Liabilities and Interest

CHAPTER 
9
Learning Objectives
After studying this chapter, you should be able to
•	Account for current liabilities
•	Measure and account for long-term liabilities
•	Account for bond issues over their entire life
•	Value and account for long-term lease obligations
•	Evaluate pensions and other postretirement benefits
•	Interpret deferred tax liabilities
•	Use ratio analysis to assess a company’s debt levels
Learning Objectives
After studying this chapter, you should be able to
•	Compute and interpret present and future values (Appendix 9)
Liabilities in Perspective
•	Liabilities are a company’s obligations to pay cash or to provide goods and services
–	Current liabilities are obligations that fall due within one year or the normal operating cycle, if longer
–	Long-term liabilities are those that fall due more than one year beyond the balance sheet date
Accounting for Current Liabilities
•	Accounts payable
–	Are amounts owned to suppliers
–	Require a carefully designed system of internal control including source documents to support all checks:
•	Purchase order—specifies the quantities and prices of items ordered
•	Receiving report—indicates that the company received shipment of the goods
•	Invoice—is a bill from the seller
Notes Payable
•	A promissory note is a written promise to pay the loan principal plus interest at specific future dates
–	Notes that are payable in one year are classified as current liabilities
•	Commercial paper is a debt contract issued by prominent companies that borrow directly from investors 
Accrued Employee Compensation
•	A line of credit sets up a predetermined maximum amount that a company can borrow without additional credit checking 
•	Accrued liabilities are expenses that a company has recognized but not yet paid
–	Example: Wages payable to employees for service already provided
Accrued Employee Compensation
•	Assume that a May Company department store has a $100,000 monthly payroll.  The only amounts it withholds are $15,000 for income taxes and $7,000 for Social Security taxes.
•	The journal entry for this $100,000 payroll is:

Accrued Employee Compensation
•	Payroll taxes are amounts paid to the government for items such as the employer’s portion of
–	Social Security
–	Federal and state unemployment taxes
–	Workers’ compensation taxes
•	Fringe benefits include
–	Employee pensions
–	Life and health insurance
–	Vacation pay

Accrued Employee Compensation
•	Suppose the May Company pays an employer’s FICA tax equal to the $7,000 withheld from the employee and 10% of gross wages into a retirement account
•	The following journal entry summarizes the effect on May Company’s financial statements:
Income Taxes Payable
•	Corporations make periodic installment payments based on their estimated tax for the year
•	The accrued liability for income taxes at year-end is generally much smaller than the annual income tax expense
Current Portion of Long-Term Debt
•	A company’s long-term debt often includes payments due within a year that should be reported as current liabilities
•	The journal entry for reclassifying the current portion of long-term debt is illustrated below:
Sales Tax
•	Retailers collect sales taxes on behalf of the state or local government
•	Suppose customers pay a 7% sales tax on sales of $10,000
–	The sales shown on the income statement would be $10,000
–	The sales tax never affects the income statement
–	The $700 received for taxes affects the current liability account Sales Tax Payable
Sales Tax
•	The journal entries illustrating the (1) collection and (2) payment of sales taxes are shown below:
Product Warranties
•	A sales warranty creates a liability, but warranty claims arising in the future must be estimated in the year of the sale
•	Companies base the estimated warranty expenses on past experience for replacing or remedying defective products

Product Warranties
•	The accounting entry estimating warranty expense is:

•	When a warranty claim arises, the following entry is made:
Returnable Deposits
•	Companies that receive deposits record them as current liabilities
•	The accounting entries by the recipients of deposits have the following basic pattern:
Unearned Revenue
•	Unearned revenue is revenue that a company collects in cash before it delivers goods or services
•	Unearned revenues are classified as current liabilities because they require a company to either 
–	Deliver the product or service or 
–	Make a full refund
Unearned Revenue
•	Examples of unearned revenue include:
–	Lease rentals
–	Magazine subscriptions
–	Insurance premiums
–	Advance airline or theater ticket sales
–	Advance repair service contracts
Unearned Revenue
•	The journal entries to record $100,000 of prepayments for services and the subsequent performance of those services and appropriate revenue recognition are as follows:
Long-Term Liabilities
•	Long-term liabilities are 
–	Obligations that are not due for at least one year
–	Measured at their present value, adjusting for the Time Value of Money (Appendix 9)
•	Examples of long-term liabilities are:
–	Corporate notes and bonds
–	Lease liabilities
–	Pension liabilities
–	Current and deferred income tax liabilities
–	Contingent liabilities

Corporate bonds
•	Bonds are formal certificates of debt that include:
–	A promise to pay interest in cash at a specified annual rate, known as the
•	Nominal interest rate
•	Contractual rate
•	Coupon rate or
•	Stated rate
–	A promise to pay the principal (face amount or par value) of the loan amount at a specific maturity date
•	Bonds generally pay interest every 6 months
Specific Bond Characteristics
•	Bondholders have a preference in liquidation over equity holders
–	Liquidation means converting assets to cash and paying off outside claims
•	A mortgage bond is secured by the pledge of specific property
•	A debenture is a debt security with a general claim against the company’s total assets
Specific Bond Characteristics
•	A debenture bondholder shares the available assets with other general creditors
•	Subordinated bondholders have claims against only the assets that remain after satisfying the claims of other general creditors
•	Bond covenants restrict the ability of the borrower to take certain actions or give the lender the ability to force early payment
Specific Bond Characteristics
•	Callable bonds allow the issuer the option to redeem (call) them before maturity
–	The call premium is the amount by which the redemption price exceeds the face value of the bond 
•	Sinking fund bonds require the issuer to make annual payments into a sinking fund that can be used to redeem the bonds at maturity
•	Convertible bonds are bonds that lenders may exchange for a preset number of shares of the issuing company’s common stock

Bond Interest Rates, Bond Discount 
and Bond Premium
•	The market rate is the amount of interest that investors require to purchase bonds
•	When the market rate exceeds the coupon rate, bonds sell at a discount
–	The excess  of the face amount over the proceeds from the bond
•	When the coupon rate exceeds the market rate, bonds sell at a premium
–	The excess of the proceeds over the face amount
Bond Interest Rates, Bond Discount
and Bond Premium
•	The current market rate after issuance (or yield to maturity) is the interest rate at which all contractual cash flows for interest and principal have a present value equal to the current price of the bond
Bond Interest Rates, Bond Discount
and Bond Premium
•	The market interest rate is determined by three basic components:
–	The real interest rate – the return that investors demand because they are delaying their consumption 
–	The inflation premium – the extra interest that investors require because the general price level may increase between now and the time they receive their money
–	The firm-specific risk – the risk that the firm will not repay the loan or will not pay the interest on time
Issuing and Trading Bonds
•	A syndicate of investment bankers (called underwriters) sells a corporation’s bonds
•	After a company initially issues bonds, the bondholders can trade the bonds in secondary markets
•	Bonds typically have a face value of $1,000, but their values are usually quoted in terms of percentages of face value
Issuing and Trading Bonds
•	Examples of bond quotes are presented below:
Bonds Issued at Par
•	Suppose that on December 31, 2003
–	Delta Company
•	Issued 10,000 $1,000, 2-year, 10% debentures at par
•	Received cash exactly the amount of the bond principal or face value
–	The market rate is equal to the coupon rate of 10%
•	In this case, the interest expense equals the amount of the interest payments
Bonds Issued at Par
•	The journal entries for the issue are:
Bonds Issued at a Discount
•	Now suppose Delta
–	Issues its 10,000 bonds when annual market interest rates are 12% (6% for each six-month period)
–	Receives $965.35 for each bond, for total proceeds of $9,653,500
–	Recognizes a discount of $346,500 ($10,000,000 - $9,653,500) at issuance
•	The journal entry is
Bonds Issued at a Discount
•	Discount on bonds payable is a contra account, which is deducted from the face amount to show the balance sheet carrying amount (book value)
Bonds Issued at a Discount
•	Spreading the discount over the life of the bonds is called discount amortization
•	The FASB requires companies to use effective-interest amortization
–	Each period bears an interest expense equal to the carrying value of the debt multiplied by the market interest rate
–	The difference between the interest expense and the cash interest payment is the amount of discount amortized
Bonds Issued at a Discount
•	Below are the journal entries for the first two payments and discount amortization:
Bonds Issued at a Premium
•	Bond premiums differ from bond discounts in the following ways:
–	The cash proceeds exceed the face amount
–	The amount of the contra account Premium on Bonds Payable is added to the face amount to determine the net liability reported in the balance sheet
–	Amortization of the bond premium causes interest expense to be less than the cash payment for interest
Bonds Issued at a Premium
•	Suppose Delta
–	Issued the 10,000 bonds when annual market interest rates were 8% (semiannual rates 4%)
–	Receives $1,036.30 for each bond, for total proceeds of $10,363,000
•	The interest expense equals the net liability (carrying value) each period multiplied by the market interest rate
Bonds Issued at a Premium
•	The journal entries for the issuance and first two payments are:
Cash Flow Statement Effects
•	The issuance of bonds is a cash inflow from financing activities on the statement of cash flows
•	Semiannual interest payments are operating cash outflows
•	Payments at maturity are financing cash outflows

Cash Flow Statement Effects
•	Amortization of bond discounts and premiums does not appear in the operating section under the direct method
•	Under the indirect method, amortization of bond discount is added to (premium is deducted from) net income to get cash flow from operating activities
Early Extinguishment
•	Early extinguishment is when a company chooses to redeem its own bonds before maturity
•	The difference between the cash paid and the net carrying amount of the bonds is recognized as a gain or loss
Non-Interest-Bearing 
Notes and Bonds
•	Zero coupon bonds pay all interest amounts at maturity
•	Zero coupon does not mean that there is no interest
–	Companies sell zero coupon bonds and notes for less than the face or maturity value
–	The issuer amortizes the discount as interest over the life of the note

Non-Interest-Bearing 
Notes and Bonds
•	Consider a 2-year, non-interest-bearing, $10,000 face-value note issued by Gamma Company on December 2003, when market interest rates were 10% (5% semiannually)
•	Gamma receives cash equal to the present value (PV) of the $10,000 payment

•	The journal entries are presented next:
Non-Interest-Bearing 
Notes and Bonds
Accounting for Leases
•	A lease is a contract whereby a lessor (owner) grants the use of property to a lessee in exchange for regular payments
•	Legal title to the property remains with the lessor, but the lessee uses the property as if it had ownership
•	Accountants categorize leases into two categories: 
•	Capital leases
•	Operating leases
Operating and Capital leases
•	Capital leases 
–	Transfer most of the risks and benefits of ownership to the lessee
–	Are transactions in which economic substance prevails over the legal form
–	Are similar to installment sales in which the purchaser pays the price of an item over time along with interest payments
–	Are transactions in which the property becomes an asset and the obligation to pay for it becomes a liability
Operating and Capital leases
•	A capital lease must meet at least one of the following four conditions:
•	The lessor transfers ownership of the asset to the lessee by the end of the lease term
•	The lease contains a bargain purchase option
–	A provision that the lessee can inexpensively purchase the asset from the lessor at the end of the lease
•	The lease term equals or exceeds 75% of the estimated economic life of the property
•	The present value of minimum lease payments is at least 90% of the property’s fair value
Operating and Capital leases
•	All other leases are operating leases
•	Companies account for operating leases as ordinary rent expense
•	Suppose the Bestick company can acquire a truck with useful life of 4 years and no residual value under the following conditions:
Operating and Capital leases
•	Capital leasing creates an obligation for four $16,462 payments that have a present value of $50,000:

•	Bestick accounts for the lease as a capital lease
Operating and Capital leases
•	The signing of the capital lease requires the following journal entry:

•	The current liability is the payment due in the next year less the first year’s interest: $16,462 – (12% x 50,000) = $10,462.  The remainder, $50,000 - $10,462 = $39,538 is a long-term liability
Operating and Capital leases
•	Straight-amortization of the asset is $50,000/4 = $12,500 annually
•	The journal entry for the leasehold amortization expense each year is:
Operating and Capital leases
•	Under the effective interest method, each lease payment consists of interest expense and a reduction of the lease liability
•	The journal entry for the lease payment for Year 1 is:
Operating and Capital leases
•	If treated as an operating lease, Bestick would make the following journal entry for each payment:

•	No leasehold asset or liability is recorded
Differences in Financial Statements
•	Income statement:
–	Capital leases tend to produce heavier expenses and lower income than operating leases in the early years
•	Balance sheet:
–	Capital leases create an asset and liability
–	Operating leases do not
•	Statement of cash flows:
–	Cash payments for operating leases are operating activities
–	Capital leases affect both operating and financing sections
Pensions
•	Benefits provided to retired employees fall into two categories:
•	Pensions—payments to employees after they retire
•	Other postretirement benefits—health care and other benefits
•	Pensions are divided into two types:
•	Defined contribution plans
•	Defined benefit plans
Pensions
•	Defined contribution plans
–	Employer contributions to a pension fund belong to the employees
–	Retirement payments depend on how well the fund performs
•	Defined benefit plans
–	Retirement pay is guaranteed or fixed
–	The pension obligation is the present value of the expected future benefits to employees
–	Employers disclose the pension obligation and the fund assets in the financial statement footnotes
Defined Benefit Plans
•	If the value of the fund assets is < the present value of the pension obligation, a net liability is recognized on the balance sheet
•	Pension expense is roughly the increase in the pension liability for the year
•	If the annual expense is computed to be $108,000,000 and $84,000,000 is funded, the journal entry would be:
Deferred Taxes
•	Revenue recognition and expense recognition rules for tax purposes can differ from GAAP rules on two dimensions:
•	Whether to recognize an item (permanent differences) and
•	When to recognize it (temporary differences)
•	Corporations pay taxes for the current year based on taxable income:
Pemanent Differences
•	A permanent difference arises when a company recognizes a revenue or expense for either tax or financial reporting purposes, but not both
•	Example: Municipal bond interest is not taxable, but it is recognized as interest revenue on the income statement
Temporary Differences
•	A temporary difference arises when a company recognizes a revenue and expense item at a different time for tax purposes than for financial reporting purposes
•	Example: Using accelerated depreciation for tax purposes and straight-line depreciation for financial reporting purposes
Temporary Differences
•	Suppose Webster Company earns $40,000 per year before deducting depreciation and taxes and has a 40% tax rate.  Webster acquires a $10,000 asset with a 2-year useful life.  It deducts the $10,000 immediately for tax purposes and will depreciate it $5,000 per year for financial reporting.
•	The tax liability for Year 1 is $12,000 [($40,000 - $10,000) x 40%]
Temporary Differences
•	A $2,000 deferred liability arises because of predictable future taxes ($10,000-$5,000) x 40%
•	The journal entry for Year 1 is:

Temporary Differences
•	In Year 2, the temporary difference reverses as the company pays the $2,000 that it treated as a deferred tax liability in Year 1
•	The journal entry for Year 2 is:

•	The current tax liability for Year 2 is $16,000 ($40,000 x 40%)

Restructuring Liabilities
•	A restructuring involves the closing of a plant, downsizing the workforce, and terminating or relocating various activities
•	Restructuring costs are recognized as an expense on the income statement and an accrued liability on the balance sheet
•	The liability may be classified as current or long-term depending upon when it expects to incur the costs
Contingent Liabilities
•	A contingent liability is
–	A potential liability (and expense) that depends on a future event arising out of a past transaction
–	Recorded in the financial statements if 
•	The event is probable and
•	It can be reasonably estimated
•	If just one of the criteria is met, the contingency is only disclosed in the footnotes
Debt Ratios and 
Interest-Coverage Ratios
•	Four common debt ratios are:
Debt Ratios and 
Interest-Coverage Ratios
•	Four common debt ratios are:
Debt Ratios and 
Interest-Coverage Ratios
•	The first three ratios are alternate ways of expressing debt burden of a company
–	The higher the ratio, the riskier the firm and the higher the interest rate it must pay
•	The fourth ratio measures the firm’s ability to meet its interest obligation
–	The lower the ratio, the more likely the company will have difficulty making payments
•	Debt burdens vary across firms and industries
Compound Interest, Future Value, and Present Value

Appendix 9
Compound Interest
•	The amount borrowed in a loan is called the loan principal
•	Interest is the cost the borrower pays the lender to use the principal
•	The interest rate is a stated percentage of the principal
•	The interest period is the time period over which the borrower uses the principal
Compound Interest
•	Simple interest = interest rate x principal
•	Compound interest = interest rate x principal amount that increases each time interest is earned but not paid
Future Value
•	Future value (FV) is the value in the future of a cash inflow or outflow
•	The general formula for computing the FV of S dollars in n years at interest rate i is:

•	Table 9A-1 in the text shows the future values of $1 for various periods and interest rates
•	Example: $10,000 grows to $13,310 over 3 years ($10,000 x 1.3310) assuming an i of 10%
Present Value
•	The present value (PV) is the value today of a future cash inflow or outflow
•	Present values are also called discounted values
•	Interest rates are called discount rates
•	The process of finding the present value is called discounting

Present Value
•	The present value of a future sum at the end of n years at interest rate i is:

•	Table 9A-2 in the text gives factors for the PV of $1 for various periods and interest rates
•	Example: the present value of $13,310 received in 3 years at 10% interest is (.7513 x $13,310) or $10,000
Present Value of an 
Ordinary Annuity
•	An ordinary annuity is a series of equal cash flows that take place at the end of successive periods of equal length
•	The present value of an ordinary annuity for n periods and interest rate i is:

•	Table 9A-3 in the text provides factors for PVA for various combinations of n and i

Present Value of an 
Ordinary Annuity
•	Example: The PV of an annuity of $1,000 received at the end of each year for 20 years earning 6% interest is ($1,000 x 11.4699) or $11,469.90