Liabilities in Perspective

• Liabilities are a company’s obligations to pay cash or to provide goods and services to other companies or individuals.

• Accrual accounting recognizes expenses when they occur rather than when they are paid.– When an expense is recognized before it is paid,

a liability is created.

Liabilities in Perspective• Liabilities are classified as either current or long

term to help readers interpret the immediacy of a company’s obligations.– Current liabilities - obligations that fall due within the

coming year or within the company’s normal operating cycle

– Long-term liabilities - obligations that fall due beyond one year from the balance sheet date

• If long-term liabilities are paid gradually, the portion that comes due within the year becomes a current liability.

Liabilities in Perspective

• In the general ledger, each liability (wages, salaries, interest, etc.) is kept in a different account.

• However, in the financial statements, liabilities may be combined and shown as a single amount.– The terms “accrued” or “payable” may

sometimes be used to denote liabilities.

Accounting for Current Liabilities

• Not all current liabilities are recorded the same way.– Some are the result of a transaction with a third

party, such as a supplier or a lender.– Some are the result of an adjusting

journal entry made to acknowledge an obligation arising over time, such as interest or wages.

Accounts Payable

• Accounts payable (or trade accounts payable) are amounts owed to suppliers.

• Large sums of money flow through accounts payable systems, so data-processing and internal control systems are carefully designed for accounts payable.– The company must ensure that checks are written

only for legitimate obligations of the company.

Notes Payable

• Promissory note (note payable) - a written promise to repay principal plus interest at specific future dates– Notes payable can be classified as current or

long term depending on when they are payable.

Notes Payable

• Rather than having to apply for many small loans at different times, companies obtain lines of credit with lenders.– Line of credit - an agreement with a bank to

automatically provide short-term loans up to some preestablished maximum

• The lender does not have to do extensive paperwork or credit checks every time a borrower needs money.

• The borrower has a preset amount of borrowing available.

Notes Payable

• Companies sometimes borrow directly from investors in the form of commercial paper.

• Commercial paper - a short-term debt contract issued by prominent companies that borrow directly from investors– These liabilities usually fall due within 9

months, often within 60 days.

Income Taxes Payable

• Corporations make periodic installment payments based on their estimated tax for the year. Therefore, the accrued tax liability at year end is generally much smaller than the actual income tax expense.

• Corporations must adjust their periodic payments to reflect changes in the estimates in earnings for the year.

Current Portion ofLong-Term Debt

• If long-term liabilities are paid gradually, the portion that comes due within the year becomes a current liability.

• The journal entry to reclassify a liability is:

Long-term debt xxxx

Current portion of long-term debt xxxx

Sales Tax

• When companies collect sales taxes, they are collecting on behalf of a state or local government.

• Sales taxes do not affect the income statement.

– They are recorded in a liability account called Sales Tax Payable until they are remitted to the governmental unit.

Product Warranties• A sales warranty creates a liability, but warranty

claims will arise in the future and cannot be estimated precisely.– If warranty obligations are

material, they must be accrued when the products are sold.

– Warranty obligations are usually based on past experience for

replacing or fixing defective products.

Product Warranties

• The entries related to product warranties are as follows:

To record the estimated liability:Warranty expense 30,000

Liability for warranties 30,000

To record a claim against the warranty:Liability for warranties 500

Cash, accounts payable, etc. 500

Unearned Revenue• Revenues that are collected before services or

goods are delivered are called unearned revenues.– Examples include lease rentals, magazine

subscriptions, insurance premiums, advance ticket sales, etc.

– These amounts are recorded as current liabilities and are converted to revenues as the services or goods are delivered, i.e., when a month passes or when an issue of a magazine is delivered to a subscriber.

Long-Term Liabilities

• Some long-term liabilities are much like some short-term liabilities except for the time frame.– Car loans or mortgage loans are much like

notes payable, but they are for a longer term.– As time passes, payments of interest and

principal eliminate the loan obligation.

Long-Term Liabilities

• Illustration and analysis of a loan:– Assume that $10,000 is borrowed at 10%

interest. The yearly payment is to be $3,154.71 for four years on December 31 of each year.

– The total repayment amount is $12,618.83, which consists of the $10,000 principal plus $2,618.83 in interest.

Bonds and Notes• Both bonds and notes are legal contracts that

specify how much is to be borrowed and the dates and amounts for repayment by the borrower.– Notes and bonds are called negotiable financial

instruments because they can be transferred from one lender to another.

– Some bonds and notes are private placements, which means that only a few sources of borrowing are used rather than the general public.

Bonds and Notes

• Bond - a formal certificate of indebtedness that is typically accompanied by (1) a promise to pay interest in cash at a specified annual rate plus (2) a promise to pay the principal at a specific maturity date– The interest rate is often called the nominal interest

rate, contractual rate, coupon rate, or stated rate.– The principal amount is also known as the face

amount.

Bonds and Notes

• Interest rate - the percentage applied to a principal amount to calculate the amount of interest that must be paid on the loan– Interest represents the return the lender can earn

for loaning money.– In general, riskier loans demand higher interest

rates.

Bond Accounting• On December 31, 2000, a company issued $10,000,000 in 2-year, 10% bonds. Interest is to be paid semiannually on June 30 and December 31. Assuming that the bonds are held to maturity, the journal entries are:To record the issuance of the bonds

Cash 10,000,000 Bonds payable 10,000,000

To record the payments of the semiannual interestInterest expense 500,000 Cash (($10,000,000 x 10%) / 2) 500,000

To record the repayment of principal at maturityBonds payable 10,000,000 Cash 10,000,000

Deferred Taxes• As discussed before, delays in payment of taxes

between the time that income is earned and taxes are due leads to short-term taxes payable.

• However, another reason for taxes payable arises because of differences between U.S. income tax rules and GAAP.– Sometimes tax rules can cause income tax expense to

be recorded long before it is actually paid and creates a deferred tax liability.

Deferred Taxes

• Differences arise because GAAP is designed to provide useful information to investors, while the tax code is written to generate revenues for the government.– Managers try to pay the least amount of taxes at

the latest time possible.– They try to delay reporting taxable revenue as

long as possible while deducting expenses as quickly as possible.

Deferred Taxes

• Differences may be created because:– Rules for financial reporting and tax rules

differ.– Managers make different choices of accounting

treatment for financial reporting than for tax reporting.

• Managers have an incentive to keep taxable income low, but they have an incentive to make financial income high.

Contingent Liabilities• Contingent liabilities - a potential liability that

depends on a future event arising out of a past transaction

• Some contingent liabilities are certain in amount.– Smith Company may guarantee a loan for Parker

Company. Smith Company will pay if, and only if, Parker Company does not pay.

• This is a liability of Parker Company and a contingent liability of Smith Company.

Contingent Liabilities• More often, contingent liabilities are

of an indefinite amount.– Lawsuits are common examples.

These are possible obligations of uncertain amounts.

• Some companies show contingent liabilities on the balance sheet, but most disclose such amounts in the footnotes to the financial statements.

Debt Ratios andInterest-Coverage Ratios

• Debt ratios are used to measure the extent to which a company has used borrowing to finance its activities.– The more borrowing, and the less equity, the

riskier it is to lend money to a firm.

Debt Ratios andInterest-Coverage Ratios

equity rs'shareholde Total

sliabilitie Total

Debt-to-equity ratio

Long-term-debt-to-total-capital ratio

=Total long-term debt

Total shareholders’ equity + long-term debt

Debt Ratios andInterest-Coverage Ratios

assets Total

sliabilitie Total

Debt-to-total-assets

ratio

expenseInterest

expenseInterest incomePretax

Interest-coverage

ratio