Topic 7

1. Topic 7 Accounting for Current Liabilities and Long-Term Liabilities

2. Learning Objectives • Explain a current liability and identify the major types of current liabilities. • Describe the accounting for notes payable. • Explain a long-term liability and identify the major types of long-term liabilities. • Describe the accounting for notes payable and mortgage payable

3. Current Liabilities • Definition: • A debt that can reasonably be expected to be paid (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.

4. Current Liabilities • Types: (1) accounts payable – exists when goods are purchased on credit. (2) unearned revenue – exists when revenue is received in advance. (3) accrued expenses – exists when expenses due are not paid within the relevant accounting period. (4) notes payable – written promises to pay a certain sum of money on a specified future date.

5. Notes Payable • Types: (1) Short-term notes payable - a debt that can reasonably be expected to be paid within one year or operating cycle, whichever is longer. (2) Long-term notes payable - a debt that cannot reasonably be expected to be paid within one year or operating cycle, whichever is longer.

6. Accounting for Short-Term Notes Payable • Notes payable usually require the borrower to pay interest. • There are: (1) interest-bearing notes, and (2) zero-interest-bearing notes.

7. Interest-Bearing Note • Assume that Castle National Bank agrees to lend RM100,000 on September 1, 2007 to Landscape Co. if the company signs a RM100,000, 12%, 4-month note. The entry to record the cash received by Landscape Co. on September 1 is: September 1 Debit: Cash 100,000 Credit: Notes Payable 100,000 (To record issuance of 12%, 4-month note to Castle National Bank.)

8. Interest-Bearing Note (cont’d) • If Landscape Co. prepares financial statements monthly, an adjusting entry at the end of each month would have been recognized interest expense and interest payable of RM1,000 (100,000 x 12% x 1/12). The adjusting entry is: Sept 30, Oct 31, Nov 30, & Dec 31 Debit: Interest Expense 1,000 Credit: Interest Payable 1,000 (To accrue interest for a months on Castle National Bank note.)

9. Interest-Bearing Note (cont’d) • If Landscape Co. prepares financial statements on December 31, 2007, an adjusting entry is required to recognized interest expense and interest payable of RM4,000 (100,000 x 12% x 4/12) at December 31. The adjusting entry is: December 31 Debit: Interest Expense 4,000 Credit: Interest Payable 4,000 (To accrue interest for 4 months on Castle National Bank note.)

10. Interest-Bearing Note (cont’d) • Presentation in the Financial Statement: Landscape Co. Income Statement (partial) for the year ended Dec 31, 2007 Landscape Co. Balance Sheet (partial) at December 31, 2007

11. Interest-Bearing Note (cont’d) • At maturity date of January 1, 2008, Landscape Co. must pay the face value of the note (RM100,000) plus RM4,000 interest. The entry to record payment of the note and accrued interest is as follows: January 1, 2008 Debit: Notes Payable 100,000 Debit: Interest Payable 4,000 Credit: Cash 104,000 (To record payment of Castle National Bank interest-bearing note and accrued interest at maturity.)

12. Zero-Interest-Bearing Note • Zero-interest-bearing note means that the borrower borrows money at a discount. In other word, the borrower receives in cash at the present value of the note. • The present value equals the face value of the note at maturity minus the interest or discount charged by the lender for the term of the note.

13. Zero-Interest-Bearing Note (cont’d) • Assume that Landscape Co. issues a RM104,000, 4-month, zero-interest-bearing note to Castle National Bank. The present value of the note is RM100,000. The entry to record this transaction for Landscape Co. is as follows: September 1 Debit: Cash 100,000 Debit: Discount on Notes Payable 4,000 Credit: Notes Payable 104,000 (To record issuance of 4-month, zero-interest- bearing note to Castle National Bank.)

14. Zero-Interest-Bearing Note (cont’d) • Presentation in the financial statement: Landscape Co. Balance Sheet (partial) at December 31, 2007

15. Long-Term Liabilities • Definition: • Consists of probable future sacrifices of economic benefits arising from present obligation that are not payable within a year or the operating cycle of the business, whichever is longer. • Types: • Long-term notes payable • Bonds payable • Mortgages payable • Pension liabilities • Lease

16. Other Current Liabilities • Estimated liability under warranties. To record the estimated warranty cost: Debit: Warranty Expense 20,000 Credit: Estimated Liability under Warranties 20,000 To record warranty costs incurred: Debit: Estimated Liability under Warranties 20,000 Credit: Cash, Materials, Labour 20,000

17. Other Current Liabilities (cont’d) (2) Estimated Liability for Premium (free gift) To record the purchase of premium (example: cinema ticket) Debit: Inventory of Premium Cinema Ticket 15,000 Credit: Cash 15,000 To record the redemption of the premium: Debit: Premium Expense 5,000 Credit: Inventory of Premium Cinema Ticket 5,000 To record the outstanding premium: Debit: Premium Expense 10,000 Credit: Estimated Liability for Premium 10,000

18. Long-Term Notes Payable • Categories of long-term notes payable: (A) Notes issued at face value (B) Notes not issued at face value (i) Zero-interest-bearing notes (ii) Interest-bearing notes

19. Long-Term Notes Payable (cont’d) (A) Notes issued at face value - stated rate = effective rate - no premium or discount is recognized as the present value of the note and its face value are the same. Example: Assume that on January 1, 2001 a RM10,000, 3-year note issued at face value by Scandinavian Imports to Bigelow Corporation. The stated rate and effective rate are at 10% per annum. The issuance of the note is recorded by Scandinavian Imports as follows:

20. Long-Term Notes Payable (cont’d) Notes Issued at Face Value January 1, 2001 Debit: Cash 10,000 Credit: Notes Payable 10,000 (To record the issuance of RM10,000, 3-year note issued at face value, stated rate 10% to Bigelow Corp.)

21. Long-Term Notes Payable (cont’d) Notes Issued at Face Value If Scandinavian Imports prepares its financial statement on December 31, 2001, the adjusting entry is as follows: Debit: Interest Expense 1,000 Credit: Interest Payable 1,000 (To accrue interest for a year.)

22. Long-Term Notes Payable (cont’d) Notes Issued at Face Value Presentation in the financial statement: Scandinavian Imports Income Statement (partial) for the year ended December 31, 2001 Scandinavian Imports Balance Sheet (partial) at December 31, 2001

23. Long-Term Notes Payable (cont’d) Notes Issued at Face Value On January 1, 2002, Scandinavian Imports settles its first cash interest to Bigelow Corp. The journal entry is as follows: Debit: Interest Payable 1,000 Credit: Cash 1,000 (To record the interest cash payment to Bigelow Corp.)

24. Long-Term Notes Payable (cont’d) Notes Issued at Face Value On January 1, 2004, Scandinavian Imports settles its final cash interest plus the principal (face value) to Bigelow Corp. The journal entry is as follows: Debit: Notes Payable 10,000 Debit: Interest Payable 1,000 Credit: Cash 11,000 (To record the settlement of note issued at face value plus the final cash interest to Bigelow Corp.)

25. Long-Term Notes Payable (cont’d) (B) Notes Not Issued at Face Value (i) Zero-Interest-Bearing Notes - The note is issued at a discount (the difference between the face value (future value) and the present value (cash received)). - The discount is amortized to interest expense over the life of the note. - Stated rate < Effective rate - No interest is paid every year.

26. Long-Term Notes Payable (cont’d) (i) Zero-Interest-Bearing Notes Present value, PV = ? Principal = FV = RM10,000 Stated rate = 0% Effective rate, i = 9% Number of years, n = 3 PV = FV / (1 + i)n = 10,000 (1.09)3 = RM7,721.80 The journal entry on January 1, 2001: Debit: Cash 7,721.80 Debit: Discount on Notes Payable 2,278.20 Credit: Notes Payable 10,000

27. Long-Term Notes Payable (cont’d) • Zero-Interest-Bearing Notes Schedule of Note Discount Amortization Effective Interest Method 0% Note Discounted at 9%

28. Long-Term Notes Payable (cont’d) • Zero-Interest-Bearing Notes • The adjusting entry on December 31, 2001 is as follows: Debit: Interest Expense 694.96 Credit: Discount on Notes Payable 694.96 (7,721.80 x 9% = 694.96) • Presentation in the financial statement: Scandinavian Imports Income Statement (partial) for the year ended December 31,2001

29. Long-Term Notes Payable (cont’d) • Zero-Interest-Bearing Notes • Presentation in the financial statement: Scandinavian Imports Balance Sheet (partial) at December 31, 2001

30. Long-Term Notes Payable (cont’d) • Zero-Interest-Bearing Notes • The adjusting entry on December 31, 2002 is as follows: Debit: Interest Expense 757.51 Credit: Discount on Notes Payable 757.51 [(7,721.80 + 694.96) x 9% = 757.51] • Presentation in the financial statement: Scandinavian Imports Income Statement (partial) for the year ended December 31,2002

31. Long-Term Notes Payable (cont’d) • Zero-Interest-Bearing Notes • Presentation in the financial statement: Scandinavian Imports Balance Sheet (partial) at December 31, 2002

32. Long-Term Notes Payable (cont’d) • Zero-Interest-Bearing Notes • The adjusting entry on December 31, 2003 is as follows: Debit: Interest Expense 825.73 Credit: Discount on Notes Payable 825.73 [(8,914.76 + 757.51) x 9% = 825.73] • Presentation in the financial statement: Scandinavian Imports Income Statement (partial) for the year ended December 31,2003

33. Long-Term Notes Payable (cont’d) • Zero-Interest-Bearing Notes • Presentation in the financial statement: Scandinavian Imports Balance Sheet (partial) at December 31, 2003 • On January 1, 2004, the journal entry to record the settlement of the notes to Bigelow is as follows: Debit: Notes Payable 10,000 Credit: Cash 10,000

34. Long-Term Notes Payable (cont’d) • Interest-Bearing Notes - Interest is paid every year over the life of the notes. PV = ? FV = RM10,000 Stated rate = 10% Effective rate, i = 12% Number of years, n = 3

35. Long-Term Notes Payable (cont’d) • Interest-Bearing Notes Face value of the note 10,000 Present value of the principal: 10,000 / (1.12)3 = 7,118 Present value of the interest: 10,000 x 10% = 1,000 1,000 / [1 – 1/ (1.12)3] / 12% = 2,402 Present value of the note 9,520 Difference (Discount on Notes Payable) 480 ======

36. Long-Term Notes Payable (cont’d) • Interest-Bearing Notes On the date of issuance of the notes (January 1, 2001), Scandinavian Imports will record the following: Debit: Cash 9,520 Debit: Discount on Notes Payable 480 Credit: Notes Payable 10,000

37. Long-Term Notes Payable (cont’d) • Interest-Bearing Notes Schedule of Note Discount Amortization Effective Interest Method 10% Note Discounted at 12%

38. Long-Term Notes Payable (cont’d) • Interest-Bearing Notes If Scandinavian Imports prepares its financial statement on December 31, 2001, the adjusting entry is as follows: Debit: Interest Expense 1,142 Credit: Discount on Notes Payable 142 Interest Payable 1,000 On January 1, 2002, Scandinavian Imports will record the cash interest payment to Bigelow Corp. Debit: Interest Payable 1,000 Credit: Cash 1,000

39. Long-Term Notes Payable (cont’d) • Interest-Bearing Notes Presentation in the financial statement: Scandinavian Imports Income Statement (partial) for the year ended Dec 31, 2001 Scandinavian Imports Balance Sheet (partial) at December 31, 2001

40. Long-Term Notes Payable (cont’d) • Interest-Bearing Notes If Scandinavian Imports prepares its financial statement on December 31, 2002, the adjusting entry is as follows: Debit: Interest Expense 1,159 Credit: Discount on Notes Payable 159 Interest Payable 1,000 On January 1, 2003, Scandinavian Imports will record the cash interest payment to Bigelow Corp. Debit: Interest Payable 1,000 Credit: Cash 1,000

41. Long-Term Notes Payable (cont’d) • Interest-Bearing Notes Presentation in the financial statement: Scandinavian Imports Income Statement (partial) for the year ended Dec 31, 2002 Scandinavian Imports Balance Sheet (partial) at December 31, 2002

42. Long-Term Notes Payable (cont’d) • Interest-Bearing Notes If Scandinavian Imports prepares its financial statement on December 31, 2003, the adjusting entry is as follows: Debit: Interest Expense 1,179 Credit: Discount on Notes Payable 179 Interest Payable 1,000 On January 1, 2004, Scandinavian Imports will record the cash interest payment to Bigelow Corp. Debit: Notes Payable 10,000 Debit: Interest Payable 1,000 Credit: Cash 11,000

43. Long-Term Notes Payable (cont’d) • Interest-Bearing Notes Presentation in the financial statement: Scandinavian Imports Income Statement (partial) for the year ended Dec 31, 2003 Scandinavian Imports Balance Sheet (partial) at December 31, 2003

44. Mortgage Payable • Similar to notes payable: • a written promise to pay a stated sum of money at one or more specified future dates. • Difference between note payable and mortgage payable: • Notes payable issued for the purpose of borrowing money (cash). • Mortgage payable issued for the purpose of purchasing tangible asset, typically real estate whereby the asset is the collateral on the loan.