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Chapter 10

Chapter 10. Liabilities. PowerPoint Authors: Brandy Mackintosh Lindsay Heiser. Learning Objective 10-1. Explain the role of liabilities in financing a business. The Role of Liabilities. Liabilities are created when a company:. Buys goods and services on credit.

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Chapter 10

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  1. Chapter 10 Liabilities PowerPoint Authors: Brandy Mackintosh Lindsay Heiser

  2. Learning Objective 10-1 Explain the role of liabilities in financing a business.

  3. The Role of Liabilities Liabilities are created when a company: Buys goods and services on credit Obtains short-term loans Issues long-term debt Current liabilities are short-term obligations that will be paid with current assets within the company’s current operating cycle or within one year of the balance sheet date, whichever is longer.

  4. The Role of Liabilities The liability section of the General Mills 2010 and 2011 comparative balance sheets.

  5. Learning Objective 10-2 Explain how to account for common types of current liabilities.

  6. Measuring Liabilities Initial Amount of the Liability Cash Equivalent Increase Liability Additional Liability Amounts Decrease Liability Payments Made

  7. Current Liabilities Accounts Payable Increases(Credited) Decreases (Debited) when a company receives goods or services on credit when a company pays on its account Accrued Liabilities Liabilities that have been incurred but not yet paid.

  8. Accrued Payroll Payroll Deductions Payroll deductions are either required by law or voluntarily requested by employees and create a current liability for the company. Examples include: Income tax FICA tax Other deductions (charitable donations, union dues, etc.) Payroll Liabilities Payroll Deductions Employer Payroll Taxes

  9. Accrued Payroll Gross Pay Payroll Deductions: Federal Income Taxes FICA Taxes Other Total Payroll Deductions Net Pay $ 58.00 48.80 10.00 $ 600.00 116.80 $ 483.20

  10. Stockholders’ Equity + Cash (-A) -$483,200 Payroll Expense(+E, -SE) -$600,000 FIT Withheld (+L) +$58,000 FICA Payable (+L)+$48,800 United Way (+L) +$10,000 Accrued Payroll Adam Palmer earned gross pay of $600 in the current payroll period. General Mills withheld $58 in Federal income taxes, $48.80 for FICA, and $10 for United Way, resulting in net pay of $483.20. Let’s assume that General Mills has 1,000 workers just like Adam. 600,000 58,000 48,800 10,000 483,200 dr Wages and Salaries Expense (+E, -SE) cr Withheld Income Taxes Payable (+L) cr FICA Payable (+L) cr United Way Payable (+L) cr Cash (-A) Analyze Record Liabilities Assets = 1 2

  11. Stockholders’ Equity + Payroll Tax Expense (+E, -SE) -53,550 FICA Payable (+L) +48,800 FUTA Payable (+L) +750 SUTA Payable (+L) +4,000 Accrued Payroll Employer Payroll Taxes Employers have other liabilities related to payroll. FICA tax (a “matching” contribution) Federal unemployment tax State unemployment tax Assume General Mills was required to contribute $48,800 for FICA, $750 for federal unemployment tax, and $4,000 for state unemployment tax. 53,550 48,800 750 4,000 dr Payroll Tax Expense (+E, -SE) cr FICA Tax Payable (+L) cr Federal Unemployment Tax Payable (+L) cr State Unemployment Tax Payable (+L) Analyze Record Liabilities Assets = 1 2

  12. Stockholders’ Equity + Income Tax Expense (+E, -SE) -350,000 Income Tax Payable (+L) +350,000 Accrued Income Taxes Corporations calculate taxable income bysubtracting tax-allowed expenses from revenues. This taxable income is then multiplied by a tax rate, which for most large corporations is about 35 percent. 350,000 350,000 dr Income Tax Expense (+E, -SE) cr Income Tax Payable (+L) Let’s assume General Mills calculated taxable income to be $1,000,000, and is subject to a 35% tax rate, so income taxes owed are $350,000 ($1,000,000 × 35%) Analyze Record Liabilities Assets = 1 2

  13. Notes Payable Four key events occur with any note payable: establishing the note, accruing interest incurred but not paid, recording interest paid, and recording principal paid. 1 3 2 4

  14. Stockholders’ Equity + Cash (+A) +100,000 Notes Payable (+L) +100,000 Notes Payable 1. Establish the note on November 1, 2012. Assume that on November 1, 2012, General Mills borrowed $100,000 cash on a one-year note that required General Mills to pay 6 percent interest and $100,000 principal, both on October 31, 2013. 100,000 100,000 dr Cash (+A) cr Notes Payable (+L) Analyze Record Liabilities Assets = 1 2

  15. Stockholders’ Equity + Interest Expense (+E, -SE) -1,000 Interest Payable (+L) +1,000 Notes Payable 2. Accrue interest owed but not paid on December 31, 2012. 1,000 1,000 dr Interest Expense (+E, -SE) cr Interest Payable (+L) Analyze Record Liabilities Assets = 1 2

  16. Stockholders’ Equity + Cash (-A) -6,000 Interest Expense (+E, -SE) -5,000 Interest Payable (-L) -1,000 Notes Payable 3. Record interest paid on October 31, 2013. 5,000 1,000 6,000 dr Interest Expense (+E, -SE) dr Interest Payable (-L) cr Cash (-A) Analyze Record Liabilities Assets = 1 2

  17. Stockholders’ Equity + Cash (-A) -100,000 Note Payable (-L) -100,000 Notes Payable 4. Record principal paid of $100,000 on October 31, 2013. 100,000 100,000 dr Note Payable (-L) cr Cash (-A) Analyze Record Liabilities Assets = 1 2

  18. Current Portion of Long-Term Debt Long-Term Debt Current Portion of Long-term Debt Noncurrent Portion of Long-term Debt Borrowers must report in Current Liabilities the portion of long-term debt that is due to be paid within one year.

  19. Additional Current Liabilities Sales Tax Payable Payments collected from customers at time of sale create a liability that is due to the state government. Unearned Revenue Cash received in advance of providing services creates a liability of services due to the customer .

  20. Stockholders’ Equity + Cash (+A) +1,050 Sales Revenue (+R, +SE) +1,000 Sales Tax Payable (+L) +50 Additional Current Liabilities Best Buy sells a television for $1,000 cash plus 5 percent sales tax. $1,000 × 5% = $50 sales tax collected 1,050 50 1,000 dr Cash (+A) cr Sales Tax Payable (+L) cr Sales Revenue (+R, +SE) Record Analyze Liabilities Assets = 1 2 When Best Buy pays the sales tax to the state government, its accountants will reduce Sales Tax Payable (with a debit) and reduce Cash (with a credit).

  21. Stockholders’ Equity + Cash (+A) +8 Unearned Revenue (+L) +8 Additional Liabilities On May 14th 2010, Live Nation Entertainment (the owner of Ticketmaster), received $8 million cash for advance ticket sales for two Lady Gaga concerts to be held on February 21 and 22, 2011. 8 8 dr Cash (+A) cr Unearned Revenue (+L) Record Analyze Liabilities Assets = 1 2

  22. Stockholders’ Equity + Concert Revenue (+R, +SE) +4 Unearned Revenue (-L) -4 Additional Liabilities When the February 21st concert is held, Live Nation Entertainment can recognize one half of the unearned revenue as earned revenue, as they have fulfilled part of the liability. 4 4 dr Unearned Revenue (-L) cr Concert Revenue (+R, +SE) Record Analyze Liabilities Assets = 1 2

  23. Learning Objective 10-3 Analyze and record bond liability transactions.

  24. Long-Term Liabilities • Common Long-Term Liabilities • Long-term notes payable • Deferred income taxes • Bonds payable Bonds are financial instruments that outline the future payments a company promises to make in exchange for receiving a sum of money now.

  25. Bonds • Key Elements of a Bond • Maturity date • Face value • Stated interest rate $1,000 × 6% × = $60 12 12 Interest Computation Bond Pricing The bond price involves present value computations and is the amount that investors are willing to pay on the issue date for the bonds.

  26. Bonds Balance Sheet Reporting of Bond Liability Relationships between Interest Rates and Bond Pricing

  27. Stockholders’ Equity + Bonds Payable (+L)+100,000 Cash (+A) +100,000 Bonds Bonds Issued at Face Value General Mills receives $100,000 cash in exchange for issuing 100 bonds at their $1,000 face value, so the bonds are issued at total face value (100 × $1,000 = $100,000). 100,000 100,000 dr Cash (+A) cr Bonds Payable (+L) Record Analyze Liabilities Assets = 1 2

  28. Stockholders’ Equity + Cash (+A) +107,260 Bonds Payable (+L) +100,000 Premium on Bonds Payable (+L) +7,260 Bonds Bonds Issued at a Premium General Mills issues 100 of its $1,000 bonds at a price of 107.26 percent of face value, the company will receive $107,260 (100 × $1,000 × 1.0726). 107,260 100,000 7,260 dr Cash (+A) cr Bonds Payable (+L) cr Premium on Bonds Payable (+L) Analyze Record Liabilities Assets = 1 2

  29. Stockholders’ Equity + Cash (+A) +93,376 Bonds Payable (+L) +100,000 Discount on Bonds Payable (+xL,-L)-6,624 Bonds Bonds Issued at a Discount General Mills receives $93,376 for bonds with a total face value of $100,000, the cash-equivalent amount is $93,376, which represents the liability on that date. These bonds are issued at a discount because the cash received is less than the face value of the bonds. 93,376 6,624 100,000 dr Cash (+A) dr Discount on Bonds Payable (+xL, -L) cr Bonds Payable (+L) Analyze Record Liabilities Assets = $100,000 - $93,376 = $6,624 discount 1 2

  30. Stockholders’ Equity + Interest Expense (+E, -SE) -500 Interest Payable (+L) +500 Interest on Bonds Issued at Face Value General Mills issues bonds on January 1, 2013, at their total face value of $100,000. The bonds have an annual stated interest rate of 6 percent payable in cash on December 31 of each year, General Mills will need to accrue an expense and liability for interest at the end of each accounting period. The end of the first accounting period is January 31, 2013. 500 500 dr Interest Expense (+E, -SE) cr Interest Payable (+L) Analyze Record Liabilities Assets = $100,000 × 6% × 1/12 = $500 interest 1 2

  31. Interest on Bonds Issued at a Premium Cash proceeds > Face value Cash proceeds – Face value = Premium Interest expense < Cash interest paid Interest expense = Cash interest paid – Premium amortization

  32. Interest on Bonds Issued at a Discount Cash proceeds < Face value Face value – Cash proceeds = Discount Interest expense > Cash interest paid Interest expense = Cash interest paid+ Discount amortization

  33. Stockholders’ Equity + Cash (-A) -100,000 Bonds Payable (-L) -100,000 Bond Retirement General Mills’ bonds were retired with a payment equal to their $100,000 face value. Let’s analyze and record this transaction. 100,000 100,000 dr Bonds Payable (-L) cr Cash (-A) Analyze Record Liabilities Assets = 1 2

  34. Stockholders’ Equity + Cash (-A) -102,000 Loss on Bond Retirement(+E,-SE) -2,000 Bonds Payable (-L) -100,000 Bond Retirement The early retirement of bonds has three financial effects. The company pays cash, eliminates the bond liability, and reports either a gain or a loss. 100,000 2,000 102,000 dr Bonds Payable (-L) dr Loss on Bond Retirement (+E, -SE) cr Cash (-A) Assume that in 2003, General Mills issued $100,000 of bonds at face value. Ten years later, in 2013, the company retired the bonds early. At the time, the bond price was 102, so General Mills made a payment of $102,000. Analyze Record Liabilities Assets = 1 Cash Payment $103,000 Carrying Value 100,000 Loss on Retirement $3,000 2

  35. Learning Objective 10-4 Describe how to account for contingent liabilities.

  36. Contingent Liabilities Contingent liabilities are potential liabilities that arise from past transactions or events, but their ultimate resolution depends (is contingent) on a future event.

  37. Learning Objective 10-5 Calculate and interpret the quick ratio and the times interest earned ratio.

  38. Evaluate the Results Two financial ratios are commonly used to assess a company’s ability to generate resources to pay future amounts owed: Quick ratio Times interest earned ratio (Cash + Short-term Investments + Accounts Receivable, Net) Current Liabilities Quick Ratio = (Net Income + Interest Expense + Income Tax Expense) Interest Expense Times Interest Earned Ratio =

  39. Evaluate the Results At the end of its 2011 fiscal year, General Mills reported $620 million of cash and cash equivalents, no short-term investments, and $1,162 million of net accounts receivable. The company reported $3,659 million in total current liabilities. (Cash + Short-term Investments + Accounts Receivable, Net) Current Liabilities Quick Ratio = $620 + 0 + 1,162 3,659 = 0.487 A quick ratio of 0.487 implies that General Mills would be able to pay only 48.7 percent of its current liabilities, if forced to pay them immediately. However, not all current liabilities are to be paid immediately.

  40. Evaluate the Results In 2011, General Mills reported net income of $1,798 million and interest expense of $346 million, and income tax expense of $721 million. Let’s calculate the times interest earned for 2011. $1,798 + $346 + $721 $346 = 8.28 times (Net Income + Interest Expense + Income Tax Expense) Interest Expense Times Interest Earned Ratio = The ratio means that General Mills generates $8.28 of income (before the costs of financing and taxes) for each dollar of interest expense. Reaching this level of interest coverage was important to General Mills because its long-term debt note reported that loan covenants required a minimum ratio of 2.5.

  41. Chapter 10Supplement 10A Straight-Line Method of Amortization

  42. Stockholders’ Equity + Cash (-A) -6,000 Interest Expense (+E, -SE) -4,185 Premium on Bonds Payable (-L) -1,815 Bond Premium Cash Interest $6,000 Amortization of Premium (1,815) Interest Expense $4,185 Bond premium or discount decreases each year, until it is completely eliminated on the bond’s maturity date. This process is called amortizing the bond premium or discount. The straight-line method ofamortization reduces the premium or discount by an equal amount each period. Recall our example when General Mills received $107,260 on the issue date (January 1, 2013) but repays only $100,000 at maturity (December 31, 2016). Under the straight-line method, this $7,260 is spread evenly as a reduction in interest expense over the four years ($7,260 ÷ 4 = $1,815 per year). 4,185 1,815 6,000 dr Interest Expense (+E, -SE) dr Premium on Bonds Payable (-L) cr Cash (-A) Analyze Record Liabilities Assets = 1 2

  43. Bond Premium Amortization Schedule of Bonds Issued at a Premium $7,260 - $1,815 = $5,445 $7,260 ÷ 4 = $1,815 $107,260 – $1,815 = $105,445 $100,000 × 6% × 12/12 = $6,000 $6,000 - $1,815 = $4,185 Notice that each of these amounts would plot as a straight-line!

  44. Stockholders’ Equity + Cash (-A) -6,000 Discount on Bonds Payable(-xL,+L)+1,656 Interest Expense (+E, -SE) -7,656 Bond Discount Recall our example where General Mills received $93,376 for four-year bonds with a total face value of $100,000, implying a discount of $6,624. The annual amortization of the discount is $1,656 ($6,624 ÷ 4). 7,656 1,656 6,000 dr Interest Expense (+E, -SE) cr Discount on Bonds Payable (-xL, +L) cr Cash (-A) Analyze Record Liabilities Assets = 1 Cash Interest $6,000 Amortization of Discount 1,656 Interest Expense $7,656 2

  45. Bond Discount Amortization Schedule of Bonds Issued at a Discount $6,624 - $1,656 = $4,968 $6,624 ÷ 4 = $1,656 $93,376 + $1,656 = $95,032 $100,000 × 6% × 12/12 = $6,000 $6,000 + $1,656 = $7,656

  46. Chapter 10Supplement 10B Effective-Interest Method of Amortization

  47. When General Mills adds this $7,260 premium to the $100,000 face value, it reports a carrying value of $107,260 ($100,000 + $7,260) on January 1, 2013. The proceeds indicates that the market interest rte was 4 percent. Interest (I) = Principal (P) × Rate (R) × Time (T) Interest Expense = Carrying Value × Market Rate × n/12 $4,290 = $107,260 × 4% × 12/12 Effective Interest Amortization The effective-interest method of amortization is considered a conceptually superior method of accounting for bonds because it correctly calculates interest expense by multiplying the market interest rate times the carrying value of the bonds.

  48. Stockholders’ Equity + Cash (-A) -6,000 Interest Expense (+E, -SE) -4,290 Premium on Bonds Payable (-L) -1,710 Effective Interest Amortization General Mills issued 6% stated rate bonds for $107,260. The market rate of interest on these bonds is 4%. The face amount of the bonds, $100,000, results in cash interest is $6,000 ($100,000 × 6%). Let’s amortize the premium on the bonds at the first interest payment date. 4,290 1,710 6,000 dr Interest Expense (+E, -SE) dr Premium on Bonds Payable (-L) cr Cash (-A) Cash Interest $ 6,000 Effective Interest 4,290 Amortization of Premium $1,710 Interest (I) = Principal (P) × Rate (R) × Time (T) Interest Expense = Carrying Value × Market Rate × n/12 $4,290 = $107,260 × 4% × 12/12 Analyze Record Liabilities Assets = 1 2

  49. Effective Interest Amortization $6,000 - $4,290 = $1,710 $7,260 - $1,710 = $5,550 Effective Interest Amortization of Bonds Issued at a Premium $107,260 × 4% × 12/12 = $4,290 $100,000 × 6% × 12/12 = $6,000 $107,260 - $1,710 = $105,550 Interest Expense decreases and Premium Amortizationincreases each period. Cash interest is unchanged.

  50. Stockholders’ Equity + Cash (-A) -6,000 Discount on Bonds Payable(-xL,+L)+1,470 Interest Expense (+E, -SE) -7,470 Effective Interest Amortization General Mills issued $100,000 face value, 6%, 4-year bonds at a market price to yield investors 8%. The bonds were issued at a discount of $6,624. Let’s determine the effective interest for the first interest payment period. 7,470 1,470 6,000 dr Interest Expense (+E, -SE) cr Discount on Bonds Payable (-L) cr Cash (-A) Interest (I) = Principal (P) × Rate (R) × Time (T) Interest Expense = Carrying Value × Market Rate × n/12 $7,470 = $93,376 × 8% × 12/12 Cash Interest $ 6,000 Effective Interest 7,470 Amortization of Discount $ 1,470 Analyze Record Liabilities Assets = 1 2

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