Chap 010 Notes
Transcript of Chap 010 Notes
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LIABILITIES
Chapter
10
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I.O.U.
Defined as debts or obligationsarising from past transactions or
events.
Maturity = 1 year or less Maturity > 1 year
CurrentLiabilities NoncurrentLiabilities
The Nature of Liabilities
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The acquisition of assets is financedfrom two sources:
Funds from creditors, witha definite due date, and
sometimes bearinginterest.
Funds fromowners
DEBT EQUITY
Distinction BetweenDebt and Equity
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Devon Mfg. borrows $100,000 from FirstBank. The loan will be repaid in 20 years
and has an annual interest rate of 8%.
Is this a current liability or anoncurrent liability?
LiabilitiesQuestion
The obligation will not be paidwithin one year or one operating
cycle, so it is a noncurrent liability.
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Current Ratio = Current Assets Current Liabilities
Working Capital = Current Assets- Current Liabilities
An important indicator of a companys abilityto meet its current obligations.
Two commonly used measures:
Evaluating Liquidity
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Devon Mfg. has current liabilities of$230,000 and current assets of $322,000.
What is Devons current ratio?
LiabilitiesQuestion
Current
Ratio
=Current
Assets
Current
Liabilities= 322,000$ 230,000$
= 1.4
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Short-term obligations to suppliers for purchases ofmerchandise and to others for goods and services.
Merchandiseinventory
invoices
Shippingcharges
Utility andphone bills
Officesuppliesinvoices
Accounts Payable
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Total NotesPayable
Current Notes Payable
Noncurrent Notes Payable
When a company borrows money, a note payable iscreated.
Current Portion of Notes Payable
The portion of a note payable that is due within oneyear, or one operating cycle, whichever is longer.
Notes Payable
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PROMISSORY NOTE
Location Date
after this date
promises to pay to the order of
the sum of with interest at the rate
of per annum.signed
title
Miami, Fl Nov. 1, 2005
Six months Porter Company
John CaldwellSecurity National Bank
$10,000.00
12.0%
treasurer
Notes Payable
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On November 1, 2005, Porter Companywould make the following entry.
Date Description Debit CreditNov. 1 Cash 10,000
Note Payable 10,000
Notes Payable
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Interest expenseis thecompensation to the lender forgiving up the use of money for aperiod of time.
The liability is calledinterestpayable.
To the lender, interest is a
revenue.
To the borrower, interest is anexpense.
Interest
RateUp!
Interest Payable
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The interest formula includes three variablesthat must be considered when computing
interest:
Interest = Principal Interest Rate Time
When computing interest for one year, Time
equals 1. When the computation period is lessthan one year, then Time is a fraction.
Interest Payable
For example, if we needed to compute interest for3 months, Time would be 3/12.
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What entry would Porter Company makeon December 31, the fiscal year-end?
Date Description Debit Credit
Interest PayableExample
Date Description Debit Credit
Dec. 31 Interest Expense 200
Interest Payable 200
$10,00012% 2/12 = $200
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Net Pay
Payroll Liabilities
Medicare
Taxes
State andLocal Income
Taxes
FICA TaxesFederal
Income Tax
VoluntaryDeductions
Gross Pay
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Deferredrevenue isrecorded.
a liability account.
Cash isreceived
inadvance.
Cash is sometimes collected from thecustomer before the revenue is
actually earned.
Unearned Revenue
Earnedrevenue isrecorded.
As the earningsprocess is
completed . .
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Relatively small debtneeds can be filled from
single sources.
BanksInsurance
CompaniesPension
Plans
or or
Long-Term Liabilities
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Large debt needs are oftenfilled by issuing bonds.
Long-Term Liabilities
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Long-term notes that call for a series ofinstallment payments.
Each payment coversinterest for the periodAND a portion of the
principal.
With each payment, theinterest portion gets
smaller and the principalportion gets larger.
Installment Notes Payable
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Identify the unpaid principalbalance.
Unpaid Principal Interest rate
= Interest expense.Installment payment - Interest
expense = Reduction in unpaidprincipal balance.
Compute new unpaid principalbalance.
Allocating Installment PaymentsBetween Interest and Principal
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On January 1, 2005, RocketCorp. borrowed $7,581.57 from
First Bank of River City. Theloan was a five-year loan andhad an interest rate of 10%. The
annual payment is $2,000.
Prepare an amortization table forRocket Corp.s loan.
Allocating Installment PaymentsBetween Interest and Principal
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Date Payment
Interest
Expense
Reduction in
Unpaid
Balance
Unpaid
Balance
Jan. 1, 2005 7,581.57$
Dec. 31, 2005 2,000.00$ 758.16$ 1,241.84$ 6,339.73
Dec. 31, 2006 2,000.00 633.97 1,366.03 4,973.70
Dec. 31, 2007 2,000.00 497.37 1,502.63 3,471.07
Dec. 31, 2008 2,000.00 347.11 1,652.89 1,818.18
Dec. 31, 2009 2,000.00 181.82 1,818.18 (0.00)
Now, prepare the entry for the first payment onDecember 31, 2005.
Allocating Installment PaymentsBetween Interest and Principal
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The information needed for the journal entry can befound on the amortization table. The payment
amount, the interest expense, and the amount todebit to principal are all on the table.
Date Description Debit Credit
Dec. 31 Interest Expense 758.16
Note Payable 1,241.84
Cash 2,000.00
Allocating Installment PaymentsBetween Interest and Principal
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Bonds usually involve theborrowing of a large sum ofmoney, called principal.
The principal is usually paidback as a lump sum at theend of the bond period.
Individual bonds are oftendenominated with a par value,orface value, of $1,000.
Bonds Payable
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Bonds usually carry a statedrate of interest, also called acontract rate.
Interest is normally paidsemiannually.
Interest is computed as:
Interest = Principal Stated Rate Time
Bonds Payable
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Bonds are issued through anintermediary called an underwri ter.
Bonds can be sold on organized
securities exchanges. Bond prices are usually quoted as
a percentage of the face amount.
For example, a $1,000 bondpriced at 102 would sell for$1,020.
Bonds Payable
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MortgageBonds
ConvertibleBonds
Junk Bonds
DebentureBonds
Types of Bonds
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On January 1, 2005, Rocket Corp. issues $1,500,000 of12%, 10-year bonds payable. Interest is payable
semiannually, each July 1 and January 1.
Assume the bonds are issued at face value.Record the issuance of the bonds.
Accounting for Bonds Payable
Date Description Debit Credit
Jan. 1
Date Description Debit Credit
Jan. 1 Cash 1,500,000Bonds Payable 1,500,000
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Record the interest payment
on July 1, 2005.
Accounting for Bonds Payable
Date Description Debit Credit
July 1
Date Description Debit Credit
July 1 Interest Expense 90,000Cash 90,000
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Present value of the bond
+ Accrued interest since the
last interest payment= Selling price of the bond
Bonds Sold Between Interest Dates
Bonds are often sold between interest dates. The selling price of the bond is computed as:
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PresentValue
The Concept of Present Value
FutureValue
$1,000invested
today at 10%.
In 5 years itwill be worth
$1,610.51.
In 25 years itwill be worth$10,834.71!
Money can grow over time,because it can earn interest.
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How much is a future amount worth today?
PresentValue
FutureValue
Interest compounding periods
Today
The Concept of Present Value
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The Concept of Present Value
How much is a future amount worth today?
Three pieces of information must be knownto solve a present value problem:
The future amount.
The interest rate (i).
The number of periods (n) the amount will
be invested.
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Two types of cash flows are involvedwith bonds:
Today
Principal paymentat maturity.
Periodic interest payments called annuities.
Maturity
The Concept of Present Value
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The Present Value Concept and BondPrices
The selling price of the bond is determinedby the market based
on the time value of money.
Present Value of the Principal (a single payment)
+ Present Value of the Interest Payments (an annuity)
= Selling Price of the Bond
Interest Bond Accounting for Rates Price the Difference
Stated Market Bond Par Value There is no difference
Rate Rate Price of the Bond to account for.
Stated Market Bond Par Value The difference is accounted
Rate Rate Price of the Bond for as a bond discount.
Stated Market Bond Par Value The difference is accounted
Rate Rate Price of the Bond for as a bond premium.
=
>
75% of the economic
life of the property.
The PV of the minimumlease payments = 90% ofthe FMV of the property.
A lease must be recorded asa Capital Lease if it meets
any of the following criteria.
Capital Lease Criteria
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Employers offer pensionplans to employees.
Retirees receivepensionpayments from
the pensionfund.
The employer makespayments to a pensionfund. Usually, this is an
independent entity
managed by aprofessional fund
manager.
Pensions
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Actuaries make the pension expensecomputations, based on:
Average age, retirement age, lifeexpectancy.
Employee turnover rates.
Compensation levels.
Expected rate of return for the fund.
The accountant then posts the entry torecord pension expense and pension
liability.
Pensions
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Many companies offer benefitsto retirees other than pensions,
such as health coverage orfitness club memberships.
Other Postretirement Benefits
Unfunded liability
for nonpensionpostretirement
benefits
Currentliability
Long-termliability
Amount tobe fundednext year
Remainderof unfunded
amount
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Corporationspay incometaxes
quarterly.
Deferred Income Taxes
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The difference between tax expense and taxpayable is recorded in an account called
deferred taxes.
The Internal RevenueCode is the set of
rules for preparing taxreturns.
Financial statementincome tax expense.
IRS income taxespayable.
GAAP is the set ofrules for preparing
financial statements.
Results in . . . Results in . . .Usually. . .
Deferred Income Taxes
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Examine the December 31, 2005, informationfor X-Off Inc.
X-Off uses straight-line depreciation for financialreporting and accelerated depreciation for
income tax reporting. X-Offs tax rate is 30%.
Revenues 1,000,000$
Depreciation Expense:Straight-line 200,000
Accelerated 320,000
Other Expenses 650,000
Deferred Income TaxesExample
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Income TaxStatement Return Difference
Revenues 1,000,000$
Less:
Depreciation 200,000
Other expenses 650,000Income before taxes 150,000$
Tax rate 30%
Income taxes 45,000$
The income taxamount computedbased on financialstatement income
is income taxexpense for the
period.
Compute X-Offs income tax expenseand income tax payable.
Deferred Income TaxesExample
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Compute X-Offs income tax expenseand income tax payable.
Income TaxStatement Return Difference
Revenues 1,000,000$ 1,000,000$
Less:
Depreciation 200,000 320,000
Other expenses 650,000 650,000Income before taxes 150,000$ 30,000$
Tax rate 30% 30%
Income taxes 45,000$ 9,000$
Income taxesbased on tax
returnincome arethe taxes
payable forthe period.
Deferred Income TaxesExample
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Income TaxStatement Return Difference
Revenues 1,000,000$ 1,000,000$ -$
Less:
Depreciation 200,000 320,000 (120,000)
Other expenses 650,000 650,000 -Income before taxes 150,000$ 30,000$ 120,000$
Tax rate 30% 30% 30%
Income taxes 45,000$ 9,000$ 36,000$
The deferred tax for the period of $36,000 is thedifference between income tax expense of $45,000 and
income tax payable of $9,000.
Deferred Income TaxesExample
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Evaluating the Safety
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Evaluating the Safetyof Creditors Claims
This ratio indicates a margin of
protection for creditors.
Operating Income
Interest Expense
Interest
Coverage
Ratio=
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Borrowing at one rateand investing at a
higher rate.
If we borrow$1,000,000 at 8% andinvest it at 10%, we
will clear $20,000profit!
Financial Leverage
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End of Chapter 10