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Chapter 10

Chapter 10. Current and Long-Term Liabilities. Objectives of the Chapter. Discuss the accounting for major types of current liabilities. Discuss the issuance of bonds (i.e., why bonds are issued; the issuing procedures of bonds, etc.)

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Chapter 10

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  1. Chapter 10 Current and Long-Term Liabilities

  2. Objectives of the Chapter • Discuss the accounting for major types of current liabilities. • Discuss the issuance of bonds (i.e., why bonds are issued; the issuing procedures of bonds, etc.) • Prepare the entries for the issuance of bonds and the recording of the subsequent interest payments. • Discuss the accounting for bond retirement and bond conversion. • Debt to total assets ratio and time interest earned ratio.

  3. Liabilities • Legal obligations require the future payments of cash or services as a result of past transactions. In this chapter we look at. • I. current liabilities as a result of business transactions, and • II. long-term liabilities (i.e., bonds payable). Current and Long-Term Liabilities

  4. Current Liabilities: • Obligations must be fulfilled in one year or one operating cycle, whichever is longer. Current and Long-Term Liabilities

  5. I. Current Liabilities as a Result of Business Transactions: • A. Current liabilities with definite amount • B. Estimated liabilities Current and Long-Term Liabilities

  6. A. Current Liabilities with Definite Amount • a. Accounts Payable (A/P) • b. Short-Term Notes Payable (N/P) • c. Sales Tax Payable • d. Current maturity portion of long-term liability (i.e., bonds payable) • e. Accrued Liabilities (i.e., interest payable) • f. Payroll Taxes withholdings (payroll liabilities) • g. Unearned Revenues Current and Long-Term Liabilities

  7. a. Accounts Payable: • Amounts owed to suppliers for products or services purchased on account. Current and Long-Term Liabilities

  8. b. Short-Term Notes Payable: • Notes payable due in one year or one operating cycle whichever is longer. • Companies often issue notes to borrow money or to purchase inventory or other assets. • If the note payable is an interest bearing note, an accrued interest should also be recognized at the end of the period, if there is any. Current and Long-Term Liabilities

  9. Example of A Transaction Involving N/P: • J. E. • Inventory XXX • N/P XXX • or • Cash XXX • N/P XXX Current and Long-Term Liabilities

  10. b. Short-Term Notes Payable: (contd..) • Short-term N/P can also be issued at discount to borrow cash from a bank. Bank will subtract the interest amount from the note’s face value and the borrower will receive the net amount. Current and Long-Term Liabilities

  11. Example: • P&G discounts a $200,000, 90-day note payable to its bank on 12/1/x8. The bank charges 12% annual interest on the borrowing. P&G will receive $200,000 - 200,000 x 12% x 90/360 = 200,000 - 6,000 =$194,000. Current and Long-Term Liabilities

  12. Example (coned) • P&G’s entries to record the discounting of the note and related entries are as follows: • 12/1/x8 Cash 194,000 • Discount on N/P 6,000 • N/P 200,000 • 12/31/x8 Interest Exp.* 2,000 • Discount on N/P 2,000 • * $200,000 x 12% x 30/360 = 2,000 Current and Long-Term Liabilities

  13. Example (contd.) • B/S presentation: • B/S (12/31/x8) • Current Liabilities: • N/P - Short-term 200,000 • Dis. on N/P (4,000) • $196,000 Current and Long-Term Liabilities

  14. Example (contd.) • At maturity (3/1/x9), the P&G’s entries are: • 3/1/x9 Int. Exp.* 4,000 • Dis. on N/P 4,000 • * $200,000 x 12% x 60/360 = $4,000 • 3/1/x9 N/P 200,000 • Cash 200,000 Current and Long-Term Liabilities

  15. c. Sales Taxes Payable: • Sales taxes are taxes levied by states on retail sales, not on manufacturers (i.e., GE, GM, etc). • Every state, except Alaska, Delaware, Montana, New Hampshire, and Oregon, levies state sales taxes on retail sales. • The rate varies state by state (for example, California has a statewide sales tax at 7.25% with a local supplementary tax for up to 8.75%). Current and Long-Term Liabilities

  16. c. Sales Taxes Payable: (contd.) • Retailers charge their customers the sales taxes in addition to the price of the merchandise. • The retailers have to forward the collected sales taxes to the state at regular intervals. Current and Long-Term Liabilities

  17. Example • Assume that the 12/22/x8 sales of Macy’s in California totaled $2,000,000. The state tax rate is 8.25%. The business would record the day’s sales as follows: • Cash 2,165,000 • Sales Revenue 2,000,000 • Sales Taxes Payable 165,000 Current and Long-Term Liabilities

  18. Example • When forwarding the collected sales taxes to the state, the following entry will be recorded: • Sales Taxes Payable 165,000 • Cash 165,000 Current and Long-Term Liabilities

  19. d. Current Portion of Long-Term Debt: • Some bonds payable are paid in installments. The current maturity portion of a long-term debt should be reported as a current liability. Current and Long-Term Liabilities

  20. e. Accrued Liabilities: • Expenses incurred but have not yet been paid by the company. • If these liabilities are due within one year or one operating cycle whichever is longer, they should be reported as current liabilities. Current and Long-Term Liabilities

  21. f. Payroll and Payroll Taxes Payable • Include salary payable to employees, employee income taxes payable (employee income taxes withholdings), FICA taxes payable (employee’s FICA taxes withholdings by the employer),etc. Current and Long-Term Liabilities

  22. Example • Salaries Expense 50,000 • Employee FICA Taxes Payable* 3,825 • Federal I/T Payable 12,500 • State I/T Payable 4,000 • Employee Union Dues Payable 250 • Salaries Payable` 29,425 • For 2008, FICA (Federal Insurance Contributions Act) tax includes 6.2% and 1.45% of Social Security and Medicare taxes, respectively, on the first $102,000 gross income. This payroll tax is imposed by the federal government on both employees and employers to fund Social security and Medicare. • * 50,000 x (6.2% + 1.45%) = 3,825

  23. g. Unearned Revenues: • Revenues collected in advance before providing services. • Example: Assume that New Magazine collects $300 subscription fee in advance from a subscriber. The entry will be: • Cash 300 • Unearned Subscription Revenue 300 Current and Long-Term Liabilities

  24. Estimated Liabilities • Liabilities exist but the amount is unknown (i.e., property taxes, warranty obligations, coupon and premium obligations …) Current and Long-Term Liabilities

  25. Estimated Liabilities (contd.) • a. Warranty Obligations (Product Warranty) • b. Premium and Coupon Obligations • c. Estimated Vacation Pay Liability Current and Long-Term Liabilities

  26. a. Warranty Obligations • These obligations are associated with the sales of the period and are recognized at the end of the period. • Journal Entry: • Warranty Expenses xxx • Estimated Warranty Liabilities xxx • When warranty services are provided: • Estimated warranty liabilities xxx • Cash (or Inventory) xxx Current and Long-Term Liabilities

  27. b. Premium and Coupon Obligations • Liabilities of premiums and coupons should be estimated and recognized in the year when sales are made. • Journal Entry • Premium (or Coupon) Expenses xxx • Estimated Premium Claims • (or coupon) outstanding xxx Current and Long-Term Liabilities

  28. b. Premium and Coupon Obligations (contd.) • When premium (or coupon) are claimed: • Journal Entry • Estimated Premium Claims • (coupon) outstanding xxx • Inventory xxx • * If the actual redemption of coupons (or premiums) is greater than the estimated liabilities, the underestimated amount would be recognized as the expense of the current year. (APB Opinion No. 20) Current and Long-Term Liabilities

  29. c. Estimated Vacation Pay Liability: • Example: • 12/31/X1 • Vacation Pay Expense xxx • Estimated Vacation Pay Liability xxx • 2/1/X2 • Estimated Vacation Pay Liability xxx • Cash xxx Current and Long-Term Liabilities

  30. II. Long-Term Liabilities • 1. Present value concept • 2. Annuity • 3. Topics of long-term liabilities Current and Long-Term Liabilities

  31. 1. Present Value Concept • Present value of $1 is the value today of $1 to be received at some future date, given a specific interest rate. Current and Long-Term Liabilities

  32. Example 1 • What is the present value of $100 to be received a year from now given the annual market interest rate is 10%? • P.V. * (1 + 10%) = $100 • P.V. = $100/1.1 • = $100 x 0.9091 • = $90.91 Current and Long-Term Liabilities

  33. Example 2 • What is the present value of $100 to be received two years from now given the annual interest rate is 10%? • P.V * (1-10%) * (1+10%) = $100 • P.V * (1-10%)2 = $100 • P.V. * 1.21= $100 • P.V. = $100 / 1.21 • = $100 * 0.8264 • = $82.64 Current and Long-Term Liabilities

  34. $100 $100 $100 $100 $100 1 year 2. Annuity • Receiving (or paying)a constant amount of money at the end of each period (equal time internal) for a given number of periods. • Receiving $100 every year for the following 5 years. (period = 1 year) (starting a year from now) Current and Long-Term Liabilities

  35. 2. Annuity (contd.) • Present Value (P.V.) of an annuity: • Using the example above given 10% Interest rate: • P.V. of the first $100 = $100 * 0.9091 = $90.91 • P.V. of the second $100 = $100 * 0.8264 = $82.64 • P.V. of the third $100 = $100 * 0.7513 = $75.13 • P.V. of the fourth $100 = $100 * 0.6830 = $68.30 • P.V. of the fifth $100 = $100 * 0.6209 = $62.09 • Total 3.7907 $379.07 Current and Long-Term Liabilities

  36. 2. Annuity (contd.) • The P.V. of $100 annuity receiving every year for the following 5 years, starting a year from now => • $100  3.7907 = $379.07 • Can be obtained from the annuity table under 10%, 5 periods. Current and Long-Term Liabilities

  37. 3. Topics of Long-Term Liabilities • A. Corporate bonds • B. Convertible bonds and notes • C. Other long-term liabilities Current and Long-Term Liabilities

  38. A. Corporate Bonds • Bonds are securities issued by a corporation to borrow money from the public. • The corporation will receive cash when bonds are issued. • The face value (principal) of the bonds must be repaid to the bondholders on the maturity date. • the bond issuers will pay interests to the bondholders periodically (i.e., semi-annually .

  39. Topics of Bonds • The procedures of bond issuance. • Units of bonds. • Types of bonds. • Determination of bond price. • Present value of bonds. • Issuance of bonds at face value, at a discount or at a premium. • Accounting for bonds payable. • Bond retirement before maturity.

  40. The Procedures of Bond Issuance • 1. Receive the approval from the board of directors and stockholders. • 2. Draw a bond indenture* and print bond certificates**. • 3. Make a public announcement of its intent to sell the bonds on a particular date. • *a written agreement between the issuer and bondholders (a legal document) with terms such as stated interest rate, the maturity date, the convertibility, the trustee, etc. • **provides information such as bond issuer, face value, stated interest rate, the maturity date, etc. See Illustration 11-10 for an example.

  41. The Procedures of Bond Issuance (contd..) • 4. Negotiate the appropriate selling price with the underwriters based on the terms of bond issue (i.e., the stated interest rate), the general bond market conditions, the risk of the bonds and the expected state of the economy. • 5. The underwriter purchases the bonds from the issuing company and resells them to the clients or the underwriter may sell the bonds for the company for a commission. Current and Long-Term Liabilities

  42. Units of Bonds • Bonds are usually issued at the unit of $1,000 or a multiple of $1,000. • Price of bonds: stated at 100s • i.e., $1,000 issued at 98 • issuing price = $1,000 * 0.98 = $980 Current and Long-Term Liabilities

  43. Types of Bonds • On the basis whether the bonds are secured: • Secured bonds (with assets pledged) • Unsecured bonds (Debentures) • On the basis of how the bonds mature: • Term Bonds • Serial Bonds Current and Long-Term Liabilities

  44. Determination of Bond Price • The obligations of bond issuers: • (1) to pay the principle (the face value) when bonds mature on the maturity date. • (2) to pay stated (or contractual) interest periodically (i.e., semiannually or annually) over the life the bond. Current and Long-Term Liabilities

  45. Present Value of Bonds • Bond Price: equals the present value (PV) of the bond. • PV of the bond equals the sum of • (1) the present value of the principal received on the maturity date plus • (2) the present value of the periodic interests (an annuity). Current and Long-Term Liabilities

  46. Present Value of Bonds • Discount rate = effective rate = market interest rate • This rate depends on the riskiness of the issuer and the economic condition. • In general, a higher risk will result in a higher market interest rate. Current and Long-Term Liabilities

  47. Bonds Issued at Face Value • When the stated interest rate equals the market interest rate, the bond price will equal the face value of the bond. Current and Long-Term Liabilities

  48. Example 1 • Page company issued a 5-year term bond with face amount $100,000 and stated annual interest rate 10%. • The interests are paid semiannually. • Assume that the annual market interest (effective rate) demanded by investors for bonds of this level of risk is also 10%. • What is the present value of the bond? Current and Long-Term Liabilities

  49. Example 1 (stated rate = market interest rate) • (1)P.V. of the principal ($100,000 mature in 5 years, semiannual discount rate 5%, 10 periods): $100,000 * 0.6139 = $61,390 • (2) P.V. of the stated interests received semiannually for 10 periods (annuity, semiannual discount rate = 5%, 10 periods) 5,000* x 7.7217 = 38,608.5 • * The semiannual stated interest paid • = $100,000 x 10% x 1/2 = $5,000

  50. Example 1 (contd.) • The P.V. of the bond = the sum of (1) and (2) • (1) + (2) = $61,390 + 38,608.5 = $100,000 Current and Long-Term Liabilities

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