Chapter 10
Liabilities
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10-1
Introduction: Debt
Buying items on credit is a characteristic of modern business.
Each day, large retailers and credit card companies encourage
consumers to go deeper and deeper into debt. Add to credit
card and other consumer debt various long-term obligations—
such as home mortgages and automobile loans—and it’s not
surprising that payments on total household debt make up a
high percentage of total disposable income in the United
States.
Large corporations also borrow large amounts of capital by
issuing debt to finance expansion, make major acquisitions, and
for a wide variety of other purposes. The tremendous debt
service costs associated with corporate borrowing can require
a significant portion of a company’s operating cash flows.
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10-2
Introduction: Debt (concluded)
Consider the case of corporate giant Procter & Gamble (P&G).
In the company’s recent balance sheet, total liabilities are over
$65 billion, which represents approximately 55 percent of the
company’s assets. Included in this amount is long-term debt of
almost $21 billion, including 23 different issues of bonds and
other forms of debt instruments with varying repayment dates
that range as far out in the future as 2047.
From this illustration, you can see that long-term debt financing
is a major source of capital for large companies like Procter &
Gamble. Debt has a significant impact on all of P&G ’s financial
statements. This places significant responsibility on management
in terms of having available the necessary cash to service the
debt at specific dates during the year, as well as being in the
financial position required to repay the debt as it matures. Debt
financing is one of the major financial resources of companies.
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10-3
Nature of Liabilities
 Liabilities may be defined as debts or obligations arising
from past transactions or events that require settlement
at a future date.
 All liabilities have certain characteristics in common;
however, the specific terms of different liabilities and the
rights of the creditors vary greatly.
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10-4
Debt Vs. Equity
Businesses have two basic sources of financing:
1. Liabilities
2. Owners’ equity
Liabilities
◦ All liabilities eventually
mature.
◦ They come due and
must be paid.
◦ Providers of money
are considered
creditors rather than
owners.
Owners’ Equity
◦ Can be separated into
the original
investments of owners
and equity that was
earned and retained
by the company.
◦ Does not mature.
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10-5
Claims of Creditors
 The claims of creditors have legal priority over the
claims of owners.
 If a business ceases operations and liquidates, creditors
must be paid in full before any distributions can be
made to the owners.
 The relative security of creditors’ claims, however, can
vary among the creditors.
 Liabilities that are not secured by specific assets are
termed general credit obligations.
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10-6
Liabilities Bearing Interest
 Many long-term liabilities, and some short-term ones,
require the borrower to pay interest.
 Only interest accrued as of the balance sheet date
appears as a liability in the borrower’s balance sheet.
 The borrower’s obligation to pay interest in future
periods may be disclosed in the notes to the financial
statements, but it is not an existing liability.
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10-7
Estimated Liabilities
 Many liabilities are for a definite dollar amount, clearly
stated by contract. Examples include:
◦ Notes payable
◦ Accounts payable
◦ Accrued expenses
◦ Interest payable
◦ Salaries payable
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10-8
Estimated Liabilities (concluded)
 Estimated liabilities have two basic characteristics:
◦ The liability is known to exist.
◦ The precise dollar amount cannot be determined
until a later date.
EXAMPLE
The automobiles sold by most automakers are accompanied by a
warranty obligating the automaker to replace defective parts for a
period of several years and/or a specified number of miles. As each
car is sold, the automaker incurs a liability to perform any work that
may be required under the warranty. The dollar amount of this liability,
however, can only be estimated.
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10-9
Liability Classification
 Current Liabilities
◦ Expected to be paid within one year or within the
operating cycle, whichever is longer.
◦ Debt will be paid from current assets or through the
rendering of services.
 Long-term Liabilities
◦ All liabilities not meeting the criteria to be classified
as current.
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10-10
Common Indicators of Liquidity (ability
to pay debts in the near future)
Working Capital = Current Assets − Current Liabilities
Current Ratio = Current Assets
Current Liabilities
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10-11
Examples of Current Liabilities
Among the most common examples of current liabilities
are:
1. Accounts payable
2. Short-term notes payable
3. Current portion of long-term debt
4. Accrued liabilities
a. Interest payable
b. Income taxes payable
c. Payroll liabilities
5. Unearned revenue
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10-12
Accounts Payable
Accounts payable often are subdivided into the categories
of:
 Trade accounts payable
◦ Short-term obligations to suppliers for purchases of
merchandise.
 Other accounts payable
◦ Include liabilities for any goods and services other
than merchandise.
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10-13
Notes Payable
Notes payable usually are issued when bank loans are
obtained. Other transactions that may give rise to notes
payable include:
• Purchase of real estate or costly equipment.
• Purchase of merchandise.
• Substitution of a note for a past-due account
payable.
KEY POINT
Notes payable usually require the borrower to pay an interest charge.
Normally, the interest rate is stated separately from the principal
amount of the note.
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10-14
Note Payable: Example
On November 1, Porter Company borrows $10,000 from its
bank for a period of six months at an annual interest rate of 6
percent. Six months later on May 1, Porter Company will have
to pay the bank the principal amount of $10,000, plus $300
interest ($10,000 × 0.06 × 6/12). As evidence of this loan, the
bank will require Porter Company to issue a note payable
similar to the one below:
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10-15
Note Payable: Example (cont.)
The journal entry in Porter Company’s accounting records for
this November 1 borrowing is as follows:
No liability is recorded for the interest charges when the note
is issued. At the date the $10,000 is borrowed, the borrower
has a liability only for the principal amount of the loan; the
liability for interest accrues gradually over the life of the loan.
At December 31, two months’ interest expense has accrued,
and the following year-end adjusting entry is made.
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10-16
Note Payable: Example (concluded)
For simplicity, we assume that Porter Company makes
adjusting entries only at year-end. The entry on May 1 to
record payment of the note will be as follows:
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10-17
Current Portion of Long-Term Debt
Some long-term debts, such as mortgage loans, are payable
in a series of monthly or quarterly installments.
• Principal amount due within one year (or the
operating cycle) is regarded as a current liability.
• Remainder of the obligation is classified as a longterm liability.
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10-18
Accrued Liabilities
 Accrued liabilities arise from the recognition of
expenses for which payment will be made in a future
period.
 For this reason, accrued liabilities are sometimes
referred to as accrued expenses.
 Examples of accrued liabilities include:
◦ Interest payable
◦ Income taxes payable
◦ Payroll liabilities
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10-19
Payroll Liabilities
1.
Payroll Taxes and Mandated Costs
a. Social Security and Medicare taxes
o All employers must pay based on the wages and
salaries paid to each employee.
o The portion of earnings subject to these taxes
varies from year to year.
b. Federal Unemployment Taxes
o Apply only to the first set dollar amount earned
by each employee during the year.
c. State Unemployment Taxes
o Vary from state to state.
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10-20
Payroll Liabilities (cont.)
d. Workers’ Compensation Insurance
o State-mandated program that provides insurance
to employees against job-related injury.
o Premiums vary by state and occupational
classification.
2. Other Payroll-Related Costs
a. Many employers pay a portion or all of the
following for the benefit of employees:
o Health insurance
o Life insurance
o Employee pension plans
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10-21
Payroll Liabilities (concluded)
3.
Amounts Withheld from Employees’ Pay
a. Federal income taxes
b. State income taxes
c. Social Security taxes
d. Medicare taxes
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10-22
Unearned Revenue
 A liability for unearned revenue arises when a customer
pays in advance.
 Upon receipt of an advance payment from a customer,
the company debits Cash and credits a liability account
such as Unearned Revenue or Customers’ Deposits.
 As the services are rendered to the customer, an entry
is made debiting or reducing the liability account and
crediting or increasing a revenue account.
KEY POINT
Most liabilities are expected to be repaid with cash. Notice, however,
that a liability for unearned revenue normally is satisfied by delivering
goods or rendering services to the creditor, rather than by making
cash payments.
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10-23
Long-Term Liabilities
 Transactions involving long-term liabilities are relatively
few in number but usually involve large dollar amounts.
 Current liabilities usually arise from routine operating
transactions and occur frequently on a recurring basis.
 Long-term debt financing may become a permanent
part of the financial structure of the business.
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10-24
Maturing Obligations to Be Refinanced
 One special type of long-term liability is an obligation
that will mature in the current period but that is
expected to be refinanced on a long-term basis.
 If management has both the intent and the ability to
refinance soon-to-mature obligations on a long-term
basis, these obligations are classified as long-term
liabilities.
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10-25
International Case in Point
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10-26
Allocating Installment Payments Between
Interest and Principal
1. Identify the unpaid principal balance.
2. Interest Expense = Unpaid Principal × Interest Rate.
3. Reduction in Unpaid Principal Balance = Installment
Payment – Interest Expense.
4. Compute new unpaid principal balance.
On October 15,Year 1, King’s Inn purchases furnishings at a
cost of $16,398. The loan is an 18-month loan and has an
interest rate of 12 percent. The monthly payment is $1,000,
beginning November 15.
Let’s prepare an amortization table for King’s Inn.
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10-27
Preparing an Amortization Table
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10-28
Using the Amortization Table
The information needed for the journal entry can be
found on the amortization table. The cash payment
amount, the interest expense, and the principal
reduction amount are all in the table.
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10-29
Using the Amortization Table (cont.)
If December 31, year 1, is the end of the King’s Inn’s
financial reporting period, the company must make an
adjusting entry to record one-half month’s accrued
interest on this liability. The amount of this adjusting entry
is based on the unpaid balance shown in the amortization
table as of the last payment (December 15). At
December 31, year 1, this would be for $74: $14,718
× 1% × 1/2 month.
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10-30
Bonds Payable: Introduction
 To finance a particularly large project, such as developing
an oil field or purchasing a controlling interest in the
capital stock of another company, a corporation may
need more capital than any single lender can supply.
 When a corporation needs to raise particularly large
amounts of long-term capital—perhaps 50, 100, or 500
million dollars—it generally sells additional shares of
capital stock or issues bonds payable.
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10-31
Bonds Payable: Issuance
 When bonds are issued, the corporation usually utilizes
the services of an investment banking firm, called an
underwriter.
 The use of an underwriter assures the corporation
that the entire bond issue will be sold without delay
and that the entire amount of the proceeds will be
available at a specific date.
 Bonds can be sold on organized securities exchanges.
 Bond prices are usually quoted as a percentage of the
face amount.
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10-32
Types of Bonds
 Mortgage bond—secured by the pledge of assets.
 Debenture bond—unsecured.
 Callable bond—corporation has the right to
redeem the bonds in advance of the maturity date
by paying a specified call price.
 Convertible bond—may be exchanged at the
option of the bondholder for a specified number of
shares of capital stock.
 Junk bond—a bond issue that involves a
substantially greater risk of default than normal.
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10-33
Tax Advantage of Bond Financing
 An important advantage of raising money
by issuing bonds instead of stock is that
interest payments are deductible in
determining income subject to corporate
income taxes.
 Dividends paid to stockholders, however,
are not deductible in computing taxable
income.
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10-34
Tax Advantage: Example
Assume that a corporation pays income taxes at a rate of 30
percent on its taxable income. If this corporation issues $10
million of 6 percent bonds payable, it will incur interest
expense of $600,000 per year. This interest expense, however,
will reduce taxable income by $600,000, reducing the
corporation’s annual income taxes by $180,000. As a result,
the after-tax cost of borrowing the $10 million is actually only
$420,000.
This effectively reduces the cost of borrowing to 4.2 percent
($420,000/$10,000,000), considerably lower than the stated
rate of 6 percent.
A shortcut approach to computing the after-tax cost of borrowing is
simply multiplying the interest expense by 1 minus the company’s
tax rate, as follows: $600,000 × (1 – 0.30) = $420,000.
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10-35
Bonds Payable: Accountable Events
The accountable events for a bond issue usually
are:
• Issuance of the bonds.
• Periodic interest payments.
• Accrual of interest payable at the end of
each accounting period.
• Retirement of the bonds at maturity.
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10-36
Bonds Payable: Example
On March 1, 2021, Wells Corporation issues $1,000,000 of
6 percent, 20-year bonds payable, dated March 1. Interest
is payable semiannually, each March 1 and September 1.
Assume the bonds are issued at par (face) value.
Record the issuance of the bonds.
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10-37
Bonds Payable: Example (cont.)
Record the semi-annual interest payment on
September 1, 2021.
Annual interest =1,000,000 x 6% = $60,000
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10-38
Bonds Payable: Example (cont. 2)
Record the accrued interest at December 31, 2021.
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10-39
Bonds Payable: Example (concluded)
Record the interest payment on March 1, 2022.
At maturity date: 1/3/2041:
Interest exp
10,000
Interest payable 20,000
Cash
30,000
Bond payable
1,000,000
Cash
1,000,000
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10-40
Bonds Issued Between Interest Dates
 Bonds are often issued between the specified interest
dates.
 The investor pays the interest accrued up to the date of
issuance in addition to the stated price of the bond.
 The corporation then pays a full six months’ interest on
all bonds outstanding at the next stated interest
payment date.
◦ In effect, investors purchase the accrued interest
when they purchase the bond, and the corporation
returns that interest to the investors on the next
interest payment date.
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10-41
The company issues bonds on 1 May; interest payment dates 1
March, 1 Sept
 On the issuance date 1 May:
Cash 1,010,000
Bonds payable
1,000,000
Bonds Interest payable 10,000
Interest from 1 March to 1 May
1,000,000 x 6% x 2/12 = 10,000
 On the first bond interest payment 1 Sept:
Bonds interest expense 20,000
Bonds interest payable 10,000
Cash
30,000
1,000,000 x 6% x 6/12= 30,000

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10-42
Bonds Issued at a Discount or a Premium
The amount that corporations actually receive from the sale of
bonds is the present value of the principal and interest payments
they will pay in the future.
 Underwriters usually purchase bonds from the issuing corporation
at a discount—that is, at a price below face value.
 When bonds are issued, the borrower records a liability equal to
the amount received.
o If the bonds are issued at a discount—which is the normal
case—this liability is smaller than the face value of the bond
issue. However, at the maturity date, the issuing corporation
must repay the full face value of the bonds. As a result of this
process, over the term of the bond issue, the borrower’s
liability gradually increases from the original issue price to the
maturity value.

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10-43
Bonds Issued at a Discount: Example
Wells Corporation issues bonds on March 1, 2021.
Principal = $1,000,000
Issue price = $970,000
Stated interest rate = 6%
Interest dates = 9/1 and 3/1
Maturity date = March 1, 2041 (20 years)
Principal
$ 1,000,000
Cash
Proceeds
− $ 970,000
Discount
= $ 30,000
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10-44
Bonds Issued at a Discount: Example
(cont.)
To record the bond issue, Wells Corporation
would make the following entry on March 1,
2021.
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10-45
Bonds Issued at a Discount: Example
(concluded)
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10-46
Discount Amortization Journal Entry
Bonds interest expense 30,000
Cash
30,000
Bonds interest expense 750
Bonds discount
750
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10-47
Discount Amortization Journal Entry
(cont.)
Bonds interest expense 20,000
Bonds interest payable 20,000
Bonds interest expense. 500
Bonds discount
500
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10-48
Discount Amortization Journal Entry
(concluded)
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10-49
Illustration: Bonds Payable with Premium
Assume that on March 1, 2021, Wells Corporation sells $1 million of 6
percent, 20-year bonds payable to an underwriter at a price of 103
(meaning that the bonds were sold to the underwriter at 103 percent
of their face value). On March 1, 2021, Wells Corporation receives
$1,030,000 cash from the underwriter ($1,000,000 × 1.03) and
records a liability equal to this amount. When these bonds mature in
20 years, however, Wells will owe its bondholders only the $1 million
face value of the bond issue. The company’s initial liability must be
reduced by $30,000 over the 20 years that the bonds are outstanding.
This represents a reduction in the total cost of borrowing over the 20
years of the bond issue.
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10-50
Balance Sheet at Date of Issuance
Wells Corporation’s liability at the date of issuance will
appear in the balance sheet as follows.
Note that because the Premium on Bonds Payable account has
a credit balance, it is shown in the balance sheet as an increase
in the face or par value of bonds payable.
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10-51
Recording Interest Expense
Each September 1, the company records interest expense of $29,250,
computed as follows.
The entry to record interest expense on September 1 throughout the
life of the bond issue is as follows.
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10-52
31/12/2021:
DR Bonds interest expense. 19,500
DR Bonds premium
.
500
CR Bonds interest payable.
20,000
(bonds premium = 1500 x 4/12 =500)
1/3/2022:
DR Bonds interest expense. 9,750
DR Bonds interest payable. 20,000
DR Bonds premium.
.
250
CR Cash
30,000
DR Bonds interest expense. 10,000
DR Bonds interest payable. 20,000
CR Cash
30,000
DR Bonds premium
.
250
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10-53
CR Bond interest expense
250
Discounts and Premiums in Perspective
From a conceptual point of view, investors might pay a premium
price to purchase bonds that pay an above-market rate of
interest. If the bonds pay a below-market rate, investors will
buy them only at a discount.
But these concepts seldom come into play when bonds are first
issued. Most bonds are issued at the market rate of interest.
Corporate bonds are rarely issued at a premium. Bonds often
are issued at a small discount that represents only the
underwriter’s profit margin, not investors’ response to a belowmarket interest rate. The annual effects of amortizing bond
discounts or premiums may be relatively small because these
amounts are amortized over the relatively long life of the bond
issue.
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10-54
Concept of Present Value
The present value of a future cash receipt is the amount
that a knowledgeable investor will pay today for the right
to receive that future payment. The exact amount of the
present value depends on:
 The amount of the future payment.
 The length of time until the payment will be received.
 The rate of return required by the investor.
The present value will always be less than the future amount.
This is because money received today can be invested to earn
interest and grow to a larger amount in the future.
FV = 100 x (1+r)
PV = Sum(FV/(1+r))
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10-55
Rate of Interest
 The rate of interest that will cause a given present value
to grow to a given future amount is called the discount
rate or effective rate.
 The effective interest rate required by investors at any
given time is regarded as the going market rate of
interest.
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10-56
Case in Point
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10-57
Your Turn:You as a Financial Advisor
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10-58
Early Retirement of Bonds Payable
 Bonds are sometimes retired before the maturity date.
The principal reason for retiring bonds early is to
relieve the issuing corporation of the obligation to make
future interest payments.
 If the bonds can be purchased by the issuing
corporation at less than their carrying value, a gain is
realized on the retirement of the debt.
 If the bonds are reacquired by the issuing corporation
at a price in excess of their carrying value, a loss must
be recognized.
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10-59
Estimated Liabilities Defined
 The term estimated liabilities refers to liabilities that
appear in financial statements at estimated dollar
amounts.
 By definition, estimated liabilities involve some degree of
uncertainty. However, when the following conditions are
met, a liability is recognized and becomes a part of the
company’s financial statements:
◦ The liabilities are known to exist.
◦ The uncertainty as to dollar amount is not so great as
to prevent the company from making a reasonable
estimate and recording the liability.
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10-60
Loss Contingencies
 A loss contingency is a possible loss, stemming from
past events, that is expected to be resolved in the
future.
 Loss contingencies differ from estimated liabilities in
two ways.
1. First, a loss contingency may involve a greater
degree of uncertainty.
a. Often the uncertainty extends to whether any
loss or expense actually has been incurred.
b. In contrast, the loss or expense relating to an
estimated liability is known to exist.
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10-61
Loss Contingencies (cont.)
2. The concept of a loss contingency extends not
only to possible liabilities but also to possible
impairments of assets.
EXAMPLE
A common example of a loss contingency is a lawsuit pending against
a company. The lawsuit is based on past events, but until the suit is
resolved, uncertainty exists as to whether the company has sustained
a loss and, if it has, how much was that loss.
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Loss Contingencies (concluded)
 Loss contingencies are recorded in the accounting
records only when both of the following criteria are
met:
1. It is probable that a loss has been incurred.
2. The amount of loss can be reasonably estimated.
 When these criteria are not met, loss contingencies are
not formally recorded, but rather are disclosed in notes
to the financial statements if there is a reasonable
possibility that a material loss has been incurred.
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Example: Contingency Disclosure
Note 8: Contingencies
In October of 2021, the Company was named as
defendant in a $250 million patent infringement lawsuit.
The Company denies all charges and is preparing its
defense against them. It is not possible at this time to
determine the ultimate legal or financial responsibility that
may arise as a result of this litigation.
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Commitments
 Contracts for future transactions are called
commitments. They are not liabilities, but, if material, they
are disclosed in notes to the financial statements.
 Examples of commitments include:
◦ A corporation’s long-term employment contract with
a key officer.
◦ A contract for construction of a new plant.
◦ A contract to buy or sell inventory at future dates.
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Evaluating the Safety of Creditors’
Claims
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Evaluating the Safety of Creditors’
Claims (concluded)
Interest
Operating Income
Coverage = Annual Interest Expense
Ratio
This ratio indicates a margin of protection for
creditors. From the creditor’s point of view, the higher
this ratio, the better.
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How Much Debt Should a Business Have?
Is it wise for a company to use long-term debt to finance
growth and expansion? The answer hinges on another
question: Can the borrowed funds be invested within the
company to earn a return higher than the rate of
interest paid to creditors?
Summarizing the effects of leverage:
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Ethics, Fraud, & Governance Related to Debt
•
•
•
•
One of the most infamous financial frauds in U.S. history
occurred at Enron and was revealed in the fall of 2001.
A major part of the Enron fraud involved the
understatement of debt.
Enron understated its debt by at least $550 million each
year from 1997 to 2000.
WHY?
Enron’s management was motivated to understate debt in
order to maintain a high credit rating from Moody’s and
Standard & Poor’s.
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Special Types of Liabilities
Special types of liabilities common to most large
organizations:
1. Leases—contracts where the lessor (owner of the property)
gives the lessee (the renter) the right to use an asset for a
specified period of time in exchange for periodic rental
payments.
2. Pensions and other postretirement benefits—an obligation of
the employer for benefits that employees earn the right to
receive while they are working for that employer.
3. Deferred taxes—the portion of income taxes expense that is
deferred to future tax returns as a result of timing differences
between accounting principles and tax rules.
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Learning Objective Summary LO10-1
LO10-1: Define liabilities and distinguish between current
and long-term liabilities. Liabilities are obligations arising from
past transactions or events that require payment (or the rendering
of services) at some future date. Current liabilities are those
maturing within one year or the company’s operating cycle
(whichever is longer) and that are expected to be paid from current
assets. Liabilities classified as long term include obligations maturing
more than one year in the future and shorter-term obligations that
will be refinanced or paid from noncurrent assets.
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Learning Objective Summary LO10-2
LO10-2: Account for notes payable and interest expense.
Initially, a liability is recorded only for the principal amount of a
note—that is, the amount owed before including any interest
charges. Interest expense accrues over time. Any accrued interest
expense is recognized at the end of an accounting period by an
adjusting entry that records both the expense and a short-term
liability for accrued interest payable.
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Learning Objective Summary LO10-3
LO10-3: Describe the costs and the basic accounting
activities relating to payrolls. The basic cost of payrolls is the
salaries and wages earned by employees. However, all employers also
incur various payroll taxes, such as the employer’s share of Social
Security and Medicare, workers’ compensation premiums, and
unemployment insurance. Many employers also incur costs for
various employee benefits, such as health insurance and
postretirement benefits. These additional payroll-related costs
represent significant increases in the total cost of payroll when
added to the basic wages and salaries expense.
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Learning Objective Summary LO10-4
LO10-4: Prepare an amortization table allocating payments
between interest and principal. A typical amortization table
includes four money columns, showing (1) the amount of each
payment, (2) the portion of the payment representing interest
expense, (3) the portion of the payment that reduces the principal
amount of the loan, and (4) the remaining unpaid balance (or
principal amount). A separate line for each payment shows how the
total is allocated between interest expense and a reduction in
principal, as well as indicating the new unpaid balance subsequent to
the payment. As the principal amount declines, each successive
payment includes a smaller amount of interest and a larger amount
applied to reducing the principal.
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Learning Objective Summary LO10-5
LO10-5: Describe corporate bonds and explain the tax
advantage of debt financing. Corporate bonds are transferable
long-term notes payable. Each bond usually has a face value of
$1,000 (or a multiple of $1,000), calls for interest payments at a
contractual rate, and has a stated maturity date. By issuing
thousands of bonds to the investing public at one time, the
corporation divides a very large and long-term loan into many
transferable units.
One principal advantage of issuing bonds instead of capital stock is
that interest payments to bondholders are deductible in
determining taxable income, whereas dividend payments to
stockholders are not.
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Learning Objective Summary LO10-6
 LO10-6: Account for bonds issued at a discount or
premium. Bonds are issued at a discount or a premium when
the stated rate on the bonds differs from the market rate
otherwise available to investors. In the case of a discount, the
borrower must repay more than the amount originally
borrowed. Any discount in the issuance price represents
additional cost in the overall borrowing transaction.The
matching principle requires that the borrower recognize this
cost gradually over the life of the bond issue as interest
expense.

When bonds are issued at a premium, at maturity the
borrower will repay an amount less than the amount originally
borrowed. The premium reduces the overall cost of the
borrowing transaction. The matching principle requires that this
reduction in interest expense be recognized gradually over the
life of the bond issue.
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Learning Objective Summary LO10-7
 LO10-7: Explain the concept of present value as it
relates to bond prices. The basic concept of present value is
that an amount of money that will not be paid or received until
some future date is equivalent to a smaller amount of money
today. This is because the smaller amount available today could
be invested to earn interest and thereby accumulate over time
to the larger future amount.

The amount today considered equivalent to the future amount
is termed the present value of that future amount.The concept
of present value is used in the valuation of most long-term
liabilities. It also is widely used in investment decisions. The
concept of present value is covered in greater depth in
Appendix B in this text.
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Learning Objective Summary LO10-8
LO10-8: Explain how estimated liabilities, loss
contingencies, and commitments are disclosed in financial
statements. Estimated liabilities, such as an automobile
manufacturer’s warranties, appear in the financial statements at
their estimated dollar amounts. Loss contingencies appear as
liabilities only when it is probable that a loss has already been
incurred and the amount can be reasonably estimated. Unless both
these conditions are met, loss contingencies are not formally
recorded, but are disclosed in notes to the financial statements.
Commitments are contracts for future transactions; they are not
liabilities. However, if considered material, they are often disclosed
in the notes to the financial statements.
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Learning Objective Summary LO10-9
LO10-9 Evaluate the safety of creditors’ claims. Short-term
creditors may evaluate the safety of their claims using such
measures of liquidity as the current ratio, the quick ratio, the
available lines of credit, and the debtor’s credit rating. Long-term
creditors look more to signs of stability and long-term financial
health, including the debt ratio, interest coverage ratio, and trends in
net income and net cash flow from operating activities.
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Learning Objective Summary LO10-10
LO10-10: Describe reporting issues related to leases,
post-retirement benefits, and deferred taxes. Leases that are
essentially equivalent to a sale of property by the lessor to the
lessee are regarded as capital/Type A) leases. Under a capital lease
arrangement, the lessee reports in its balance sheet the present
values of both an asset (for example, leased equipment) and a
liability (lease payment obligations). Lease arrangements that do
not qualify as capital leases are treated as operating/ Type B leases,
requiring that lease payments be treated as expenses when paid.
Unfunded postretirement costs are reported in the balance sheet
at their discounted present values as long-term liabilities. Unfunded
postretirement benefits are often called a noncash expense. That is,
the expense is charged against current earnings without a
corresponding outlay of cash.
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Learning Objective Summary LO10-10
(cont.)
LO10-10 (cont.): Deferred income taxes result from
differences in timing of revenue and expense transaction between
financial accounting principles and tax rules. Items appearing in
the income statement today may not be subject to income taxes
until future years. Likewise, items included in income taxes today
may not appear in the company’s income statement until future
periods. Depending on the specific circumstances, deferred taxes
may appear in the balance sheet as liabilities.
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End of Chapter 10
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