CHAPTER 10
LIABILITIES
Student Learning Objectives and Related Assignment Materials
Student Learning
Objectives
Mini–
Exercises
Exercises
Coached
Problems
Problems
(Groups
A & B)
Compre-
hensive
Problem
Skills
Develop-
ment
Cases
Continuing
Cases
LO 10-1 Explain the
role of liabilities
in financing a
business.
3
LO 10-2 Explain
how to account
for common types
of current
liabilities.
1, 2, 3,
4, 5*, 6,
7
1, 2*,
3*, 4, 5,
6
1, 2, 3
A1, A2,
A3*, B1,
B2, B3
1^+
3
1†, 2^£
LO 10-3 Analyze
and record bond
liability
transactions.
8, 9, 10,
11
7, 8*, 9
A4, B4,
B5
3, 4, 5
LO 10-4 Describe
how to account
for contingent
liabilities.
12
4
A5
3
LO 10-5 Calculate
and interpret the
debt-to–assets
ratio and times
interest earned
ratio.
13, 14
5, 10*
1, 2, 5
A1, A2,
B1, B2
1^+
1, 2, 3, 6
LO 10-S-1 Use
straight-line bond
amortization.
15
11, 14
6, 9
A6, B6
7
LO 10-S-2 Use
effective-interest
bond
amortization.
16
12, 15
7, 10
A7, B7
8
LO 10-S-3 Use
simplified
effective-interest
bond
amortization.
17
13, 16
8, 10
A8, B8
9
(Table footnotes on next page.)
Student Learning Objectives and Related Assignment Materials, continued
* Animated solution included in the PowerPoint Slides.
^ Particularly challenging; requires students to combine multiple concepts in order to advance to the
next level of accounting knowledge.
+ Comprehensive Problem 10-1 also covers LO 9-3 and LO 9-7
† Continuing Case 10-1 builds on the story of Nicole’s Getaway Spa, introduced in earlier chapters. This
case focuses on analyzing transactions and preparing journal entries for notes payable and contrasting
the accounting for notes payable and notes receivable. This case will be extended in future chapters.
£ Continuing Case 10-2 builds on the story of Wiki Art Gallery (WAG), an instructional case in
Connect. This case focuses on the calculation of interest expense and the impact of a decision
regarding salary. The case will be extended in future chapters.
Overview
The significant role that current and long-term liabilities play in financing businesses is highlighted.
Students learn accounting principles applied to current liabilities (including Accounts Payable, Accrued
Liabilities, Accrued Payroll, Notes Payable, Sales Tax Payable, Unearned Revenue, and Current Portion
of Long-Term Debt) and bond liabilities.
Synopsis of Chapter Revisions
• Updated focus company illustrations
• New Spotlight on Business Decisions to discuss accounting for crowdfunding liabilities arising from
Indiegogo, Kickstarter, and Prosper arrangements
• New illustration to distinguish different bond types and features
• Replaced quick ratio with debt-to-assets ratio
• New Chapter Supplement 10D included in Connect on installment notes
• Reviewed, updated, and introduced new end-of-chapter material
PowerPoint Slides
Student Learning Objective
PowerPoint® Slides
LO 10-1 Explain the role of liabilities in financing a business.
10-2 through 10-4
LO 10-2 Explain how to account for common types of current liabilities.
10-5 through 10-22
LO 10-3 Analyze and record bond liability transactions.
10-23 through 10-34
LO 10-4 Describe how to account for contingent liabilities.
10-35 through 10-36
LO 10-5 Calculate and interpret the debt-to–assets ratio and times interest
earned ratio.
10-37 through 10-40
LO 10-S-1 Use straight-line bond amortization.
10-41 through 10-46
LO 10-S-2 Use effective-interest bond amortization.
10-47 through 10-53
LO 10-S-3 Use simplified effective-interest bond amortization.
10-54 through 10-58
Animated Builds and Animated Solutions
PowerPoint® Slides
Mini-Exercise 10-5
10-60
Exercise 10-2
10-61 through 10-62
Exercise 10-3
10-63 through 10-64
Exercise 10-8
10-65 through 10-66
Exercise 10-10
10-67 through 10-68
Problem A10-3
10-69 through 10-71
Chapter Summary
LO 10-1 Explain the role of liabilities in financing a business.
• Liabilities play a vital role in allowing a business to buy goods and services on credit, cover gaps
in cash flows, and expand into new regions and markets.
• Liabilities are classified as current if due to be paid with current assets within the current
operating cycle of the business or within one year of the balance sheet date (whichever is longer).
All other liabilities are considered long term.
LO 10-2 Explain how to account for common types of current liabilities.
• Liabilities are initially reported at their cash equivalent value, which is the amount of cash that a
creditor would accept to settle the liability immediately after the transaction or event occurred.
• Liabilities are increased whenever additional obligations arise (including interest) and are reduced
whenever the company makes payments or provides services to the creditor.
LO 10– 3 Analyze and record bond liability transactions.
• For most public issuances of debt (bonds), the amount borrowed by the company does not equal
the amount repaid at maturity. The effect of a bond discount is to provide the borrower less
money than the value stated on the face of the bond, which increases the cost of borrowing above
the interest rate stated on the bond. The effect of a bond premium is to provide the borrower more
money than the face value repaid at maturity, which decreases the cost of borrowing below the
stated interest rate.
• Interest Expense reports the cost of borrowing, which equals the periodic interest payments plus
(or minus) the amount of the bond discount (or premium) amortized in that interest period.
LO 10-4 Describe how to account for contingent liabilities.
• A contingent liability is a potential liability (and loss) that has arisen as a result of a past
transaction or event. Its ultimate outcome will not be known until a future event occurs or fails to
occur. Under GAAP, it is recorded when likely and reasonably estimable.
LO 10-5 Calculate and interpret the debt-to-assets ratio and the times interest earned ratio.
• The debt-to–assets ratio is calculated by dividing total liabilities by total assets. It indicates the
percentage of assets financed by creditors, with a higher ratio indicating a riskier financing
strategy.
• The times interest earned ratio measures a company’s ability to meet its interest obligations with
resources generated from its profit-making activities.
Accounting Decision Tools
1. Debt-to-Assets Ratio = Total Liabilities ÷ Total Assets
• It tells you the percentage of assets financed by creditors.
• A higher ratio means greater financing risk.
2. Times Interest Earned Ratio = (Net Income + Interest Expense + Income Tax Expense) ÷
Interest Expense
• It tells you whether sufficient resources are generated to cover interest costs.
• The higher the number the better the coverage.
Chapter Outline
Teaching Notes
I. Understand the Business
LO 10-1 Explain the role of liabilities in financing a business.
A. The Role of Liabilities
1. Liabilities are created when a company buys goods and
services on credit, obtains short-term loans to cover gaps
in cash flows, and issues long-term debt to obtain money
for expanding into new regions and markets.
2. To help financial statement users know when liabilities
must be repaid, companies prepare a classified balance
sheet.
Illustrated in Exhibit 10.1
3. Current Liabilities––Short-term obligations that will be
paid or fulfilled within the current operating cycle or one
year, whichever is longer.
II. Study the Accounting Methods
A. Measuring Liabilities
1. The dollar amount reported for liabilities is the result of
three things:
a. The initial amount of the liability—Initially, a
company records each liability at the amount of cash
that a creditor would accept to settle the liability
immediately after the transaction or event occurred.
b. Additional amounts owed to the creditor—The
company increases liabilities whenever additional
obligations arise, by purchasing goods or services,
receiving customer deposits, or incurring interest
charges over time.
c. Payments or services provided to the creditor—The
company decreases liabilities whenever the company
makes payments or provides services to the creditor.
LO 10-2 Explain how to account for common types of current liabilities.
B. Current Liabilities
1. Accounts Payable
a. Increased (credited) when a company receives goods
or services on credit and it is decreased (debited) when
the company pays on its account.
b. Interest free unless it becomes overdue.
2. Accrued Liabilities
Illustrated in Exhibit 10.2
a. Report the liability for expenses that have been
incurred but not paid at the end of the accounting
period.
b. Recorded in adjustments at the end of the accounting
period.
c. Relate to various unpaid expenses, including
advertising, electricity, corporate income tax, interest,
payroll tax, and warranties.
Chapter Outline
Teaching Notes
3. Accrued Payroll
a. Payroll Deductions
i. Gross earnings—Computed by multiplying the
time worked by the pay rate promised by the
employer.
ii. Payroll deductions—Amounts subtracted from
employees’ gross earnings to determine their net
pay.
Illustrated in Exhibit 10.3
• Payroll deductions create current liabilities for
the employer.
• Either required by law or voluntarily requested
by employees.
• FICA taxes withheld—Amounts paid for
Medicare and Social Security as required by the
Federal Insurance Contributions Act; in 2014,
employers were required to withhold 1.45%
from each employee’s earnings for Medicare as
well as 6.2% on earnings up to $117,000 for
Social Security.
• Employers use these same methods to account
for any other payroll deductions (including
voluntary deductions for charitable donations,
parking, union dues, retirement savings, etc.).
iii. Net pay—Equals gross earnings less payroll
deductions.
iv. Gross pay for all employees totals $600,000;
$58,000 is withheld for employees’ income tax
payable; $48,800 is withheld for FICA taxes; and
$10,000 is withheld for voluntary United Way
contributions.
• Analyze:
Assets = Liabilities + Stockholders’ Equity
Cash (A) –483,200; Withheld Income Tax
Payable (L) +58,000; FICA Payable (L)
+48,800; United Way Payable (L) +10,000;
Wages and Salaries Expense (E) –600,000
• Record:
Wages and Salaries Expense
600,000
Withheld Income Tax Payable
58,000
FICA Payable
48,800
United Way Payable
10,000
Cash
483,200
Chapter Outline
Teaching Notes
b. Employer Payroll Taxes
1. Employers are also required to pay FICA taxes
equal to 100% of total employee contributions
(called a “matching” contribution).
✓ Supplemental
Enrichment Activity
(Activity) #1
2. Employers are also required by the Federal
Unemployment Tax Act (FUTA) and State
Unemployment Tax Act (SUTA) to pay
unemployment taxes; the rates vary.
3. Reporting:
• Payroll taxes are reported as an additional
operating expense on the income statement.
• Until paid, liabilities for these taxes are reported
as current liabilities.
4. The company was required to contribute $48,800
for FICA, $750 for federal unemployment tax, and
$4,000 for state unemployment tax.
• Analyze:
Assets = Liabilities + Stockholders’ Equity
FICA Payable (L) +48,800; Unemployment Tax
Payable (L) +4,750; Payroll Tax Expense (E) –
53,550
• Record:
Payroll Tax Expense
53,550
FICA Payable
48,800
Unemployment Tax Payable
4,750
5. When the amounts withheld and payroll taxes are
paid, the related liability accounts decrease (with
debits) and Cash decreases (with a credit).
c. Accrued Income Taxes—Corporations pay taxes not
only on payroll but also on income they earn.
1. The corporate tax return, Form 1120, is similar to
the company’s income statement, except that it
calculates taxable income by subtracting tax-
allowed expenses from revenues.
2. This taxable income is then multiplied by a tax
rate, which ranges from about 15% to 35%.
3. Corporate income taxes are due two and a half
months after year-end, although most corporations
are required to pay advance installments during the
year.
Chapter Outline
Teaching Notes
4. Notes Payable
Stress that the accounting for
a. Notes Payable—A liability that represents the amount
the company owes to others as a result of issuing
promissory notes.
notes payable mirrors that of
notes receivable (chapter 8)
b. Establish the note payable
✓ Activity #2
i. On November 1, 2015, the company borrowed
$100,000 cash on a one-year note that required it to
pay 6% interest and $100,000 principal, both on
October 31, 2016.
ii. Analyze:
Assets = Liabilities + Stockholders’ Equity
Cash (A) +100,000; Note Payable (L) +100,000
iii. Record:
Cash
100,000
Note Payable
100,000
c. Accrue interest incurred by not paid
i. Under accrual accounting, interest must be
recorded as it is incurred over time.
Illustrated in Exhibit 10.4
ii. Interest owed on the note is calculated as Interest ×
Principal Owed × Interest Rate × Time.
iii. From the date the note was established (11/1/15) to
the end of the year (12/31/15), the company
incurred two months of interest expense, which
equals $1,000 (or $100,000 × 6% × 2/12).
• Analyze:
Assets = Liabilities + Stockholders’ Equity
Interest Payable (L) +1,000; Interest Expense
(E) –1,000
• Record:
Interest Expense
1,000
Interest Payable
1,000
d. Record interest paid
i. At maturity, the company pays interest of $6,000
(or $100,000 × 6% × 12/12), which includes the
$1,000 that was accrued as Interest Payable at
12/31/15, plus interest expense incurred during the
10 months between 1/1/16 and 10./31/16 of
$5,000 (or $100,000 × 6% × 10/12).
ii. Analyze:
Assets = Liabilities + Stockholders’ Equity
Cash (A) –6,000; Interest Payable (L) –1,000;
Interest Expense (E) –5,000
iii. Record:
Interest Payable
1,000
Interest Expense
5,000
Cash
6,000
Chapter Outline
Teaching Notes
e. Record principal paid—At maturity, the company will
record the payment of the note by debiting Notes
Payable and crediting Cash
5. Additional Current Liabilities
a. Sales Tax Payable—Retail companies are required to
charge a sales tax in all but five states.
i. Retailers collect sales tax from consumers at the
time of sale and forward it to the state government.
ii. The sales tax collected by the company is reported
as a current liability until paid; the sales tax
collected is not an expense to the retailer because
the tax is simply collected and passed on to the
government.
iii. Retailers record sales by debiting Cash (for the
amount collected by the customer), crediting Sales
Tax Payable (for the amount of the sale times the
tax rate) and crediting Sales Revenue.
iv. The payment of the sales tax by the retailer to the
state government would be recorded by debiting
Sales Tax Payable and crediting Cash.
b. Unearned Revenue
✓ Activity #3
i. Receive cash and create a liability—When a
company receives cash from a customer before
providing the goods or services, it initially debits
Cash and credits a liability called Unearned
Revenue.
Remind students that
Unearned Revenues were
covered in chapter 4.
ii. Fulfill part of the liability and earn revenue
• As each accounting period passes, the company
will make an adjustment to show that it has
continued to fulfill its obligation and earn its
revenues.
The “Spotlight on Business
Decisions” feature addresses
jumpstarting a business with
crowdfunding.
• The adjustment decreases Unearned Revenue
(with a debit) and increases Service Revenue
(with a credit).
6. Current Portion of Long-Term Debt
a. If a company borrows money with the promise to
repay it after the current operating cycle or one year,
whichever is longer, the amount of the loan is
classified as long-term debt.
b. Only the accrued interest on the loan is reported as a
current liability in that year’s balance sheet.
Chapter Outline
Teaching Notes
C. Long-Term Liabilities
LO 10-3 Analyze and record bond liability transactions.
1. Financial instruments that outline the future payments a
company promises to make in exchange for receiving a
sum of money now.
2. Bonds—Financial instruments that outline the future
payments a company promises to make in exchange for
receiving a sum of money now.
a. From the company’s perspective, the bond is a long–
term liability.
b. From the bondholder’s perspective, the bond is an
investment; bonds can be attractive because:
i. They return higher interest rates than bank savings
accounts, and after a company issues the bonds,
they can be traded on established exchanges.
ii. After a company issues the bonds, they can be
traded on established exchanges.
c. Three key elements of a bond:
i. Maturity Date—The date on which the bonds are
due to be paid in full.
ii. Face Value—The payment made when the bond
matures.
iii. Stated Interest Rate—The rate stated on the face
of the bond, which is used to compute interest
payments
3. Bond Pricing
a. Bond Issue Price––The amount that investors are
willing to pay on the issue date in exchange for the
cash payments that the company promises to make
over the life of the bond.
The “Spotlight on Financial
Reporting” feature addresses
bond prices in the financial
press.
b. Theoretically, the issue price is based on Present
Value––A mathematical calculation that determines
the amount that one or more payments made in the
future are worth today.
Described in Appendix C at
the end of this book.
4. Accounting for a Bond Issue
a. The amount of cash the company receives from
investors when the bonds are first issued may be equal
to the face value, above the face value, or below the
face value.
i. A bond is issued at a premium when the issue price
is greater than the face value; Premium––the
amount by which a bond’s issue price exceeds its
face value.
ii. A bond is issued at a discount when the issue price
is less than the face value; Discount––The amount
by which a bond’s issue price is less than its face
value.
Chapter Outline
Teaching Notes
b. Bonds Issued at Face Value
i. The company receives $100,000 cash in exchange
for issuing 100 bonds at their $1,000 face value.
ii. Analyze:
Assets = Liabilities + Stockholders’ Equity
Cash (A) +100,000; Bonds Payable (L) +100,000
iii. Record:
Cash
100,000
Bonds Payable
100,000
c. Bonds Issued at a Premium
i. The company issues 100 of its $1,000 bonds at a
price of 107.26 and receives $107,260 (or 100 ×
$1,000 × 1.0726).
ii. Analyze:
Assets = Liabilities + Stockholders’ Equity
Cash (A) +107,260; Bonds Payable (L) +100,000;
Premium on Bonds Payable (L) +7,260
iii. Record:
Cash
107,260
Bonds Payable
100,000
Premium on Bonds
Payable
7,260
iv. If a bond offers something attractive, such as a
high interest rate, bondholders may be willing to
pay a premium to acquire it.
d. Bonds Issued at a Discount
i. The company receives $93,376 for bonds with a
total face value of $100,000; the discount of $6,624
(or $100,000 – $93,376) offsets the face value, so
accountants will record it in a contra-liability
account (identified as xL).
ii. Analyze:
Assets = Liabilities + Stockholders’ Equity
Cash (A) +93,376; Bonds Payable (L) +100,000;
Discount on Bonds Payable (xL) +6,624
iii. Record:
Cash
93,376
Discount on Bonds
Payable
6,624
Bonds Payable
100,000
iv. If a bond promises to pay interest at a stated rate of
6 percent when other financial instruments offer 8
percent, no one will be willing to buy the bond
unless the company discounts it.
v. The discount increases the return that bondholders
earn on their initial investment.
vi. Market Interest Rate––The rate of interest that
investors demand from a bond.