Financial Accounting

Weygandt, Kimmel, Kieso

Eleventh Edition

Chapter 10

Liabilities

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©2020 John Wiley & Sons, Inc. All rights reserved.

Financial Accounting

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Liabilities

Learning Objectives
LO 1 Explain how to account for current liabilities.
LO 2 Describe the major characteristics of bonds.
LO 3 Explain how to account for bond transactions.
LO 4 Explain how to account for long-term notes payable.
LO 5 Discuss how liabilities are reported and analyzed.

©2020 John Wiley & Sons, Inc. All rights reserved. 3

Learning Objective 1
Explain How to Account for Current Liabilities
What Is a Current Liability?
A debt that a company expects to pay within
• one year or
• the operating cycle, whichever is longer.
Current liabilities include notes payable, accounts payable,
unearned revenues, and accrued liabilities such as taxes payable,
salaries and wages payable, and interest payable.

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What Is a Current Liability?
Question

To be classified as a current liability, a debt must be expected to be

paid within:
a. one year.
b. the operating cycle.
c. 2 years.
d. (a) or (b), whichever is longer.

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What Is a Current Liability?
Answer

To be classified as a current liability, a debt must be expected to be

paid within:
a. one year.
b. the operating cycle.
c. 2 years.
d. Answer: (a) or (b), whichever is longer.

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Current Liabilities
Notes Payable

• Written promissory note.

• Frequently issued to meet short-term financing needs.
• Requires the borrower to pay interest.
• Issued for varying periods.

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Notes Payable
Data for Illustration

Illustration: First National Bank agrees to lend $100,000 on

September 1, 2022, if Cole Williams Co. signs a $100,000,
12%, four-month note maturing on January 1.
Instructions
a) Prepare the entry on September 1.
b) Prepare the adjusting entry on December 31, assuming
monthly adjusting entries have not been made.
c) Prepare the entry required on January 1, 2023, the
maturity date.

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Notes Payable
Sept. 1, 2022 entry and Dec. 31, 2022 entry

• Illustration: First National Bank agrees to lend $100,000 on

September 1, 2022, if Cole Williams Co. signs a $100,000, 12%,
four-month note maturing on January 1.
a) Prepare the entry on September 1.
Sept. 1 Cash 100,000
Notes Payable 100,000

b) Prepare the adjusting entry on December 31.

Dec. 31 Interest Expense 4,000
Interest Payable 4,000

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Notes Payable
Jan. 1, 2023 entry

Illustration: First National Bank agrees to lend $100,000 on

September 1, 2022, if Cole Williams Co. signs a $100,000, 12%,
four-month note maturing on January 1, 2023.
c) Prepare the entry at maturity.

Jan. 1 Notes Payable 100,000

Interest Payable 4,000
Cash 104,000

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Current Liabilities
Sales Taxes Payable

• Sales taxes are expressed as a stated percentage of the

sales price.
• Selling company (retailer)
o collects tax from the customer.
o enters tax separately in cash register or includes in total
receipts.
o remits the collections to the state’s department of
revenue.

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Sales Taxes Payable

• Illustration: The March 25 cash register reading for Cooley

Grocery shows sales of $10,000 and sales taxes of $600 (sales
tax rate of 6%), the journal entry is:

Mar. 25 Cash 10,600

Sales Revenue 10,000
Sales Taxes Payable 600

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Sales Taxes Payable
Another Illustration

Sometimes companies do not enter sales taxes separately in the

cash register.
Cooley Grocery enters total receipts of $10,600. Because the
amount received from the sale is equal to the sales price 100% plus
6% of sales, (sales tax rate of 6%), the journal entry is:

Mar. 25 Cash 10,600

Sales Revenue 10,000*
Sales Taxes Payable 600
*$10,600 ÷ 1.06 = $10,000

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Current Liabilities
Unearned Revenues

Revenues received before the company

• delivers goods or
• provides services.

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Unearned Revenue
Journal Entries

Illustration: Superior University sells 10,000 season football tickets

at $50 each for its five-game home schedule. The entry for the sale
of season tickets is:
Aug. 6 Cash (10,000 x $50) 500,000
Unearned Ticket Revenue 500,000

As each game is completed, Superior records the recognition

of revenue with the following entry.
Sept. 7 Unearned Ticket Revenue 100,000*
Ticket Revenue 100,000
(*$500,000 ÷ 5)

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Current Liabilities
Current Maturities of Long-Term Debt

• Portion of long-term debt that comes due in the current year.

• No adjusting entry required.
Illustration: Wendy Construction issues a five-year, interest-bearing
$25,000 note on January 1, 2022. This note specifies that each
January 1, starting January 1, 2023, Wendy should pay $5,000 of
the note. When the company prepares financial statements on
December 31, 2022,
1. What amount should be reported as a current liability? $5,000
2. What amount should be reported as a long-term liability? $20,000

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DO IT! 1a: Current Liabilities
Question and Solution for Part 1

You and several classmates are studying for the next

accounting examination. They ask you to answer the following
questions.
1. If cash is borrowed on a $50,000, six-month, 12% note on
September 1, how much interest expense would be
incurred by December 31?
Solution
4
$50, 000×12%× = $2, 000
12

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DO IT! 1a: Current Liabilities
Question and Solution for Part 2

You and several classmates are studying for the next accounting
examination. They ask you to answer the following questions.
2. How is the sales tax amount determined when the cash register
total includes sales taxes?
Solution
First, divide the total cash register receipts by 100% plus the sales
tax percentage to find the sales revenue amount.
Second, subtract the sales revenue amount from the total cash
register receipts to determine the sales taxes.

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DO IT! 1a: Current Liabilities
Question and Solution for Part 3

You and several classmates are studying for the next

accounting examination. They ask you to answer the following
questions.
3. If $15,000 is collected in advance on November 1 for three
months’ rent, what amount of rent revenue should be
recognized by December 31?
Solution
2
$15, 000× = $10, 000
3

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Current Liabilities
Payroll and Payroll Taxes Payable

The term “payroll” pertains to both:

Salaries - managerial, administrative, and sales personnel
(monthly or yearly rate).
Wages - store clerks, factory employees, and manual
laborers (rate per hour).
Determining the payroll involves computing three amounts:
(1) gross earnings, (2) payroll deductions, and (3) net pay.

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Payroll and Payroll Taxes Payable
Gross Pay – Payroll Deductions = Net Pay

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Payroll and Payroll Taxes Payable
Journal Entries to Record Payroll and Pay Payroll

Illustration: Assume Cargo Corporation records its payroll for the

week of March 7 as follows:
Mar. 7 Salaries and Wages Expense 100,000
FICA Taxes Payable 7,650
Federal Income Taxes Payable 21,864
State Income Taxes Payable 2,922
Salaries and Wages Payable 67,564

Record the payment of this payroll on March 7.

Mar. 7 Salaries and Wages Payable 67,564
Cash 67,564

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Payroll and Payroll Taxes Payable
Payroll Tax Expense

Payroll tax expense results from additional taxes that

governmental agencies levy on employers.
These taxes are:
• Employer’s share of FICA (Social Security and Medicare)
taxes
• Federal unemployment taxes
• State unemployment taxes

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Payroll and Payroll Taxes Payable
Journal Entry to Record Payroll Taxes

Illustration: Based on Cargo Corp.’s $100,000 payroll, the

company would record the employer’s expense and liability
for these payroll taxes as follows.
Mar. 7 Payroll Tax Expense 13,850
FICA Taxes Payable 7,650
Federal Unemployment Taxes Payable 800
State Unemployment Taxes Payable 5,400

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Payroll and Payroll Taxes Payable
Question

Employer payroll taxes do not include:

a. Federal unemployment taxes.
b. State unemployment taxes.
c. Federal income taxes.
d. FICA taxes.

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Payroll and Payroll Taxes Payable
Answer

Employer payroll taxes do not include:

a. Federal unemployment taxes.
b. State unemployment taxes.
c. Answer: Federal income taxes.
d. FICA taxes.

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Anatomy of a Fraud
Art was a custodial supervisor for a large school district. The district was supposed to employ
between 35 and 40 regular custodians, as well as 3 or 4 substitute custodians to fill in when regular
custodians were absent. Instead, in addition to the regular custodians, Art “hired” 77 substitutes. In
fact, almost none of these people worked for the district. Instead, Art submitted time cards for these
people, collected their checks at the district office, and personally distributed the checks to the
“employees.” If a substitute’s check was for $1,200, that person would cash the check, keep $200, and
pay Art $1,000.
Total take: $150,000
The Missing Controls
Human resource controls. Thorough background checks should be performed. No employees should
begin work until they have been approved by the Board of Education and entered into the payroll
system. No employees should be entered into the payroll system until they have been approved by a
supervisor. All paychecks should be distributed directly to employees at the official school locations
by designated employees or direct-deposited into approved employee bank accounts.
Independent internal verification. Budgets should be reviewed monthly to identify situations where
actual costs significantly exceed budgeted amounts.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 164 to 171.

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DO IT! 1b: Wages And Payroll Taxes

During the month of September, Lake Corporation’s employees

earned wages of $60,000. Withholdings related to these wages
were $4,590 for FICA, $6,500 for federal income tax, and $2,000 for
state income tax. Costs incurred for unemployment taxes were $90
for federal and $150 for state.
Prepare the September 30 journal entries for
a) salaries and wages expense and salaries and wages payable,
assuming that all September wages will be paid in October, and
b) the company’s payroll tax expense.

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DO IT! 1b: Wages and Payroll Taxes
Journal Entry to Record Payroll

Prepare the September 30 journal entries for

a) salaries and wages expense and salaries and wages payable,
assuming that all September wages will be paid in October.

Sept. 30 Salaries and Wages Expense 60,000

FICA Taxes Payable 4,590
Federal Income Taxes Payable 6,500
State Income Taxes Payable 2,000
Salaries and Wages Payable 46,910

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DO IT! 1b: Wages and Payroll Taxes
Journal Entry to Record Payroll Tax Expense

Prepare the September 30 journal entries for

b) the company’s payroll tax expense.

Sept. 30 Payroll Tax Expense 4,830

FICA Taxes Payable 4,590
Federal Unemployment Taxes Payable 90
State Unemployment Taxes Payable 150

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Learning Objective 2
Describe the Major Characteristics of Bonds
Long-term liabilities are obligations that are expected to be
paid more than one year in the future.
Bonds are a form of interest-bearing notes payable.
• Sold in small denominations (usually $1,000 or multiples of
$1,000).
• Attract many investors.
• Corporation issuing bonds is borrowing money.
• Person who buys the bonds (the bondholder) is lending
money.

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Types of Bonds

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Bonds
Issuing Procedures

• State laws grant corporations the power to issue bonds.

• Board of directors and stockholders must approve bond
issues.
• Board of directors must stipulate number of bonds to be
authorized, total face value, and contractual interest rate.
• Bond terms set forth in legal document known as a bond
indenture.
• Bond certificate, typically a $1,000 face value.

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Bonds
Issuing Procedures (continued)

• Represents a promise to pay:

o sum of money at designated maturity date, plus
o periodic interest at a contractual (stated) rate on the maturity
amount (face value).
• Interest payments usually made semiannually.
• Issued to obtain large amounts of long-term capital.
• Investment company sells the bonds for the issuing
company.

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Bonds
Example

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Bond Trading

Bondholders can sell their bonds on national exchanges.

• Bond prices are quoted as a percentage of the face value.
• A quoted price of 97 means 97% of face value.

Time Warner Cable has outstanding 6.75%, $1,000 bonds that

mature in 2039. They currently yield a 5.49% return. At the close of
trading, the price was 116.4% of face value, or $1,164.

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Determining the Market Value of a Bond

Current market price (present value) is a function of three

factors:
1. dollar amounts to be received,
2. length of time until the amounts are received, and
3. market rate of interest.
The market interest rate is the rate investors demand for
loaning funds.

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Determining the Market Value of a Bond
(Continued)
Illustration: Assume that Acropolis Company on January 1, 2022,
issues $100,000 of 9% bonds, due in five years, with interest
payable annually at year-end. The purchaser of the bonds would
receive the following two types of cash payments: (1) principal of
$100,000 to be paid at maturity, and (2) five $9,000 interest
payments ($100,000 × 9%) over the term of the bonds.

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Determining the Market Value of a Bond
Calculation

The current market price of a bond is equal to the present

value of all the future cash payments promised by the bond.

Using present value tables, the computations in this example

are $100,000 × .64993 = $64,993, and $9,000 × 3.88965 =
$35,007 (rounded).

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Investor Insight
Running Hot!
Recently, the market for bonds was running hot. For example, consider
these two large deals: Apple Inc. sold $17 billion of debt, which at the
time was the largest corporate bond ever issued. But shortly thereafter,
it was beaten by Verizon Communications Inc., which sold $49 billion of
debt. The chart highlights the increased issuance of bonds.
As one expert noted about these increases, “Companies are taking
advantage of this lower-rate environment in the limited period of time it
is going to be around.” An interesting aspect of these bond issuances is
that some companies, like Philip Morris International, Medtronic, and
Simon Property Group, are even selling 30-year bonds. These bonds
issuers are benefitting from “a massive sentiment shift,” says one bond
expert. The belief that the economy will continue to improve is making
investors more comfortable holding longer-term bonds, as they search
for investments that offer better returns than U.S. Treasury bonds.
Sources: Vipal Monga, “The Big Number,” Wall Street Journal (March 20,
2012), p. B5; and Mike Cherney, “Renewed Embrace of Bonds Sparks
Boom,” Wall Street Journal (March 8-9, 2014), p. B5.

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Investor Insight (Question and Answer)

Running Hot!
What are the advantages for companies of
issuing 30-year bonds instead of 5-year bonds?
Answer:
The major advantages for companies are to
extend their debt and to pay low interest rates.
This locks in these low rates for a considerable
period of time.

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DO IT! 2: Bond Terminology
State whether each of the following statements is true or false. If
false, indicate how to correct the statement.

True 1. Mortgage bonds and sinking fund bonds are both

examples of secured bonds.
True 2. Unsecured bonds are also known as debenture bonds.
False 3. The contractual interest rate is the rate investors demand
for loaning finds.
True 4. The face value is the amount of principal the issuing
company must pay at the maturity date.
False 5. The market price of a bond is equal to its face value.

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Learning Objective 3
Explain How to Account for Bond Transactions
Corporation records bond transactions when it
• issues (sells),
• redeems (buys back) bonds, and
• when bondholders convert bonds into common stock.
Note: If bondholders sell their bond investments to other
investors, the issuing company receives no further money on
the transaction, nor does the issuing company journalize the
transaction.

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Issuing Bonds at Face Value

Illustration: On January 1, 2022, Candlestick, Inc. issues $100,000,

five-year, 10% bonds at 100 (100% of face value). The entry to
record the sale is:

Jan. 1 Cash 100,000

Bonds Payable 100,000

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Issuing Bonds at Face Value
Adjusting Entry on Dec. 31, 2022

Illustration: On January 1, 2022, Candlestick, Inc. issues $100,000,

five-year, 10% bonds at 100 (100% of face value). Assume that
interest is payable annually on January 1. At December 31, 2022,
Candlestick recognizes interest expense incurred with the following
entry. Assume monthly accruals have not been made.

Dec. 31 Interest Expense 10,000

Interest Payable 10,000

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Issuing Bonds at Face Value
Payment of Interest on January 1, 2023

Illustration: On January 1, 2022, Candlestick, Inc. issues

$100,000, five-year, 10% bonds at 100 (100% of face
value). Assume that interest is payable annually on
January 1. Candlestick records the payment on January 1,
2023 as follows.
Jan. 1 Interest Payable 10,000
Cash 10,000

LO 3 ©2020 John Wiley & Sons, Inc. All rights reserved. 46

Accounting for Bond Transactions

Issue at Face Value, Discount, or Premium?

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Accounting for Bond Transactions
Question

The rate of interest investors demand for loaning funds to a

corporation is the:
a. contractual interest rate.
b. face value rate.
c. market interest rate.
d. stated interest rate.

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Accounting for Bond Transactions
Answer

The rate of interest investors demand for loaning funds to a

corporation is the:
a. contractual interest rate.
b. face value rate.
c. Answer: market interest rate.
d. stated interest rate.

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Issuing Bonds at a Discount

Illustration: On January 1, 2022,

Candlestick, Inc. sells $100,000, five-year,
10% bonds for $98,000 (98% of face
value). Interest is payable annually
January 1. The entry to record the
issuance is:

Jan. 1 Cash 98,000

Discount on Bonds Payable 2,000
Bonds Payable 100,000

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Issuing Bonds at a Discount
Statement Presentation

Sale of bonds below face value (discount) =

total cost of borrowing > interest paid.
Reason: Borrower is required to pay the bond discount at the
maturity date. Therefore, the bond discount is considered to be an
increase in the cost of borrowing.
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Issuing Bonds at a Discount
Total Cost of Borrowing

OR

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Issuing Bonds at a Discount
Effect of Bond Discount Amortization on Carrying Value

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Issuing Bonds at a Discount
Question

Discount on Bonds Payable:

a. has a credit balance.
b. is a contra account.
c. is added to bonds payable on the balance sheet.
d. increases over the term of the bonds.

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Issuing Bonds at a Discount
Answer

Discount on Bonds Payable:

a. has a credit balance.
b. Answer: is a contra account.
c. is added to bonds payable on the balance sheet.
d. increases over the term of the bonds.

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Issuing Bonds at a Premium
Statement Presentation

Sale of bonds above face value (premium) =

total cost of borrowing < interest paid.
Reason: Borrower is not required to pay the bond premium at the
maturity date of the bonds. Therefore, the bond premium is
considered to be a reduction in the cost of borrowing.

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Issuing Bonds at a Premium

Illustration: On January 1, 2022,

Candlestick, Inc. sells $100,000, five-
year, 10% bonds for $102,000 (102%
of face value). Interest is payable
annually January 1. The entry to
record the issuance is:

Jan. 1 Cash 102,000

Bonds Payable 100,000
Premium on Bonds Payable 2,000

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Issuing Bonds at a Premium
Total Cost of Borrowing

OR

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Issuing Bonds at a Premium
Effect of Bond Premium Amortization on Carrying Value

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DO IT! 3a Bond Issuance

Giant Corporation issues $200,000 of bonds for $189,000. (a)

Prepare the journal entry to record the issuance of the bonds, and
(b) show how the bonds would be reported on the balance sheet at
the date of issuance.
Solution
a)Cash 189,000
Discount on Bonds Payable 11,000
Bonds Payable 200,000
b)Long-term liabilities
Bonds payable $200,000
Less: Discount on bonds payable 11,000 $189,000

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Accounting for Bond Transactions
Bonds Issued at Premium Question

Karson Inc. issues 10-year bonds with a maturity value of

$200,000. If the bonds are issued at a premium, this indicates
that:
a. the contractual interest rate exceeds the market
interest rate.
b. the market interest rate exceeds the contractual
interest rate.
c. the contractual interest rate and the market interest
rate are the same.
d. no relationship exists between the two rates.
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Accounting for Bond Transactions
Bonds Issued at Premium Answer

Karson Inc. issues 10-year bonds with a maturity value of $200,000.

If the bonds are issued at a premium, this indicates that:
a. Answer: the contractual interest rate exceeds the market
interest rate.
b. the market interest rate exceeds the contractual interest
rate.
c. the contractual interest rate and the market interest rate are
the same.
d. no relationship exists between the two rates.

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Redeeming Bonds at Maturity

Assuming that the company pays and records separately the

interest for the last interest period, Candlestick records the
redemption of its bonds at maturity as follows:

Jan. 1 Bonds Payable 100,000

Cash 100,000

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Redeeming Bonds before Maturity

When bonds are redeemed before maturity, it is necessary to:

1. eliminate carrying value of bonds at redemption date;
2. record cash paid; and
3. recognize gain or loss on redemption.
The carrying value of the bonds is the face value of the bonds
less any remaining bond discount or plus any remaining bond
premium at the redemption date.

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Redeeming Bonds before Maturity
Question

When bonds are redeemed before maturity, the gain or loss

on redemption is the difference between the cash paid and
the:
a. carrying value of the bonds.
b. face value of the bonds.
c. original selling price of the bonds.
d. maturity value of the bonds.

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Redeeming Bonds before Maturity
Answer

When bonds are redeemed before maturity, the gain or loss

on redemption is the difference between the cash paid and
the:
a. Answer: carrying value of the bonds.
b. face value of the bonds.
c. original selling price of the bonds.
d. maturity value of the bonds.

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Redeeming Bonds before Maturity
Illustration

Assume Candlestick, Inc. has sold its bonds at a premium. At

the end of the fourth period, Candlestick retires these bonds
at 103 after paying the annual interest. The carrying value of
the bonds at the redemption date is $100,400. Candlestick
makes the following entry to record the redemption at the
end of the fourth interest period (January 1, 2026):

Jan. 1 Bonds Payable 100,000

Premium on Bonds Payable 400
Loss on Bond Redemption 2,600
Cash 103,000

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People, Planet, and Profit Insight
How About Some Green Bonds?
Green bonds are debt used to fund activities such as renewable-energy
projects. For example, a company may use the proceeds from the sale of
green bonds to clean up its manufacturing operations and cut waste (such as
that related to energy consumption).
The use of green bonds has taken off as companies now have guidelines as to
how to disclose and report on these green-bond proceeds. These
standardized disclosures provide transparency as to how these bonds are
used and their effect on overall profitability.
Investors are taking a strong interest in these bonds. Investing companies are
installing socially responsible investing teams and have started to integrate
sustainability into their investment processes. The disclosures of how
companies are using the bond proceeds help investors to make better
financial decisions.
Source: Ben Edwards, “Green Bonds Catch On,” Wall Street Journal (April 3,
2014), p. C5.

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People, Planet, and Profit Insight (Question
and Answer)
How About Some Green Bonds?
Why might standardized disclosure help investors
to better understand how proceeds from the sale
or issuance of bonds are used?

Answer:
By requiring transparency as to how a bond's
proceeds are to be used and how it will affect a
company's sustainable profitability, investors will
make better financial decisions.

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DO IT! 3b Bond Redemption

R & B Inc. issued $500,000, 10-year bonds at a discount. Prior to

maturity, when the carrying value of the bonds is $496,000, the
company redeems the bonds at 98. Prepare the entry to record the
redemption of the bonds.
Solution
Bonds Payable 500,000
Discount on Bonds Payable 4,000
Gain on Bond Redemption 6,000
Cash ($500,000 × 98%) 490,000

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Learning Objective 4
Explain How to Account for Long-Term Notes Payable

Accounting for Long-Term Notes Payable

• May be secured by a mortgage that pledges title to specific
assets as security for a loan.
• Typically, the terms require the borrower to make
installment payments over the term of the loan. Each
payment consists of
o interest on the unpaid balance of the loan and
o a reduction of loan principal.
• Companies initially record mortgage notes payable at face
value.
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Accounting for Long-Term Notes Payable
Interest Expense and Reduction of Principal

Illustration: Porter Technology Inc. issues a $500,000, 8%, 20-year

mortgage note on December 31, 2022. The terms provide for
annual installment payments of $50,926 (not including real estate
taxes and insurance).

LO 4 ©2020 John Wiley & Sons, Inc. All rights reserved. 72

Accounting for Long-Term Notes Payable
Entries to Record Mortgage and Make First Payment

Illustration: Porter Technology Inc. issues a $500,000, 8%, 20-year

mortgage note on December 31, 2022. The terms provide for
annual installment payments of $50,926 (not including real estate
taxes and insurance). Prepare the entries to record the mortgage
and first payment.
Dec. 31, 2022 Cash 500,000
Mortgage Payable 500,000
Dec. 31, 2023 Interest Expense 40,000
Mortgage Payable 10,926
Cash 50,926

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Accounting for Long-Term Notes Payable
Question

Each payment on a mortgage note payable consists of:

a. interest on the original balance of the loan.
b. reduction of loan principal only.
c. interest on the original balance of the loan and
reduction of loan principal.
d. interest on the unpaid balance of the loan and
reduction of loan principal.

LO 4 ©2020 John Wiley & Sons, Inc. All rights reserved. 74

Accounting for Long-Term Notes Payable
Answer

Each payment on a mortgage note payable consists of:

a. interest on the original balance of the loan.
b. reduction of loan principal only.
c. interest on the original balance of the loan and
reduction of loan principal.
d. Answer: interest on the unpaid balance of the loan and
reduction of loan principal.

LO 4 ©2020 John Wiley & Sons, Inc. All rights reserved. 75

DO IT! 4 Long-Term Notes

Cole Research issues a $250,000, 6%, 20-year mortgage note to obtain

needed financing for a new lab. The terms call for annual payments of
$21,796 each. Prepare the entries to record the mortgage loan and the
first payment.
Solution

Cash 250,000
Mortgage Payable 250,000
Interest Expense ($250,000 × 6%) 15,000
Mortgage Payable 6,796
Cash 21,796

LO 4 ©2020 John Wiley & Sons, Inc. All rights reserved. 76

Learning Objective 5
Discuss How Liabilities Are Reported and Analyzed

Presentation on the Balance Sheet

• Current liabilities are the first category.
• Companies list each of the principal types of current
liabilities separately within the category.
• Companies disclose the terms of notes payable and other
key information about the individual items in the notes to
the financial statements.
• Companies seldom list current liabilities in the order of
liquidity.
LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 77
Presentation

LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 78

Analysis

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Liquidity

Liquidity refers to the ability to pay maturing obligations and

meet unexpected needs for cash.
The relationship of current assets to current liabilities is
critical in analyzing liquidity. We can express this relationship
as a
• dollar amount (working capital) and
• ratio (current ratio).

LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 80

Liquidity
Working Capital and Current Ratio

Working capital is the excess of current assets over current

liabilities.

The current ratio permits us to compare the liquidity of different-

sized companies and of a single company at different times.

LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 81

Solvency

Solvency refers to the ability of a company to survive over a

long period of time.
Two ratios that provide information about long-run solvency
and the ability to meet interest payments as they come due
are:
• Debt to Assets Ratio
• Times Interest Earned

LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 82

Solvency
Debt to Assets Ratio

Illustration: General Motors reported total liabilities of $176,282

million and total assets of $212,482 million. General Motors’ debt
to assets ratio is 83%.

The higher the percentage of debt to assets, the greater the risk
that the company may be unable to meet its maturing obligations.

LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 83

Solvency
Times Interest Earned

Illustration: General Motors in 2017 reported a net loss of $3,882

million, interest expense of $575 million, and income tax expense
of $11,533 million. General Motors’ times interest earned is 14.3
times.

Times interest earned indicates the company’s ability to meet

interest payments as they come due.

LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 84

Investor Insight
Debt Masking

In the wake of the financial crisis of 2008, many financial

institutions are wary of reporting too much debt on their financial
statements, for fear that investors will consider them too risky. The
Securities and Exchange Commission (SEC) is concerned that some
companies engage in “debt masking” to make it appear that they
have less debt than they actually do. These companies enter into
transactions at the end of the accounting period that essentially
remove debt from their books. Shortly after the end of the period,
they reverse the transaction and the debt goes back on their
books. The Wall Street Journal reported that 18 large banks “had
consistently lowered one type of debt at the end of each of the
past five quarters, reducing it on average by 42% from quarterly
peaks.”
Source: Tom McGinty, Kate Kelly, and Kara Scannell, “Debt
‘Masking’ Under Fire,” Wall Street Journal Online (April 21, 2010).

LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 85

Investor Insight
Debt Masking (Question and Answer)

What implications does debt masking have for an investor that is

using the debt to assets ratio to evaluate a company’s solvency?

Answer:
Since the debt to assets ratio is calculated using financial
statement numbers from the end of the accounting period, debt
masking could result in investors making incorrect assumptions
about a company's solvency. By engaging in debt masking, a
company is misleading investors because what it is disclosing at
the end of the period does not reflect what its normal financial
position was during most of the accounting period.

LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 86

Use of Ratios
Question

Working capital is calculated as:

a. current assets minus current liabilities.
b. total assets minus total liabilities.
c. long-term liabilities minus current liabilities.
d. both (b) and (c).

LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 87

Use of Ratios
Answer

Working capital is calculated as:

a. Answer: current assets minus current liabilities.
b. total assets minus total liabilities.
c. long-term liabilities minus current liabilities.
d. both (b) and (c).

LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 88

Debt and Equity Financing

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Debt and Equity Financing (Continued)
Illustration: Microsystems, Inc. is considering two plans for financing the
construction of a new $5 million plant. Plan A involves issuing 200,000 shares of
common stock at the current market price of $25 per share. Plan B involves
issuance of $5 million, 8% bonds at face value. Income before interest and taxes
on the new plant will be $1.5 million. Income taxes are expected to be 30%.
Microsystems currently has 100,000 shares of common stock outstanding.

LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 90

DO IT! 5 Analyzing Liabilities
Part a

Trout Company balance sheet information as of December 31, 2022.

Current assets $10,500 Current liabilities $ 8,000
Long-term assets 24,200 Long-term liabilities 16,000
Total assets $34,700 Stockholders’ equity 10,700
Total liabilities and
stockholders’ equity $34,700

In addition, Trout reported net income for 2022 of $14,000, income tax expense
of $2,800, and interest expense of $900.
Instructions
a) Compute the current ratio and working capital for Trout for 2022.
Current ratio is 1.31:1 ($10,500 ÷ $8,000).
Working capital is $2,500 ($10,500 − $8,000).
LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 91
DO IT! 5 Analyzing Liabilities
Part b
Trout Company balance sheet information as of December 31, 2022.
Current assets $10,500 Current liabilities $ 8,000
Long-term assets 24,200 Long-term liabilities 16,000
Total assets $34,700 Stockholders’ equity 10,700
Total liabilities and
stockholders’ equity $34,700

In addition, Trout reported net income for 2022 of $14,000, income tax expense of
$2,800, and interest expense of $900.
Instructions
b) Assume that at the end of 2022, Trout used $2,000 cash to pay off $2,000 of
accounts payable. How would the current ratio and working capital have changed?

Current ratio is 1.42:1 ($8,500 ÷ $6,000).

Working capital is $2,500 ($8,500 − $6,000).
LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 92
DO IT! 5 Analyzing Liabilities
Part c
Trout Company balance sheet information as of December 31, 2022.
Current assets $10,500 Current liabilities $ 8,000
Long-term assets 24,200 Long-term liabilities 16,000
Total assets $34,700 Stockholders’ equity 10,700
Total liabilities and
stockholders’ equity $34,700
In addition, Trout reported net income for 2022 of $14,000, income tax expense of
$2,800, and interest expense of $900.
Instructions
c) Compute the debt to assets ratio and the times interest earned for Trout for 2022.

Debt to assets ratio is 69.2% ($24,000 ÷ $34,700).

Times interest earned is 19.67 times [($14,000 + $2,800 + $900) ÷ $900].

LO 5 ©2020 John Wiley & Sons, Inc. All rights reserved. 93

Learning Objective 6
Apply the Straight-Line Method of Amortizing Bond Discount
and Bond Premium
Amortizing Bond Discount
Illustration: Candlestick, Inc., sold $100,000, five-year, 10%
bonds on January 1, 2022, for $98,000 (discount of $2,000).
Interest is payable on January 1.

LO 6 ©2020 John Wiley & Sons, Inc. All rights reserved. 94

Amortizing Bond Discount
Journal Entry to Record Interest and Discount Amortization

Illustration: Candlestick, Inc., sold $100,000, five-year, 10% bonds

on January 1, 2022, for $98,000 (discount of $2,000). Interest is
payable on January 1. The bond discount amortization for each
interest period is $400 ($2,000 ÷ 5).
The journal entry to record the first accrual of bond interest and
the amortization of bond discount on December 31 is as follows.

Dec. 31 Interest Expense 10,400

Discount on Bonds Payable 400
Interest Payable ($100,000 x 10%) 10,000

LO 6 ©2020 John Wiley & Sons, Inc. All rights reserved. 95

Amortizing Bond Premium
Illustration: Candlestick, Inc., sold $100,000, five-year, 10%
bonds on January 1, 2022, for $102,000 (premium of $2,000).
Interest is payable on January 1.

LO 6 ©2020 John Wiley & Sons, Inc. All rights reserved. 96

Amortizing Bond Premium
Journal Entry to Record Interest and Amortize Premium

Illustration: Candlestick, Inc., sold $100,000, five-year, 10%

bonds on January 1, 2022, for $102,000 (premium of $2,000).
Interest is payable on January 1. The bond premium
amortization for each interest period is $400 ($2,000 ÷ 5).
Candlestick records the first accrual of interest on December
31 as follows.

Dec. 31 Interest Expense 9,600

Premium on Bonds Payable 400
Interest Payable ($100,000 x 10%) 10,000

LO 6 ©2020 John Wiley & Sons, Inc. All rights reserved. 97

Learning Objective 7
Apply the Effective-Interest Method of Amortizing Bond
Discount and Bond Premium
Under the effective-interest method, the amortization of
bond discount or bond premium results in period interest
expense equal to a constant percentage of the carrying value
of the bonds.
Required steps:
1. Compute the bond interest expense.
2. Compute the bond interest paid or accrued.
3. Compute the amortization amount.

LO 7 ©2020 John Wiley & Sons, Inc. All rights reserved. 98

Effective-Interest Method

Required steps:
1. Compute the bond interest expense.
2. Compute the bond interest paid or accrued.
3. Compute the amortization amount.

LO 7 ©2020 John Wiley & Sons, Inc. All rights reserved. 99

Effective-Interest Method
Interest Expense and Discount Amortization

Illustration: Candlestick, Inc. issues $100,000 of 10%, five-year

bonds on January 1, 2022, for $98,000, with interest payable each
January 1. This results in a discount of $2,000.

LO 7 ©2020 John Wiley & Sons, Inc. All rights reserved. 100
Amortizing Bond Discount
Year 1 Entry to Record Interest and Discount Amortization

Candlestick, Inc. records the accrual of interest and amortization of

bond discount on December 31 as follows.
Dec. 31 Interest Expense 10,324
Interest Payable 10,000
Discount on Bonds Payable 324

LO 7 ©2020 John Wiley & Sons, Inc. All rights reserved. 101
Amortizing Bond Discount
Year 2 Entry to Record Interest and Discount Amortization

For the second interest period, at December 31, Candlestick

makes the following adjusting entry.
Dec. 31 Interest Expense 10,358
Interest Payable 10,000
Discount on Bonds Payable 358

LO 7 ©2020 John Wiley & Sons, Inc. All rights reserved. 102
Amortizing Bond Premium
Effective Interest Method

Illustration: Candlestick, Inc. issues $100,000 of 10%, five-year

bonds on January 1, 2022, for $102,000, with interest payable
January 1. This results in a premium of $2,000.

LO 7 ©2020 John Wiley & Sons, Inc. All rights reserved. 103
Amortizing Bond Premium
Year 1 Entry to Record Interest and Premium Amortization

The entry Candlestick makes on December 31 is:

Dec. 31 Interest Expense 9,669
Premium on Bonds Payable 331
Interest Payable 10,000

LO 7 ©2020 John Wiley & Sons, Inc. All rights reserved. 104
 A Look at IFRS
Similarities

LO 8: Compare the Accounting for Liabilities Under GAAP and IFRS

Key Points
Similarities
• IFRS requires that companies classify liabilities as current or
noncurrent on the face of the statement of financial position
(balance sheet), except in industries where a presentation based on
liquidity would be considered to provide more useful information
(such as financial institutions). When current liabilities (also called
short-term liabilities) are presented, they are generally presented in
order of liquidity.

LO 8 ©2020 John Wiley & Sons, Inc. All rights reserved. 105
 A Look at IFRS
More Similarities

Key Points
More Similarities
• Under IFRS, liabilities are classified as current if they are expected to be paid within 12
months.
• Similar to GAAP, items are normally reported in order of liquidity. Companies
sometimes show liabilities before assets. Also, they will sometimes show long-term
liabilities before current liabilities.
• The basic definition of a liability under G AAP and IFRS is very similar. Liabilities are
defined by the IASB as a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits.
• The accounting for current liabilities such as notes payable, unearned revenue, and
payroll taxes payable are similar between G AAP and IFRS.

LO 8 ©2020 John Wiley & Sons, Inc. All rights reserved. 106
 A Look at IFRS
Even More Similarities

Key Points
Even More Similarities
• The basic calculation for bond valuation is the same under G AAP and IFRS. In
addition, the accounting for bond liability transactions is essentially the same
between GAAP and IFRS.
• IFRS requires use of the effective-interest method for amortization of bond
discounts and premiums. GAAP allows use of the straight-line method where
the difference is not material. Under IFRS, companies do not use a premium
or discount account but instead show the bond at its net amount. For
example, if a $100,000 bond was issued at 97, under I FRS a company would
record:
Cash 97,000
Bonds Payable 97,000

LO 8 ©2020 John Wiley & Sons, Inc. All rights reserved. 107
 A Look at IFRS
Differences

Key Points
Differences
• The accounting for convertible bonds differs between I FRS
and GAAP. Unlike GAAP, IFRS splits the proceeds from the
convertible bond between an equity component and a debt
component. The equity conversion rights are reported in
equity.
• Under IFRS, companies sometimes will net current liabilities
against current assets to show working capital on the face
of the statement of financial position.
LO 8 ©2020 John Wiley & Sons, Inc. All rights reserved. 108
 A Look at IFRS
Bonds Payable Question

IFRS Self-Test Questions

The accounting for bonds payable is:
a) essentially the same under IFRS and GAAP.
b) different under IFRS as GAAP requires use of the straight-line
method for amortization of bond premium and discount.
c) the same under IFRS and GAAP, except that market prices may be
different because the present value calculations are different
between IFRS and GAAP.
d) not covered by IFRS.

LO 8 ©2020 John Wiley & Sons, Inc. All rights reserved. 109
 A Look at IFRS
Bonds Payable Answer

IFRS Self-Test Questions

The accounting for bonds payable is:
a) Answer: essentially the same under IFRS and GAAP.
b) different under IFRS as GAAP requires use of the straight-
line method for amortization of bond premium and
discount.
c) the same under IFRS and GAAP, except that market prices
may be different because the present value calculations are
different between IFRS and GAAP.
d) not covered by IFRS.
LO 8 ©2020 John Wiley & Sons, Inc. All rights reserved. 110
 A Look at IFRS
Liabilities Question

IFRS Self-Test Questions

Which of the following is false?
a) Under IFRS, current liabilities must always be presented
before noncurrent liabilities.
b) Under IFRS, an item is a current liability if it will be paid
within the next 12 months.
c) Under IFRS, current liabilities are sometimes netted against
current assets on the statement of financial position.
d) Under IFRS, a liability is only recognized if it is a present
obligation.

LO 8 ©2020 John Wiley & Sons, Inc. All rights reserved. 111
 A Look at IFRS
Liabilities Answer

IFRS Self-Test Questions

Which of the following is false?
a) Answer: Under IFRS, current liabilities must always be presented
before noncurrent liabilities.
b) Under IFRS, an item is a current liability if it will be paid within the
next 12 months.
c) Under IFRS, current liabilities are sometimes netted against current
assets on the statement of financial position.
d) Under IFRS, a liability is only recognized if it is a present obligation.

LO 8 ©2020 John Wiley & Sons, Inc. All rights reserved. 112
 A Look at IFRS
Amortization Question

IFRS Self-Test Questions

Which of the following is true regarding accounting for
amortization of bond discount and premium?
a) Both IFRS and GAAP must use the effective-interest method.
b) G A A P must use the effective-interest method, but I F R S may
use either the effective-interest method or the straight-line
method.
c) IFRS is required to use the effective-interest method.
d) GAAP is required to use the straight-line method.

LO 8 ©2020 John Wiley & Sons, Inc. All rights reserved. 113
 A Look at IFRS
Amortization Answer

IFRS Self-Test Questions

Which of the following is true regarding accounting for
amortization of bond discount and premium?
a) Both IFRS and GAAP must use the effective-interest method.
b) GAAP must use the effective-interest method, but IFRS may
use either the effective-interest method or the straight-line
method.
c) Answer: IFRS is required to use the effective-interest method.
d) GAAP is required to use the straight-line method.

LO 8 ©2020 John Wiley & Sons, Inc. All rights reserved. 114
Copyright

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