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McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 10
Reporting and Interpreting Liabilities

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Fred Phillips, Ph.D., CA

Learning Objective 1

Explain the role of liabilities in financing a business.

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The Role of Liabilities


Liabilities are created when a company:
Buys goods and services on credit Obtains short-term loans Issues long-term debt

Current liabilities are short-term obligations that will be paid with current assets within the companys current operating cycle or within one year of the balance sheet date, whichever is longer.
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The Role of Liabilities


The liability section of the General Mills 2007 and 2008 comparative balance sheets.

10-5

Learning Objective 2

Explain how to account for common types of current liabilities.

10-6

Measuring Liabilities
Initial Amount of the Liability Cash Equivalent

Additional Liability Amounts

Increase Liability

Payments Made

Decrease Liability

10-7

Current Liabilities
Accounts Payable
Increases (Credited) Decreases (Debited)

when a company receives goods or services on credit

when a company pays on its account

Accrued Liabilities
Liabilities that have been incurred but not yet paid.

10-8

Accrued Payroll
1. Payroll Deductions create a current liability for the requested by employees and
company. Examples include: 1. Income tax 2. Employer Payroll Taxes 2. FICA tax 3. Other deductions (charitable donations, union dues, etc.)

Payroll Liabilities Payroll Deductionsor voluntarily Payroll deductions are either required by law

10-9

Accrued Payroll

Gross Pay Payroll Deductions: Federal Income Taxes FICA Taxes Other Total Payroll Deductions Net Pay
10-10

$ 600.00 $ 58.00 48.80 10.00 116.80 $ 483.20

Accrued Payroll
Adam Palmer earned gross pay of $600 in the current payroll period. General Mills withheld $58 in Federal income taxes, $48.80 for FICA, and $10 for United Way, resulting in net pay of $483.20.

Analyze
Assets = Liabilities + Stockholders' Equity Cash (-A) -$483.20 FIT Withheld (+L) +$58.00 Payroll Expense FICA Payable (+L) +$48.80 (+E, -SE) -$600.00 United Way (+L) +$10.00

Record
dr Wages and Salaries Expense (+E, -SE) cr Withheld Income Taxes Payable (+L) cr FICA Payable (+L) cr United Way Payable (+L) cr Cash (-A) 600.00 58.00 48.80 10.00 483.20

10-11

Accrued Payroll
Employer Payroll Taxes
Employers have other liabilities related to payroll. 1. FICA tax (a matching contribution) 2. Federal unemployment tax 3. State unemployment tax

Assume General Mills was required to contribute $16,400 for FICA, $250 for federal unemployment tax, and $1,350 for state unemployment tax. 1 Analyze
Assets = Liabilities + Stockholders' Equity FICA Payable (+L) +16,400 Payroll Tax Expense FUTA Payable (+L) +250 (+E, -SE) -18,000 SUTA Payable (+L) +1,350

Record
dr Payroll Tax Expense (+E, -SE) cr FICA Tax Payable (+L) cr Federal Unemployment Tax Payable (+L) cr State Unemployment Tax Payable (+L) 18,000 16,400 250 1,350

10-12

Accrued Income Taxes


Corporations calculate taxable income by subtracting tax-allowed expenses from revenues. This taxable income is then multiplied by a tax rate, which for most large corporations is about 35 percent. General Mill calculated taxable income to be $1,000,000, and is subject to a 35% tax rate, so income taxes owed are $350,000 ($1,000,000 35%)

1 Analyze
Assets = Liabilities Income Tax Payable (+L) +350,000 + Stockholders' Equity Income Tax Expense (+E, -SE) +350,000

Record
dr Income Tax Expense (+E, -SE) cr Income Tax Payable (+L) 350,000 350,000

10-13

Notes Payable
Four key events occur with any note payable: 1. establishing the note, 2. accruing interest incurred but not paid, 3. recording interest paid, and 4. recording principal paid.

10-14

Notes Payable
1. Establish the note on November 1, 2009.
Assume that on November 1, 2009, General Mills borrowed $100,000 cash on a one-year note that required General Mills to pay 6 percent interest and $100,000 principal, both on October 31, 2010. 1 Analyze
Assets Cash (+A) $100,000 = Liabilities Notes Payable (+L) $100,000 + Stockholders' Equity

Record
dr Cash (+A) cr Notes Payable (+L) 100,000 100,000

10-15

Notes Payable
2. Accrue interest owed but not paid on December 31, 2009. $100,000 6% 2/12 = $1,000 accrued interest
1 Analyze
Assets = Liabilities Interest Payable (+L) $1,000 + Stockholders' Equity Interest Expense (+E, -SE) $1,000

Record
dr Interest Expense (+E, -SE) cr Interest Payable (+L) 1,000 1,000

10-16

Notes Payable
3. Record interest paid on October 31, 2010.
$100,000 6% 12/12 = $6,000 interest paid
1 Analyze
Assets Cash (-A) -$6,000 = Liabilities Interest Payable (-L) -$1,000 + Stockholders' Equity Interest Expense (+E, -SE) $5,000

Record
dr dr Interest Expense (+E, -SE) Interest Payable (-L) cr Cash (-A) 5,000 1,000 6,000

10-17

Notes Payable
4. Record principal paid of $100,000 on October 31, 2010.
1 Analyze
Assets = Liabilities Cash (-A) -$100,000 NotePayable (-L) -$100,000 + Stockholders' Equity

Record
dr Note Payable (-L) cr Cash (-A) 100,000 100,000

10-18

Current Portion of Long-Term Debt


Long-Term Debt

Current Portion of Long-term Debt

Noncurrent Portion of Long-term Debt

Borrowers must report in Current Liabilities the portion of long-term debt that is due to be paid within one year.

10-19

Additional Current Liabilities


Sales Tax Payable
Payments collected from customers at time of sale create a liability that is due to the state government.

Unearned Revenue

Cash received in advance of providing services creates a liability of services due to the customer .

10-20

Additional Current Liabilities


Best Buy sells a television for $1,000 cash plus 5 percent sales tax. $1,000 5% = $50 sales tax collected
1 Analyze
Assets Cash (+A) +$1,050 = Liabilities + Stockholders' Equity Sales Tax Payable (+L) +$50 Sales Revenue (+R, +SE)

Record
dr Cash (+A) cr Sales Tax Payable (+L) cr Sales Revenue (+R, +SE) 1,050 50 1,000

When Best Buy pays the sales tax to the state government, its accountants will reduce Sales Tax Payable (with a debit) and reduce Cash (with a credit).
10-21

Additional Liabilities
On October 1 IAC, an internet provider, received $30 cash for threemonths of internet access, paid in advance.
1 Analyze
Assets Cash (+A) +$30 = Liabilities Unearned Revenue (+L) $30 + Stockholders' Equity

Record
dr Cash (+A) cr Unearned Revenue (+L) 30 30

10-22

Additional Liabilities
At the end of October, IAC provided one month of internet service to its customer. $30 3 months = $10 per month
1 Analyze
Assets = Liabilities Unearned Revenue (-L) $10 + Stockholders' Equity Subscription Revenue (+R, +SE) $10

Record
dr Unearned Revenue (-L) cr Subscription Revenue (+R, +SE) 10 10

10-23

Learning Objective 3

Analyze and record bond liability transactions.

10-24

Long-Term Liabilities
Common Long-Term Liabilities 1. Long-term notes payable 2. Deferred income taxes 3. Bonds payable Bonds are financial instruments that outline the future payments a company promises to make in exchange for receiving a sum of money now.

10-25

Bonds
Key Elements of a Bond 1. Maturity date 2. Face value 3. Stated interest rate
Interest Computation 12 $1,000 6% 12 = $60

Bond Pricing The bond price involves present value computations and is the amount that investors are willing to pay on the issue date for the bonds.
10-26

Bonds
Balance Sheet Reporting of Bond Liability

Relationships between Interest Rates and Bond Pricing

10-27

Bonds
Bonds Issued at Face Value
General Mills receives $100,000 cash in exchange for issuing 100 bonds at their $1,000 face value, so the bonds are issued at total face value (1,000 $1,000 = $100,000).
1 Analyze
Assets = Liabilities + Stockholders' Equity Cash (+A) +$100,000 Bonds Payable (+L) $100,000

Record
dr Cash (+A) cr Bonds Payable (+L) 100,000 100,000

10-28

Bonds
Bonds Issued at a Premium
General Mills issues 100 of its $1,000 bonds at a price of 107.26 percent of face value, the company will receive $107,260 (100 $1,000 1.0726).
1 Analyze
Assets = Liabilities + Stockholders' Equity Cash (+A) +$107,260 Bonds Payable (+L) $100,000 Premium on Bonds Payable (+L) $7,260

Record
dr Cash (+A) cr Bonds Payable (+L) cr Premium on Bonds Payable (+L) 107,260 100,000 7,260

10-29

Bonds
Bonds Issued at a Discount
General Mills receives $93,376 for bonds with a total face value of $100,000, the cash-equivalent amount is $93,376, which represents the liability on that date. These bonds are issued at a discount because the cash received is less than the face value of the bonds.
1 Analyze
Assets = Liabilities + Stockholders' Equity Cash (+A) +$93,376 $100,000 Bonds Payable (+L) $100,000 - $93,376 = $6,624 discount Discount on Bonds Payable (+xL, -L) $6,624

Record
dr dr Cash (+A) Discount on Bonds Payable (+xL, -L) cr Bonds Payable (+L) 93,376 6,624 100,000

10-30

Interest on Bonds Issued at Face Value


General Mills issues bonds on January 1, 2010, at their total face value of $100,000. The bonds have an annual stated interest rate of 6 percent payable in cash on December 31 of each year, General Mills will need to accrue an expense and liability for interest at the end of each accounting period. The end of the first accounting period is January 31, 2010.
1 Analyze
Assets

$100,000 6% 1/12 = $500 interest


= Liabilities + Stockholders' Equity Interest Payable (+L) $500 Interest Expense (+E, -SE) $500

Record
dr Interest Expense (+E, -SE) cr Interest Payable (+L) 500 500

10-31

Interest on Bonds Issued at a Premium


Cash proceeds > Face value Cash proceeds Face value = Premium Interest expense < Cash interest paid Interest expense = Cash interest paid Premium amortization

10-32

Interest on Bonds Issued at a Discount


Cash proceeds < Face value Face value Cash proceeds = Discount Interest expense > Cash interest paid Interest expense = Cash interest paid+ Discount amortization

10-33

Bond Retirement
General Mills bonds were retired with a payment equal to their $100,000 face value. Lets analyze and record this transaction.
1 Analyze
Assets = Liabilities + Stockholders' Equity Cash (-A) -$100,000 Bonds Payable (-L) $100,000

Record
dr Bonds Payable (-L) cr Cash (-A) 100,000 100,000

10-34

Bond Retirement
The early retirement of bonds has three financial effects. The company 1. pays cash, 2. eliminates the bond liability, and 3. reports either a gain or a loss. Assume that in 2000, General Mills issued $100,000 of bonds at face value. Ten years later, in 2010, the company retired the bonds early. At the time, the bond price was 103, so General Mills made a payment of $103,000. 1 Analyze Cash Payment $103,000

Assets = Liabilities + Stockholders' Equity Carrying Value 100,000 Cash (-A) -$103,000 Bonds Payable (-L) $100,000 Loss on Bond Loss on Retirement $3,000 Retirement (+E, -SE) $3,000

Record
dr dr Bonds Payable (-L) Loss on Bond Retirement (+E, -SE) cr Cash (-A) 100,000 3,000 103,000

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Learning Objective 4

Describe how to account for contingent liabilities.

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Contingent Liabilities
Contingent liabilities are potential liabilities that arise from past transactions or events, but their ultimate resolution depends (is contingent) on a future event.

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Learning Objective 5

Calculate and interpret the quick ratio and the times interest earned ratio.

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Evaluate the Results


Two financial ratios are commonly used to assess a companys ability to generate resources to pay future amounts owed: 1. Quick ratio 2. Times interest earned ratio
Quick Ratio =

(Cash + Short-term Investments + Accounts Receivable, Net) Current Liabilities

Times Interest = Earned Ratio

(Net Income + Interest Expense + Income Tax Expense) Interest Expense

10-39

Evaluate the Results


In 2008, General Mills reported $661 million of cash and cash equivalents, no short-term investments, and $1,082 million of net accounts receivable. The company reported $4,856 million in total current liabilities. (Cash + Short-term Investments + Accounts Receivable, Net) Current Liabilities

Quick Ratio =

$661 + 0 + 1,082 4,856

0.359

A quick ratio of 0.359 implies that General Mills would be able to pay only 35.9 percent of its current liabilities, if forced to pay them immediately. However, not all current liabilities are to be paid immediately.

10-40

Evaluate the Results


In 2008, General Mills reported net income of $290 million and interest expense of $100 million, and income tax expense of $230 million. Lets calculate the times interest earned for 2008.

Times Interest = Earned Ratio

(Net Income + Interest Expense + Income Tax Expense) Interest Expense

$290 + $100 + $230 $100

6.20 times

The ratio means that General Mills generates $6.20 of income (before the costs of financing and taxes) for each dollar of interest expense. No doubt this ratio is part of the reason that General Mills has earned a favorable credit rating of BBB+.
10-41

Chapter 10 Supplement 10A


Straight-Line Method of Amortization

Bond Premium
Bond premium or discount decreases each year, until it is completely eliminated on the bonds maturity date. This process is called amortizing the bond premium or discount. The straight-line method of amortization reduces the premium or discount by an equal amount each period. Recall our example when General Mills received $107,260 on the issue date (January 1, 2010) but repays only $100,000 at maturity (December 31, 2013). Under the straight-line method, this $7,260 is spread evenly as a reduction in interest expense over the four years ($7,260 4 = $1,815 per year).

1 Analyze

Cash Interest Liabilities $6,000 Assets = + Stockholders' Equity Amortization of Premium (1,815) Cash (-A) -$6,000 Premium on Bonds Payable Interest Expense (-L) (+E, Interest Expense -$1,815 $4,185 -SE) $4,185

Record
dr dr Interest Expense (+E, -SE) Premium on Bonds Payable (-L) cr Cash (-A) 4,185 1,815 6,000

10-43

Bond Premium
Amortization Schedule of Bonds Issued at a Premium

$7,260 - $1,815 = $5,445 $7,260 4 = $1,815 $100,000 6% 12/12 = $6,000 $107,260 $1,815 = $105,445 $6,000 - $1,815 = $4,185

Notice that each of these amounts would plot as a straight-line!


10-44

Bond Discount
Recall our example where General Mills received $93,376 for four-year bonds with a total face value of $100,000, implying a discount of $6,624. The annual amortization of the discount is $1,656 ($6,624 4).
1 Analyze

Cash Interest Liabilities $6,000 Assets = + Stockholders' Equity Amortizationon Bonds Payable 1,656 Cash (-A) -$6,000 Discont of Discount Interest Expense (-xL, +L) -1,656 (+E, Interest Expense $7,656 -SE) +$7,656

Record
dr Interest Expense (+E, -SE) cr Discount on Bonds Payable (-xL, +L) cr Cash (-A) 7,656 1,656 6,000

10-45

Bond Discount
Amortization Schedule of Bonds Issued at a Discount

$6,624 - $1,656 = $4,968 $6,624 4 = $1,656 $100,000 6% 12/12 = $6,000 $93,376 + $1,656 = $95,032 $6,000 + $1,656 = $7,656

10-46

Chapter 10 Supplement 10B


Effective-Interest Method of Amortization

Effective Interest Amortization


The effective-interest method of amortization is considered a conceptually superior method of accounting for bonds because it correctly calculates interest expense by multiplying the market interest rate times the carrying value of the bonds. When General Mills adds this $7,260 premium to the $100,000 face value, it reports a carrying value of $107,260 ($100,000 + $7,260) on January 1, 2010. The proceeds indicates that the market interest rate was 4 percent. Interest (I) = Principal (P) Rate (R) Time (T) Interest Expense = Carrying Value Market Rate n/12 $4,290 = $107,260 4% 12/12

10-48

Effective Interest Amortization


General Mills issued 6% stated rate bonds for $107,260. The market rate of interest on these bonds is 4%. The face amount of the bonds, $100,000, results in cash interest is $6,000 ($100,000 6%). Lets amortize the premium on the bonds at the first interest payment date. 1 Analyze

Interest (I) = Principal (P) Rate (R)+ Stockholders' Equity Time (T) Assets = Liabilities CashInterest Expense = Carrying Value Market Rate n/12 (-A) -$6,000 Premium on Bonds Payable Interest Expense (-L) +1,710 (+E, +$4,290 $4,290 = $107,260 4% 12/12 -SE)

Record
dr dr

Interest Expense (+E, -SE) Effective Interest 4,290 Premium on Bonds Payable (-L) Amortization of Premium $1,710 cr Cash (-A)

Cash Interest

$ 6,000

4,290 1,710 6,000

10-49

Effective Interest Amortization


$6,000 - $4,290 = $1,710 $7,290 - $1,710 = $5,550

Effective Interest Amortization of Bonds Issued at a Premium

$107,260 4% 12/12 = $4,290 $100,000 6% 12/12 = $6,000 $107,260 - $1,710 = $105,550

Interest Expense decreases and Premium Amortization increases each period. Cash interest is unchanged.
10-50

Effective Interest Amortization


General Mills issued $100,000 face value, 6%, 4-year bonds at a market price to yield investors 8%. The bonds were issued at a discount of $6,624. Lets determine the effective interest for the first interest payment period.

1 Analyze

Interest (I) = Principal (P) Rate (R)+ Stockholders' Equity Time (T) Assets = Liabilities CashInterest Expense = Carrying Value Market Rate n/12 (-A) -$6,000 Discount on Bonds Payable Interest Expense $7,470 = $93,376 8% 12/12 -SE) (-xL, +L) +1,470 (+E, $7,470

Record
dr

Interest Expense (+E, -SE) Effective Interest 7,470 7,470 cr Discount on Bonds Payable (+xL, -L) 1,470 Amortization of Discount $ cr Cash (-A)

Cash Interest

$ 6,000

1,470 6,000

10-51

Effective Interest Amortization


$7,470 - $6,000 = $1,470 $7,470 - $1,470 = $5,154

Effective Interest Amortization of Bonds Issued at a Discount

$93,376 8% 12/12 = $7,470 $100,000 6% 12/12 = $6,000 $93,376 + $1,470 = $94,846

Both Interest Expense and Discount Amortization increase each period. Cash interest is unchanged.
10-52

Chapter 10 Supplement 10C


Simplified Effective-Interest Amortization

Accounting for Bond Issue.


The shortcut method records the bonds at issuance at Bonds Payable, Net. That is face amount less discount or face amount plus premium. The following journal entries demonstrate how the shortcut is applied to bonds issued at a premium, at face value, and at a discount.
Description dr Cash (+A) cr Bonds Payable, Net (+L)
Bonds i s s ued a t a premi um

Debit 107,260

Credit 107,260

dr Cash (+A) cr Bonds Payable, Net (+L)


Bonds i s s ued a t fa ce a mount

100,000 100,000

dr Cash (+A) cr Bonds Payable, Net (+L)


Bonds i s s ued a t a di s count

93,376 93,376

10-54

Bond Premium
Interest (I) = Principal (P) Rate (R) Time (T) Interest Expense = Bonds Payable, Net Market Rate n/12 Interest Expense $4,290 = $107,260 4% 12/12

1 Analyze
Assets Cash (-A) -$6,000 = Liabilities Bonds Payable, Net (-L) -$1,710 + Stockholders' Equity Interest Expense (+E, -SE) -$4,290

Record
dr dr Interest Expense (+E, -SE) Bonds Payable, Net (-L) cr Cash (-A) 4,290 1,710 6,000

10-55

Bond Discount
Interest (I) = Principal (P) Rate (R) Time (T) Interest Expense = Bonds Payable, Net Market Rate n/12 Interest Expense $7,470 = $93,376 8% 12/12

1 Analyze
Assets Cash (-A) -$6,000 = Liabilities + Stockholders' Equity Bonds Payable, Net (+L) +$1,470 Interest Expense (+E, -SE) -$7,470

Record
dr Interest Expense (+E, -SE) cr Bonds Payable, Net (+L) cr Cash (-A) 7,470 1,470 6,000

10-56

Chapter 10 Solved Exercises


M10-5, E10-2, E10-3, E10-8, E10-10, PA10-3

M10-5 Reporting Current and Noncurrent Portions of Long-Term Debt Assume that on December 1, 2010, your company borrowed $14,000, a portion of which is to be repaid each year on November 30. Specifically, your company will make the following principal payments: 2011, $2,000; 2012, $3,000; 2013, $4,000; and 2014, $5,000. Show how this loan will be reported in the December 31, 2011 and 2010 balance sheets, assuming that principal payments will be made when required.
As of December 31, 2011 2010 Current Liabilities: Current Portion of Long-term Debt Long-term Debt Total Liabilities $ 3,000 $ 2,000

9,000 $ 12,000

12,000 $ 14,000

10-58

E10-2 Recording a Note Payable through Its Time to Maturity Many businesses borrow money during periods of increased business activity to finance inventory and accounts receivable. Target Corporation is one of Americas largest general merchandise retailers. Each Christmas, Target builds up its inventory to meet the needs of Christmas shoppers. A large portion of Christmas sales are on credit. As a result, Target often collects cash from the sales several months after Christmas. Assume that on November 1, 2010, Target borrowed $6 million cash from Metropolitan Bank and signed a promissory note that matures in six months. The interest rate was 7.5 percent payable at maturity. The accounting period ends December 31. Required: 1. Give the journal entry to record the note on November 1, 2010. 2. Give any adjusting entry required on December 31, 2010. 3. Give the journal entry to record payment of the note and interest on the maturity date, April 30, 2011, assuming that interest has not been recorded since December 31, 2010.

10-59

E10-2 Recording a Note Payable through Its Time to Maturity

November 1, 2010:

Borrowed on 6-month, 7.5%, note payable.

December 31, 2010 (end of the accounting period):

Adjusting entry for 2 months accrued interest ($6,000,000 x 7.5% x 2/12 = $75,000).

April 30, 2011 (maturity date):

Paid note plus interest at maturity.

10-60

E10-3 Recording Payroll Costs with Discussion McLoyd Company completed the salary and wage payroll for March 2010. The payroll provided the following details:
Salaries and wages earned Employee income taxes withheld FICA taxes withheld Unemployment taxes $ 230,000 50,200 16,445 1,600

Required: 1. Considering both employee and employer payroll taxes, use the preceding information to calculate the total labor cost for the company. 2. Prepare the journal entry to record the payroll for March, including employee deductions (but excluding employer payroll taxes). 3. Prepare the journal entry to record the employers FICA taxes and unemployment taxes.

10-61

E10-3 Recording Payroll Costs with Discussion


Req. 1 The total labor cost was $248,045, made up of the $230,000 in gross salaries and wages plus the $16,445 for employer FICA taxes and $1,600 for unemployment taxes.

Req. 2 March 31, 2010 dr Salaries and Wages Expense (+E, -SE) 230,000 cr Withheld Income Taxes Payable (+L) 50,200 cr FICA Taxes Payableemployees (+L) 16,445 cr Cash (-A) 163,355
Payroll for March including employee deductions.

Req. 3 March 31, 2010 dr Payroll Tax Expense (+E,-SE) cr FICA Taxes Payableemployer (+L) cr Unemployment Taxes Payable (+L)
Employer payroll taxes on March payroll.

18,045 16,445 1,600

10-62

E10-8 Preparing Journal Entries to Record Issuance of Bonds at Face Value, Payment of Interest, and Early Retirement On January 1, 2010, Innovative Solutions, Inc., issued $200,000 in bonds at face value. The bonds have a stated interest rate of 6 percent. The bonds mature in 10 years and pay interest once per year on December 31. Required: 1. Prepare the journal entry to record the bond issuance. 2. Prepare the journal entry to record the interest payment on December 31, 2010. Assume no interest has been accrued earlier in the year. 3. Assume the bonds were retired immediately after the first interest payment at a quoted price of 102. Prepare the journal entry to record the early retirement of the bonds.

10-63

E10-8 Preparing Journal Entries to Record Issuance of Bonds at Face Value, Payment of Interest, and Early Retirement

Req. 1 dr Cash (+A) 200,000 cr Bonds Payable (+L) 200,000

Req. 2

dr Interest Expense (+E, -SE) cr Cash (-A)


($200,000 x 6% x 12/12) = $12,000

12,000

12,000

Req. 3

dr Bonds Payable (-L) 200,000 dr Loss on Bonds Retired (+E, -SE) 4,000 cr Cash (-A) 204,000
($200,000 x 102%) = $204,000

10-64

E10-10 Calculating and Interpreting the Quick Ratio and Times Interest Earned Ratio
According to its Web site, Kraft Foods Inc. sells enough Kool-Aid mix to make 1,000 gallons of the drink every minute during the summer and over 560 million gallons each year. At December 31, 2008, the company reported no short-term investments but did report the following amounts (in millions) in its financial statements:
Cash and Cash Equivalents Accounts Receivable, Net Total Current Liabilities Interest Expense Income Tax Expense Net Income 2008 $ 1,244 4,704 11,044 1,240 728 2,901 2007 $ 567 5,197 17,086 604 1,002 2,590

Required: 1. Compute the quick ratio and times interest earned ratio (to two decimal places) for 2008 and 2007. 2. Did Kraft appear to have increased or decreased its ability to pay current liabilities and future interest obligations as they become due? How can you explain the seemingly conflicting findings of your ratio analysis?

10-65

E10-10 Calculating and Interpreting the Quick Ratio and Times Interest Earned Ratio
Req. 1

Req. 2

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E10-10 Calculating and Interpreting the Quick Ratio and Times Interest Earned Ratio
Req. 3 The times interest earned ratio has decreased from 6.95 to 3.93,

suggesting a decline in Krafts ability to cover its interest through profitable operations. The quick ratio has increased from 0.34 in 2007 to 0.54 in 2008, suggesting Kraft is in a better position to quickly pay its current liabilities at the end of 2008. These findings seem to conflict, but can be explained as follows. In 2008, when the economy was suffering, Kraft realized that it could no longer rely as much on obtaining short-term financing to cover cash needs. Consequently, Kraft borrowed more funds through long-term debt, which doubled the amount the company held in Cash and Cash Equivalents. Obtaining more long-term debt financing came at a cost, however, as indicated by the doubling of Interest Expense. The results of these shifts were an increase in the quick ratio (associated with the increase in Cash) and a decrease in the times interest earned ratio (associated with the increase in Interest Expense).

10-67

PA10-3 Recording and Reporting Current Liabilities During 2010, Lakeview Company completed the following two transactions. The annual accounting period ends December 31. a. On December 31, 2010, calculated the payroll, which indicates gross earnings for wages ($80,000), payroll deductions for income tax ($8,000), payroll deductions for FICA ($6,000), payroll deductions for American Cancer Society ($2,000), employer contributions for FICA (matching), state unemployment taxes ($500), and federal unemployment taxes ($100). Employees were paid in cash, but these payments and the corresponding payroll deductions and employer taxes have not yet been recorded. b. Collected rent revenue of $3,600 on December 10, 2010, for office space that Lakeview rented to another business. The rent collected was for 30 days from December 11, 2010, to January 10, 2011, and was credited in full to Rent Revenue. Required: 1. Give the journal entries to record payroll on December 31, 2010. 2. Give ( a ) the journal entry for the collection of rent on December 10, 2010, and ( b ) the adjusting journal entry on December 31, 2010. 3. Show how any liabilities related to these items should be reported on the companys balance sheet at December 31, 2010. 4. Explain why the accrual basis of accounting provides more relevant information to financial analysts than the cash basis.

10-68

PA10-3 Recording and Reporting Current Liabilities

Req. 1 dr Wage Expense (+E, -SE) 80,000 cr Withheld Income Tax Payable (+L) 8,000 cr FICA Payable (+L) 6,000 cr American Cancer Society Payable (+L) 2,000 cr Cash (-A) 64,000 dr Payroll Tax Expense (+E, -SE) 6,600 cr FICA Payable (+L) cr State Unemployment Tax Payable (+L) cr Federal Unemployment Tax Payable (+L) December 10, 2010: Req. 2 (a) dr Cash (+A) cr Rent Revenue (+R, +SE)
Collection of rent revenue for one month.

6,000 500 100

3,600 3,600

(b) December 31, 2010: dr Rent Revenue (-R, -SE) cr Unearned Rent Revenue (+L)

1,200 1,200

Earned 20 days of rent but initially recorded as if all was earned. Need to reduce revenue for 10 days unearned (10/30 x $3,600 = $1,200).
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PA10-3 Recording and Reporting Current Liabilities

Req. 3 Balance sheet at December 31, 2010: Current Liabilities: Withheld Income Taxes Payable FICA Payable American Cancer Society Payable State Unemployment Tax Payable Federal Unemployment Tax Payable Unearned Rent Revenue

8,000 12,000 2,000 500 100 1,200

Req. 4 Accrual basis accounting is beneficial to financial analysts because it records revenues when they are earned and expenses when they are incurred, regardless of when the related cash is received or paid. Cash basis accounting only records revenues when they are received and expenses when they are paid. A financial analyst is looking towards the future of the company, so it is helpful to know how much cash will be coming into and out of the company at later dates. Cash basis accounting limits financial analysts to only what has happened in prior periods and tells them very little about future events and cash flows that will affect the financial health of the company.
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End of Chapter 10

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