978-0136115274 Chapter 7 Lecture Notes

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CHAPTER 7

ACCOUNTING FOR LIABILITIES

CHAPTER OVERVIEW

The chapter begins with a discussion of types of liabilities: definitely determinable and

estimated. Accounting for payroll, warranties, long-term notes payable, and mortgages are

presented.

The next part of the chapter introduces bonds. Examples are provided that show how bonds are

issued and how periodic interest payments are made (including the effects of these transactions

on the financial statement accounts). Issuing bonds at par, premium, or discount is also covered.

Next, the chapter presents the calculation of bond proceeds from bonds issued at a premium or

discount. Finally, this section includes a discussion of amortizing the bond discount or premium

(effective interest method), pointing out that the amortization is a natural process of the

difference between the interest payments (based on face value and stated rate) and interest

expense (based on carrying value and market rate).

The chapter includes a summary problem that continues the Team Sports example from previous

chapters and presents the student with transactions for the seventh month of business. The

student is then shown how to record the transactions, make adjusting entries at the end of July,

and prepare the four financial statements for the business.

The debt-to-equity ratio is discussed. At the end of the chapter there is a section covering the

major risks associated with debt.

LEARNING OBJECTIVES

After completing Chapter 7, your students should be able to answer these questions:

1. Define a definitely determinable liability and explain how payroll is recorded.

2. Define estimated liability and explain how warranties are recorded.

3. Explain how long-term notes and mortgages work.

4. Record the issue of bonds and payment of interest to bondholders.

5. Prepare financial statements that include long-term debt.

6. Explain capital structure and compute the debt-to-equity ratio.

7. Identify the major risk associated with long-term debt and the related controls.

CHAPTER OUTLINE

Types of Liabilities (LO 1)

I. All liabilities, current or long term, can be classified as either definitely determinable,

estimated, or contingent.

a. Definitely determinable liabilities are obligations that can be measured exactly.

i. Examples include payroll, accounts payable, lines of credit, and notes payable.

b. Estimated liabilities are obligations that have some uncertainty in the amount, such

as the cost to honor a warranty.

Payroll (LO 1)

I. Payroll is a definitely determinable liability.

a. Gross pay is not the amount that an employee takes home.

b. Gross pay – deductions = net pay

c. Net pay is the amount that an employee takes home.

d. Deductions are withholdings a company makes.

e. Examples of deductions include federal and state taxes, social security, and Medicare.

f. Social security taxes (FICA) are currently 6.2%.

g. Medicare taxes are currently 1.45%.

h. When payroll is recorded, salary expense is increased. The deductions are increases

to individual payable accounts. The net pay is a decrease to cash.

i. Later, the deductions are paid. The payables and cash are decreased.

Teaching Tip

Use Exhibit 7.2 to illustrate the relationship among gross pay, deductions, and net pay.

Estimated Liabilities (LO 2)

I. Warranties

a. The costs associated with the warranty must be recognized in the same period as the

sale.

b. This will increase warranty expense and estimated warranty liability.

c. When a product is repaired, estimated warranty liability is decreased. Cash is also

decreased for the cost of repairs.

Long-Term Notes Payable and Mortgages (LO 3)

I. When a company borrows money for longer than one year, that obligation is called a

long-term note payable.

a. Typically repaid with a series of equal payments over the life of the note

b. Each monthly payment includes interest and principal reduction.

c. The amount of periodic interest expense declines over the life of the note, while the

amount of principal reduction increases.

Teaching Tip

Use Exhibit 7.3, Payments Comprised of Principal and Interest, to illustrate the payment on a

note payable.

II. A mortgage is a special kind of note payable.

a. Used for the specific purpose of purchasing property

b. Gives the lender a claim against that property if payments are not made

Teaching Tip

Use the example that begins on page 324 and Exhibit 7.4, Amortization Schedule for a Mortgage,

to show how payments reduce the outstanding principal.

Long-Term Liabilities: Raising Money by Issuing Bonds (LO 4)

I. What is a bond?

a. A bond is an interest-bearing, long-term note payable issued by corporations,

universities, and governmental agencies.

b. There are three main reasons why a company would borrow money by issuing bonds

rather than going to a bank for a loan:

i. Firms can borrow more money by issuing bonds than a bank may be willing to

lend.

ii. Bondholders are willing to lend money for a longer period of time than banks.

iii. Rate of interest on bonds is usually lower than the rate of interest on a bank

loan.

c. The issuance of bonds may involve disadvantages, such as restrictions against

additional borrowing or requirements to maintain certain financial ratio levels.

II. More about bonds:

a. Bondholders are creditors of a company, not owners.

b. Most bonds pay interest semiannually.

c. Most bonds have a face value in multiples of $1,000.

d. Bonds can be bought and sold in the secondary market.

e. Bond prices have an inverse relationship with interest rates.

i. When interest rates fall, bond prices increase.

ii. When interest rates rise, bond prices decrease.

f. Bonds issued at par are bonds issued for the face value of the bond.

i. Market rate is equal to bond’s stated rate of interest.

g. Bonds issued at a discount are bonds issued for an amount less than the face value

of the bond.

i. Market rate is greater than the bond’s stated rate of interest.

h. Bonds issued at a premium are bonds issued for an amount more than the face value

of the bond.

i. Market rate is less than the bond’s stated rate of interest.

i. Bonds may be secured or unsecured.

i. Secured bonds give the bondholders a claim to specific assets in case of

default.

ii. Unsecured bonds (debenture bonds) are not linked to specific assets of the

company.

j. Bonds may be term or serial.

i. Term bonds all mature on the same date.

ii. Serial bonds mature periodically over a period of several years.

Teaching Tip

Exhibit 7.6 provides a summary of types of bonds.

Teaching Tip

What factors cause a bond to sell at a discount? Initially, the underwriters try to estimate the

interest rate the market will be willing to accept. But the bonds are trading long after the

contract rate is set. There is lag time between when the interest rate is set and when the bonds

are actually issued. Many other factors may cause the bond to sell at a discount: the interest rate

on other investments available on the market; the rating of the bond; the interest rate on treasury

notes and bonds; general economic and political conditions; the supply of investment capital and

the demand for those funds; the nature of the business issuing the bonds; and specific events that

occur in the business’s operations. (Note: These same factors also can have the opposite effect

on the price of a bond and cause it to sell at a premium.)

Recording the Bond Issue (LO 4)

I. The market sets the price for a bond to be equal to the present value of the future cash

flows.

II. To get the present value, you must know the market rate of interest. This is the interest

rate that an investor could earn in an equally risky investment.

Accounting for Bonds Payable (LO 4)

I. Issuing bonds

a. Bonds issued at par

i. If market rate = stated rate, bonds sell at par.

ii. Investors pay face value for the bonds.

iii. Cash and bonds payable are increased.

b. Bonds issued at a discount

i. If market rate > stated rate, bonds will sell at a discount.

ii. Investors pay below face value for the bonds.

iii. The price of the bond is equal to:

1. The present value of the face value plus,

2. The present value of the interest payments.

3. Use the market rate of interest when calculating the present value

amounts.

iv. Cash, bonds payable, and discount on bonds payable are increased.

v. Discount on bonds payable is a contra-liability that is deducted from bonds

payable on the balance sheet. It is the difference between the face value of the

bond and its selling price, when the selling price is less than the face (par)

value.

vi. The carrying value of a bond is the amount that the balance sheet shows as

the net value of the bond, similar in meaning to the carrying value of a fixed

asset. It is equal to the face value of the bond minus any discount or plus any

premium.

Teaching Tip

Refer to Exhibit 7.7 for an example of how cash flows are discounted to calculate the price of a

bond.

c. Bonds issued at a premium

i. If market rate < stated rate, bonds will sell at a premium.

ii. Investors pay above face value for the bonds.

iii. The price of the bond is equal to:

1. The present value of the face value plus,

2. The present value of the interest payments.

3. Use the market rate of interest when calculating the present value

amounts.

iv. Cash, bonds payable, and premium on bonds payable are increased.

v. Premium on bonds payable is an adjunct liability that is added to bonds

payable on the balance sheet. It is the difference between the face value of the

bond and its selling price, when the selling price is more than the face (par)

value.

II. Paying the bondholders

a. Interest is calculated as principal (face value) x interest rate x time

b. Every interest payment will be identical.

i. Cash paid to the bondholder is determined by the terms of the bond

agreement.

ii. Not affected by issue price

Teaching Tip

Point out that in all cases, the market (investors) is getting the return (interest rate) that it wants.

Regardless of what is printed on the bond, the market will determine the issue price, giving the

investors the return they desire. The price is equal to the sum of the present value of the series of

interest payments (annuity) and the present value of the maturity value (lump sum).

III. Amortizing bond discounts and premiums: effective interest method

a. Bond discounts and premiums are written off over the life of the bond.

i. The amount of the discount or premium is reduced until it is zero.

ii. The write-off will increase or decrease the interest expense incurred by the

company and will cause interest expense to be different than the amount paid

to the bondholders).

iii. Carrying value = bonds payable minus the unamortized discount (or plus the

unamortized premium)

iv. Interest expense = carrying value of the bond x market rate of interest

v. Interest payment = face value of the bond x stated rate of interest

vi. Difference between interest expense and interest payment is the amount of

discount or premium written off during the period.

b. Payment of interest to bondholders and amortization of a discount (the interest

expense will be greater than the interest payment)

c. Payment of interest to bondholders and amortization of a premium (the interest

expense will be less than the interest payment)

Teaching Tip

Exhibits 7.8 and 7.9 provide examples of amortization schedules for bonds issued at a discount

and at a premium.

Teaching Tip

The amortization table can be very intimidating to students. One way to help overcome the

intimidation factor is to demonstrate how to prepare a table by walking them through it with their

calculators. This is a tedious exercise, but it can help to alleviate some of the anxiety about

producing a table.

IV. Straight-line amortization of bond discounts and premiums

a. Divide the discount or premium by the number of interest payments.

b. Not allowed by GAAP unless it produces substantially the same results as the

effective interest method

Team Shirts for July (LO 5)

I. The summary problem uses the Team Shirts example developed in previous chapters.

II. Transactions for the month of July are introduced.

III. The students are shown how to record the July transactions in a worksheet, make the

necessary adjusting entries, and prepare financial statements for the month of July.

Applying Your Knowledge: Financial Statement Analysis (LO 6)

I. Two ways to finance a business are debt and equity.

a. The combination of debt and equity financing that a company chooses is called the

capital structure.

b. Financial leverage

i. Concept of using borrowed funds to increase return is financial leverage.

ii. When the benefit of borrowing (what the company can earn) exceeds the cost

of borrowing (interest expense), then borrowing is a good idea (positive

financial leverage).

II. Debt-to-equity ratio

a. Equal to total liabilities divided by stockholders’ equity

b. Compares the amount of creditors’ claims to the assets to the owners’ claims to those

assets

c. A firm with a high debt-to-equity ratio is said to be highly leveraged.

III. Much of the information about a company’s debt is in the notes to the financial

statements.

Business Risk, Control, and Ethics (LO 7)

I. Risk associated with debt is risk to both the company and its creditors.

II. Primary risk associated with debt is not being able to make debt payments.

III. The more debt a company has, the more risk there is that the company won’t be able to

pay the debt as it comes due.

IV. To minimize the risk associated with debt:

a. Thoroughly analyze whether there is a probability of earning a higher return with the

borrowed funds than the interest cost associated with borrowing the funds.

b. Study the characteristics of the various types of debt and evaluate their attractiveness

for the particular circumstances.