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CHAPTER 10
Liabilities

FEATURE STORY

Financing His Dreams

What would you do if you had a great idea for a new product but couldn’t come up with the cash to get the business off the ground? Small businesses often cannot attract investors. Nor can they obtain traditional debt financing through bank loans or bond issuances. Instead, they often resort to unusual, and costly, forms of non-traditional financing.

Such was the case for Wilbert Murdock. Murdock grew up in a low-income housing project but always had high goals. His entrepreneurial spirit led him into some business ventures that failed, such as a device to keep people from falling asleep while driving. Another idea was computerized golf clubs that analyze a golfer’s swing and provide immediate feedback. Murdock saw great potential in the idea. Many golfers are willing to shell out considerable sums of money for devices that might improve their game. But Murdock had no cash to develop his product, and banks and other lenders had shied away. Rather than give up, Murdock resorted to credit cards—in a big way. He quickly owed $25,000 to credit card companies.

While funding a business with credit cards might sound unusual, it isn’t. A recent study by the London-based Institute of Directors found that more than half of companies seeking bank financing had been turned down. About 20% of the 1,000 companies studied relied, at least in part, on credit card financing.

Murdock’s credit card debt forced him to sacrifice nearly everything in order to keep his business afloat. His car stopped running, he barely had enough money to buy food, and he lived and worked out of a dimly lit apartment in his mother’s basement. Through it all he tried to maintain a positive spirit, joking that, if he becomes successful, he might some day get to appear in an American Express (USA) commercial.

Sources: Rodney Ho, “Banking on Plastic: To Finance a Dream, Many Entrepreneurs Binge on Credit Cards,” Wall Street Journal (March 9, 1998), p. A1; Brian Groom, “Banks Fail to Help Half of Companies, Say IoD,” Financial Times Online (FT.com) (February 16, 2010).

PREVIEW OF CHAPTER 10

Inventor-entrepreneur Wilbert Murdock, as you can tell from the Feature Story, had to use multiple credit cards to finance his business ventures. Murdock’s credit card debts would be classified as current liabilities because they are due every month. Yet, by making minimal payments and paying high interest each month, Murdock used this credit source long-term. Some credit card balances remain outstanding for years as they accumulate interest.

Earlier, we defined liabilities as creditors’ claims on total assets and as existing debts and obligations. These claims, debts, and obligations must be settled or paid at some time in the future by the transfer of assets or services. The future date on which they are due or payable (maturity date) is a significant feature of liabilities. This “future date” feature gives rise to two basic classifications of liabilities: (1) current liabilities and (2) non-current liabilities. Our discussion in this chapter is divided into these two classifications.

The content and organization of Chapter 10 are as follows.

Current Liabilities

Learning Objective 1

Explain a current liability, and identify the major types of current liabilities.

What Is a Current Liability?

You have learned that liabilities are defined as “creditors’ claims on total assets” and as “existing debts and obligations.” Companies must settle or pay these claims, debts, and obligations at some time in the future by transferring assets or services. The future date on which they are due or payable (the maturity date) is a significant feature of liabilities.

As explained in Chapter 4, a current liability is a debt that a company expects to pay within one year or the operating cycle, whichever is longer. is a debt that a company expects to pay within one year or the operating cycle, whichever is longer. Debts that do not meet this criterion are non-current liabilities.

Financial statement users want to know whether a company’s obligations are current or non-current. A company that has more current liabilities than current assets often lacks liquidity, or short-term debt-paying ability. In addition, users want to know the types of liabilities a company has. If a company declares bankruptcy, a specific, predetermined order of payment to creditors exists. Thus, the amount and type of liabilities are of critical importance.

The different types of current liabilities include notes payable, accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest payable. In the sections that follow, we discuss common types of current liabilities.

Notes Payable

Learning Objective 2

Describe the accounting for notes payable.

Companies record obligations in the form of written notes as notes payable. Notes payable are often used instead of accounts payable because they give the lender formal proof of the obligation in case legal remedies are needed to collect the debt. Companies frequently issue notes payable to meet short-term financing needs. Notes payable usually require the borrower to pay interest.

Notes are issued for varying periods of time. Those due for payment within one year of the statement of financial position date are usually classified as current liabilities.

To illustrate the accounting for notes payable, assume that Hong Kong National Bank agrees to lend HK$100,000 on September 1, 2017, if C. W. Co. signs a HK$100,000, 12%, four-month note maturing on January 1. When a company issues an interest-bearing note, the amount of assets it receives upon issuance of the note generally equals the note’s face value. C. W. Co. therefore will receive HK$100,000 cash and will make the following journal entry.

Interest accrues over the life of the note, and the company must periodically record that accrual. If C. W. Co. prepares financial statements annually, it makes an adjusting entry at December 31 to recognize interest expense and interest payable of $HK $ 4,000 (HK $ 100,000 \times 12 % \times 4 / 12)$ $HK $ 4,000 (HK $ 100,000 \times 12 % \times 4 / 12)$ . Illustration 10-1 shows the formula for computing interest and its application to C. W. Co.’s note.

C. W. Co. makes an adjusting entry as follows.

In the December 31 financial statements, the current liabilities section of the statement of financial position will show notes payable HK$100,000 and interest payable HK$4,000. In addition, the company will report interest expense of HK$4,000 under “Other income and expense” in the income statement. If C. W. Co. prepared financial statements monthly, the adjusting entry at the end of each month would have been $HK $ 1,000 (HK $ 100,000 \times 12 % \times 1 / 12)$ $HK $ 1,000 (HK $ 100,000 \times 12 % \times 1 / 12)$ .

At maturity (January 1, 2018), C. W. Co. must pay the face value of the note (HK$100,000) plus HK$4,000 interest $(HK $ 100,000 \times 12 % \times 4 / 12)$ $(HK $ 100,000 \times 12 % \times 4 / 12)$ . It records payment of the note and accrued interest as follows.

Sales Taxes Payable

Learning Objective 3

Explain the accounting for other current liabilities.

Many of the products we purchase at retail stores are subject to sales taxes.¹ Many governments also are now collecting sales taxes on purchases made on the Internet as well. Sales taxes are expressed as a percentage of the sales price. The selling company collects the tax from the customer when the sale occurs. Periodically (usually monthly), the retailer remits the collections to the government’s department of revenue.

Under most government sales tax laws, the selling company must enter separately on the cash register the amount of the sale and the amount of the sales tax collected. The company then uses the cash register readings to credit Sales Revenue and Sales Taxes Payable. For example, if the March 25 cash register reading for Cooley Grocery shows sales of NT$10,000 and sales taxes of NT$600 (sales tax rate of 6%), the journal entry is as follows.

When the company remits the taxes to the taxing agency, it debits Sales Taxes Payable and credits Cash. The company does not report sales taxes as an expense. It simply forwards to the government the amount paid by the customers. Thus, Cooley Grocery serves only as a collection agent for the taxing authority.

Sometimes companies do not enter sales taxes separately in the cash register. To determine the amount of sales in such cases, divide total receipts by 100% plus the sales tax percentage. For example, assume that Cooley Grocery enters total receipts of NT$10,600. The receipts from the sales are equal to the sales price (100%) plus the tax percentage (6% of sales), or 1.06 times the sales total. We can compute the sales amount as follows.

NT $ 10,600 \div 1.06 = NT $ 10,000

$NT $ 10,600 \div 1.06 = NT $ 10,000$

Thus, we can find the sales tax amount of NT$600 by either (1) subtracting sales from total receipts $(NT $ 10,600 - NT $ 10,000)$ $(NT $ 10,600 - NT $ 10,000)$ or (2) multiplying sales by the sales tax rate $(NT $ 10,000 \times .06)$ $(NT $ 10,000 \times .06)$ .

• HELPFUL HINT
For point-of-sale systems, the company receives sales information through the computer network.

Unearned Revenues

An airline company, such as Qantas Airways (AUS), often receives cash when it sells tickets for future flights. A magazine publisher, such as Finance Asia (HKG), receives customers’ payments when they order magazines. Season tickets for concerts, sporting events, and theater programs are also paid for in advance. How do companies account for unearned revenues that are received before goods are delivered or services are performed?

When a company receives the advance payment, it debits Cash and credits a current liability account identifying the source of the unearned revenue.
When the company recognizes revenue, it debits an unearned revenue account and credits a revenue account.

To illustrate, assume that the Busan IPark (KOR) sells 10,000 season football tickets at 50,000 each for its five-game home schedule. The club makes the following entry for the sale of season tickets (in thousands of ).

As each game is completed, Busan IPark records the recognition of revenue with the following entry (in thousands of ).

The account Unearned Ticket Revenue represents unearned revenue, and Busan IPark reports it as a current liability. As the club recognizes revenue, it reclassifies the amount from unearned revenue to Ticket Revenue. Unearned revenue is substantial for some companies. In the airline industry, for example, tickets sold for future flights represent almost 50% of total current liabilities. At United Airlines (USA), unearned ticket revenue is its largest current liability, recently amounting to over $1 billion.

Illustration 10-2 shows specific unearned revenue and revenue accounts used in selected types of businesses.

Current Maturities of Long-Term Debt

Companies often have a portion of long-term debt that comes due in the current year. That amount is considered a current liability. As an example, assume that Wendy Construction issues a five-year, interest-bearing €25,000 note on January 1, 2017. This note specifies that each January 1, starting January 1, 2018, Wendy should pay €5,000 of the note. When the company prepares financial statements on December 31, 2017, it should report €5,000 as a current liability and €20,000 as a non-current liability. (The €5,000 amount is the portion of the note that is due to be paid within the next 12 months.) Companies often identify current maturities of long-term debt on the statement of financial position as long-term debt due within one year.

It is not necessary to prepare an adjusting entry to recognize the current maturity of long-term debt. At the statement of financial position date, all obligations due within one year are classified as current, and all other obligations as non-current.

> DO IT!

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?
How is the sales tax amount determined when the cash register total includes sales taxes?
If $15,000 is collected in advance on November 1 for 3 months’ rent, what amount of rent revenue is recognized by December 31?

Action Plan

✓ Use the interest formula: Use the interest formula: Face value of note × Annual interest rate × Time in terms of one year.
✓ Divide total receipts by 100% plus the tax rate to determine sales revenue; then subtract sales revenue from the total receipts.
✓ Determine what fraction of the total unearned rent should be recognized this year.

Solution

Related exercise material: BE10-2, BE10-3, BE10-4, E10-1, E10-2, E10-3, E10-4, and DO IT! 10-1.

The Navigator

Statement Presentation and Analysis

PRESENTATION

As indicated in Chapter 4, current liabilities are presented after non-current liabilities on the statement of financial position. Each of the principal types of current liabilities is listed separately. In addition, companies disclose the terms of notes payable and other key information about the individual items in the notes to the financial statements.

Companies seldom list current liabilities in the order of liquidity. The reason is that varying maturity dates may exist for specific obligations such as notes payable. A more common method of presenting current liabilities is to list them by order of magnitude, with the largest ones first. Or, as a matter of custom, many companies show notes payable first and then accounts payable, regardless of amount. Then the remaining current liabilities are listed by magnitude. Illustration 10-3 (page 486) shows this form of presentation.

ANALYSIS

Use of current and non-current classifications makes it possible to analyze a company’s liquidity. Liquidity refers to the ability to pay maturing obligations and meet unexpected needs for cash. The relationship of current assets to current liabilities is critical in analyzing liquidity. We can express this relationship as an amount of currency (working capital) and as a ratio (the current ratio).

Illustration 10-3 Statement of financial position presentation of current liabilities (in thousands)

• HELPFUL HINT
For other examples of current liabilities sections, refer to the TSMC and Nestlé statements of financial position in Appendices A and B.

The excess of current assets over current liabilities is working capital. Illustration 10-4 shows the formula for the computation of Croix Company’s working capital, assuming current assets were €20,856 (euro amounts in thousands).

Illustration 10-4 Working capital formula and computation (in thousands)

As an absolute euro amount, working capital offers limited informational value. For example, €1 million of working capital may be far more than needed for a small company but inadequate for a large corporation. Also, €1 million of working capital may be adequate for a company at one time but inadequate at another time.

The current ratio permits us to compare the liquidity of different-sized companies and of a single company at different times. The current ratio is calculated as current assets divided by current liabilities. Illustration 10-5 shows the formula for this ratio, along with its computation using Croix Company’s current asset and current liability data (euro amounts in thousands).

Illustration 10-5 Current ratio formula and computation (in thousands)

Historically, companies and analysts considered a current ratio of 2:1 to be the standard for a good credit rating. In recent years, however, many healthy companies have maintained ratios well below 2:1 by improving management of their current assets and liabilities. Croix Company’s ratio of 1.29:1 is adequate but certainly below the standard of 2:1.

Non-Current Liabilities

Learning Objective 4

Explain why bonds are issued, and identify the types of bonds.

Non-current liabilities are obligations that a company expects to pay more than one year in the future. In this section, we explain the accounting for the principal types of obligations reported in the non-current liabilities section of the statement of financial position. These obligations often are in the form of bonds or long-term notes.

Bond Basics

Bonds are a form of interest-bearing notes payable. To obtain large amounts of long-term capital, corporate management usually must decide whether to issue ordinary shares (equity financing) or bonds. Bonds offer three advantages over ordinary shares, as shown in Illustration 10-6.

Illustration 10-6 Advantages of bond financing over ordinary shares

As Illustration 10-6 shows, one reason to issue bonds is that they do not affect shareholder control. Because bondholders do not have voting rights, owners can raise capital with bonds and still maintain corporate control. In addition, bonds are attractive to corporations because the cost of bond interest is tax-deductible in some countries. As a result of this tax treatment, which share dividends do not offer, bonds may result in a lower cost of financing than equity financing.

To illustrate the third advantage, on earnings per share, assume that Micro-systems AG is considering two plans for financing the construction of a new €5 million plant. Plan A involves issuance of 200,000 ordinary shares at the current market price of €25 per share. Plan B involves issuance of €5 million, 8% bonds at face value. Income before interest and taxes on the new plant will be €1.5 million. Income taxes are expected to be 30%. Microsystems currently has 100,000 ordinary shares outstanding. Illustration 10-7 shows the alternative effects on earnings per share.

Illustration 10-7 Effects on earnings per share—equity vs. debt

Note that net income is €280,000 less $(€ 1,050,000 - € 770,000)$ $(€ 1,050,000 - € 770,000)$ with long-term debt financing (bonds). However, earnings per share is higher because there are 200,000 fewer ordinary shares outstanding.

One disadvantage in using bonds is that the company must pay interest on a periodic basis. In addition, the company must also repay the principal at the due date. A company with fluctuating earnings and a relatively weak cash position may have great difficulty making interest payments when earnings are low.

• HELPFUL HINT
Besides corporations, governmental agencies and universities also issue bonds to raise capital.

A corporation may also obtain long-term financing from notes payable and leasing. However, notes payable and leasing are seldom sufficient to furnish the amount of funds needed for plant expansion and major projects like new buildings.

Bonds are sold in relatively small denominations (usually €1,000 multiples). As a result of their size and the variety of their features, bonds attract many investors.

TYPES OF BONDS

Bonds may have many different features. In the following sections, we describe the types of bonds commonly issued.

SECURED AND UNSECURED BONDS Secured bonds have specific assets of the issuer pledged as collateral for the bonds. A bond secured by real estate, for example, is called a mortgage bond. A bond secured by specific assets set aside to redeem (retire) the bonds is called a sinking fund bond.

Unsecured bonds, also called debenture bonds, are issued against the general credit of the borrower. Companies with good credit ratings use these bonds extensively. For example, at one time, DuPont (USA) reported over $2 billion of debenture bonds outstanding.

CONVERTIBLE AND CALLABLE BONDS Bonds that can be converted into ordinary shares at the bondholder’s option are convertible bonds. The conversion feature generally is attractive to bond buyers. Bonds that the issuing company can redeem (buy back) at a stated currency amount (call price) prior to maturity are callable bonds. A call feature is included in nearly all corporate bond issues.

ISSUING PROCEDURES

Governmental laws grant corporations the power to issue bonds. Both the board of directors and shareholders usually must approve bond issues. In authorizing the bond issue, the board of directors must stipulate the number of bonds to be authorized, total face value, and contractual interest rate. The total bond authorization often exceeds the number of bonds the company originally issues. This gives the corporation the flexibility to issue more bonds, if needed, to meet future cash requirements.

The face value is the amount of principal the issuing company must pay at the maturity date. The maturity date is the date that the final payment is due to the investor from the issuing company. The contractual interest rate, often referred to as the stated rate, is the rate used to determine the amount of cash interest the issuing company pays and the investor receives. Usually the contractual rate is stated as an annual rate.

The terms of the bond issue are set forth in a legal document called a bond indenture. The indenture shows the terms and summarizes the rights of the bondholders and their trustees, and the obligations of the issuing company. The trustee (usually a financial institution) keeps records of each bondholder, maintains custody of unissued bonds, and holds conditional title to pledged property.

In addition, the issuing company arranges for the printing of bond certificates. The indenture and the certificate are separate documents. As shown in Illustration 10-8, a bond certificate provides the following information: name of the issuer, face value, contractual interest rate, and maturity date. An investment company that specializes in selling securities generally sells the bonds for the issuing company.

BOND TRADING

Bondholders have the opportunity to convert their holdings into cash at any time by selling the bonds at the current market price on national securities exchanges. Bond prices are quoted as a percentage of the face value of the bond, which is usually $1,000. A $1,000 bond with a quoted price of 97 means that the selling price of the bond is 97% of face value, or $970. Newspapers and the financial press publish bond prices and trading activity daily as shown in Illustration 10-9.

Illustration 10-8 Bond certificate

Illustration 10-9 Market information for bonds

This bond listing indicates that Boeing Co. (USA) has outstanding 5.125%, $1,000 bonds that mature in 2017. They currently yield a 5.747% return. On this day, $33,965,000 of these bonds were traded. At the close of trading, the price was 96.595% of face value, or $965.95.

• HELPFUL HINT
The price of a $1,000 bond trading at 95¼ is $952.50. The price of a $1,000 bond trading at 101⅞ is $1,018.75.

A corporation makes journal entries only when it issues or buys back bonds, or when bondholders convert bonds into ordinary shares. For example, Siemens (DEU) does not journalize transactions between its bondholders and other investors. If Tom Smith sells his Siemens bonds to Faith Jones, Siemens does not journalize the transaction.

Determining the Market Price of a Bond

If you were an investor wanting to purchase a bond, how would you determine how much to pay? To be more specific, assume that Coronet AG issues a zero- interest bond (pays no interest) with a face value of €1,000,000 due in 20 years. For this bond, the only cash you receive is a million euros at the end of 20 years. Would you pay a million euros for this bond? We hope not! A million euros received 20 years from now is not the same as a million euros received today.

The term time value of money is used to indicate the relationship between time and money—that a euro received today is worth more than a euro promised at some time in the future. If you had €1 million today, you would invest it. From that investment, you would earn interest such that at the end of 20 years, you would have much more than €1 million. Thus, if someone is going to pay you €1 million 20 years from now, you would want to find its equivalent today, or its present value. In other words, you would want to determine the value today of the amount to be received in the future after taking into account current interest rates.

The current market price (present value) of a bond is the value at which it should sell in the marketplace. Market price therefore is a function of the three factors that determine present value: (1) the amounts to be received, (2) the length of time until the amounts are received, and (3) the market interest rate. The market interest rate is the rate investors demand for loaning funds.

To illustrate, assume that Acropolis SA on January 1, 2017, issues €100,000 of 9% bonds, due in five years, with interest payable annually at year-end. The purchaser of the bonds would receive the following two types of cash payments: (1) principal of €100,000 to be paid at maturity, and (2) five €9,000 interest payments $(€ 100,000 \times 9 %)$ $(€ 100,000 \times 9 %)$ over the term of the bonds. Illustration 10-10 shows a time diagram depicting both cash flows.

Illustration 10-10 Time diagram depicting cash flows

The current market price of a bond is equal to the present value of all the future cash payments promised by the bond. Illustration 10-11 lists and totals the present values of these amounts, assuming the market rate of interest is 9%.

Illustration 10-11 Computing the market price of bonds

Tables are available to provide the present value numbers to be used, or these values can be determined mathematically or with financial calculators.² Appendix 5, near the end of the textbook, provides further discussion of the concepts and the mechanics of the time value of money computations.

People, Planet, and Profit Insight

How About Some Green Bonds?

Unilever (GBR and NLD)

CarpathianPrince

Unilever (GBR and NLD) 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.

Q Why might standardized disclosure help investors to better understand how proceeds from the sale or issuance of bonds are used? (See page 532.)

> DO IT!

Bond Terminology

State whether each of the following statements is true or false. If false, indicate how to correct the statement.

_____ Mortgage bonds and sinking fund bonds are both examples of secured bonds.
_____ Unsecured bonds are also known as debenture bonds.
_____ The stated rate is the rate investors demand for loaning funds.
_____ The face value is the amount of principal the issuing company must pay at the maturity date.
_____ The bond issuer must make journal entries to record transfers of its bonds among investors.

Action Plan

✓ Review the types of bonds and the basic terms associated with bonds.

Solution

Related exercise material: BE10-5, E10-6, E10-7, and DO IT! 10-2.

The Navigator

Accounting for Bond Issues

Learning Objective 5

Prepare the entries for the issuance of bonds and interest expense.

As indicated earlier, a corporation records bond transactions when it issues (sells) or redeems (buys back) bonds and when bondholders convert bonds into ordinary shares. If bondholders sell their bond investments to other investors, the issuing company receives no further money on the transaction, nor does the issuing company journalize the transaction (although it does keep records of the names of bondholders in some cases).

Bonds may be issued at face value, below face value (discount), or above face value (premium). Bond prices for both new issues and existing bonds are quoted as a percentage of the face value of the bond. Face value is usually €1,000. Thus, a €1,000 bond with a quoted price of 97 means that the selling price of the bond is 97% of face value, or €970.

ISSUING BONDS AT FACE VALUE

To illustrate the accounting for bonds issued at face value, assume that on January 1, 2017, Candlestick AG issues €100,000, five-year, 10% bonds at 100 (100% of face value). The entry to record the sale is as follows.

Candlestick reports bonds payable in the non-current liabilities section of the statement of financial position because the maturity date is January 1, 2022 (more than one year away).

Over the term (life) of the bonds, companies make entries to record bond interest. Interest on bonds payable is computed in the same manner as interest on notes payable, as explained on page 482. Assume that interest is payable annually on January 1 on the Candlestick bonds. In that case, Candlestick accrues interest of $€ 10,000 (€ 100,000 \times 10 %)$ $€ 10,000 (€ 100,000 \times 10 %)$ on December 31. At December 31, Candlestick recognizes the €10,000 of interest expense incurred with the following entry.

The company classifies interest payable as a current liability because it is scheduled for payment within the next year. When Candlestick pays the interest on January 1, 2018, it debits (decreases) Interest Payable and credits (decreases) Cash for €10,000.

Candlestick records the payment on January 1 as follows.

DISCOUNT OR PREMIUM ON BONDS

The Candlestick example assumed that the contractual (stated) interest rate and the market (effective) interest rate paid on the bonds were the same. Recall that the contractual interest rate is the rate applied to the face (par) value to arrive at the interest paid in a year. The market interest rate is the rate investors demand for loaning funds to the corporation. When the contractual interest rate and the market interest rate are the same, bonds sell at face value (par value).

However, market interest rates change daily. The type of bond issued, the state of the economy, current industry conditions, and the company’s performance all affect market interest rates. As a result, contractual and market interest rates often differ. To make bonds salable when the two rates differ, bonds sell below or above face value.

To illustrate, suppose that a company issues 10% bonds at a time when other bonds of similar risk are paying 12%. Investors will not be interested in buying the 10% bonds, so their value will fall below their face value. When a bond is sold for less than its face value, the difference between the face value of a bond and its selling price is called a discount. As a result of the decline in the bonds’ selling price, the actual interest rate incurred by the company increases to the level of the current market interest rate.

Conversely, if the market rate of interest is lower than the contractual interest rate, investors will have to pay more than face value for the bonds. That is, if the market rate of interest is 8% but the contractual interest rate on the bonds is 10%, the price of the bonds will be bid up. When a bond is sold for more than its face value, the difference between the face value and its selling price is called a premium. Illustration 10-12 shows these relationships.

Illustration 10-12 Interest rates and bond prices

Issuance of bonds at an amount different from face value is quite common. By the time a company prints the bond certificates and markets the bonds, it will be a coincidence if the market rate and the contractual rate are the same. Thus, the issuance of bonds at a discount does not mean that the issuer’s financial strength is suspect. Conversely, the sale of bonds at a premium does not indicate that the financial strength of the issuer is exceptional.

ISSUING BONDS AT A DISCOUNT

To illustrate issuance of bonds at a discount, assume that on January 1, 2017, Candlestick AG sells €100,000, five-year, 10% bonds for €98,000 (98% of face value). Interest is payable annually on January 1. The entry to record the issuance is as follows.

Illustration 10-13 shows how the bonds payable of Candlestick AG would be presented on the statement of financial position if it was prepared on the day the bonds were issued.

Illustration 10-13 Statement presentation of bonds issued at a discount

The €98,000 represents the carrying (or book) value of the bonds. On the date of issue, this amount equals the market price of the bonds.

The issuance of bonds below face value—at a discount—causes the total cost of borrowing to differ from the bond interest paid. That is, the issuing company must pay not only the contractual interest rate over the term of the bonds but also the face value (rather than the issuance price) at maturity. Therefore, the difference between the issuance price and face value of the bonds—the discount—is an additional cost of borrowing. The company records this additional cost as interest expense over the life of the bonds.

The total cost of borrowing €98,000 for Candlestick is therefore €52,000, computed as follows.

Illustration 10-14 Total cost of borrowing—bonds issued at a discount

Alternatively, we can compute the total cost of borrowing as follows.

Illustration 10-15 Alternative computation of total cost of borrowing—bonds issued at a discount

To follow the expense recognition principle, companies allocate bond discount to expense in each period in which the bonds are outstanding. This is referred to as amortizing the discount. Amortization of the discount increases the amount of interest expense reported each period. That is, after the company amortizes the discount, the amount of interest expense it reports in a period will exceed the contractual amount. As shown in Illustration 10-14, for the bonds issued by Candlestick, total interest expense will exceed the contractual interest by €2,000 over the life of the bonds.

As the discount is amortized, its balance declines. As a consequence, the carrying value of the bonds will increase, until at maturity the carrying value of the bonds equals their face amount. This is shown in Illustration 10-16. Appendices 10A and 10B at the end of this chapter discuss procedures for amortizing bond discount.

Illustration 10-16 Amortization of bond discount

ISSUING BONDS AT A PREMIUM

To illustrate the issuance of bonds at a premium, we now assume the Candlestick AG bonds described above sell for €102,000 (102% of face value) rather than for €98,000. The entry to record the sale is as follows.

Candlestick adds the premium on bonds payable to the bonds payable amount on the statement of financial position, as shown in Illustration 10-17.

Illustration 10-17 Statement presentation of bonds issued at a premium

The sale of bonds above face value causes the total cost of borrowing to be less than the bond interest paid. The reason: 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. Therefore, the company credits the bond premium to Interest Expense over the life of the bonds.

The total cost of borrowing €102,000 for Candlestick, AG is shown in Illustrations 10-18 and 10-19.

Illustration 10-18 Total cost of borrowing—bonds issued at a premium

Alternatively, we can compute the cost of borrowing as follows.

Illustration 10-19 Alternative computation of total cost of borrowing—bonds issued at a premium

Similar to bond discount, companies allocate bond premium to expense in each period in which the bonds are outstanding. This is referred to as amortizing the premium. Amortization of the premium decreases the amount of interest expense reported each period. That is, after the company amortizes the premium, the amount of interest expense it reports in a period will be less than the contractual amount. As shown in Illustration 10-18, for the bonds issued by Candlestick, contractual interest will exceed the interest expense by €2,000 over the life of the bonds.

As the premium is amortized, its balance declines. As a consequence, the carrying value of the bonds will decrease, until at maturity the carrying value of the bonds equals their face amount. This is shown in Illustration 10-20 (page 496). Appendices 10A and 10B at the end of this chapter discuss procedures for amortizing bond premium.

Illustration 10-20 Amortization of bond premium

Accounting for Bond Redemptions

Learning Objective 6

Describe the entries when bonds are redeemed.

An issuing corporation retires bonds either when it buys back (redeems) the bonds or when bondholders exchange convertible bonds for ordinary shares. We explain the entries for bond redemptions in the following sections. (The entries for convertible bonds are covered in advanced accounting courses.)

REDEEMING BONDS AT MATURITY

Regardless of the issue price of bonds, the book value of the bonds at maturity will equal their face value. Assuming that the company pays and records separately the interest for the last interest period, Candlestick AG records the redemption of its bonds at maturity as follows.

REDEEMING BONDS BEFORE MATURITY

Bonds also may be redeemed before maturity. A company may decide to redeem bonds before maturity to reduce interest cost and to remove debt from its statement of financial position. A company should redeem debt early only if it has sufficient cash resources.

• HELPFUL HINT
If a bond is redeemed prior to its maturity date and its carrying value exceeds its redemption price, this results in a gain.

When a company redeems bonds before maturity, it is necessary to (1) eliminate the carrying value of the bonds at the redemption date, (2) record the cash paid, and (3) recognize the gain or loss on redemption. The carrying value of the bonds is the face value of the bonds adjusted for bond discount or bond premium amortized up to the redemption date.

To illustrate, assume that Candlestick AG has sold its bonds at a premium. At the end of the fourth period, Candlestick redeems these bonds at 103 after paying the annual interest. Assume that the carrying value of the bonds at the redemption date is €100,476. Candlestick makes the following entry to record the redemption at the end of the fourth interest period (January 1, 2021) as follows.

Note that the loss of €2,524 is the difference between the cash paid of €103,000 and the carrying value of the bonds of €100,476.

Accounting for Long-Term Notes Payable

Learning Objective 7

Describe the accounting for long-term notes payable.

The use of notes payable in long-term debt financing is quite common. Long-term notes payable are similar to short-term interest-bearing notes payable except that the term of the notes exceeds one year.

A long-term note may be secured by a mortgage that pledges title to specific assets as security for a loan. Individuals widely use mortgage notes payable to purchase homes, and many small and some large companies use them to acquire plant assets. At one time, approximately 18% of McDonald’s (USA) long-term debt related to mortgage notes on land, buildings, and improvements.

Like other long-term notes payable, the mortgage loan terms may stipulate either a fixed or an adjustable interest rate. The interest rate on a fixed-rate mortgage remains the same over the life of the mortgage. The interest rate on an adjustable-rate mortgage is adjusted periodically to reflect changes in the market rate of interest. Typically, the terms require the borrower to make equal installment payments over the term of the loan. Each payment consists of (1) interest on the unpaid balance of the loan and (2) a reduction of loan principal. While the total amount of the payment remains constant, the interest decreases each period, and the portion applied to the loan principal increases.

Companies initially record mortgage notes payable at face value. They subsequently make entries for each installment payment. To illustrate, assume that Mongkok Technology Ltd. issues a HK$500,000, 8%, 20-year mortgage note on December 31, 2017, to obtain needed financing for a new research laboratory. The terms provide for annual installment payments of HK$50,926. The installment payment schedule for the first four years is as follows.

Illustration 10-21 Mortgage installment payment schedule

Mongkok records the mortgage loan on December 31, 2017, as follows.

On December 31, 2018, Mongkok records the first installment payment as follows.

In the statement of financial position, the company reports the reduction in principal for the next year as a current liability, and it classifies the remaining unpaid principal balance as a non-current liability. At December 31, 2018, the total liability is HK$489,074. Of that amount, HK$11,800 is current, and $HK $ 477,274 (HK $ 489,074 - HK $ 11,800)$ $HK $ 477,274 (HK $ 489,074 - HK $ 11,800)$ is non-current.

Accounting Across the Organization

Bonds versus Notes?

Companies have a choice in the form of long-term borrowing they undertake—issue bonds or issue notes. Notes are generally issued to a single lender (usually through a loan from a bank). Bonds, on the other hand, allow the company to divide the borrowing into many small investing units, thereby enabling more than one investor to participate in the borrowing. As indicated in the graph to the left, U.S. companies are recently borrowing more from bond investors than from banks and other loan providers in a bid to lock in cheap, long-term funding.

Why this trend? For one thing, low interest rates and rising inflows into fixed-income funds have triggered record bond issuances as banks cut back lending. In addition, for some high-rated companies, it can be riskier to borrow from a bank than the bond markets. The reason: High-rated companies tended to rely on short-term financing to fund working capital but were left stranded when these markets froze up. Some are now financing themselves with longer-term bonds instead.

Source: A. Sakoui and N. Bullock, “Companies Choose Bonds for Cheap Funds,” Financial Times (October 12, 2009).

Q Why might companies prefer bond financing instead of short-term financing? (See page 532.)

Statement Presentation and Analysis

Learning Objective 8

Identify the methods for the presentation and analysis of non-current liabilities.

PRESENTATION

Companies report non-current liabilities in a separate section of the statement of financial position immediately before current liabilities, as shown in Illustration 10-22 (page 500). Alternatively, companies may present summary data in the statement of financial position, with detailed data (interest rates, maturity dates, conversion privileges, and assets pledged as collateral) shown in a supporting schedule.

Illustration 10-22 Statement of financial position presentation of non-current liabilities

• Alternative Terminology
Another term sometimes used for non-current liabilities is long-term liabilities.

Companies report the current maturities of long-term debt under current liabilities if they are to be paid within one year or the operating cycle, whichever is longer.

ANALYSIS

Long-term creditors and shareholders are interested in a company’s long-run solvency. Of particular interest is the company’s ability to pay interest as it comes due and to repay the face value of the debt at maturity. Here we look at two ratios that provide information about debt-paying ability and long-run solvency.

The debt to assets ratio measures the percentage of the total assets provided by creditors. As shown in the formula in Illustration 10-23, it is computed by dividing total liabilities (both current and non-current liabilities) by total assets. The higher the percentage of debt to assets, the greater the risk that the company may be unable to meet its maturing obligations.

Times interest earned indicates the company’s ability to meet interest payments as they come due. It is computed by dividing the sum of net income, interest expense, and income tax expense by interest expense.

To illustrate these ratios, we will use data from LG’s (KOR) recent annual report. The company had total liabilities of 22,839 billion, total assets of 35,528 billion, interest expense of 827 billion, income taxes of 354 billion, and net income of 223 billion. LG’s debt to assets ratio and times interest earned are shown below.

Illustration 10-23 Debt to assets and times interest earned ratios, with computations (in billions)

LG has a relatively high debt to assets percentage of 64.3%. Its interest coverage of 1.70 times might be considered low.

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 more recent years, when lots of cash was available, lenders began reducing or completely eliminating covenants from loan agreements in order to be more competitive with other lenders. When the economy declined, lenders lost big money when companies defaulted.

Source: Cynthia Koons, “Risky Business: Growth of ‘Covenant-Lite’ Debt,” Wall Street Journal (June 18, 2007), p. C2.

Q How can financial ratios such as those covered in this chapter provide protection for creditors? (See page 532.)

> DO IT!

Analyzing Liabilities

Trout Company provides you with the following statement of financial position information as of December 31, 2017.

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

Instructions

Compute the debt to assets ratio for Trout for 2017.
Compute the times interest earned for Trout for 2017.

Action Plan

✓ Use the formula for the debt to assets ratio: Total liabilities ÷ Total assets.
✓ Use the formula for times interest earned: (Net income + Interest expense + Income tax expense) ÷ Interest expense.

Solution

Related exercise material: BE10-12, E10-15, and DO IT! 10-6.

The Navigator

APPENDIX 10A Effective-Interest Method of Bond Amortization

Learning Objective *9

Apply the effective-interest method of amortizing bond discount and bond premium.

Financial liabilities, such as bonds, are to be accounted for at amortized cost. IFRS states that amortized cost is to be determined using the effective-interest method. Under the effective-interest method of amortization, the amortization of bond discount or bond premium results in periodic interest expense equal to a constant percentage of the carrying value of the bonds. The effective-interest method results in varying amounts of amortization and interest expense per period but a constant percentage rate.

The following steps are required under the effective-interest method.

Compute the bond interest expense by multiplying the carrying value of the bonds at the beginning of the interest period by the effective-interest rate.
Compute the bond interest paid (or accrued) by multiplying the face value of the bonds by the contractual interest rate.
Compute the amortization amount by determining the difference between the amounts computed in steps (1) and (2).

Illustration 10-24 depicts these steps.

Illustration 10A-1 Computation of amortization—effective-interest method

Amortizing Bond Discount

In the Candlestick AG example (page 493), the company sold €100,000, five year, 10% bonds on January 1, 2017, for €98,000. This resulted in a €2,000 bond discount $(€ 100,000 - € 98,000)$ $(€ 100,000 - € 98,000)$ . This discount results in an effective-interest rate of approximately 10.5348%. (The effective-interest rate can be computed using the techniques shown in Appendix 5 near the end of this textbook.)

Preparing a bond discount amortization schedule as shown in Illustration 10-25 facilitates the recording of interest expense and the discount amortization. Note that interest expense as a percentage of carrying value remains constant at 10.5348%.

Illustration 10A-2 Bond discount amortization schedule

For the first interest period, the computations of bond interest expense and the bond discount amortization are as follows.

Illustration 10A-3 Computation of bond discount amortization

As a result, Candlestick records the accrual of interest and amortization of bond discount on December 31 as follows.

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

Amortizing Bond Premium

Continuing our example, assume Candlestick AG sells the bonds described above for €102,000 rather than €98,000 (see page 494). This would result in a bond premium of $€ 2,000 (€ 102,000 - € 100,000)$ $€ 2,000 (€ 102,000 - € 100,000)$ . This premium results in an effective-interest rate of approximately 9.4794%. (The effective-interest rate can be solved for using the techniques shown in Appendix 5 near the end of this textbook.) Illustration 10-27 shows the bond premium amortization schedule.

Illustration 10A-4 Bond premium amortization schedule

For the first interest period, the computations of bond interest expense and the bond premium amortization are as follows.

Illustration 10A-5 Computation of bond premium amortization

The entry Candlestick makes on December 31 is as follows.

For the second interest period, interest expense will be €9,638, and the premium amortization will be €362. Note that the amount of periodic interest expense decreases over the life of the bond when companies apply the effective-interest method to bonds issued at a premium. The reason is that a constant percentage is applied to a decreasing bond carrying value to compute interest expense. The carrying value is decreasing because of the amortization of the premium.

> DO IT!

Effective-Interest Amortization

Gardner SA issues €1,750,000, 10-year, 12% bonds on January 1, 2017, at €1,968,090, to yield 10%. The bonds pay annual interest on January 1. Gardner uses the effective-interest method of amortization.

Instructions

Prepare the journal entry to record the issuance of the bonds.
Prepare the adjusting entry to record the accrual of interest on December 31, 2018.

Action Plan

✓ Compute interest expense by multiplying bond carrying value at the beginning of the period by the effective-interest rate.
✓ Compute credit to cash (or interest payable) by multiplying the face value of the bonds by the contractual interest rate.
✓ Compute bond premium or discount amortization, which is the difference between interest expense and cash paid.
✓ Interest expense decreases when the effective-interest method is used for bonds issued at a premium. The reason is that a constant percentage is applied to a decreasing carrying value to compute interest expense.

Solution

The Navigator

APPENDIX 10B Straight-Line Amortization

Learning Objective *10

Apply the straight-line method of amortizing bond discount and bond premium.

Amortizing Bond Discount

The effective-interest method presented in Appendices 10A is the method required by IFRS to determine amortized cost. Under U.S. GAAP, companies are allowed to use an alternative approach, straight-line amortization, when the results do not differ materially from the effective-interest method. Under the straight-line method of amortization, the amortization of bond discount or bond premium results in periodic interest expense of the same amount in each interest period. In other words, the straight-line method results in a constant amount of amortization and interest expense per period. The amount is determined using the formula in Illustration 10-29 on the next page.

Illustration 10B-1 Formula for straight-line method of bond discount amortization

In the Candlestick AG example (page 493), the company sold €100,000, five-year, 10% bonds on January 1, 2017, for €98,000. This resulted in a €2,000 bond discount $(€ 100,000 - € 98,000)$ $(€ 100,000 - € 98,000)$ . The bond discount amortization is $€ 400 (€ 2,000 \div 5)$ $€ 400 (€ 2,000 \div 5)$ for each of the five amortization periods. Candlestick records the first accrual of bond interest and the amortization of bond discount on December 31 as follows.

Over the term of the bonds, the balance in Bonds Payable will decrease annually by the same amount until it has a zero balance at the maturity date of the bonds. Thus, the carrying value of the bonds at maturity will be equal to the face value of the bonds.

Preparing a bond discount amortization schedule, as shown in Illustration 10-30, is useful to determine interest expense, discount amortization, and the carrying value of the bond. As indicated, the interest expense recorded each period is €10,400. Also note that the carrying value of the bond increases €400 each period until it reaches its face value of €100,000 at the end of period 5.

Illustration 10B-2 Bond discount amortization schedule

Amortizing Bond Premium

The amortization of bond premium parallels that of bond discount. Illustration 10-31 presents the formula for determining bond premium amortization under the straight-line method.

Illustration 10B-3 Formula for straight-line method of bond premium amortization

Continuing our example, assume Candlestick AG sells the bonds described previously for €102,000, rather than €98,000 (see page 494). This results in a bond premium of $€ 2,000 (€ 102,000 - € 100,000)$ $€ 2,000 (€ 102,000 - € 100,000)$ . The premium amortization for each interest period is $€ 400 (€ 2,000 \div 5)$ $€ 400 (€ 2,000 \div 5)$ . Candlestick records the first accrual of interest on December 31 as follows.

Over the term of the bonds, the balance in Bonds Payable will decrease annually by the same amount until it has a zero balance at maturity.

A bond premium amortization schedule, as shown in Illustration 10-32, is useful to determine interest expense, premium amortization, and the carrying value of the bond. As indicated, the interest expense Candlestick records each period is €9,600. Note that the carrying value of the bond decreases €400 each period until it reaches its face value of €100,000 at the end of period 5.

Illustration 10B-4 Bond premium amortization schedule

APPENDIX 10C Employee-Related Liabilities

Learning Objective *11

Identify types of employee-related liabilities.

Companies report as a current liability the amounts owed to employees for salaries or wages at the end of an accounting period. In addition, they often also report as current liabilities the following items related to employee compensation.

Payroll deductions.
Bonuses.

Payroll Deductions

The most common types of payroll deductions are taxes, insurance premiums, employee savings, and union dues. To the extent that a company has not remitted the amounts deducted to the proper authority at the end of the accounting period, it should recognize them as current liabilities.

SOCIAL SECURITY TAXES

Most governments provide a level of social benefits (for retirement, unemployment, income, disability, and medical benefits) to individuals and families. The benefits are generally funded from taxes assessed on both the employer and the employees. These taxes are often referred to as Social Security taxes or Social Welfare taxes. Funds for these payments generally come from taxes levied on both the employer and the employee. Employers collect the employee’s share of this tax by deducting it from the employee’s gross pay, and remit it to the government along with their share. The government often taxes both the employer and the employee at the same rate. Companies should report the amount of unremitted employee and employer Social Security tax on gross wages paid as a current liability.

INCOME TAX WITHHOLDING

Income tax laws generally require employers to withhold from each employee’s pay the applicable income tax due on those wages. The employer computes the amount of income tax to withhold according to a government-prescribed formula or withholding tax table. That amount depends on the length of the pay period and each employee’s taxable wages, marital status, and claimed dependents. Illustration 10-33 summarizes payroll deductions and liabilities.

Illustration 10C-1 Summary of payroll liabilities

PAYROLL DEDUCTIONS EXAMPLE

Assume a weekly payroll of $10,000 entirely subject to Social Security taxes (8%), with income tax withholding of $1,320 and union dues of $88 deducted. The company records the wages and salaries paid and the employee payroll deductions as follows.

It records the employer payroll taxes as follows.

The employer must remit to the government its share of Social Security tax along with the amount of Social Security tax deducted from each employee’s gross compensation. It should record all unremitted employer Social Security taxes as payroll tax expense and payroll tax payable.

Companies classify the payroll and payroll tax liability accounts as current liabilities because these amounts must be paid to employees or remitted to taxing authorities in the near term. Taxing authorities impose substantial fines and penalties on employers if the withholding and payroll taxes are not computed correctly and paid on time. A more complete discussion of payroll accounting is provided in Appendix I.

Profit-Sharing and Bonus Plans

Many companies give a bonus to certain or all employees in addition to their regular salaries or wages. Frequently, the bonus amount depends on the company’s yearly profit. A company may consider bonus payments to employees as additional salaries and wages and should include them as a deduction in determining the net income for the year.

To illustrate the entries for an employee bonus, assume that Palmer Inc. shows income for the year 2017 of $100,000. It will pay out bonuses of $10,700 in January 2018. Palmer makes an adjusting entry dated December 31, 2017, to record the bonuses as follows.

In January 2018, when Palmer pays the bonus, it makes this journal entry:

Palmer should show the expense account in the income statement as an operating expense. The liability, Salaries and Wages Payable, is usually payable within a short period of time. Companies should include it as a current liability in the statement of financial position. An obligation under a profit-sharing or bonus plan must be accounted for as an expense and not a distribution of profit since it results from employee service and not a transaction with owners.

REVIEW AND PRACTICE

LEARNING OBJECTIVES REVIEW

The Navigator

Explain a current liability, and identify the major types of current liabilities. A current liability is a debt that a company expects to pay within one year or the operating cycle, whichever is longer. The major types of current liabilities are notes payable, accounts payable, sales taxes payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest payable.
Describe the accounting for notes payable. When a promissory note is interest-bearing, the amount of assets received upon the issuance of the note is generally equal to the face value of the note. Interest expense accrues over the life of the note. At maturity, the amount paid equals the face value of the note plus accrued interest.
Explain the accounting for other current liabilities. Companies record sales taxes payable at the time the related sales occur. The company serves as a collection agent for the taxing authority. Sales taxes are not an expense to the company. Companies initially record unearned revenues in an Unearned Revenue account. As a company recognizes revenue, a transfer from unearned revenue to revenue occurs. Companies report the current maturities of long-term debt as a current liability in the statement of financial position.
Explain why bonds are issued, and identify the types of bonds. Companies may sell bonds to investors to raise long-term capital. Bonds offer the following advantages over equity financing: (a) shareholder control is not affected, (b) tax savings result, and (c) earnings per share may be higher. The following types of bonds may be issued: secured and unsecured, and convertible and callable bonds.
Prepare the entries for the issuance of bonds and interest expense. When companies issue bonds, they debit Cash for the cash proceeds and credit Bonds Payable for the face value of the bonds. Interest on bonds payable is computed in the same manner as interest on notes payable.
Describe the entries when bonds are redeemed. When bondholders redeem bonds at maturity, the issuing company credits Cash and debits Bonds Payable for the face value of the bonds. When bonds are redeemed before maturity, the issuing company (a) eliminates the carrying value of the bonds at the redemption date, (b) records the cash paid, and (c) recognizes the gain or loss on redemption.
Describe the accounting for long-term notes payable. Each payment consists of (1) interest on the unpaid balance of the loan and (2) a reduction of the loan principal. The interest decreases each period, while the reduction applied to the loan principal increases.
Identify the methods for the presentation and analysis of non-current liabilities. Companies should report the nature and amount of each long-term debt in the statement of financial position or in the notes accompanying the financial statements. Shareholders and long-term creditors are interested in a company’s long-run solvency. Debt to assets and times interest earned are two ratios that provide information about debt-paying ability and long-run solvency.
Apply the effective-interest method of amortizing bond discount and bond premium.
The effective-interest method results in varying amounts of amortization and interest expense per period but a constant percentage rate of interest.
Apply the straight-line method of amortizing bond discount and bond premium.
The straight-line method of amortization results in a constant amount of amortization and interest expense per period.
Identify types of employee-related liabilities.
Companies report as a current liability the amounts owed related to employee compensation. These employee-related liabilities are (1) payroll deductions and (2) bonuses.

GLOSSARY REVIEW

Bond certificate: A legal document that indicates the name of the issuer, the face value of the bonds, the contractual interest rate, and the maturity date of the bonds. (p. 488).
Bond indenture: A legal document that sets forth the terms of the bond issue. (p. 488).
Bonds: A form of interest-bearing notes payable. (p. 487).
Callable bonds: Bonds that are subject to redemption at a stated currency amount prior to maturity at the option of the issuer. (p. 488).
Contractual interest rate: Rate used to determine the amount of cash interest the borrower pays and the investor receives. (p. 488).
Convertible bonds: Bonds that permit bondholders to convert them into ordinary shares at the bondholders’ option. (p. 488).
Current liabilities: Obligations that a company expects to pay within one year or the operating cycle, whichever is longer. (p. 482).
Current ratio: A measure of a company’s liquidity; computed as current assets divided by current liabilities. (p. 486).
Debenture bonds: Bonds issued against the general credit of the borrower. Also called unsecured bonds. (p. 488).
Debt to assets ratio: A solvency measure that indicates the percentage of total assets provided by creditors; computed as total liabilities divided by total assets. (p. 500).
Discount (on a bond): The difference between the face value of a bond and its selling price, when the bond is sold for less than its face value. (p. 492).
* Effective-interest method of amortization: A method of amortizing bond discount or bond premium that results in periodic interest expense equal to a constant percentage of the carrying value of the bonds. (p. 502).
Face value: Amount of principal the issuer must pay at the maturity date of the bond. (p. 488).
Market interest rate: The rate investors demand for loaning funds to the corporation. (p. 490).
Maturity date: The date on which the final payment on the bond is due from the bond issuer to the investor. (p. 488).
Mortgage bond: A bond secured by real estate. (p. 488).
Mortgage notes payable: A long-term note secured by a mortgage that pledges title to specific assets as security for a loan. (p. 497).
Non-current liabilities: Obligations expected to be paid more than one year in the future. (p. 486).
Notes payable: Obligations in the form of written notes. (p. 482).
Premium (on a bond): The difference between the selling price and the face value of a bond, when the bond is sold for more than its face value. (p. 493).
Secured bonds: Bonds that have specific assets of the issuer pledged as collateral. (p. 488).
Sinking fund bonds: Bonds secured by specific assets set aside to redeem them. (p. 488).
* Straight-line method of amortization: A method of amortizing bond discount or bond premium that results in allocating the same amount to interest expense in each interest period. (p. 505).
Times interest earned: A solvency measure that indicates a company’s ability to meet interest payments; computed by dividing the sum of net income, interest expense, and income tax expense by interest expense. (p. 500).
Time value of money: The relationship between time and money. A dollar received today is worth more than a dollar promised at some time in the future. (p. 490).
Unsecured bonds: Bonds issued against the general credit of the borrower. Also called debenture bonds. (p. 488).
Working capital: A measure of a company’s liquidity; computed as current assets minus current liabilities. (p. 486).

PRACTICE MULTIPLE-CHOICE QUESTIONS

(LO 1)

The time period for classifying a liability as current is one year or the operating cycle, whichever is:
1. longer.
2. shorter.
3. probable.
4. possible.

(LO 1)

To be classified as a current liability, a debt must be expected to be paid within:
1. one year.
2. the operating cycle.
3. 2 years.
4. (a) or (b), whichever is longer.

(LO 2)

Maggie Sharrer SA borrows R$88,500 on September 1, 2017, from Sandwich Bank by signing an R$88,500, 12%, one-year note. What is the accrued interest at December 31, 2017?
1. R$2,655.
2. R$4,425.
3. R$3,540.
4. R$10,620.

(LO 3)

Becky Sherrick SE has total proceeds from sales of €4,515. If the proceeds include sales taxes of 5%, the amount to be credited to Sales Revenue is:
1. €4,000.
2. €4,300.
3. €4,289.25.
4. No correct answer given.

(LO 3)

Sensible Insurance collected a premium of £18,000 for a 1-year insurance policy on April 1. What amount should Sensible report as a current liability for Unearned Service Revenue at December 31?
1. £0.
2. £4,500.
3. £13,500.
4. £18,000.

(LO 4)

The term used for bonds that are unsecured is:
1. callable bonds.
2. indenture bonds.
3. debenture bonds.
4. convertible bonds.

(LO 5)

Karson Ltd. issues 10-year bonds with a maturity value of £200,000. If the bonds are issued at a premium, this indicates that:
1. the contractual interest rate exceeds the market interest rate.
2. the market interest rate exceeds the contractual interest rate.
3. the contractual interest rate and the market interest rate are the same.
4. no relationship exists between the two rates.

(LO 6)

Gester Ltd. redeems its HK$1,000,000 face value bonds at 105 on January 1, following the payment of annual interest. The carrying value of the bonds at the redemption date is HK$1,037,450. The entry to record the redemption will include a:
1. credit of HK$37,450 to Loss on Bond Redemption.
2. debit of HK$1,037,450 to Bonds Payable.
3. credit of HK$12,550 to Gain on Bond Redemption.
4. debit of HK$50,000 to Bonds Payable.

(LO 7)

Andrews Ltd. issues a €497,000, 10%, 3-year mortgage note on January 1. The note will be paid in three annual installments of €200,000, each payable at the end of the year. What is the amount of interest expense that should be recognized by Andrews in the second year?
1. €16,567.
2. €49,700.
3. €34,670.
4. €346,700.

(LO 7)

Howard Ltd. issued a 20-year mortgage note payable on January 1, 2017. At December 31, 2017, the unpaid principal balance will be reported as:
1. a current liability.
2. a non-current liability.
3. part current and part non-current liability.
4. interest payable.

(LO 8)

For 2017, Kim Ltd. reported net income of 300,000. Interest expense was 40,000 and income taxes were 100,000. The times interest earned was:
1. 3 times.
2. 4.4 times.
3. 7.5 times.
4. 11 times.

(LO 9)

* On January 1, Besalius plc issued £1,000,000, 9% bonds for £938,554. The market rate of interest for these bonds is 10%. Interest is payable annually on December 31. Besalius uses the effective-interest method of amortizing bond discount. At the end of the first year, Besalius should report unamortized bond discount of:
1. £54,900.
2. £57,591.
3. £51,610.
4. £51,000.

(LO 9)

*On January 1, Dias SA issued R$1,000,000, 10%, 5-year bonds with interest payable annually on December 31. The bonds sold for R$1,072,096. The market rate of interest for these bonds was 12%. On the first interest date, using the effective-interest method, the debit entry to Interest Expense is for:
1. R$120,000.
2. R$125,581.
3. R$128,652.
4. R$140,000.

(LO 10)

*On January 1, 2017, Hurley Ltd. issued NT$5,000,000, 5-year, 12% bonds at 96 with interest payable annually on December 31. The entry on December 31, 2018, to record payment of bond interest and the amortization of bond discount using the straight-line method will include a:
1. debit to Interest Expense NT$300,000.
2. debit to Interest Expense NT$600,000.
3. credit to Bonds Payable NT$40,000.
4. credit to Bonds Payable NT$20,000.

(LO 10)

*For the bonds issued in Question 14 above, what is the carrying value of the bonds at the end of the third interest period?
1. NT$4,920,000.
2. NT$4,880,000.
3. NT$4,860,000.
4. NT$4,640,000.

Solutions

(a) The time period for classifying a liability as current is one year or the operating cycle, whichever is longer, not (b) shorter, (c) probable, or (d) possible.
(d) To be classified as a current liability, a debt must be expected to be paid within one year or the operating cycle. Choices (a) and (b) are both correct, but (d) is the better answer. Choice (c) is incorrect.
(b) Accrued interest at 12/31/17 is computed as the face value (R$88,500) times the interest rate (12%) times the portion of the year the debt was outstanding (4 months out of 12), or $R $ 3,540 (R $ 88,500 \times 12 % \times \frac{4}{12})$ $R $ 3,540 (R $ 88,500 \times 12 % \times \frac{4}{12})$ , not (a) R$2,655, (c) R$4,425, or (d) R$10,620.
(b) Dividing the total proceeds (€4,515) by one plus the sales tax rate (1.05) will result in the amount of sales to be credited to the Sales Revenue account of $€ 4,300 (€ 4,515 \div 1.05)$ $€ 4,300 (€ 4,515 \div 1.05)$ . The other choices are therefore incorrect.
(b) The monthly premium is £1,500 or £18,000 divided by 12. Because Sensible has recognized 9 months of insurance revenue (April 1–December 31), 3 months’ insurance premium is still unearned. The amount that Sensible should report as Unearned Service Revenue is therefore $£ 4,500 (3 months \times £ 1,500)$ $£ 4,500 (3 months \times £ 1,500)$ , not (a) £0, (c) £13,500, or (d) £18,000.
(c) Debenture bonds are not secured by any collateral. The other choices are incorrect because (a) callable bonds can be paid off or redeemed by the issuer before they reach their maturity date, (b) indenture bonds do not exist, and (d) convertible bonds permit bondholders to convert them into ordinary shares at the bondholders’ option.
(a) When bonds are issued at a premium, this indicates that the contractual interest rate is higher than the market interest rate. The other choices are incorrect because (b) when the market interest rate exceeds the contractual interest rate, bonds are sold at a discount; (c) when the contractual interest rate and the market interest rate are the same, bonds will be issued at par; and (d) the relationship between the market rate of interest and the contractual rate of interest determines whether bonds are issued at par, a discount, or a premium.
(b) The entry to record the redemption of bonds will include a debit to Bonds Payable of HK$1,037,450, a credit to Cash of $HK $ 1,050,000 (HK $ 1,000,000 \times 1.05)$ $HK $ 1,050,000 (HK $ 1,000,000 \times 1.05)$ and a debit to Loss on Bond Redemption of $HK $ 12,550 (HK $ 1,050,000 - HK $ 1,037,450)$ $HK $ 12,550 (HK $ 1,050,000 - HK $ 1,037,450)$ . The other choices are therefore incorrect.
(c) In the first year, Andrews will recognize €49,700 of interest expense $(€ 497,000 \times 10 %)$ $(€ 497,000 \times 10 %)$ . After the first payment is made, the amount remaining on the note will be $€ 346,700 [€ 497,000 principal - (€ 200,000 payment - € 49,700 interest)]$ $€ 346,700 [€ 497,000 principal - (€ 200,000 payment - € 49,700 interest)]$ . The remaining balance (€346,700) is multiplied by the interest rate (10%) to compute the interest expense to be recognized for the second year, $€ 34,670 (€ 346,700 \times 10 %)$ $€ 34,670 (€ 346,700 \times 10 %)$ , not (a) €16,567, (b) €49,700, or (d) €346,700.
(c) Howard Ltd. reports the reduction in principal for the next year as a current liability, and it classifies the remaining unpaid principal balance as a non-current liability. The other choices are therefore incorrect.
(d) Times interest earned = Net income + Interest expense + Income tax expense (300,000 + 40,000 + 100,000 = 440,000) divided by Interest expense (40,000), which equals 11 times, not (a) 3, (b) 4.4, or (c) 7.5 times.
(b) * The beginning balance of unamortized discount is $£ 61,446 (£ 1,000,000 - £ 938,554)$ $£ 61,446 (£ 1,000,000 - £ 938,554)$ . The discount amortization is £3,855, the difference between the cash interest payment of $£ 90,000 (£ 1,000,000 \times 9 %)$ $£ 90,000 (£ 1,000,000 \times 9 %)$ and the interest expense recorded of $£ 93,855 (£ 938,554 \times 10 %)$ $£ 93,855 (£ 938,554 \times 10 %)$ . This discount amortization (£3,855) is then subtracted from the beginning balance of unamortized discount (£61,446), to arrive at a balance of £57,591 at the end of the first year, not (a) £54,900, (c) £51,610, or (d) £51,000.
(c) * The debit to $Interest Expense = R $ 1,072,096 (initial carrying value of bond) \times 12 % (market rate) = R $ 128,652$ $Interest Expense = R $ 1,072,096 (initial carrying value of bond) \times 12 % (market rate) = R $ 128,652$ , not (a) R$120,000, (b) R$125,581, or (d) R$140,000.
(c) * $[NT $ 5,000,000 - (96 % \times NT $ 5,000,000)] = NT $ 200,000; NT $ 200,000 \div 5 = NT $ 40,000$ $[NT $ 5,000,000 - (96 % \times NT $ 5,000,000)] = NT $ 200,000; NT $ 200,000 \div 5 = NT $ 40,000$ of discount to amortize annually. As a result, the entry would involve a credit to Bonds Payable of NT$40,000. The other choices are therefore incorrect.
(a) * The carrying value of bonds increases by the amount of the periodic discount amortization. Discount amortization using the straight-line method is NT$40,000 each period. Total discount amortization for three periods is $NT $ 120,000 (NT $ 40,000 \times 3 periods)$ $NT $ 120,000 (NT $ 40,000 \times 3 periods)$ which is added to the initial carrying value (NT$4,800,000) to arrive at NT$4,920,000, the carrying value at the end of the third interest period, not (b) NT$4,880,000, (c) NT$4,860,000, or (d) NT$4,640,000.

PRACTICE EXERCISES

Prepare entries for interest-bearing notes..

(LO 2)

On June 1, JetSet plc borrows £150,000 from First Bank on a 6-month, £150,000, 8% note.

Instructions

Prepare the entry on June 1.
Prepare the adjusting entry on June 30.
Prepare the entry at maturity (December 1), assuming monthly adjusting entries have been made through November 30.
What was the total financing cost (interest expense)?

Solution

Prepare entries for bonds issued at face value..

(LO 5)

Global Airlines Ltd. issued NT$900,000 of 8%, 10-year bonds on January 1, 2017, at face value. Interest is payable annually on January 1.

Instructions

Prepare the journal entries to record the following events.

The issuance of the bonds.
The accrual of interest on December 31.
The payment of interest on January 1, 2018.
The redemption of bonds at maturity, assuming interest for the last interest period has been paid and recorded.

Solution

Prepare entries to record mortgage note and installment payments.

(LO 7)

Trawler SA borrowed €500,000 on December 31, 2017, by issuing a €500,000, 7% mortgage note payable. The terms call for annual installment payments of €80,000 on December 31.

Instructions

Prepare the journal entries to record the mortgage loan and the first two installment payments.
Indicate the amount of mortgage note payable to be reported as a current liability and as a non-current liability at December 31, 2018.

Solution

PRACTICE PROBLEM

Prepare entries to record issuance of bonds and longterm notes, interest accrued, and bond redemption..

(LO 5, 6)

Lee Software Ltd. has successfully developed a new spreadsheet program. To produce and market the program, the company needs additional financing. On January 1, 2017, Lee borrowed money as follows.

Lee issued NT$1 million, 10%, 10-year bonds at face value. Interest is payable annually on January 1.
Lee also issued a NT$400,000, 6%, 15-year mortgage payable. The terms provide for annual installment payments of NT$41,185 on December 31.

Instructions

For the 10-year, 10% bonds:
1. Journalize the issuance of the bonds on January 1, 2017.
2. Prepare the journal entries for interest expense in 2017.
3. Prepare the entry for the redemption of the bonds at 101 on January 1, 2020, after paying the interest due on this date.
For the mortgage payable:
1. Prepare the entry for the issuance of the note on January 1, 2017.
2. Prepare a payment schedule for the first four installment payments.
3. Indicate the current and non-current amounts for the mortgage payable at December 31, 2017.

Solution

WileyPLUS

Brief Exercises, DO IT! Review, Exercises, and Problems, and many additional resources are available for practice in WileyPLUS.

NOTE: Asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

QUESTIONS

Brenda Gable believes a current liability is a debt that can be expected to be paid in one year. Is Brenda correct? Explain.
Delhi Ltd. obtains Rs300,000 in cash by signing a 9%, 6-month, Rs300,000 note payable to First Bank on July 1. Delhi’s fiscal year ends on September 30. What information should be reported for the note payable in the annual financial statements?
1. Your roommate says, “Sales taxes are reported as an expense in the income statement.” Do you agree? Explain.
2. Planet Hollywood has cash proceeds from sales of £7,400. This amount includes £400 of sales taxes. Give the entry to record the proceeds.
Rotterdam University sold 10,000 season football tickets at €90 each for its five-game home schedule. What entries should be made (a) when the tickets were sold, and (b) after each game?
What is liquidity? What are two measures of liquidity?
(a) What are non-current liabilities? Give three examples. (b) What is a bond?
(a) As a source of long-term financing, what are the major advantages of bonds over ordinary shares? (b) What are the major disadvantages in using bonds for long-term financing?
Contrast the following types of bonds: (a) secured and unsecured, and (b) convertible and callable.
The following terms are important in issuing bonds: (a) face value, (b) contractual interest rate, (c) bond indenture, and (d) bond certificate. Explain each of these terms.
Describe the two major obligations incurred by a company when bonds are issued.
Assume that Bedazzled Ltd. sold bonds with a face value of €100,000 for €104,000. Was the market interest rate equal to, less than, or greater than the bonds’ contractual interest rate? Explain.
If a 6%, 10-year, R$800,000 bond is issued at face value and interest is paid annually, what is the amount of the interest payment at the end of the first period?
If the Bonds Payable account has a balance of HK$8,400,000 and the amount of the unamortized bond discount is HK$600,000, what is the face value of the bonds?
Which accounts are debited and which are credited if a bond issue originally sold at a premium is redeemed before maturity at 97 immediately following the payment of interest?
Roy Toth, a friend of yours, has recently purchased a home for €125,000, paying €25,000 down and the remainder financed by a 6.5%, 20-year mortgage, payable at €745.57 per month. At the end of the first month, Roy receives a statement from the bank indicating that only €203.90 of principal was paid during the month. At this rate, he calculates that it will take over 40 years to pay off the mortgage. Is he right? Discuss.
*In general, what are the requirements for the financial statement presentation of non-current liabilities?
*Ginny Bellis is discussing the advantages of the effective-interest method of bond amortization with her accounting staff. What do you think Ginny is saying?
*Redbone AG issues CHF500,000 of 8%, 5-year bonds on January 1, 2014, at 104. If Redbone uses the effective-interest method in amortizing the premium, will the annual interest expense increase or decrease over the life of the bonds? Explain.
*Explain the straight-line method of amortizing discount and premium on bonds payable.
*Fleming Ltd. issues £400,000 of 7%, 5-year bonds on January 1, 2017, at 105. Assuming that the straightline method is used to amortize the premium, what is the total amount of interest expense for 2017?
*Identify two taxes commonly withheld by the employer from an employee’s gross pay.

BRIEF EXERCISES

Identify whether obligations are current liabilities.

(LO 1)

BE10-1 Cardinal SpA has the following obligations at December 31: (a) a note payable for €100,000 due in 2 years, (b) a 10-year mortgage payable of €300,000 payable in ten €30,000 annual payments, (c) interest payable of €12,000 on the mortgage, and (d) accounts payable of €60,000. For each obligation, indicate whether it should be classified as a current liability. (Assume an operating cycle of less than one year.)

Prepare entries for an interestbearing note payable.

(LO 2)

BE10-2 Becky Ltd. borrows £60,000 on July 1 from the bank by signing a £60,000, 10%, one-year note payable.

Prepare the journal entry to record the proceeds of the note.
Prepare the journal entry to record accrued interest at December 31, assuming adjusting entries are made only at the end of the year.

Compute and record sales taxes payable.

(LO 3)

BE10-3 Goodwin Auto Supply does not segregate sales and sales taxes at the time of sale. The register total for March 16 is £12,826. All sales are subject to a 6% sales tax. Compute sales taxes payable, and make the entry to record sales taxes payable and sales revenue.

Prepare entries for unearned revenues.

(LO 3)

BE10-4 Hamburg University sells 4,000 season basketball tickets at €180 each for its 10-game home schedule. Give the entry to record (a) the sale of the season tickets and (b) the revenue recognized for playing the first home game.

Compare bond versus share financing.

(LO 4)

BE10-5 Shaffer Ltd. is considering two alternatives to finance its construction of a new €2 million plant.

Issuance of 200,000 ordinary shares at the market price of €10 per share.
Issuance of €2 million, 6% bonds at face value.

Complete the following table, and indicate which alternative is preferable.

Prepare entries for bonds issued at face value.

(LO 5)

BE10-6 Meera Ltd. issued 4,000, 8%, 5-year, £1,000 bonds dated January 1, 2017, at 100. Interest is paid each January 1.

Prepare the journal entry to record the sale of these bonds on January 1, 2017.
Prepare the adjusting journal entry on December 31, 2017, to record interest expense.
Prepare the journal entry on January 1, 2018, to record interest paid.

Prepare entries for bonds sold at a discount and a premium.

(LO 5)

BE10-7 Nasreen Company issues €2 million, 10-year, 8% bonds at 97, with interest payable each January 1.

Prepare the journal entry to record the sale of these bonds on January 1, 2017.
Assuming instead that the above bonds sold for 104, prepare the journal entry to record the sale of these bonds on January 1, 2017.

Prepare entries for bonds issued.

(LO 5)

BE10-8 Frankum SpA has issued three different bonds during 2017. Interest is payable annually on each of these bonds.

On January 1, 2017, 1,000, 8%, 5-year, €1,000 bonds dated January 1, 2017, were issued at face value.
On July 1, €900,000, 9%, 5-year bonds dated July 1, 2017, were issued at 102.
On September 1, €400,000, 7%, 5-year bonds dated September 1, 2017, were issued at 98.

Prepare the journal entry to record each bond transaction at the date of issuance.

Prepare entry for redemption of bonds.

(LO 6)

BE10-9 The statement of financial position for Miley Consulting reports the following

Miley decides to redeem these bonds at 101 (face value of bonds £1,000,000) after paying annual interest. Prepare the journal entry to record the redemption on July 1, 2017.

Prepare entries for long-term notes payable.

(LO 7)

BE10-10 Hanschu plc issues an £800,000, 10%, 10-year mortgage note on December 31, 2017, to obtain financing for a new building. The terms provide for annual installment payments of £130,196. Prepare the entry to record the mortgage loan on December 31, 2017, and the first installment payment on December 31, 2018.

Prepare statement presentation of non-current liabilities.

(LO 8)

BE10-11 Presented below are non-current liability items for Suarez AG at December 31, 2017. Prepare the non-current liabilities section of the statement of financial position for Suarez.

Analyze solvency.

(LO 3, 8)

BE10-12 Suppose the 2017 adidas financial statements contain the following selected data (in millions)

Compute the following values and provide a brief interpretation of each.

Working capital.
Current ratio.
Debt to assets ratio.
Times interest earned.

Use effective-interest method of bond amortization.

(LO 9)

*BE10-13 Presented below is the partial bond discount amortization schedule for Gomez SA. Gomez uses the effective-interest method of amortization.

Prepare the journal entry to record the payment of interest and the discount amortization at the end of period 1.
Explain why interest expense is greater than interest paid.
Explain why interest expense will increase each period.

Prepare entries for bonds issued at a discount.

(LO 10)

*BE10-14 Zhu Ltd. issues HK$5 million, 10-year, 9% bonds at 96, with interest payable annually on January 1. The straight-line method is used to amortize bond discount.

Prepare the journal entry to record the sale of these bonds on January 1, 2017.
Prepare the adjusting journal entry to record interest expense and bond discount amortization on December 31, 2017.

Prepare entries for bonds issued at a premium.

(LO 10)

*BE10-15 Golden plc issues £4 million, 5-year, 10% bonds at 102, with interest payable annually January 1. The straight-line method is used to amortize bond premium.

Prepare the journal entry to record the sale of these bonds on January 1, 2017.
Prepare the adjusting journal entry to record interest expense and bond premium amortization on December 31, 2017.

Prepare entry to record payroll.

(LO 11)

*BE10-16 Lexington AG’s weekly payroll of €24,000 included Social Security taxes withheld of €1,920, income taxes withheld of €2,990, and insurance premiums withheld of €250. Prepare the journal entry to record Lexington’s payroll.

Prepare entries to record profit-sharing bonus.

(LO 11)

*BE10-17 Mayaguez Ltd. provides its officers with bonuses based on net income. For 2017, the bonuses total £350,000 and are paid on February 15, 2018. Prepare Mayaguez’s December 31, 2017, adjusting entry and the February 15, 2018, entry.

> DO IT! REVIEW

Answer questions about current liabilities..

(LO 2, 3)

DO IT! 10-1 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 NT$2,100,000, 9-month, 7% note on August 1, how much interest expense would be incurred by December 31?
The cash register total including sales taxes is NT$1,260,000 and the sales tax rate is 5%. What is the sales taxes payable?
If NT$1,080,000 is collected in advance on December 1 for 6-month magazine subscriptions, what amount of subscription revenue is recognized by December 31?

Evaluate statements about bonds..

(LO 4)

DO IT! 10-2 State whether each of the following statements is true or false. If false, indicate how to correct the statement.

______ Mortgage bonds and sinking fund bonds are both examples of debenture bonds.
______ Convertible bonds are also known as callable bonds.
______ The market rate is the rate investors demand for loaning funds.
______ Annual interest paid on bonds is equal to the face value times the stated rate.
______ The present value of a bond is the value at which it should sell in the market.

Prepare journal entry for bond issuance and show statement of financial position presentation.

(LO 5)

DO IT! 10-3 Jeon Enterprises, Ltd. issues W300,000,000 of bonds for W306,000,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the statement of financial position at the date of issuance.

Prepare entry for bond redemption.

(LO 6)

DO IT! 10-4 Jeske Industries, SA issued €400,000 of 10-year bonds at a discount. Prior to maturity, when the carrying value of the bonds was €390,000, the company redeemed the bonds at 99. Prepare the entry to record the redemption of the bonds.

Prepare entries for mortgage note and installment payment on note.

(LO 7)

DO IT! 10-5 Mattsen Orchard issues a R$700,000, 6%, 15-year mortgage note to obtain needed financing for a new lab. The terms call for annual payments of R$72,074 each. Prepare the entries to record the mortgage loan and the first installment payment.

Analyze liabilities.

(LO 8)

DO IT! 10-6 Grouper Company provides you with the following statement of financial position information as of December 31, 2017.

In addition, Grouper reported net income for 2017 of $16,000, income tax expense of $3,200, and interest expense of $1,300.

Compute the debt to assets ratio for Grouper for 2017.
Compute times interest earned for Grouper for 2017.

EXERCISES

Prepare entries for interest-bearing notes.

(LO 2)

E10-1 Padillio SpA had the following transactions involving notes payable.

July 1, 2017	Borrows €60,000 from Fourth National Bank by signing a 9-month, 8% note.
Nov. 1, 2017	Borrows €42,000 from Livingston Bank by signing a 3-month, 7% note.
Dec. 31, 2017	Prepares adjusting entries.
Feb. 1, 2018	Pays principal and interest to Livingston Bank.
Apr. 1, 2018	Pays principal and interest to Fourth National Bank.

Instructions

Prepare journal entries for each of the transactions.

Prepare entries for interest-bearing notes.

(LO 2)

E10-2 On June 1, Yoon Ltd. borrows €70,000 from First Bank on a 6-month, €70,000, 9% note.

Instructions

Prepare the entry on June 1.
Prepare the adjusting entry on June 30.
Prepare the entry at maturity (December 1), assuming monthly adjusting entries have been made through November 30.
What was the total financing cost (interest expense)?

Journalize sales and related taxes.

(LO 3)

E10-3 In performing accounting services for small businesses, you encounter the following situations pertaining to cash sales.

Kemer A.Ş. enters sales and sales taxes separately on its cash register. On April 10, the register totals are sales 30,000 and sales taxes 1,800.
Bodrum A.Ş. does not segregate sales and sales taxes. Its register total for April 15 is 20,330, which includes a 7% sales tax.

Instructions

Prepare the entry to record the sales transactions and related taxes for each client.

Journalize unearned subscription revenue.

(LO 3)

E10-4 Nevin Ltd. publishes a monthly sports magazine, Fishing Preview. Subscriptions to the magazine cost £18 per year. During November 2017, Nevin sells 12,000 subscriptions beginning with the December issue. Nevin prepares financial statements quarterly and recognizes subscription revenue at the end of the quarter. The company uses the accounts Unearned Subscription Revenue and Subscription Revenue.

Instructions

Prepare the entry in November for the receipt of the subscriptions.
Prepare the adjusting entry at December 31, 2017, to record sales revenue recognized in December 2017.
Prepare the adjusting entry at March 31, 2018, to record sales revenue recognized in the first quarter of 2018.

Calculate current ratio and working capital before and after paying accounts payable.

(LO 3)

E10-5 The following financial data were reported by 3M Company (USA) for 2012 and 2013 (dollars in millions).

Instructions

Calculate the current ratio and working capital for 3M for 2012 and 2013.
Suppose that at the end of 2013, 3M management used $200 million cash to pay off $200 million of accounts payable. How would its current ratio and working capital have changed?

Evaluate statements about bonds.

(LO 4)

E10-6 Liane Hansen has prepared the following list of statements about bonds.

Bonds are a form of interest-bearing notes payable.
When seeking long-term financing, an advantage of issuing bonds over issuing ordinary shares is that shareholder control is not affected.
When seeking long-term financing, an advantage of issuing ordinary shares over issuing bonds is that tax savings result.
Secured bonds have specific assets of the issuer pledged as collateral for the bonds.
Secured bonds are also known as debenture bonds.
A conversion feature may be added to bonds to make them more attractive to bond buyers.
The rate used to determine the amount of cash interest the borrower pays is called the stated rate.
Bond prices are usually quoted as a percentage of the face value of the bond.
The present value of a bond is the value at which it should sell in the marketplace.

Instructions

Identify each statement as true or false. If false, indicate how to correct the statement.

Compare two alternatives of financing—issuance of ordinary shares vs. issuance of bonds.

(LO 4)

E10-7 Global Car Rental is considering two alternatives for the financing of a purchase of a fleet of cars. These two alternatives are:

Issue 60,000 ordinary shares at ¥40 per share. (Cash dividends have not been paid nor is the payment of any contemplated.)
Issue 7%, 10-year bonds at face value for ¥2,400,000.

It is estimated that the company will earn ¥800,000 before interest and taxes as a result of this purchase. The company has an estimated tax rate of 30% and has 90,000 ordinary shares outstanding prior to the new financing.

Instructions

Determine the effect on net income and earnings per share for these two methods of financing.

Prepare entries for issuance of bonds, and payment and accrual of bond interest.

(LO 5)

E10-8 On January 1, 2017, Klosterman Ltd. issued £500,000, 10%, 10-year bonds at face value. Interest is payable annually on January 1.

Instructions

Prepare journal entries to record the following.

The issuance of the bonds.
The accrual of interest on December 31, 2017.
The payment of interest on January 1, 2018.

Prepare entries for bonds issued at face value.

(LO 5)

E10-9 On January 1, 2017, Forrester SA issued R$400,000, 8%, 5-year bonds at face value. Interest is payable annually on January 1.

Instructions

Prepare journal entries to record the following.

The issuance of the bonds.
The accrual of interest on December 31, 2017.
The payment of interest on January 1, 2018.

Prepare entries to record issuance of bonds at discount and premium.

(LO 5)

E10-10 Pueblo Company issued €500,000 of 5-year, 8% bonds at 97 on January 1, 2017. The bonds pay interest annually.

Instructions

1. Prepare the journal entry to record the issuance of the bonds.
2. Compute the total cost of borrowing for these bonds.
Repeat the requirements from part (a), assuming the bonds were issued at 105.

Prepare entries for bond interest and redemption.

(LO 5, 6)

E10-11 The following section is taken from Ohlman Ltd.’s. statement of financial position at December 31, 2016.

Bond interest is payable annually on January 1. The bonds are callable on any interest date.

Instructions

Journalize the payment of the bond interest on January 1, 2017.
Assume that on January 1, 2017, after paying interest, Ohlman calls bonds having a face value of HK$6,000,000. The call price is 103. Record the redemption of the bonds.
Prepare the entry to record the accrual of interest on December 31, 2017.

Prepare entries for redemption of bonds.

(LO 6)

E10-12 Presented below are two independent situations.

Longbine plc redeemed £130,000 face value, 12% bonds on June 30, 2017, at 102. The carrying value of the bonds at the redemption date was £117,500. The bonds pay annual interest, and the interest payment due on June 30, 2017, has been made and recorded.
Tastove Ltd. redeemed £150,000 face value, 12.5% bonds on June 30, 2017, at 98. The carrying value of the bonds at the redemption date was £151,000. The bonds pay annual interest, and the interest payment due on June 30, 2017, has been made and recorded.

Instructions

Prepare the appropriate journal entry for the redemption of the bonds in each situation.

Prepare entries to record mortgage note and payments.

(LO 7)

E10-13 Jernigan Co. receives €240,000 when it issues a €240,000, 6%, mortgage note payable to finance the construction of a building at December 31, 2017. The terms provide for annual installment payments of €33,264 on December 31.

Instructions

Prepare the journal entries to record the mortgage loan and the first two payments.

Prepare non-current liabilities section.

(LO 8)

E10-14 The adjusted trial balance for Zhang Ltd. at the end of the current year contained the following accounts.

Interest Payable	HK$ 9,000
Lease Liability	59,500
Bonds Payable, due 2022	204,000

Instructions

Prepare the non-current liabilities section of the statement of financial position.

Calculate liquidity and solvency ratios; discuss impact of unrecorded obligations on liquidity and solvency.

(LO 3, 8)

E10-15 Suppose Lin Ltd.’s 2017 financial statements contain the following selected data (in millions).

Current assets	NT$ 3,416.3	Interest expense	NT$ 473.2
Total assets	30,224.9	Income taxes	1,936.0
Current liabilities	2,988.7	Net income	4,551.0
Total liabilities	16,191.0

Instructions

Compute the following values and provide a brief interpretation of each.
1. Working capital.
2. Current ratio.
3. Debt to assets ratio.
4. Times interest earned.
Suppose the notes to Lin’s financial statements show that subsequent to 2017, the company will have future minimum lease payments under operating leases of NT$10,717.5 million. If these assets had been purchased with debt, assets and liabilities would rise by approximately NT$8,800 million. Recompute the debt to assets ratio after adjusting for this. Discuss your result.

Prepare entries for issuance of bonds, payment of interest, and amortization of discount using effective-interest method.

(LO 9)

*E10-16 Lorance SpA issued €400,000, 7%, 20-year bonds on January 1, 2017, for €360,727. This price resulted in an effective-interest rate of 8% on the bonds. Interest is payable annually on January 1. Lorance uses the effective-interest method to amortize bond premium or discount.

Instructions

Prepare the journal entries to record the following. (Round to the nearest euro.)

The issuance of the bonds.
The accrual of interest and the discount amortization on December 31, 2017.
The payment of interest on January 1, 2018.

Prepare entries of issuance of bonds, payment of interest, and amortization of discount using effective-interest method.

(LO 9)

*E10-17 LRNA Ltd. issued £380,000, 7%, 10-year bonds on January 1, 2017, for £407,968. This price resulted in an effective-interest rate of 6% on the bonds. Interest is payable annually on January 1. LRNA uses the effective-interest method to amortize bond premium or discount.

Instructions

Prepare the journal entries to record the following. (Round to the nearest pound.)

The issuance of the bonds.
The accrual of interest and the premium amortization on December 31, 2017.
The payment of interest on January 1, 2018.

Prepare entries to record issuance of bonds, payment of interest, amortization of premium, and redemption at maturity.

(LO 5, 10)

*E10-18 Adcock A/S issued €600,000, 9%, 20-year bonds on January 1, 2017, at 103. Interest is payable annually on January 1. Adcock uses straight-line amortization for bond premium or discount.

Instructions

Prepare the journal entries to record the following.

The issuance of the bonds.
The accrual of interest and the premium amortization on December 31, 2017.
The payment of interest on January 1, 2018.
The redemption of the bonds at maturity, assuming interest for the last interest period has been paid and recorded.

Prepare entries to record issuance of bonds, payment of interest, amortization of discount, and redemption at maturity.

(LO 5, 10)

*E10-19 Gridley Ltd. issued £800,000, 11%, 10-year bonds on December 31, 2016, for £730,000. Interest is payable annually on December 31. Gridley uses the straight-line method to amortize bond premium or discount.

Instructions

Prepare the journal entries to record the following.

The issuance of the bonds.
The payment of interest and the discount amortization on December 31, 2017.
The redemption of the bonds at maturity, assuming interest for the last interest period has been paid and recorded.

Record payroll-related deductions.

(LO 10)

*E10-20 Dan Noll’s gross earnings for the week were $1,780, his income tax withholding was $303, and his social security tax total was $136.

Instructions

What was Noll’s net pay for the week?
Journalize the entry for the recording of his pay in the general journal. (Note: Use Salaries and Wages Payable; not Cash.)
Record the issuing of the check for Noll’s pay in the general journal.

PROBLEMS: SET A

Prepare current liability entries, adjusting entries, and current liabilities section.

(LO 1,2,3)

P10-1A On January 1, 2017, the ledger of Shumway Ltd. contains the following liability accounts.

Accounts Payable	£52,000
Sales Taxes Payable	5,800
Unearned Service Revenue	13,000

During January, the following selected transactions occurred.

Jan.	5	Sold merchandise for cash totaling £22,470, which includes 7% sales taxes.
	12	Performed services for customers who had made advance payments of £10,000. (Credit Service Revenue.)
	14	Paid revenue department for sales taxes collected in December 2016 (£5,800).
	20	Sold 700 units of a new product on credit at £52 per unit, plus 7% sales tax.
	21	Borrowed £14,000 from DeKalb Bank on a 3-month, 6%, £14,000 note.
	25	Sold merchandise for cash totaling £12,947, which includes 7% sales taxes.

Instructions

Journalize the January transactions.
Journalize the adjusting entries at January 31 for the outstanding notes payable. (Hint: Use one-third of a month for the DeKalb Bank note.)
Prepare the current liabilities section of the statement of financial position at January 31, 2017. Assume no change in accounts payable.

Journalize and post note transactions; show statement of financial position presentation.

(LO 2)

P10-2A The following are selected transactions of Graves ASA. Graves prepares financial statements quarterly.

Jan.	2	Purchased merchandise on account from Ally Company, €30,000, terms 2/10, n/30. (Graves uses the perpetual inventory system.)
Feb.	1	Issued a 6%, 2-month, €30,000 note to Ally in payment of account.
Mar.	31	Accrued interest for 2 months on Ally note.
Apr.	1	Paid face value and interest on Ally note.
July	1	Purchased equipment from Clark Equipment paying €8,000 in cash and signing a 7%, 3-month, €40,000 note.
Sept.	30	Accrued interest for 3 months on Clark note.
Oct.	1	Paid face value and interest on Clark note.
Dec.	1	Borrowed €15,000 from the Jonas Bank by issuing a 3-month, 6% note with a face value of €15,000.
Dec.	31	Recognized interest expense for 1 month on Jonas Bank note.

Instructions

Prepare journal entries for the listed transactions and events.
Post to the accounts Notes Payable, Interest Payable, and Interest Expense.
Show the statement of financial position presentation of notes and interest payable at December 31.
What is total interest expense for the year?

(d) €1,075

Prepare entries to record issuance of bonds, interest accrual, and bond redemption.

(LO 5, 6, 8)

P10-3A On May 1, 2017, Herron Industries AG issued CHF600,000, 9%, 5-year bonds at face value. The bonds were dated May 1, 2017, and pay interest annually on May 1. Financial statements are prepared annually on December 31.

Instructions

Prepare the journal entry to record the issuance of the bonds.
Prepare the adjusting entry to record the accrual of interest on December 31, 2017.
Show the statement of financial position presentation on December 31, 2017.
Prepare the journal entry to record payment of interest on May 1, 2018.
Prepare the adjusting entry to record the accrual of interest on December 31, 2018.
Assume that on January 1, 2019, Herron pays the accrued bond interest and calls the bonds at 102. Record the payment of interest and redemption of the bonds.

(d) Int. exp. CHF18,000

(f) Loss CHF12,000

Prepare entries to record issuance of bonds, interest accrual, and bond redemption.

(LO 5, 6, 8)

P10-4A Kershaw Electric Ltd. sold £6,000,000, 10%, 15-year bonds on January 1, 2017. The bonds were dated January 1, 2017, and paid interest on January 1. The bonds were sold at 98.

Instructions

Prepare the journal entry to record the issuance of the bonds on January 1, 2017.
At December 31, 2017, the amount of amortized bond discount is £8,000. Show the statement of financial position presentation of the bond liability at December 31, 2017.
On January 1, 2019, when the carrying value of the bonds was £5,896,000, the company redeemed the bonds at 102. Record the redemption of the bonds assuming that interest for the period has already been paid.

Prepare installment payments schedule and journal entries for a mortgage note payable.

(LO 7, 8)

P10-5A Talkington Electronics issues a R$400,000, 8%, 10-year mortgage note on December 31, 2016. The proceeds from the note are to be used in financing a new research laboratory. The terms of the note provide for annual installment payments, exclusive of real estate taxes and insurance, of R$59,612. Payments are due on December 31.

Instructions

Prepare an installment payments schedule for the first 4 years.
Prepare the entries for (1) the loan and (2) the first installment payment.
Show how the total mortgage liability should be reported on the statement of financial position at December 31, 2017.

(b) December 31 debit Mortgage Payable R$27,612

Prepare journal entries to record issuance of bonds, payment of interest, and amortization of bond discount using effective-interest method.

(LO 5, 9)

*P10-6A On January 1, 2017, Lock Industries Ltd. issued £1,800,000 face value, 5%, 10-year bonds at £1,667,518. This price resulted in an effective-interest rate of 6% on the bonds. Lock uses the effective-interest method to amortize bond premium or discount. The bonds pay annual interest January 1.

Instructions

(Round all computations to the nearest pound.)

Prepare the journal entry to record the issuance of the bonds on January 1, 2017.
Prepare an amortization table through December 31, 2019 (3 interest periods) for this bond issue.
Prepare the journal entry to record the accrual of interest and the amortization of the discount on December 31, 2017.
Prepare the journal entry to record the payment of interest on January 1, 2018.
Prepare the journal entry to record the accrual of interest and the amortization of the discount on December 31, 2018.

Prepare journal entries to record issuance of bonds, payment of interest, and effective-interest amortization, and statement of financial position presentation.

(LO 5, 9)

(a) (4) Interest Expense €128,162

*P10-7A On January 1, 2017, Jade SA issued €2,000,000 face value, 7%, 10-year bonds at €2,147,202. This price resulted in a 6% effective-interest rate on the bonds. Jade uses the effective-interest method to amortize bond premium or discount. The bonds pay annual interest on each January 1.

Instructions

Prepare the journal entries to record the following transactions.
1. The issuance of the bonds on January 1, 2017.
2. Accrual of interest and amortization of the premium on December 31, 2017.
3. The payment of interest on January 1, 2018.
4. Accrual of interest and amortization of the premium on December 31, 2018.
Show the proper non-current liabilities statement of financial position presentation for the bond liability at December 31, 2018.
Provide the answers to the following questions in narrative form.
1. What amount of interest expense is reported for 2018?
2. Would the bond interest expense reported in 2018 be the same as, greater than, or less than the amount that would be reported if the straight-line method of amortization were used?

Prepare entries to record issuance of bonds, interest accrual, and straight-line amortization for 2 years.

(LO 5, 10)

*P10-8A Paris Electric sold €3,000,000, 10%, 10-year bonds on January 1, 2017. The bonds were dated January 1 and pay interest annually on January 1. Paris Electric uses the straight-line method to amortize bond premium or discount. The bonds were sold at 104.

Instructions

Prepare the journal entry to record the issuance of the bonds on January 1, 2017.
Prepare a bond premium amortization schedule for the first 4 interest periods.
Prepare the journal entries for interest and the amortization of the premium in 2017 and 2018.
Show the statement of financial position presentation of the bond liability at December 31, 2018.

(b) Amortization €12,000

(d) Bonds payable €3,096,000

Prepare entries to record -issuance of bonds, interest, and straight-line amortization of bond premium and discount.

(LO 5, 10)

(a) Amortization Rs14,000

(b) Amortization Rs7,000

*P10-9A Saberhagen Ltd. sold Rs3,500,000, 8%, 10-year bonds on January 1, 2017. The bonds were dated January 1, 2017, and pay interest annually on January 1. Saberhagen Company uses the straight-line method to amortize bond premium or discount.

Instructions

Prepare all the necessary journal entries to record the issuance of the bonds and bond interest expense for 2017, assuming that the bonds sold at 104.
Prepare journal entries as in part (a) assuming that the bonds sold at 98.
Show the statement of financial position presentation for the bonds at December 31, 2017, for both the requirements in (a) and (b).

Prepare entries to record interest payments, straight-line premium amortization, and redemption of bonds.

(LO 6, 10)

*P10-10A The following is taken from the Colaw SA statement of financial position.

Interest is payable annually on January 1. The bonds are callable on any annual interest date. Colaw uses straight-line amortization for any bond premium or discount. From December 31, 2017, the bonds will be outstanding for an additional 10 years (120 months).

Instructions

Journalize the payment of bond interest on January 1, 2018.
Prepare the entry to amortize bond premium and to accrue the interest due on December 31, 2018.
Assume that on January 1, 2019, after paying interest, Colaw calls bonds having a face value of €1,200,000. The call price is 101. Record the redemption of the bonds.
Prepare the adjusting entry at December 31, 2019, to amortize bond premium and to accrue interest on the remaining bonds.

(b) Amortization €20,000

(d) Amortization €12,000

PROBLEMS: SET B

Prepare current liability entries, adjusting entries, and current liabilities section.

(LO 1, 2, 3)

P10-1B On January 1, 2017, the ledger of Zaur Ltd. contains the following liability accounts.

Accounts Payable	¥42,500
Sales Taxes Payable	5,800
Unearned Service Revenue	15,000

During January, the following selected transactions occurred.

Jan.	1	Borrowed ¥15,000 in cash from Platteville Bank on a 4-month, 6%, ¥15,000 note.
	5	Sold merchandise for cash totaling ¥9,828, which includes 8% sales taxes.
	12	Performed services for customers who had made advance payments of ¥9,400. (Credit Service Revenue.)
	14	Paid government treasurer’s department for sales taxes collected in December 2016, ¥5,800.
	20	Sold 700 units of a new product on credit at ¥44 per unit, plus 8% sales tax.
	25	Sold merchandise for cash totaling ¥16,308, which includes 8% sales taxes.

Instructions

Journalize the January transactions.
Journalize the adjusting entries at January 31 for the outstanding notes payable.
Prepare the current liabilities section of the statement of financial position at January 31, 2017. Assume no change in accounts payable.

Prepare entries to record issuance of bonds, interest accrual, and bond redemption.

(LO 5, 6, 8)

P10-2B On June 1, 2017, Weller SA issued €1,200,000, 8%, 5-year bonds at face value. The bonds were dated June 1, 2017, and pay interest annually on June 1. Financial statements are prepared annually on December 31.

(d) Int. Exp. €40,000

(f) Loss €24,000

Instructions

Prepare the journal entry to record the issuance of the bonds.
Prepare the adjusting entry to record the accrual of interest on December 31, 2017.
Show the statement of financial position presentation on December 31, 2017.
Prepare the journal entry to record payment of interest on June 1, 2018.
Prepare the adjusting entry to record the accrual of interest on December 31, 2018.
Assume that on January 1, 2019, Weller pays the accrued interest and calls the bonds at 102. Record the payment of interest and redemption of the bonds.

Prepare entries to record issuance of bonds, interest accrual, and bond redemption.

(LO 5, 6, 8)

P10-3B Shonrock Co. sold R$800,000, 9%, 10-year bonds on January 1, 2017. The bonds were dated January 1, 2017, and paid interest on January 1. The bonds were sold at 105.

Instructions

Prepare the journal entry to record the issuance of the bonds on January 1, 2017.
At December 31, 2017, the amount of amortized bond premium is R$4,000. Show the statement of financial position presentation of the bond liability at December 31, 2017.
On January 1, 2019, when the carrying value of the bonds was R$832,000, the company redeemed the bonds at 106. Record the redemption of the bonds, assuming that interest for the period has already been paid.

Prepare installment payments schedule and journal entries for a mortgage note payable.

(LO 7, 8)

P10-4B Crosetti’s Electronics issues an £800,000, 8%, 10-year mortgage note on December 31, 2016, to help finance a plant expansion program. The terms of the note provide for annual installment payments, exclusive of real estate taxes and insurance, of £119,224. Payments are due on December 31.

(b) Debit Mortgage Payable £55,224

Instructions

Prepare an installment payments schedule for the first 4 years.
Prepare the entries for (1) the loan and (2) the first installment payment.
Show how the total mortgage liability should be reported on the statement of financial position at December 31, 2017.

Prepare entries to record issuance of bonds, payment of interest, and amortization of bond discount using effective-interest method.

(LO 5, 9)

P10-5B On January 1, 2017, Witherspoon Satellites issued £4,500,000, 9%, 10-year bonds at £4,219,600. This price resulted in an effective-interest rate of 10% on the bonds. Witherspoon uses the effective-interest method to amortize bond premium or discount. The bonds pay annual interest January 1.

(e) Amortization £18,656

Instructions

(Round all computations to the nearest pound.)

Prepare the journal entry to record the issuance of the bonds on January 1, 2017.
Prepare an amortization table through December 31, 2018 (2 interest periods) for this bond issue.
Prepare the journal entry to record the accrual of interest and the amortization of the discount on December 31, 2017.
Prepare the journal entry to record the payment of interest on January 1, 2018.
Prepare the journal entry to record the accrual of interest and the amortization of the discount on December 31, 2018.

Prepare entries to record issuance of bonds, payment of interest, and amortization of premium using effective--interest method.

(LO 5, 9)

(a) (2) Amortization €36,510

(a) (4) Amortization €39,431

(b) Bond carrying value €4,467,686

P10-6B On January 1, 2017, Ashlock Chemical AG issued €4,000,000, 10%, 10-year bonds at €4,543,627. This price resulted in an 8% effective-interest rate on the bonds. Ashlock uses the effective-interest method to amortize bond premium or discount. The bonds pay annual interest on each January 1.

Instructions

(Round all computations to the nearest euro.)

Prepare the journal entries to record the following transactions.
1. The issuance of the bonds on January 1, 2017.
2. Accrual of interest and amortization of the premium on December 31, 2017.
3. The payment of interest on January 1, 2018.
4. Accrual of interest and amortization of the premium on December 31, 2018.
Show the proper non-current liabilities statement of financial position presentation for the bond liability at December 31, 2018.
Provide the answers to the following questions in narrative form.
1. What amount of interest expense is reported for 2018?
2. Would the bond interest expense reported in 2018 be the same as, greater than, or less than the amount that would be reported if the straight-line method of amortization were used?

Prepare entries to record issuance of bonds, interest accrual, and straight-line amortization for 2 years.

(LO 5, 10)

(b) Amortization ¥12,000

(d) Bonds payable ¥5,784,000

P10-7B Wu Ltd. sold ¥6,000,000, 8%, 20-year bonds on January 1, 2017. The bonds were dated January 1 and pay interest annually on January 1. Wu uses the straight-line method to amortize bond premium or discount. The bonds were sold at 96.

Instructions

Prepare the journal entry to record the issuance of the bonds on January 1, 2017.
Prepare a bond discount amortization schedule for the first 4 interest periods.
Prepare the journal entries for interest and the amortization of the discount in 2017 and 2018.
Show the statement of financial position presentation of the bond liability at December 31, 2018.

Prepare entries to record issuance of bonds, interest, and straight-line amortization of bond premium and discount.

(LO 5, 10)

(a) Amortization £12,000

(b) Amortization £16,000

P10-8B Rosewell Ltd. sold £4,000,000, 7%, 10-year bonds on January 1, 2017. The bonds were dated January 1, 2017, and pay interest annually on January 1. Rosewell uses the straight-line method to amortize bond premium or discount.

Instructions

Prepare all the necessary journal entries to record the issuance of the bonds and bond interest expense for 2017, assuming that the bonds sold at 103.
Prepare journal entries as in part (a), assuming that the bonds sold at 96.
Show the statement of financial position presentation for the bond liability at December 31, 2017, for both parts (a) and (b).

Prepare entries to record interest payments, straight-line discount amortization, and redemption of bonds.

(LO 5, 6, 10)

P10-9B The following is taken from the Sinjh ASA statement of financial position.

SINJH ASA Statement of Financial Position December 31, 2016
Non-current liabilities
Bonds payable (face value €2,400,000), 9%, due January 1, 2027	€2,310,000
Current liabilities
Interest payable (for 12 months from January 1 to December 31)	216,000

Interest is payable annually on January 1. The bonds are callable on any annual interest date. Sinjh uses straight-line amortization for any bond premium or discount. From December 31, 2016, the bonds will be outstanding for an additional 10 years (120 months).

Instructions

(Round all computations to the nearest euro).

(b) Amortization €9,000

(d) Amortization €6,000

Journalize the payment of bond interest on January 1, 2017.
Prepare the entry to amortize bond discount and to accrue the interest due on December 31, 2018.
Assume that on January 1, 2018, after paying interest, Sinjh calls bonds having a face value of €800,000. The call price is 102. Record the redemption of the bonds.
Prepare the adjusting entry at December 31, 2018, to amortize bond discount and to accrue interest on the remaining bonds.

COMPREHENSIVE PROBLEMS

CP10-1 James Ltd.’s statement of financial position at December 31, 2016, is presented below.

During 2017, the following transactions occurred.

James paid £2,500 interest on the bonds on January 1, 2017.
James purchased £241,100 of inventory on account.
James sold for £450,000 cash inventory which cost £250,000. James also collected £31,500 sales taxes.
James paid £230,000 on accounts payable.
James paid £2,500 interest on the bonds on July 1, 2017.
The prepaid insurance (£5,600) expired on July 31.
On August 1, James paid £12,000 for insurance coverage from August 1, 2017, through July 31, 2018.
James paid £24,000 sales taxes to the government.
Paid other operating expenses, £91,000.
Redeemed the bonds on December 31, 2017, by paying £47,000 plus £2,500 interest.
Issued £90,000 of 8% bonds on December 31, 2017, at 104. The bonds pay interest every December 31.

Adjustment data:

Recorded the insurance expired from item 7.
The equipment was acquired on December 31, 2016, and will be depreciated on a straight-line basis over 5 years with a £3,000 residual value.
The income tax rate is 30%. (Hint: Prepare the income statement up to income before taxes and multiply by 30% to compute the amount.)

Instructions

(b) Totals £652,070

(You may want to set up T-accounts to determine ending balances.)

Prepare journal entries for the transactions listed above and adjusting entries.
Prepare an adjusted trial balance at December 31, 2017.
Prepare an income statement and a retained earnings statement for the year ending December 31, 2017, and a classified statement of financial position as of December 31, 2017.

CP10-2 Eastland AG and Westside AG are competing businesses. Both began operations 6 years ago and are quite similar in most respects. The current statements of financial position data for the two companies are shown below.

You have been engaged as a consultant to conduct a review of the two companies. Your goal is to determine which of them is in the stronger financial position.

Your review of their financial statements quickly reveals that the two companies have not followed the same accounting practices. The differences and your conclusions regarding them are summarized below.

Eastland has used the allowance method of accounting for bad debts. A review shows that the amount of its write-offs each year has been quite close to the allowances that have been provided. It therefore seems reasonable to have confidence in its current estimate of bad debts.

Westside has used the direct write-off method for bad debts, and it has been somewhat slow to write off its uncollectible accounts. Based upon an aging analysis and review of its accounts receivable, it is estimated that CHF18,000 of its existing accounts will probably prove to be uncollectible.
Eastland estimated a useful life of 12 years and a residual value of CHF30,000 for its plant and equipment. It has been depreciating them on a straight-line basis.

Westside has the same type of plant and equipment. However, it estimated a useful life of 10 years and a residual value of CHF10,000. It has been depreciating its plant and equipment using the double-declining-balance method.

Based upon engineering studies of these types of plant and equipment, you conclude that Westside’s estimates and method for calculating depreciation are the more appropriate.
Among its current liabilities, Eastland has included the portions of non-current liabilities that become due within the next year. Westside has not done so.

You find that CHF16,000 of Westside’s CHF82,000 of non-current liabilities are due to be repaid in the current year.

Instructions

(a) Total assets:

Eastland CHF885,225

Westside CHF915,550

Revise the statements of financial position presented above so that the data are comparable and reflect the current financial position for each of the two companies.
Prepare a brief report to your client stating your conclusions.

MATCHA CREATIONS

(Note: This is a continuation of the Matcha Creations problem from Chapters 1–9.)

MC10 Recall that Matcha Creations sells fine European mixers that it purchases from Kzinski Supply Co. Kzinski warrants the mixers to be free of defects in material and workmanship for a period of one year from the date of original purchase. If the mixer has such a defect, Kzinski will repair or replace the mixer free of charge for parts and labor.

images

Go to the book’s companion website, www.wiley.com/college/weygandt, to see the completion of this problem.

BROADENING YOUR PERSPECTIVE

Financial Reporting and Analysis

Financial Reporting Problem: TSMC, Ltd. (TWN)

BYP10-1 The financial statements of TSMC appear in Appendix A. The notes to consolidated financial statements appear in the 2013 annual report, which can be found in the Investors section of the company’s website, www.tsmc.com.

Instructions

Refer to TSMC’s financial statements and answer the following questions about liabilities.

What were TSMC’s total current liabilities at December 31, 2013? What was the increase/decrease in TSMC’s total current liabilities from the prior year?
What were the components of total current liabilities on December 31, 2013?
What was TSMC’s total non-current liabilities at December 31, 2013? What was the increase/decrease in total non-current liabilities from the prior year? What were the components of total non-current liabilities on December 31, 2013?

Comparative Analysis Problem: Nestlé SA (CHE) vs. Petra Foods Ltd. (SGP)

BYP10-2 Nestlé’s financial statements are presented in Appendix B. Financial statements of Petra Foods are presented in Appendix C.

Instructions

At the end of the most recent fiscal year reported, what was Nestlé’s largest current liability account? What were its total current liabilities? What was Petra Foods’ largest current liability account? What were its total current liabilities?
Based on information contained in those financial statements, compute the following for each company for the most recent fiscal year reported.
1. Working capital.
2. Current ratio.
What conclusions concerning the relative liquidity of these companies can be drawn from these data?
Based on the information contained in those financial statements, compute the following ratios for each company for the most recent fiscal year reported.
1. Debt to assets ratio.
2. Times interest earned.
What conclusions concerning the companies’ long-run solvency can be drawn from these ratios?

Real-World Focus

BYP10-3 Purpose: Bond or debt securities pay a stated rate of interest. This rate of interest is dependent on the risk associated with the investment. Fitch Ratings provides ratings for companies that issue debt securities.

Address: www.fitchratings.com, or go to www.wiley.com/college/weygandt

Instructions

Answer the following questions.

In what year did Fitch introduce its bond rating scale? (See Our Organization.)
What letter values are assigned to debt investments that are considered “investment grade” and “speculative grade”? (See Ratings Definitions.)
Search the Internet to identify two other major credit rating agencies.

Critical Thinking

Decision-Making Across the Organization

*BYP10-4 On January 1, 2015, Fleming Ltd. issued £2,400,000 of 5-year, 8% bonds at 95; the bonds pay interest annually on January 1. By January 1, 2017, the market rate of interest for bonds of risk similar to those of Fleming had risen. As a result, the market value of these bonds was £2,000,000 on January 1, 2017—below their carrying value. Debra Fleming, president of the company, suggests repurchasing all of these bonds in the open market at the £2,000,000 price. To do so, the company will have to issue £2,000,000 (face value) of new 10-year, 11% bonds at par. The president asks you, as controller, “What is the feasibility of my proposed repurchase plan?”

Instructions

With the class divided into groups, answer the following.

What is the carrying value of the outstanding Fleming 5-year bonds on January 1, 2017? (Assume straight-line amortization.)
Prepare the journal entry to redeem the 5-year bonds on January 1, 2017. Prepare the journal entry to issue the new 10-year bonds.
Prepare a short memo to the president in response to her request for advice. List the economic factors that you believe should be considered for her repurchase proposal.

Communication Activity

BYP10-5 Ron Seiser, president of Seiser AG, is considering the issuance of bonds to finance an expansion of his business. He has asked you to (1) discuss the advantages of bonds over equity financing, (2) indicate the types of bonds he might issue, and (3) explain the issuing procedures used in bond transactions.

Instructions

Write a memo to the president, answering his request.

Ethics Case

BYP10-6 Dylan Horn is the president, founder, and majority owner of Wesley Medical Ltd., an emerging medical technology products company. Wesley is in dire need of additional capital to keep operating and to bring several promising products to final development, testing, and production. Dylan, as owner of 51% of the outstanding shares, manages the company’s operations. He places heavy emphasis on research and development and on long-term growth. The other principal shareholder is Mary Sommers who, as a non-employee investor, owns 40% of the shares. Mary would like to deemphasize the R&D functions and emphasize the marketing function, to maximize short-run sales and profits from existing products. She believes this strategy would raise the market price of Wesley’s shares.

All of Dylan’s personal capital and borrowing power is tied up in his 51% share ownership. He knows that any offering of additional shares will dilute his controlling interest because he won’t be able to participate in such an issuance. But, Mary has money and would likely buy enough shares to gain control of Wesley. She then would dictate the company’s future direction, even if it meant replacing Dylan as president and CEO.

The company already has considerable debt. Raising additional debt will be costly, will adversely affect Wesley’s credit rating, and will increase the company’s reported losses due to the growth in interest expense. Mary and the other minority shareholders express opposition to the assumption of additional debt, fearing the company will be pushed to the brink of bankruptcy. Wanting to maintain his control and to preserve the direction of “his” company, Dylan is doing everything to avoid a share issuance. He is contemplating a large issuance of bonds, even if it means the bonds are issued with a high effective-interest rate.

Instructions

Who are the stakeholders in this situation?
What are the ethical issues in this case?
What would you do if you were Dylan?

Answers to Insight and Accounting Across the Organization Questions

p. 491 How About Some Green Bonds? Q: Why might standardized disclosure help investors to better understand how proceeds from the sale or issuance of bonds are used? A: By requiring transparency as to how a bond’s proceeds are to be used and how they will affect a company’s sustainable profitability, investors will make better financial decisions.

p. 499 Bonds versus Notes? Q: Why might companies prefer bond financing instead of short-term financing? A: In some cases, it is difficult to get loans from banks. In addition, low interest rates have encouraged companies to go more long-term and fix their rates. Recently, short-term loans suddenly froze, leading to liquidity problems for certain companies.

p. 501 “Covenant-Lite” Debt Q: How can financial ratios such as those covered in this chapter provide protection for creditors? A: Financial ratios such as the current ratio, debt to assets ratio, and times interest earned provide indications of a company’s liquidity and solvency. By specifying minimum levels of liquidity and solvency, as measured by these ratios, a creditor creates triggers that enable it to step in before a company’s financial situation becomes too dire.

A Look at U.S. GAAP

Learning Objective 12

Compare the accounting for liabilities under IFRS and U.S. GAAP.

IFRS and GAAP have similar definitions of liabilities. IFRSs related to reporting and recognition of liabilities are found in IAS 1 (revised) (“Presentation of Financial Statements”) and IAS 37 (“Provisions, Contingent Liabilities, and Contingent Assets”). The general recording procedures for payroll are similar although differences occur depending on the types of benefits that are provided in different countries. For example, companies in other countries often have different forms of pensions, unemployment benefits, welfare payments, and so on. The accounting for various forms of compensation plans under IFRS is found in IAS 19 (“Employee Benefits”) and IFRS 2 (“Share-based Payments”). IAS 19 addresses the accounting for a wide range of compensation elements, including wages, bonuses, post-employment benefits, and compensated absences. Both of these standards were recently amended, resulting in significant convergence between IFRS and GAAP.

Key Points

Similarities

The basic definition of a liability under GAAP and IFRS is very similar. Liabilities may be legally enforceable via a contract or law but need not be; that is, they can arise due to normal business practice or customs.
Both GAAP and IFRS classify liabilities as current or non-current on the face of the statement of financial position. IFRS specifically states, however, that industries where a presentation based on liquidity would be considered to provide more useful information (such as financial institutions) can use that format instead.
The basic calculation for bond valuation is the same under GAAP and IFRS. In addition, the accounting for bond liability transactions is essentially the same between GAAP and IFRS.

Differences

Under IFRS, companies sometimes show liabilities before assets. Also, they will sometimes show non-current liabilities before current liabilities. Neither of these presentations is used under GAAP.
Under IFRS, companies sometimes will net current liabilities against current assets to show working capital on the face of the statement of financial position. This practice is not used under GAAP.
IFRS requires use of the effective-interest method for amortization of bond discounts and premiums. GAAP allows use of the straight-line method where the difference is not material.
GAAP often uses a separate discount or premium account to account for bonds payable. IFRS records discounts or premiums as direct increases or decreases to Bonds Payable. To illustrate, if a $100,000 bond was issued at 97, under GAAP a company would record:

Under IFRS, a company would record:
The accounting for convertible bonds differs between IFRS and GAAP. GAAP requires that the proceeds from the issuance of convertible debt be shown solely as debt. Unlike GAAP, IFRS splits the proceeds from the convertible bond between an equity component and a debt component. The equity conversion rights are reported in equity.
To illustrate, assume that Harris Corp. issues convertible 7% bonds with a face value of $1,000,000 and receives $1,000,000. Comparable bonds without a conversion feature would have required a 9% rate of interest. To determine how much of the proceeds would be allocated to debt and how much to equity, the promised payments of the bond obligation would be discounted at the market rate of 9%. Suppose that this results in a present value of $850,000. The entry to record the issuance under GAAP would be:

Under IFRS, the entry would be:
IFRS reserves the use of the term contingent liability to refer only to possible obligations that are not recognized in the financial statements but may be disclosed if certain criteria are met. Under GAAP, contingent liabilities are recorded in the financial statements if they are both probable and can be reasonably estimated. If only one of these criteria is met, then the item is disclosed in the notes.
IFRS uses the term provisions to refer to liabilities of uncertain timing or amount. Examples of provisions would be provisions for warranties, employee vacation pay, or anticipated losses. Under GAAP, these are considered recordable contingent liabilities.

Looking to the Future

The FASB and IASB 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.

GAAP Practice

GAAP Self-Test Questions

Which of the following is false?
1. Under GAAP, current liabilities are presented before non-current liabilities.
2. Under GAAP, an item is a current liability if it will be paid within the next 12 months or the operating cycle, whichever is longer.
3. Under GAAP, current liabilities are shown in order of magnitude.
4. Under GAAP, a liability is only recognized if it is a present obligation.
The accounting for bonds payable is:
1. essentially the same under IFRS and GAAP.
2. different in that GAAP requires use of the straight-line method for amortization of bond premium and discount.
3. the same except that market prices may be different because the present value calculations are different between IFRS and GAAP.
4. not covered by IFRS.
Stevens Corporation issued 5% convertible bonds with a total face value of $3,000,000 for $3,000,000. If the bonds had not had a conversion feature, they would have sold for $2,600,000. Under GAAP, the entry to record the transaction would require a credit to:
1. Bonds Payable for $3,000,000.
2. Bonds Payable for $400,000.
3. Share Premium—Conversion Equity for $400,000.
4. Discount on Bonds Payable for $400,000.
Which of the following is true regarding accounting for amortization of bond discount and premium?
1. Both IFRS and GAAP must use the effective-interest method.
2. GAAP must use the effective-interest method, but IFRS may use either the effective-interest method or the straight-line method.
3. IFRS is required to use the effective-interest method.
4. GAAP is required to use the straight-line method.
The joint projects of the FASB and IASB could potentially:
1. change the definition of liabilities.
2. change the definition of equity.
3. change the definition of assets.
4. All of the above.

GAAP Exercises

GAAP10-1 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to the accounting for liabilities.

GAAP10-2 Ratzlaff Company issues $2 million, 10-year, 8% bonds at 97, with interest payable on January 1.

Instructions

Prepare the journal entry to record the sale of these bonds on January 1, 2017, using GAAP.
Assuming instead that the above bonds sold for 104, prepare the journal entry to record the sale of these bonds on January 1, 2017, using GAAP.

GAAP10-3 Archer Company issued £4,000,000 par value, 7% convertible bonds at 99 for cash. The net present value of the debt without the conversion feature is £3,800,000. Prepare the journal entry to record the issuance of the convertible bonds (a) under GAAP and (b) under IFRS.

GAAP Financial Statement Analysis: Apple Inc.

GAAP10-4 The financial statements of Apple are presented on Appendix D. The company’s complete annual report, including the notes to its financial statements, is available at http://investor.apple.com.

Instructions

Use the company’s financial statements and notes to the financial statements to answer the following questions.

What were Apple’s total current liabilities at September 28, 2013? What was the increase/decrease in Apple’s total current liabilities from the prior year?
How much were the accounts payable at September 28, 2013?
What were the components of total current liabilities on September 28, 2013?

Answers to GAAP Self-Test Questions

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Table of Contents for Chapter 10: Liabilities

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FEATURE STORY

Financing His Dreams

PREVIEW OF CHAPTER 10

Current Liabilities

Learning Objective 1

What Is a Current Liability?

Notes Payable

Learning Objective 2

Sales Taxes Payable

Learning Objective 3

Unearned Revenues

Current Maturities of Long-Term Debt

GLOSSARY REVIEW

PRACTICE MULTIPLE-CHOICE QUESTIONS

Solutions

PRACTICE EXERCISES

Instructions

Solution

Instructions

Solution

Instructions

Solution

PRACTICE PROBLEM

Instructions

Solution

WileyPLUS

QUESTIONS

BRIEF EXERCISES

EXERCISES

PROBLEMS: SET A

PROBLEMS: SET B

COMPREHENSIVE PROBLEMS

MATCHA CREATIONS

BROADENING YOUR PERSPECTIVE

Financial Reporting and Analysis

Financial Reporting Problem: TSMC, Ltd. (TWN)

Comparative Analysis Problem: Nestlé SA (CHE) vs. Petra Foods Ltd. (SGP)

Real-World Focus

Critical Thinking

Decision-Making Across the Organization

Communication Activity

Ethics Case

Answers to Insight and Accounting Across the Organization Questions

A Look at U.S. GAAP

Learning Objective 12

Key Points

Similarities

Table of Contents for
Chapter 10: Liabilities