FINANCIAL ACCOUNTING CHAPTER 9 (up and until page 563)

1. LIABILITIES

Liability: present obligation which will be settled through an outflow of resources embodying
economic benefits
 Recognized on the balance sheet when it is probable that such an outflow will occur and the
amount of which can be measured reliably
 Liabilities are classified into current (short-term) and non-current (long-term) depending on the
timing of expected outflow of economic resources
Current/short-term liabilities: obligations due within one year or within a company’s normal
operating cycle  expressed in nominal amounts
Non-current/long-term liabilities: obligations due beyond the period of a current liability 
expressed in present values, taking into account the time value of money

 Size of a current liabilities is known for accounts payable, short-term notes payable, sales tax
payable, accrued liabilities, payroll liabilities, unearned revenues, and current portion of long-
term debt

ACCOUNTS PAYABLE
Accounts Payable/ trade payable: Amounts owed for products or services purchased on account 
typically short term, as credit terms are usually between 30 and 90 days

 Entities may decide to use different account names and different ways of aggregating its
liabilities

ACCRUED LIABILITIES (ACCRUED EXPENSES)

Accrued Liabilities: usually results from an expense the business has incurred but not yet paid.
Therefore, an accrued expense creates a liability, which explains why it is also called an accrued
expense (e.g. wages)  most accruals are short-term liabilities

UNEARNED REVENUES
Unearned Revenues (deferred revenues/revenues collected in advance): the business has received
cash from customers before earning the revenue  the company has an obligation to provide goods
or services to the customer

 Typically a current liability

 Journal entry: debit cash and credit unearned revenue
 Adjusting entry: debit unearned revenue and credit revenue (equity)

PAYROLL-RELATED LIABILITIES

 Payroll, also called employee compensation, is a substantial expense for many companies
Payroll-related liabilities: can take many different forms. The form is related to the industry or the
business the company operates in. Preferences of the company also play a role.

 Salary: employee pay stated at a monthly or yearly rate

 Wage: employee pay stated at an hourly rate
 Commission: percentage of the sales and employee has made (typical for sales employees)
 Bonus: amount over and above regular compensation

 salary expense represents gross pay

TWO BASIC SCHEMES IN RELATION TO EMPLOYEE’S POST-RETIREMENT OBLIGATIONS

1. defined contribution: employers contribute a fixed amount of money to an employee’s pension

funds and the employer’s obligation ends once the contribution has been made  as members
of the pension fund, the employees are able to use, invest or withdraw the contribution
accumulated subject to the fund’s rules and regulations
2. defined benefit plan: the employee is promised some post-retirement benefits, usually referred
to as pensions and companies may also provide other post-retirement benefits such as medical
insurance for retired employees  Company records pension and retirement benefit expenses
while employees work for the company

 as employees earn their pensions and the company pays into the pension pan, the plan’s assets
grow and at the end of each period, the company compares:
1. The fair market value of the assets in the retirement plans – cash and investments – with
2. The plans’ accumulated benefit obligation, which is the present value of promised future
payments to retirees
 The plan is said to be overfunded if the plan assets exceed the accumulated benefit obligations (in
this case the asset and obligation amounts are to be reported in the notes only)
OR
 The plan is said to be underfunded when the accumulated benefit obligation exceeds plan assets
 If this is the case, the company must report the excess liability amount as a long-term liability on
the balance sheet.

SALES TAX PAYABLE

Sales Tax Payable: liability account in which the aggregate amount of sales taxes that a business has
collected from customers on behalf of a governing tax authority is stored

 Usually called Goods and Services Tax (GST), Value Added Tax (VAT) or simply sales tax
 Retailers collect the tax from customers and thus owe the tax authority for dales tax collected
 Journal entries: debit cash (by the amount of the sales + tax), credit Sales Revenue (by the
amount of the sales) and credit Sales Tax Payable  assets, liabilities and equity increase
 When the sales tax payable is remitted to the tax authority: debit sales tax payable and credit
cash (by the amount of the tax)  no impact on revenue or equity
TAX PAYABLE
Tax Payable: Income tax payable is a liability that an entity incurs that is based on its reported level
of profitability
 Taxation rules vary from one jurisdiction to another
 Can be calculated as the prevailing tax rates multiplied by the profit before tax

PROVISIONS AND WARRANTIES

Provision: liabilities of uncertain timing and amount, the amount of an expense that an entity elects
to recognize now before it has precise information about the exact amount of the expense

 A business may know that a liability exists but not know its exact amount  must still report the
liability to perform services or repairs should the need arise on the balance sheet based on the
best estimated possible
 Many businesses guarantee their products under some form of warranty agreements  the
warranty period may extend from a short period to multiple years
 At the date of the sale however the company does not know which products are (or will be)
defective
 Information based on product testing on historical experience lead a company to estimate a
percentage of products/services that require warranty service and an average cost of the service
 percentage of defect products * sales (probability-weighted-expected value)
 Journal Entry: Debit Warranty Expense and credit Provision for Warranty Repairs

Warranty Expense 100

Provision for Warranty Repairs 100
to accrue warranty expense

When the company spent less on the warranty than expected (80):
Provision for Warranty Repairs 80
Inventory 80
to replace defective products under warranty

 At the end of the year, the company will repeat the process  starts by re-estimating the
required amount of provision and compares it to the current level of provisions  the difference
would be the warranty expense for next year
 The estimated warranty payable account probably won’t ever zero out

NOTES PAYABLE

 Depending on the maturity/ term of the note, you may have short-term notes, medium-term
notes or long-term notes

Short-term notes payable: may be issued to borrow cash or purchase assets  on its notes payable,
the business must accrue interest expense and interest payable at the end of the period

 Initial journal entry: debit inventory, credit notes payable

 at year end, the business must accrue interest expense  Journal entry: debit interest expense
(by the amount that was accumulated since the firm issued the note) and credit interest payable
 the balance sheet at year end will report eh note payable and the related interest payable as
current liabilities and the income statement will report interest expense
 Journal Entry at maturity: debit Note Payable, debit Interest Payable, debit Interest Expense
(remaining) and credit Cash (by the amount of the three)

DEBT
Current portion of long term debt (CPLTD): the part of the loan that is due in the coming financial
year, shown as a current liability. At the end of each year, an entity reclassifies (from long-term debt
to a current liability) the amount of its long-term debt that must be paid next year

CONTINGENT LIABILITIES
Contingent liability: is not an actual liability, is a disclosure item in the notes to the financial
statement.

 IAS-37 states that a contingent liability arises when:

 There is a possible obligation to be confirmed by a future event that is outside the control of
the entity; or
 A present obligation may, but probably will not, require an outflow of resources; or
 A sufficiently reliable estimate of the amount of a present obligation cannot be made

 Examples: corporate guarantees, law-suits, tax disputes or violations of environmental protection

laws
 There is no need to report a contingent loss that is unlikely to occur (an entity should wait until
new information is available to provide further clarity)

ARE ALL LIABILITIES REPORTED IN THE BALANCE SHEET?

 The big danger with liabilities is that a firm may fail to report a large debt on your balance
sheet which leads to understated liabilities and therefore also an understated debt ratio
 probably overstates the firm’s net income  leads to a better picture of the company than is
actually is

2. LONG-TERM LIABILITIES: BONDS

Bonds payable: groups of notes payable issued to multiple lenders, called bondholders
 companies can issue large amounts of cash by issuing bonds or notes payable

BONDS: AN INTRODUCTION
 Each bond payable is, in effect, a note payable
 Bonds payable are debts of the issuing company
 Purchasers of bonds receive a bond certificate which states the company’s name, the principle
stated in units of 1000$, the maturity date, the interest rate and the dates that the interest
payments are due
Principal: Bond´s face value, maturity value or par value
Maturity date: Date at which the issuing company has to pay the debt to the bondholders
Underwriter: purchases the bonds from the issuing company and resells them to its clients, or it may
sell the bonds to its clients and earn a commission on the sale

TYPES OF BONDS
Term bonds: All the bonds in a particular issue that mature at the same time
Serial bonds: All the bonds mature in installments over a period of time
Secured/mortgage bonds: are backed up by the right for the bondholder to claim specified assets of
the issuer if the company defaults

Debentures: unsecured bonds, backed only by the good faith of the borrower, carry higher rate of
interest than secured bonds because of higher risk

BOND PRICES
 Investors may buy and sell bonds through bond markets
 Bond prices are quoted at a percentage of their maturity value  A $1000 bond quoted at 100 is
bought or sold for $1000
 The price of the bond on the market may change while face value and interest payments do not
change

BOND PREMIUM AND BOND DISCOUNT

Premium: a bond issued at a price above its face (par) value

 Premium on bonds payable has a credit balance

Discount: a bonds issued at a price below its face (par) value

 Discount on bond payable has a debit balance  bond discount is a contra liability account
 as a bond nears maturity, its market price moves towards par value (premium decreases and
discount increases towards face value)
 on the maturity date, a bond’s market value equals its face value

TIME VALUE OF MONEY

 A dollar received today is worth more than a dollar to be received in the future  time value of
money
Present Value: The amount to invest now to receive more later

PRESENT VALUE DEPENDS ON

1. The amount of the future payment

2. The length of the time from investment date to maturity date
3. Interest rate during the period
BOND INTEREST RATES DETERMINE BOND PRICES
 Bonds are always sold at their market price, which is the amount investors will pay for the bond
Market price: the bond’s present value, which equals the present value of the principal payment plus
the present value of the interest payments
 Interest is usually paid semi-annually

TWO INTEREST RATES WORK TO SET THE PRICE OF A BOND

1. Stated interest rate (coupon rate): is the interest rate printed on the bond certificate, specifies
the amount of cash interest the borrower has to pay the lender (percentage of the bond’s face
value) (fixed)
2. Market interest rate (effective interest rate): the rate that investors demand for loaning their
money (can fluctuate after issuance of a bond)

Effective interest rate =

(stated interest rate+(1−bond price∈percentage )/ years¿ maturity)/bond price∈% ¿  YTM

Stated interest Rate = Market interest rate  Par

Stated interest Rate < Market interest rate  Discount
Stated interest Rate > Market interest rate  Premium

ISSUING BONDS PAYABLE AT PAR (FACE VALUE)

 does not have a premium nor a discount
 Assets and liabilities increase when a company issues bonds payable  Cash increases (debit),
Bonds Payable increases (credit), the borrower makes a one-time entry to record the receipt of
cash and the issuance of bonds
 payment of interest expense decreases assets and equity  Interest Expense increases (debit)
and Cash decreases (credit)  Bonds payable are not affected (face value * stated interest rate *
month/12)
 at year end, the company might have to accrue interest expense and interest payable 
increase/ debit Interest Expense and increase/credit Interest Payable (if the interest then is paid
 debit Interest payable and credit Cash)
 at maturity, the company pays of the bond  debit Bonds Payable and credit Cash (both by th
amount of the principle)

ISSUING BONDS PAYABLE AT A DISCOUNT

 When bonds are issued at discount, the lender has to note down the discount in an account
called “Discount on Bonds Payable”: contra account to Bonds Payable, a decrease in the
company’s liabilities
 Subtracting the discount from Bonds Payable yields the carrying amount of the bonds

HOW TO RECORD BONDS THAT TRADE AT A DISCOUNT

1. Issuing the bond: debit Cash (by the amount of the bond’s issuance price), debit Discount on
Bonds Payable (by the difference between the bond’s face value and issuance price), credit
Bonds Payable (by the amount of the face value)
 2. Paying interest (as calculated in amortization table): debit Interest Expense, credit Discount on
Bonds Payable, credit Cash OR in case of accrued interest: debit Interest Expense, credit Discount
on Bonds Payable, credit Interest Payable
3. Repay the bond: debit Bonds Payable, Credit Cash

WHAT IS THE INTEREST EXPENSE ON THESE BONDS PAYABLE?

 Interest expense increases as the bonds march toward maturity

 An amortization table does two things:
1. Determine the periodic interest expense
2. Show the bond’s carrying amount

INTEREST EXPENSE ON BONDS ISSUED AT A DISCOUNT

 The discount is allocated to interest expense through amortization over the term of the bond

The credit to Discount on Bonds Payable accomplishes two purposes:

1. It adjusts the carrying value of the bonds as they march upward towards maturity value
2. It amortizes the discount to interest expense

 The real interest expense exceeds the formal interest payment that is defined and fixed in the
contract, and it includes a reduction of the discount for which you have to pay for (interest
expense = interest payable + amortization of discount)
 The interest payment is fixed (face value * stated interest rate)
 The interest expense can be determined by multiplying the effective interest rate with the
carrying amount (face value – current discount) of the previous period
 Interest expense increases as the bond carrying amount increases/ as the bond approaches
maturity
 The discount account balance decreases when amortized
 At maturity, the discount is amortized to zero and the bond’s carrying amount will be the face
value

Interest Payment=Stated Interest Rate ( annually∨semi−annually ) × face value

Interest Expense=preceding bond carrying amount × market interest rate( annually∨semi−annually)

Discount amortization=Interest expense−Interest Payment

Discount Account Balance=Preceding Discount Accoiunt Balance−Discount Amortization

Bond Carrying amount=Face Value−Discount Account Balance

A B C D E
Interest Interest Interest Discount Amortization Discount Account Balance Bond Carrying amount
 Date Payment Expense (B – A) (Pre. D – C) (Face Value – D)
Example
Jan 1, 2013 4500 4807 307 3544 96456
Jan 1, 2014 4500 4823 323 3221 96779

PARTIAL-PERIOD INTEREST AMOUNT

 Companies don’t always issue bonds at the beginning or the end of their account year  They
issue bonds when market conditions are most favorable, and that can be any date
 Entry numbers have to be adjusted by multiplying by the time actually occurred (e.g. Interest
Expense * (2 months/12 months))

ISSUING BONDS PAYABLE AT A PREMIUM

 Premiums are rare
 The procedure is the same as for bonds at a discount, only that you now have to debit the
account “Premium on Bonds Payable” instead of credit the account “Discount on Bonds
Payable”. The cash outflow changes as well
 Bonds are amortized by the effective-interest method

HOW TO RECORD BONDS THAT TRADE AT A PREMIUM

1. Issuing the bond: debit Cash (by the issuance price), credit Premium on Bonds Payable (by the
difference between the face value and the issuance price) (liability), credit Bonds Payable (by the
face value)
2. Paying interest (as calculated in amortization table): debit Interest Expense, debit Premium on
Bonds Payable, credit Interest Payable or Cash
3. Repay the bond: debit Bonds Payable, credit Cash

INTEREST EXPENSE ON BONDS ISSUED AT PREMIUM

 The real interest expense is lower than the formal interest payment that is defined and fixed in
the contract  due to a reduction that derives from the premium

( Interest expense=Interest payment−Premium Amortization )

 Interest expense decreases as the bond carrying amount decreases  as the bond reaches
maturity
 The interest payment is fixed (face value * stated interest rate). The interest expense can be
determined by multiplying the effective interest rate with the carrying amount (face value +
current premium) of the previous period
 The premium balance decreases when amortized
 The bond carrying amount decreases from issuance until maturity

Premium Amortization=Interest Payment−Interest Expense

 Bond Carrying Amount=Face Value+ Premium Account Balance

A B C D E
Interest Interest Interest Premium Amortization Premium Account Bond Carrying Amount
Date Payment Expense (A – B) Balance (Pre. D – C) (Face Value + D)
Example
Jan 1, 2013 4500 4164 336 3764 103764
Jan 1, 2014 4500 4151 349 3415 103415

THE STRAIGHT-LINE AMORTIZATION METHOD: A QUICK WAY TO MEASURE

INTEREST EXPENSE
 Less precise way to amortize bond discount or premium

Straight-line amortization method: divides a bond discount (or premium) into equal periodic
amounts over the bond’s term  amount of interest expense is the same for each interest period

 This method is a simply “quick and dirty” way to estimate interest expense when the tools to use
the effective interest rate method are not available as required by IAS-39
 Not allowed by IAS 39

SHOULD WE RETIRE BONDS PAYABLE BEFORE THEIR MATURITY?

 Main reason to retire bonds early: to relieve the pressure of making high interest payments and
because the company may be able to borrow at a lower interest rate
 Some bonds are callable, which means that the issuer may call, or pay off, those bonds at a
prearranged price (this is the call price) whenever the issuer chooses  The call price is often a
percentage point or two above the par value, perhaps 101 or 102
 Callable bonds give the issuer the benefit of being able to pay off the bonds whenever it is most
favorable to do so
 The alternative to calling the bonds is to purchase them in the open market at their current
market price
 Gains and losses on early retirement of bonds payable are usually reported as Other income
 (loss) on the income statement

CONVERTIBLE BONDS AND NOTES

Convertible bonds: some corporate bonds that may be converted into the issuing company’s share
capital (also called convertible notes)

 For investors these bonds combine the safety of

a) assured receipt of interest and principal on the bonds, with
b) the opportunity for gains on the shares.
 The conversion feature can be so attractive that investors are willing to accept a lower interest
rate than they would on non-convertible bonds
 Conversion of the notes payable into share will decrease liabilities and increase equity
 If the investor converts the notes into shares, the company will report: Debit Notes Payable (by
the amount of the note), Credit Share Capital (by the amount of the shares * the share price par)
and credit Capital in Excess of Par (by the difference of the Notes Payable and the share Capital)
(Equity)
 The carrying amount of the notes ceases to be debt and becomes shareholders’ equity
 Share Capital is recorded at its par value, which is (for example) a dollar amount assigned to each
share
 The extra carrying amount of the notes payable is credited to another shareholders’ equity
account, Capital in Excess of Par