Liabilities

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Liabilities
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Liabilities are..

• Creditors claims on total assets
• Existing debts and obligations

• Liabilities must be settled in the future by
  transfer of assets or services.

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Current Liabilities

• Can reasonably be expected to paid
• From existing current assets or through the
  creation of other current liabilities.
• Within 1 year or the operating cycle, whichever
  is longer.

Debts that do not meet both criteria are
Long-Term Liabilities.
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Current Liability Types

• Notes Payable
• Accounts Payable
• Unearned Revenues
• Accrued Liabilities

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Notes Payable are...

• Obligations in the form of written
  notes.
• Often used instead of accounts payable - they
  give written documentation if needed for legal
  remedies.
• Used for short-term and long-term financing
  needs.

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Journal
Mar 1 Cash 100,000 Notes
Payable 100,000 (To record issuance of 12,
4-month note to bank)

• Remember - Interest accrues over life of the note
  and must be recorded periodically.

Mar 31 Interest Expense
1,000 Interest Payable 1,000 (To
accrue interest for 1 month on note)
100,000 x .12 x 1/12 months
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Sales Taxes Payable...

• Are collected from customers.
• Are expressed as a of sales price.
• Are required by law.
• Must be sent to state often.
• Are often rung separately from sales on the cash
  register.

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Journal
Mar 25 Cash 10,600
Sales 10,000 Sales Taxes Payable
600 (To record daily sales and
sales taxes)
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Payroll Taxes...

• Amount required by law to be withheld from
  employees gross pay.
• Social Security taxes withheld (FICA)
• Federal Income Taxes
• State Income Taxes (if applicable)

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Journal
Mar 7 Salaries and Wages Expense 100,000 FICA
Taxes Payable 7,250 Federal Income Taxes
Payable 21,864 States Income Taxes
Payable 2,922 Salaries and Wages Payable
67,964 Then Salaries and Wages Payable
67,964 Cash 67,964

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Unearned Revenues...

• Cash received before revenues are earned and
  recorded as liabilities until they are earned.

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Unearned Revenues...

• Magazine subscriptions
• Rent received in advance
• Customer deposits
  for future service
• Sale of airline tickets
  for future travel
• Sale to season sporting
  events
  

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Current Maturities of Long-Term Debt

• The portion of the long-term debt that is due
  within the current year or operating cycle should
  be classified as a current liability.

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Liquidity Ratios...

• Measure the short-term ability of a company to
  pay its maturing obligations and to meet
  unexpected needs for cash.

• Working capital
• Current ratio
• Acid-test ratio

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Liquidity Ratios...

• Working Capital
• Current Ratio

Current Assets - Current Liabilities
Working Capital
Current Assets Current Liabilities
Current Ratio
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Acid-Test Ratio

• Measure of companys immediate short-term
  ability to pay obligations

Acid-Test Ratio
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Line of Credit...

• Is a prearranged agreement between a company
  and a lender to allow the company to borrow up to
  an agreed-upon amount.

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Long-Term Liabilities...

• Are obligations that are expected to be paid
  after 1 year.

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Bonds...

• Are a form of interest-bearing notes payable
  issued by corporations, universities and
  governmental agencies.
• Are sold in small denominations, which makes them
  attractive to investors.

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Illustration 10-6
Advantages of Bond Financing Over Common Stock
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Secured Bonds...

• Have specific assets of the issuer pledged as
  collateral for bonds.
• Mortgage Bond - a
  bond secured by real
  estate.
  
• Sinking Fund Bond - a
  bond secured by specific assets
  to retire the bonds.
  
  
  

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Unsecured or Debenture Bonds...
Page 463 in book

• Are issued against the general credit of the
  borrower.
  

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Term Bonds...
Page 463 in book

• Are due for payment (mature) at a single
  specified future date.
• 
  

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Serial Bonds...
Page 463 in book

• mature in installments.

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Convertible Bonds...

• Can be changed into common stock at the
  bondholders option.

Callable BondsCan be retired early at the
issuers option.
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Issuing Bonds...

• Requires formal approval by board of directors
  and stockholders.
• Board of Directors must stipulate
• Total number of bonds to be authorized
• Total face value
• Contractual
  Interest Rate

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The amount of principle due at maturity date.
Face Value...
Contractual Interest Rate...
Is the rate used to determine the amount of cash
interest the borrower pays and investor receives.
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Market Interest Rate...
The rate that investors demand for loaning
funds.
Not the same as contractual or stated rate.
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Accounting for Bond Issues

• Bonds may be issued at
• Face value
• Below face value (discount) or
• Above face value (premium).

The bonds are reported in the long-term liability
section of the balance sheet because the maturity
date is more than 1 year away.
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Issuing Bonds at Face Value

• Assume that Devour Corporation issued 1,000,
  10-year 10, 1,000 bonds dated January 1, 2001
  at 100 (100 of face value) with interest payable
  on July 1 and January 1.
• 1/1 Cash 1,000,000 Bonds Payable
  1,000,00
• (To record sale of bonds at face value)

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Issuing Bonds at Face Value

• The entry to record the semiannual interest on
  July 1 is
• 7/1 Bond Interest Expense 50,000 Cash
  50,000
• (To record the payment of bond interest)
• (1,000,000 x 10 x 6/12)

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Issuing Bonds at Face Value

• On December 31 the following adjusting entry is
  required to record the 50,000 of interest
  accrued since July 1
• 12/31 Bond Interest Expense 50,000 Bond
  Interest Payable 50,000 (To accrue
  bond interest)

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Discount or Premiums on Bonds

• Often the contractual (stated) interest rate and
  the market (effective) interest rate differ
  therefore bonds sell above or below face value.

WHY? To adjust the contractual interest to the
market interest rate.
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Bond Discount...

• When the investor pays less than the face value
  of the bond.

Bond Premium...
When the investor pays more than the face value
of the bond.
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Bond Prices Vary Inversely With Changes in
Market Interest Rates
Illustration 10-11
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Selling Bonds at Discount

• Assume that on January 1, 1998, Candlestick,
  Inc., sells 1 million, 5-year, 10 bonds at 98
  with interest payable on July 1 and January 1.
• 1/1 Cash 980,000 Discount on Bonds
  Payable 20,000 Bonds
  Payable 1,000,000
• (To record sale of bonds at a discount)

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Carrying (Book) Value of Bonds
Illustration 10-12

• Long-term liabilities
• Bonds payable 1,000,000
• Less Discount on bonds 20,000
  980,000 payable

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Selling Bonds at Premium

• Assume that on January 1, 2001, Candlestick,
  Inc., sells 1 million, 5-year, 10 bonds at 102
  with interest payable on July 1 and January 1.
• 1/1 Cash 1,020 000 Bonds
  Payable 1,000,000
• Premium Bonds Payable 20,000
• (To record sale of bonds at a premium)

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Carrying (Book) Value of Bonds
Illustration 10-17

• Long-term liabilities
• Bonds payable 1,000,000
• Add Premium on bonds 20,000
  1,020,000
• payable

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Straight-line Method of Allocation Is Used to
Comply with Matching Principle
Page 471 in Book
Amortizing Bond Premium
Page 469 in Book
Amortizing Bond Discount
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Amortizing Bond Discount/Premium

• Candlelight would amortize the 20,000
  discount/premium as follows
• 20,000 10 Interest Periods
• 2,000 Semiannually

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Amortizing Bond Discount/Premium

• Interest Expense 52,000 Bond Discount
  2,000 Cash 50,000
• Interest Expense 48,000
• Bond Premium 2,000 Cash 50,000

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Bond Retirement

• Bonds may be redeemed at maturity or before
  maturity.

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Redeeming Bonds Before Maturity

• A company may decide to retire bonds before
  maturity to
• reduce interest cost
• remove debt from its balance sheet.
• A company should retire debt early only if it has
  sufficient cash resources.

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Redeeming Bonds Before Maturity

• When bonds are retired before maturity, it is
  necessary to
• Eliminate the carrying value of the bonds at the
  redemption date
• Record the cash paid
• Recognize the gain or loss on redemption.

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Redeeming Bonds Before Maturity

• Long-term liabilities
• Bonds payable 10 due in 2009 1,000,000
• Less Discount on bonds payable 80,000
  920,000

Redeem at 91 Bonds Payable 1,000,000 Discount
80,000 Cash 910,000 Gain on
Retirement 10,000
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Debt to Total Assets Ratio...
Illustration 10-23

• Indicates the extent to which a companys debt
  could be repaid by liquidating assets.

Debt to Total Assets Ratio Total
Liabilities Total Assets
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Times Interest Earned Ratio...
Illustration 10-23

• Provides an indication of companys ability to
  meet interest payments as they come due.

Times Interest Earned Ratio Income Before
Interest Expense Income Tax Interest Expense
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Contingent Liabilities...

• Are events with uncertain outcomes.
• Must be recorded in the financial statements
• if the company can determine a reasonable
  estimate of the expected loss and
• if it is a probable loss.

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Lease Liabilities

• In some instances the lease contract transfers
  substantially all the benefits and risks of
  ownership to the lessee, so that the lease is in
  effect a purchase of the property.
• The type of lease described above is called a
  capital lease because the fair value of the
  leased asset is capitalized by the lessee
  recording it on its balance sheet.

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Capital Lease

• Is it likely that the lessee will end up with the
  assets at the end of the lease?
• Will the lessee use the asset for most of its
  useful life?
• Will the payments made by the lessee be
  approximately the same as the payments it would
  have made if it had purchased the asset?

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Capital Lease

• Lessee must record the asset and a related
  liability for the lease payments.
• Most lessees do not like to report leases on
  their balance sheets because the lease liability
  increases the company's total liabilities.
• The procedure of keeping liabilities off the
  balance sheet is often referred to as off-balance
  sheet financing.

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