Slide

10-1

Chapter

10

McGraw-Hill/Irwin

LIABILITIES

The McGraw-Hill Companies, Inc.

Slide
10-2

The
The Nature
Nature of
of Liabilities
Liabilities
Defined
Defined as
as debts
debts or
or obligations
obligations
arising
arising from
from past
past transactions
transactions or
or
events.
events.
Maturity = 1 year or less

Maturity > 1 year

Current
Liabilities

Noncurrent
Liabilities
I.O.U.

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-3

Distinction
Distinction Between
Between
Debt
Debt and
and Equity
Equity
The acquisition of assets is financed from two
sources:
DEBT
DEBT

Funds from creditors, with

a definite due date, and
sometimes bearing
interest.
McGraw-Hill/Irwin

EQUITY
EQUITY

Funds from
owners

The McGraw-Hill Companies, Inc.

Slide
10-4

Liabilities
Liabilities Question
Question
Devon
Devon Mfg.
Mfg. borrows
borrows $100,000
$100,000 from
from First
First
Bank.
Bank. The
The loan
loan will
will be
be repaid
repaid in
in 20
20 years
years and
and
has
has an
an annual
annual interest
interest rate
rate of
of 8%.
8%.

Is
Is this
this aa current
current liability
liability or
or aa
noncurrent
noncurrent liability?
liability?
The
The obligation
obligation will
will not
not be
be paid
paid
within
within one
one year
year or
or one
one operating
operating
cycle,
cycle, so
so itit is
is aa noncurrent
noncurrent liability.
liability.
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-5

Evaluating
Evaluating Liquidity
Liquidity
An
An important
important indicator
indicator of
of aa companys
companys ability
ability
to
to meet
meet its
its current
current obligations.
obligations.
Two
Two commonly
commonly used
used measures:
measures:
Working Capital = Current Assets - Current Liabilities
Current Ratio = Current Assets Current Liabilities
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-6

Liabilities
Liabilities Question
Question
Devon
Devon Mfg.
Mfg. has
has current
current liabilities
liabilities of
of
$230,000
$230,000 and
and current
current assets
assets of
of $322,000.
$322,000.

What
What is
is Devons
Devons current
current ratio?
ratio?

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-7

Accounts
Accounts Payable
Payable
Short-term
Short-termobligations
obligationsto
tosuppliers
suppliersfor
for purchases
purchasesof
of
merchandise
merchandiseand
andto
to others
othersfor
for goods
goodsand
andservices.
services.

Office
Office
supplies
supplies
invoices
invoices

Merchandise
Merchandise
inventory
inventory
invoices
invoices
Shipping
Shipping
charges
charges
McGraw-Hill/Irwin

Utility
Utilityand
and
phone
phonebills
bills

The McGraw-Hill Companies, Inc.

Slide
10-8

Notes
Notes Payable
Payable
When
Whenaacompany
companyborrows
borrowsmoney,
money,aanote
notepayable
payable is
is
created.
created.

Current
Current Portion
Portion of
of Notes
Notes Payable
Payable
The
Theportion
portionof
of aanote
notepayable
payablethat
that is
isdue
duewithin
withinone
one
year,
year,or
orone
oneoperating
operatingcycle,
cycle,whichever
whicheveris
islonger.
longer.

Total Notes
Payable
McGraw-Hill/Irwin

Current Notes Payable

Noncurrent Notes Payable

The McGraw-Hill Companies, Inc.

Slide
10-9

Notes
Notes Payable
Payable
PROMISSORY NOTE
Miami, Fl
Location
Six months after this date
promises to pay to the order of
the sum of
of

12.0%

$10,000.00

Nov. 1, 2003
Date
Porter Company
Security National Bank
with interest at the rate

per annum.
signed
title

McGraw-Hill/Irwin

John Caldwell
treasurer

The McGraw-Hill Companies, Inc.

Slide
10-10

Notes
Notes Payable
Payable
On November 1, 2003, Porter Company
would make the following entry.

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-11

Interest
Interest Payable
Payable

Interest
Interest expense
expense is
is the
the

compensation
compensation to
to the
the lender
lender for
for
giving
giving up
up the
the use
use of
of money
money for
for aa
period
period of
of time.
time.

The
The liability
liability is
is called
called interest
interest
payable.
payable.

To
Tothe
the lender,
lender, interest
interest is
is aa revenue.
revenue.

To
Tothe
the borrower,
borrower, interest
interest is
is an
an

Interest
Rate
Up!

expense
expense..

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-12

Interest
Interest Payable
Payable
The
The interest
interest formula
formula includes
includes three
three variables
variables
that
that must
must be
be considered
considered when
when computing
computing
interest:
interest:
Interest = Principal Interest Rate Time
When
Whencomputing
computinginterest
interestfor
forone
oneyear,
year,Time
Time
equals
equals1.
1. When
Whenthe
thecomputation
computationperiod
periodis
isless
less
than
thanone
oneyear,
year,then
thenTime
Timeis
isaafraction.
fraction.
For
Forexample,
example,ififwe
weneeded
neededto
tocompute
computeinterest
interestfor
for
33months,
months,Time
Timewould
wouldbe
be3/12.
3/12.
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-13

Interest
Interest Payable
Payable Example
Example
What
What entry
entry would
would Porter
Porter Company
Company make
make
on
on December
December 31,
31, the
the fiscal
fiscal year-end?
year-end?

22
$10,00012%

$10,00012% //1212 == $200

$200
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-14

Payroll
Payroll Liabilities
Liabilities
Gross Pay
Net Pay

FICA Taxes
McGraw-Hill/Irwin

Medicare
Taxes

Federal
Income Tax

State and
Voluntary
Local Income Deductions
Taxes

The McGraw-Hill Companies, Inc.

Slide
10-15

Unearned
Unearned Revenue
Revenue
Cash
Cash is
is sometimes
sometimes collected
collected from
from the
the
customer
customer before
before the
the revenue
revenue is
is
actually
actually earned.
earned.
As the earnings
process is
completed .
Cash is
received
in
advance.
McGraw-Hill/Irwin

Deferred
revenue is
recorded.

aaliability
liabilityaccount.
account.

.
Earned
revenue is
recorded.

The McGraw-Hill Companies, Inc.

Slide
10-16

Long-Term
Long-Term Debt
Debt
Relatively
Relatively small
small debt
debt
needs
needs can
can be
be filled
filled from
from
single
single sources.
sources.

or
Banks
McGraw-Hill/Irwin

Insurance
Companies

or

Pension
Plans

The McGraw-Hill Companies, Inc.

Slide
10-17

Long-Term
Long-Term Debt
Debt
Large
Large debt
debt needs
needs are
are often
often
filled
filled by
by issuing
issuing bonds.
bonds.

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-18

Installment
Installment Notes
Notes Payable
Payable
Long-term
Long-term notes
notes that
that call
call for
for aa series
series of
of
installment
installment payments.
payments.

Each
Eachpayment
payment covers
covers
interest
interestfor
for the
theperiod
period
AND
ANDaaportion
portionof
ofthe
the
principal.
principal.
McGraw-Hill/Irwin

With
Witheach
eachpayment,
payment,the
the
interest
interest portion
portion gets
gets
smaller
smaller and
and the
theprincipal
principal
portion
portion gets
getslarger.
larger.

The McGraw-Hill Companies, Inc.

Slide
10-19

Allocating
Allocating Installment
Installment Payments
Payments
Between
Between Interest
Interest and
and Principal
Principal

Identify
Identify the
theunpaid
unpaid principal
principal

balance.
balance.

Unpaid
Unpaid Principal
Principal Interest
Interest rate
rate ==
Interest
Interest expense.
expense.

Installment
Installment payment
payment -- Interest
Interest
expense
expense == Reduction
Reduction in
in unpaid
unpaid
principal
principal balance.
balance.

Compute
Compute new
newunpaid
unpaid principal
principal
balance.
balance.
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-20

Allocating
Allocating Installment
Installment Payments
Payments
Between
Between Interest
Interest and
and Principal
Principal

On
On January
January 1,
1, 2003,
2003, Rocket
Rocket
Corp.
Corp. borrowed
borrowed $7,581.57
$7,581.57 from
from
First
First Bank
Bank of
of River
River City.
City. The
The
loan
loan was
was aa five-year
five-year loan
loan and
and
had
had an
an interest
interest rate
rate of
of 10%.
10%. The
The
annual
annual payment
payment is
is $2,000.
$2,000.
Prepare
Prepare an
an amortization
amortization table
table for
for
Rocket
Rocket Corp.s
Corp.s loan.
loan.
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-21

Allocating
Allocating Installment
Installment Payments
Payments
Between
Between Interest
Interest and
and Principal
Principal

Now,
Now,prepare
preparethe
theentry
entryfor
for the
thefirst
first payment
paymenton
on
December
December31,
31,2003.
2003.
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-22

Allocating
Allocating Installment
Installment Payments
Payments
Between
Between Interest
Interest and
and Principal
Principal
The
Theinformation
informationneeded
neededfor
for the
thejournal
journal entry
entrycan
canbe
be
found
foundon
onthe
theamortization
amortizationtable.
table. The
Thepayment
payment
amount,
amount,the
theinterest
interestexpense,
expense,and
andthe
the amount
amountto
to
credit
creditto
toprincipal
principalare
are all
allon
onthe
thetable.
table.

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-23

Bonds
Bonds Payable
Payable

Bonds usually
usually involve
involve the
the
Bonds

borrowing
borrowing of
of aa large
large sum
sum of
of
money,
money,called
called principal.
principal.

The principal
principal is
is usually
usually paid
paid
The
back
back as
as aa lump
lump sum
sum at
at the
the end
end
of
of the
the bond
bond period.
period.

Individual bonds
bonds are
are often
often
Individual
denominated
denominated with
with aa par
par value,
value,
or
or face
face value,
value, of
of $1,000.
$1,000.
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-24

Bonds
Bonds Payable
Payable
Bonds usually carry a stated
rate of interest, also called a
contract rate.

Interest is normally paid

semiannually.

Interest is computed as:

Interest
Interest == Principal
Principal Stated
Stated Rate
Rate Time
Time
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-25

Bonds
Bonds Payable
Payable

Bonds
Bonds are
are issued
issued through
through an
an

intermediary
intermediary called
called an
an
underwriter.
underwriter.

Bonds
Bonds can
can be
be sold
sold on
on organized
organized
securities
securities exchanges.
exchanges.

Bond
Bond prices
prices are
are usually
usually quoted
quoted
as
as aa percentage
percentage of
of the
the face
face
amount.
amount.

For
For example,
example, aa $1,000
$1,000 bond
bond

priced
priced at
at 102
102 would
would sell
sell for
for
$1,020.
$1,020.

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-26

Types
Types of
of Bonds
Bonds

Mortgage
Mortgage
Bonds
Bonds

Debenture
Debenture
Bonds
Bonds

Convertible
Convertible
Bonds
Bonds

Junk
JunkBonds
Bonds

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-27

Accounting
Accounting for
for Bonds
Bonds Payable
Payable
On
OnJanuary
January1,
1,2003,
2003, Rocket
Rocket Corp.
Corp. issues
issues$1,500,000
$1,500,000of
of
12%,
12%,10-year
10-yearbonds
bondspayable.
payable. Interest
Interest is
ispayable
payable
semiannually,
semiannually,each
eachJuly
July11and
andJanuary
January1.
1.
Assume
Assumethe
thebonds
bondsare
areissued
issued at
at face
face value.
value.
Record
Recordthe
theissuance
issuanceof
ofthe
thebonds.
bonds.

McGraw-Hill/Irwin

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Slide
10-28

Accounting
Accounting for
for Bonds
Bonds Payable
Payable
Record
Record the
the interest
interest payment
payment
on
on July
July 1,
1, 2003.
2003.

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-29

Bonds
Bonds Sold
Sold Between
Between Interest
Interest Dates
Dates

Bonds
Bonds are
are often
often sold
sold between
between interest
interest dates.
dates.

The
The selling
selling price
price of
of the
the bond
bond isis computed
computed as:
as:

McGraw-Hill/Irwin

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Slide
10-30

The
The Concept
Concept of
of Present
Present Value
Value

$1,000
invested
today at 10%.

Present
Present
Value
Value
McGraw-Hill/Irwin

In 5 years it
will be worth
$1,610.51.

Money can grow over time,

because it can earn interest.

In 25 years it
will be worth
$10,834.71!

Future
Future
Value
Value

The McGraw-Hill Companies, Inc.

Slide
10-31

The
The Concept
Concept of
of Present
Present Value
Value
How
How much
much isis aa future
future amount
amount worth
worth today?
today?
Three
Three pieces
pieces of
of information
information must
must be
be known
known to
to
solve
solve aa present
present value
value problem:
problem:
Present
The futureInterest
compounding periods
amount.
The
future
amount.
Value
The interest rate (i).
The interest rate (i).

Future
Value

The number of periods (n) the amount will be

The number of periods (n) the amount will be

Today
invested.

invested.

McGraw-Hill/Irwin

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Slide
10-32

The
The Concept
Concept of
of Present
Present Value
Value
Two types of cash flows are involved
with bonds:
Periodic interest payments called annuities.

Today

Maturity

Principal payment
at maturity.
McGraw-Hill/Irwin

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Slide
10-33

The
The Present
Present Value
Value Concept
Concept and
and
Bond
Bond Prices
Prices
The selling price of the bond is determined by
the market based
on the time value of money.

<

<

>

>

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-34

Early
Early Retirement
Retirement of
of Debt
Debt
B o n d s c a n b e re tire d b y . . .
E x e r c is in g a c a ll
p r o v is io n .

P u r c h a s in g th e
b o n d s o n th e
o p e n m a rk e t.

Gains
Gains or
orlosses
losses incurred
incurred as
as aa result
result of
of retiring
retiring bonds
bonds
should
should be
be reported
reported as
as extraordinary
extraordinaryitems
items on
on the
the
income
income statement.
statement.
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-35

Lease
Lease Payment
Payment Obligations
Obligations
Operating
Operating Leases
Leases

Capital
Capital Leases
Leases

Lessor
Lessor retains
retainsrisks
risks and
and
benefits
benefits associated
associatedwith
with
ownership.
ownership.

Lease
Leaseagreement
agreement transfers
transfers
risks
risksand
and benefits
benefits
associated
associatedwith
withownership
ownership
to
tolessee.
lessee.

Lessee
Lesseerecords
recordsrent
rent
expense
expense as
asincurred.
incurred.

Lessee
Lesseerecords
recordsaaleased
leased
asset
assetand
andlease
leaseliability.
liability.

McGraw-Hill/Irwin

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Slide
10-36

Capital
Capital Lease
Lease Criteria
Criteria
A le a s e m u s t b e r e c o r d e d a s
a C a p ita l L e a s e if it m e e ts
a n y o f th e fo llo w in g c r ite r ia .

T h e le a s e tr a n s fe r s
o w n e r s h ip to th e
le s s e e .

T h e le a s e c o n ta in s
a b a r g a in p u r c h a s e
o p tio n .

T h e le a s e te r m is e q u a l to
o r > 7 5 % o f th e e c o n o m ic
life o f th e p r o p e r ty .

T h e P V o f th e m in im u m
le a s e p a y m e n ts = 9 0 % o f
th e F M V o f th e p ro p e rty .

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-37

Pensions
Pensions
Employers
Employersoffer
offerpension
pension
plans
plansto
toemployees.
employees.

Retirees
Retireesreceive
receive
pension
pension
payments
paymentsfrom
from
the
thepension
pension
fund.
fund.
McGraw-Hill/Irwin

The
Theemployer
employermakes
makes
payments
paymentsto
toaapension
pension
fund.
fund. Usually,
Usually,this
thisis
isan
an
independent
independententity
entity
managed
managedby
byaa
professional
professionalfund
fund
manager.
manager.

The McGraw-Hill Companies, Inc.

Slide
10-38

Pensions
Pensions
Actuaries
Actuariesmake
makethe
thepension
pensionexpense
expense
computations,
computations,based
basedon:
on:

Averageage,
age,retirement
retirementage,
age,life
lifeexpectancy.
expectancy.
Average

Employeeturnover
turnoverrates.
rates.
Employee

Compensationlevels.
levels.
Compensation

Expectedrate
rateof
ofreturn
returnfor
forthe
thefund.
fund.
Expected
The
Theaccountant
accountantthen
thenposts
poststhe
theentry
entryto
to
record
recordpension
pension expense
expenseand
andpension
pension
liability.
liability.
McGraw-Hill/Irwin

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Slide
10-39

Other
Other Postretirement
Postretirement Benefits
Benefits
Many
Manycompanies
companiesoffer
offerbenefits
benefits
to
toretirees
retireesother
otherthan
thanpensions,
pensions,
such
suchas
ashealth
healthcoverage
coverageor
or
fitness
fitnessclub
clubmemberships.
memberships.

Unfunded liability
for nonpension
postretirement
benefits

McGraw-Hill/Irwin

Amount to
be funded
next year

Current
liability

Remainder
of unfunded
amount

Long-term
liability

The McGraw-Hill Companies, Inc.

Slide
10-40

Deferred
Deferred Income
Income Taxes
Taxes

Corporations pay
income taxes
quarterly.

McGraw-Hill/Irwin

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Slide
10-41

Deferred
Deferred Income
Income Taxes
Taxes
GAAP
GAAPis
isthe
theset
set of
of
rules
rulesfor
forpreparing
preparing
financial
financial statements.
statements.
Results in . . .

Financial
Financial statement
statement
income
incometax
taxexpense.
expense.

The
TheInternal
Internal Revenue
Revenue
Code
Codeis
isthe
theset
set of
of
rules
rulesfor
forpreparing
preparingtax
tax
returns.
returns.
Usually. . .

Results in . . .

IRS
IRSincome
incometaxes
taxes
payable.
payable.

The
The difference
difference between
between tax
tax expense
expense and
and tax
tax
payable
payable is
is recorded
recorded in
in an
an account
account called
called
deferred
deferred taxes.
taxes.
McGraw-Hill/Irwin

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Slide
10-42

Deferred
Deferred Income
Income Taxes
Taxes Example
Example
Examine the December 31, 2003, information
for X-Off Inc.

X-Off uses straight-line depreciation for financial

reporting and accelerated depreciation for
income tax reporting. X-Offs tax rate is 30%.
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.

Slide
10-43

Deferred
Deferred Income
Income Taxes
Taxes Example
Example
Compute X-Offs income tax expense
and income tax payable.
Income
Statement
Revenues
$ 1,000,000
Less:
Depreciation
200,000
Other expenses
650,000
Income before taxes $
150,000
Tax rate
Income taxes
McGraw-Hill/Irwin

30%
45,000

Tax
The
income
tax
The
income
tax
Return Difference

amount
amount computed
computed
based
basedon
onfinancial
financial
statement
statementincome
income
is
isincome
incometax
tax
expense
expensefor
forthe
the
period.
period.

The McGraw-Hill Companies, Inc.

Slide
10-44

Deferred
Deferred Income
Income Taxes
Taxes Example
Example
Compute X-Offs income tax expense
and income tax payable.
Income
Statement
Revenues
$ 1,000,000
Less:
Depreciation
200,000
Other expenses
650,000
Income before taxes $
150,000
Tax rate
Income taxes
McGraw-Hill/Irwin

Tax
Return
$ 1,000,000

30%
45,000 $

320,000
650,000
30,000
30%
9,000

Difference
Income
Income taxes
taxes

based
basedon
ontax
tax
return
return
income
incomeare
are
the
the taxes
taxes
payable
payablefor
for
the
theperiod.
period.

The McGraw-Hill Companies, Inc.

Slide
10-45

Deferred
Deferred Income
Income Taxes
Taxes Example
Example
The
Thedeferred
deferredtax
tax for
for the
theperiod
periodof
of$36,000
$36,000is
isthe
the
difference
differencebetween
betweenincome
incometax
taxexpense
expenseof
of $45,000
$45,000and
and
income
incometax
taxpayable
payableof
of$9,000.
$9,000.
Income
Statement
Revenues
$ 1,000,000
Less:
Depreciation
200,000
Other expenses
650,000
Income before taxes $
150,000
Tax rate
Income taxes
McGraw-Hill/Irwin

Tax
Return
$ 1,000,000

30%
45,000 $

320,000
650,000
30,000

Difference
$

(120,000)
120,000

30%
9,000 $

30%
36,000

The McGraw-Hill Companies, Inc.

Slide
10-46

Financial
Financial Leverage
Leverage
Borrowing at one rate and
investing at a higher rate.

McGraw-Hill/Irwin

If we borrow
$1,000,000 at 8% and
invest it at 10%, we
will clear $20,000
profit!

The McGraw-Hill Companies, Inc.

Slide
10-47

End
End of
of Chapter
Chapter 10
10
Are we
having fun
yet?

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc.