income tax
Return Difference
amount computed
based on financial
statement income
is income tax
expense for the
period.
© The McGraw-Hill Companies, Inc., 2002
Slide
10-44
Deferred Income Taxes – Example
Compute X-Off’s income tax expense
and income tax payable.
Income
Statement
Revenues
$ 1,000,000
Less:
Depreciation
200,000
Other expenses
650,000
Income before taxes $
150,000
× Tax rate
Income taxes
McGraw-Hill/Irwin
$
Tax
Return
$ 1,000,000
$
30%
45,000 $
320,000
650,000
30,000
30%
9,000
Difference
Income taxes
based on tax
return
income are
the taxes
payable for
the period.
© The McGraw-Hill Companies, Inc., 2002
Slide
10-45
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
Statement
Revenues
$ 1,000,000
Less:
Depreciation
200,000
Other expenses
650,000
Income before taxes $
150,000
× Tax rate
Income taxes
McGraw-Hill/Irwin
$
Tax
Return
$ 1,000,000
$
30%
45,000 $
320,000
650,000
30,000
Difference
$
-
$
(120,000)
120,000
30%
9,000 $
30%
36,000
© The McGraw-Hill Companies, Inc., 2002
Slide
10-46
Financial Leverage
Borrowing at one
rate and investing
at a higher rate.
McGraw-Hill/Irwin
If we borrow
$1,000,000 at 8% and
invest it at 10%, we
will clear $20,000
profit!
© The McGraw-Hill Companies, Inc., 2002
Slide
10-47
End of Chapter 10
Are we
having fun
yet?
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002