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Unformatted text preview: Financial Accounting, 5e Weygandt, Kieso, & Kimmel Prepared by Kurt M. Hull, MBA CPA California State University, Los Angeles John Wiley & Sons, Inc. CHAPTER 11 LIABILITIES STUDY OBJECTIVES After studying this chapter, you should understand: Major types of current liabilities Accounting for notes payable Accounting for other current liabilities The purpose of bonds, and major types of bonds Entries for bond issuance and interest expense Entries for bond redemption Accounting for long-term notes payable Presentation and analysis of long-term liabilities STUDY OBJECTIVE 1 TYPES OF CURRENT LIABILITIES Key features of a current liability: It is expected to be paid from existing current assets or through the creation of other current liabilities It will be paid within one year or the operating cycle, whichever is longer. Notes Payable Accounts Payable Unearned Revenues Accrued Liabilities STUDY OBJECTIVE 2 NOTES PAYABLE Key features of a note payable: Promissory note Interest Notes due within a year are current liabilities NOTES PAYABLE ISSUANCE DATE General Journal Date Account Titles Debit Credit March 1 Cash Notes Payable 100,000 100,000 Assume First National Bank agrees to lend $100,000 on March 1, 2006 to Cole Williams Co. The loan calls for a 12%, 4-month note. Assets received = face value of note INTEREST FORMULA If the loan term is expressed in days, use the number of days divided by 365. If loan term is expressed in months, use the number of months divided by 12. Using the Cole Williams Co. data: Face Value of Note Annual Interest Rate Time in Terms of One Year Interest $100,000 x 12% x 4/12 = $4,000 NOTES PAYABLE INTEREST ACCRUAL General Journal Date Account Titles Debit Credit June 30 Interest Expense Interest Payable 4,000 4,000 If Cole Williams Co. prepares financial statements semiannually, an adjusting entry is required to recognize interest expense and interest payable of $4,000 at June 30. Remember, we took out the loan on March 1, so the 4 months have elapsed but the maturity date is July 1 and we need to finalize our financial statements as of June 30th. NOTES PAYABLE MATURITY DATE General Journal Date Account Titles Debit Credit July 1 Notes Payable Interest Payable Cash 100,000 4,000 104,000 When the loan is paid, the FACE VALUE is debited, any interest accrued is removed, and cash is decreased by this combined amount. REVIEW QUESTION INTEREST ACCRUAL Shari Uecker Company borrows $88,500 on September 1, 2006 From Egg Harbor State Bank by signing a one year, 12% note. What is the accrued interest at December 31, 2006? Answer: $88,500 x 12% x 4/12 = $3,540 UNEARNED REVENUES Unearned Revenues occur when a company receives cash before a service is rendered. Examples: Airline sells a ticket for future flights Attorney receives legal fees before work is done. UNEARNED REVENUES CASH RECEIPT General Journal Date Account Titles Debit Credit Aug. 6 Cash Unearned Football Ticket Revenue 500,000 500,000 Superior University sells 10,000 season football tickets at $50 each for its five-game home schedule. UNEARNED REVENUES EARNINGS DATE General Journal Date Sept. 7 Account Titles Unearned Football Ticket Revenue Debit 100,000 Credit 100,000 Football Ticket Revenue As each game is completed, Unearned Football Ticket Revenue is debited for 1/5 of the unearned revenue. The earned revenue, Football Ticket Revenue, is credited. UNEARNED AND EARNED REVENUE ACCOUNTS Shown below are specific unearned and earned revenue accounts in selected types of businesses. Type of Business Airline Magazine Publisher Hotel Insurance Company Account Title Unearned Revenue Unearned passenger Ticket Revenue Unearned Subscription Revenue Unearned Rental Revenue Unearned Premium Revenue Earned Revenue Passenger Revenue Subscription Revenue Rental Revenue Premium Revenue STUDY OBJECTIVE 3 OTHER CURRENT LIABILITIES SALES TAXES PAYABLE • Sales tax is expressed as a stated percentage of the sales price on goods sold to customers by a retailer. • The retailer collects the tax from the customer when the sale occurs. Retailer periodically remits the collections to the state’s department of revenue. Retailer is a collection agent for the tax authority. SALES TAXES PAYABLE SALE DATE General Journal Date Account Titles Debit Credit Mar. 25 Cash Sales Sales Tax Payable 10,600 10,000 600 On March 25th cash register readings for Cooley Grocery show sales of $10,000 and sales taxes of $600. Sales tax rate = 6% EXTRACTING SALES TAX FROM TOTAL RECEIPTS If Cooley Grocery “rings up” total receipts of $10,600, and the sales tax percentage is 6%, we can figure sales as follows: $10,600 / 1.06 = $10,000 Total receipts – Sales = Tax collected $10,600 - $10,000 = $600 PAYROLL DEDUCTIONS Wage Computation Withholding Tax Table NOTE: If you were a sole-proprietorship, your FICA tax rate is doubled. FUTA Tax Rates • The FUTA tax rate is 6.2% of taxable wages. The taxable wage base is the first $7,000 paid in wages to each employee during a calendar year. • Employers who pay the state unemployment tax, on a timely basis, will receive an offset credit of up to 5.4% regardless of the rate of tax they pay the state. • Therefore, the net FUTA tax rate is generally 0.8% (6.2% 5.4%), for a maximum FUTA tax of $56.00 per employee, per year (.008 X $7,000. = $56.00). SUTA Generally, any employing unit that has paid wages for employment in Nevada of $225 or more during any calendar quarter must register with the Employment Security Division, and pay taxes on those wages. Employers starting a new business in Nevada must pay unemployment insurance (UI) tax at a rate of 2.95 percent (.0295) of wages paid to each employee up to the taxable wage limit. Once an employer becomes eligible for "experience rating," he will receive one of 18 unemployment insurance (UI) tax rates, ranging from .25 percent to 5.40 percent of taxable wages. Each employer's tax rate may vary from year to year, depending on previous experience with unemployment and the rate schedule in effect. Although the total wages paid to each employee must be reported to the division each quarter, any wages paid to an individual which exceed the taxable wage base during the calendar year are not taxed. The taxable wage base is as follows: Other Possible Deductions from Paycheck • • • • • • • • Charitable Contributions Repayment of Loans Child Care Union Dues Life Insurance Health Insurance Pension Plans Savings Bonds PAYROLL AND PAYROLL TAXES PAYABLE Liabilities relating to employee wages and salaries include: Wages and salaries payable Withholding taxes Date March 7 Account Salaries & Wages Expense FICA Taxes Payable Federal Income Taxes Payable State Income Taxes Payable Salaries & Wages Payable (record payroll & w/h taxes for week of March 7) Debit 100,000 Credit 7,650 21,864 2,922 67,564 March 11 Salaries & Wages Payable Cash (to record payment of March 7 payroll) 67,564 67,564 EMPLOYER PAYROLL TAXES PAYROLL AND PAYROLL TAXES PAYABLE Various payroll taxes are levied upon the employer: Date March 7 Payroll Tax Expense Account (Federal Insurance Contributions Act) (Federal Unemployment Tax Act) (State Unemployment Tax Authority) Debit 13,850 Credit FICA Taxes Payable FUTA Taxes Payable SUTA Taxes Payable 7,650 800 5,400 (record employer’s payroll taxes for week of March 7) STUDY OBJECTIVE 4 BONDS PAYABLE A form of interest-bearing notes payable issued by corporations, universities, & governmental agencies. Can be sold in small denominations to attract many investors. Sold to obtain long term capital. An alternative to issuing stock. ADVANTAGES OF BOND FINANCING OVER STOCK EFFECTS ON EPS BONDS VS. STOCK TYPES OF BONDS Bond Type Distinguishing characteristics Secured Unsecured Term Serial Registered Bearer Convertible Callable Backed by specific assets Backed by credit of issuer (debentures) Paid at end of specified term Paid in installments Issued in name of specific holder Not registered. (Coupon bonds) Can be converted to common stock Can be retired before maturity STUDY OBJECTIVE 5 BOND ISSUANCE PROCEDURES • Corporate bonds are traded on securities exchanges. • Bond prices are quoted as a percentage of the face value of the bond (usually $1,000). • Transactions between a bondholder and other investors are not journalized by the issuing corporation. • A corporation records entries when it issues/buys back bonds, and when bondholders convert bonds into stock. DETERMINING MARKET VALUE OF BONDS The present value (PV) of a bond is a function of three factors: 1. Dollar amount 2. Time 3. Market rate of interest The process of determining the PV is discounting. ISSUING BONDS AT FACE VALUE Assume that Devor Corporation issues 1000 10-year, 9% $1,000 bonds dated January 1, 2006, at 100 (100% of face value). The entry to record the sale is: Date Jan 1 Cash Bonds payable (record sale of bonds at face value) Account Debit 1,000,000 Credit 1,000,000 1000 bonds x $1000 = $1,000,000 BOND INTEREST PAYMENT Assume that interest is payable semi-annually on January 1 and July 1. Next payment Is due July 1, 2006. The entry is: Date July 1 Cash Account Bond Interest Expense (record semi-annual bond interest payment) Debit 45,000 Credit 45,000 $1,000,000 x 9% x 6/12 = $45,000 BOND INTEREST ACCRUAL Assume that interest is payable semi-annually on January 1 and July 1. Next payment Is due July 1, 2006. At December 31, 2005 the entry to accrue interest is: Date Dec 31 Account Bond Interest Expense Bond Interest Payable (record sale of bonds at face value) Debit 45,000 Credit 45,000 $1,000,000 x 9% x 6/12 = $45,000 INTEREST RATES AND BOND PRICES Issued when: Market Rates 8% BOND CONTRACTUAL INTEREST RATE 10% Bonds Sell at: Premium 10% Face Value 12% Discount ISSUING BONDS AT A DISCOUNT On January 1, 2006, Candlestick, Inc. sells $100,000, 5-year, 10% bonds for $92,639 with interest payable on payable on July 1 & January 1. The entry to record the issuance is: Date Jan 1 Cash Discount on Bonds Payable Bonds Payable (record issuance of bonds at a discount) Account Debit 92,639 7,361 Credit 100,000 Market value of bonds = $92,639 FINANCIAL STATEMENT PRESENTATION--DISCOUNT Discount on Bonds Payable is a contra account, which is deducted from bonds payable on the balance sheet: CANDLESTICK, INC. Balance Sheet (partial) Longterm liabilities Bonds payable $100,000 Less: Discount on Bond Payable $7,361 $92,639 Carrying value of bonds = $92,639 TOTAL COST OF BORROWING BONDS ISSUED AT A DISCOUNT • The discount is an additional cost of borrowing that is recorded as bond interest expense over the life of the bonds. • The total cost of borrowing for Candlestick, Inc., is computed as follows: Bonds Issued at a Discount Semiannual Interest Payments ($100,000*10%*.5=$5,000; $5,000*10) Add: Bond Discount ($100,000-$92,639) Total Cost of Borrowing $50,000 $7,361 $57,361 ISSUING BONDS AT A PREMIUM On January 1, 2006, Candlestick, Inc. sells $100,000, 5-year, 10% bonds for $108,111 with interest payable on payable on July 1 & January 1. The entry to record the issuance is: Date Jan 1 Cash Premium on Bonds Payable Bonds Payable (record issuance of bonds at a premium) Account Debit 108,111 Credit 8,111 100,000 Market value of bonds = $108,111 FINANCIAL STATEMENT PRESENTATION—PREMIUM Premium on Bonds Payable is added to bonds payable on the balance sheet: CANDLESTICK, INC. Balance Sheet (partial) Longterm liabilities Bonds payable $100,000 Add: Premium on Bonds Payable $8,111 $ 108,111 Carrying value of bonds = $108,111 TOTAL COST OF BORROWING BONDS ISSUED AT A PREMIUM The premium is considered to be a reduction in the cost of borrowing that should be credited to Bond Interest Expense over the life of the bonds. Bonds Issued at a Premium Semiannual Interest Payments ($100,000*10%*.5=$5,000; $5,000*10) Less: Bond Premium ($108,111-$100,000) Total Cost of Borrowing $50,000 $8,111 $41,889 BONDS SOLD AT A PREMIUM On January 1, Dias Corporation issued $1,000,000, 14%, 5-year bonds with interest payable on July 1 and January 1. the bonds sold for $1,098,540. The market rate of interest was 12%. On the first interest date, using the effective interest method, what is the debit to bond interest expense? REVIEW QUESTION Answer: $1,098,540 x 6% = $65,192 STUDY OBJECTIVE 6 REDEEMING BONDS AT MATURITY Book value of the bonds at maturity will equal their face value. The entry to record the redemption of the Candlestick bonds at maturity is: Date Maturity date Bonds Payable Cash (record payment of bonds at maturity) Account Debit 100,000 Credit 100,000 This assumes all interest has been paid to maturity. The entry will be the same regardless of whether The bonds were issued at face value, discount, or premium REDEEMING BONDS BEFORE MATURITY Assume the bonds were sold at a premium. At the end of the eighth interest period, Candlestick retires the bonds for $103,000. Carrying value on date of redemption is $101,623 The entry to retire the bonds is: Date Jan 1 Bonds Payable Premium on Bonds Payable Loss on Bond Redemption Cash (record redemption and loss prior to maturity) Account Debit 100,000 1,623 1,377 Credit 103,000 Loss calculation: Cash paid – carrying value $103,000 - $101,623 CONVERTING BONDS TO COMMON STOCK Market prices of the bonds and the stock are ignored. The carrying value of the bonds is transferred to capital. No gain or loss is recognized. On July 1 Saunders Associates converts $100,000 bonds sold at face value into 2,000 shares of $10 par value common stock. Both the bonds and the common stock have a market value of $130,000. The entry to record the conversion is: Date July 1 Bonds Payable Common Stock (2,000 x $10) Paid in capital in excess of par (100,000 – 20,000) (record bond conversion) Account Debit 100,000 Credit 20,000 80,000 STUDY OBJECTIVE 7 LONG-TERM NOTES PAYABLE • • • • Terms exceed one year. May be secured by a specific assets (mortgage). Mortgage N/P are recorded initially at face value. Subsequent entries required for installment payments. Porter Technology Inc. issues a $500,000, 12%, 20-year mortgage note on December 31, 2006, to build a research lab. The terms provide for semiannual installment payment of $33,231. The installment payment schedule for the first year is shown below: Semiannual Interest Period (A) Cash Payment (B) Interest Expense (D) x 6% (C) Reduction Of Principal (A) – (B) (D) Principal Balance (D) –(C) Issue date 1 2 33,231 $33,231 $30,000 29,806 $3,231 3,425 $500,000 496,769 493,344 LONG-TERM NOTES PAYABLE JOURNAL ENTRIES The entries to record the issuance and first interest payment are: Date Dec 31 Cash Mortgage Notes Payable (record mortgage loan) June 30 Interest Expense Mortgage Notes Payable Cash (record first installment payment) 30,000 3,231 33,231 Account Debit 500,000 Credit 500,000 STUDY OBJECTIVE 8 PRESENTATION & ANALYSIS The long-term liabilities for LAX Corporation are shown below: LAX Corporation Balance Sheet (partial) Long-term liabilities $1,000,000 Bonds payable 10% due in 2012 80,000 $920,000 Less: Discount on bonds payable Mortgage notes payable, 11%, due in 2018 500,000 and secured by plant assets 540,000 Lease liability $1,960,000 Total long-term liabilities CURRENT MATURITIES OF LONG-TERM DEBT That portion of long-term debt due within 1 year. Classified as a current liability on the balance sheet FINANCIAL STATEMENT PRESENTATION Congratulations! You have a winning lottery ticket and the state has provided you with three possible options for payment. They are: 1.Receive $10,000,000 in 3 years. 2. Receive $7,000,000 immediately. 3. Receive $3,500,000 at the end of each year for 3 years. Which option do you choose? Why? Assume that you are willing to invest a sum of money that will yield $1,000 at the end of one year. In other words, what amount would you need to invest today to have $1,000 one year from now? Using the above table, we can see that the present value of each dollar can be computed by using the factor at the intersecting point where the percentage and number of periods meet. For example, if we wanted to know what we need to invest today to have $2,000 in two years at 8% interest (assume that we have semi-annual interest periods), we would multiply the $2,000 by the factor .73503 which would tell us that we need $1,470. Present Value of an Annuity Assuming that you want to receive $1,000 a year from an annuity, the chart shows how each year can be calculated to show what we need to invest today to provide for the payments. Using the same goal of $1,000 per year for three years, we can achieve the same computation of the prior slide by simply finding the factor that intersects the periods (3) and interest rate (10%). Multiplying this factor by $1,000 will give us the same result. Present value of principal and interest (face value) Actual payout for the bond is $150,000 (100,000 for bond and 10 interest payments at $5,000 each. Now assume that the investor’s required rate of return is 12%, not 10%. What is the Present Value of the $100,000 bond with the same $5,000 interest payments over 10 periods? If the discount rate is 8% and the contractual rate is 10%, what is the Present Value of the $100,000 bond with the same $5,000 interest payments over 10 periods? WORKING CAPITAL FORMULA Working Capital The excess of current assets over current liabilities. A measure of short-term liquidity. Current Assets - Current Liabilities = Working Capital $ 16,791 - $ 12,621 = $ 4,170 CURRENT RATIO FORMULA Current Ratio The ratio of current assets to current liabilities. A measure of short-term liquidity. Current Assets / Current Liabilities = = Current Ratio $16,791 / $12,621 1.33 : 1 DEBT TO TOTAL ASSETS RATIO Measures the percentage of total assets provided by creditors, indicating the degree of leverage. Data from Johnson & Johnson’s 2003 annual report appears below: TOTAL DEBT DEBT TO TOTAL ASSETS = ———————— Total debt = $21,394 Total Assets = $48,263 $21,394 ÷ $48,263 = 44.3% TOTAL ASSETS TIMES INTEREST EARNED RATIO Indicates the company’s ability to meet interest payments as they come due. Johnson & Johnson’s 2003 annual report data is used below: TIMES INT INCOME BEFORE INC. TAXES & INTEREST EXPENSE EARNED = ——————————————————————————— 50.8 times = INTEREST EXPENSE ($7197 + $3111 + $207) $207 ...
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