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Chapter 10 - Liabilities
10 LIABILITIES
Chapter Summary
At the outset, the chapter distinguishes between current and long-
term liabilities before addressing the accounting issues surrounding each
category.
Among current liabilities, notes payable and payroll related costs are
analyzed in detail. Journal entries are introduced to record the issuance of a
note, the accrual of interest expense, and the payment of interest and
principal. Payroll costs such as FICA and Medicare taxes, unemployment
insurance, workers’ compensation, and the employer’s share of bene$ts are
explained and contrasted with other amounts withheld from the employees’
paychecks. A number of other current liabilities with which the student is
already familiar are reviewed in brief.
Long-term liabilities are introduced using installment notes payable.
An example of an amortization schedule illustrates the allocation of
installment payments between interest expense and principal reduction.
The amortization table serves as the basis for preparing journal entries
relative to the note, and is also used to demonstrate that the portion of
principal scheduled to be paid in the next 12 months is classified as a
current liability.
Bonds payable are discussed in some detail with emphasis on the
nature and advantages of bond $nancing. Accounting treatment covers
bonds issued at par, at a premium, and at a discount. A number of
advanced topics are covered including issuance between interest payment
dates, price ,uctuations after issuance, and early retirement. Estimated
liabilities, commitments, and contingencies are discussed. Other long-term
liabilities introduced include leases, pensions and other post-retirement
costs, and deferred income taxes.
The chapter includes an analysis of the interest coverage ratio and
$nancial leverage. This discussion emphasizes how creditors use accounting
data to evaluate the safety of their claims.
Learning Objectives
1. De$ne liabilities and distinguish between current and long-term
liabilities.
2. Account for notes payable and interest expense.
3. Describe the costs and the basic accounting activities relating to
payrolls.
4. Prepare an amortization table allocating payments between interest
and principal.
5. Describe corporate bonds and explain the tax advantage of debt
financing.
6. Account for bonds issued at a discount or premium.
7. Explain the concept of present value as it relates to bond prices.
8. Explain how estimated liabilities, loss contingencies, and commitments
are disclosed in $nancial statements.
9. Evaluate the safety of creditors’ claims.
10. Describe reporting issues related to leases, postretirement bene$ts,
and deferred taxes.
Brief topical outline
AThe nature of liabilities
1Distinction between debt and equity
2Many liabilities bear interest
3Estimated liabilities
BCurrent liabilities
1Accounts payable
2Notes payable
3The current portion of long-term debt
4Accrued liabilities
5Payroll liabilities
aPayroll taxes and mandated costs
bOther payroll-related costs
cAmounts withheld from employees' pay
dRecording payroll activities
6Unearned revenue
CLong-term liabilities
1Maturing obligations intended to be refinanced – see Case in Point (page 438)
2 Installment notes payable
aAllocating installment payments between interest and principal
bPreparing an amortization table
cUsing an amortization table
dThe current portion of long-term debt
3 Bonds payable
aWhat are bonds?
bThe issuance of bonds payable
cTransferability of bonds
dQuoted market prices
eTypes of bonds
Chapter 10 - Liabilities
fJunk bonds
gTax advantage of bond financing
hAccounting for bonds payable
iBonds issued between interest dates
DBonds issued at a discount or a premium
1Accounting for a bond discount: an illustration
aBond discount: part of the cost of borrowing
bAmortization of the discount
2 Accounting for a bond premium: an illustration
aBond premium: a reduction in the cost of borrowing
bAmortization of the premium
3Bond discount and premium in perspective
4The concept of present value
a The present value concept and bond prices
5Bond prices after issuance - see Case in Point (page 451)
aVolatility of short-term and long-term bond prices
- see Your Turn (page 452)
6Early retirement of bonds payable
EEstimated liabilities, loss contingencies, and commitments
1Estimated liabilities
2Loss contingencies
aLoss contingencies in financial statements
3Commitments
FEvaluating the safety of creditors' claims
1 Methods of determining creditworthiness
a Interest coverage ratio
b Less formal means of determining creditworthiness
2How much debt should a business have?
GFinancial analysis and decision making – see Your Turn (page 456) and Ethics,
Fraud & Corporate Governance (page 457)
HSpecial types of liabilities
1Lease payment obligations
2Operating leases
3 Capital leases
aDistinguishing between capital leases and operating leases
4Liabilities for pensions and other postretirement benefits
aDetermining pension expense
bPostretirement benefits other than pensions
cUnfunded postretirement costs are noncash expenses
dUnfunded liabilities for postretirement costs: are they significant amounts?
5Deferred income taxes
aDeferred income taxes in financial statements
IConcluding remarks
Chapter 10 - Liabilities
Topical coverage and suggested assignment
Class
Meetings
on Chapter
Topical
Outline
Coverage
Discussion
Questions
Brief
Exercises Exercises Problems
Critical
Thinking
Cases
1 A - B 1, 2, 3 1, 2 1, 2, 3, 4 2, 3
2 C - D 6, 7, 8 3, 4, 5, 6 7, 8, 9 4, 6 2
3 E - I 11, 12, 13 9, 10 12, 13, 14 8
Comments and observations
Teaching objectives for Chapter 10
In presenting the broad topic of liabilities, our teaching objectives in this chapter are to:
1Define liabilities. Distinguish between liabilities and owners' equity.
2Distinguish between current and long-term liabilities (including classification of the
current portions of long-term debt and of short-term liabilities expected to be
refinanced on a long-term basis).
3Account for notes payable when interest is stated separately.
4Explain the nature of payroll liabilities including payroll taxes and other mandated costs.
5Explain the purpose of an amortization table. Illustrate the preparation and use of
such a table in the context of an installment note payable.
6Discuss the characteristics of corporate bonds including their tax advantages, and the
basic journal entries to record their issuance, payment of interest, and redemption.
7 Explain the nature of bonds issued at a discount or premium.
8Introduce the concept of present value and its relationship to bond prices.
9Distinguish between capital leases and operating leases and briefly explain their
accounting treatment.
10 Introduce other long-term liabilities including pensions, post-retirement benefits, and deferred
taxes. Describe the presentation of these items in the financial statements.
11 Describe the cash effects of transactions involving liabilities.
12 Explain the usefulness of the debt ratio and the interest coverage ratio.
13 Explain the nature of estimated liabilities, loss contingencies, and commitments.
Describe the presentation of these items in financial statements.
General comments
Chapter 10 opens with a general discussion of the nature of current liabilities. We recommend
Problem 1 to distinguish between current and contingent liabilities, and to show that liabilities
relate to past, rather than future, transactions.
What actually constitutes a "liability" is not a cut-and-dried issue, either for introductory
accounting students, or in accounting practice. Hence, we always review in class an assignment
such as Exercise 3 and/or Case 1. These assignments address the nature and classification of
liabilities, and of obligations that do not qualify as "liabilities." We believe that if students
understand the concepts involved in these assignments, they have acquired a good working
knowledge of how various types of obligations are reported and disclosed in financial statements.
In discussing the general nature of liabilities, we point out that only interest that has
accrued through the balance sheet date is a liability. No liability currently exists with respect to
interest charges applicable to future periods. This concept provides the foundation for
accounting for notes payable.
We devote little class time to payroll taxes. We do explain that taxes withheld from
employees are current liabilities of the employer, but do not increase the overall cost of having
employees on the payroll (except for administration costs). On the other hand, payroll taxes
levied upon the employer increase the cost of employing a work force to an amount greater than
the wages and salaries expense. In view of the various current proposals for financing health care,
this has become a particularly important point.
We also devote little class time to bonds payable. The basic entries concerning a bond
issue—issuance, interest payments, and retirements—may be illustrated quickly by reviewing an
assignment such as Exercise 9 or Problem 5.
Many corporations have recorded the one time charge for post-retirement benefits. We
have therefore commented upon the significance of these unfunded liabilities and their cash flow
effects.
Loss contingencies are of vital importance but can be covered quickly as the topic
generally does not involve computations or entries in the accounting records. We highly
recommend an in-class review of Case 3 to give students "a feel" for what types of loss
contingencies should be accrued, disclosed, or ignored. Examples of critically important loss
contingencies abound, as indicated in the Asides below:
An aside We like to use a few "real world" examples to indicate the potential impact of loss
contingencies. For example, the Texas State Courts awarded Pennzoil an $11 billion judgment
against Texaco for Texaco's alleged "improper actions" in outbidding Pennzoil for the acquisition
of Getty Oil. This judgment forced Texaco, one of the world's largest and most profitable oil
companies, to seek the protection of the Bankruptcy Court under Chapter 11 of the Bankruptcy
Code. During the following year, Texaco emerged from Chapter 11 when this $11 billion loss
contingency was settled for approximately $3 billion.
The large pharmaceutical company A. H. Robbins was forced into bankruptcy by product
liability suits, brought against the company by users of the Dalkon Shield, an intrauterine birth
control device.
In most cases, the footnotes to the companies' financial statements disclose the nature of
the pending litigation long before a company is forced into bankruptcy. However, it remains for
Chapter 10 - Liabilities
the reader of the financial statements to evaluate the financial risk associated with the pending
litigation.
Supplemental Exercises
Group Exercise
Current liabilities are de$ned as obligations that will be paid from
current assets. As a result creditors and potential creditors are keenly
interested in the relationship between a company’s current assets and is
current liabilities. This relationship is often measured by dividing current
assets by current liabilities to produce what is called the current ratio. The
ratio shows how many dollars of current assets are available for each dollar
of current liabilities. Clearly, the larger the ratio the more secure are the
claims of short-term creditors.
Choose a number of companies and using their annual reports,
compute the current ratio for each. Based on your results, discuss how
secure the claims of these companies’ short term creditors seem to be.
Internet Exercise
1. Obtain the annual report of the Harley Davidson Company either from
its website www.harley-davidson.com or from the SEC’s EDGAR site.
Read the footnote regarding postretirement health bene$ts and describe the
information you $nd.
2. It is widely appreciated that the Federal Reserve System controls
interest rates in the United States. Visit www.federalreserve.gov and
write a short report on the history of the Federal Reserve Board.
CHAPTER 10 NAME ________________# ______
10-MINUTE QUIZ A SECTION __________________________________________
Indicate the best answer for each question in the space provided.
On November 30, 2010, Central Food purchased two trucks for a total of
$140,000, issuing a one-year, 6% note payable, all due at maturity. The
interest on this loan is stated separately.
1Refer to the above data. The December 31, 2010, adjusting entry
for this note includes:
aA credit to Cash for $1,400.
bA credit to Interest Payable for $8,400.
cA credit to Interest Payable for $1,400.
dA credit to Interest Payable for $700.
2Refer to the above data. The total liabilities related to this note
reported in Central Food’s December 31, 2010, balance sheet is:
a$140,000. b$148,400. c$140,700. d$141,400.
3Refer to the above data. What is the amount of interest expense
Central Food’s recognizes on this note in 2011?
a$700. b$8,400. c$7,700. d$1,400.
4Refer to the above data. How much must Central Food pay the
lender upon maturity of this note?
a$140,700. b$140,000. c$147,700. d$148,400.
5Refer to the above data. The liability for this loan as of December
31, 2010:
aIs equal to its maturity value.
bIs equal to the book value of the two trucks that were acquired in
exchange.
cIs classi$ed as a long-term liability, since it was used to acquire
non-current assets.
dIs classi$ed as a long-term liability if Central Food has the intent
and ability to re$nance by taking out a new loan not due for
several years.
CHAPTER 10 NAME #
10-MINUTE QUIZ B SECTION
Shown below is a summary of the annual payroll data of Rose Co.:
Wages and salaries expense (gross pay) $2,250,00
0
Amounts withheld from employees’ pay:
Income taxes.......................................
$170,00
0
Social Security and Medicare............... $150,00
0
320,000
Payroll taxes expense:
Social Security and Medicare............... $150,00
0
Unemployment taxes.......................... 58,00
0
208,000
Workers’ compensation premiums................ 130,000
Group health insurance premiums (paid by
employer)
252,000
Contributions to employees’ pension plan
(paid by
employer and fully funded)..................
140,000
Cost of other postretirement bene$ts:
Funded................................................ $90,000
Unfunded............................................ 120,000
210,000
Financial Accounting, 16e 10- 7
Chapter 10 - Liabilities
1Refer to the above data. Rose Company’s total payroll-related
expense for the year is:
a$2,250,000. b$3,510,000. c$2,840,000. d$3,190,000.
2Refer to the above data. Compute the company’s cash outlays
during the year for payroll-related costs. Assume short-term
obligations such as insurance premiums and payroll taxes have been
paid.
a$2,750,000. b$3,070,000. c$1,930,000. d$3,510,000.
3Refer to the above data. The annual ”take-home-pay” of Rose’
employees is:
a$2,520,000. b$2,250,000. c$1,930,000. d$2,750,000.
4 Refer to the above data Amounts paid during the year to retirees for
pension and other postretirement bene$ts total:
a$140,000. b$350,000. c$230,000. dNone of above.
5Refer to the above data. When a company has a fully-funded
pension plan:
aThe dollar amounts paid to retirees are greater than the amounts
recognized as pension expense by the employer.
bPension expense is equal to the cash payments made to retirees
during the current period.
cNo pension expense is recognized in the income statement.
dIt does not use the services of a trustee to operate the pension
plan.
CHAPTER 10 NAME #
10-MINUTE QUIZ C SECTION
Seaview Industries received authorization on December 31, Year 1, to issue $7,000,000 face value of 6%, 10-
year bonds. The interest payment dates are June 30 and December 31. All the bonds were issued at par, plus
accrued interest, April 1, Year 2. The bonds are callable by Seaview Industries at any time at 102
1Prepare the journal entry to record issuance of the bonds on April 1, Year 2.
2Prepare the journal entry to record the $rst semiannual interest payment on the
bonds at June 30, Year 2.
3What is the amount of bond interest expense that appears in Seaview’s Year 2
income statement relating to these bonds?
$_________________________
4What is the amount of accrued bond interest expense that appears in Seaview’s
balance sheet at December 31, Year 2, with respect to these bonds?
$_________________________
5Seaview exercises the call provision and retires one-half of the bond issue on
July, 1, Year 4. Prepare the journal entry to record this transaction on July 1, Year
4.
CHAPTER 10 NAME #
10-MINUTE QUIZ D SECTION
On December 1, 2009, Fisher Corporation incurs a 30-year, $400,000 mortgage
liability upon purchase of a warehouse. This mortgage is payable in monthly
installments of $4,116, which include interest computed at the rate of 12% per
year. The $rst monthly payment is made on December 31, 2009.
1How much of the $rst payment made on December 31, 2009, is allocated to
repayment of principal? $________
2What is the total liability related to this mortgage to be reported in Fisher’s
balance sheet at December 31, 2009? (Do not separate into current and long-
term portions.)
$________
3The portion of the second monthly payment made on January 31, 2010, which
represents interest expense is: $________
4What is the aggregate amount paid by Fisher over the 30-year life of the
mortgage?
$________
5Over the 30-year life of the mortgage, the total amount Fisher will pay for
interest charges is
$________
SOLUTIONS TO CHAPTER 10 10-MINUTE QUIZZES
QUIZ A QUIZ B
QUIZ C
1
Cash ......................................................................... 7,105,000
Bonds Payable...................................................... 7,000,000
Bond Interest Payable........................................... 105,000
Issued $7,000,000 face value bonds at par,
interest for the period that the bonds were outstanding. ($7,000,000 x 6% x 9/12 =
$315,000)
4
Financial Accounting, 16e 10- 9
Chapter 10 - Liabilities
$0 accrued bond interest payable.
The interest payment date is Dec. 31; therefore, interest for the last six months of a
year is paid and does not appear as a liability in the balance sheet.
5
Bonds Payable........................................................... 3,500,000
Loss on Early Retirement of Bonds
bonds, originally issued at par, at 102.
QUIZ
1
$116 [$4,116 - $4,000 interest ($400,000 x .12 x 1/12)]
2
$399,884 [$400,000 - $116 repayment of principal]
Chapter 10 - Liabilities
Assignment Guide to Chapter 10
Brief
Exercise
s
Exercises Problems Cases Net
1-10 1-15
1
23456781 2 3 4 5
Time estimate (in minutes) <15 <15 4
0
4
0
2
5
3
0
3
0
3
0
4
0
4
0
3
0
20 2
5
20 20
difficulty rating E E M M S M M M M M M S M M S
Learning Objectives:
2, 3 √ √
1. De<ne liabilities and
distinguish between current
and long-term liabilities.
2. Account for notes payable and
interest expense. 1 2, 3
3. Describe the costs and the
basic accounting activities
relating to payrolls.
2, 4, 5
4. Prepare an amortization table
allocating payments between
interest and principal.
1, 2, 3, 6
5. Describe corporate bonds and
explain the tax advantage of
debt <nancing.
2 2, 3, 7, 8, 9,
10
√ √
6. Account for bonds issued at a
discount or premium. 3, 4, 5,
6, 8
2, 3, 9, 10 √ √
7. Explain the concept of present
value as it relates to bond
prices.
8. Explain how estimated
liabilities, loss contingencies,
and commitments are
disclosed in <nancial
statements.
3
Financial Accounting, 16e 10- 11
9. Evaluate the safety of
creditors’ claims.
7 11, 15
10. Describe reporting issues
related to leases,
postretirement bene<ts, and
deferred taxes.
9, 10 12, 13, 14
10-12 Instructor’s Resource Manual
