Financial Accounting: Liabilities

Financial Accounting
Eleventh Edition
Global Edition
Chapter 9
Liabilities
Copyright © 2018 Pearson Education, Inc. All Rights Reserved.

Learning Objectives
9.1 Understand the various types of liabilities
9.2 Account for contingent liabilities
9.3 Account for bonds
9.4 Account for leases
9.5 Analyze the advantages and disadvantages of borrowing
9.6 Evaluate a company’s debt-paying abilities

Learning Objective 9.1
Understand the various types of liabilities

Understand the Various Types of
Liabilities (1 of 23)
The Conceptual Framework defines liability as
• Obligations settled through outflow of resources
embodying economic benefit
• Two kinds:
– If short-term  current liability
– If long-term  non-current liability

Account for Current and Contingent
Current Liabilities of Known Amounts
• Accounts payable
• Accrued liabilities (or accrued expenses)
• Deposits
• Unearned revenues
• Payroll-related liabilities

Current Liabilities of Known Amounts
• Sales tax payable
• Tax payable
• Provisions
• Notes payable
• Debt

Accounts Payable
• Amounts owed for products or services purchased on
account
• Example: credit purchase of inventory
• Accounts payable turnover
– Important measure of liquidity
– Measures the number of times a year a company is
able to pay its accounts payable

Accrued Liabilities (or Accrued Expenses)
• Results from an expense that the business has incurred
but not yet paid
• Accrued expenses create a liability
• Categories:
– Salaries and Wages Payable
– Interest Payable

Deposits
• Amount paid for securing goods and property, or services
such as power supplies and telephony services
• Deposits are refundable

Unearned Revenues
• Also called deferred revenues and revenues collected
in advance
• Business has received cash from customers before
earning the revenue
• Creates a liability – an obligation to provide goods or
services to the customer

Unearned Revenues. On December 15, Thai Airways
collects $1,000 for a round-trip ticket from Bangkok to
Madrid. It records the cash collection and related liability:

Unearned Revenues. Suppose on December 28, the
customer flies to Madrid. The entry is as follows:

Unearned Revenues. On January 4, 20X1, the customer
returns to Bangkok and Thai Airways records the revenue
earned as follows:

Payroll-related Liabilities
• Also called employee compensation
• Major expense account
• Takes many different forms:
– Salary
– Wage
– Commission
– Bonus

Exhibit 9-1 Accounting for Payroll
Expenses and Liabilities
Accounting for all forms of compensation follows the pattern
illustrated here (using assumed figures):

• Pension and Postretirement Liabilities
– Employee compensation that will be received during
retirement
– One of the most complex areas of accounting
– Obligation for future pension payments accumulates
over time
– Each period the company must determine if the plan is
over or underfunded by comparing:
 Fair market value of assets in the retirement plan, to
 Plans’ projected benefit obligation

Sales Tax Payable
• Most states levy sales tax on retail sales
– Goods and Services Tax (GST)
– Value-Added Tax (VAT)
• Retailers collect sales tax from customers and then remit
collections to the state.

Sales Tax Payable. Sales at a IKEA totaled $200,000 (all in
cash). IKEA collected an additional 5% ($10,000) of sales
tax. The store would record that day’s sales as follows:

Tax Payable
• Calculated as the prevailing tax rates multiplied by the
profit before tax of the business.
• Corporate tax may be paid in instalments during the year.

Provisions
• Liabilities of uncertain timing and amount
• Covered under IAS 37—Provisions, Contingent Assets and
Contingent Liabilities
• Companies may guarantee their products under a warranty
• May extend for 90 days to a year
• Matching principle demands the company records the
warranty expense in the same period the business records
sales revenue

Provisions. Black & Decker sold 100,000 power tools. It
uses IAS 37 to work out its warranty obligation amounting to
$75,000. The warranty expense would be recorded as the
following entry:

Provisions. In the following year, Black & Decker spent
$72,000 repairing these faulty products. The expense would
be recorded as:

Notes Payable – Short-Term
• Common form of financing
• Due within one year
• Issued to borrow cash or purchase assets
• May accrue interest expense and interest payable at the
end of the period.

Short-Term Notes Payable. The following entries cover the
purchase of inventory costing $8,000, accrual of interest
expense, and payment of a 10% short-term note payable
due in one year:

Short-Term Notes Payable. The following entries cover the
purchase of inventory costing $8,000, accrual of interest
expense, and payment of a 10% short-term note payable
due in one year:

Short-Term Notes Payable. The following entry records the
note’s payment at maturity on March 1, 20X1:

Debts – Current Portion of Long-Term Debt
• Also called current maturity or current installment
• Amount of the principal that is payable within one year
• At the end of each year, company reclassifies amount of
long-term debt that must be paid next year
– Reclassified from long-term to current.

Account for contingent liabilities

Account for Contingent Liabilities
(1 of 2)
• A potential liability that depends on the future outcome of
past events
– Possible obligation to be confirmed by a future event
– Present obligation that may/may not require outflow of resources
– Reliable estimate of amount of present obligation cannot be made
• Examples: future liabilities that may arise due to lawsuits,

tax disputes, or alleged violations of environmental
protection laws
• Either: accrue, disclose, or neither.

Account for Contingent Liabilities
(2 of 2)
• Can be overlooked when creating a Balance Sheet as they
aren’t actual debts
• Net income will be overstated if the company fails to
accrue interest on liability

Summary of Current Liabilities

Account for bonds

Account for Bonds (1 of 24)
Bonds: An Introduction
• Debts of an issuing company
• Bond certificate states:
– Issuing corporation’s name
– Maturity date
– Principal amount (face value, maturity value, par value)
– Annual interest rate
– Interest payment dates

Exhibit 9-2 Bond Certificate (Adapted)

• Types of bonds:
– Term: all mature at the same time
– Serial: mature in installments over time
– Secured: give the bondholder the right to assets of the
issuer if the company defaults
– Debentures (unsecured): backed only by the good
faith of the borrower

• Bond Prices
– Quoted as a percentage of their maturity value
• Bond Premium and Bond Discount
– Premium  issued above face value (credit balance)
– Discount  issued below face value (debit balance)

• Time value of money
– Affects the pricing of bonds
• Bond interest rates determine bond prices
– Always sold at market price (bond’s present value)
– Stated interest rate (coupon rate)
– Market interest rate (effective interest rate)

Exhibit 9-3 How Stated Interest Rate and Market
Interest Rate Interact to Determine the Price of a
Bond

Issuing Bonds Payable at Par. Suppose Jardine has
$50,000 of 9% bonds payable that mature in five years.
Jardine issued these bonds at par on January 1, 20X1.

Issuing Bonds Payable at Par. Interest payments occur
each January 1 and July 1. Jardine’s entry to record the first
semiannual interest payment is as follows:

Issuing Bonds Payable at Par. At year-end, Jardine
accrues interest expense and interest payable for six months
(July through December), as follows:

Issuing Bonds Payable at Par. At maturity, January 1,
20X6, Jardine pays off the bonds as follows:

Issuing Bonds Payable at a Discount. Jardine issued
$100,000 of 9%, five-year bonds when the market interest
rate is 10%. The market price of the bonds drops, and
Jardine receives $96,139 at issuance.

Jardine’s balance sheet:

Each semi-annual cash interest payment is set by the
bond contract and remains constant over the life of the
bond:

Exhibit 9-4 Debt Amortization for a
Bond Discount (1 of 8)

Exhibit 9-4 Bond Amortization Table
(2 of 8)

(3 of 8)
Interest Expense on Bonds Issued at a Discount

(4 of 8)
Column B: Interest payment is fixed by contract

Column C: Interest expense increases as the discount bond
approaches maturity
(5 of 8)
Interest Market interest x Preceding bond

Expense = rate of 5% carrying amount
4,807 = .05 x 96,149

(6 of 8)
Column D:
Interest Payment – Interest Expense = Discount
Amortization
(7 of 8)
Column E: Discount balance decreases when amortized

(8 of 8)
Column F: Bond carrying amount increases from

issuance to maturity by the amount of the discount
amortization each period

Exhibit 9-5 Interest Expense on
Bonds Payable Issued at a Discount

Exhibit 9-6 Amortizing Bonds Payable
Issued at a Discount

Issuing Bonds Payable at a Discount. Jardine’s journal
entry to record interest expense and the interest payment for
the first 6 months follows:

Issuing Bonds Payable at a Discount. At December 31,
20X1, Jardine accrues interest and amortizes the bond
discount for July through December as follows:

Issuing Bonds Payable at a Premium. On January 1,
20X1, Jardine issued $100,000 of 9%, five-year bonds when
the market interest rate is 8%. The issue price is $104,055.
The issuance of the bonds is recorded as follows:

Jardine’s balance sheet

Exhibit 9-7 Debt Amortization for a
Bond Premium (1 of 8)

(2 of 8)

(3 of 8)

(4 of 8)
Column B: Interest payment is fixed by contract

Column C: Interest expense decreases as the premium
bond approaches maturity

(5 of 8)
Interest Market interest Preceding bond

Expense = rate of 4%
x carrying amount
4,164 = .04 x 104,100

(6 of 8)
Column D:
Interest payment – Interest expense = Premium
Amortization

(7 of 8)
Column E: Premium balance decreases when amortized

throughout the bond’s life

(8 of 8)
Column F: Bond carrying amount decreases from

issuance to maturity as the premium is amortized

Exhibit 9-8 Interest Expense on
Bonds Payable Issued at a Premium

Exhibit 9-9 Amortizing Premium on
Bonds Payable

Issuing Bonds Payable at a Premium. Jardine’s journal
entry to record the first interest expense and the interest
payment follows:

Partial-Period Interest Amounts. Fuji-Xerox issues
$100,000 of 8% bonds payable at 96 on August 31, 20X0.
The market interest rate was 9%, and these bonds pay semi-
annual interest. The first few lines of Fuji-Xerox’s
amortization table are as follows:

Partial-Period Interest Amounts. Fuji-Xerox’s accounting
year end is December 31, so at year-end it must accrue
interest and amortize bond discount for 4 months as follows:

The Straight-line Amortization Method
• Interest expense increases each period
• Discount amortized over term of the bonds
• Straight-line amortization divides the bond discount into
equal amounts over bond’s term
Jardine’s bond amortization is calculated as follows:

The Straight-line Amortization Method. Jardine’s entry to
record interest expense on July 1, 20X1 using the straight-
line amortization method is as follows:

Should We Retire Bonds Before Maturity?
• Reasons to retire early
– Relieve the pressure of high interest payments
– May be able to borrow at a lower rate
• Callable bonds
– Issuer may pay off at a prearranged price whenever
issuer chooses
– Creates gain or loss

Jardine has $300 million of debenture bonds outstanding.
The unamortized discount is $30 million and the bonds are
callable at 101. If the market price of the bonds is 99, will
Jardine call the bonds at 101 or purchase them for 99 in the
open market?

Convertible Bonds and Notes
• Bonds may be converted into share
• Investors benefit from:
– Assured receipt of interest and principal on the bonds
– Potential for gains on share
• Very attractive to investors, often accept lower interest rate

Convertible Bonds and Notes. Jardine has convertible
notes payable of $100 million. Assume the note holders
convert notes into 4 million shares of Jardine’s shares ($1
par) on May 14.

Account for leases

Account for Leases (1 of 3)
• Lease – rental agreement in which the tenant agrees to
make rent payments to the property owner in exchange for
the use of the assets
• IAS 17—Leases provides for two categories of leases
– Operating – give the lessee the right to use asset but
provide no continuing rights, sometimes cancelable
– Capital – often used to finance acquisition of long-term
assets, noncancelable debt (also referred to as
Finance Leases)

Understand Other Long-Term
Capital Lease Criteria
1. Lease transfers title at the end of the term
2. Lease contains a bargain purchase option
3. Lease term is 75% or more of the asset’s estimated
useful life
4. Present value of the lease payments is 90% or more of
market value of leased asset

Analyze the advantages and disadvantages of borrowing
•

Analyze the Advantages and
Disadvantages of Borrowing (1 of 3)
• Three main ways to finance operations:
– Financed by retained earnings
– Issuing shares
– Issuing bonds or notes payable

• Earnings Per Share (EPS)

– Amount of a company’s net income for each share
outstanding
– Single most important statistic for evaluating a
company
– Standard measure of operating performance

Exhibit 9-10 Earnings-Per-Share
Advantage of Borrowing
Assume your business needs $500,000 for expansion. Now suppose it has net income of
$300,000 and 100,000 shares outstanding. You are considering two financing plans. Plan 1
is to issue $500,000 of 6% bonds payable, and Plan 2 is to issue 50,000 shares for
$500,000. You believe the new cash can be invested in operations to earn income of
$200,000 before interest and taxes.
Trading on the Equity, or Leverage
Measures the proportion of total liabilities to total assets
Average total assets

Leverage ratio 
Average common stockholder's equity
Known as the equity multiplier, ratio shows a company’s

total assets per amount of share capital

Evaluate a company’s debt-paying ability
•

Evaluate a Company’s Debt-Paying
Ability (1 of 2)
Debt Ratio
Total debt (liabilities)
Debt ratio 
Total assets
– Measure of an entity’s indebtedness

– A debt ratio below 50% is considered low

Evaluate a Company’s Debt-Paying
Ability (2 of 2)
• Times-Interest-Earned Ratio
– Measures the number of times that operating income
can cover interest expense
– Also called the interest-coverage ratio

Exhibit 9-13 Jardine Matheson’s Consolidated
Statement of Cash Flows

Financial Accounting: Liabilities

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Financial Accounting: Liabilities

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Financial Accounting

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• Examples: future liabilities that may arise due to lawsuits,

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Interest Expense on Bonds Issued at a Discount

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Interest Expense on Bonds Issued at a Discount

Column B: Interest payment is fixed by contract

Interest Expense on Bonds Issued at a Discount

Interest Market interest x Preceding bond

4,807 = .05 x 96,149

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Interest Expense on Bonds Issued at a Discount

Interest Expense on Bonds Issued at a Discount

Column E: Discount balance decreases when amortized

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Interest Expense on Bonds Issued at a Discount

Column F: Bond carrying amount increases from