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Chapter
LIABILITIES
10
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The Nature of Liabilities
Defined as debts or obligations
arising from past transactions or
events.
Maturity = 1 year or less Maturity > 1 year
Current Noncurrent
Liabilities Liabilities
I.O.U.
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Distinction Between
Debt and Equity
The acquisition of assets is financed from two
sources:
DEBT EQUITY
Funds from creditors, with Funds from
a definite due date, and owners
sometimes bearing
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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.
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Evaluating Liquidity
An important indicator of a company’s ability
to meet its current obligations.
Two commonly used measures:
Working Capital = Current Assets - Current Liabilities
Current Ratio = Current Assets ÷ Current Liabilities
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Liabilities – Question
Devon Mfg. has current liabilities of
$230,000 and current assets of $322,000.
What is Devon’s current ratio?
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Accounts Payable
Short-term obligations to suppliers for purchases of
merchandise and to others for goods and services.
Office
Merchandise supplies
inventory invoices
invoices
Utility and
Shipping phone bills
charges
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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 Noncurrent Notes Payable
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Notes Payable
PROMISSORY NOTE
Miami, Fl Nov. 1, 2003
Location Date
Six months after this date Porter Company
promises to pay to the order of Security National Bank
the sum of $10,000.00 with interest at the rate
of 12.0% per annum.
signed John Caldwell
title treasurer
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Notes Payable
On November 1, 2003, Porter Company
would make the following entry.
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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 Interest
Rate
revenue. Up!
To the borrower, interest is an
expense.
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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.
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Interest Payable – Example
What entry would Porter Company make
on December 31, the fiscal year-end?
$10,000 × 12% × 2/12 = $200
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Payroll Liabilities
Gross Pay
Net Pay
State and Voluntary
Medicare Federal Local Income Deductions
FICA Taxes
Taxes Income Tax Taxes
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Unearned Revenue
Cash is sometimes collected from the
customer before the revenue is
actually earned.
As the earnings
process is
completed . .
Cash is
Deferred Earned
received
revenue is revenue is
in
recorded. recorded.
advance.
a liability account. © The McGraw-Hill Companies, Inc., 2002
McGraw-Hill/Irwin

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Long-Term Debt
Relatively small debt
needs can be filled from
single sources.
or Insurance
or Pension
Banks Companies Plans
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Long-Term Debt
Large debt needs are often
filled by issuing bonds.
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Installment Notes Payable
Long-term notes that call for a series of
installment payments.
Each payment covers With each payment, the
interest for the period interest portion gets
AND a portion of the smaller and the principal
principal. portion gets larger.
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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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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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Allocating Installment Payments
Between Interest and Principal
Now, prepare the entry for the first payment on
December 31, 2003.
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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.
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Bonds Payable
qBonds usually involve the
borrowing of a large sum of
money, called principal.
qThe principal is usually paid
back as a lump sum at the end
of the bond period.
qIndividual bonds are often
denominated with a par value,
or face value, of $1,000.
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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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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.
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Types of Bonds
Mortgage Debenture
Bonds Bonds
Convertible
Junk Bonds
Bonds
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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.
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Accounting for Bonds Payable
Record the interest payment
on July 1, 2003.
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Bonds Sold Between Interest Dates
Bonds are often sold between interest dates.
The selling price of the bond is computed as:
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The Concept of Present Value
$1,000 In 5 years it In 25 years it
invested will be worth will be worth
today at 10%. $1,610.51. $10,834.71!
Present Future
Value Money can grow over time, Value
because it can earn interest.
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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 future amount.
– The Interest compounding periods Future
Value Value
— The interest rate (i).
˜ The number of periods (n) the amount will be
Today
invested.
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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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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.
= =
< <
> >
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Early Retirement of Debt
B o n d s c a n b e re tire d b y . . .
E x e r c is in g a c a ll P u r c h a s in g th e
p r o v is io n . b o n d s o n th e
o p e n m a rk e t.
Gains or losses incurred as a result of retiring bonds
should be reported as extraordinary items on the
income statement.
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Lease Payment Obligations
Operating Leases Capital Leases
Lease agreement transfers
Lessor retains risks and
risks and benefits
benefits associated with
associated with ownership
ownership.
to lessee.
Lessee records rent Lessee records a leased
expense as incurred. asset and lease liability.
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Capital Lease Criteria
A le a s e m u s t b e r e c o r d e d a s
a C a p ita l L e a s e if it m e e ts
a n y o f th e fo llo w in g c r ite r ia .
T h e le a s e tr a n s fe r s T h e le a s e c o n ta in s
o w n e r s h ip to th e a b a r g a in p u r c h a s e
le s s e e . o p tio n .
T h e le a s e te r m is e q u a l to T h e P V o f th e m in im u m
o r > 7 5 % o f th e e c o n o m ic le a s e p a y m e n ts = 9 0 % o f
life o f th e p r o p e r ty . th e F M V o f th e p ro p e rty .
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Pensions
Employers offer pension
plans to employees.
The employer makes
payments to a pension
fund. Usually, this is an
Retirees receive independent entity
pension managed by a
payments from professional fund
the pension manager.
fund.
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Pensions
Actuaries make the pension expense
computations, based on:
q Average age, retirement age, life expectancy.
q Employee turnover rates.
q Compensation levels.
q Expected rate of return for the fund.
The accountant then posts the entry to
record pension expense and pension
liability.
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Other Postretirement Benefits
Many companies offer benefits
to retirees other than pensions,
such as health coverage or
fitness club memberships.
Amount to
Current
be funded
liability
Unfunded liability next year
for nonpension
postretirement
benefits Remainder
Long-term
of unfunded
liability
amount
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Deferred Income Taxes
Corporations
pay income
taxes quarterly.
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Deferred Income Taxes
The Internal Revenue
GAAP is the set of
Code is the set of
rules for preparing
rules for preparing tax
financial statements.
returns.
Results in . . . Usually. . . Results in . . .
Financial statement IRS income taxes
income tax expense. payable.
The difference between tax expense and tax
payable is recorded in an account called
deferred taxes.
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Deferred Income Taxes – Example
Examine the December 31, 2003, information
for X-Off Inc.
X-Off uses straight-line depreciation for financial
reporting and accelerated depreciation for
income tax reporting. X-Off’s tax rate is 30%.
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Deferred Income Taxes – Example
Compute X-Off’s income tax expense
and income tax payable.
Income Tax
The income tax
Statement Return Difference
amount computed
Revenues $ 1,000,000
Less: based on financial
Depreciation 200,000 statement income
Other expenses 650,000 is income tax
Income before taxes $ 150,000
expense for the
× Tax rate 30% period.
Income taxes $ 45,000
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Deferred Income Taxes – Example
Compute X-Off’s income tax expense
and income tax payable.
Income Tax
Statement Return Difference
Income taxes
Revenues $ 1,000,000 $ 1,000,000 based on tax
Less:
Depreciation 200,000 320,000
return
Other expenses 650,000 650,000 income are
Income before taxes $ 150,000 $ 30,000 the taxes
payable for
× Tax rate 30% 30%
the period.
Income taxes $ 45,000 $ 9,000
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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 Tax
Statement Return Difference
Revenues $ 1,000,000 $ 1,000,000 $ -
Less:
Depreciation 200,000 320,000 (120,000)
Other expenses 650,000 650,000 -
Income before taxes $ 150,000 $ 30,000 $ 120,000
× Tax rate 30% 30% 30%
Income taxes $ 45,000 $ 9,000 $ 36,000
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Financial Leverage
Borrowing at one If we borrow
rate and investing $1,000,000 at 8% and
invest it at 10%, we
at a higher rate. will clear $20,000
profit!
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End of Chapter 10
Are we
having fun
yet?
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