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Chapter 10: Liabilities
Objective 10.1: Explain the role of liabilities in financing a business.
The Role of Liabilities
Different types of liabilities that can be formed:
Accounts Payable is created when a company buys goods and services on credit.
A liability caused by short term loans.
If a company issues Long Term Debt, this can create a Notes Payable or a Bonds Payable.
Current liabilities are short term liabilities that expected to be paid off within a year OR within the company’s operating cycle. It depends on which one is longer.
Non-current liabilities are long term and are paid in a time frame that is longer than the operating cycle or year (paid after a year).
You can find these liabilities on a classified balance sheet.
Objective 10.2: Explain how to account for common types of current liabilities.
Measuring Liabilities
The cash equivalent is how much we own or borrow, which is the initial amount of the liability.
Certain aspects can increase a liability, like credit cards or buying more goods/services, which means more is owed to creditors.
When payments are made towards the liability, it goes down.
Current Liabilities
Accounts Payable
Increases when goods/services are received on credit (you owe money)
Decreases when a payment is made.
This increase and decrease applies to Notes Payable as well.
Accounts Payable has a normal credit balance.
Accrued Liabilities
They are incurred, but have not been paid.
Usually used to purchase supplies or inventory.
Includes advertising, payroll, taxes, interest, and other accrued liabilities.
Accrued Payroll
Payroll deductions can be required by law or voluntarily requested by employees. Both create a current liability.
Ex: Income tax, FICA tax, charitable donations, union dues, etc.
Whatever an employee is paid, these are deducted from their gross pay.
Every time an employer pays their employees, two things can happen:
They have to pay the employee (payroll deductions).
They pay taxes for the luxury of having these employees.
When the employer cuts a check to an employee, there are two journal entries:
One to pay the employee.
One to pay, for example, the State of Nevada or Federal gov.
Example: During the current payroll period, earned gross pay was $700. The company they work for withheld $70.90 in Federal income taxes, $45.90 for FICA, and $10 for charitable contributions, which gives net pay of $573.20. The company have 1,000 workers.
Step 1: Multiply each value by 1,000 (for the number of workers).
$700 x 1,000 = $700,000
$70.90 x 1,000 = $70,900
$45.90 x 1,000 = $10,000
$10 x 1,000 = $10,000
$573.20 x 1,000 = $573,200
Step 2: Use those results to create the first journal entry (to the employees).
Salaries and Wages Expense | $700,000 | ||
|---|---|---|---|
Withheld Income Taxes Payable | $70,900 | ||
FICA Payable | $45,900 | ||
Charitable Contributions Payable | $10,000 | ||
Cash | $573,200 |
Step 3: The company was required to contribute $45,900 for FICA (“matching” contribution, FICA matches employee) and $4,700 for federal and state unemployment tax. Create the journal entry for the employer.
Payroll Tax Expense | $50,000 | ||
|---|---|---|---|
FICA Payable | $45,900 | ||
Unemployment Tax Payable | $4,100 |
Accrued Income Taxes: Equation to calculate taxable income
(Revenues - Tax allowed expenses) x Federal tax rate
Example: A company has taxable income of 1,500,000 and its conditional tax rate is 21%.
Step 1: Find Taxable Income.
$1,500,000 x 21%
Income tax owed = $315,000
Step 2: Create the journal entry.
Income Tax Expense | $315,000 | ||
|---|---|---|---|
Income Tax Payable | $315,000 |
Notes Payable
Current liability with a promissory note.
The process of a Notes Payable:
Establish the note (with promissory note).
Incur accruing interest (not paid).
Record the interest paid.
Record the principal paid.
Reminder: Equation for calculating interest:
(Principal x Rate x Time)/12
Example is found in chapter 8 notes.
Additional Current Liabilities:
Sales Tax Payable are payments from customers at the time of sale of the good/service. The liability generated is due to the state government.
Deferred Revenue means we have received cash, but we still owe the good or service to the customer. Once the good or service is delivered, the liability decreases.
Current Portion of Long Term Debt
Current portion of long term debt is due within 12 months.
Non-current portion of long term debt is due in over 12 months.
Objective 10.3: Analyze and record bond liability transactions.
Long Term Liabilities
Long term = paid in more than one year.
Examples: Long term Notes Payable, Deferred income taxes, and Bonds Payable.
Deferred income taxes are found on the balance sheet and is the amount a company will at some point pay. Large deductions (larger than whats on their income statement) are taken from the company’s income tax return.
Bonds
Bonds are considered a long term liability for companies and an investment for bondholders. They are a loan from an investor that will be used by a company.
With bonds, you know you will get a future stream of interest payments.
They are tradable on established exchanges, like the New York Bond Exchange.
On the top of a bond, you will find the:
Maturity date (due date)
Face value (the amount payable on the maturity date)
Stated interest rate (amount of interest you can expect to receive).
Bond pricing is based on what the investors are willing to pay on the issue date.
Face value is usually $1,000 for bonds.
The stated interest rate is an annual rate.
The pricing of a bond may be more than or less than face value.
The price does not affect the amount of interest
The carrying value of a bond is the face value plus a premium OR minus a discount.
Equation to calculate carrying value:
Face Value + Premium = Carrying Value
Face Value - Discount = Carrying Value
A bond that is issued over the face value of a bond is a premium.
A bond that is issued under the face value of a bond is a discount.
Example (Face Value): A company issues 100 bonds at face value ($1,000)
The company receives $100,000 (100 x $1,000 = $100,000)
Journal entry:
Cash | $100,000 | ||
|---|---|---|---|
Bonds Payable | $100,000 |
Bonds Premium
With a bonds premium, the issuer receives more money on the issue date than the maturity date.
The investor gets more interest income over time than the market.
Interest expense for the company is lower.
Cash proceeds are great than face value.
Equation to calculate premiums:
Cash proceeds - Face value
Interest expense is lower than the cash interest paid
Equation to calculate interest expense (premium):
Cash interest paid - Premium amortization
Example (Premium): A company issues 100 bonds out of their $1,000 at the price of 105.27% of its face value.
The company receives $105,270 (100 x $1,000 x 1.0527 = $105,270)
Premium is $5,270
Cash proceeds - Face value = Premium
$105,270 - $100,000 = $5,270
Journal entry:
Cash | $105,270 | ||
|---|---|---|---|
Cash | $100,000 | ||
Premium on Bonds Payable | $5,270 |
Bonds Discount
With a bonds discount, the company receives less cash on the issue date than whats received on the maturity date.
The investor gives less than the face value because the interest is less than the market.
Investor gets less interest income than the market.
Interest expense for the company is higher.
Cash proceeds is less than face value.
Equation to calculate discounts:
Face value - Cash proceeds
Interest expense is higher than cash interest paid
Equation to calculate interest expense (discount):
Cash interest paid + Discount amortization
Example (Discount): A company receives $97,800 for bonds that have a total face value of $100,000. $97,800 is the cash equivalent amount. This is a discount because the amount received is less than the face value of the bond.
The discount amount is $2,200 ($100,000 - $97,800 = $2,200).
Journal entry:
Cash | $97,800 | ||
|---|---|---|---|
Discount on Bonds Payable | $2,200 | ||
Bonds Payable | $100,000 |
Bond Retirement
Payment of the bond on the maturity date is retiring the bond.
Bonds can be retired early, which deceases future interest expense and increases net income.
When bonds are retired early, the company:
Pays cash for the bond.
Decreases the Bonds Payable.
Reports a gain or loss.
Equation to calculate loss or gain on retirement:
Cash payment - Carrying value
Positive # = Gain
Negative # = Loss
Example: A company retires a bond that is equal to its initial face value, $100,000.
Bonds Payable | $100,000 | ||
|---|---|---|---|
Cash | $100,000 |
Example (early bond retirement): A company retires a bond early, its face value was $100,000. The bond price is now $105,000 and that is the price the company pays to retire it.
Cash payment - Carrying value = Gain/Loss
$100,000 - $105,000 = (-5,000)
It is negative, so it is a loss.
Journal entry:
Bonds Payable | $100,000 | ||
|---|---|---|---|
Loss on Bond Retirement | $5,000 | ||
Cash | $105,000 |
Objective 10.4: Describe how to account for contingent liabilities.
Contingent Liabilities
Contingent liabilities are liabilities that came from past transactions and effect the future outcome.
In other words, something bad happened and the future outcome is unknown.
This may result in a legal expense.
Objective 10.5: Calculate and interpret the debt to assets ratio and the times interest earned ratio.
Evaluate the Results
The Debt-to-Asset ratio and the Times Interest Earned Ratio is used to see if company’s can successfully get resources to cover future payments.
The debt-to-asset ratio shows how many assets are financed by liabilities.
Equation to calculate the debt-to-assets ratio:
Total Liabilities/Total Assets
If assets are financed by debt, it will be a high ratio (not good).
Example (debt-to-asset): At the end of the fiscal year, a company reported liabilities totaling $24,400,000 and assets totaling $32,240,000.
Divide liabilities by assets.
$24,400,000/$32,240,000
The debt-to-asset ratio = 0.757
The times interest earned ratio will tell us if resources will cover interest cost.
Equation to calculate the times interest earned ratio:
(Net Income + Interest expense + Income tax expense)/ Interest expense
A high number means better interest coverage.
Example (interest earned ratio): A company reports $1,490,000 of net income, $530,000,000 of interest expense, and $360,000,000 of income tax expense. Calculate the times interest earned.
($1,490,000 + $530,000,000 + $360,000,000)/ $530,000,000
Times interest earned = 1.68 times (bad ratio)