Chapter 7 liability

OPEN UNIVERSITY HCMC
MBA PREPARATORY COURSE

Principles of Financial
Accounting
Lecturer: NGUYEN TAN BINH

06/04/16

NGUYEN TAN BINH - PHAN DUC DUNG

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Chapter 7

Liabilities and Interest

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Learning Objectives
After studying this chapter, you should be able to:
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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.
Use ratio analysis to assess a company’s debt levels.
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Liabilities in Perspective
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Liabilities are a company’s obligations to pay cash or to
provide goods and services to other companies or
individuals.
Accrual accounting recognizes expenses when they occur
rather than when they are paid.


When an expense is recognized before it is
paid, a liability is created.

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Liabilities in Perspective


Liabilities are important to investors, financial analysts,
management, and creditors.
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Excess liabilities often cause investors and
creditors to stay away from the company with
the excess liabilities.

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Liabilities in Perspective
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Liabilities are classified as either current or long
term to help readers interpret the immediacy of a
company’s obligations.
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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
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If long-term liabilities are paid gradually, the portion that comes
due within the year becomes a current liability.

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Liabilities in Perspective
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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.

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Liabilities in Perspective
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Presentation of liabilities in the balance sheet:
Current liabilities
Current maturities of long-term debt
Accounts payable
Wages payable
Interest payable
Total current liabilities

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$19,500
26,250
1,750
2,500
$50,000

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Accounting for Current
Liabilities

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Not all current liabilities are recorded the same way.
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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.
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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.

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Notes Payable
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Promissory note (note payable) - a
written promise to repay principal plus
interest at specific future dates
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Notes payable can be classified as
current or long term depending on
when they are payable.

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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
preestablished maximum


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The lender does not have to do extensive paperwork or
credit checks every time a borrower needs money.
The borrower has a preset amount of borrowing available.

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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.

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Current Portion of
Long-Term Debt
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If long-term liabilities are paid gradually, the portion that
comes due within the year becomes a current liability.
The journal entry to reclassify a liability is:
Long-term debt
Current portion of long-term debt

xxxx

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xxxx

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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.
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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
documents.
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Internal Control Over
Payables


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

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Long-Term Liabilities


Some long-term liabilities are much like some shortterm liabilities except for the time frame.
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Car loans or mortgage loans are much like
notes payable, but they are for a longer
term.
As time passes, payments of interest and
principal eliminate the loan obligation.

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Long-Term Liabilities
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Illustration and analysis of a loan:
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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.
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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
sources of borrowing are used rather than the
general public.

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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

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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.

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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
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Interest represents the return the
lender can earn for loaning money.
In general, riskier loans demand higher
interest rates.

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Bond Accounting


On December 31, 2000, a company issued $10,000,000 in 2year, 10% bonds. Interest is to be paid semiannually on
June 30 and December 31. Assuming that the bonds are held
to maturity, the journal entries are:
To record the issuance of the bonds
Cash
10,000,000
Bonds payable
10,000,000
To record the payments of the semiannual interest
Interest expense
500,000
Cash (($10,000,000 x 10%) / 2)
500,000
To record the repayment of principal at maturity
Bonds payable
10,000,000
Cash
10,000,000

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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.

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Debt Ratios and
Interest-Coverage Ratios
Total liabilities
Debt-to=
equity ratio
Total shareholders' equity
Long-termTotal long-term debt
debt-to-total- =
Total shareholders’ equity + long-term debt
capital ratio

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Debt Ratios and
Interest-Coverage Ratios
Debt-toTotal liabilities
total-assets =
Total
assets
ratio
InterestPretax income + Interest expense
coverage =
Interest expense
ratio
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