Chapter 9

Liabilities
 Main Points
Account for liabilities and contingent liabilities

Account for bonds payable and measure interest

expense

Account for capital and operating leases

Understand the advantages and disadvantages of

borrowing

Report liabilities on the balance sheet

 Current Liabilities

Obligations due within one year

Two types:

Known amounts

Estimated amounts
Current Liabilities: Known
Amount
Accounts Short-term Sales tax
payable notes payable payable

Accrued Payroll Unearned

liabilities liabilities revenues

Current
portion of
long-term debt
Current Liabilities: Known
Amount
Accounts payable

Amounts owed for products or services purchased

on account

Short-term notes payable

Due within one year

Used to borrow cash or purchase asset

Accrue interest
Accounting for Short-Term Notes
Payable
JOURNAL
Date Accounts and explanation Debit Credit
Mar Inventory 8,000
31

Note payable, short-term 8,000

Purchase of inventory by issuing a note payable

Dec 31 Interest expense (8,000 x 10% x 9/12) 600

Interest payable 600
Accrued interest on note payable
Accounting for Short-Term Notes
Payable
JOURNAL
Date Accounts and explanation Debit Credit
Mar Note payable, short-term 8,000
31
Interest payable 600
Interest expense (8,000 x 10% x 3/12) 200
Cash 8,800
To record payment of note payable
 Sales Tax Payable
Levied on retail sales

Collected from customers and remitted to state

JOURNAL
Date Accounts and explanation Debit Credit
Cash 210,000
Sales 200,000
Sales tax payable 10,000
 Accrued Liabilities

Result from expenses incurred but not yet paid

Categories:

Salaries and wages payable

Interest payable

Income taxes payable

 Payroll
Major expense of most companies
Many different forms:
Salary
Wage
Commission

JOURNAL
Date Accounts and explanation Debit Credit
Salary expense
Employee income taxes payable
FICA taxes payable
Salaries payable
 Payroll Liabilities

FICA tax payable

Employee income (Federal
tax payable Insurance
Contributions Act)

Salaries payable
 Unearned Revenues
Business receives cash before earning revenue

Results in a liability
JOURNAL
Date Accounts and explanation Debit Credit

Cash

Unearned revenue

Received advance payment from customer

Unearned revenue

Revenue

Earned revenue that was collected in

advance
 Current Portion of
Long-Term Debt

Long-term debt often paid in installments

Amount of principal payable within one year

Company reclassifies amount from long-term to

current
Estimated Current Liabilities

Provision for
Contingent
Warranty
Liabilities
Repairs
 Provision for Warranty
Repairs
Warranty expense is estimated in the year product is
sold

Matching principle
JOURNAL
Date Accounts and explanation Debit Credit
Warranty expense
Provision for Warranty Repairs
To accrue warranty expense
Provision for Warranty Repairs
Inventory
To replace defective products sold under warranty
 SUMMARY OF
CURRENT LIABILITIES
 Summary Problem
Assume that Estée Lauder faced the following liability situations at June 30,
20X1, the end of the company’s fiscal year. Show how Estée Lauder would
report these liabilities on its balance sheet at June 30, 20X1.

a. Salary expense for the last payroll period of the year was $900,000. Of this
amount, employees’ withheld income tax totaled $88,000 and employer’s
payroll taxes were $61,000. These payroll amounts will be paid in early
July.

b. In fiscal year 20X1, management estimates new warranty obligation of $8

million arising from sales in 20X1. One year ago, at June 30, 20X0,
provision for warranty stood at $3 million. Warranty payments were $9
million during the year ended June 30, 20X1.

c. The company pays royalties on its purchased trademarks. Royalties for

the trade- marks are equal to a percentage of Estée Lauder’s sales.
Assume that sales in 20X1 were $400 million and were subject to a royalty
rate of 3%. At June 30, 20X1, Estée Lauder owes two-thirds of the year’s
royalty, to be paid in July.

d. Long-term debt totals $100 million and is payable in annual installments

of $10 million each. The interest rate on the debt is 7%, and the interest is
paid each December 31.
 Contingent Liabilities

Possible obligation that depends on future outcome

of past events, or

Present obligation that may, but probably will not,

require outflow of resources, or

Sufficiently reliable estimate of the amount of a

present obligation cannot be made
Long-Term Liabilities

Bonds Notes
payable payable
 Bonds Payable
Debts of issuing company

Bond certificate states:

Company name

Principal

Maturity date

Interest rate

Interest payment dates

 Types of Bonds

Term Secured

Serial Unsecured
 Bond Prices
Quoted as percent of maturity value
Premium Discount
Price above face Price below face
Credit balance Debit balance
Market price Market price
decreases towards increases towards
maturity value maturity value
At
maturity Face Market
date value value
 Time Value of Money

Dollar received today is worth more than one

received in the future
Dollar invested earns income
Amount invested now to receive more later
Present Value
Present value depends on:
Amount of future payment
Length of time
Interest rate
Interest Rates & Bond Prices
Bonds always sold at market price

Bond’s present value

Two interest rates set bond price

Stated interest rate (coupon rate)

Printed on bond certificate

Determines cash interest paid to bondholders

Market interest rate (effective interest rate)

Demanded by investors for loaning money

Stated
Can rateafter
fluctuate usually differs
bond issuance from market rate
Issue Price of Bonds Payable

Case A

Stated = Market interest Therefore, Issued at

interest rate rate Par

Case B

Stated < Market interest Therefore, Issued at

interest rate rate Discount

Case C

Stated > Market interest Therefore, Issued at

interest rate rate Premium
 Issuing Bonds Payable at Par
Suppose GSK issues $50,000, 9% bonds at par on January 1, 20X1. The
bonds pay interests on a semi-annual basis (July 1 and January 1 each
year following issuance) and are of five years’ duration, i.e. they will
mature on January 1, 20X6.
JOURNAL

Date Accounts and explanation Debit Credit

Jan 1 Cash 50,000
Bonds payable 50,000
To issue bonds at par

Jul 1 Interest expense 2,250

Cash 2.250
To pay semi-annual interest
 Issuing Bonds Payable at Par
At date of retirement

JOURNAL
Date Accounts and explanation Debit Credit
Bonds payable 50,000
Cash 50,000
To pay bonds at maturity
Issuing Bonds Payable at a Discount
Suppose GSK issued $100,000 of 9%, five-year bonds
when the market interest rate is 10%. The issuance price
of the bonds drops, and GSK receives $96,1491 at
issuance.
JOURNAL

Date Accounts and explanation Debit Credit

Cash 96,149

Discount on bonds payable 3,851

Bonds payable 100,000

To issue bonds at a discount

 Balance Sheet Presentation
Balance Sheet

Long-term liabilities:

Bonds payable $100,000

Less: Discount on bonds payable (3,851) $96,149

 Interest Payment vs. Interest
Expense

Interest Stated
Face
payment value
interes 1/2
t rate

Interest Market
Carrying
expense amount
interes 1/2
t rate
 Bond Discount Example
Issue Date January 1, 2010
Face value $100,000
Stated interest rate 9%
Interest payments Semi-annual
Maturity date January 1, 2015
Market interest rate 10%
Issue price $96,149
Interest paid – 4.5% $4,500
semiannually
 A B C D D

Bond
Interest Interest Discount Discount
Date carrying
payment expense amortization balance
amount

1-10 $3,851 $96,149

7-10 $4,500 $4,807 $307 3,544 96,456

1-11 $4,500 4,823 323 3,221 96,779

1-15 $4.500 4,961 461 0 100,000

 5,000

I
n
t 4,800
e
r
e
s
t Discount Amortization

E
x
p
e
n 4,600
s
e
Interest Payment

4,400
1 2 3 4 5 6 7 8 9 10
Semiannual Interest Payment
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 101,000

Face value

B 100,000
o
n
d

C
a
99,000
r
r
y
i
n
g
98,000
A
m
o
u
n
t
97,000

96,000

95,000

94,000
1 2 3 4 5 6 7 8 9 10 11
Semiannual Interest Payments

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 JOURNAL

Date Accounts and explanation Debit Credit

2010

Jul 1 Interest expense 4,807

Discount on bonds payable 307

Cash 4,500

To pays semiannual interest and amortize bond discount

Dec. 31 Interest expense 4,823

Discount on bonds payable 323

Interest payable 4,500

To accrue semiannual interest and amortize bond discount.

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 Balance Sheet
December 31, 2010

Long-term liabilities:

Bonds payable $100,000

Less: Discount on bonds payable (3,221) $96,779

 Partial-Period Interest Payments
Companies don’t always issue bonds at the beginning or the end of their
accounting year. They issue bonds when market conditions are most favorable,
and that may be on May 16, August 1, or any other date.
To illustrate partial period interest, assume a company issued $100,000, 10-year
8% bonds on August 31, at 96 when the market rate was 9%. The bonds pay
interest every February 28 and August 31. On December 31, four months’ of
interest must be accrued.
JOURNAL
Date Accounts and explanation Debit Credit
Dec. Interest expense 2,880
31
Discount on bonds payable 213
Interest payable 2,667

$96,000 carrying amount x 9% market rate x 4/12

$100,000 face value x 10% market rate x 4/12

 Bond Premium Example
Issue Date January 1, 2010

Face value $100,000

Stated interest rate 9%

Interest payments Semi-annual

Maturity date January 1, 2015

Market interest rate 8%

Issue price $104,100

 A B C D D

Bond
Interest Interest Premium Premium
Date carrying
payment expense amortization balance
amount

1-10 $4,100 $104,100

7-10 $4,500 $4,164 $336 3,764 103,764

1-11 $4,500 4,137 349 3,415 103,415

1-15 $4,500 3,955 545 0 100,000

 4,600

Interest Payment

I
n
t 4,400
e
r
e Premium Amortization
s
t

E
x
p
e
4,200
n
s
e

4,000
1 2 3 4 5 6 7 8 9 10
Semiannual Interest Payment
B 105,000
o
n
d

C
a
r 104,000
r
y
i
n
g

A 103,000
m
o
u
n
t

102,000

101,000

100,000
Face value

99,000
1 2 3 4 5 6 7 8 9 10 11
Semiannual Interest Payments
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 Straight-Line Method

Discount or premium
Amortization
Number of interest payments

Interest Interest Amortization

expense payment O
R
 Retiring Bonds Before
Maturity
Reasons to pay off bonds early

Can relieve high interest payments

Can borrow at a lower interest rate

Callable feature

Issuer can pay off bonds at a prearranged price

Results in a gain or loss

 Convertible Bonds

Bondholders can exchange bonds for share

Investors benefit from:

Guaranteed receipt of principal and interest

on bonds

Potential for gains on shares

 Leases

OPERATING CAPITAL

Lessee has right to use Lessee has rights to use

the asset asset
Lessor retains risks and Lessee assumes risks and
rewards of owing rewards of ownership and
associated obligations
Lessee records Rent
Expense Present value of lease
payment capitalized
Capital Lease Criteria as per IFRS

Transfer of title Bargain

at end of lease purchase option

Present value of
Lease term >
lease payments
75% of useful
>90% of fair
life
value of asset
 Accounting for Capital
Leases
Lessee will record the present value of lease
payments on its books

Depreciated in accordance to the entity’s usual

depreciation policy

Lease payments made will be set off against lease

interest expense, and remaining balance used to
reduce the outstanding lease payment
 Lease Example
Assume on 1 July 20X1, a company signed a capital
lease that requires a payment of $10,000 per year for the
next five years. The present value is determined to be
$43,295 using a 5% interest rate.

When the first payment is made, the $10,000 payment is

first applied to the interest for the lease liability for the
period, which is $2,165 ($43,295 x 5%), and the balance
of $7,835 ($10,000 less $2,165) reduces the lease liability.
 Journal Entries for
Capital Leases
• On signing the lease on July 1 20X1
20X1
July 1 Lease Asset 43, 295
Lease Liability 43,295
To record capital lease ($10,000 per year
for 5 years @5%).

• On making 1st lease payment on June 30 20X2

20X2
June 30 Lease Liability 7,835
Interest Expense 2,165
Cash 10,000
To record first capital
Copyrightlease payment.
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 Lease Amortization
Schedule
Period Begin LL Payment Interest Principal End LL

1 $ 43,295 $10,000 $ 2,165 $ 7,835 $35,460

2 $35,460 $10,000 $ 1,773 $ 8,227 $ 27, 232

3 $27,232 $10,000 $ 1,362 $ 8,638 $ 18,594

4 $18,594 $10,000 $ 930 $ 9,070 $ 9,524

5 $9,524 $10,000 $ 476 $ 9,524 $ -0-

Financing Operations

Issuing Retained
shares earnings

Issuing
bonds
 Effect on Financing
alternatives on EPS

Earnings per share (EPS) is the amount of a company’s

net income for each share of its shares.

EPS is the single most important statistic for evaluating

companies because EPS is a standard measure of
operating performance that applies to companies of
different sizes and from different industries.
 Earnings per Share
Plan 1 Plan 2
Borrow $500,000 6% Issue $500,000 of
shares of $ 10 par value
Net income before
expansion $300,000 $300,000
Expected project income
before interest & taxes $200,000 $200,000
Interest expense (30,000) 0
Income taxes (40%) (68,000) (80,000)
Expected project net
income 102,000 120,000
Total net income 402,000 420,000
Common shares 100,000 150,000
Earnings per share $4.02 $2.80
The preceding table shows the earnings-per-share
advantage of borrowing. As you can see, the
company’s EPS amount is higher if the company
borrows by issuing bonds . The company earns more
on the investment ($102,000) than the interest it pays
on the bonds ($30,000). This is called trading on the
equity, or using leverage. It is widely used to increase
earnings per share.
 Times Interest Earned

Operating Income

Interest Expense

High ratio = ease Low ratio =

in paying difficulty in
interest paying interest
 Pensions and
Postretirement Liabilities
Expense recorded while employees work for the
company

Cash contributed into pension plan assets

Obligations grows for future payments to employees

Overfunded
Underfunded
Plan assets
Plan assets less
greater than
than obligation
obligation
 Note 10: Financial Instruments
Partial Balance Sheet Long-term debt
December 31, 2011

Liabilities Revolving credit $400

Current liabilities: 9% notes due 2015 350

Accounts payable $650 8% notes due 2018 750

Accrued liabilities 985 U.K. credit 600

arrangement

Unearned revenue 877 7.5$ notes due 2017 585

Current portion of long-term 225 Total long-term debt 2,685

debt

Total current liabilities 2,737 Less: current maturities (225)

Long-term debt 2,460 Long-term debt $2,460

Other long-term liabilities 1.987

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