10-1 10 Liabilities Learning Objectives 10-2 1 Explain how to account for current liabilities. 2 Describe the major characteristics of bonds. 3 Explain how to account for bond transactions. 4 Explain how to account for long-term notes payable. 5 Discuss how liabilities are reported and analyzed. LEARNING OBJECTIVE 1 Explain how to account for current liabilities. What Is a Current Liability? A debt that a company expects to pay 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 payable, salaries and wages payable, and interest payable. 10-3 LO 1 What Is a Current Liability? Question To be classified as a current liability, a debt must be expected to be paid within: a. one year. b. the operating cycle. c. 2 years. d. (a) or (b), whichever is longer 10-4 LO 1 Current Liabilities Notes Payable 10-5 Written promissory note. Frequently issued to meet short-term financing needs. Requires the borrower to pay interest. Issued for varying periods. LO 1 Notes Payable Illustration: First National Bank agrees to lend $100,000 on September 1, 2017, if Cole Williams Co. signs a $100,000, 12%, four-month note maturing on January 1. Instructions a) Prepare the entry on September 1st. b) Prepare the adjusting entry on December 31st, assuming monthly adjusting entries have not been made. c) Prepare the entry required on January 1, 2018, the maturity date. 10-6 LO 1 Notes Payable Illustration: First National Bank agrees to lend $100,000 on September 1, 2017, if Cole Williams Co. signs a $100,000, 12%, four-month note maturing on January 1. a) Prepare the entry on September 1st. Cash 100,000 Notes Payable 100,000 b) Prepare the adjusting entry on December 31st. Interest Expense Interest Payable 4,000 4,000 $100,000 x 12% x 4/12 = $4,000 10-7 LO 1 Notes Payable Illustration: First National Bank agrees to lend $100,000 on September 1, 2017, if Cole Williams Co. signs a $100,000, 12%, four-month note maturing on January 1, 2018. c) Prepare the entry at maturity. Notes Payable Interest Payable Cash 10-8 100,000 4,000 104,000 LO 1 Current Liabilities Sales Taxes Payable 10-9 Sales taxes are expressed as a stated percentage of the sales price. Selling company (retailer) ► collects tax from the customer. ► enters tax separately in cash register or includes in total receipts. ► remits the collections to the state’s department of revenue. LO 1 Sales Taxes Payable Illustration: The March 25 cash register reading for Cooley Grocery shows sales of $10,000 and sales taxes of $600 (sales tax rate of 6%), the journal entry is: Mar. 25 Cash Sales Revenue Sales Taxes Payable 10-10 10,600 10,000 600 LO 1 Sales Taxes Payable Sometimes companies do not enter sales taxes separately in the cash register. Illustration: Cooley Grocery enters 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 Sales Revenue Sales Tax Payable 10,600 10,000 * 600 * $10,600 ÷ 1.06 = $10,000 10-11 LO 1 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. 10-12 LO 1 Payroll and Payroll Taxes Payable 10-13 Illustration 10-2 Payroll deductions LO 1 Payroll and Payroll Taxes Payable Illustration: Assume Cargo Corporation records its payroll for the week of March 7 as follows: Salaries and Wages Expense 100,000 FICA Taxes Payable 7,650 Federal Income Taxes Payable 21,864 State Income Taxes Payable 2,922 Salaries and Wages Payable 67,564 Record the payment of this payroll on March 7. Salaries and Wages Payable Cash 10-14 67,564 67,564 LO 1 Payroll and Payroll Taxes Payable Payroll tax expense results from additional taxes that governmental agencies levy on employers. These taxes are: 10-15 Employer’s share of Social Security (FICA) taxes Federal unemployment taxes State unemployment taxes LO 1 Payroll and Payroll Taxes Payable 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 Taxes Payable State Unemployment Taxes Payable Federal Unemployment Taxes Payable 10-16 7,650 800 5,400 LO 1 Payroll and Payroll Taxes Payable Question Employer payroll taxes do not include: a. Federal unemployment taxes. b. State unemployment taxes. c. Federal income taxes. d. FICA taxes. 10-17 LO 1 ANATOMY OF A FRAUD Art was a custodial supervisor for a large school district. The district was supposed to employ between 35 and 40 regular custodians, as well as 3 or 4 substitute custodians to fill in when regular custodians were absent. Instead, in addition to the regular custodians, Art “hired” 77 substitutes. In fact, almost none of these people worked for the district. Instead, Art submitted time cards for these people, collected their checks at the district office, and personally distributed the checks to the “employees.” If a substitute’s check was for $1,200, that person would cash the check, keep $200, and pay Art $1,000. Total take: $150,000 THE MISSING CONTROLS Human resource controls. Thorough background checks should be performed. No employees should begin work until they have been approved by the Board of Education and entered into the payroll system. No employees should be entered into the payroll system until they have been approved by a supervisor. All paychecks should be distributed directly to employees at the official school locations by designated employees. Independent internal verification. Budgets should be reviewed monthly to identify situations where actual costs significantly exceed budgeted amounts. Source: Adapted from Wells, Fraud Casebook (2007), pp. 164–171. 10-18 Advance slide in slide show to reveal missing controls. LO 1 DO IT! 1a Wages and Payroll Taxes During the month of September, Lake Corporation’s employees earned wages of $60,000. Withholdings related to these wages were $4,590 for Social Security (FICA), $6,500 for federal income tax, and $2,000 for state income tax. Costs incurred for unemployment taxes were $90 for federal and $150 for state. Prepare the September 30 journal entries for a) salaries and wages expense and salaries and wages payable, assuming that all September wages will be paid in October, and b) the company’s payroll tax expense. 10-19 LO 1 DO IT! 1a Wages and Payroll Taxes Prepare the September 30 journal entries for a) salaries and wages expense and salaries and wages payable, assuming that all September wages will be paid in October. Salaries and Wages Expense 10-20 60,000 FICA Taxes Payable 4,590 Federal Income Taxes Payable 6,500 State Income Taxes Payable 2,000 Salaries and Wages Payable 46,910 LO 1 DO IT! 1a Wages and Payroll Taxes Prepare the September 30 journal entries for b) the company’s payroll tax expense. Payroll Tax Expense FICA Taxes Payable Federal Unemployment Taxes Payable State Unemployment Taxes Payable 10-21 4,830 4,590 90 150 LO 1 Current Liabilities Unearned Revenue Revenues received before the company 10-22 delivers goods or provides services. Illustration 10-3 Unearned revenue and revenue accounts LO 1 Unearned Revenue Illustration: Superior University sells 10,000 season football tickets at $50 each for its five-game home schedule. The entry for the sale of season tickets is: Aug. 6 Cash 500,000 Unearned Ticket Revenue 500,000 As each game is completed, Superior records the recognition of revenue with the following entry. Sept. 7 Unearned Ticket Revenue Ticket Revenue 10-23 100,000 100,000 LO 1 Current Liabilities Current Maturities of Long-Term Debt Portion of long-term debt that comes due in the current year. No adjusting entry required. Illustration: Wendy Construction issues a five-year, interest-bearing $25,000 note on January 1, 2017. This note specifies that each January 1, starting January 1, 2018, Wendy should pay $5,000 of the note. When the company prepares financial statements on December 31, 2017, $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? _________ 10-24 LO 1 DO IT! 1b Current Liabilities You and several classmates are studying for the next accounting examination. They ask you to answer the following questions. 1. If cash is borrowed on a $50,000, 6-month, 12% note on September 1, how much interest expense would be incurred by December 31? Solution $50,000 x 12% x 4/12 = $2,000 10-25 LO 1 DO IT! 1b Current Liabilities You and several classmates are studying for the next accounting examination. They ask you to answer the following questions. 2. How is the sales tax amount determined when the cash register total includes sales taxes? Solution First, divide the total cash register receipts by 100% plus the sales tax percentage to find the sales revenue amount. Second, subtract the sales revenue amount from the total cash register receipts to determine the sales taxes. 10-26 LO 1 DO IT! 1b Current Liabilities You and several classmates are studying for the next accounting examination. They ask you to answer the following questions. 3. If $15,000 is collected in advance on November 1 for 3 months’ rent, what amount of rent revenue should be recognized by December 31? Solution $15,000 x 2/3 = $10,000 10-27 LO 1 LEARNING OBJECTIVE 2 Describe the major characteristics of bonds. Long-term liabilities are obligations that are expected to be paid after one year. Bonds are a form of interest-bearing notes payable. 10-28 Sold in small denominations (usually $1,000 or multiples of $1,000). Attract many investors. Corporation issuing bonds is borrowing money. Person who buys the bonds (the bondholder) is investing in bonds. LO 2 Types of Bonds 10-29 LO 2 Bonds Issuing Procedures 10-30 State laws grant corporations the power to issue bonds. Board of directors and stockholders must approve bond issues. Board of directors must stipulate number of bonds to be authorized, total face value, and contractual interest rate. Bond terms set forth in legal document known as a bond indenture. Bond certificate, typically a $1,000 face value. LO 2 Bonds Issuing Procedures 10-31 Represents a promise to pay: ► sum of money at designated maturity date, plus ► periodic interest at a contractual (stated) rate on the maturity amount (face value). Interest payments usually made semiannually. Issued to obtain large amounts of long-term capital. Investment company sells the bonds for the issuing company. LO 2 Bonds Illustration 10-4 Bond certificate 10-32 LO 2 Bond Trading Bondholders can sell their bonds on national exchanges. Bond prices are quoted as a percentage of the face value. A quoted price of 97 means 97% of face value. Illustration 10-5 Market information for bonds Boeing Co. has outstanding 5.125%, $1,000 bonds that mature in 2017. They currently yield a 5.747% return. On this day, $33,965,000 of these bonds were traded. At the close of trading, the price was 96.595% of face value, or $965.95. 10-33 LO 2 Determining the Market Value of a Bond Current market price (present value) is a function of the three factors: 1. dollar amounts to be received, 2. length of time until the amounts are received, and 3. market rate of interest. The market interest rate is the rate investors demand for loaning funds. 10-34 LO 2 DO IT! 2 Bond Terminology State whether each of the following statements is true or false. If false, indicate how to correct the statement. True 1. Mortgage bonds and sinking fund bonds are both _______ examples of secured bonds. True 2. Unsecured bonds are also known as debenture bonds. _______ False 3. The stated rate is the rate investors demand for loaning _______ funds. True 4. The face value is the amount of principal the issuing _______ company must pay at the maturity date. False 5. The market price of a bond is equal to its maturity _______ value. 10-35 LO 2 LEARNING OBJECTIVE 3 Explain how to account for bond transactions. Corporation records bond transactions when it issues (sells), redeems (buys back) bonds, and when bondholders convert bonds into common stock. NOTE: If bondholders sell their bond investments to other investors, the issuing company receives no further money on the transaction, nor does the issuing company journalize the transaction. 10-36 LO 3 Accounting for Bond Transactions Issue at Face Value, Discount, or Premium? Illustration 10-8 Interest rates and bond prices Bond Contractual Interest Rate 10% 10-37 LO 3 Accounting for Bond Transactions 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. 10-38 LO 3 Accounting for Bond Transactions 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. 10-39 LO 3 Issuing Bonds at Face Value Illustration: On January 1, 2017, Candlestick, Inc. issues $100,000, five-year, 10% bonds at 100 (100% of face value). The entry to record the sale is: Jan. 1 Cash 100,000 Bonds Payable 10-40 100,000 LO 3 Issuing Bonds at Face Value Illustration: On January 1, 2017, Candlestick, Inc. issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest is payable annually on January 1. At December 31, 2017, Candlestick recognizes interest expense incurred with the following entry. Assume monthly accruals have not been made. Dec. 31 Interest Expense Interest Payable 10-41 10,000 10,000 LO 3 Issuing Bonds at Face Value Illustration: On January 1, 2017, Candlestick, Inc. issues $100,000, five-year, 10% bonds at 100 (100% of face value). Assume that interest is payable annually on January 1. Candlestick records the payment on January 1, 2018 as follows. Jan. 1 Interest Payable Cash 10-42 10,000 10,000 LO 3 Issuing Bonds at a Discount Illustration: On January 1, 2017, Candlestick, Inc. sells $100,000, five-year, 10% bonds for $98,000 (98% of face value). Interest is payable annually January 1. The entry to record the issuance is: Jan. 1 Cash 98,000 Discount on Bonds Payable Bonds Payable 10-43 2,000 100,000 LO 3 Issuing Bonds at a Discount Statement Presentation Illustration 10-9 Statement presentation of discount on bonds payable Carrying value or book value Sale of bonds below face value (discount) = total cost of borrowing > interest paid. Reason: Borrower is required to pay the bond discount at the maturity date. Therefore, the bond discount is considered to be a increase in the cost of borrowing. 10-44 LO 3 Issuing Bonds at a Discount Total Cost of Borrowing Illustration 10-10 OR 10-45 Illustration 10-11 LO 3 Issuing Bonds at a Discount Illustration 10-12 Amortization of bond discount 10-46 LO 3 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. 10-47 LO 3 Issuing Bonds at a Premium Illustration: On January 1, 2017, Candlestick, Inc. sells $100,000, five-year, 10% bonds for $102,000 (102% of face value). Interest is payable annually January 1. The entry to record the issuance is: Jan. 1 Cash 102,000 Bonds Payable Premium on Bonds Payable 10-48 100,000 2,000 LO 3 Issuing Bonds at a Premium Statement Presentation Illustration 10-13 Statement presentation of discount on bonds payable Sale of bonds above face value (premium) = total cost of borrowing < interest paid. Reason: Borrower is not required to pay the bond premium at the maturity date of the bonds. Therefore, the bond premium is considered to be a reduction in the cost of borrowing. 10-49 LO 3 Issuing Bonds at a Premium Total Cost of Borrowing Illustration 10-14 OR 10-50 Illustration 10-15 LO 3 Issuing Bonds at a Premium Illustration 10-16 Amortization of bond premium 10-51 LO 3 DO IT! 3a Bond Issuance Giant Corporation issues $200,000 of bonds for $189,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the balance sheet at the date of issuance. Solution (a) Cash Discount on Bonds Payable 189,000 11,000 Bonds Payable (b) Long-term liabilities Bonds payable Less: Discount on bonds payable 10-52 200,000 $200,000 11,000 $189,000 LO 3 Redeeming Bonds at Maturity Assuming that the company pays and records separately the interest for the last interest period, Candlestick records the redemption of its bonds at maturity as follows: Jan. 1 Bonds Payable Cash 10-53 100,000 100,000 LO 3 Redeeming Bonds Before Maturity When bonds are redeemed before maturity, it is necessary to: 1. eliminate carrying value of bonds at redemption date; 2. record cash paid; and 3. recognize gain or loss on redemption. The carrying value of the bonds is the face value of the bonds less any remaining bond discount or plus any remaining bond premium at the redemption date. 10-54 LO 3 Redeeming Bonds Before Maturity 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. 10-55 LO 3 Redeeming Bonds Before Maturity Illustration: Assume Candlestick, Inc. has sold its bonds at a premium. At the end of the fourth period, Candlestick retires these bonds at 103 after paying the annual interest. The carrying value of the bonds at the redemption date is $100,400. Candlestick makes the following entry to record the redemption at the end of the fourth interest period (January 1, 2021): Jan. 1 Bonds Payable Premium on Bonds Payable Loss on Bond Redemption Cash 10-56 100,000 400 2,600 103,000 LO 3 Converting Bonds into Common Stock Until conversion, the bondholder receives interest on the bond. For the issuer, the bonds sell at a higher price and pay a lower rate of interest than comparable debt securities without the conversion option. Upon conversion, the company transfers the carrying value of the bonds to paid-in capital accounts. No gain or loss is recognized. 10-57 LO 3 Converting Bonds into Common Stock Illustration: On July 1, Saunders Associates converts $100,000 bonds sold at face value into 2,000 shares of $10 par value common stock. Both the bonds and the common stock have a market value of $130,000. Saunders makes the following entry to record the conversion: July 1 Bonds Payable 10-58 100,000 Common Stock (2,000 x $10) 20,000 Paid-in Capital in Excess of Par— Common Stock 80,000 LO 3 Converting Bonds into Common Stock 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 paidin 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. 10-59 LO 3 People, Planet, and Profit Insight Unilever How About Some Green Bonds? Unilever recently began producing popular frozen treats such as Magnums and Cornettos, funded by green bonds. Green bonds are debt used to fund activities such as renewable- energy projects. In Unilever’s case, the proceeds from the sale of green bonds are used to clean up the company’s manufacturing operations and cut waste (such as related to energy consumption). The use of green bonds has taken off as companies now have guidelines as to how to disclose and report on these green-bond proceeds. These standardized disclosures provide transparency as to how these bonds are used and their effect on overall profitability. Investors are taking a strong interest in these bonds. Investing companies are installing socially responsible investing teams and have started to integrate sustainability into their investment processes. The disclosures of how companies are using the bond proceeds help investors to make better financial decisions. Source: Ben Edwards, “Green Bonds Catch On.” Wall Street Journal (April 3, 2014), p. C5. 10-60 LO 3 DO IT! 3b Bond Redemption R & B Inc. issued $500,000, 10-year bonds at a discount. Prior to maturity, when the carrying value of the bonds is $496,000, the company redeems the bonds at 98. Prepare the entry to record the redemption of the bonds. Solution Bonds Payable Discount on Bonds Payable 4,000 Gain on Bond Redemption 6,000 Cash ($500,000 x 98%) 10-61 500,000 490,000 LO 3 LEARNING OBJECTIVE 4 Explain how to account for long-term notes payable. Accounting for Long-Term Notes Payable May be secured by a mortgage that pledges title to specific assets as security for a loan. 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. 10-62 Companies initially record mortgage notes payable at face value. LO 4 Accounting for Long-Term Notes Payable Illustration: Porter Technology Inc. issues a $500,000, 8%, 20- year mortgage note on December 31, 2017. The terms provide for annual installment payments of $50,926 (not including real estate taxes and insurance). 10-63 Illustration 10-17 Mortgage installment payment schedule LO 4 Accounting for Long-Term Notes Payable Illustration: Porter Technology Inc. issues a $500,000, 8%, 20-year mortgage note on December 31, 2017. The terms provide for annual installment payments of $50,926 (not including real estate taxes and insurance). Prepare the entries to record the mortgage and first payment. Dec. 31 Cash 2017 Mortgage Payable Dec. 31 Interest Expense 2018 Mortgage Payable Cash 10-64 500,000 500,000 40,000 10,926 50,926 LO 4 Accounting for 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. 10-65 LO 4 DO IT! 4 Long-Term Notes Cole Research issues a $250,000, 6%, 20-year mortgage note to obtain needed financing for a new lab. The terms call for annual payments of $21,796 each. Prepare the entries to record the mortgage loan and the first payment. Solution Cash 250,000 Mortgage Payable Interest Expense ($250,000 x 6%) Mortgage Payable Cash 10-66 250,000 15,000* 6,796 21,796 LO 4 LEARNING OBJECTIVE 5 Discuss how liabilities are reported and analyzed. Illustration 10-18 Balance sheet presentation of current liabilities 10-67 LO 5 LEARNING OBJECTIVE 5 Presentation Discuss how liabilities are reported and analyzed. Illustration 10-19 Balance sheet presentation of long-term liabilities Companies report the current maturities of long-term debt under current liabilities if they are to be paid within one year or the operating cycle, whichever is longer. 10-68 LO 5 Use of Ratios Liquidity refers to the ability to pay maturing obligations and meet unexpected needs for cash. The relationship of current assets to current liabilities is critical in analyzing liquidity. We can express this relationship 10-69 as a dollar amount (working capital) and as a ratio (current ratio). LO 5 Use of Ratios Liquidity refers to the ability to pay maturing obligations and meet unexpected needs for cash. Illustration 10-20 Working capital formula and computation Current ratio permits us to compare the liquidity of differentsized companies and of a single company at different times. 10-70 Illustration 10-21 Current ratio formula and computation LO 5 Use of Ratios Two ratios that provide information about long-run solvency and the ability to meet interest payments as they come due are: 10-71 Debt to Assets Ratio Times Interest Earned LO 5 Use of Ratios Illustration: Kellogg Company reported total liabilities of $8,925 million, total assets of $11,200 million, interest expense of $295 million, income taxes of $476 million, and net income of $1,208 million. Illustration 10-22 Debt to assets ratio The higher the percentage of debt to assets, the greater the risk that the company may be unable to meet its maturing obligations. 10-72 LO 5 Use of Ratios Illustration: Kellogg Company reported total liabilities of $8,925 million, total assets of $11,200 million, interest expense of $295 million, income taxes of $476 million, and net income of $1,208 million. Illustration 10-23 Times interest earned Times interest earned indicates the company’s ability to meet interest payments as they come due. 10-73 LO 5 Investor Insight “Covenant-Lite” Debt In many corporate loans and bond issuances, the lending agreement specifies debt covenants. These covenants typically are specific financial measures, such as minimum levels of retained earnings, cash flows, times interest earned, or other measures that a company must maintain during the life of the loan. If the company violates a covenant, it is considered to have violated the loan agreement. The creditors can then demand immediate repayment, or they can renegotiate the loan’s terms. Covenants protect lenders because they enable lenders to step in and try to get their money back before the borrower gets too deeply into trouble. During the 1990s, most traditional loans specified between three to six covenants or “triggers.” In more recent years, when lots of cash was available, lenders began reducing or completely eliminating covenants from loan agreements in order to be more competitive with other lenders. Lending to weaker companies on easy terms is now common as investors’ appetite for higher-yielding debt grows stronger and the Federal Reserve keeps money flowing at ultralow rates. Since the 2008 financial crisis, companies have been able to borrow more without offering investors what were once considered standard protections against possible losses. Sources: Cynthia Koons, “Risky Business: Growth of ’Covenant-Lite’ Debt,” Wall Street Journal (June 18, 2007), p. C2; and Katy Burne, “More Loans Come with Few Strings Attached,” Wall Street Journal June 12, 2014). 10-74 LO 5 Use of Ratios Question Working capital is calculated as: a. current assets minus current liabilities. b. total assets minus total liabilities. c. long-term liabilities minus current liabilities. d. both (b) and (c). 10-75 LO 5 Debt and Equity Financing Illustration 10-24 Advantages of bond financing over common stock 10-76 LO 5 Debt and Equity Financing Illustration: Microsystems, Inc. is considering two plans for financing the construction of a new $5 million plant. It is considering two alternatives for raising an additional $5 million: Plan A involves issuing 200,000 shares of common stock at the current market price of $25 per share. Plan B involves issuing $5 million of 8% bonds at face value. Income before interest and taxes will be $1.5 million; income taxes are expected to be 30%. Illustration 10-25 10-77 DO IT! 5 Analyzing Liabilities Trout Company balance sheet information as of December 31, 2017. Current assets Long-term assets Total assets $10,500 24,200 $34,700 Current liabilities Long-term liabilities Stockholders’ equity Total liabilities and stockholders’ equity $ 8,000 16,000 10,700 $34,700 In addition, Trout reported net income for 2017 of $14,000, income tax expense of $2,800, and interest expense of $900. Instructions a) Compute the current ratio and working capital for Trout for 2017. Current ratio is 1.31:1 ($10,500 ÷ $8,000). Working capital is $2,500 ($10,500 - $8,000). 10-78 LO 5 DO IT! 5 Analyzing Liabilities Trout Company balance sheet information as of December 31, 2017. Current assets Long-term assets Total assets $10,500 24,200 $34,700 Current liabilities Long-term liabilities Stockholders’ equity Total liabilities and stockholders’ equity $ 8,000 16,000 10,700 $34,700 In addition, Trout reported net income for 2017 of $14,000, income tax expense of $2,800, and interest expense of $900. Instructions b) Assume that at the end of 2017, Trout used $2,000 cash to pay off $2,000 of accounts payable. How would the current ratio and working capital have changed? Current ratio is 1.42:1 ($8,500 ÷ $6,000). Working capital is $2,500 ($8,500 - $6,000). 10-79 LO 5 DO IT! 5 Analyzing Liabilities Trout Company balance sheet information as of December 31, 2017. Current assets Long-term assets Total assets $10,500 24,200 $34,700 Current liabilities Long-term liabilities Stockholders’ equity Total liabilities and stockholders’ equity $ 8,000 16,000 10,700 $34,700 In addition, Trout reported net income for 2017 of $14,000, income tax expense of $2,800, and interest expense of $900. Instructions c) Compute the debt to assets ratio and the times interest earned for Trout for 2017. Debt to assets ratio is 71.2% ($24,000 ÷ $34,700). 10-80 Times interest earned is 19.67 times [($14,000 + $2,800 + $900) ÷ $900]. LO 5 LEARNING OBJECTIVE 6 APPENDIX 10A: Apply the straight-line method of amortizing bod discount and bond premium. Amortizing Bond Discount Illustration: Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $98,000 (discount of $2,000). Interest is payable on January 1. Illustration 10C-2 10-81 Illustration 10A-2 Bond discount amortization schedule LO 6 Amortizing Bond Discount Illustration: Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $98,000 (discount of $2,000). Interest is payable on January 1. The bond discount amortization for each interest period is $400 ($2,000 ÷ 5). Journal entry to record the first accrual of bond interest and the amortization of bond discount on December 31 as follows. Dec. 31 Interest Expense Discount on Bonds Payable Cash 10-82 10,400 400 10,000 LO 6 Amortizing Bond Premium Illustration: Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $102,000 (premium of $2,000). Interest is payable on January 1. Illustration 10A-4 Bond premium amortization schedule 10-83 LO 6 Amortizing Bond Premium Illustration: Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $102,000 (premium of $2,000. Interest is payable on January 1. The bond premium amortization for each interest period is $400 ($2,000 ÷ 5). Candlestick records the first accrual of interest on December 31 as follows. Dec. 31 Interest Expense Premium on Bonds Payable Cash 10-84 9,600 400 10,000 LO 6 LEARNING OBJECTIVE 7 APPENDIX 10B: Apply the effective-interest method of amortizing bod discount and bond premium. Under the effective-interest method, the amortization of bond discount or bond premium results in period interest expense equal to a constant percentage of the carrying value of the bonds. Required steps: 1. Compute the bond interest expense. 2. Compute the bond interest paid or accrued. 3. Compute the amortization amount. 10-85 LO 7 Effective-Interest Method Required steps: 1. Compute the bond interest expense. 2. Compute the bond interest paid or accrued. 3. Compute the amortization amount. Illustration 10B-1 Computation of amortization using effective-interest method 10-86 LO 7 Effective-Interest Method Amortizing Bond Discount Illustration: Candlestick, Inc. issues $100,000 of 10%, five-year bonds on January 1, 2017, for $98,000, with interest payable each January 1. This results in a discount of $2,000. Illustration 10B-2 Illustration 10B-2 Bond discount amortization schedule 10-87 LO 7 Amortizing Bond Discount Illustration 10B-2 Bond discount amortization schedule Candlestick, Inc. records the accrual of interest and amortization of bond discount on December 31 as follows. Dec. 31 Interest Expense Interest Payable Discount on Bonds Payable 10-88 10,319 10,000 319 LO 7 Amortizing Bond Discount Illustration 10B-2 Bond discount amortization schedule For the second interest period, at December 31, Candlestick makes the following adjusting entry. Dec. 31 Interest Expense Interest Payable Discount on Bonds Payable 10-89 10,353 10,000 353 LO 7 Amortizing Bond Premium Illustration: Candlestick, Inc. issues $100,000 of 10%, five-year bonds on January 1, 2017, for $102,000, with interest payable January 1. This results in a premium of $2,000. Illustration 10B-4 Bond premium amortization schedule 10-90 LO 7 Amortizing Bond Premium Illustration 10B-4 Bond premium amortization schedule The entry Candlestick makes on December 31 is: Dec. 31 Interest Expense Premium on Bonds Payable Interest Payable 10-91 9,670 330 10,000 LO 7 LEARNING OBJECTIVE 8 Compare the accounting for liabilities under GAAP and IFRS. Key Points Similarities 10-92 The basic definition of a liability under GAAP and IFRS is very similar. 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. The accounting for current liabilities such as notes payable, unearned revenue, and payroll taxes pa y able are similar between GAAP and IFRS. LO 8 Key Points 10-93 IFRS requires that companies classify liabilities as current or noncurrent 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). When current liabilities (also called short-term liabilities) are presented, they are generally presented in order of liquidity. Under IFRS, liabilities are classified as current if they are expected to be paid within 12 months. Similar to GAAP, items are normally reported in order of liquidity. Companies sometimes show liabilities before assets. Also, they will sometimes show long-term liabilities before current liabilities. LO 8 Key Points The basic calculation for bond valuation is the same under GAAP and IFRS. In addition, the a c counting for bond liability transactions is essentially the same between GAAP and IFRS. 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. For example, if a $100,000 bond was issued at 97, under IFRS a company would record: Cash Bonds Payable 10-94 97,000 97,000 LO 8 Key Points Differences 10-95 The accounting for convertible bonds differs across IFRS and GAAP, 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. Under IFRS, companies sometimes will net current liabilities against current assets to show working capital on the face of the statement of financial position. LO 8 Looking to the Future The FASB and IASB are currently involved in two projects, each of which has implications for the accounting for liabilities. 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. 10-96 LO 8 IFRS Self-Test Questions The accounting for bonds payable is: a) essentially the same under IFRS and GAAP. b) differs in that GAAP requires use of the straight-line method for amortization of bond premium and discount. c) the same except that market prices may be different because the present value calculations are different between IFRS and GAAP. d) not covered by IFRS. 10-97 LO 8 IFRS Self-Test Questions Which of the following is false? a) Under IFRS, current liabilities must always be presented before noncurrent 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. 10-98 LO 8 IFRS Self-Test Questions 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. 10-99 LO 8 Copyright “Copyright © 2015 John Wiley & Sons, Inc. 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