accounting for liabilities chapter 7 copyright © 2012 by the mcgraw-hill companies, inc. all rights...

Accounting for Liabilities

Chapter 7

Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

7-2

Learning Objective 1

Show how notes payable and related interest expense affect financial statements.

7-3

Accounting for Notes Payable

= +

Cash = Notes Pay. + Int. Pay. +

Com. Stk. + Ret. Earn. Revenue - Expenses =

Net Income

Cash Flow

90,000 = 90,000 + n/a + n/a + n/a n/a - n/a = n/a 90,000 FA

Assets Liab. Stockholders' Equity

09/01/12 Borrowing

On September 1, 2012 Herrera Supply Company (HSC) borrowed $90,000 from the National Bank. HSC issued a note payable due in one year with an annual interest rate of 9%.

7-4

Accrual of Interest Expense

Assets = +

Cash = Notes Pay. + Int. Pay. + Com. Stk. + Ret. Earn. Revenue - Expenses =

Net Income Cash Flow

n/a = n/a + 2,700 + n/a + (2,700) n/a - 2,700 = (2,700) n/a

Stockholders' EquityLiabilities

12/31/12 Recognition of Interest Expense

At the end of 2012, HSC must accrue interest on its note payable.

$90,000 $90,000 × 9% × 4/12 = $2,700 interest × 9% × 4/12 = $2,700 interest expenseexpense

$90,000 $90,000 × 9% × 4/12 = $2,700 interest × 9% × 4/12 = $2,700 interest expenseexpense

7-5

Paying principal & interest at maturity date

Assets = +



n/a = n/a + 5,400 + n/a + (5,400) n/a - 5,400 = (5,400) n/a


Assets = +



(8,100) = n/a + (8,100) + n/a + n/a n/a - n/a = n/a (8,100) OA (90,000) = (90,000) + n/a + n/a + n/a n/a - n/a = n/a (90,000) FA


08/31/13 Recognition of interest expense. Payment of principal and interest on the maturity date, August 31, 2013. $90,000 $90,000 × 9% × 8/12 = $5,400 interest × 9% × 8/12 = $5,400 interest

expenseexpense$90,000 $90,000 × 9% × 8/12 = $5,400 interest × 9% × 8/12 = $5,400 interest

expenseexpense

Now, record payment of principal and interest payable.

7-6


Show how sales tax liabilities affect financial statements.

7-7

Accounting for Sales Tax

Assets = Liabilities +

Cash = Sales Tax

Pay + Com. Stk. + Ret. Earn. Revenue - Expenses =


2,120 = 120 + n/a + 2,000 2,000 - n/a = 2,000 2,120 OA

Stockholders' Equity

Most states require retail companies to collect sales tax on items sold to their customers. The retailer then remits the tax to the state at regular intervals. Sales tax is a liability to the retailer until paid to the state.

HSC sells merchandise to a customer for $2,000 cash in a state where the sales tax rate is 6%.

7-8

Accounting for Sales Tax


Cash = Sales Tax

Pay + Com.

Stk. + Ret. Earn. Revenue - Expenses =

Net Income

Cash Flow

(120) = (120) + n/a + n/a n/a - n/a = n/a (120) OA

Stockholders' Equity

Remitting the tax (paying cash to the state tax authority) is an asset use transaction.

7-9


Define contingent liabilities and explain how they are reported in financial statements.

7-10

Reporting Contingent Liabilities

7-11


Explain how warranty obligations affect financial statements.

7-12

Warranty Obligations

= Liab. + Equity

Cash + Inventory = + Ret. Earn. Rev. - Exp. = Net

Income Cash Flow

7,000 + n/a = n/a + 7,000 7,000 - n/a = 7,000 7,000 OA

n/a + (4,000) = n/a + (4,000) n/a - 4,000 = (4,000) n/a

Assets

To attract customers, many companies guarantee their products or services. Within the warranty period, the seller promises to replace or repair defective products without charge.Event 1 Sale of MerchandiseHSC sells $7,000 of merchandise for cash. The merchandise had a cost of $4,000.

7-13


Assets = Liabilities + Equity

= Warr. Pay + Ret. Earn. Revenue - Expenses = Net

Income Cash Flow n/a = 100 + (100) n/a - 100 = (100) n/a

Event 2 Recognition of Warranty ExpenseHSC estimates that warranty expense associated with the current sale will be $100.

7-14



Cash = Warr. Pay + Ret. Earn. Revenue - Expenses = Net

Income Cash Flow (40) = (40) + n/a n/a - n/a = n/a (40) OA

Event 3 Settlement of Warranty ObligationHSC pays $40 cash to repair defective merchandise returned by a customer.

7-15

Financial Statements

Assets Cash 8,960$ Inventory 2,000 Total Assets 10,960$

Liabilities Warranties Payable 60 Stockholders' Equity Common Stock 5,000 Retained Earnings 5,900 Total Liab. & Stockholders' Equity 10,960$

Balance Sheet

Operating Activities Inflow from Customers 7,000$ Outflows for Warranty (40) Net Inflows From Oper. 6,960 Investing Activities 0Financing Activities 0 Beginning Cash Balance 2,000

Ending Cash Balance 8,960$

Statement of Cash Flows

Sales Revenue 7,000$ Cost of Goods Sold (4,000) Gross Margin 3,000 Warranty Expense (100) Net Income 2,900$

Income Statement

7-16


Show how installment notes affect financial statements.

7-17

Long-term installment notes are liabilities that usuallyhave terms from two to five years.

Long-term installment notes are liabilities that usuallyhave terms from two to five years.

Each payment covers interest for the period and a

portion of the principal.

Each payment covers interest for the period and a

portion of the principal.

As payments are made, the amount allocated to

interest gets smaller and to principal gets

larger.

As payments are made, the amount allocated to

interest gets smaller and to principal gets

larger.

Principal

Company Lender

Payments

Installment Notes Payable

7-18

Applying payments to principal and interest

1. Identify the unpaid principal balance.

2. Amount applied to interest = Unpaid principal balance (1) × Interest rate.

3. Amount applied to principal = Cash payment less the amount applied to interest (2).

4. New unpaid principal balance = Unpaid principal balance (1) less the amount applied to principal (3).

Applying payments to principal and interest

1. Identify the unpaid principal balance.

2. Amount applied to interest = Unpaid principal balance (1) × Interest rate.

3. Amount applied to principal = Cash payment less the amount applied to interest (2).

4. New unpaid principal balance = Unpaid principal balance (1) less the amount applied to principal (3).


7-19

On January 1, 2012, Blair Company issued a $100,000 face value installment note to National Bank. The note had a 9 percent annual interest rate and a five year term. The loan agreement called for five equal

payments of $25,709 to be made on December 31 of each year.

Prepare an amortization table for Blair’s note.

On January 1, 2012, Blair Company issued a $100,000 face value installment note to National Bank. The note had a 9 percent annual interest rate and a five year term. The loan agreement called for five equal

payments of $25,709 to be made on December 31 of each year.

Prepare an amortization table for Blair’s note.


7-20Installment Notes PayableCash payment determined using present valueconcepts presented in a later chapter.Cash payment determined using present valueconcepts presented in a later chapter.

All computations rounded to the nearest dollar; after the 2016 payment the loan balance is 0.

Accounting Period

Unpaid Principal

Balance on January 1

Cash Payment on

December 31

Amount Applied to

Interest

Amount Applied to Principal

2012 100,000$ 25,709$ 9,000$ 16,709$ 2013 83,291 25,709 7,496 18,213 2014 65,078 25,709 5,857 19,852 2015 45,226 25,709 4,070 21,639 2016 23,587 25,710 2,123 23,587

7-21

$-

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

Year 1 Year 2 Year 3 Year 4 Year 5

Interest

Principal

With each payment the amount applied to the principal increases and the amount applied to

interest decreases.

With each payment the amount applied to the principal increases and the amount applied to

interest decreases.

Annual payments

are constant.


7-22



Cash = Note Pay. + Com. Stk. + Ret. Earn. Revenue - Expenses = Net

Income Cash Flow 100,000 = 100,000 + n/a + n/a n/a - n/a = n/a 100,000 FA

Equity

Issuing the note has the following effecton Blair’s 2012 financial statements:Issuing the note has the following effecton Blair’s 2012 financial statements:

The December 2012 cash payment has the followingeffect on Blair’s 2012 financial statements:The December 2012 cash payment has the followingeffect on Blair’s 2012 financial statements:

Assets = Liab. +

Cash = Notes Pay. +

Com. Stk. + Ret. Earn. Rev. - Exp. =


(25,709) = (16,709) + n/a + (9,000) n/a - 9,000 = (9,000) (9,000) OA

(16,709) FA

Equity

7-23


Show how a line of credit affects financial statements.

7-24

Line of CreditLines of credit are

pre-approved financing plans

that allow companies to

borrow and repay funds as needed

up to the maximum credit line set by the

creditor.

Lines of credit are pre-approved

financing plans that allow

companies to borrow and repay funds as needed

up to the maximum credit line set by the

creditor.

Lines of credit are normally

used forrelatively short-term borrowing

tofinance seasonal business needs.

Lines of credit are normally

used forrelatively short-term borrowing

tofinance seasonal business needs.

7-25

Line of CreditLagoon Company borrows money using a line of credit to finance building up its inventory. Lagoon repays the loan over the summer using cash generated from sales. (Interest rates generally fluctuate based on a designated interest rate benchmark.)

Each borrowing is an asset source transaction. Each repayment is an asset use transaction.

7-26


Explain how to account for bonds issued at face value and their related interest costs.

7-27

Mason Company issues bonds on January 1, 2011.Principal = $100,000Stated Interest Rate = 9%Interest Date = 12/31Maturity Date = Dec. 31, 2015 (5 years)


Bond Certificateat Face Value


Bond Selling Price

Mason Company

Investors





Bond Selling Price

Mason Company

Investors

Bonds Issued at Face Value

7-28Bonds Issued at Face Value

Event 1 Issue Bonds for CashIssuing the bonds has the following effect on Mason’s 2012 financial statements:

Event 1 Issue Bonds for CashIssuing the bonds has the following effect on Mason’s 2012 financial statements:


Cash = Bonds

Pay. + Revenue - Expenses = Net

Income Cash Flow

100,000 = 100,000 + n/a n/a - n/a = n/a 100,000 FA

Event 2 Investment in LandPaying $100,000 cash to purchase land is an asset exchange transaction.

Event 2 Investment in LandPaying $100,000 cash to purchase land is an asset exchange transaction.


Cash Land + Revenue - Expenses = Net

Income

Cash Flow

(100,000) + 100,000 = n/a n/a n/a - n/a = n/a (100,000) IA


Event 3 Revenue RecognitionRecognizing $12,000 cash revenue from renting the property is an asset source transaction.

Event 3 Revenue RecognitionRecognizing $12,000 cash revenue from renting the property is an asset source transaction.


Cash = + Ret. Earn. Revenue - Expenses = Net

Income Cash Flow (9,000) = n/a + (9,000) n/a - 9,000 = (9,000) (9,000) OA

Event 4 Expense RecognitionMason’s $9,000 ($100,000 x 0.09) cash payment in each of the 5 years represents interest expense.

Event 4 Expense RecognitionMason’s $9,000 ($100,000 x 0.09) cash payment in each of the 5 years represents interest expense.


Cash = + Ret. Earn. Revenue - Expenses =

Net Income

Cash Flow

12,000 = n/a + 12,000 12,000 - n/a = 12,000 12,000 OA


Bond Interest Payments

Mason Company

Investors

On each yearly interest payment date, Mason Company will pay $9,000 in interest. The amount is computed as follows:

On each yearly interest payment date, Mason Company will pay $9,000 in interest. The amount is computed as follows:

$100, 000 × 9% = $9,000 $100, 000 × 9% = $9,000

7-31

Bonds Issued at Face Value

Event 6 Payoff of Bond LiabilityThe principal repayment on December 31, 2016 will have thefollowing effect on Mason’s 2016 financial statements:

Event 6 Payoff of Bond LiabilityThe principal repayment on December 31, 2016 will have thefollowing effect on Mason’s 2016 financial statements:


Cash = Bonds Pay. + Revenue - Expenses = Net

Income Cash Flow (100,000) = (100,000) + n/a n/a - n/a = n/a (100,000) FA


Cash Land + Revenue - Expenses = Net

Income

Cash Flow

100,000 + (100,000) = n/a n/a n/a - n/a = n/a 100,000 IA

Event 5 Sale of Investment in LandSelling the land for cash equal to its $100,000 book value is an asset exchange transaction.

Event 5 Sale of Investment in LandSelling the land for cash equal to its $100,000 book value is an asset exchange transaction.


Bond Principal

at Maturity Date

Mason Company

Investors

On December 31, 2016, Mason Company will return the $100,000 principal amount to the

investors.

On December 31, 2016, Mason Company will return the $100,000 principal amount to the

investors.

7-34


Use the straight-line method to amortize bond discounts and premiums.

7-35





Bond Selling Price

Mason Company

Investors

Mason Company issues bonds on January 1, 2012.Principal = $100,000Issued at 95 instead of face; cash proceeds of $95,000Stated Interest Rate = 9%Interest Date = 12/31

Maturity Date = Dec. 31, 2016 (5 years)





Bond Selling Price

Mason Company

Investors

Bonds Issued at a Discount

7-36





Bond Selling Price

Mason Company

Investors

$100,000 face issued at 95:

Bonds Payable $100,000

Less: Discount on Bonds Payable (5,000)

Carrying Value $ 95,000



Less: Discount on Bonds Payable (5,000)




Bond Selling Price

Mason Company

Investors


7-37Bonds Issued at a Discount

Expense Recognition for Bond issued at 95Mason’s cash payment is $9,000 ($100,000 x 0.09) Amortization of the discount of $5,000 over 5 years is $1,000 per year.Interest expense recognized is $9,000 plus $1,000 = $10,000

Expense Recognition for Bond issued at 95Mason’s cash payment is $9,000 ($100,000 x 0.09) Amortization of the discount of $5,000 over 5 years is $1,000 per year.Interest expense recognized is $9,000 plus $1,000 = $10,000

Cash =

Carrying Value of

Bond Liability + Ret. Earn. Revenue - Expenses =

Net Income

Cash Flow

(9,000) = 1,000 + (10,000) n/a - 10,000 = (10,000) (9,000) OA

7-39





Bond Selling Price

Mason Company

Investors

Mason Company issues bonds on January 1, 2012.Principal = $100,000Issued at 105 instead of face, cash proceeds of $105,000Stated Interest Rate = 9%Interest Date = 12/31


Mason Company issues bonds on January 1, 2012.Principal = $100,000Issued at 105 instead of face, cash proceeds of $105,000Stated Interest Rate = 9%Interest Date = 12/31




Bond Selling Price

Mason Company

Investors

Bonds Issued at a Premium

7-40





Bond Selling Price

Mason Company

Investors



Plus: Premium on Bonds Payable 5,000




Plus: Premium on Bonds Payable 5,000




Bond Selling Price

Mason Company

Investors


7-41Bonds Issued at a Premium

Expense Recognition for Bond issued at 105Mason’s cash payment is $9,000 ($100,000 x 0.09) Amortization of the premium of $5,000 over 5 years is $1,000 per year.Interest expense recognized is $9,000 less $1,000 = $8,000

Expense Recognition for Bond issued at 105Mason’s cash payment is $9,000 ($100,000 x 0.09) Amortization of the premium of $5,000 over 5 years is $1,000 per year.Interest expense recognized is $9,000 less $1,000 = $8,000

Cash =

Carrying Value of

Bond Liability + Ret. Earn. Revenue - Expenses =

Net Income

Cash Flow

(9,000) = (1,000) + (8,000) n/a - 8,000 = (8,000) (9,000) OA

7-42


Distinguish between current and noncurrent assets and liabilities.

7-43

Current Versus Noncurrent

Current assets are expected to be converted to cash or consumed within one year or an

operating cycle, whichever is longer. Current assets include:

•Cash•Marketable Securities•Accounts Receivable•Short-Term Notes Receivable•Interest Receivable•Inventory•Supplies•Prepaid Items

•Cash•Marketable Securities•Accounts Receivable•Short-Term Notes Receivable•Interest Receivable•Inventory•Supplies•Prepaid Items

7-44

Current Versus Noncurrent

Current liabilities are due within one year or an operating cycle, whichever is longer. Current

liabilities, also called short-term liabilities, include:

•Accounts PayableAccounts Payable•Short-Term Notes PayableShort-Term Notes Payable•Wages PayableWages Payable•Taxes PayableTaxes Payable•Interest PayableInterest Payable

•Accounts PayableAccounts Payable•Short-Term Notes PayableShort-Term Notes Payable•Wages PayableWages Payable•Taxes PayableTaxes Payable•Interest PayableInterest Payable

7-45


Prepare a classified balance sheet.

7-47


Use the effective interest rate method to amortize bond discounts and premiums (Appendix).

7-48





Bond Selling Price

Mason Company

Investors







Bond Selling Price

Mason Company

Investors


7-49

Bonds Issued At A Discount – Effective Interest Rate

MethodInterest paid in cash each year is

$9,000.The effective interest rate method is

based on the market rate of interest on the day of issue and results in:o varying amount of interest expenseo related and varying addition to the

carrying value of the bonds each year.

7-50

Amortization Schedule for Bond Discount

7-51





Bond Selling Price

Mason Company

Investors

United Company issues bond with face value of $100,000Issued price is $107,985Stated Interest Rate = 10%; Effective rate of interest = 8%Interest Date = 12/31

Term of bond is 5 years

United Company issues bond with face value of $100,000Issued price is $107,985Stated Interest Rate = 10%; Effective rate of interest = 8%Interest Date = 12/31

Term of bond is 5 years



Bond Selling Price

Mason Company

Investors


7-52

Amortization Schedule for Bond Premium

7-53Effective Interest Rate Method to Amortize the

Premium.

See Exhibit 7.14. Cash of $10,000 is paid for interest. Interest expense of $8,639 is recognized and $1,361 is subtracted from the carrying value of the bond liability

See Exhibit 7.14. Cash of $10,000 is paid for interest. Interest expense of $8,639 is recognized and $1,361 is subtracted from the carrying value of the bond liability

7-54

End of Chapter Seven

accounting for liabilities chapter 7 copyright © 2012 by the mcgraw-hill companies, inc. all rights...

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