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
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programs or from the use of the information contained herein.”
10-100