7-1

CHAPTER 7

Accounting for and Presentation of Liabilities

McGraw-Hill/Irwin

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

7-2

What Should You Learn in Chapter 7?

1. The financial statement presentation of short-term and current maturities of longterm debt. 2. The difference between interest calculated on a straight basis and on a discount basis. 3. What unearned revenues are and how they are presented in the balance sheet. 4. The importance of making estimates for certain accrued liabilities and how these items are presented in the balance sheet.

7-3

What Should You Learn in Chapter 7?

5. The different characteristics of a bond, which is the formal document representing most long-term debt. 6. Why bond discount or premium arises and how it is accounted for. 7. What noncontrolling (minority) interest is, why it arises, and what it means in the balance sheet.

7-4

LO1

Nature of Liabilities
Liabilities

are obligations that represent probable future sacrifice of economic benefits. The term accrued expenses is often used on the balance sheet to describe liabilities. Current liabilities are those liabilities that will be paid within one year of the current balance sheet date.

7-5

LO1

Nature of Liabilities
Current liabilities include: Accounts payable Short-term debt (Notes payable) Current maturities of long-term debt Unearned revenue or deferred credits Other accrued liabilities Noncurrent liabilities include: Long-term debt (Bonds payable) Deferred tax liabilities Minority interest in subsidiaries

7-6

LO1

Current Liabilities
Short-Term Debt
On 1 January, 2008 Matrix, Inc. borrows $25,000 from 1st National Bank to provide working capital. The following entry is recorded:
GENERAL JOURNAL Date Account Titles and Explanation 2008 Jan 1 Cash Short-term Debt Debit 25,000 25,000 Credit

Financial Statement effect of this transaction

Assets + Cash $25,000 = Liabilities + Debt $25,000 + Owners' Equity Net income = Revenues Expenses

7-7

LO1

Current Liabilities
Interest Expense
The following entry is recorded to accrue interest each month:
GENERAL JOURNAL Date Account Titles and Explanation 2008 Jan 31 Interest Expense Interest Payable Debit 187.50 187.50 Credit

Financial Statement effect of this transaction

Assets = Liabilities + Interest payable $187.50 + Owners' Equity Net income = Revenues Expenses + Interest expense $187.50

7-8

LO2

Interest Calculation Methods

Straight Interest
Interest = Principal Rate Time in years = $25,000 0.09 1 = $ 2,250 per year or $187.50 per month

Annual Percentage Interest Rate (APR)

APR = Interest Paid Money available Time = $2,250 $25,000 1 = 9%

7-9

LO2

Interest Calculation Methods

Discount Basis - Interest is Paid in Advance
Proceeds = Principal Interest = $25,000 $2,250 = $22,750

Annual Percentage Interest Rate (APR)

APR = Interest Paid Money available Time = $2,250 $22,750 1 = 9.89%

7-10

LO2

Current Liabilities
Discount Basis
On 1 January, 2008, Matrix, Inc. borrows $25,000 from 1st National Bank to provide working capital. The note was discounted by the bank and the net proceeds given to Matrix.
GENERAL JOURNAL Date Account Titles and Explanation 2008 Jan 1 Cash Discount on Short-term Debt Short-term Debt Debit 22,750 2,250 25,000 Credit

Financial Statement effect of this transaction

Balance Sheet Assets Cash + 22,750 = Liabilities + Short-term Debt +25,000 Discount on ST Debt -2,250 + Owners' Equity Net income Income Statement = Revenues Expenses

7-11

LO2

Current Liabilities
GENERAL JOURNAL Date Account Titles and Explanation 2008 Jan 31 Interest Expense Discount on Short-term Debt Debit $187.50 $187.50 Credit

The Prepaid interest on the Note Payable will be reclassified as an expense each month using an adjusting entry

Financial Statement effect of this transaction

Balance Sheet Assets = Liabilities - Discount on ST Debt -$187.50 + Owners' Equity Net income Income Statement = Revenues Expenses + Interest Expense $187.50

Principal of note Discount on ST debt Carrying value after adj

$ $

25,000.00 2,062.50 22,937.50

7-12

LO2

Current Maturities on Long-Term Debt

Any portion of long-term debt that is to be repaid within a year of the balance sheet date is reclassified from the noncurrent liability section to the current liability section under the title, current maturities of long-term debt.

7-13

LO3

Unearned Revenue or Deferred Credits

Unearned revenue is created when customers pay for services or products before delivery.

On 1 January, 2008, Matrix, Inc. receives $2,400 cash as an advance payment for a one-year subscription to its monthly investment newsletter.
Cash received for one-year subscription

< 12-month subscription >

1/1/08

31/01/08 Month end

28/02/08 Month end

31/01/08 Month end

Our goal is to recognize revenue as the subscription is fulfilled each month.

7-14

LO3

Unearned Revenue or Deferred Credits

On 1 January, 2008, Matrix, Inc. receives $2,400 cash as an advance payment for a one-year subscription to its monthly investment newsletter.
GENERAL JOURNAL Date Account Titles and Explanation 2008 Jan 1 Cash Unearned Revenue Debit 2,400 2,400 Credit

Financial Statement effect of this transaction

Balance Sheet Assets = Liabilities Unearned revenue +2,400 + Owners' Equity Net income Income Statement = Revenues Expenses

Cash +2,400

7-15

LO3

Unearned Revenue or Deferred Credits

On 31 January 2008, Matrix would prepare the following adjusting entry to recognize revenue earned.
GENERAL JOURNAL Date Account Titles and Explanation 2008 Jan 31 Unearned Revenue Subscription Revenue Debit 200 200 Credit

$2,400 12 = $200

Financial Statement effect of this transaction

Balance Sheet Assets = Liabilities Uearned revenue 200 + Owners' Equity Net income Income Statement = Revenues Subscription revenue +200 Expenses

7-16

LO4

Liability for Warranties

It is appropriate to recognize the estimated warranty expense in the same period as the sale is recorded.

Matrix, Inc. sells 1,000 DVD recorders for $500 each during 2008. Each DVD has a two-year warranty. Matrix estimates that warranty costs will be $30 per recorder.
GENERAL JOURNAL Date Account Titles and Explanation 2008 Dec. 31 Cash Sales revenue Debit 500,000 500,000 Credit

Financial Statement effect of this transaction

Balance Sheet Assets Cash +500,000 = Liabilities + Owners' Equity Net income Income Statement = Revenues Sales revenue +500,000 Expenses

7-17

LO4

Liability for Warranties

Adjusting Entry to reflect Warranty Liability for 2008 Sales
GENERAL JOURNAL Date Account Titles and Explanation 2008 Dec. 31 Warranty expense Estimated warranty liability Debit 30,000 30,000 Credit

Financial Statement effect of this transaction

Balance Sheet Assets = Liabilities Estimated warranty liability $30,000 + Owners' Equity Net income Income Statement = Revenues Expenses Estimated warranty expense $ 30,000

7-18

LO4

Liability for Warranties

During 2008, Matrix paid $3,500 in warranty costs.
GENERAL JOURNAL Date Account Titles and Explanation 2008 Dec. 31 Estimated warranty liability Cash Debit 3,500 3,500 Credit

Financial Statement effect of this transaction

Balance Sheet Assets = Liabilities Estimated warranty liability 3,500 + Owners' Equity Net income Income Statement = Revenues Expenses

Cash 3,500

7-19

LO5

Bond Terminology
Bond Indenture Trustee of Bonds Debenture Bonds Mortgage Bonds

Registered Bonds

Term Bonds

Coupon Bonds Convertible Bonds

Serial Bonds

7-20

LO5

Bonds Payable - Terminology

Interest 10% 30/06 & 31/12

Face Value $1,000

BOND PAYABLE
Bond Date 1/1/2008 Maturity Date 31/12/2012

Face Value is the amount an investor will receive at maturity. Bond Date is the date the bond was issued. Stated Interest Rate is typically an annual rate. Interest Payment Dates are dates when investor is paid interest. Maturity Date is date when face value of bond is repaid to investor.

7-21

LO5

Issuance of Bonds Payable At Par Value

On 1/1/08 Matrix, Inc. issued the following bonds: Par Value = $1,500,000 (1,500 bonds @ $1,000 face) Stated Interest Rate = 10% Market Interest Rate = 10% Interest Dates = 30/06 & 31/12 of each year Bond Date = 1 January , 2008 Maturity Date = 31 Dec. , 2012 (5 years)
GENERAL JOURNAL Date 2008 Jan 1 Account Titles and Explanation Cash Bonds Payable Debit 1,500,000 1,500,000 Credit

Financial Statement effect of this transaction

Balance Sheet Assets Cash +1,500,000 = Liabilities Bonds Payable +1,500,000 + Owners' Equity Net income Income Statement = Revenues Expenses

7-22

LO6

Issuance of Bonds Payable at a Discount or a Premium

Market Rate Effect of Bond Selling Prices

Above the market rate Equal to the market rate Below the market rate

A premium Face amount (at par) A discount

The prior example we looked at illustrated

Stated Rate of Interest = to Market Rate

7-23

LO6

Bonds Issued at a Discount

On 1/1/08 Matrix, Inc. issued the following bonds: Par Value = $1,500,000 (1,500 bonds) Stated Interest Rate = 10% Market Interest Rate = 12% Interest Dates = 30/06 and 31/12 Bond Date = 1 January, 2008 Maturity Date = 31 Dec. 2012 (5 years)

7-24

LO6

Bonds Issued at a Discount

Table PV of $1 PV of an annuity of $1 Table Value Amount Present Value 0.5584 $ 1,500,000 $ 837,600.00 7.3601 75,000 552,008.00 $ 1,389,608.00

Cash Flow Face amount Interest annuity Issue price of the bonds

1. Semiannual rate (i) = 6% (Market rate 12% 2)

2. Semiannual periods (n) = 10 (5 years 2)

$1,500,000 10% = $75,000

Lets look at the issuance of the bonds

7-25

LO6

Bonds Issued at a Discount

GENERAL JOURNAL Date Account Titles and Explanation 2008 Jan 1 Cash Discount on Bonds Payable Short-term Debt Debit 1,389,608.00 110,392.00 1,500,000.00 Credit

Financial Statement effect of this transaction

Balance Sheet Assets Cash + $1,389,608 = Liabilities Bonds Payable +1,500,000 *Discount on Bonds Payable $110,392 + Owners' Equity Net income Income Statement = Revenues Expenses

* A contra-liability account that will be amortized over the life of the bond as an
adjustment to interest expense. A discount amortization increases periodic interest expense and a premium amortization decreases interest expense.

7-26

LO5 LO6

Retirement of Bonds Payable

When Matrix retires the bonds at maturity the following entry will be made:
GENERAL JOURNAL Date Account Titles and Explanation 2012 Dec. 31 Bonds Payable Cash Debit 1,500,000.00 1,500,000.00 Credit

Financial Statement effect of this transaction

Balance Sheet Assets Cash 1,500,000 = Liabilities Bonds Payable 1,500,000 + Owners' Equity Net income Income Statement = Revenues Expenses

7-27

LO5 LO6

Early Retirement of Bonds

On 18 June 2008, Matrix, Inc. retired $1,000,000 face amount of bonds by paying bondholders $1,020,000. At the date of retirement, the bonds had unamortized discount of $62,000.
GENERAL JOURNAL Date Account Titles and Explanation 2008 June 18 Bonds Payable Loss on Retirement of Bonds Discount on Bonds Payable Cash Debit 1,000,000 82,000 62,000 1,020,000 Credit

Financial Statement effect of this transaction

Balance Sheet Assets Cash 1,020,000 = Liabilities Bonds Payable 1,000,000 Discount on bonds payable +62,000 + Owners' Equity Net income Income Statement = Revenues Expenses Loss on retirement 82,000

7-28

LO7

Other Noncurrent Liabilities

Obligations relating to pension plans and other employee benefit plans, including deferred compensation and bonus plans.
Expenses relating to these plans are accrued and reflected in the income statement of the fiscal period in which the benefits are earned by the employees. Some companies pay postretirement benefits. Costs associated with these plans are usually expensed in the fiscal period in which payments are made to providers.

7-29

LO7

Other Noncurrent Liabilities

Minority Interest in Subsidiaries
Financial statements of a parent company and its subsidiaries are usually combined or consolidated at the end of the accounting period. If a parent company owns more than 50% but less than 100% of a subsidiary, the minority shareholders interest in the subsidiary is shown on the balance sheet of the parent.

7-30

LO7

Other Noncurrent Liabilities

Contingent Liabilities Potential claims on the resources of a company arising from pending litigation, environmental hazards, casualty losses to property, product warranties, or unsettled disputes with the government about taxes.

7-31

LO7

Gain/Loss Contingency
Dollar Amount of Potential Loss Reasonably Not Reasonably Known Estimable Estimable No Disclosure Note No Disclosure Note No Disclosure Note Disclosure Note Only Disclosure Note Only Disclosure Note Only Liability Accrued & Disclosure Note Liability Accrued & Disclosure Note Only Disclosure Note

Likelihood of Adverse Outcome Remote Reasonably Possible Probable

Remote

Reasonably Possible

Probable

Occurrence Probability is Slight.

Occurrence Probability is More Than Remote but Less Than Likely.

Occurrence Probability is Likely.

7-32

End of Chapter 7