Slide

10-1

Chapter

10

McGraw-Hill/Irwin

LIABILITIES

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Slide
10-2

The Nature of Liabilities

Defined as debts or obligations
arising from past transactions or
events.
Maturity = 1 year or less

Maturity > 1 year

Current
Liabilities

Noncurrent
Liabilities
I.O.U.

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Slide
10-3

Distinction Between
Debt and Equity
The acquisition of assets is financed from two
sources:
DEBT

Funds from creditors, with

a definite due date, and
sometimes bearing
interest.
McGraw-Hill/Irwin

EQUITY

Funds from
owners
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Slide
10-4

Liabilities Question
Devon Mfg. borrows $100,000 from First
Bank. The loan will be repaid in 20 years
and has an annual interest rate of 8%.

Is this a current liability or a

noncurrent liability?
The obligation will not be paid
within one year or one operating
cycle, so it is a noncurrent liability.
McGraw-Hill/Irwin

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Slide
10-5

Evaluating Liquidity
An important indicator of a companys ability
to meet its current obligations.
Two commonly used measures:
Working Capital = Current Assets - Current Liabilities

Current Ratio = Current Assets Current Liabilities

McGraw-Hill/Irwin

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Slide
10-6

Liabilities Question
Devon Mfg. has current liabilities of
$230,000 and current assets of $322,000.

What is Devons current ratio?

Current
Ratio

McGraw-Hill/Irwin

Current
Current
=

Assets
Liabilities
= $ 322,000 $ 230,000
=
1.4
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Slide
10-7

Accounts Payable
Short-term obligations to suppliers for purchases of
merchandise and to others for goods and services.

Office
supplies
invoices

Merchandise
inventory
invoices
Shipping
charges
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Utility and
phone bills

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Slide
10-8

Notes Payable
When a company borrows money, a note payable is
created.

Current Portion of Notes Payable

The portion of a note payable that is due within one
year, or one operating cycle, whichever is longer.

Current Notes Payable

Total Notes
Payable
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Noncurrent Notes Payable

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Slide
10-9

Notes Payable
PROMISSORY NOTE
Miami, Fl
Location
Six months after this date
promises to pay to the order of

the sum of
of
12.0%

$10,000.00
per annum.

Nov. 1, 2003
Date
Porter Company
Security National Bank
with interest at the rate
signed
title

McGraw-Hill/Irwin

John Caldwell
treasurer
The McGraw-Hill Companies, Inc., 2002

Slide
10-10

Notes Payable
On November 1, 2003, Porter Company
would make the following entry.
Date

Description

Nov. 1 Cash
Note Payable

McGraw-Hill/Irwin

Debit

Credit

10,000
10,000

The McGraw-Hill Companies, Inc., 2002

Slide
10-11

Interest Payable
Interest expense is the
compensation to the lender for
giving up the use of money for a
period of time.

The liability is called interest

payable.

To the lender, interest is a

revenue.

Interest
Rate
Up!

To the borrower, interest is an

expense.
McGraw-Hill/Irwin

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Slide
10-12

Interest Payable
The interest formula includes three variables
that must be considered when computing
interest:
Interest = Principal Interest Rate Time
When computing interest for one year, Time
equals 1. When the computation period is less
than one year, then Time is a fraction.
For example, if we needed to compute interest for
3 months, Time would be 3/12.
McGraw-Hill/Irwin

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Slide
10-13

Interest Payable Example

What entry would Porter Company make
on December 31, the fiscal year-end?
Date

Description

Dec. 31 Interest Expense

Interest Payable

Debit

Credit

200
200

$10,00012% 2/12 = $200

McGraw-Hill/Irwin

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Slide
10-14

Payroll Liabilities
Gross Pay
Net Pay

FICA Taxes
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Medicare
Taxes

Federal
Income Tax

State and
Voluntary
Local Income Deductions
Taxes

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Slide
10-15

Unearned Revenue
Cash is sometimes collected from the
customer before the revenue is
actually earned.
As the earnings
process is
completed .
Cash is
received
in
advance.
McGraw-Hill/Irwin

Deferred
revenue is
recorded.

a liability account.

.
Earned
revenue is
recorded.

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Slide
10-16

Long-Term Debt
Relatively small debt
needs can be filled from
single sources.

or
Banks
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Insurance
Companies

or

Pension
Plans

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Slide
10-17

Long-Term Debt
Large debt needs are often
filled by issuing bonds.

McGraw-Hill/Irwin

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Slide
10-18

Installment Notes Payable

Long-term notes that call for a series of
installment payments.

Each payment covers

interest for the period
AND a portion of the
principal.
McGraw-Hill/Irwin

With each payment, the

interest portion gets
smaller and the principal
portion gets larger.
The McGraw-Hill Companies, Inc., 2002

Slide
10-19

Allocating Installment Payments

Between Interest and Principal

Identify the unpaid principal

balance.

Unpaid Principal Interest rate =

Interest expense.

Installment payment - Interest

expense = Reduction in unpaid
principal balance.

Compute new unpaid principal

balance.
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Slide
10-20

Allocating Installment Payments

Between Interest and Principal

On January 1, 2003, Rocket

Corp. borrowed $7,581.57 from
First Bank of River City. The
loan was a five-year loan and
had an interest rate of 10%. The
annual payment is $2,000.
Prepare an amortization table for
Rocket Corp.s loan.
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Slide
10-21

Allocating Installment Payments

Between Interest and Principal
Reduction in
Interest
Unpaid
Expense
Balance

Date
Payment
Jan. 1, 2003
Dec. 31, 2003 $ 2,000.00 $ 758.16 $
Dec. 31, 2004
2,000.00
633.97
Dec. 31, 2005
2,000.00
497.37
Dec. 31, 2006
2,000.00
347.11
Dec. 31, 2007
2,000.00
181.82

1,241.84
1,366.03
1,502.63
1,652.89
1,818.18

Unpaid
Balance
$ 7,581.57
6,339.73
4,973.70
3,471.07
1,818.18
(0.00)

Now, prepare the entry for the first payment on

December 31, 2003.
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Slide
10-22

Allocating Installment Payments

Between Interest and Principal
The information needed for the journal entry can be
found on the amortization table. The payment
amount, the interest expense, and the amount to
credit to principal are all on the table.
Date

Description

Dec. 31 Interest Expense

Note Payable
Cash

McGraw-Hill/Irwin

Debit

Credit

758.16
1,241.84
2,000.00

The McGraw-Hill Companies, Inc., 2002

Slide
10-23

Bonds Payable

Bonds usually involve the

borrowing of a large sum of
money, called principal.

The principal is usually paid

back as a lump sum at the end
of the bond period.

Individual bonds are often

denominated with a par value,
or face value, of $1,000.

McGraw-Hill/Irwin

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Slide
10-24

Bonds Payable
Bonds usually carry a stated
rate of interest, also called a
contract rate.

Interest is normally paid

semiannually.

Interest is computed as:

Interest = Principal Stated Rate Time
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Slide
10-25

Bonds Payable
Bonds are issued through an
intermediary called an
underwriter.

Bonds can be sold on organized

securities exchanges.

Bond prices are usually quoted

as a percentage of the face
amount.

For example, a $1,000 bond

priced at 102 would sell for
$1,020.

McGraw-Hill/Irwin

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Slide
10-26

Types of Bonds

Mortgage
Bonds

Debenture
Bonds

Convertible
Bonds

Junk Bonds

McGraw-Hill/Irwin

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Slide
10-27

Accounting for Bonds Payable

On January 1, 2003, Rocket Corp. issues $1,500,000 of
12%, 10-year bonds payable. Interest is payable
semiannually, each July 1 and January 1.
Assume the bonds are issued at face value.
Record the issuance of the bonds.
Date

Description

Jan. 1 Cash
Bonds Payable

McGraw-Hill/Irwin

Debit

Credit

1,500,000
1,500,000

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Slide
10-28

Accounting for Bonds Payable

Record the interest payment

on July 1, 2003.
Date

Description

July 1 Interest Expense

Cash

McGraw-Hill/Irwin

Debit

Credit

90,000
90,000

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Slide
10-29

Bonds Sold Between Interest Dates

Bonds are often sold between interest dates.
The selling price of the bond is computed as:
Present value of the bond
+ Accrued interest since the
last interest payment
= Selling price of the bond

McGraw-Hill/Irwin

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Slide
10-30

The Concept of Present Value

$1,000
invested
today at 10%.

Present
Value
McGraw-Hill/Irwin

In 5 years it
will be worth
$1,610.51.

Money can grow over time,

because it can earn interest.

In 25 years it
will be worth
$10,834.71!

Future
Value
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Slide
10-31

The Concept of Present Value

How much is a future amount worth today?
Three pieces of information must be known to
solve a present value problem:
Present
compounding periods
The futureInterest
amount.
Value

The interest rate (i).

The number of periods (n) the amount will be
Today
invested.

McGraw-Hill/Irwin

Future
Value

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Slide
10-32

The Concept of Present Value

Two types of cash flows are involved
with bonds:
Periodic interest payments called annuities.

Today

Maturity

Principal payment
at maturity.
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Slide
10-33

The Present Value Concept and

Bond Prices
The selling price of the bond is determined by
the market based
on the time value of money.

Interest
Bond
Accounting for
Present
Principal (a single
payment)
Rates Value of the
Price
the Difference
+ Present
Value
of the Interest
annuity)
Stated
Market
Bond
Par Value Payments
There is(an
no difference
= Rate
= Bond
of the Bond
to account for.
=Rate
Selling
Price Price
of the
Stated
Rate
Stated
Rate

<

Market Bond
Par Value The difference is accounted
Rate Price < of the Bond
for as a bond discount.

>

Market Bond
Par Value The difference is accounted
Rate Price > of the Bond
for as a bond premium.

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Slide
10-34

Early Retirement of Debt

Bonds can be retired by . . .
Exercising a call
provision.

Purchasing the
bonds on the
open market.

Gains or losses incurred as a result of retiring bonds

should be reported as extraordinary items on the
income statement.
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Slide
10-35

Lease Payment Obligations

Operating Leases

Capital Leases

Lessor retains risks and

benefits associated with
ownership.

Lease agreement transfers

risks and benefits
associated with ownership
to lessee.

Lessee records rent

expense as incurred.

Lessee records a leased

asset and lease liability.

McGraw-Hill/Irwin

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Slide
10-36

Capital Lease Criteria

A lease must be recorded as
a Capital Lease if it meets
any of the following criteria.

The lease transfers

ownership to the
lessee.

The lease contains

a bargain purchase
option.

The lease term is equal to

or > 75% of the economic
life of the property.

The PV of the minimum

lease payments = 90% of
the FMV of the property.

McGraw-Hill/Irwin

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Slide
10-37

Pensions
Employers offer pension
plans to employees.

Retirees receive
pension
payments from
the pension
fund.
McGraw-Hill/Irwin

The employer makes

payments to a pension
fund. Usually, this is an
independent entity
managed by a
professional fund
manager.

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Slide
10-38

Pensions
Actuaries make the pension expense
computations, based on:
Average age, retirement age, life expectancy.
Employee turnover rates.
Compensation levels.
Expected rate of return for the fund.

The accountant then posts the entry to

record pension expense and pension
liability.
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Slide
10-39

Other Postretirement Benefits

Many companies offer benefits
to retirees other than pensions,
such as health coverage or
fitness club memberships.

Unfunded liability
for nonpension
postretirement
benefits

McGraw-Hill/Irwin

Amount to
be funded
next year

Current
liability

Remainder
of unfunded
amount

Long-term
liability
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Slide
10-40

Deferred Income Taxes

Corporations
pay income
taxes quarterly.

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Slide
10-41

Deferred Income Taxes

GAAP is the set of
rules for preparing
financial statements.
Results in . . .

Financial statement
income tax expense.

The Internal Revenue

Code is the set of
rules for preparing tax
returns.
Usually. . .

Results in . . .

IRS income taxes

payable.

The difference between tax expense and tax

payable is recorded in an account called
deferred taxes.
McGraw-Hill/Irwin

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Slide
10-42

Deferred Income Taxes Example

Examine the December 31, 2003, information
for X-Off Inc.
Revenues
Depreciation Expense:
Straight-line
Accelerated
Other Expenses

$ 1,000,000
200,000
320,000
650,000

X-Off uses straight-line depreciation for financial

reporting and accelerated depreciation for
income tax reporting. X-Offs tax rate is 30%.
McGraw-Hill/Irwin

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Slide
10-43

Deferred Income Taxes Example

Compute X-Offs income tax expense
and income tax payable.
Income
Statement
Revenues
$ 1,000,000
Less:
Depreciation
200,000
Other expenses
650,000
Income before taxes $
150,000
Tax rate
Income taxes

McGraw-Hill/Irwin

30%
45,000

Tax
The income tax
Return Difference

amount computed
based on financial
statement income
is income tax
expense for the
period.

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Slide
10-44

Deferred Income Taxes Example

Compute X-Offs income tax expense
and income tax payable.
Income
Statement
Revenues
$ 1,000,000
Less:
Depreciation
200,000
Other expenses
650,000
Income before taxes $
150,000
Tax rate
Income taxes

McGraw-Hill/Irwin

Tax
Return
$ 1,000,000

30%
45,000 $

320,000
650,000
30,000
30%
9,000

Difference
Income taxes

based on tax
return
income are
the taxes
payable for
the period.

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Slide
10-45

Deferred Income Taxes Example

The deferred tax for the period of $36,000 is the
difference between income tax expense of $45,000 and
income tax payable of $9,000.
Income
Statement
Revenues
$ 1,000,000
Less:
Depreciation
200,000
Other expenses
650,000
Income before taxes $
150,000
Tax rate
Income taxes

McGraw-Hill/Irwin

Tax
Return
$ 1,000,000

30%
45,000 $

320,000
650,000
30,000

Difference
$

(120,000)
120,000

30%
9,000 $

30%
36,000

The McGraw-Hill Companies, Inc., 2002

Slide
10-46

Financial Leverage
Borrowing at one
rate and investing
at a higher rate.

McGraw-Hill/Irwin

If we borrow
$1,000,000 at 8% and
invest it at 10%, we
will clear $20,000
profit!

The McGraw-Hill Companies, Inc., 2002

Slide
10-47

End of Chapter 10
Are we
having fun
yet?

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