Liabilities

Chapter 9
Chapter Outline
Applications to people within and
outside the firm
Current liabilities
Long-term liabilities
Raising capital: stocks versus bonds
Evaluating the level of debt
Lease liabilities
Pensions and post-retirement benefits
 APPLICATIONS TO PEOPLE
WITHIN & OUTSIDE FIRM
 Liabilities are the debts of a firm.
 Internal users: Managers decide whether
to pay for items with cash on hand or to
use debt financing.
– Too much debt increases the risk that the
company will be unable to repay loans.
 External users: Investors, lenders, and
suppliers pay attention to a company’s
liabilities.
CURRENT LIABILITIES

 Current liabilities are those that are due

within one year or less.

 Most current liabilities are definite

amounts, but some must be estimated.
 Current liabilities
ethical dilemma
A person may be tempted to underestimate the
amount of a current liability in order to improve
the appearance of the company’s financial
position.
Failure to show the best estimate is unethical and
possibly fraudulent.
In addition, the real liability will eventually have
to be paid and questions may arise regarding the
original estimate.
 Current Liabilities
 The following current liabilities will be
discussed:
- Accounts payable
- Short-term payables
- Current portions of long-term notes payable
- Accrued expenses
- Payroll liabilities
- Deferred (unearned) revenue
- Warranty liabilities
- Income taxes payable
Accounts payable
(current liability)

 Accounts payable is the amount owed to

suppliers for credit purchases of goods
and services.
 A journal entry for accounts payable:
Inventory 2,000
Accounts Payable 2,000
Short-term notes payable
(current liability)

 Business firms routinely borrow money

or purchase assets using short-term
notes payable.
 Notes payable are represented by
documents called promissory notes,
which indicate:
– the principal amount borrowed,
– interest rate, and
– time period of the loan.
Current portions of long-term
notes payable (current liability)

 Sometimes part of a long-term debt is

payable within the year and must be
reclassified as a current liability.
Accrued liabilities
(current liability)

 Accrued liabilities are expenses that have

been incurred but not yet paid (also called
accrued expenses).
 Examples include accrued interest,
accrued payroll, and income taxes.
 Accrued liabilities are usually recorded
with other adjusting entries at the end of
an accounting period.
Payroll liabilities
(current liability)

 Employers are responsible for collecting

payroll deductions like taxes from
employee paychecks. These amounts are
classified as liabilities until they are paid
over to the appropriate government
agencies.
 Payroll liabilities are the current
liabilities for payroll expenses that have
been incurred but not yet paid.
 Payroll liabilities:
Employee payroll and deductions
 Payroll, also called employee
compensation, includes wages, salaries,
bonuses, and commissions.
 Net pay, also called take-home pay, is the
amount left over after withholding all
deductions.
 Deductions include federal income tax,
state income tax, social security tax
(FICA), Medicare tax, health insurance,
and pension contributions.
Payroll liabilities:
Employer’s payroll taxes
 Law requires an employer to match the
amount of FICA paid by its employees.
 Law requires an employer to pay federal
unemployment insurance tax, state
unemployment insurance tax, and
Medicare tax.
 Some employers voluntarily contribute to
health insurance and pension plans.
Deferred (unearned) revenue
(current liability)

 A deferred revenue results when a

customer pays cash in advance before
receiving the goods or services.
 The business firm has a liability in that
there is an obligation to deliver the
goods at a future time.
 Deferred revenue example

 An apartment company collects payment in

advance for 3 months rent:
Cash 2,400
Unearned Rent Revenue 2,400

 To record one month’s rent revenue earned:

Unearned Rent Revenue 800
Rent Revenue 800
Warranty liabilities
(current liability)

 The expense of replacing products under

warranty constitutes a current liability for
the company.
 The matching principal requires that
warranty expense be recorded in the same
period that the company records sales
revenue. Since the company does not
know the exact amount of products that
will be returned in the future, the
warranty expense must be estimated.
 Income taxes payable
(current liability)

 Corporations are taxed on their income.

– The federal government collects corporate income
tax, as do most states, and some cities.
 Income tax liability is estimated.
– The exact amount is usually not known until the
following year.
 Journal entry:
Income Tax Expense 24,800
Income Taxes Payable 24,800
LONG-TERM LIABILITIES

 Long-term liabilities are due more than

one year in the future.
 Long-term liabilities are often very
large financial commitments that
require years of future cash outlays.
 A bond is a type of long-term liability.
Bonds payable

 A bond represents debt owed by the

issuer to the bondholder.
 The bond issuer promises to repay the
bond’s principal at a future maturity date
and to pay interest.
 An underwriter, such as Merrill Lynch,
buys bonds from the issuing company
and resells them to others.
 Bonds payable
 The bond principal is the amount to be
received on the maturity date.
 The principal is the sum of money on which
interest is charged. The principal is also
referred to as the bond’s face value, maturity
value, denomination, or par value.
 The bond certificate is a legal document
showing the details of the bond.
 Investors buy and sell bonds in bond markets,
just like stocks.
 Types of bonds

 Secured bonds provide a guarantee of repayment

by pledging specified corporate assets.
 Unsecured bonds are backed only by the good
faith of the borrower.
 The term bond issue specifies the total number of
bonds issued.
 A supplementary agreement, the bond indenture,
specifies the restrictions, rights, and privileges
associated with the bonds.
 Present value of money
 Present value (PV) is the monetary worth
today of an amount to be received at a future
time.
 Money received today is worth more than the
same amount of money received a year from
now, because that money could have been
earning interest during the year.
 Investors refer to this concept as the “time
value of money,” which simply means that
money earns income over time .
 Present value computation:

 Compute the present value of $100,000 to be

received five years in the future at an annual
interest rate of 6%.
 In a present value table, you find that the PV of
$1 at five periods in the future at an interest rate
of 6% is $0.747. Multiply this amount times the
$100,000 (.747 x $100,000) and the present
value $74,700.
 Annuity
 An annuity pays a fixed amount of money at the
end of each period for a specified number of
periods.
– Example: $20,000 a year for 5 years at an annual
interest rate of 6%.
 Present value computation:
Look in a present value annuity table to find the
present value of annuity of $1 for five periods at
an interest rate of 6% is $4.212. Multiply
$20,000 by 4.212. The present value of the
annuity is $84,240.
Bond pricing & present value

 The price that a bond sells for today is

referred to as its market price (or
market value).
 The bond’s market price is the
combined present value of two items:
– The present value of the bond’s principal.
– The present value of the bond’s cash
interest payments.
 Computing market price of
$1,000 bond:
PV of principal (face value) $ 635
PV of cash interest payments 395
Bond market price $ 1,030
Bond principal 1,000
Bond premium $ 30

If the present value of the bond’s principal and

cash interest payments is more than the bond’s
principal, then the bond sells at a premium. If
it is less than the bond’s principal, then the
bond sells at a discount.
 Interest rate on bonds

 Stated interest rate is the rate stated on

the bond certificate; the rate paid to the
bondholder.

 Market interest rate is the interest rate

demanded by investors for the loan of
their money.
Interest rate on bonds

 When the stated interest rate does not

match the market rate, people pay more
(premium) or less (discount) for the
bonds, thus causing the interest payments
relative to the amount actually paid for
the bonds to be the market interest rate.
 Bond amortization is the process of
reducing the bond’s discount or premium
to zero, over the term of the bond.
 Determining bond issue price
(Exhibit 9.5)
Stated Market
Interest Interest
Rate Rate Issue Price
6% 6% Face Value: $100,000 bonds issued for
$100,000
6% 7% Discount: $100,000 bonds sell for
less than $100,000
6% 5% Premium: $100,000 bonds sell for
more than $100,000
Issuing bonds at par
 Suppose Disney issues $100,000 in 6%
bonds that mature in 4 years. The bonds
are issued at par.
 Disney records the receipt of $100,000
in cash on the day the bonds are issued.
The investors who purchased the bonds
may later sell the bonds in the bond
markets. The buy-and-sell transactions
between investors have no effect on
Disney.
Issuing bonds at a discount
 Suppose Proctor & Gamble issues
$100,000 of 7%, 3-year bonds.
 The market interest rate is 8%; thus, the
market price (present value) of the
bonds will be less than maturity value,
$100,000.
 Since there are two payments per year,
use one-half the annual rate for the
calculation, that is 4% (8% / 2).
Calculation follows.
 Determining market price of
bonds (Exhibit 9.6)

Market (Effective) Number of Semiannual

PV of Principal (face value): Interest Rate / 2 Interest Payments
$100,000 x PV of single amount 4% 6 periods
$100,000 x .790* $79,000

PV of cash interest payments:

$100,000 x .035 x PV of annuity 4% 6 periods
$3,500 x 5.242** 18,347
$97,347
__________
* from PV of $1 Table
** from PV Annuity of $1 Table

Investors are willing to pay a market price of

$97,347 for the bonds.
 Recording bonds issued at a
discount

 Journal entry to issue bonds at a discount:

Cash 97,347
Discount on bonds Payable 2,653
Bonds Payable 100,000
 Amortizing a bond discount

 Total interest expense is the sum of all the cash

interest payments plus the discount, as shown:
Interest payments ($100,000 x .07 x 3 years) $21,000
Discount on Bonds Payable 2,653
Total interest expense $23,653

 The discount causes the actual interest paid to be

equal to the market interest rate, not the bond stated
interest rate.
 Amortizing a bond discount
 To calculate the actual interest expense, the
company must amortize the discount.
 Amortization adjusts the bond carrying value
toward its maturity value.
 Each interest payment is a constant amount. The
interest expense is the interest rate multiplied by
the bond carrying value. The difference between
the interest payment and the interest expense is
how much the bond discount is amortized.
The amortization of bond discount using the effective interest rate
method is shown next. Remember, the effective interest rate is
another name for the market interest rate.
 Amortization of bond discount
Issue Date: Jan. 1, 2008
Maturity Date: Jan. 1, 2011
Maturity Value: 100,000
Issue Price: 97,347
Bond Stated Interest Rate: 7.00%
Bond Stated Interest Rate - Semiannual: 3.50%
Market Interest Rate on Issue Date: 8.00%
Market Interest Rate on Issue Date - Semiannual: 4.00%

A B C D E F
Interest
Interest Expense
Payment (4% of Discount Bond Bond
Interest (3.5 % of Carrying Amortization Discount Carrying
Payment Date Principal) Value) (C-B) Balance Value

Jan. 1, 2008 2,653 97,347

July 1 3,500 3,894 394 2,259 97,741
Jan. 1, 2009 3,500 3,910 410 1,849 98,151
July 1 3,500 3,926 426 1,423 98,577
Jan. 1, 2010 3,500 3,943 443 980 99,020
July 1 3,500 3,961 461 520 99,480
Jan. 1, 2011 3,500 4,020 * 520 (0) 100,000
Exh. 9.7 * Adjusted for rounding effect.
Issuing bonds at a premium

 Suppose Proctor & Gamble issues

$100,000 of 9%, 4-year bonds when the
market interest rate is 8%.
 The bond’s market price is $103,400,
thus the premium is $3,400.
 Investors are willing to pay $103,400 for
P&G bonds because the bonds make
cash interest payments of 9%, which is
more than the market interest rate of 8%.
 Amortizing a bond premium
 The premium on bonds payable is added
to the maturity value of the bonds to
calculate the bonds’ carrying value.
 Over the life of the bond, the premium
is incrementally reduced to zero, so that
the carrying value will equal the
maturity value on the maturity date.
The amortization of bond premium using the
effective interest rate method is shown next.
 Amortization of bond premium
Issue Date: Jan. 1, 2008
Maturity Date: Jan. 1, 2012
Maturity Value: 100,000
Issue Price: 103,400
Bond Stated Interest Rate: 9.00%
Bond Stated Interest Rate - Semiannual: 4.50%
Market Interest Rate on Issue Date: 8.00%
Market Interest Rate on Issue Date - Semiannual: 4.00%

A B C D E F
Interest
Interest Expense
Payment (4% of Premium Bond Bond
Interest (4.5% of Carrying Amortization Premium Carrying
Payment Date Principal) Value) (B-C) Balance Value

Jan. 1, 2008 3,400 103,400

July 1 4,500 4,136 364 3,036 103,036
Jan. 1, 2009 4,500 4,121 379 2,657 102,657
July 1 4,500 4,106 394 2,264 102,264
Jan. 1, 2010 4,500 4,091 409 1,854 101,854
July 1 4,500 4,074 426 1,428 101,428
Jan. 1, 2011 4,500 4,057 443 986 100,986
July 1 4,500 4,039 461 525 100,525
Exh. 9.8 Jan. 1, 2012 4,500 3,975 * 525 0 100,000

* Adjusted for rounding effect..

 Journal entries
 To issue bonds at a premium:
Jan. 1 Cash 103,400
Bonds Payable 100,000
Premium on bonds Payable 3,400

 To pay bond interest and amortize bond premium:

July 1 Interest Expense 4,136
Premium on Bonds Payable 364
Cash 4,500
Straight-line method of
bond amortization
 Bond interest expense can be
“approximated” using the straight line
amortization method.
 The bond discount or premium is
allocated into equal amounts over the
bond’s term.
– Thus, the interest expense is the same
in each interest period.
The amortization of bond premium using the
straight-line interest method is shown next.
 Amortization of bond premium using
the straight line interest method
Issue Date: Jan. 1, 2008
Maturity Date: Jan. 1, 2011
Maturity Value: 100,000
Issue Price: 103,400
Bond Stated Interest Rate: 9.00%
Bond Stated Interest Rate - Semiannual: 4.50%
Market Interest Rate on Issue Date: 8.00%
Market Interest Rate on Issue Date - Semiannual: 4.00%

A B C D E F
Interest
Payment Interest Premium Bond Bond
Interest (4.5 % of Expense (B- Amortization Premium Carrying
Payment Date Principal) D) (3,400/8) Balance Value

Jan. 1, 2008 3,400 103,400

July 1 4,500 4,075 425 2,975 102,975
Jan. 1, 2009 4,500 4,075 425 2,550 102,550
July 1 4,500 4,075 425 2,125 102,125
Jan. 1, 2010 4,500 4,075 425 1,700 101,700
July 1 4,500 4,075 425 1,275 101,275
Jan. 1, 2011 4,500 4,075 425 850 100,850
Exh. 9.9 July 1 4,500 4,075 425 425 100,425
Jan. 1, 2012 4,500 4,075 425 0 100,000
 Journal entry

 To pay bond interest and amortize bond premium:

Interest Expense 4,075
Premium on Bonds Payable 425
Cash
4,500
RAISING CAPITAL:
STOCKS VERSUS BONDS

Management must evaluate which method

is the optimum way for a company to
obtain capital:
1. Borrow the money by issuing bonds
payable.
2. Raise the money by issuing stock.
Issue bonds payable

Advantages:
 Issuing bonds payable does not affect
stockholders’ equity. Current
stockholders retain the same share of
ownership.
 Earnings per share goes up, assuming
earnings on debt exceeds interest
expense. This situation is referred to as
leveraging.
 Issue stock

Advantage:
 Issuing stock does not increase
liabilities or interest expense; thus, this
approach is less risky than issuing
bonds payable.
Earnings per share (EPS)

 How will the decision to issue bonds

payable or stock affect a company’s
earnings per share (EPS)?
 Earnings per share (EPS) is computed by
dividing the company’s net income by
the number of shares of common stock.
– In other words, EPS is the company’s net
income per share.
 Decision making example:
bonds versus stock
 Baggins Pipe Company needs one
million dollars for a new plant.
 Baggins has net income of $600,000 and
200,000 shares of common stock
outstanding.
 Management anticipates that the new
plant will generate income of $400,000
before interest and taxes. The tax rate is
40 percent.
Two options for Baggins:

1. Issue $1 million of 8% corporate

bonds payable.
2. Issue 100,000 share of common stock
for $1 million.
 Impact of issuing stock versus
bonds on EPS (Exh. 9.10)
Plan 1: Stock Issue
Issue 100,000 Shares of
Common Stock for $1 million
Plan 2: Bond Issue
Issue Bonds Payable
of $1 million at 8%

Earnings (Net Income) before Expansion 600,000 600,000

Expected Plant Earnings Before Interest & Tax 400,000 400,000
Less Interest Expense 0 80,000
Expected Plant Earnings Before Tax 400,000 320,000
Less Income Tax 160,000 128,000
Expected Plant Earnings 240,000 192,000
Total Company Earnings 840,000 792,000
Earnings Per Share (EPS) after Expansion
Plan 1 (300,000 common stock shares) 2.80
Plan 2 (200,000 common stock shares) 3.96

Issuing bonds leads to a higher EPS for Baggins because the

company earns more on the investment ($192,000) than the
interest it pays on the bonds ($80,000).
 EVALUATING THE LEVEL
OF DEBT

 Determining when and how much

money to borrow is a huge challenge for
business managers.
 Borrowing can lead to higher earnings
per share, but debt carries certain risks.
 Borrowing is a cross-functional decision

For example:
 The marketing department may project an increase in
product demand that warrants an increase in production.
 However, production can only increase output by
building an additional manufacturing plant.
 The finance department determines the cost of different
financing arrangements that will provide the money
necessary to build.
 Accounting calculates and reports the estimated impact
of the additional sales and higher operating costs on the
firm’s profits.
 Times-interest-earned ratio
 The financial ratio, times-interest-earned ratio,
is used to assess a company’s ability to pay
interest expense.
 = operating income / interest expense.
 It shows the number of times that operating
income can cover interest expense.
 The higher the ratio, the easier a company can
pay its interest expense.
 Times-interest-earned ratio
example (Exhibit 9.11)
J.C. Penney Stein Mart

Operating Income 790,000 7,934

Times-interest-earned ratio = Interest Expense = 261,000 1,688

= 3.0 4.7

Note: Amounts are in thousands

Penney’s income from operations covers its interest expense

3 times; Stein Mart’s ratio is 4.7. Since Penney is a much
larger company than Stein Mart, Penney can manage a lower
interest coverage ratio.
LEASE LIABILITIES
 A lease is an arrangement in which a
tenant (lessee) agrees to make rent
payments to a property owner (lessor) in
return for use of the property.
 When a company does not have the cash
to purchase equipment, it may obtain a
short-term or long-term lease to acquire
the equipment.
 A lease liability can be a long-term
liability.
Lease Liabilities

 Leases are accounted for differently,

depending on whether they are
categorized as:
– Operating leases (short-term)
– Capital leases (long-term)
 Operating lease

 An operating lease is short-term and cancelable.

 Once the lease expires, there are no provisions
for the lessee to continue using the property.
 Journal entry to record lease payment:
Rent Expense 2,000
Cash 2,000
 An advantage of an operating lease is that it has
no impact on the balance sheet.
 Capital lease
 A capital lease is long-term and non-cancelable.
 It is more like an installment purchase than an
actual lease.
 Advantages of a capital lease:
– It costs less than an operating lease.
– It doesn’t require an immediate outlay of cash
for a down payment.
– Rent payments are fully deductible for tax
purposes.
 Capital lease

A capital lease must meet one of these criteria:

– Title of the leased asset transfers from the
lessor to the lessee at the end of the lease
term.
– Lease agreement includes a bargain purchase
option; the lessee is expected to purchase.
– The term of the lease is 75% or more of the
leased asset’s useful life.
– Present value of lease payments is 90% or
more of the leased asset’s market price.
 Deciding on the type of lease

Example:
 McDonald’s will lease restaurant facilities
overseas; these assets are valued at $2 billion.
 Should the lease be set up as an operating lease
or as a capital lease?
 Deciding on the type of lease
McDonald’s example
 If McDonald’s goal is to lock in a long-term
arrangement, then a capital lease may be preferred.
 McDonald’s may be able to negotiate a lower rent
payment with a long-term capital lease.
 However, the capital lease requires McDonald’s to
capitalize the leased asset and record the lease liability
as if they had purchased the asset with long-term debt.
 The capital lease increases both total assets and total
liabilities on the balance sheet. In contrast, the
operating lease has no impact on the balance sheet.
 Cross-functional issues in
McDonald’s example
 From the perspective of the VP of operations and the
restaurant managers, the goal is to acquire the assets
needed for doing business, regardless of whether an
operating or capital lease is used.
 However, the VP of finance is concerned about which
financing arrangement will decrease short-term
profitability.
 Other departments may be concerned with the long-
term effects. A decision may hurt profits in the short-
term, but may be beneficial in the long-term.
 Deciding on the type of lease
McDonald’s example
 In choosing a lease, McDonalds must consider
the effect upon the company’s debt ratio.
 Debt ratio helps investors and lenders assess the
financial position of a company, specifically, the
weight of debt on the company’s financial
resources.
 If the debt ratio is too high, then McDonald’s
may have to pay a higher interest rate on future
borrowings.
 Computation of McDonald’s debt
ratio using each lease
Exh. 9.12
Operating Lease:
Total Liabilities 13.5
Debt Ratio = Total Assets = 25.5 = 52.9%

Capital Lease:
Total Liabilities 13.5 + 2 15.5
Debt Ratio = Total Assets = 25.5 + 2 = 27.5 = 56.4%

If a debt ratio of 56.4% under a capital lease causes

McDonald’s to pay a significantly higher interest rate on
future borrowings, then they will choose the operating
lease.
PENSIONS AND POST-
RETIREMENT BENEFITS
 A pension plan is an arrangement in
which employees receive compensation
after they retire.
 Post-retirement benefits include other
retiree benefits, primarily health care and
life insurance.
 Typically, employees contribute to their
pension plan with each salary payment,
with companies often providing a
matching contribution.
Pensions & Post-Retirement
Benefits
 Pension contributions accumulate in a
pension fund.
 The company’s liability for future pension
payments also accumulates.
 If the pension plan assets are more than
the accumulated obligations, the plan is
called over-funded.
 If the pension plan obligations exceed the
plan assets, then the pension plan is
under-funded and must be reported as a
long-term liability.