Liabilities and Interest in Financial Accounting

1. Chapter 8 Liabilities and Interest

2. Learning Objectives After studying this chapter, you should be able to: • Account for current liabilities. • Design an internal control system for cash disbursements. • Explain simple long-term liabilities. • Relate bond covenants to the riskiness of a bond. • Interpret deferred tax liabilities. • Locate and understand the contingent liabilities information in a company’s financial statements. • Use ratio analysis to assess a company’s debt levels.

3. Liabilities in Perspective • Liabilities are a company’s obligations to pay cash or to provide goods and services to other companies or individuals. • Accrual accounting recognizes expenses when they occur rather than when they are paid. • When an expense is recognized before it is paid, a liability is created.

4. Liabilities in Perspective • Liabilities are important to investors, financial analysts, management, and creditors. • Excess liabilities often cause investors and creditors to stay away from the company with the excess liabilities.

5. Liabilities in Perspective • Liabilities are classified as either current or long term to help readers interpret the immediacy of a company’s obligations. • Current liabilities - obligations that fall due within the coming year or within the company’s normal operating cycle • Long-term liabilities - obligations that fall due beyond one year from the balance sheet date • If long-term liabilities are paid gradually, the portion that comes due within the year becomes a current liability.

6. Liabilities in Perspective • In the general ledger, each liability (wages, salaries, interest, etc.) is kept in a different account. • However, in the financial statements, liabilities may be combined and shown as a single amount. • The terms “accrued” or “payable” may sometimes be used to denote liabilities.

7. Liabilities in Perspective • Presentation of liabilities in the balance sheet: Current liabilities Current maturities of long-term debt $19,500 Accounts payable 26,250 Wages payable 1,750 Interest payable 2,500 Total current liabilities $50,000 ===============

8. Accounting for Current Liabilities • Not all current liabilities are recorded the same way. • Some are the result of a transaction with a third party, such as a supplier or a lender. • Some are the result of an adjusting journal entry made to acknowledge an obligation arising over time, such as interest or wages.

9. Accounts Payable • Accounts payable (or trade accounts payable) are amounts owed to suppliers. • Large sums of money flow through accounts payable systems, so data-processing and internal control systems are carefully designed for accounts payable. • The company must ensure that checks are written only for legitimate obligations of the company.

10. Notes Payable • Promissory note (note payable) - a written promise to repay principal plus interest at specific future dates • Notes payable can be classified as current or long term depending on when they are payable.

11. Notes Payable • Rather than having to apply for many small loans at different times, companies obtain lines of credit with lenders. • Line of credit - an agreement with a bank to automatically provide short-term loans up to some preestablished maximum • The lender does not have to do extensive paperwork or credit checks every time a borrower needs money. • The borrower has a preset amount of borrowing available.

12. Notes Payable • Companies sometimes borrow directly from investors in the form of commercial paper. • Commercial paper - a short-term debt contract issued by prominent companies that borrow directly from investors • These liabilities usually fall due within 9 months, often within 60 days.

13. Accrued Employee Compensation • Employers must withhold some employee earnings and pay them to third parties, such as the government, insurance companies, charitable organizations, etc. • Most companies have separate current liability accounts for such items.

14. Accrued Employee Compensation • Companies must pay payroll taxes and fringe benefits in addition to salaries and wages. • Payroll taxes are amounts paid to the government for the employer’s portion of social security taxes, federal and state unemployment taxes, and workers’ compensation taxes. • Fringe benefits are extra benefits paid to employees in lieu of cash, such as employee pensions, life and health insurance, and vacation pay.

15. Accrued Employee Compensation Assume a company pays its employees $100,000 and withholds $15,000 for income taxes and $7,000 for social security taxes. The employer pays its portion of social security taxes and puts $10,000 into a retirement account. How are these transactions recorded?

16. Accrued Employee Compensation The transactions are recorded as follows: Compensation expense 100,000 Salaries and wages payable 78,000 Income tax withholding payable 15,000 Social security withholding payable 7,000 Employee benefits expense 17,000 Employer social security payable 7,000 Pension liability payable 10,000

17. Income Taxes Payable • Corporations make periodic installment payments based on their estimated tax for the year. Therefore, the accrued tax liability at year end is generally much smaller than the actual income tax expense. • Corporations must adjust their periodic payments to reflect changes in the estimates in earnings for the year.

18. Current Portion ofLong-Term Debt • If long-term liabilities are paid gradually, the portion that comes due within the year becomes a current liability. • The journal entry to reclassify a liability is: Long-term debt xxxx Current portion of long-term debt xxxx

19. Sales Tax • When companies collect sales taxes, they are collecting on behalf of a state or local government. • Sales taxes do not affect the income statement. • They are recorded in a liability account called Sales Tax Payable until they are remitted to the governmental unit.

20. Product Warranties • A sales warranty creates a liability, but warranty claims will arise in the future and cannot be estimated precisely. • If warranty obligations are material, they must be accrued when the products are sold. • Warranty obligations are usually based on past experience for replacing or fixing defective products.

21. Product Warranties • The entries related to product warranties are as follows: To record the estimated liability: Warranty expense 30,000 Liability for warranties 30,000 To record a claim against the warranty: Liability for warranties 500 Cash, accounts payable, etc. 500

22. Returnable Deposits • Customers must occasionally pay deposits that will be returned, either with or without interest, at some time in the future. • Most apartment complexes require deposits when a lease is signed. • Companies that require deposits record them as a type of payable because the amounts are due back to the customer. • Deposits are considered current liabilities.

23. Unearned Revenue • Revenues that are collected before services or goods are delivered are called unearned revenues. • Examples include lease rentals, magazine subscriptions, insurance premiums, advance ticket sales, etc. • These amounts are recorded as current liabilities and are converted to revenues as the services or goods are delivered, i.e., when a month passes or when an issue of a magazine is delivered to a subscriber.

24. Internal Controls Over Payables • Since huge sums of money flow through payables systems, good internal control must be present to ensure that all payments involve properly approved and valid obligations of the company. • Most disbursement systems require payments to be made only by checks because the prenumbered checks make record keeping easier. • All checks issued must be supported by source documents.

25. Internal Control Over Payables • Before a check can be written, a series of source documents must be completed to document the obligation. • Purchase order - a document that specifies the items ordered and the price to be paid by the company • Receiving report - a document that specifies the items received by the company and their condition • Invoice - a bill from the seller to a buyer indicating the number of items shipped, their prices, any additional costs such as shipping, and payment terms

26. Internal Control Over Payables • Checks in excess of a certain amount usually require additional authorization or must be signed by two people. • This process leaves a paper trail in case anything goes wrong. • Because more than one person is involved in the payment, errors should be avoided or detected quickly.

27. Internal Control Over Payables • The more people within an organization that see a transaction the better. • Requiring different employees to create the source documents, keep purchase records, and prepare the checks makes it harder for one person to succeed with fraud.

28. Internal Control Over Payables • Computers allow the maintenance of an approved vendor file. • Checks for payables can be written only to approved vendors, and high-level employees must approve additions to the vendor list. • Even with the best control systems in place, mistakes still occur. • One common mistake is overpayment, usually because of a company billing a customer twice.

29. Long-Term Liabilities • Some long-term liabilities are much like some short-term liabilities except for the time frame. • Car loans or mortgage loans are much like notes payable, but they are for a longer term. • As time passes, payments of interest and principal eliminate the loan obligation.

30. Long-Term Liabilities • Illustration and analysis of a loan: • Assume that $10,000 is borrowed at 10% interest. The yearly payment is to be $3,154.71 for four years on December 31 of each year. • The total repayment amount is $12,618.83, which consists of the $10,000 principal plus $2,618.83 in interest.

31. Bonds and Notes • Both bonds and notes are legal contracts that specify how much is to be borrowed and the dates and amounts for repayment by the borrower. • Notes and bonds are called negotiable financial instruments because they can be transferred from one lender to another. • Some bonds and notes are private placements, which means that only a few sources of borrowing are used rather than the general public.

32. Bonds and Notes • Bond - a formal certificate of indebtedness that is typically accompanied by (1) a promise to pay interest in cash at a specified annual rate plus (2) a promise to pay the principal at a specific maturity date • The interest rate is often called the nominal interest rate, contractual rate, coupon rate, or stated rate. • The principal amount is also known as the face amount.

33. Bonds and Notes • Interest rate - the percentage applied to a principal amount to calculate the amount of interest that must be paid on the loan • Interest represents the return the lender can earn for loaning money. • In general, riskier loans demand higher interest rates.

34. Bond Accounting • On December 31, 2000, a company issued $10,000,000 in 2-year, 10% bonds. Interest is to be paid semiannually on June 30 and December 31. Assuming that the bonds are held to maturity, the journal entries are: To record the issuance of the bonds Cash 10,000,000 Bonds payable 10,000,000 To record the payments of the semiannual interest Interest expense 500,000 Cash (($10,000,000 x 10%) / 2) 500,000 To record the repayment of principal at maturity Bonds payable 10,000,000 Cash 10,000,000

35. Mortgage Bonds and Debentures • Mortgage bond - a form of long-term debt that is secured by the pledge of specific property • In case of default, the lender can sell the pledged property to satisfy the debt. • Debenture - a debt secured with a general claim against all assets rather than a specific claim against particular assets

36. Mortgage Bonds and Debentures • If a borrower defaults on a loan, the company may be liquidated to satisfy the loan obligation. • Liquidation - converting assets to cash and paying off outside claims or obligations • If all claims were equal, each lender would receive a proportional share of the cash remaining after liquidation. • Debentures have a lower priority claim than mortgage bonds to recover the loan amount.

37. Mortgage Bonds and Debentures • Debentures can have different priorities also. • Subordinated debentures - debt securities whose holders have claims against only the assets that remain after the claims of general creditors are satisfied • Generally have the lowest priority of recovery • Also carry the highest interest rate because they carry the most risk

38. Bond Provisions • Trust indenture - a contract whereby the issuing corporation of a bond promises a trustee that it will abide by stated provisions • These provisions are sometimes called protective covenants or covenants. • The covenants pertain to payments of principal and interest, sales of pledged property, restrictions on paying dividends, etc., all included to protect the bondholders’ interests.

39. Callable, Sinking Fund, and Convertible Bonds • Callable bonds - bonds subject to redemption before maturity at the option of the issuer • Usually, the bonds are callable at a call premium - the redemption amount exceeds the par value of the bond. • This feature is good for the issuer because the bonds can be paid off early. • However, this feature creates uncertainty for investors and might cause interest rates to be higher.

40. Callable, Sinking Fund, and Convertible Bonds • Sinking fund bonds - bonds with indentures that require the issuer to make annual payments to a sinking fund • Sinking fund - a pool of cash or securities segregated for meeting certain obligations • The sinking fund assures investors that enough money will be on hand to repay the bonds upon maturity. • This increases attractiveness to investors and generally lowers the interest rate on the borrowing.

41. Callable, Sinking Fund, and Convertible Bonds • Convertible bonds - bonds that may be exchanged for other securities at the holder’soption • Conversion is usually for a preset number of shares of the issuing corporation’s stock. • This feature makes bondholders more willing to accept a lower interest rate.

42. Restructuring • Restructuring - a significant makeover of part of the company typically involving the closing of plants, firing of employees, and relocation of activities • Companies record restructuring charges and some recognize significant liabilities for future costs.

43. Deferred Taxes • As discussed before, delays in payment of taxes between the time that income is earned and taxes are due leads to short-term taxes payable. • However, another reason for taxes payable arises because of differences between U.S. income tax rules and GAAP. • Sometimes tax rules can cause income tax expense to be recorded long before it is actually paid and creates a deferred tax liability.

44. Deferred Taxes • Differences arise because GAAP is designed to provide useful information to investors, while the tax code is written to generate revenues for the government. • Managers try to pay the least amount of taxes at the latest time possible. • They try to delay reporting taxable revenue as long as possible while deducting expenses as quickly as possible.

45. Deferred Taxes • Rules under GAAP and tax rules differ on two dimensions: • Whether an item is recognized (permanent difference) • When an item is recognized (temporary difference)

46. Deferred Taxes • Taxes are calculated as a percentage of taxable income of a company. • Taxable income results from subtracting deductible expenses from taxable revenues. • The percentage used to calculate the tax is the tax rate.

47. Deferred Taxes • Differences may be created because: • Rules for financial reporting and tax rules differ. • Managers make different choices of accounting treatment for financial reporting than for tax reporting. • Managers have an incentive to keep taxable income low, but they have an incentive to make financial income high.

48. Permanent Differences • Permanent differences - revenue or expense items that are recognized for tax purposes but not recognized under GAAP, or vice versa • An example of a permanent difference is municipal bond interest. • For GAAP purposes, this interest is reported on the income statement. • For tax purposes, this interest is not included in taxable income.

49. Temporary Differences • Temporary differences (timing differences) - differences between GAAP income and taxable income that arise because some revenue and expense items are recognized at different times for tax purposes than for financial reporting purposes • An example of a temporary difference is using straight-line depreciation for financial reporting purposes and accelerated depreciation (MACRS) for tax purposes.

50. Temporary Differences Burton Company has $100,000 in income before depreciation. The company can take $20,000 depreciation for reporting purposes and $40,000 for tax purposes. The company’s tax rate is 40%. The temporary difference is determined as follows: Reporting purposesIncome tax purposes Income $100,000 $100,000 Depreciation 20,000 40,000 Net income $ 80,000 $ 60,000 Tax rate x 40% x 40% Income taxes $ 32,000 $ 24,000 =================== ==================