10

Reporting and Analyzing

Liabilities

10-1
 CHAPTER OUTLINE
LEARNING OBJECTIVES

1 Explain how to account for current liabilities.

2 Describe the major characteristics of bonds.

3 Explain how to account for bond transactions.

4 Discuss how liabilities are reported and analyzed.

10-2
LEARNING Explain how to account for current
OBJECTIVE 1 liabilities.

WHAT IS A CURRENT LIABILITY?

A debt that a company expects to pay
1. from existing current assets or through the creation of
other current liabilities, and
2. 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, salaries and wages,
and interest.

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 NOTES PAYABLE

◆ Written promissory note.

◆ Usually require the borrower to pay interest.

◆ Frequently issued to meet short-term financing needs.

◆ Issued for varying periods of time.

◆ Those due for payment within one year of the balance

sheet date are usually classified as current liabilities.

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 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. When a
company issues an interest-bearing note, the amount of
assets it receives generally equals the note’s face value.

Sept. 1 Cash 100,000

Notes Payable 100,000

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 NOTES PAYABLE

Illustration: If Cole Williams Co. prepares financial statements

annually, it makes an adjusting entry at December 31 to
recognize interest.

Dec. 31 Interest Expense 4,000 *

Interest Payable 4,000

* $100,000 x 12% x 4/12 = $4,000

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 NOTES PAYABLE

Illustration: At maturity (January 1), Cole Williams Co. must

pay the face value of the note plus interest. It records payment
as follows.

Jan. 1 Notes Payable 100,000

Interest Payable 4,000
Cash 104,000

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 SALES TAXES PAYABLE

◆ Sales taxes are expressed as a stated percentage of

the sales price.

◆ Selling company

► collects tax from the customer.

► remits the collections to the state’s department of

revenue.

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 SALES TAXES PAYABLE

Illustration: The March 25 cash register readings for Cooley

Grocery show sales of $10,000 and sales taxes of $600 (sales
tax rate of 6%), the journal entry is:

Mar. 25 Cash 10,600

Sales Revenue 10,000
Sales Taxes Payable 600

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 SALES TAXES PAYABLE

Sometimes companies do not ring up sales taxes separately on

the cash register.

Illustration: Cooley Grocery rings up 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 10,600

Sales Revenue 10,000 *
Sales Taxes Payable 600

* $10,600 ÷ 1.06 = $10,000

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 UNEARNED REVENUES

Revenues that are received before goods are delivered or

services are performed.
1. Company increases (debits) Cash
and increases (credits) a current
liability account, Unearned
Revenue.

2. When the company recognizes

revenue, it decreases (debits) the
unearned revenue account and
increases (credits) a revenue
account.
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 UNEARNED REVENUES

Illustration: Superior University sells 10,000 season football

tickets at $50 each for its five-game home schedule. The entry
for the sales of season tickets is:

Aug. 6 Cash 500,000

Unearned Ticket Revenue 500,000

As each game is completed, Superior records the earning of

revenue.

Sept. 7 Unearned Ticket Revenue 100,000

Ticket Revenue 100,000

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 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, 2016. This note specifies that each
January 1, starting January 1, 2017, Wendy should pay $5,000 of the
note. When the company prepares financial statements on December
31, 2016,
$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? ________
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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.

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PAYROLL AND PAYROLL TAXES PAYABLE

Illustration: Assume Cargo Corporation records its payroll for the

week of March 7 as follows:

Mar. 7 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.

Mar. 7 Salaries and Wages Payable 67,564

Cash 67,564
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PAYROLL AND PAYROLL TAXES PAYABLE

Payroll tax expense results from three taxes that

governmental agencies levy on employers.

These taxes are:

◆ FICA tax

◆ Federal unemployment tax

◆ State unemployment tax

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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 7,650
Federal Unemployment Taxes Payable 800
State Unemployment Taxes Payable 5,400

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LEARNING Describe the major characteristics of
OBJECTIVE 2 bonds.

Bonds are a form of interest-bearing notes payable

issued by corporations, universities, and governmental
agencies.

Sold in small denominations (usually $1,000 or multiples of

$1,000).

When a corporation issues bonds, it is borrowing money.

The person who buys the bonds (the bondholder) is
investing in bonds.

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 TYPES OF BONDS

Secured and Unsecured Bonds

◆ Secured bonds have specific assets of the issuer
pledged as collateral for the bonds.
◆ Unsecured bonds are issued against the general
credit of the borrower.

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 TYPES OF BONDS

Convertible and Callable Bonds

◆ Convertible bonds can be converted
into common stock at the bondholder’s
option.
◆ Callable bonds can be redeemed
(bought back), by the issuing
company, at a stated dollar amount
prior to maturity.

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 ISSUING PROCEDURES

◆ Bond certificate ALTERNATIVE TERMINOLOGY

The contractual rate is often
referred to as the stated rate.
► Issued to the investor.

► Provides name of the company issuing bonds, face

value, maturity date, and contractual (stated) interest
rate.

◆ Face value - principal due at the maturity.

◆ Maturity date - date final payment is due.
◆ Contractual interest rate – rate to determine cash
interest paid, contractual rate is stated as an annual
rate.
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 ILLUSTRATION 10-3
Bond certificate

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LO 2
 DETERMINING THE MARKET PRICE
OF BONDS

The current market price (present value) of a bond is a

function of three factors:
1. the dollar amounts to be received,

2. the length of time until the amounts are received, and

3. the market rate of interest.

The process of finding the present

value is referred to as discounting the
future amounts.

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 DETERMINING THE MARKET VALUE

Illustration: Assume that Acropolis Company on January 1, 2017,

issues $100,000 of 9% bonds, due in five years, with interest
payable annually at year-end.
ILLUSTRATION 10-4
Time diagram
depicting cash
flows

ILLUSTRATION 10-5
Computing the market price of bonds
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LEARNING Explain how to account for bond
OBJECTIVE 3 transactions.

A corporation records bond transactions when it

◆ issues (sells) or redeems (buys back) bonds and
◆ when bondholders convert bonds into common stock.

Bonds may be issued at

◆ face value,
◆ below face value (discount), or
◆ above face value (premium).
Bond prices are quoted as a percentage of face value.

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 ISSUING BONDS AT FACE VALUE

Illustration: Devor Corporation issues 100, five-year, 10%,

$1,000 bonds dated January 1, 2017, at 100 (100% of face value).
The entry to record the sale is:

Jan. 1 Cash 100,000

Bonds Payable 100,000

Prepare the entry Devor would make to accrue interest on

December 31. ($100,000 x 10% x 12/12)

Dec. 31 Interest Expense 10,000

Interest Payable 10,000

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 ISSUING BONDS AT FACE VALUE

Prepare the entry Devor would make to pay the interest on Jan. 1,
2018.

Jan. 1 Interest Payable 10,000

Cash 10,000

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 DISCOUNT OR PREMIUM ON BONDS
ILLUSTRATION 10-6
Issue at Par, Discount, or Premium? Interest rates and bond
prices

▼ HELPFUL HINT
Bond prices vary inversely with changes in the market interest rate. As market interest
rates decline, bond prices increase. When a bond is issued, if the market interest rate
is below the contractual rate, the bond price is higher than the face value.
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LO 3
 ISSUING BONDS AT A DISCOUNT

Illustration: Assume that on January 1, 2017, Candlestick Inc.

sells $100,000, five-year, 10% bonds at 98 (98% of face value)
with interest payable on January 1. The entry to record the
issuance is:

Jan. 1 Cash 98,000

Discount on Bonds Payable 2,000
Bonds Payable 100,000

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 ISSUING BONDS AT A DISCOUNT
ILLUSTRATION 10-7
Statement Presentation Statement presentation of
discount on bonds payable

Sale of bonds below face value causes the total cost of borrowing to
be more than the bond interest paid.
The issuing corporation not only must pay the contractual interest
rate over the term of the bonds but also must pay the face value
(rather than the issuance price) at maturity.
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 Total Cost of Borrowing ILLUSTRATION 10-8
Computation of total cost
of borrowing—bonds
issued at discount

ILLUSTRATION 10-9
10-31 Alternative computation of total cost of borrowing—bonds issued at discount LO 3
 ISSUING BONDS AT A DISCOUNT

Amortization of bond discount:

◆ Allocated to expense in each period.
◆ Increases the amount of interest expense reported each
period.
◆ Amount of interest expense reported each period will
exceed the contractual amount paid.
◆ As the discount is amortized, its balance declines.
◆ The carrying value of the bonds will increase, until at
maturity the carrying value of the bonds equals their
face amount.
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 ISSUING BONDS AT A PREMIUM

Illustration: Assume that the Candlestick Inc. bonds previously

described sell at 102 rather than at 98. The entry to record the sale
is:

Jan. 1 Cash 102,000

Bonds Payable 100,000
Premium on Bonds Payable 2,000

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 ISSUING BONDS AT A PREMIUM
ILLUSTRATION 10-11
Statement Presentation Statement presentation of
bonds premium

Sale of bonds above face value causes the total cost of borrowing
to be less than the bond interest paid.
The borrower is not required to pay the bond premium at the maturity
date of the bonds. Thus, the bond premium is considered to be a
reduction in the cost of borrowing.
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 ILLUSTRATION 10-12
Total Cost of Borrowing Computation of total cost
of borrowing—bonds
issued at premium

ILLUSTRATION 10-13
10-35 Alternative computation of total cost of borrowing—bonds issued at premium LO 3
 ISSUING BONDS AT A PREMIUM

Amortization of bond premium:

◆ Allocated to expense in each period.
◆ Decreases the amount of interest expense reported
each period.
◆ Amount of interest expense reported each period will be
less than the contractual amount paid.
◆ As the premium is amortized, its balance declines.
◆ The carrying value of the bonds will decrease, until at
maturity the carrying value of the bonds equals their
face amount.
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 REDEEMING BONDS AT MATURITY

Candlestick records the redemption of its bonds at maturity as

follows:

Bonds Payable 100,000

Cash 100,000

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 REDEEMING BONDS BEFORE MATURITY

When a company retires bonds before maturity, it is

necessary to:
1. eliminate the carrying value of the bonds at the
redemption date;

2. record the cash paid; and

3. recognize the gain or loss on redemption.

The carrying value of the bonds is the face value of the

bonds less unamortized bond discount or plus unamortized
bond premium at the redemption date.

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 REDEEMING BONDS BEFORE MATURITY

Illustration: Assume at the end of the fourth period, Candlestick

Inc., having sold its bonds at a premium, retires the bonds at 103
after paying the annual interest. Assume that the carrying value of
the bonds at the redemption date is $100,400 (principal $100,000
and premium $400). Candlestick records the redemption at the end
of the fourth interest period (January 1, 2021) as:

Jan. 1 Bonds Payable 100,000

Premium on Bonds Payable 400
Loss on Bond Redemption 2,600
Cash 103,000

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LEARNING Discuss how liabilities are reported
OBJECTIVE 4 and analyzed.

ILLUSTRATION 10-15
10-40 Balance sheet presentation of liabilities LO 4
 ANALYSIS

ILLUSTRATION 10-16
Simplified balance sheets for General Motors
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 ANALYSIS

Liquidity ILLUSTRATION 10-17

Current ratio

Liquidity ratios measure the short-term ability of a company to

pay its maturing obligations and to meet unexpected needs for
cash.

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 General Motors data
ANALYSIS

Solvency

Illustration 10-18

Solvency ratios measure the ability of a company to survive

over a long period of time.
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