Chapter 7 liability

Liabilities in Perspective Liabilities are important to investors, financial analysts, management, and creditors..  Excess liabilities often cause investors and creditors to stay away

Chapter 7

Liabilities and Interest

Learning Objectives

After studying this chapter, you should be able to:

 Account for current liabilities

 Design an internal control system for cash disbursements

 Explain simple long-term liabilities

 Relate bond covenants to the riskiness of a bond

 Interpret deferred tax liabilities

 Locate and understand the contingent liabilities

information in a company’s financial statements

 When an expense is recognized before it is

paid, a liability is created.

Liabilities in Perspective

 Liabilities are important to investors, financial analysts, management, and creditors

 Excess liabilities often cause investors and

creditors to stay away from the company with the excess liabilities.

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

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.

Internal Controls Over

Payables

 Since huge sums of money flow through payables systems, good internal control must be present to ensure that all payments involve properly

approved and valid obligations of the company.

 Most disbursement systems require payments to be

made only by checks because the prenumbered checks make record keeping easier

 All checks issued must be supported by source

Internal Control Over

Payables

 Before a check can be written, a series of source documents must be completed to document the

obligation.

 Purchase order - a document that specifies the items

ordered and the price to be paid by the company

 Receiving report - a document that specifies the

items received by the company and their condition

 Invoice - a bill from the seller to a buyer indicating the

number of items shipped, their prices, any additional

costs such as shipping, and payment terms

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

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 year, 10% bonds Interest is to be paid semiannually on

2-June 30 and December 31 Assuming that the bonds are held

to maturity, the journal entries are:

To record the issuance of the bonds

Debt Ratios and

Interest-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 and Interest-Coverage Ratios

equity rs'

shareholde Total

s liabilitie

Total

=

equity ratio

Debt-to-

Long-term-

debt-to-total-capital ratio

Total shareholders’ equity + long-term debt

Debt Ratios and

Interest-Coverage Ratios

assets Total

s liabilitie

Total

=

total-assets

Debt-to-ratio

expense Interest

expense Interest

Debt Ratios and

Interest-Coverage Ratios

 The first three ratios are alternative ways of

expressing what part of a firm’s resources is

obtained by borrowing and what part is invested