Chapter 10 – Liabilities
Financial and Managerial Accounting, 17e 10-1
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 benefits 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 financing. 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 fluctuations 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 financial leverage.
This discussion emphasizes how creditors use accounting data to evaluate the safety of their
claims.
Learning Objectives
1. Define 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.
Chapter 10 – Liabilities
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
financial statements.
9. Evaluate the safety of creditors’ claims.
10. Describe reporting issues related to leases, postretirement benefits, and deferred taxes.
Brief topical outline
A The nature of liabilities
1 Distinction between debt and equity
2 Many liabilities bear interest
3 Estimated liabilities
B Current liabilities
1 Accounts payable
2 Notes payable
3 The current portion of long-term debt
4 Accrued liabilities
5 Payroll liabilities
a Payroll taxes and mandated costs
b Other payroll-related costs
c Amounts withheld from employees’ pay
d Recording payroll activities
6 Unearned revenue
C Long-term liabilities
1 Maturing obligations intended to be refinanced – see Case in Point (page 438)
2 Installment notes payable
a Allocating installment payments between interest and principal
b Preparing an amortization table
c Using an amortization table
d The current portion of long-term debt
3 Bonds payable
a What are bonds?
b The issuance of bonds payable
c Transferability of bonds
d Quoted market prices
e Types of bonds
f Junk bonds
g Tax advantage of bond financing
h Accounting for bonds payable
i Bonds issued between interest dates
D Bonds issued at a discount or a premium
1 Accounting for a bond discount: an illustration
Chapter 10 – Liabilities
Financial and Managerial Accounting, 17e 10-3
a Bond discount: part of the cost of borrowing
b Amortization of the discount
2 Accounting for a bond premium: an illustration
a Bond premium: a reduction in the cost of borrowing
b Amortization of the premium
3 Bond discount and premium in perspective
4 The concept of present value
a The present value concept and bond prices
5 Bond prices after issuance – see Case in Point (page 451)
a Volatility of short-term and long-term bond prices
– see Your Turn (page 452)
6 Early retirement of bonds payable
E Estimated liabilities, loss contingencies, and commitments
1 Estimated liabilities
2 Loss contingencies
a Loss contingencies in financial statements
3 Commitments
F Evaluating the safety of creditors’ claims
1 Methods of determining creditworthiness
a Interest coverage ratio
b Less formal means of determining creditworthiness
2 How much debt should a business have?
G Financial analysis and decision making – see Your Turn (page 456) and Ethics,
Fraud & Corporate Governance (page 457)
H Special types of liabilities
1 Lease payment obligations
2 Operating leases
3 Capital leases
a Distinguishing between capital leases and operating leases
4 Liabilities for pensions and other postretirement benefits
a Determining pension expense
b Postretirement benefits other than pensions
c Unfunded postretirement costs are noncash expenses
d Unfunded liabilities for postretirement costs: are they significant
amounts?
5 Deferred income taxes
a Deferred income taxes in financial statements
I Concluding 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:
1 Define liabilities. Distinguish between liabilities and owners’ equity.
2 Distinguish 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).
3 Account for notes payable when interest is stated separately.
4 Explain the nature of payroll liabilities including payroll taxes and other mandated costs.
5 Explain the purpose of an amortization table. Illustrate the preparation and use of
such a table in the context of an installment note payable.
6 Discuss 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.
8 Introduce the concept of present value and its relationship to bond prices.
9 Distinguish 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.
Chapter 10 – Liabilities
Financial and Managerial Accounting, 17e 10-5
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.
Chapter 10 – Liabilities
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
the reader of the financial statements to evaluate the financial risk associated with the pending
litigation.
Supplemental Exercises
Group Exercise
Current liabilities are defined 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 benefits and describe the information you find.
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 – Liabilities
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.
1 Refer to the above data. The December 31, 2010, adjusting entry for this note includes:
a A credit to Cash for $1,400.
b A credit to Interest Payable for $8,400.
c A credit to Interest Payable for $1,400.
d A credit to Interest Payable for $700.
2 Refer 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.
3 Refer 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.
4 Refer 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.
5 Refer to the above data. The liability for this loan as of December 31, 2010:
a Is equal to its maturity value.
b Is equal to the book value of the two trucks that were acquired in exchange.
c Is classified as a long-term liability, since it was used to acquire non-current assets.
d Is classified as a long–term liability if Central Food has the intent and ability to
refinance by taking out a new loan not due for several years.