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CHAPTER 10
LIABILITIES
Overview of Exercises, Problems, Cases,
and internet assignment
Exercises Topic Learning Objectives Character of Assignment 10–1 You as a student 4 Personal, mechanical 10–2 Accounting equation 1–4 Conceptual 10–3 Effects of transactions upon financial statements 1, 4, 5, 7 Conceptual 10–4 Balance sheet presentation 1, 5, 10* Conceptual 10–5 Payroll-related costs 3 Mechanical 10–6 Use of an amortization table 4 Mechanical, conceptual 10–7 Tax benefit of debt financing 5 Mechanical, conceptual 10–8 Bonds payable and interest 5 Mechanical, conceptual 10–9 Bond price volatility 5, 11** Research, conceptual 10–10 Bonds payable and interest 5, 11** Mechanical, conceptual 10–11 Accounting for leases 6 Mechanical, conceptual, ethics 10–12 Pension plans 6, 7 Mechanical, conceptual, ethics 10–13 Deferred income taxes 8 Conceptual 10–14 Analyzing solvency 9 Conceptual, analytical, real— Tyco Toys and Hasbro 10–15 Identifying debt 9 Conceptual, real— Tootsie Roll Problems 10–1 Effects of transactions upon the accounting equation
Conceptual 10–2 Balance sheet presentation 1, 2, 4, 10* Conceptual 10–3 Notes payable 2 Mechanical, conceptual 10–4 Preparation and use of an amortization table 4 Mechanical, conceptual 10–5 Bonds issued at par 5 Mechanical, conceptual 10–6 Bond discount and premium 11** Mechanical, conceptual 10–7 Balance sheet presentation 1, 5, 7, 8 Conceptual, mechanical
- Supplemental Topic A, “Estimated Liabilities, Loss Contingencies, and Commitments.” ** Supplemental Topic B, “Bonds Issued at a Discount or a Premium.”
Cases Topic Learning Objectives Character of Assignment 10–1 Nature of liabilities 1, 3, 10* Conceptual, can be group assignment, real— 7 companies 10–2 Balance sheet presentation 1, 7, 10* Conceptual, group 10–3 Factors affecting bond prices 5, 6 Conceptual, analytical, group, real — Occidental Petroleum 10–4 Loss contingencies 10* Conceptual, group Business Week Assignment 10–4 Business Week assignment 7 Ethics, group assignment, communication Internet Assignment 10–1 Credit ratings for bonds 9 Internet, research
- Supplemental Topic A, “Estimated Liabilities, Loss Contingencies, and Commitments.”
Discuss the nature of various liabilities appearing in the balance sheets of well-known companies.
- 10–2 Redford Grain Corporation Students are asked to analyze eight independent events occurring at or near year-end to determine for each event whether it creates a current liability or should be presented elsewhere in the financial statements. 20 Easy
- 10–3 Occidental Petroleum Requires student to understand the relationship between a bond’s issue price and the effective rate of interest, and to differentiate between cash flow and interest expense. Also requires that students understand that the time remaining until a bond matures is a factor in determining the bond’s current value. 20 Strong *10–4 Loss Contingencies? Students are asked to evaluate four situations, indicating whether the situation describes a loss contingency and explaining the proper financial statement treatment of the matter. 25 Medium
Business Week Assignment
10–5 Business Week Assignment Students are asked to discuss the ethical implications of a company’s decision to discontinue health care benefits as part of a retirement package. No time estimate
Internet Assignment
10–1 Credit Ratings Students are introduced to bond ratings and how they correspond to bond yields. No time estimate
*Supplemental Topic A, “Estimated Liabilities, Loss Contingencies, and Commitments.”
suggested answers to discussion questions
- Liabilities are debts or obligations arising from past transactions or events, and which require settlement at a future date. Liabilities and owners’ equity are the two primary means by which a business finances ownership of its assets and its business operations. The feature which most distinguishes liabilities from equity is that liabilities mature, whereas owners’ equity does not. In the event of liquidation of the business, the claims of creditors (liabilities) have priority over the claims of owners (equity). Also, interest paid to creditors is deductible in the determination of taxable income, whereas dividends paid to stockholders are not deductible.
- In the event of liquidation of a business, the claims of creditors (liabilities) have priority over the claims of owners (equity). The relative priorities of individual creditors, however, vary greatly. Secured creditors have top priority with respect to proceeds stemming from the sale of the specific assets that have been pledged as collateral securing their loans. The priority of unsecured creditors is determined by legal statutes and indenture contracts.
- Current liabilities are those maturing within one year or the company’s operating cycle (whichever is longer) and expected to be paid from current assets. Liabilities classified as long-term include obligations maturing more than one year in the future, and also shorter term obligations that will be refinanced or paid from noncurrent assets. A 10-year bond issue would be classified as a current liability once it comes within 12 months of the maturity date, assuming that the issue will be paid from current assets. A note payable maturing in 30 days would be classified as a long-term liability if (a) management had both the intent and the ability to refinance this obligation on a long-term basis, or (b) the liability will be paid from noncurrent assets.
- Accounts Payable (Smith Supply Company)................................................. 8, Notes Payable..................................................................................... 8, Issued a 12%, 90-day note payable to replace an account payable to Smith Supply Company. Notes Payable................................................................................................. Interest Expense.............................................................................................
Cash.................................................................................................... 8, Paid 12%, 90-day note to Smith Supply Company.
- All employers are required by law to pay the following payroll taxes and insurance premiums: Social Security and Medicare taxes, unemployment taxes, and workers’ compensation insurance premiums. In addition, many employers include the following as part of the “compensation package” provided to employees: group health insurance premiums, contributions to employee pension plans, and postretirement benefits (such as health insurance). Both mandated and discretionary costs are included as part of total payroll cost in addition to the wages and salaries earned by employees.
- Workers’ compensation premiums are a mandated payroll cost—the cost of providing insurance coverage to employees in case of job-related injury. The dollar amount of the premiums varies by state and by employees’ occupation. The employer pays workers’ compensation premiums. Social Security and Medicare taxes are paid half by the employer and half by the employee.
- $62,537 [$63,210 balance at the beginning of the period, less $673 of the payment that applies to principal ($1,200 $527 representing interest)].
- The lessee accounts for an operating lease as a rental arrangement; the lease payments are recorded as rental expense and no asset or liability (other than a short-term liability for accrued rent payable) is recorded. A capital lease, on the other hand, should be viewed by the lessee as essentially a purchase of the related asset. The lessee accounts for a capital lease by debiting an asset account (such as Leased Equipment) and crediting a liability account (Lease Payment Obligation) for the present value of the future lease payments. Lease payments made by the lessee must be allocated between interest expense and a reduction in the liability, Lease Payment Obligation. The asset account is depreciated over the life of the leased asset. An operating lease is sometimes called off-balance-sheet financing because the obligation for future lease payments does not appear as a liability in the lessee’s balance sheet.
- As the pension plan is fully funded, Ortega Industries has paid its pension obligations to the pension fund trustee as these obligations have accrued. Therefore, no liability need appear in Ortega’s balance sheet relating to the pension plans. Retired employees will collect their postretirement benefits directly from the trustee of the pension plan.
- Most pension plans are fully funded —that is, the corporation deposits cash in the pension fund each period in an amount equal to the current-period liability. Thus, no liability for pension payments appears in the corporation’s balance sheet. Most corporations, however, do not fully fund their obligations for nonpension postretirement benefits. The difference between the amount funded and the present value of promised future benefits—the unfunded amount—is reported as a liability. This liability gets larger each year as the funded portion lags further and further behind the present value of promised benefits.
- Postretirement costs are recognized as expense currently as workers earn the right to receive these benefits. If these costs are fully funded, the company makes cash payments within the current period equal to the expense recognized. If the benefits are not funded, the cash payments are not made until after the employees retire.
- Deferred income taxes are the portion of this year’s income taxes expense (as shown in the income statement) which will appear in the income tax returns of future years. Therefore, due to differences between income tax regulations and accounting principles, the taxpayer is able to postpone the payment of some income taxes so long that these obligations become a long-term liability. Note to instructor: Situations in which certain expenses are deductible for financial reporting purposes but not for income tax purposes may cause deferred taxes to be classified as an asset instead of a liability.
- Because the maturing bonds were paid from a sinking fund, the bonds were never classified as a current liability. As the sinking fund was never classified as a current asset, the maturity of the bonds had no effect upon the company’s current ratio. The debt ratio is equal to total liabilities divided by total assets. NDP is a solvent business; therefore, the total liabilities are less than total assets, and the debt ratio is less than 100%. Under these circumstances, reducing the numerator and denominator of the ratio by an equal amount causes the debt ratio to decrease. One also should arrive at this conclusion through common sense —repaying debt reduces the percentage of total assets financed with capital provided by creditors.
- Low-Cal’s very low interest coverage ratio should be of greater concern to stockholders than to short-term creditors. The fact that operating income amounts to only 75% of annual interest implies that Low-Cal may have great difficulty in remaining solvent in the long run. It does not imply, however, that the company is not currently solvent. Short-term creditors, because of their shorter investment horizon, should be concerned about the current relationships between the company’s liquid resources and its short-term obligations.
- The return on assets represents the average return that a business earns from all of the capital. If this average rate is higher than the cost of borrowing, the business can benefit from using borrowed capital—that is, applying leverage. In essence, if you can borrow money at a relatively low rate and invest it at a significantly higher one, you will benefit from doing so. But some businesses have borrowed such large amounts—and at such high interest rates—that they have been unable to earn enough to pay the interest. In these cases, the owners must come up with additional money to cover the interest charges, or the business eventually will “go under.” *24. Estimated liabilities have two basic characteristics: (1) the liability is known to exist and (2) the precise dollar amount cannot be determined until a later date. Examples include the liability to honor warranties on products sold, liabilities for income taxes payable, and an accrual of liability relating to a loss contingency. *25. A loss contingency is a possible loss (or expense) stemming from past events that will be resolved as to existence and amount by some future event. Examples include pending litigation, all estimated liabilities, the allowance for uncollectible accounts, and the risk that the political climate in foreign countries has impaired the value of assets in those locations. Loss contingencies are accrued (recorded) if it is both (1) probable that a loss has been incurred, and (2) the amount of loss can be estimated reasonably. Even if these conditions are not met, loss contingencies should be disclosed in financial statements if it is reasonably possible that a material loss has been incurred. *26. A commitment is a contractual obligation to conduct future transactions on agreed-upon terms. Examples include employment contracts, contracts with suppliers of services, and contracts to make future purchases or sales of inventory or of other assets. If they are material in dollar amount, the terms of commitments should be disclosed in financial statements. No liability normally is recorded, because the commitment relates to future transactions, rather than to past transactions. **27. Issuing bonds at a discount increases the cost of borrowing. Not only does the issuing company have the use of less borrowed money in exchange for its regular interest payments, but it also must repay more than the original amount borrowed. Thus, an additional interest charge is built into the maturity value of the bonds.
- Supplemental Topic A, “Estimated Liabilities, Loss Contingencies, and Commitments.” ** Supplemental Topic B, “Bonds Issued at a Discount or a Premium.”
Ex. 10–4 a. Current liabilities: Unearned revenue........................................................................................ $300, Lease payment obligation (current portion).............................................. 10, Accrued bond interest payable................................................................... 36, Total current liabilities.................................................................................... $346, b. Long-term liabilities: Lease payment obligation ($80,000 $10,000)........................................... $ 70, Bonds payable.............................................................................................. 900, Notes payable to be refinanced on a long-term basis................................ 75, Total long-term liabilities................................................................................ $1,045, The interest expense that will arise from existing obligations is not yet a liability. The lawsuit pending against the company is a loss contingency. It should be disclosed, but no liability is recorded as no reasonable estimate can be made of the dollar amount. The 3-year salary commitment relates to future transactions and, therefore, is not yet a liability of the company. Ex. 10–5 a. Total payroll related costs: Wages and salaries expense......................................................................... $ 7,200, Payroll taxes................................................................................................. 580, Workers’ compensation premiums............................................................. 250, Group health insurance premiums............................................................. 725, Contributions to employees’ pension plan................................................. 450, Other postretirement benefits (whether funded or not)............................ 350, Total payroll related costs........................................................................... $ 9,555, b. Employees’ “take-home pay”: Wages and salaries earned.......................................................................... $7,200, Amounts withheld from employees’ pay.................................................... 2,200, “Take-home pay”......................................................................................... $5,000, c. (1) 133% ($9,555,000 $7,200,000) (2) 191% ($9,555,000 $5,000,000) d. The costs of postretirement benefits were determined by estimating the present value of the future costs of retirement benefits earned during the year by today’s workforce. These estimates are made by an actuary. Only the unfunded portion of the postretirement costs results in a liability. The liability represents only the present value of the expected future payments. Therefore, the actual payments to retirees will be far larger than this liability.
Ex. 10–6 a. Amortization Table (12% Note Payable for $150,000; Payable in Monthly Installments of $1,543) Monthly Interest Period
(A)
Monthly Payment
(B)
Interest Expense (1% of the Last Unpaid Balance) Reduction in Unpaid Balance (A) (B) Unpaid Balance Original balance 1 2
b. Interest Expense............................................................................... 1, Mortgage Payable............................................................................ 43 Cash...................................................................................... 1, To record second monthly installment on mortgage payable. c. Decrease. Interest expense is based on the unpaid principal balance at the end of each month. As the unpaid principal balance decreases each period, interest expense will decrease also. Ex. 10–7 a. Annual interest expense ($50 million 10%)................................................ $5,000, Less: Income tax savings ($5,000,000 40%)............................................... 2,000, Annual after-tax cost of borrowing................................................................. $ 3,000, b. 6% ($3,000,000 $50 million) Ex. 10–8 a. Apr. 30 Cash................................................................................. 50, Bonds Payable..................................................... Bond Interest Payable........................................
Issued $50,000 face value of 9%, 30-year bonds at 100 plus accrued interest for one month. b. Sept. 30 Bond Interest Payable.................................................... 375 Bond Interest Expense................................................... 1, Cash..................................................................... 2, Paid semiannual interest on $50,000 face value of 9% bonds. c. Dec. 31 Bond Interest Expense................................................... 1, Bond Interest Payable........................................ 1, Adjusting entry to recognize three months’ interest accrued on $50,000 face value 9% bonds since September 30.
d. (1) Amortization of bond discount increases annual interest expense and, consequently, reduces annual net income. (2) Amortization of bond discount is a noncash component of annual interest expense and has no effect upon annual net cash flow from operating activities. (Receipt of cash upon issuance of bonds and payment of cash to retire bonds at maturity are both classified as financing activities.) Ex. 10–11 a. Rent Expense.................................................................................... 2, Cash...................................................................................... 2, To record monthly rental expense on equipment under an operating lease agreement. b. Leased Equipment........................................................................... 20, Lease Payment Obligation.................................................. 17, Cash...................................................................................... 2, To record the acquisition of equipment through a capital lease agreement. c. Under an operating lease, no asset or liability (other than perhaps a short-term liability for accrued rent payable) relating to the lease appears in the lessee’s balance sheet. d. If the lease is unquestionably a capital lease, it would be unacceptable, unethical and possibly illegal for a publicly owned company to account for it as an operating lease. Such presentation would understate the company’s total liabilities. Ex. 10–12 a. Pension Expense.............................................................................. 2,500, Cash...................................................................................... 2,500, To summarize payments to a fully funded pension plan. b. Nonpension Postretirement Benefits Expense............................... 750, Cash...................................................................................... 50, Unfunded Liability for Nonpension Postretirement Benefits..................................................... 700, To summarize partial funding of nonpension postretirement benefits expense for the year and an increase in the related unfunded liability. c. Because the pension plan is fully funded each year, and because the plan is an entity separate from Western Electric, this plan should contain assets approximately equal to the pension benefits earned by employees in prior years. Thus, even if Western Electric becomes insolvent, the plan will continue to invest these assets and should be able to pay these earned benefits in future years. d. A company does not have an ethical (or legal) responsibility to fund its nonpension postretirement benefits as they accrue. It does, however, have an ethical responsibility to provide to employees all of the benefits they have earned during their working careers.
Ex. 10–13 a. Deferred taxes are the income taxes that will become due in future years upon earnings that already have been reported in a company’s income statement. Deferred taxes arise because of timing differences between the recognition of certain revenue and expenses in income tax returns and in financial statements. b. $1,300,000 ($960,000 already paid, plus $340,000 currently payable) c. Current liabilities: Income taxes payable.................................................................................... $ 340, Deferred taxes payable (current portion)................................................... 30, Total current tax liabilities....................................................................... $ 370, Long-term liabilities: Deferred taxes payable ($200,000, less current portion of $30,000)......... $ 170,
Ex. 10– a. Current Ratio: (1) Current assets 12/31/99 $224, (2) Current liabilities 12/31/99 56, Current ratio (1) (2) 4.00: Quick Ratio: (1) Financial assets 12/31/99 $184, (2) Current liabilities 12/31/99 56, Quick ratio (1) (2) 3.28: Given these strong ratios, and the fact that the company has over $159 million in cash, cash equivalents, and marketable securities, it appears that it will have no problem repaying its current liabilities as they come due. b. Debt Ratio: (1) Total liabilities 12/31/99 $ 98, (2) Total assets 12/31/99 529, Debt ratio (1) (2) 18.7% The company has a very low debt load. Only 18.7% of each asset dollar is debt financed. Of this amount, most is short-term. c. The company reports current liabilities of approximately $56.1 million at the end of 1999. Cash flows from operating activities for the year amount to $72.9 million. If similar cash flows are generated in 2000, no problems should be encountered in paying these liabilities.
25 Minutes, Easy
SOLUTIONS TO PROBLEMS
PROBLEM 10–
COMPUTER SPECIALISTS, INC.
Income Statement Balance Sheet Current Long-Term Owners’ Transaction Revenue ^ Expenses ^ Net Income Assets ^ Liabilities ^ Liabilities ^ **Equity a NE I D NE I NE D b NE NE NE NE I D NE c NE I D D I NE D d I NE I NE D NE I e NE NE NE NE D I NE f NE I D D D NE D g NE I D D NE D D h NE I D D NE NE D i NE I D D D NE D j NE I D D NE NE D k NE I D NE I I D l NE I D NE I I D *m NE I D NE I NE D n NE NE NE NE NE NE NE o NE NE NE NE NE NE NE
- Supplemental Topic A, “Estimated Liabilities, Loss Contingencies, and Commitments.”
a. General Journal 20__ Aug 6 Cash 1 2 0 0 0 Notes Payable 1 2 0 0 0 Borrowed $12,000 @ 12% per annum from Maple Grove Bank. issued a 45-day promissory note. Sept 16 Office Equipment 1 8 0 0 0 Notes Payable 1 8 0 0 0 Issued 3-month, 10% note to Seawald Equipment as payment for office equipment. Sept 20 Notes Payable 1 2 0 0 0 Interest Expense 1 8 0 Cash 1 2 1 8 0 Paid note and interest to Maple Grove Bank ($12,000 x 12% x 45/360 = $180). Nov 1 Cash 2 5 0 0 0 0 Notes Payable 2 5 0 0 0 0 Obtained 90-day loan from Mike Swanson; interest @ 15% per annum. Dec 1 Inventory 5 0 0 0 Notes Payable 5 0 0 0 To record purchase of merchandise, and issuance of 90-day, 14% note payable to Gathman Corporation. Dec 16 Notes Payable 1 8 0 0 0 Interest Expense 4 5 0 Cash 4 5 0 Notes Payable 1 8 0 0 0 Paid interest on note to Seawald Equipment which matured today and issued a 30-day, 16% renewal note. Interest: $18,000 x 10% x 3/12 = $450. b. Adjusting Entry Dec 31 Interest Expense 6 4 2 8 Interest Payable 6 4 2 8 To record interest accrued on notes payable: Mike Swanson ($250,000 x 15% x 2/12 = $6,250); Gathman Corporation ($5,000 x 14% x 1/12 = $58); and Seawald Equipment ($18,000 x 16% x 1/12 x 1/2 = $120). c. The Seawald Equipment note dated September 16 was due in full on December 16. The higher rate of interest on the new note may be associated with the increased risk of collecting in 30 days the $18,000 principal, plus accrued interest due.
25 Minutes, Medium PROBLEM 10–
QUICK LUBE
a. and d. a. The amount of the monthly payments exceeds the amount of the monthly interest expense. Therefore, a portion of each payment reduces the unpaid balance of the loan. The continuous reduction in the unpaid balance, in turn, causes the monthly interest expense to be less in each successive month, and the amount applied to the unpaid balance to increase. Thus, the loan principal is repaid at an ever-increasing rate. d. At December 31, 2002, two amounts relating to this mortgage loan will appear as current liabilities in the borrower’s balance sheet. First, as payments are due on the first day of each month, one month’s interest has accrued since the December 1 payment. This accrued interest will be paid on January 1, 2003, and therefore, is a current liability. Next, the portion of the unpaid principal that will be repaid during 2003 represents a current liability. Parts b and c appear on the following page.
