CHAPTER 7

ACCOUNTING FOR AND PRESENTATION OF

LIABILITIES

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objectives1. What is the financial statement

presentation of short-term debt and current maturities of long-term debt?

2. What is the difference between interest calculated on a straight basis and on a discount basis?

3. What are unearned revenues and how are they presented in the balance sheet?

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 4. What is the accounting for

employer’s liability for payroll and payroll taxes?

5. What is the importance of making estimates for certain accrued liabilities and how are these items presented in the balance sheet?

6. What is leverage and how is it provided by long-term debt?

7. What are the different characteristics of a bond?

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 8. Why does bond discount or premium

arise and how is it accounted for?9. What are deferred income taxes and

why do they arise?10. What is minority interest, why does it

arise, and what does it mean in the balance sheet?

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 1

• What is the financial statement presentation of short-term debt and current maturities of long-term debt?

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Current Liabilities• Amounts due within one year or

operating cycle

• A working capital loan is a short-term loan with the expectation that it will be repaid from the collection of accounts receivable generated by the sale of inventory

• A revolving line of credit is a predetermined maximum amount, but flexibility in timing and amount borrowed

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Notes Payable

• A note is a formal promise to pay a stated amount at a stated date, usually with interest

• Prime rate is the term frequently used to express the interest rate on short-term loans

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 2

• What is the difference between interest calculated on a straight basis and on a discount basis?

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Interest Calculation Methods• Straight interest is calculated as follows:

Interest = Principal X Rate X Time (in years)

• A discount is interest that is subtracted from the loan principal and the borrower receives the difference

• The difference received by the borrower is called the proceeds

• The discounted amount is shown in the balance sheet as a contra liability

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Current Maturities of Long-Term Debt

• The portion of long-term borrowing that must be repaid within a year of the balance sheet date is reported as a current liability

• The remainder of the long-term debt is shown in noncurrent liabilities

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Accounts Payable• Accounts payable are amounts owed to

suppliers for goods and services that have been provided to the entity on credit

• May be reported using either the gross or the net method

• The gross method recognizes cash discounts when the invoices are paid within the discount period

• The net method recognizes cash discounts when purchases are made

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 3

• What are unearned revenues and how are they presented in the balance sheet?

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Unearned Revenues or Deferred Credits

• Unearned revenues occur when customers pay for goods or services before the goods or services are delivered:

Cash XXUnearned revenue XX

• When earned, the liability of unearned revenues is removed and recorded as revenues:

Unearned revenue XXRevenue XXMcGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 4

• What is the accounting for employer’s liability for payroll and payroll taxes?

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Payroll Taxes and Other Withholdings

• Gross pay is wages earned byan employee

• Net pay is the amount the employee receives after deductions

• Deductions include federal income tax, state income tax, FICA withholding, union dues, and many others

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Liabilities from Withholdings• Amounts withheld are liabilities to the

employer until paid

• Additional liabilities result since employers are subject to federal and state payroll taxes

• These payroll taxes are an expense to the employer

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Other Accrued Liabilities

• There are many other liabilities that are accrued by entities– Accrued property taxes– Estimated warranty liabilities– Accrued interest – if not reported

separately

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 5

• What is the importance of making estimates for certain accrued liabilities and how are these items presented in the balance sheet?

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Presentation of Accrued Liabilities

• Estimates of accrued liabilities are presented on the balance sheet as current liabilities since they are due within one year of the balance sheet date

• These estimated items are originally recorded as increases in expenses and increases in liabilities

• Adjustments are made to the liabilities as the actual cost is determinedMcGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 6

• What is leverage and how is it provided by long-term debt?

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Noncurrent Liabilities• Capital structure is the mix of debt and

owners’ equity used to finance the acquisition of the firm’s assets

• Using long-term debt has the advantage of having interest expense being deductible – whereas dividends on stock are not deductible

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Financial Leverage

• Financial leverage is the difference between the rate of return earned on assets (ROI) and the rate of return earned on owners’ equity (ROE)

• A firm can borrow money to purchase assets and use those assets to earn a rate of return greater than the interest incurred on the borrowed funds

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 7

• What are the different characteristics of a bond?

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Bonds Payable• Most long-term debt is issued in the

form of bonds

• A bond is a formal debt document usually issued in denominations of $1,000

• Bond prices are expressed as a percentage of the bonds principal amount

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 8

• Why does bond discount or premium arise and how is it accounted for?

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Bond Premiums and Bond Discounts

• A bond premium is the excess of a bond’s market value over its face amount

• A bond discount is the excess of the face amount over the market value of the bond

• Premiums and discounts usually result from differences between stated interest rates on the bonds and the market rate of interest

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Reporting Bonds – At Par• Issuance of bond:

Cash XXBonds payable XX

• Recording interest expense:

Interest expense XXCash XX

• Retirement of bond:

Bonds payable XXCash XX

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Reporting Bonds – At Discount• Issuance of bond:

Cash XXDiscount on bonds payable XXBonds payable XX

• Recording interest expense:

Interest expense XXDiscount on bonds payable XXCash XX

• Retirement of bond:

Bonds payable XXCash XX

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Reporting Bonds – At Premium

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

• Issuance of bond:

Cash XX Premium on bonds payable XXBonds payable XX

• Recording interest expense:

Interest expense XXPremium on bonds payable XXCash XX

• Retirement of bond:

Bonds payable XXCash XX

Types of Bonds• Callable bonds – the issuer may payoff

the bonds before the scheduled maturity date

• Registered bonds – the name and address of the bond owner is known to the issuer

• Coupon bonds – the owner is not known to the issuer

• Debenture bonds – secured only by the general credit of the issuer

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

More Types of Bonds• Mortgage bonds – secured by a lien

against real estate owned by the issuer

• Term bonds – requires a lump-sum payment of the face amount of the bonds at maturity

• Serial bonds – repaid in installments

• Convertible bonds – may be converted into stock of the issuer corporation at the option of the bondholder

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 9

• What are deferred income taxes and why do they arise?

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Deferred Tax Liabilities• Deferred tax liabilities are provided for

temporary differences between income tax and financial statement recognition of revenues and expenses

• Normally are long-term liabilities

• The most significant temporary difference is related to depreciation expense

• The deferred tax liability is the difference between income tax expense and income tax payable

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Other Noncurrent Liabilities• Obligations related to pension plans

are noncurrent liabilities• Obligations related to post-retirement

benefits• Estimated liability under lawsuits in

progress also may be listed as noncurrent liabilities

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 10

• What is minority interest, why does it arise, and what does it mean in the balance sheet?

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Minority Interest in Subsidiaries• A subsidiary is a corporation that is more

than 50% owned by the firm for which financial statements have been prepared

• The resulting financial statements are called consolidated financial statements

• Minority interest arises if the subsidiary is not 100% owned by the parent corporation

• The minority is the equity of other shareholders

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002