General Comments for Chapter 7
Accounting for Liabilities
Chapter 7 introduces the accounting for both current and long-term liabilities and the
preparation of a classified balance sheet. Throughout the chapter, the focus is on how liabilities
and interest expense affect the financial statements, rather than on specific procedural details.
The current liabilities covered in the chapter include notes payable, sales tax liabilities, warranty
liabilities, and contingent liabilities. Students will also explore longer-term debt financing:
installment notes, lines of credit, and bonds payable.
You should focus on how the recognition and payment of interest affects the income
statement and statement of cash flows differently. Use a note payable that is issued in one
accounting period and matures in the following period. Record the borrowing event, the accrual
of interest expense in the first period, the recognition of interest expense in the second period, the
cash payment of interest, and the repayment of principal in a statements model. Highlight the
differences between the amounts of expense recognized versus the amount of cash paid in the
two accounting periods.
The information on contingent liabilities provides an opportunity to discuss the broader topic
of expense recognition and matching of expenses to revenues. What should and should not be
shown in the financial statements? When should the expense for product warranties be reported
on the income statement?
This chapter covers accounting for long-term debt. It includes term notes and lines of credit
as well as bond liabilities. Coverage of bonds is limited to issuance of bonds at face value;
premium and discount on bonds are not mentioned in the text. In an ideal world we would have
time to pursue both conceptual understanding and procedural proficiency. Instructors, however,
do not teach in an ideal world. We are forced to make choices about how to allocate the scarce
resource known as class time.
Detailed Outline of a Lesson Plan for Chapter 7
I. Use Demonstration Problem 7-1 to introduce accrued interest payable. The following
description of the transactions includes explanatory comments (in italics) for the
instructor.
A. Events for 2014 are as follows:
1. Canton Company borrowed $10,000 cash from the National Bank on September
1, 2014. This problem focuses on borrowing money, using the borrowed money
to invest in land, and matching the rent revenue from the land with the interest
expense.
2. Canton invested the borrowed money in land.
3. Canton leased the land and earned rental revenue of $600 cash.
4. As of December 31, 2014, accrued interest payable (interest expense) on
Canton’s bank loan was $400. The amount of interest is provided. This
example focuses on how interest expense affects the financial statements.
Have students record the events under an accounting equation and prepare financial
statements for the accounting period ended December 31, 2014.
B. After preparing the 2014 statements, assume these 2015 events:
1. Canton earned rent revenue of $1,350 cash in 2015.
2. Canton sold its land for $10,000 cash.
3. Canton accrued interest of $800 on the bank loan. The accrual of interest and
the payment of interest are shown as separate transactions. While combining
transactions reduces recording time in a manual accounting system, doing so
masks the logic behind the steps.
4. Canton paid cash for the interest due on the bank loan.
5. Canton repaid the $10,000 bank loan (see Event 1 in Part A above) with cash.
II. Hand out Demonstration Problem 7-2. After you have shown students how accrued
interest affects the accounting equation and the financial statements in Demonstration
Problem 7-1, use Demonstration Problem 7-2 to show them how to compute accrued
interest.
Demonstration Problem 7-2: Accrued Interest Computations
Johnson Company borrowed $1,000 cash by issuing a one-year note to McCoy Company.
McCoy charged Johnson interest on the note at a 12 percent annual rate. Both companies
close their books on December 31, 2014. Determine the amount of accrued interest
expense Johnson would report and the amount of accrued interest revenue McCoy would
report at December 31, 2014, under each of the three following independent assumptions
of the note issue date. The note was issued (money was borrowed) on (1) April 1, 2014;
(2) June 1, 2014; and (3) October 1, 2014.
Solution:
Date Principal x Rate x Time = Accrued Interest
April 1, 2014 $1,000 x .12 x 9/12 = $90
June 1, 2014 $1,000 x .12 x 7/12 = $70
Oct. 1, 2014 $1,000 x .12 x 3/12 = $30
Point out that the interest expense on Johnson’s books equals the interest revenue on
McCoy’s books. Students should learn to handle both interest expense and interest
revenue.
III. Use an exercise in the text to demonstrate sales taxes. Exercise 7-3 serves as a good
demonstration problem. Exercise 7-4 works well as a reinforcement exercise for
homework.
IV. Use exercises in the text to demonstrate contingent liabilities and product
warranties. The topic of contingent liabilities can serve as a forum for a broader
discussion of expense recognition. Exercise 7-5 provides a good basis for discussion.
The text discusses warranty obligations. Exercises 7-6 and 7-7 provide comprehensive
problems dealing with warranties. They serve as excellent demonstration problems for a
brief lecture on how to report warranty obligations.
V. Demonstration Problem 7-3 illustrates accounting for a term loan repaid with equal
annual payments of principal and interest. Work this problem in class. Use the work
papers to save time and focus attention on financial statement effects. (Refer to
Demonstration Problem 7-3 for data used to determine the following amounts.)
A. Get your students started by showing them how to construct the amortization table.
Record the 2014 entries in the table. Have the students complete the entries in the
amortization table for 2015 and 2016.
B. Walk your students through the 2014 statements line by line. Then have them
continue the problem as an in-class assignment while you circulate through the room
helping those with questions.
Year 2014
1. Revenue. The problem specifies the 2014 revenue as $7,000.
2. Expense. Compute the 2014 interest expense: multiply the principal balance that
was outstanding during the year by the interest rate ($60,000 x .10). Have the
students record the interest expense in the income statement and determine the
amount of net income.
3. Cash. The December 31, 2014 cash balance is determined as follows: cash
increased $60,000 from issuing the note. Cash also increased by $7,000 from
receiving rent revenue. Cash decreased by the $24,127 payment on December 31
for interest and principal reduction. The ending cash balance is therefore $42,873
($60,000 + $7,000 − $24,127).
4. Note Payable. The amount of the note payable reported on the year-end balance
sheet is the beginning balance less the principal repayment portion of the annual
payment ($60,000 − $18,127 = $41,873) at December 31, 2014.
5. Retained Earnings. Because no dividends were paid, the total amount of net
income was retained in the business. Retained earnings are $1,000.
6. Cash Flow. Because revenue was collected in cash, the amount of cash received
from customers was $7,000. The $60,000 inflow from issuing the note is a
financing activity. Finally, cash decreased by $24,127 ($6,000 for interest and
$18,127 for principal) because of the December 31 payment of interest and
principal. The net result was a $42,873 ($60,000 + $7,000 − $24,127) cash
inflow.
Year 2015
Because the second year differs significantly from the first, you may want to walk
your students through it as well. Revenue is given as $7,000 and the amount of
interest expense is determined by multiplying the principal balance that was
outstanding during 2015 by the interest rate ($41,873 x .10 = $4,187). The cash
balance is determined by adding the cash revenue, $7,000, to the beginning balance of
$42,873, and subtracting the cash payment of $24,127 ($4,187 for interest and
$19,940 for principal repayment). The ending cash balance is $25,746. These
amounts are reported in the statement of cash flows. Because all earnings are retained
in the business, retained earnings amounts to last year’s ending balance plus the 2014
net income ($1,000 + $2,813 = $3,813).
Year 2016
Assign this year for students to complete in class. The one dollar negative
balance in the note payable account is due to rounding.
VI. Lines of credit. Businesses frequently use lines of credit to meet fluctuating borrowing
needs. One effective way to introduce the topic is by referring to lines of credit available
to consumers. For example, cash advances on credit cards represent a form of credit line
with which many students are familiar. Like consumer lines of credit, commercial lines
offer considerable flexibility by permitting borrowers to obtain and repay funds at will.
They are, therefore, a convenient source of short-term credit. Borrowers pay for this
convenience with relatively high interest rates that fluctuate with market conditions. You
can use Exercise 7-13 as a demonstration problem or a homework assignment.
VII. Demonstration Problem 7-4 illustrates accounting for a bond liability across five
consecutive accounting cycles. It is similar to the text illustration. A company issues
bonds to obtain money to purchase land which it leases to a customer. Because land does
not depreciate, the problem can focus on accounting for bond liabilities without the
distraction of other complexities. The problem requires students to prepare financial
statements.
The bonds are issued at face value and pay interest on December 31 of each year.
The accounting in these circumstances is essentially identical to that for notes
payable. The only difference is using the term bond instead of the term note. This is
a good time to explain that companies issue bonds because they can obtain more
attractive credit terms by issuing bonds to the general public than by issuing notes to
banks. In general, the term notes is used when companies borrow money from banks
or other companies; the term bonds is used when companies borrow money from the
general public.
To save time and focus attention on financial statement effects, we recommend
that you use the work papers for Demonstration Problem 7-4. Walk your students
through the first year statements line by line.
Year 2014
1. Revenue. The problem specifies the 2014 revenue as $7,000.
2. Expense. The amount of interest expense for the year is $6,000 ($50,000 x .12).
Have students fill in the amount of net income. Keep them actively involved.
3. Cash. The December 31, 2014 cash balance is determined as follows: cash
increased by $50,000 from issuing the bonds and decreased by $50,000 with the
land purchase. Cash also increased by $7,000 from receiving rent revenue. Cash
decreased by $6,000 with the December 31 interest payment. The ending cash
balance is $1,000.
4. Land. The cost of the land was $50,000. Have students fill in the amount of total
assets.
5. Bond Payable. The face value of the bond liability ($50,000) is reported on the
year-end balance sheet. Have students compute total liabilities. Since interest is
paid in cash on December 31 there is no accrued interest to report in the financial
statements.
6. Retained Earnings. Since no dividends were paid, the total amount of net
income was retained in the business. Retained earnings would be $1,000. Have
students compute total liabilities and equity.
7. Cash Flow. Since revenue was collected in cash, the operating activities section
of the statement of cash flows reports cash received from customers of $7,000.
The $6,000 outflow for interest expense is also reported in the operating activities
section. Under investing activities there is a $50,000 outflow for the purchase of
land. There’s a $50,000 inflow from the bond issue reported under financing
activities. The net result is a $1,000 increase in cash.
Year 2015
Because the second year differs somewhat from the first, you may want to walk
your students through it as well. The revenue and expenses are identical to those
reported in 2014. Cash again increases by $1,000 ($7,000 cash collected from
revenue less $6,000 paid on December 31 for interest). Therefore, the December 31,
2015 cash balance is $2,000 (the December 31, 2014 $1,000 cash balance plus the
$1,000 2015 increase). Since all income is retained in the business, retained earnings
amounts to the 2014 ending balance plus the 2015 net income ($1,000 + $1,000 =
$2,000). The only cash flows are those for the revenue collected and interest paid.
Years 2016 and 2017
Use these years as an in-class assignment for students to complete.
Year 2018
Students may need some help with this year. Revenue and expenses are the same
as in previous years. However, the land was sold and the bond liability repaid on
December 31, 2018. These events affect the balance sheet and the statement of cash
flows. The land and the bond liability will no longer appear on the balance sheet.
The operating activities section of the statement of cash flows will report the $7,000
inflow from customers and the $6,000 outflow for the payment of interest. The
investing activities section will report a $50,000 inflow from the sale of land. Also,
the financing activities section will report a $50,000 outflow for the repayment of the
bonds. The net change in cash is a $1,000 increase ($7,000 − $6,000 + $50,000 −
$50,000).
VIII. Time considerations and homework assignments. Completing Demonstration
Problems 7-1 and 7-2 should require approximately one hour of class time. Have the
students work along with you as you explain the problems. For example, in
Demonstration Problem 7-2, you can show the computations for the assumption that the
note was issued on April 1, and then have students calculate interest for the other two
issue dates. Exercises 7-1 and 7-2 are good to use as reinforcement for interest expense
recognition. Most students grasp sales tax and warranty obligations quickly. We find ten
to fifteen minutes per subject to be sufficient. Plan to spend less than one hour of class
time covering installment loans and lines of credit. Use Exercise 7-10 to reinforce
accounting for installment loans; Problem 7-33 pertains to lines of credit. Allow an
additional 30 to 45 minutes of class time to cover bond liabilities. Exercise 7-22 may be
used as homework or in-class practice in preparing a classified balance sheet. Because
both current and long-term liabilities are covered in this chapter, the chapter will require
more class time than most other chapters.
Demonstration Problems for Chapter 7
Demonstration Problem 7-1: Accrued Interest Payable
Part A
Canton Company experienced the following accounting events during 2014:
1. Canton Company borrowed $10,000 cash from the National Bank on September 1, 2014.
2. Canton invested the borrowed money in land.
3. Canton leased the land and earned rent revenue of $600 cash.
4. As of December 31, 2014, accrued interest (interest expense) on Canton’s bank loan was
$400.
Required
1. Record the events under an accounting equation.
2. Prepare an income statement, a statement of retained earnings, a balance sheet, and a
statement of cash flows for 2014.
Part B
Canton Company experienced the following accounting events during 2015:
1. Canton earned rent revenue of $1,350 cash in 2015.
2. Canton sold its land for $10,000 cash.
3. Canton accrued interest of $800 on the bank loan.
4. Canton paid cash for the interest due on the bank loan.
5. Canton repaid the $10,000 bank loan (See Event 1 in Part A above) with cash.
Required
1. Record the events under an accounting equation.
2. Prepare an income statement, a statement of retained earnings, a balance sheet, and a
statement of cash flows for 2015.
Demonstration Problem 7-2: Accrued Interest Computations
Johnson Company borrowed $1,000 cash by issuing a one-year note to McCoy Company. McCoy
charged Johnson interest on the note at a 12 percent annual rate. Both companies close their books
on December 31, 2014.
Required
Determine the amount of accrued interest expense Johnson would report and the amount of accrued
interest revenue McCoy would report at December 31, 2014, under each of the three following
independent assumptions of the note issue date. The note was issued (money was borrowed) on
(1) April 1, 2014; (2) June 1, 2014; and (3) October 1, 2014.Demonstration Problem 7-3:
Amortizing a Loan
King Company was started on January 1, 2014, when it issued a $60,000 face value term note to
State Bank. The note had a 10 percent annual interest rate and a three-year term to maturity.
Principal and interest were paid in three $24,127 payments on December 31 of 2014, 2015, and
2016. King Company earned cash revenue of $7,000 per year in 2014 through 2016 and interest
on the bank loan was the company’s only expense.
Required
a. Prepare an amortization schedule that allocates the year-end payments between interest and
principal for the three-year term of the loan.
b. Prepare income statements, balance sheets, and statements of cash flows for 2014, 2015, and
2016.
Demonstration Problem 7-4: Bond Issue
Land Development Company (LDC) was started in 2014 when it issued bonds with a face value
of $50,000. LDC purchased land with the cash proceeds from the bond issue. The land was
adjacent to one of Central Bank’s branches. Central Bank leased the land from LDC for the
construction of a parking lot.
Required
Prepare an income statement, a balance sheet, and a statement of cash flows assuming that:
1. The bonds were issued at face value on January 1, 2014. They had a five-year term and a 12
percent stated rate of interest. Interest was payable in cash annually on December 31 of each
year with the first payment due December 31, 2014.
2. LDC used the $50,000 cash proceeds to purchase the land.
3. Central Bank agreed to pay $7,000 cash per year for five years to lease the land.
4. On December 31, 2018, LDC sold the land for $50,000 cash and paid the principal due on the
bond liability.
SOLUTIONS TO
DEMONSTRATION PROBLEMS
Demonstration Problem 7-1: Solution, Parts A & B,
Accounting Equation
Assets
=
Liab.
+
Equity
2014, Part A
Cash
+
Land
=
Notes
Payable
+
Int.
Pay.
+
Com.
Stock
+
Ret.
Ear.
Beginning Balances
$ -0-
$ -0-
$ -0-
$ -0-
$ -0-
$ -0-
1. Effect of Borrowing
10,000
10,000
2. Purchase of Land
(10,000)
10,000
3. Earned Revenue
600
600
4. Accrued Int. Exp.
400
(400)
−−−−−
−−−−
−−−−
−−−−
−−−−−
−−−−−
End. / Beg. Balances
$ 600
+
$10,000
=
$10,000
+
$ 400
+
$ -0-
+
$ 200
2015, Part B
1. Earned Revenue
1,350
1,350
2. Sold Land
10,000
(10,000)
3. Accrued Int. Exp.
800
(800)
4. Paid Interest
(1,200)
(1,200)
5. Repaid Loan
(10,000)
(10,000)
−−−−−
−−−−
−−−−
−−−−
−−−−−
−−−−−
Ending Balances
$ 750
+
$ -0-
=
$ -0-
+
$ -0-
+
$ -0-
+
$ 750
════
════
════
════
═════
═════
Demonstration Problem 7-1: Solution, Parts A & B,
Financial Statements
Canton Company
Income Statements
For the Years Ended December 31,
2014
2015
Rent Revenue
$600
$1,350
Interest Expense
(400)
(800)
Net Income
$200
$550
Statements of Retained Earnings
Beginning Retained Earnings
-0-
$200
Net Income
$200
550
Dividends
-0-
-0-
Ending Retained Earnings
$200
$750
Balance Sheets at December 31
Assets
Cash
$ 600
$750
Land
10,000
-0-
Total Assets
$10,600
$750
Liabilities
Interest Payable
$ 400
-0-
Note Payable
10,000
-0-
Equity
Retained Earnings
200
$750
Total Liabilities and Equity
$10,600
$750
Statements of Cash Flows
Cash Flows from Operating Activities
Inflow from Rent Revenue
$ 600
$ 1,350
Outflow for Interest Expense
-0-
(1,200)
Net Inflow from Operating Activities
$ 600
$ 150
Cash Flow from Investing Activities
Inflow from Sale of Land
-0-
$10,000
Outflow for Purchase of Land
(10,000)
-0-
Net Inflow (Outflow) from Investing Act.
(10,000)
$10,000
Cash Flows from Financing Activities
Inflow from Issue of Note
10,000
-0-
Outflow for Repayment of Note
-0-
$(10,000)
Net Inflow (Outflow) from Financing Act.
10,000
$(10,000)
Net Change in Cash
600
$ 150
Beginning Cash Balance
-0-
600
Ending Cash Balance
$ 600
$ 750
Demonstration Problem 7-2: Solution
Johnson’s 2014 interest expense equals McCoy’s 2014 interest revenue, as follows:
Date Note Issued
Principal
x
Rate
x
Time
=
Accrued Interest
April 1, 2014
$1,000
x
.12
x
(9 / 12)
=
$90
June 1, 2014
$1,000
x
.12
x
(7 / 12)
=
$70
October 1, 2014
$1,000
x
.12
x
(3 / 12)
=
$30
Demonstration Problem 7-3: Solution, part a. Amortization Table
Column 1
Column 2
Column 3
Column 4
Column 5
Accounting
Period
Principal
Balance on
Jan. 1
Cash
Payment
Dec. 31
Applied
to
Interest
Applied
to
Principal
2014
60,000
24,127
6,000
18,127
2015
41,873
24,127
4,187
19,940
2016
21,933
24,127
2,193
21,934
Computations: Column 2 shows the liability amount on January 1. For 2014, this amount was
$60,000. For 2015 the amount in Column 2 is the $60,000 beginning balance less the $18,127
Demonstration Problem 7-3: Solution, part b. Financial Statements
Financial Statements
Income Statements
2014
2015
2016
Revenue
$7,000
$7,000
$7,000
Interest Expense
6,000
4,187
2,193
Net Income
$1,000
$2,813
$4,807
Balance Sheets
Assets
Cash
$42,873
$25,746
$ 8,619
Liabilities
Note Payable
$41,873
$21,933
$ (1)*
Equity
Retained Earnings
1,000
3,813
8,620
Total Liabilities and Equity
$42,873
$25,746
$ 8,619
Statements of Cash Flows