Chapter
Seven
Accounting
for
Liabilities
© 2015 McGraw-Hill Education.
LO 1
LO 1
Show how notes
payable and related
interest expense
affect financial
statements.
7-2
Accounting for Notes Payable
09/01/14 Borrowing
On September 1, 2014 Herrera Supply Company
(HSC) borrowed $90,000 from the National Bank.
HSC issued a note payable due in one year with an
annual interest rate of 9%.
Assets =
Cash =
90,000 =
Liab.
+
Stockholders' Equity
Notes
Com.
Pay. + Int. Pay. + Stk. + Ret. Earn.
+ n/a +
90,000 +
n/a
n/a
Net
Revenue - Expenses = Income
n/a - n/a = n/a
Cash
Flow
90,000 FA
7-3
Accrual of Interest Expense
12/31/14 Recognition of Interest Expense
At the end of 2014, HSC must accrue interest on its
note payable.
$90,000 × 9% × 4/12 = $2,700 interest expense
Assets
Cash
n/a
=
Liabilities
= Notes Pay. +
=
n/a
+
+
Int. Pay. +
2,700 +
Stockholders' Equity
Com.
Stk.
+ Ret. Earn.
n/a
+
(2,700)
Revenue - Expenses =
n/a
2,700 =
Net
Income
(2,700)
Cash Flow
n/a
7-4
Paying principal & interest at
maturity date
08/31/15 Recognition of interest expense. Payment of
principal and interest on the maturity date, August 31.
$90,000 × 9% × 8/12 = $5,400 interest expense
Assets
Cash
n/a
=
Liabilities
= Notes Pay. +
=
n/a
+
+
Int. Pay. +
5,400 +
Stockholders' Equity
Com.
Stk.
+ Ret. Earn.
n/a
+
(5,400)
Revenue - Expenses =
n/a
5,400 =
Net
Income
(5,400)
Cash Flow
n/a
Now, record payment of principal and interest payable.
Assets
=
Liabilities
Cash
= Notes Pay. +
(8,100) =
n/a
+
=
(90,000)
(90,000) +
+
Int. Pay.
+
(8,100) +
+
n/a
Stockholders' Equity
Com.
Stk.
+ Ret. Earn.
n/a
+
n/a
n/a
+
n/a
Revenue
n/a
n/a
-
Expenses
n/a
n/a
=
=
=
Net
Income
n/a
n/a
Cash Flow
(8,100) OA
(90,000) FA
7-5
LO 2
LO 1
Show how sales tax
liabilities affect
financial statements.
7-6
Accounting for Sales Tax
Most states require retail companies to collect sales
tax on items sold to their customers. The retailer then
remits the tax to the state at regular intervals. Sales
tax is a liability to the retailer until paid to the state.
HSC sells merchandise to a customer for $2,000 cash in a
state where the sales tax rate is 6%.
Assets
=
Liabilities +
Sales Tax
Cash
=
Pay
+
2,120 =
120 +
Stockholders' Equity
Com.
Stk.
+ Ret. Earn.
n/a
+
2,000
Revenue 2,000 -
Expenses =
n/a
=
Net
Income
2,000
Cash Flow
2,120 OA
7-7
Accounting for Sales Tax
Remitting the tax (paying cash to the state tax
authority) is an asset use transaction.
Assets
= Liabilities +
Sales Tax
Cash
=
+
Pay
(120) =
(120) +
Stockholders' Equity
Com.
Ret.
+ Earn.
Stk.
n/a
+
n/a
Revenue - Expenses =
n/a
n/a
=
Net
Income
n/a
Cash
Flow
(120) OA
7-8
LO 3
LO 1
Define contingent
liabilities and explain
how they are
reported in financial
statements.
7-9
Reporting Contingent Liabilities
7-10
LO 4
LO 1
Explain how
warranty obligations
affect financial
statements.
7-11
Warranty Obligations
To attract customers, many companies guarantee their
products or services. Within the warranty period, the
seller promises to replace or repair defective products
without charge.
Event 1
Sale of Merchandise
HSC sells $7,000 of merchandise for cash. The merchandise
had a cost of $4,000.
Assets
Cash
Liab.
+ Inventory =
7,000 +
n/a
=
+
n/a
+
Equity
+
Ret. Earn.
=
n/a
+
7,000
(4,000) =
n/a
+
(4,000)
Rev.
-
7,000 n/a
-
Net
Income
Exp.
=
Cash Flow
n/a
=
7,000
7,000
4,000 =
(4,000)
n/a
OA
7-12
Warranty Obligations
Event 2 Recognition of Warranty Expense
HSC estimates that warranty expense associated with
the current sale will be $100.
Assets
n/a
=
=
=
Liabilities
Warr. Pay
100
+
Equity
+ Ret. Earn.
+
(100)
Revenue
n/a
-
Expenses
100
=
=
Net
Income
(100)
Cash Flow
n/a
7-13
Warranty Obligations
Event 3 Settlement of Warranty Obligation
HSC pays $40 cash to repair defective merchandise
returned by a customer.
Assets
=
Cash
=
(40) =
Liabilities
+
Warr. Pay +
(40) +
Equity
Ret. Earn.
n/a
Revenue
n/a
-
Expenses
n/a
=
=
Net
Income
n/a
Cash Flow
(40) OA
7-14
Financial Statements
Balance Sheet
Income Statement
Sales Revenue
Cost of Goods Sold
Gross Margin
Warranty Expense
Net Income
$
$
7,000
(4,000)
3,000
(100)
2,900
Assets
Cash
Inventory
Total Assets
Liabilities
Warranties Payable
Stockholders' Equity
Common Stock
Retained Earnings
Total Liab. & Stockholders' Equity
$
$
8,960
2,000
10,960
60
$
5,000
5,900
10,960
Statement of Cash Flows
Operating Activities
Inflow from Customers
Outflows for Warranty
Net Inflows From Oper.
Investing Activities
Financing Activities
Beginning Cash Balance
Ending Cash Balance
$
$
7,000
(40)
6,960
0
0
2,000
8,960
7-15
LO 5
LO 1
Show how
installment notes
affect financial
statements.
7-16
Installment Notes Payable
Long-term installment notes are liabilities that usually
have terms from two to five years.
Principal
Payments
Company
Each payment covers
interest for the period
and a portion of the
principal.
Lender
As payments are made, the
amount allocated to
interest gets smaller and to
principal gets larger.
7-17
Installment Notes Payable
Applying payments to principal and interest
1. Identify the unpaid principal balance.
2. Amount applied to interest = Unpaid principal
balance (1) × Interest rate.
3. Amount applied to principal = Cash payment
less the amount applied to interest (2).
4. New unpaid principal balance = Unpaid
principal balance (1) less the amount applied to
principal (3).
7-18
Installment Notes Payable
On January 1, 2014, Blair Company issued a
$100,000 face value installment note to National
Bank. The note had a 9 percent annual interest
rate and a five year term. The loan agreement
called for five equal payments of $25,709 to be
made on December 31 of each year.
Prepare an amortization table for Blair’s note.
7-19
Installment Notes Payable
Cash payment determined using present value
concepts presented in a later chapter.
Unpaid
Cash
Amount
Amount
Principal
Accounting Balance on Payment on Applied to Applied to
Period
January 1 December 31 Interest Principal
2014
$
100,000 $
25,709 $
9,000 $ 16,709
2015
83,291
25,709
7,496
18,213
2016
65,078
25,709
5,857
19,852
2017
45,226
25,709
4,070
21,639
2018
23,587
25,710
2,123
23,587
All computations rounded to the nearest dollar; after the 2018 payment the loan balance is 0.
7-20
Installment Notes Payable
Annual
payments are
constant.
$30,000
$25,000
$20,000
Interest
Principal
$15,000
$10,000
$5,000
$Year 1
Year 2
Year 3
Year 4
Year 5
With each payment the amount applied to the principal
increases and the amount applied to interest decreases.
7-21
Installment Notes Payable
Issuing the note has the following effect
on Blair’s 2014 financial statements:
Assets
Cash
100,000
=
=
=
Liabilities
+
Note Pay.
100,000
Equity
+ Com. Stk. + Ret. Earn.
+
n/a
+
n/a
Revenue
n/a
-
Expenses
n/a
=
=
Net
Income
n/a
Cash Flow
100,000 FA
The December 2014 cash payment has the following
effect on Blair’s 2014 financial statements:
Assets
=
Cash
=
Liab.
Notes
Pay.
+
(25,709)
=
(16,709) +
+
Equity
Com.
Stk.
+
Ret. Earn.
n/a
+
(9,000)
Rev.
-
n/a
-
Exp.
=
9,000 =
Net
Income
(9,000)
Cash Flow
(9,000) OA
(16,709) FA
7-22
LO 6
LO 1
Show how a line of
credit affects
financial statements.
7-23
Line of Credit
Lines of credit are
pre-approved
financing plans that
allow companies to
borrow and repay
funds as needed up
to the maximum
credit line set by the
creditor.
Lines of credit are
normally used for
relatively shortterm borrowing to
finance seasonal
business needs.
7-24
Line of Credit
Lagoon Company borrows money using a line of credit to finance
building up its inventory. Lagoon repays the loan over the summer
using cash generated from sales. (Interest rates generally fluctuate based
on a designated interest rate benchmark.)
Each borrowing is an asset source transaction. Each
repayment is an asset use transaction.
7-25
LO 7
LO 1
Explain how to
account for bonds
issued at face value
and their related
interest costs.
7-26
Bonds Issued at Face Value
Mason Company issues bonds on January 1, 2011.
2014.
Principal = $100,000
Stated Interest Rate = 9%
Interest Date = 12/31
Maturity Date = Dec. 31, 2015
2018 (5 years)
Bond Selling Price
Mason
Company
Bond Certificate
at Face Value
Investors
7-27
Bonds Issued at Face Value
Event 1 Issue Bonds for Cash
Issuing the bonds has the following effect on Mason’s 2014
financial statements:
Assets
Cash
100,000
=
=
=
Liabilities
Bonds
Pay.
100,000
+
Equity
+
+
Revenue
n/a
n/a
-
Expenses
n/a
=
=
Net
Income
n/a
Cash
Flow
100,000 FA
Event 2 Investment in Land
Paying $100,000 cash to purchase land is an asset
exchange transaction.
Assets
Cash
(100,000)
=
+
Land
100,000
=
Liabilities +
n/a
Equity
+
n/a
Net
Revenue - Expenses = Income
n/a
-
n/a
=
n/a
Cash
Flow
(100,000) IA
7-28
Bonds Issued at Face Value
Event 3 Revenue Recognition
Recognizing $12,000 cash revenue from renting the
property is an asset source transaction.
Assets
Cash
12,000
=
=
=
Liabilities
n/a
+
+
+
Equity
Ret.
Earn.
12,000
Revenue
12,000
-
Expenses
n/a
=
=
Net
Income
12,000
Cash
Flow
12,000 OA
Event 4 Expense Recognition
Mason’s $9,000 ($100,000 x 0.09) cash payment in each of
the 5 years represents interest expense.
Assets
=
Cash
=
(9,000) =
Liabilities
n/a
+
Equity
+ Ret. Earn.
+
(9,000)
Revenue
n/a
-
Expenses
9,000
=
=
Net
Income
(9,000)
Cash Flow
(9,000) OA
7-29
Bonds Issued at Face Value
On each yearly interest payment date, Mason Company
will pay $9,000 in interest. The amount is computed
as follows:
$100, 000 × 9% = $9,000
Bond Interest Payments
Mason
Company
Investors
7-30
Bonds Issued at Face Value
Event 5 Sale of Investment in Land
Selling the land for cash equal to its $100,000 book value is
an asset exchange transaction.
Assets
Cash
100,000
=
+
Land
(100,000)
Liabilities +
=
Equity
+
n/a
n/a
Cash
Flow
100,000
Net
Income
Revenue - Expenses =
n/a
-
n/a
=
n/a
IA
Event 6 Payoff of Bond Liability
The principal repayment on December 31, 2018 will have the
following effect on Mason’s 2018 financial statements:
Assets
=
Liabilities
+
Cash
= Bonds Pay. +
(100,000) =
(100,000) +
Equity
n/a
Revenue
n/a
-
Expenses
n/a
=
=
Net
Income
n/a
Cash Flow
(100,000) FA
7-31
Bonds Issued at Face Value
On December 31, 2018, Mason Company will return
the $100,000 principal amount to the investors.
Bond Principal
at Maturity Date
Mason
Company
Investors
7-32
7-33
LO 8
LO 1
Use the straight-line
method to amortize
bond discounts and
premiums.
7-34
Bonds Issued at a Discount
Mason
issues
bonds
on January
1, 2014.1, 2011.
MasonCompany
Company
issues
bonds
on January
Principal
Principal= =$100,000
$100,000
Issued at 95 instead of face; cash proceeds of $95,000
Stated Interest Rate = 9%
Stated Interest Rate = 9%
Interest
Date
= 12/31
Interest Date
= 12/31
Maturity
Date
= Dec.
(5 years)
Maturity Date
= Dec.
31, 31,
20182015
(5 years)
Bond Selling Price
Mason
Company
Bond Certificate
at Face Value
Investors
7-35
Bonds Issued at a Discount
$100,000 face issued at 95:
Bonds Payable
Less: Discount on Bonds Payable
Carrying Value
$100,000
(5,000)
$ 95,000
Bond Selling Price
Mason
Company
Bond Certificate
at Face Value
Investors
7-36
Bonds Issued at a Discount
Expense Recognition for Bond issued at 95
Mason’s cash payment is $9,000 ($100,000 x 0.09)
Amortization of the discount of $5,000 over 5 years is $1,000
per year.
Interest expense recognized is $9,000 plus $1,000 = $10,000
Cash
=
(9,000) =
Carrying
Value of
Bond
Liability
1,000
+
+
Ret. Earn.
(10,000)
Revenue
n/a
-
Expenses
10,000
=
=
Net
Income
(10,000)
Cash
Flow
(9,000) OA
7-37
7-38
Bonds Issued at a Premium
Mason
issues
bonds
on January
1, 2014.1, 2011.
MasonCompany
Company
issues
bonds
on January
Principal
Principal= =$100,000
$100,000
Issued at 105 instead of face, cash proceeds of $105,000
Stated Interest Rate = 9%
Stated Interest Rate = 9%
Interest
Date
= 12/31
Interest Date
= 12/31
Maturity
Date
= Dec.
(5 years)
Maturity Date
= Dec.
31, 31,
20182015
(5 years)
Bond Selling Price
Mason
Company
Bond Certificate
at Face Value
Investors
7-39
Bonds Issued at a Premium
$100,000
Mason
Company
face issued
issues
at 105:
bonds on January 1, 2011.
Principal
= $100,000
Bonds
Payable
$100,000
Stated
InterestonRate
= 9%
Plus:
Premium
Bonds
Payable
5,000
Interest Date = 12/31
Carrying Value
$ 105,000
Maturity Date = Dec. 31, 2015 (5 years)
Bond Selling Price
Mason
Company
Bond Certificate
at Face Value
Investors
7-40
Bonds Issued at a Premium
Expense Recognition for Bond issued at 105
Mason’s cash payment is $9,000 ($100,000 x 0.09)
Amortization of the premium of $5,000 over 5 years is $1,000
per year.
Interest expense recognized is $9,000 less $1,000 = $8,000
Cash
=
(9,000) =
Carrying
Value of
Bond
Liability + Ret. Earn.
(1,000) +
(8,000)
Revenue - Expenses =
n/a
8,000 =
Net
Income
(8,000)
Cash
Flow
(9,000) OA
7-41
LO 9
LO 1
Distinguish between
current and
noncurrent assets
and liabilities.
7-42
Current Versus Noncurrent
Current assets are expected to be converted to cash or
consumed within one year or an operating cycle,
whichever is longer. Current assets include:
•Cash
•Marketable Securities
•Accounts Receivable
•Short-Term Notes Receivable
•Interest Receivable
•Inventory
•Supplies
•Prepaid Items
7-43
Current Versus Noncurrent
Current liabilities are due within one year or an
operating cycle, whichever is longer. Current liabilities,
also called short-term liabilities, include:
•Accounts Payable
•Short-Term Notes Payable
•Wages Payable
•Taxes Payable
•Interest Payable
7-44
LO 10
LO 1
Prepare a classified
balance sheet.
7-45
7-46
LO 11
LO 1
Use the effective
interest rate method
to amortize bond
discounts and
premiums
(Appendix).
7-47
Bonds Issued at a Discount
Mason
issues
bonds
on January
1, 2014.1, 2011.
MasonCompany
Company
issues
bonds
on January
Principal
Principal= =$100,000
$100,000
Issued at 95 instead of face; cash proceeds of $95,000
Stated Interest Rate = 9%
Stated Interest Rate = 9%
Interest
Date
= 12/31
Interest Date
= 12/31
Maturity
Date
= Dec.
(5 years)
Maturity Date
= Dec.
31, 31,
20182015
(5 years)
Bond Selling Price
Mason
Company
Bond Certificate
at Face Value
Investors
7-48
Bonds Issued At A Discount – Effective
Interest Rate Method
Interest paid in cash each year is $9,000.
The effective interest rate method is based
on the market rate of interest on the day of
issue and results in:
o varying amount of interest expense
o related and varying addition to the carrying
value of the bonds each year.
7-49
Amortization Schedule for Bond Discount
7-50
Bonds Issued at a Premium
United
issues
bondbonds
with face
of $100,000
MasonCompany
Company
issues
onvalue
January
1, 2011.
Issued
price
$107,985
Principal
= is$100,000
Stated Interest Rate = 10%;
Stated Interest Rate = 9%
Effective rate of interest = 8%
Interest
Date
= 12/31
Interest Date
= 12/31
Maturity
Date
Dec. 31, 2015 (5 years)
Term of bond
is 5=years
Bond Selling Price
Mason
Company
Bond Certificate
at Face Value
Investors
7-51
Amortization Schedule for Bond Premium
7-52
Effective Interest Rate Method to
Amortize the Premium.
See Exhibit 7.14. On Dec. 31, 2014, cash of $10,000 is paid
for interest. Interest expense of $8,639 is recognized and
$1,361 is subtracted from the carrying value of the bond
liability
7-53
End of Chapter Seven
7-54