Liabilities/Financial Analysis and Colgate’s Annual Report

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Financial Accounting: Tools for Business Decision Making

Eighth Edition

Kimmel ● Weygandt ● Kieso

Chapter 10

Reporting and Analyzing Liabilities

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Financial Accounting: Tools for Business Decision Making

Chapter Outline:

Learning Objectives

Explain how to account for current liabilities.

Describe the major characteristics of bonds.

Explain how to account for bond transactions.

Discuss how liabilities are reported and analyzed.

L O 1: Explain How to Account for Current Liabilities

What is a Current Liability?

A debt that a company expects to pay

from existing current assets or through the creation of other current liabilities, and

within one year or the operating cycle, whichever is longer.

Current liabilities include notes payable, accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest.

What Is a Current Liability? (1 of 2)

Review Question

To be classified as a current liability, a debt must be expected to be paid within:

a. 1 year.

b. the operating cycle.

c. 2 years.

d. (a) or (b), whichever is longer.

What Is a Current Liability? (2 of 2)

Review Question

To be classified as a current liability, a debt must be expected to be paid within:

a. 1 year.

b. the operating cycle.

c. 2 years.

d. (a) or (b), whichever is longer.

Notes Payable (1 of 4)

Written promissory note.

Usually require the borrower to pay interest.

Frequently issued to meet short-term financing needs.

Issued for varying periods of time.

Those due for payment within one year of the balance sheet date are usually classified as current liabilities.

Notes Payable (2 of 4)

Illustration: First National Bank agrees to lend $100,000 on September 1, 2017, if Cole Williams Co. signs a $100,000, 12%, four-month note maturing on January 1. When a company issues an interest-bearing note, the amount of assets it receives generally equals the note’s face value.

Sept. 1

Cash

100,000

Notes Payable

100,000

Notes Payable (3 of 4)

Illustration: If Cole Williams Co. prepares financial statements annually, it makes an adjusting entry at December 31 to recognize interest.

Dec. 31

Interest Expense

4,000 *

Interest Payable

4,000

Notes Payable (4 of 4)

Illustration: At maturity (January 1), Cole Williams Co. must pay the face value of the note plus interest. It records payment as follows.

Jan. 1

Notes Payable

100,000

Interest Payable

4,000

Cash

104,000

Sales Taxes Payable (1 of 3)

Sales taxes are expressed as a stated percentage of the sales price.

Selling company

collects tax from the customer.

remits the collections to the state’s department of revenue.

Sales Taxes Payable (2 of 3)

Illustration: The March 25 cash register readings for Cooley Grocery show sales of $10,000 and sales taxes of $600 (sales tax rate of 6%), the journal entry is:

Mar. 25

Cash

10,600

Sales Revenue

10,000

Sales Taxes Payable

600

Sales Taxes Payable (3 of 3)

Sometimes companies do not ring up sales taxes separately on the cash register.

Illustration: Cooley Grocery rings up total receipts of $10,600. Because the amount received from the sale is equal to the sales price 100% plus 6% of sales, (sales tax rate of 6%), the journal entry is:

Mar. 25

Cash

10,600

Sales Revenue

10,000 *

Sales Taxes Payable

600

* $10,600 ÷ 1.06 = $10,000

Unearned Revenues (1 of 2)

Revenues that are received before goods are delivered or services are performed.

Company increases (debits) Cash and increases (credits) a current liability account, Unearned Revenue.

When the company recognizes revenue, it decreases (debits) the unearned revenue account and increases (credits) a revenue account.

Type of Business

Airline

Magazine publisher

Hotel

Unearned Revenues (2 of 2)

Illustration: Superior University sells 10,000 season football tickets at $50 each for its five-game home schedule. The entry for the sales of season tickets is:

Aug. 6

Cash

500,000

Unearned Ticket Revenue

500,000

As each game is completed, Superior records the earning of revenue.

Sept. 7

Unearned Ticket Revenue

100,000

Ticket Revenue

100,000

Current Maturities of long-term Debt

Portion of long-term debt that comes due in the current year.

No adjusting entry required.

Illustration: Wendy Construction issues a five-year, interest-bearing $25,000 note on January 1, 2016. This note specifies that each January 1, starting January 1, 2017, Wendy should pay $5,000 of the note. When the company prepares financial statements on December 31, 2016,

What amount should be reported as a current liability?

$5,000

What amount should be reported as a long-term liability?

$20,000

Do It! 1: Current Liabilities

You and several classmates are studying for the next accounting examination. They ask you to answer the following questions.

If cash is borrowed on a $50,000, 6-month, 12% note on September 1, how much interest expense would be incurred by December 31?

The cash register total including sales taxes is $23,320, and the sales tax rate is 6%. What is the sales taxes payable?

$23,320 ÷ 1.06 = $22,000; $23,320 − $22,000 = $1,320

If $15,000 is collected in advance on November 1 for 3 months’ rent, what amount of rent revenue should be recognized by December 31?

Payroll and Payroll Taxes Payable (1 of 4)

The term “payroll” pertains to both:

Salaries - managerial, administrative, and sales personnel (monthly or yearly rate).

Wages - store clerks, factory employees, and manual laborers (rate per hour).

Determining the payroll involves computing three amounts: (1) gross earnings, (2) payroll deductions, and (3) net pay.

Payroll and Payroll Taxes Payable (2 of 4)

Illustration: Assume Cargo Corporation records its payroll for the week of March 7 as follows:

Mar. 7

Salaries and Wages Expense

100,000

F I C A Taxes Payable

7,650

Federal Income Taxes Payable

21,864

State Income Taxes Payable

2,922

Salaries and Wages Payable

67,564

Record the payment of this payroll on March 7.

Mar. 7

Salaries and Wages Payable

67,564

Cash

67,564

Payroll and Payroll Taxes Payable (3 of 4)

Payroll tax expense results from three taxes that governmental agencies levy on employers.

These taxes are:

F I C A tax

Federal unemployment tax

State unemployment tax

Payroll and Payroll Taxes Payable (4 of 4)

Illustration: Based on Cargo Corp.’s $100,000 payroll, the company would record the employer’s expense and liability for these payroll taxes as follows.

Payroll Tax Expense	13,850	Blank
F I C A Taxes Payable	Blank	7,650
Federal Unemployment Taxes Payable	Blank	800
State Unemployment Taxes Payable	Blank	5,400

Payroll Taxes (1 of 2)

Review Question

Employer payroll taxes do not include:

a. federal unemployment taxes.

b. state unemployment taxes.

c. federal income taxes.

d. F I C A taxes.

Payroll Taxes (2 of 2)

Review Question

Employer payroll taxes do not include:

a. federal unemployment taxes.

b. state unemployment taxes.

c. federal income taxes.

d. F I C A taxes.

Anatomy of a Fraud

Art was a custodial supervisor for a large school district. The district was supposed to employ between 35 and 40 regular custodians, as well as 3 or 4 substitute custodians to fill in when regular custodians were absent. Instead, in addition to the regular custodians, Art “hired” 77 substitutes. In fact, almost none of these people worked for the district. Instead, Art submitted time cards for these people, collected their checks at the district office, and personally distributed the checks to the “employees.” If a substitute’s check was for $1,200, that person would cash the check, keep $200, and pay Art $1,000.

Total take: $150,000

The Missing Controls

Human resource controls. Thorough background checks should be performed. No employees should begin work until they have been approved by the Board of Education and entered into the payroll system. No employees should be entered into the payroll system until they have been approved by a supervisor. All paychecks should be distributed directly to employees at the official school locations by designated employees or direct-deposited into approved employee bank accounts.

Independent internal verification. Budgets should be reviewed monthly to identify situations where actual costs significantly exceed budgeted amounts.

Do It! 1b: Wages and Payroll Taxes (1 of 2)

During the month of September, Lake Corporation’s employees earned wages of $60,000. Withholdings related to these wages were $3,500 for Social Security (F I C A), $6,500 for federal income tax, and $2,000 for state income tax. Costs incurred for unemployment taxes were $90 for federal and $150 for state. Prepare the September 30 journal entries for (a) salaries and wages expense and salaries and wages payable, assuming that all September wages will be paid in October, and (b) the company’s payroll tax expense.

Sep. 30

Salaries and Wages Expense

60,000

FICA Taxes Payable

3,500

Federal Income Taxes Payable

6,500

State Income Taxes Payable

2,000

Salaries and Wages Payable

48,000

Do It! 1b: Wages and Payroll Taxes (2 of 2)

Sep. 30

Payroll Tax Expense

3,740

FICA Taxes Payable

3,500

Federal Unemployment Taxes Payable

State Unemployment Taxes Payable

150

L O 2: Describe the Major Characteristics of Bonds

Bonds are a form of interest-bearing notes payable issued by corporations, universities, and governmental agencies.

Sold in small denominations (usually $1,000 or multiples of $1,000).

When a corporation issues bonds, it is borrowing money. The person who buys the bonds (the bondholder) is investing in bonds.

Types of Bonds (1 of 2)

Secured and Unsecured Bonds

Secured bonds have specific assets of the issuer pledged as collateral for the bonds.

Unsecured bonds are issued against the general credit of the borrower.

Types of Bonds (2 of 2)

Convertible and Callable Bonds

Convertible bonds can be converted into common stock at the bondholder’s option.

Callable bonds can be redeemed (bought back), by the issuing company, at a stated dollar amount prior to maturity.

Issuing Procedures (1 of 2)

Bond certificate

Issued to the investor.

Provides name of the company issuing bonds, face value, maturity date, and contractual (stated) interest rate.

Face value - principal due at the maturity.

Maturity date - date final payment is due.

Contractual interest rate – rate to determine cash interest paid, contractual rate is stated as an annual rate.

Alternative Terminology

The contractual rate is often referred to as the stated rate.

Issuing Procedures (2 of 2)

Determining the Market Price of Bonds

The current market price (present value) of a bond is a function of three factors:

the dollar amounts to be received,

the length of time until the amounts are received, and

the market rate of interest.

The process of finding the present value is referred to as discounting the future amounts.

Determining the Market Value

Illustration: Assume that Acropolis Company on January 1, 2017, issues $100,000 of 9% bonds, due in five years, with interest payable annually at year-end.

Present value of $100,000 received in 5 years	$ 64,993
Present value of $9,000 received annually for 5 years	35,007
Market price of bonds	$ 100,000 double underline

Do It! 2: Bond Terminology

Indicate whether each of the following statements is true or false.

Secured bonds have specific assets of the issuer pledged as collateral.

True

Callable bonds can be redeemed by the issuing company at a stated dollar amount prior to maturity.

True

The contractual interest rate is the rate investors demand for loaning funds.

False

The face value is the amount of principal the issuing company must pay at the maturity date.

True

The market price of a bond is equal to its maturity value.

False

L O 3: Explain How to Account for Bond Transactions

A corporation records bond transactions when it

issues (sells) or redeems (buys back) bonds and

when bondholders convert bonds into common stock.

Bonds may be issued at

face value,

below face value (discount), or

above face value (premium).

Bond prices are quoted as a percentage of face value.

Issuing Bonds (1 of 2)

Review Question

The market interest rate:

a. is the contractual interest rate used to determine the amount of cash interest paid by the borrower.

b. is listed in the bond indenture.

c. is the rate investors demand for loaning funds.

d. More than one of the above is true.

Issuing Bonds (2 of 2)

Review Question

The market interest rate:

a. is the contractual interest rate used to determine the amount of cash interest paid by the borrower.

b. is listed in the bond indenture.

c. is the rate investors demand for loaning funds.

d. More than one of the above is true.

Issuing Bonds at Face Value (1 of 2)

Illustration: Devor Corporation issues 100, five-year, 10%, $1,000 bonds dated January 1, 2017, at 100 (100% of face value). The entry to record the sale is:

Jan. 1

Cash

100,000

Bonds Payable

100,000

Prepare the entry Devor would make to accrue interest on December 31.

Dec. 31

Interest Expense

10,000

Interest Payable

10,000

Issuing Bonds at Face Value (2 of 2)

Prepare the entry Devor would make to pay the interest on Jan. 1, 2018.

Jan. 1

Interest Payable

10,000

Cash

10,000

Discount or Premium on Bonds (1 of 3)

Issue at Par, Discount, or Premium?

▼ Helpful Hint

Bond prices vary inversely with changes in the market interest rate. As market interest rates decline, bond prices increase. When a bond is issued, if the market interest rate is below the contractual rate, the bond price is higher than the face value.

Discount or Premium on Bonds (2 of 3)

Review Question

Laurel Inc. issues 10-year bonds with a maturity value of $200,000. If the bonds are issued at a premium, this indicates that:

a. the contractual interest rate exceeds the market interest rate.

b. the market interest rate exceeds the contractual interest rate.

c. the contractual interest rate and the market interest rate are the same.

d. no relationship exists between the two rates.

Discount or Premium on Bonds (3 of 3)

Review Question

Laurel Inc. issues 10-year bonds with a maturity value of $200,000. If the bonds are issued at a premium, this indicates that:

a. the contractual interest rate exceeds the market interest rate.

b. the market interest rate exceeds the contractual interest rate.

c. the contractual interest rate and the market interest rate are the same.

d. no relationship exists between the two rates.

Issuing Bonds at a Discount (1 of 2)

Illustration: Assume that on January 1, 2017, Candlestick Inc. sells $100,000, five-year, 10% bonds at 98 (98% of face value) with interest payable on January 1. The entry to record the issuance is:

Jan. 1

Cash

98,000

Discount on Bonds Payable

2,000

Bonds Payable

100,000

Issuing Bonds at a Discount (2 of 2)

Statement Presentation

Sale of bonds below face value causes the total cost of borrowing to be more than the bond interest paid.

The issuing corporation not only must pay the contractual interest rate over the term of the bonds but also must pay the face value (rather than the issuance price) at maturity.

Total Cost of Borrowing (1 of 2)

Bonds Issued at a Discount

Annual interest payments	Blank
($100,000 × 10% = $10,000; $10,000 × 5)	$50,000
Add: Bond discount ($100,000 − $98,000)	2,000
Total cost of borrowing	$52,000 double underline

Bonds Issued at a Discount

Principal at maturity	$100,000
Annual interest payments ($10,000 × 5)	50,000
Cash to be paid to bondholders	150,000
Less: Cash received from bondholders	98,000
Total cost of borrowing	$52,000 double underline

Issuing Bonds at a Discount

Amortization of bond discount:

Allocated to expense in each period.

Increases the amount of interest expense reported each period.

Amount of interest expense reported each period will exceed the contractual amount paid.

As the discount is amortized, its balance declines.

The carrying value of the bonds will increase, until at maturity the carrying value of the bonds equals their face amount.

Issuing Bonds at a Premium (1 of 2)

Illustration: Assume that the Candlestick Inc. bonds previously described sell at 102 rather than at 98. The entry to record the sale is:

Jan. 1

Cash

102,000

Bonds Payable

100,000

Premium on Bonds Payable

2,000

Issuing Bonds at a Premium (2 of 2)

Statement Presentation

Sale of bonds above face value causes the total cost of borrowing to be less than the bond interest paid.

The borrower is not required to pay the bond premium at the maturity date of the bonds. Thus, the bond premium is considered to be a reduction in the cost of borrowing.

Total Cost of Borrowing (2 of 2)

Bonds Issued at a Premium

Annual interest payments	Blank
($100,000 × 10% = $10,000; $10,000 × 5)	$50,000
Less: Bond premium ($102,000 − $100,000)	2,000
Total cost of borrowing	$48,000 double underline

Bonds Issued at a Premium

Principal at maturity	$100,000
Annual interest payments ($10,000 × 5)	50,000
Cash to be paid to bondholders	150,000
Less: Cash received from bondholders	102,000
Total cost of borrowing	$48,000 double underline

Issuing Bonds at a Premium

Amortization of bond premium:

Allocated to expense in each period.

Decreases the amount of interest expense reported each period.

Amount of interest expense reported each period will be less than the contractual amount paid.

As the premium is amortized, its balance declines.

The carrying value of the bonds will decrease, until at maturity the carrying value of the bonds equals their face amount.

Do It! 3a: Bond Issuance

Giant Corporation issues $200,000 of bonds for $189,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the balance sheet at the date of issuance.

(a)

Cash

189,000

Discount on Bonds Payable

11,000

Bonds Payable

200,000

(b)

Long-term liabilities

Bonds payable

$200,000

Less: Discount on bonds payable

$189,000

Redeeming Bonds at Maturity

Candlestick records the redemption of its bonds at maturity as follows:

Bonds Payable

100,000

Cash

100,000

Redeeming Bonds before Maturity (1 of 2)

When a company retires bonds before maturity, it is necessary to:

eliminate the carrying value of the bonds at the redemption date;

record the cash paid; and

recognize the gain or loss on redemption.

The carrying value of the bonds is the face value of the bonds less unamortized bond discount or plus unamortized bond premium at the redemption date.

Redeeming Bonds before Maturity (2 of 2)

Illustration: Assume at the end of the fourth period, Candlestick Inc., having sold its bonds at a premium, retires the bonds at 103 after paying the annual interest. Assume that the carrying value of the bonds at the redemption date is $100,400 (principal $100,000 and premium $400). Candlestick records the redemption at the end of the fourth interest period (January 1, 2021) as:

Jan. 1

Bonds Payable

100,000

Premium on Bonds Payable

400

Loss on Bond Redemption

2,600

Cash

103,000

People, Planet, and Profit Insight

How About Some Green Bonds?

Unilever recently began producing popular frozen treats such as Magnums and Cornettos, funded by green bonds. Green bonds are debt used to fund activities such as renewable-energy projects. In Unilever’s case, the proceeds from the sale of green bonds are used to clean up the company’s manufacturing operations and cut waste (such as related to energy consumption). The use of green bonds has taken off as companies now have guidelines as to how to disclose and report on these green-bond proceeds. These standardized disclosures provide transparency as to how these bonds are used and their effect on overall profitability. Investors are taking a strong interest in these bonds. Investing companies are installing socially responsible investing teams and have started to integrate sustainability into their investment processes. The disclosures of how companies are using the bond proceeds help investors to make better financial decisions.

Source: Ben Edwards, “Green Bonds Catch On.” Wall Street Journal (April 3, 2014), p. C5.

Do It! 3b: Bond Redemption

R & B Inc. issued $500,000, 10-year bonds at a discount. Prior to maturity, when the carrying value of the bonds is $496,000, the company redeems the bonds at 98. Prepare the entry to record the redemption of the bonds.

Solution

There is a gain on redemption. The cash paid, $490,000 ($500,000 × 98%), is less than the carrying value of $496,000. The entry is:

Bonds Payable

500,000

Cash

490,000

Discount on Bonds Payable

4,000

Gain on Bond Redemption

6,000

L O 4: Discuss How Liabilities Are Reported and Analyzed

Analysis (1 of 5)

Analysis (2 of 5)

Liquidity

Liquidity ratios measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash.

Analysis (3 of 5)

Solvency

($ in millions)	2014	2013
Net income	$4,018	$5,331
Interest expense	403	334
Income tax expense	228	2,127

Solvency ratios measure the ability of a company to survive over a long period of time.

Investor Insight Debt Masking

In the wake of the financial crisis, many financial institutions are wary of reporting too much debt on their financial statements, for fear that investors will consider them too risky. The Securities and Exchange Commission (S E C) is concerned that some companies engage in “debt masking” to make it appear that they use less debt than they actually do. These companies enter into transactions at the end of the accounting period that essentially remove debt from their books. Shortly after the end of the period, they reverse the transaction and the debt goes back on their books. The Wall Street Journal reported that 18 large banks “had consistently lowered one type of debt at the end of each of the past five quarters, reducing it on average by 42% from quarterly peaks.”

Source: Tom McGinty, Kate Kelly, and Kara Scannell, “Debt ‘Masking’ Under Fire,” Wall Street Journal Online (April 21, 2010).

Analysis (4 of 5)

Contingencies

Events with uncertain outcomes that may represent potential liabilities.

A common types of contingencies:

Lawsuits.

Product warranties.

Environmental cleanup obligations.

Accounting rules require that companies disclose contingencies in the notes.

Analysis (5 of 5)

Leasing

Off-balance-sheet financing is an intentional effort by a company to structure its financing arrangements so as to avoid showing liabilities on its balance sheet.

One common type of off-balance-sheet financing results from leasing.

Operating lease.

Capital leases are treated like a debt-financed purchase—increasing both assets and liabilities.

Investor Insight “Covenant-Lite” Debt

In many corporate loans and bond issuances, the lending agreement specifies debt covenants. These covenants typically are specific financial measures, such as minimum levels of retained earnings, cash flows, times interest earned, or other measures that a company must maintain during the life of the loan. If the company violates a covenant, it is considered to have violated the loan agreement. The creditors can then demand immediate repayment, or they can renegotiate the loan’s terms. Covenants protect lenders because they enable lenders to step in and try to get their money back before the borrower gets too deep into trouble. During the 1990s, most traditional loans specified between three to six covenants or “triggers.” In subsequent years, however, when there was lots of cash available, lenders began reducing or completely eliminating covenants from loan agreements in order to be more competitive with other lenders. Then, when the economy declined, these lenders lost big money when companies defaulted.

Sources: Cynthia Koons, “Risky Business: Growth of ‘Covenant-Lite’ Debt,” Wall Street Journal (June 18, 2007), p. C2; and Katy Burne, “More Loans Come with Few Strings Attached,” Wall Street Journal (June 12, 2014).

Do It! 4: Analyzing Liabilities (1 of 3)

Trout Company provides you with the following balance sheet information as of December 31, 2017.

Current assets	$10,500
Long-term assets	24,200
Total assets	$34,700 double underline

Current liabilities	$ 8,000
Long-term liabilities	16,000
Stockholders’ equity	10,700
Total liabilities and stockholders’ equity	$34,700double underline

In addition, Trout reported net income for 2017 of $14,000, income tax expense of $2,800, and interest expense of $900.

Instructions

(a) Compute the current ratio and working capital for Trout for 2017.

Current ratio is 1.31:1 ($10,500 ÷ $8,000).

Working capital is $2,500 ($10,500 − $8,000).

Do It! 4: Analyzing Liabilities (2 of 3)

Trout Company provides you with the following balance sheet information as of December 31, 2017.

Current assets	$10,500
Long-term assets	24,200
Total assets	$34,700 double underline

Current liabilities	$ 8,000
Long-term liabilities	16,000
Stockholders’ equity	10,700
Total liabilities and stockholders’ equity	$34,700double underline

In addition, Trout reported net income for 2017 of $14,000, income tax expense of $2,800, and interest expense of $900.

Instructions

(b) Assume that at the end of 2017, Trout used $2,000 cash to pay off $2,000 of accounts payable.

Current ratio is 1.42:1 ($8,500 ÷ $6,000).

Working capital is $2,500 ($8,500 − $6,000).

Do It! 4: Analyzing Liabilities (3 of 3)

Trout Company provides you with the following balance sheet information as of December 31, 2017.

Current assets	$10,500
Long-term assets	24,200
Total assets	$34,700 double underline

Current liabilities	$ 8,000
Long-term liabilities	16,000
Stockholders’ equity	10,700
Total liabilities and stockholders’ equity	$34,700double underline

In addition, Trout reported net income for 2017 of $14,000, income tax expense of $2,800, and interest expense of $900.

Instructions

Debt to assets ratio is 69.2% ($24,000 ÷ $34,700).

Times interest earned is 19.67 times [($14,000 + $2,800 + $900) ÷ $900].

L O 5: Appendix 10a: Apply the Straight-Line Method of Amortizing Bond Discount and Bond Premium

Amortizing Bond Discount

To follow the expense recognition principle, companies allocate bond discount to expense in each period in which the bonds are outstanding.

Bond Discount ÷ Number of Interest Periods = Bond Discount Amortization

Amortizing Bond Discount (1 of 6)

Illustration: Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $98,000 (discount of $2,000). Interest is payable on January 1 of each year. Prepare the entry to accrue interest and amortize the bond discount at Dec. 31, 2017.

Dec. 31

Interest Expense

10,400

Discount on Bonds Payable

400

Interest Payable

10,000

Amortizing Bond Discount (2 of 6)

Amortizing Bond Premium (1 of 5)

Illustration: Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $102,000 (premium of $2,000). Interest is payable on January 1 of each year. Prepare the entry to accrue interest and amortize the bond premium at Dec. 31, 2017.

Dec. 31

Interest Expense

9,600

Premium on Bonds Payable

400

Interest Payable

10,000

Amortizing Bond Premium (2 of 5)

L O 6: Appendix 10B: Apply the Effective-Interest Method of Amortizing Bond Discount and Bond Premium.

Under the effective-interest method, the amortization of the discount or premium results in interest expense equal to a constant percentage of the carrying value.

Required steps:

Compute the bond interest expense.

Compute the bond interest paid or accrued.

Compute the amortization amount.

Amortizing Bond Discount (3 of 6)

Illustration: Candlestick, Inc., sold $100,000, five-year, 10% bonds on January 1, 2017, for $98,000. The effective-interest rate is 10.5348% and interest is payable on Jan. 1 of each year. Prepare the bond discount amortization schedule.

Amortizing Bond Discount (4 of 6)

Amortizing Bond Discount (5 of 6)

Illustration: Candlestick, Inc. records the accrual of interest and amortization of bond discount on Dec. 31, as follows:

Dec. 31

Interest Expense

10,324

Discount on Bonds Payable

324

Interest Payable

10,000

Amortizing Bond Discount (6 of 6)

For the second interest period, bond interest expense will be $10,358 ($98,324 × 10.5348%), and the discount amortization will be $358. At December 31, Candlestick makes the following adjusting entry.

Dec. 31

Interest Expense

10,358

Discount on Bonds Payable

358

Interest Payable

10,000

Amortizing Bond Premium (3 of 5)

Illustration: Candlestick Inc. sells the bonds described above for $102,000 rather than $98,000. This would result in a bond premium of $2,000 ($102,000 − $100,000). This premium results in an effective-interest rate of approximately 9.4794%.

Amortizing Bond Premium (4 of 5)

Amortizing Bond Premium (5 of 5)

Illustration: Candlestick, Inc. records the accrual of interest and amortization of premium discount on Dec. 31, as follows:

Dec. 31

Interest Expense

9,669

Premium on Bonds Payable

331

Interest Payable

10,000

L O 7: Appendix 10C: Describe the Accounting for Long-Term Notes Payable

Long-Term Notes Payable

May be secured by a mortgage that pledges title to specific assets as security for a loan.

Typically, the terms require the borrower to make installment payments over the term of the loan. Each payment consists of

interest on the unpaid balance of the loan and

a reduction of loan principal.

Companies initially record mortgage notes payable at face value.

Long-Term Notes Payable (1 of 2)

Illustration: Porter Technology Inc. issues a $500,000, 8%, 20-year mortgage note on December 31, 2017. The terms provide for annual installment payments of $50,926.

Interest Period	(A) Cash Payment	(B) Interest Expense (D) × 8%	(C) Reduction of Principal (A) − (B)	(D) Principal Balance (D) − (C)
Issue date	Blank	Blank	Blank	$500,000
1	$50,926	$40,000	$10,926	489,074
2	50,926	39,126	11,800	477,274
3	50,926	38,182	12,744	464,530
4	50,926	37,162	13,764	450,766

Long-Term Notes Payable (2 of 2)

Illustration: Porter Technology records the mortgage loan and first installment payment as follows:

Dec. 31

Cash

500,000

Mortgage Payable

500,000

Dec. 31

Interest Expense

40,000

Mortgage Payable

10,926

Cash

50,926

A Look at I F R S-L O-8: Compare the Accounting for Liabilities Under G A A P and I F R S.

Key Points

Similarities

The basic definition of a liability under G A A P and I F R S is very similar. In a more technical way, liabilities are defined by the I A S B as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

A Look at I F R S (1 of 11)

Similarities

The accounting for current liabilities such as notes payable, unearned revenue, and payroll taxes payable are similar between G A A P and I F R S.

I F R S requires that companies classify liabilities as current or noncurrent on the face of the statement of financial position (balance sheet), except in industries where a presentation based on liquidity would be considered to provide more useful information (such as financial institutions). When current liabilities (also called short-term liabilities) are presented, they are generally presented in order of liquidity.

A Look at I F R S (2 of 11)

Similarities

Under I F R S, liabilities are classified as current if they are expected to be paid within 12 months.

Similar to G A A P, items are normally reported in order of liquidity. Companies sometimes show liabilities before assets. Also, they will sometimes show long-term liabilities before current liabilities.

The basic calculation for bond valuation is the same under G A A P and I F R S. In addition, the accounting for bond liability transactions is essentially the same between G A A P and I F R S.

A Look at I F R S (3 of 11)

Similarities

I F R S requires use of the effective-interest method for amortization of bond discounts and premiums. G A A P also requires the effective-interest method, except that it allows use of the straight-line method where the difference is not material. Under I F R S, companies do not use a premium or discount account but instead show the bond at its net amount. For example, if a $100,000 bond was issued at 97, under I F R S a company would record:

Cash

97,000

Bonds Payable

97,000

A Look at I F R S (4 of 11)

Differences

The accounting for convertible bonds differs between I F R S and G A A P. Unlike G A A P, I F R S splits the proceeds from the convertible bond between an equity component and a debt component. The equity conversion rights are reported in equity.

Under I F R S, companies sometimes will net current liabilities against current assets to show working capital on the face of the statement of financial position.

A Look at I F R S (5 of 11)

Looking to the Future

The F A S B and I A S B are currently involved in two projects, each of which has implications for the accounting for liabilities. One project is investigating approaches to differentiate between debt and equity instruments. The other project, the elements phase of the conceptual framework project, will evaluate the definitions of the fundamental building blocks of accounting. The results of these projects could change the classification of many debt and equity securities.

A Look at I F R S (6 of 11)

I F R S Practice

Which of the following is false?

a) Under I F R S, current liabilities must always be presented before noncurrent liabilities.

b) Under I F R S, an item is a current liability if it will be paid within the next 12 months.

c) Under I F R S, current liabilities are sometimes netted against current assets on the statement of financial position.

d) Under I F R S, a liability is only recognized if it is a present obligation.

A Look at I F R S (7 of 11)

I F R S Practice

Which of the following is false?

a) Under I F R S, current liabilities must always be presented before noncurrent liabilities.

b) Under I F R S, an item is a current liability if it will be paid within the next 12 months.

c) Under I F R S, current liabilities are sometimes netted against current assets on the statement of financial position.

d) Under I F R S, a liability is only recognized if it is a present obligation.

A Look at I F R S (8 of 11)

I F R S Practice

The accounting for bonds payable is:

a) essentially the same under I F R S and G A A P.

b) differs in that G A A P requires use of the straight-line method for amortization of bond premium and discount.

c) the same except that market prices may be different because the present value calculations are different between I F R S and G A A P.

d) not covered by I F R S.

A Look at I F R S (9 of 11)

I F R S Practice

The accounting for bonds payable is:

a) essentially the same under I F R S and G A A P.

b) differs in that G A A P requires use of the straight-line method for amortization of bond premium and discount.

c) the same except that market prices may be different because the present value calculations are different between I F R S and G A A P.

d) not covered by I F R S.

A Look at I F R S (10 of 11)

I F R S Practice

Which of the following is true regarding accounting for amortization of bond discount and premium?

a) Both I F R S and G A A P must use the effective-interest method.

b) G A A P must use the effective-interest method, but I F R S may use either the effective-interest method or the straight-line method.

c) I F R S is required to use the effective-interest method.

d) G A A P is required to use the straight-line method.

A Look at I F R S (11 of 11)

I F R S Practice

Which of the following is true regarding accounting for amortization of bond discount and premium?

a) Both I F R S and G A A P must use the effective-interest method.

b) G A A P must use the effective-interest method, but I F R S may use either the effective-interest method or the straight-line method.

c) I F R S is required to use the effective-interest method.

d) G A A P is required to use the straight-line method.

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