Current Liabilities

As explained in Chapter 4, a current liability is a debt that the company expects to pay within one year or the operating cycle, whichever is longer. Debts that do not meet this criterion are classified as non-current liabilities. Most companies pay current liabilities within one year by using current assets rather than by creating other liabilities.

Companies must carefully monitor the relationship of current liabilities to current assets. This relationship is critical in evaluating a company's short-term debt-paying ability. A company that has more current liabilities than current assets may not be able to meet its current obligations when they become due.

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

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, 2014, 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 × 12% × 4/12). Illustration 10-1 shows the formula for computing interest and its application to C. W. Co.'s note.

Illustration 10-1 Formula for computing interest

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 × 12% × 1/12).

At maturity (January 1, 2015), C. W. Co. must pay the face value of the note (HK$100,000) plus HK$4,000 interest (HK$100,000 × 12% × 4/12). It records payment of the note and accrued interest as follows.

Sales Taxes Payable

As a consumer, you know that many of the products you purchase at retail stores are subject to sales taxes. 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:

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 on the cash register. To determine the amount of sales in such cases, divide total receipts by 100% plus the sales tax percentage. To illustrate, assume that in the above example 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 ÷ 1.06 = NT$10,000

Thus, Cooley Grocery could find the sales tax amount it must remit to the government (NT$600) by subtracting sales from total receipts (NT$10,600 − NT$10,000).

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 provided?

1. When a company receives the advance payment, it debits Cash and credits a current liability account identifying the source of the unearned revenue.
2. 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 material 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 was 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.

Illustration 10-2 Unearned revenue and revenue accounts

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, 2013. This note specifies that each January 1, starting January 1, 2014, Wendy should pay €5,000 of the note. When the company prepares financial statements on December 31, 2013, 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.

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 shows this form of presentation.

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

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).

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. The formula for this ratio is illustrated below, 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 probably adequate but certainly below the standard of 2:1.

Non-Current Liabilities

Non-current liabilities are obligations that are expected to be paid after one year. In this section, we will 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 the illustration 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 lower cost of capital than equity financing.

To illustrate the third advantage, on earnings per share, assume that Microsystems, Inc. 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 (page 468) 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) 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.

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 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.

TERM AND SERIAL BONDS Bonds that mature—are due for payment—at a single specified future date are term bonds. In contrast, bonds that mature in installments are serial bonds.

REGISTERED AND BEARER BONDS Bonds issued in the name of the owner are registered bonds. Interest payments on registered bonds are made by check to bondholders of record. Bonds not registered are bearer (or coupon) bonds. Holders of bearer bonds must send in coupons to receive interest payments. Most bonds issued today are registered bonds.

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 retire at a stated currency amount 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 borrower pays and the investor receives. Usually the contractual rate is stated as an annual rate. Interest is generally paid semiannually.

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.

Illustration 10-8 Bond certificate

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 10-9 Market information for bonds

This bond listing indicates that Boeing Co. (USA) has outstanding 5.125%, $1,000 bonds that mature in 2014. 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.

A corporation makes journal entries only when it issues or buys back bonds, or when bondholders exchange convertible 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. (Siemens or its trustee does, however, keep records of the names of bondholders in the case of registered bonds.)

DETERMINING THE MARKET PRICE OF BONDS

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, Inc. 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 dollars at the end of 20 years. Would you pay a million dollars for this bond? We hope not! A million dollars received 20 years from now is not the same as a million dollars received today.

The term time value of money is used to indicate the relationship between time and money—that a dollar received today is worth more than a dollar promised at some time in the future. If you had a million dollars 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 a million dollars. If someone is going to pay you a million dollars 20 years from now, you would want to find its equivalent today. In other words, you would want to determine how much you must invest today at current interest rates to have a million dollars in 20 years. The amount that must be invested today at a given rate of interest over a specified time is called present value.

The 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 rate of interest. The market interest rate is the rate investors demand for loaning funds. Appendix 10A discusses the process of finding the present value for bonds. Appendix E also provides additional material for time value of money computations.

Accounting for Bond Issues

As indicated earlier, a corporation records bond transactions when it issues (sells) or retires (buys back) bonds and when bondholders convert bonds into ordinary shares. If bondholders sell their bond investments to other investors, the issuing firm receives no further money on the transaction, nor does the issuing corporation 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, 2014, Candlestick, Inc. issues €100,000, five-year, 10% bonds at 100 (100% of face value). The entry to record the sale is:

Candlestick reports bonds payable in the non-current liabilities section of the statement of financial position because the maturity date is January 1, 2019 (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 462. Assume that interest is payable semiannually on January 1 and July 1 on the Candlestick bonds. In that case, Candlestick must pay interest of €5,000 (€100,000 × 10% × 6/12) on July 1, 2014. The entry for the payment, assuming no previous accrual of interest, is:

At December 31, Candlestick recognizes the €5,000 of interest expense incurred since July 1 with the following adjusting entry:

Companies classify interest payable as a current liability because it is scheduled for payment within the next year. When Candlestick pays the interest on January 1, 2015, it debits (decreases) Interest Payable and credits (decreases) Cash for €5,000.

Candlestick records the payment on January 1 as follows.

DISCOUNT OR PREMIUM ON BONDS

In the Candlestick illustrations above, we 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 10-10 shows these relationships graphically.

Illustration 10-10 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, 2014, Candlestick, Inc. sells €100,000, five-year, 10% bonds for €92,639 (92.639% of face value). Interest is payable on July 1 and January 1. The entry to record the issuance is:

Illustration 10-11 (page 474) shows how the bonds payable of Candlestick, Inc. would be presented on the statement of financial position if it was prepared on the day the bonds were issued.

Illustration 10-11 Statement presentation of bonds issued at a discount

The €92,639 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 corporation 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. Appendices 10B and 10C show the procedures for recording this additional cost.

The total cost of borrowing €92,639 for Candlestick, Inc. is €57,361, computed as follows.

Illustration 10-12 Total cost of borrowing—bonds issued at a discount

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

Illustration 10-13 Alternative computation of total cost of borrowing—bonds issued at a discount

ISSUING BONDS AT A PREMIUM

To illustrate the issuance of bonds at a premium, we now assume the Candlestick, Inc. bonds described above sell for €108,111 (108.111% of face value) rather than for €92,639. The entry to record the sale is:

Candlestick adds the premium on bonds payable to the bonds payable amount on the statement of financial position, as shown in Illustration 10-14.

Illustration 10-14 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. The company credits the bond premium to Interest Expense over the life of the bonds. Appendices 10B and 10C show the procedures for recording this reduction in the cost of borrowing. The total cost of borrowing €108,111 for Candlestick, Inc. is computed as follows.

Illustration 10-15 Total cost of borrowing—bonds issued at a premium

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

Illustration 10-16 Alternative computation of total cost of borrowing—bonds issued at a premium

Accounting for Bond Retirements

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 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 retire bonds before maturity to reduce interest cost and to remove debt from its statement of financial position. A company should retire debt early only if it has sufficient cash resources.

When a company retires 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, Inc. has sold its bonds at a premium. At the end of the eighth period, Candlestick retires these bonds at 103 after paying the semiannual interest. Assume also that the carrying value of the bonds at the redemption date is €101,623. Candlestick makes the following entry to record the redemption at the end of the eighth interest period (January 1, 2018):

Note that the loss of €1,377 is the difference between the cash paid of €103,000 and the carrying value of the bonds of €101,623.

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. In periods of unstable interest rates, lenders may tie the interest rate on long-term notes to changes in the market rate for comparable loans. Examples are the 8.03% adjustable rate notes issued by General Motors (USA) and the floating-rate notes issued by American Express Company (USA).

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, while 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 Inc. issues a HK$500,000, 12%, 20-year mortgage note on December 31, 2014, to obtain needed financing for a new research laboratory. The terms provide for semiannual installment payments of HK$33,231. The installment payment schedule for the first two years is as follows.

Illustration 10-17 Mortgage installment payment schedule

Mongkok records the mortgage loan on December 31, 2014, as follows.

On June 30, 2015, 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, 2015, the total liability is HK$493,344. Of that amount, HK$7,478 (HK$3,630 + HK$3,848) is current, and HK$485,866 (HK$493,344 − HK$7,478) is non-current.

Statement Presentation and Analysis

PRESENTATION

Companies report non-current liabilities in a separate section of the statement of financial position immediately before current liabilities, as shown in Illustration 10-18. 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 10-18 Statement of financial position presentation of non-current 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 total assets ratio measures the percentage of the total assets provided by creditors. As shown in the formula in Illustration 10-19, it is computed by dividing total debt (both current and non-current liabilities) by total assets. The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations.

The times interest earned ratio indicates the company's ability to meet interest payments as they come due. It is computed by dividing income before income taxes and interest 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 39,048 billion, total assets of 64,782 billion, interest expense of 778 billion, income taxes of 1,092 billion, and net income of 2,967 billion. LG's debt to total assets ratio and times interest earned ratio are shown below.

Illustration 10-19 Debt to total assets and times interest earned ratios, with computations (in billions)

LG has a relatively high debt to total assets percentage of 60.3%. Its interest coverage of 6.22 times is considered safe.

SUMMARY OF LEARNING OBJECTIVES

1 Explain a current liability, and identify the major types of current liabilities. A current liability is a debt that a company can reasonably expect 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.

2 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.

3 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.

4 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, term and serial bonds, registered and bearer bonds, and convertible and callable bonds.

5 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.

6 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.

7 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 loan principal. The interest decreases each period, while the portion applied to the loan principal increases.

8 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 total assets and times interest earned are two ratios that provide information about debt-paying ability and long-run solvency.

GLOSSARY

Bearer (coupon) bonds Bonds not registered in the name of the owner. (p. 468).

Bond certificate A legal document that indicates the name of the issuer, the face value of the bonds, the contractual interest rate and maturity date of the bonds. (p. 469).

Bond indenture A legal document that sets forth the terms of the bond issue. (p. 469).

Bonds A form of interest-bearing notes payable. (p. 467).

Callable bonds Bonds that are subject to retirement at a stated currency amount prior to maturity at the option of the issuer. (p. 468).

Contractual interest rate Rate used to determine the amount of cash interest the borrower pays and the investor receives. (p. 469).

Convertible bonds Bonds that permit bondholders to convert them into ordinary shares at the bondholders' option. (p. 468).

Current liabilities Obligations that a company expects to pay within one year or the operating cycle, whichever is longer. (p. 462).

Current ratio A measure of a company's liquidity; computed as current assets divided by current liabilities. (p. 466).

Debenture bonds Bonds issued against the general credit of the borrower. Also called unsecured bonds. (p. 468).

Debt to total assets ratio A solvency measure that indicates the percentage of total assets provided by creditors; computed as total debt divided by total assets. (p. 479).

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. 473).

Face value Amount of principal the issuer must pay at the maturity date of the bond. (p. 469).

Market interest rate The rate investors demand for loaning funds to the corporation. (p. 470).

Maturity date The date on which the final payment on the bond is due from the bond issuer to the investor. (p. 469).

Mortgage bond A bond secured by real estate. (p. 468).

Mortgage notes payable A long-term note secured by a mortgage that pledges title to specific assets as security for a loan. (p. 477).

Non-current liabilities Obligations expected to be paid after one year. (p. 467).

Notes payable Obligations in the form of written notes. (p. 462).

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. 473).

Registered bonds Bonds issued in the name of the owner. (p. 468).

Secured bonds Bonds that have specific assets of the issuer pledged as collateral. (p. 468).

Serial bonds Bonds that mature in installments. (p. 468).

Sinking fund bonds Bonds secured by specific assets set aside to retire them. (p. 468).

Term bonds Bonds that mature at a single specified future date. (p. 468).

Times interest earned ratio A solvency measure that indicates a company's ability to meet interest payments; computed by dividing income before income taxes and interest expense by interest expense. (p. 479).

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. 470).

Unsecured bonds Bonds issued against the general credit of the borrower. Also called debenture bonds. (p. 468).

Working capital A measure of a company's liquidity; computed as current assets minus current liabilities. (p. 466).

APPENDIX 10A PRESENT VALUE CONCEPTS RELATED TO BOND PRICING

Congratulations! You have a winning lottery ticket, and the government has provided you with three possible options for payment. They are:

1. Receive HK$10,000,000 in three years.
2. Receive HK$7,000,000 immediately.
3. Receive HK$3,500,000 at the end of each year for three years.

Which of these options would you select? The answer is not easy to determine at a glance. To make a dollar-maximizing choice, you must perform present value computations. A present value computation is based on the concept of time value of money. Time value of money concepts are useful for the lottery situation and for pricing other amounts to be received in the future. This appendix discusses how to use present value concepts to price bonds. It also will tell you how to determine what option you should take as a lottery winner.

Present Value of Face Value

To illustrate present value concepts, assume that you are willing to invest a sum of money that will yield HK$1,000 at the end of one year. In other words, what amount would you need to invest today to have HK$1,000 one year from now? If you want to earn 10%, the investment (or present value) is HK$909.09 (HK$1,000 ÷ 1.10). Illustration 10A-1 shows the computation.

Illustration 10A-1 Present value computation—HK$1,000 discounted at 10% for one year

The future amount (HK$1,000), the interest rate (10%), and the number of periods (1) are known. We can depict the variables in this situation as shown in the time diagram in Illustration 10A-2.

Illustration 10A-2 Finding present value if discounted for one period

If you are to receive the single future amount of HK$1,000 in two years, discounted at 10%, its present value is HK$826.45 [(HK$1,000 ÷ 1.10) ÷ 1.10], depicted as follows.

Illustration 10A-3 Finding present value if discounted for two periods

We also can determine the present value of 1 through tables that show the present value of 1 for n periods. In Table 10A-1, n is the number of discounting periods involved. The percentages are the periodic interest rates, and the 5-digit decimal numbers in the respective columns are the factors for the present value of 1.

When using Table 10A-1, we multiply the future amount by the present value factor specified at the intersection of the number of periods and the interest rate. For example, the present value factor for 1 period at an interest rate of 10% is .90909, which equals the HK$909.09 (HK$1,000 × .90909) computed in Illustration 10A-1.

For two periods at an interest rate of 10%, the present value factor is .82645, which equals the HK$826.45 (HK$1,000 × .82645) computed previously.

Let's now go back to our lottery example. Given the present value concepts just learned, we can determine whether receiving HK$10,000,000 in three years is better than receiving HK$7,000,000 today, assuming the appropriate discount rate is 9%. The computation is as follows.

Illustration 10A-4 Present value of HK$10,000,000 to be received in three years

What this computation shows you is that you would be HK$721,800 better off receiving the HK$10,000,000 at the end of three years rather than taking HK$7,000,000 immediately.

Present Value of Interest Payments (Annuities)

In addition to receiving the face value of a bond at maturity, an investor also receives periodic interest payments over the life of the bonds. These periodic payments are called annuities.

In order to compute the present value of an annuity, we need to know (1) the interest rate, (2) the number of interest payments, and (3) the amount of the periodic receipts or payments. To illustrate the computation of the present value of an annuity, assume that you will receive HK$1,000 cash annually for three years and the interest rate is 10%. The time diagram in Illustration 10A-5 depicts this situation.

Illustration 10A-5 Time diagram for a three-year annuity

The present value in this situation may be computed as follows.

Illustration 10A-6 Present value of a series of future amounts computation

We also can use annuity tables to value annuities. As illustrated in Table 10A-2 below, these tables show the present value of 1 to be received periodically for a given number of payments.

From Table 10A-2, you can see that the present value factor of an annuity of 1 for three payments at 10% is 2.48685.¹ This present value factor is the total of the three individual present value factors as shown in Illustration 10A-6. Applying this amount to the annual cash flow of HK$1,000 produces a present value of HK$2,486.85.

Let's now go back to our lottery example. We determined that you would get more money if you wait and take the HK$10,000,000 in three years rather than take HK$7,000,000 immediately. But, there is still another option—to receive HK$3,500,000 at the end of each year for three years (an annuity). The computation to evaluate this option (again assuming a 9% discount rate) is as follows.

Illustration 10A-7 Present value of lottery payments to be received over three years

If you take the annuity of HK$3,500,000 for each of 3 years, you will be HK$1,137,750 richer as a result.

Time Periods and Discounting

We have used an annual interest rate to determine present value. Present value computations may also be done over shorter periods of time, such as monthly, quarterly, or semiannually. When the time frame is less than one year, it is necessary to convert the annual interest rate to the shorter time frame.

Assume, for example, that the investor in Illustration 10A-6 received HK$500 semiannually for three years instead of HK$1,000 annually. In this case, the number of payments becomes 6 (3 × 2), the interest rate is 5% (10% ÷ 2), the present value factor from Table 10A-2 is 5.07569, and the present value of the future cash flows is HK$2,537.85 (5.07569 × HK$500). This amount is slightly higher than the HK$2,486.86 computed in Illustration 10A-6 because interest is computed twice during the same year. That is, interest is earned on the first half year's interest.

Computing the Market Price of a Bond

The present value (or market price) of a bond is a function of three variables: (1) the payment amounts, (2) the length of time until the amounts are paid, and (3) the interest (discount) rate.

The first variable (amount to be paid) is made up of two elements: (1) a series of interest payments (an annuity) and (2) the principal amount (a single sum). To compute the present value of the bond, we must discount both the interest payments and the principal amount.

When the investor's interest (discount) rate is equal to the bond's contractual interest rate, the present value of the bonds will equal the face value of the bonds. To illustrate, assume the bond issue of 10%, five-year bonds with a face value of €100,000 with interest payable semiannually on January 1 and July 1, which was issued by Candlestick, Inc. on January 1, 2014 (see page 472). If the discount rate is the same as the contractual rate, the bonds will sell at face value. In this case, the investor will receive (1) €100,000 at maturity and (2) a series of ten €5,000 interest payments [€100,000 × (10% ÷ 2)] over the term of the bonds. The length of time is expressed in terms of interest periods (in this case, 10) and the discount rate per interest period (5%). The time diagram in Illustration 10A-8 depicts the variables involved in this discounting situation.

Illustration 10A-8 Time diagram for the present value of a 10%, five-year bond paying interest semiannually

The computation of the present value of Candlestick's bonds, assuming they were issued at face value (page 472), is shown below.

Illustration 10A-9 Present value of principal and interest (face value)

Now assume that the investor's required rate of return is 12%, not 10%. The future amounts are again €100,000 and €5,000, respectively. But now we must use a discount rate of 6% (12% ÷ 2). The present value of Candlestick's bonds issued at a discount (page 473) is €92,639 as computed below.

Illustration 10A-10 Present value of principal and interest (discount)

If the discount rate is 8% and the contractual rate is 10%, the present value of Candlestick's bonds issued at a premium (page 474) is €108,111, computed as shown in Illustration 10A-11 (page 488).

Illustration 10A-11 Present value of principal and interest (premium)

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 10A

9 Compute the market price of a bond. Time value of money concepts are useful for pricing bonds. The present value (or market price) of a bond is a function of three variables: (1) the payment amounts, (2) the length of time until the amounts are paid, and (3) the interest rate.

APPENDIX 10B EFFECTIVE-INTEREST METHOD OF BOND AMORTIZATION

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, 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.

1. Compute the bond interest expense. To do so, multiply the carrying value of the bonds at the beginning of the interest period by the effective-interest rate.
2. Compute the bond interest paid (or accrued). To do so, multiply the face value of the bonds by the contractual interest rate.
3. Compute the amortization amount. To do so, determine the difference between the amounts computed in steps (1) and (2).

Illustration 10B-1 depicts these steps.

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

Amortizing Bond Discount

To illustrate the effective-interest method of bond discount amortization, assume that Candlestick, Inc. issues €100,000 of 10%, five-year bonds on January 1, 2014, with interest payable each July 1 and January 1, when the market rate is 12% (pages 473–474). The bonds sell for €92,639 (92.639% of face value). This sales price results in a bond discount of €7,361 (€100,000 − €92,639) and an effective-interest rate of 12%. A bond discount amortization schedule, as shown in Illustration 10B-2, facilitates the recording of interest expense and the discount amortization. Note that interest expense as a percentage of carrying value remains constant at 6%.

Illustration 10B-2 Bond discount amortization schedule

We have highlighted columns (A), (B), and (C) in the amortization schedule to emphasize their importance. These three columns provide the numbers for each period's journal entries. They are the primary reason for preparing the schedule.

For the first interest period, the computations of interest expense and the bond discount amortization are:

Illustration 10B-3 Computation of bond discount amortization

Candlestick records the payment of interest and amortization of bond discount on July 1, 2014, as follows.

For the second interest period, bond interest expense will be €5,592 (€93,197 × 6%), and the discount amortization will be €592. At December 31, Candlestick makes the following adjusting entry.

Total interest expense for 2014 is €11,150 (€5,558 + €5,592). On January 1, Candlestick records payment of the interest by a debit to Interest Payable and a credit to Cash.

Amortizing Bond Premium

The amortization of bond premium by the effective-interest method is similar to the procedures described for bond discount. For example, assume that Candlestick, Inc. issues €100,000, 10%, five-year bonds on January 1, 2014, with interest payable on July 1 and January 1, when the market rate is 8% (pages 474–475). In this case, the bonds sell for €108,111. This sales price results in bond premium of €8,111 and an effective-interest rate of 8%. Illustration 10B-4 shows the bond premium amortization schedule.

Illustration 10B-4 Bond premium amortization schedule

For the first interest period, the computations of interest expense and the bond premium amortization are:

Illustration 10B-5 Computation of bond premium amortization

Candlestick records payments on the first interest date as follows.

For the second interest period, interest expense will be €4,297, and the premium amortization will be €703. Total bond interest expense for 2014 is €8,621 (€4,324 + €4,297).

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 10B

10 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.

GLOSSARY FOR APPENDIX 10B

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. 488).

APPENDIX 10C STRAIGHT-LINE AMORTIZATION

Amortizing Bond Discount

The effective-interest method, presented in Appendix 10B, 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 10C-1.

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

In the Candlestick, Inc. example (pages 473–475), the company sold €100,000, five-year, 10% bonds on January 1, 2014, for €92,639. This price resulted in a €7,361 bond discount (€100,000 − €92,639). Interest is payable on July 1 and January 1. The bond discount amortization for each interest period is €736 (€7,361 ÷ 10). Candlestick records the payment of bond interest and the amortization of bond discount on the first interest date (July 1, 2014) as follows.

At December 31, Candlestick makes the following adjusting entry.

Over the term of the bonds, the balance in Bonds Payable will increase annually by the same amount until it equals the face value at maturity.

It is useful to prepare a bond discount amortization schedule as shown in Illustration 10C-2. The schedule shows interest expense, discount amortization, and the carrying value of the bond for each interest period. As indicated, the interest expense recorded each period for the Candlestick bond is €5,736. Also note that the carrying value of the bond increases €736 each period until it reaches its face value €100,000 at the end of period 10.

Illustration 10C-2 Bond discount amortization schedule

We have highlighted columns (A), (B), and (C) in the amortization schedule to emphasize their importance. These three columns provide the numbers for each period's journal entries. They are the primary reason for preparing the schedule.

Amortizing Bond Premium

The amortization of bond premium parallels that of bond discount. Illustration 10C-3 presents the formula for determining bond premium amortization under the straight-line method.

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

Continuing our example, assume that Candlestick sells the bonds for €108,111 rather than €92,639 (pages 474–475). This sale price results in a bond premium of €8,111 (€108,111 − €100,000). The bond premium amortization for each interest period is €811 (€8,111 ÷ 10). Candlestick records the first payment of interest on July 1 as follows.

At December 31, the company makes the following adjusting entry.

Over the term of the bonds, the balance in Bonds Payable will decrease annually by the same amount until it equals the face value at maturity.

It is useful to prepare a bond premium amortization schedule as shown in Illustration 10C-4. It shows interest expense, premium amortization, and the carrying value of the bond. The interest expense recorded each period for the Candlestick bond is €4,189. Also note that the carrying value of the bond decreases €811 each period until it reaches its face value of €100,000 at the end of period 10.

Illustration 10C-4 Bond premium amortization schedule

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 10C

11 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.

GLOSSARY FOR APPENDIX 10C

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. 492).

APPENDIX 10D PAYROLL-RELATED LIABILITIES

Every employer incurs liabilities relating to employees' salaries and wages. One is the amount of salaries and wages owed to employees—salaries and wages payable. Another is the amount required by law to be withheld from employees' gross pay. Until a company remits these withholding taxes (U.S. federal and state income taxes, and Social Security taxes) to the governmental taxing authorities, they are credited to appropriate liability accounts. For example, if a corporation withholds taxes from its employees' wages and salaries, it would record accrual and payment of a $100,000 payroll, as shown on the next page.

Illustration 10D-1 summarizes the types of payroll deductions.

Illustration 10D-1 Payroll deductions

Also, with every payroll, the employer incurs liabilities to pay various payroll taxes levied upon the employer. These payroll taxes include the employer's share of Social Security taxes and the state and federal unemployment taxes. Based on the $100,000 payroll in the previous example, the company would make the following entry to record the employer's expense and liability for these payroll taxes.

Illustration 10D-2 shows the types of taxes levied on employers.

Illustration 10D-2 Employer payroll taxes

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 F.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 10D

12 Prepare entries for payroll and payroll taxes under U.S. law. Until employee withholding taxes are remitted to governmental taxing authorities, they are credited to appropriate liability accounts. The company must also account for payroll taxes it incurs. These include social security taxes and state and federal unemployment taxes.