Chapter 7 liability

OPEN UNIVERSITY HCMC MBA PREPARATORY COURSE Principles of Financial Accounting Lecturer: NGUYEN TAN BINH 06/04/16 NGUYEN TAN BINH - PHAN DUC DUNG Chapter Liabilities and Interest 06/04/16 NGUYEN TAN BINH - PH Learning Objectives After studying this chapter, you should be able to:        Account for current liabilities Design an internal control system for cash disbursements Explain simple long-term liabilities Relate bond covenants to the riskiness of a bond Interpret deferred tax liabilities Locate and understand the contingent liabilities information in a company’s financial statements Use ratio analysis to assess a company’s debt levels 06/04/16 NGUYEN TAN BINH - PH Liabilities in Perspective   Liabilities are a company’s obligations to pay cash or to provide goods and services to other companies or individuals Accrual accounting recognizes expenses when they occur rather than when they are paid  When an expense is recognized before it is paid, a liability is created 06/04/16 NGUYEN TAN BINH - PH Liabilities in Perspective  Liabilities are important to investors, financial analysts, management, and creditors  Excess liabilities often cause investors and creditors to stay away from the company with the excess liabilities 06/04/16 NGUYEN TAN BINH - PH Liabilities in Perspective  Liabilities are classified as either current or long term to help readers interpret the immediacy of a company’s obligations   Current liabilities - obligations that fall due within the coming year or within the company’s normal operating cycle Long-term liabilities - obligations that fall due beyond one year from the balance sheet date  If long-term liabilities are paid gradually, the portion that comes due within the year becomes a current liability 06/04/16 NGUYEN TAN BINH - PH Liabilities in Perspective   In the general ledger, each liability (wages, salaries, interest, etc.) is kept in a different account However, in the financial statements, liabilities may be combined and shown as a single amount  The terms “accrued” or “payable” may sometimes be used to denote liabilities 06/04/16 NGUYEN TAN BINH - PH Liabilities in Perspective  Presentation of liabilities in the balance sheet: Current liabilities Current maturities of long-term debt Accounts payable Wages payable Interest payable Total current liabilities 06/04/16 NGUYEN TAN BINH - PH $19,500 26,250 1,750 2,500 $50,000 Accounting for Current Liabilities  Not all current liabilities are recorded the same way   Some are the result of a transaction with a third party, such as a supplier or a lender Some are the result of an adjusting journal entry made to acknowledge an obligation arising over time, such as interest or wages 06/04/16 NGUYEN TAN BINH - PH Accounts Payable   Accounts payable (or trade accounts payable) are amounts owed to suppliers Large sums of money flow through accounts payable systems, so data-processing and internal control systems are carefully designed for accounts payable  The company must ensure that checks are written only for legitimate obligations of the company 06/04/16 NGUYEN TAN BINH - PH 10 Notes Payable  Rather than having to apply for many small loans at different times, companies obtain lines of credit with lenders  Line of credit - an agreement with a bank to automatically provide short-term loans up to some preestablished maximum   The lender does not have to extensive paperwork or credit checks every time a borrower needs money The borrower has a preset amount of borrowing available 06/04/16 NGUYEN TAN BINH - PH 12 Notes Payable   Companies sometimes borrow directly from investors in the form of commercial paper Commercial paper - a short-term debt contract issued by prominent companies that borrow directly from investors  These liabilities usually fall due within months, often within 60 days 06/04/16 NGUYEN TAN BINH - PH 13 Current Portion of Long-Term Debt   If long-term liabilities are paid gradually, the portion that comes due within the year becomes a current liability The journal entry to reclassify a liability is: Long-term debt Current portion of long-term debt xxxx 06/04/16 NGUYEN TAN BINH - PH xxxx 14 Internal Controls Over Payables  Since huge sums of money flow through payables systems, good internal control must be present to ensure that all payments involve properly approved and valid obligations of the company   Most disbursement systems require payments to be made only by checks because the prenumbered checks make record keeping easier All checks issued must be supported by source documents 06/04/16 NGUYEN TAN BINH - PH 15 Internal Control Over Payables  Before a check can be written, a series of source documents must be completed to document the obligation    Purchase order - a document that specifies the items ordered and the price to be paid by the company Receiving report - a document that specifies the items received by the company and their condition Invoice - a bill from the seller to a buyer indicating the number of items shipped, their prices, any additional costs such as shipping, and payment terms 06/04/16 NGUYEN TAN BINH - PH 16 Long-Term Liabilities  Some long-term liabilities are much like some shortterm liabilities except for the time frame   Car loans or mortgage loans are much like notes payable, but they are for a longer term As time passes, payments of interest and principal eliminate the loan obligation 06/04/16 NGUYEN TAN BINH - PH 17 Long-Term Liabilities  Illustration and analysis of a loan:   Assume that $10,000 is borrowed at 10% interest The yearly payment is to be $3,154.71 for four years on December 31 of each year The total repayment amount is $12,618.83, which consists of the $10,000 principal plus $2,618.83 in interest 06/04/16 NGUYEN TAN BINH - PH 18 Bonds and Notes  Both bonds and notes are legal contracts that specify how much is to be borrowed and the dates and amounts for repayment by the borrower  Notes and bonds are called negotiable financial instruments because they can be transferred from one lender to another  Some bonds and notes are private placements, which means that only a few sources of borrowing are used rather than the general public 06/04/16 NGUYEN TAN BINH - PH 19 Bonds and Notes  Bond - a formal certificate of indebtedness that is typically accompanied by (1) a promise to pay interest in cash at a specified annual rate plus (2) a promise to pay the principal at a specific maturity date   The interest rate is often called the nominal interest rate, contractual rate, coupon rate, or stated rate The principal amount is also known as the face amount 06/04/16 NGUYEN TAN BINH - PH 20 Bonds and Notes  Interest rate - the percentage applied to a principal amount to calculate the amount of interest that must be paid on the loan   Interest represents the return the lender can earn for loaning money In general, riskier loans demand higher interest rates 06/04/16 NGUYEN TAN BINH - PH 21 Bond Accounting  On December 31, 2000, a company issued $10,000,000 in 2year, 10% bonds Interest is to be paid semiannually on June 30 and December 31 Assuming that the bonds are held to maturity, the journal entries are: To record the issuance of the bonds Cash 10,000,000 Bonds payable 10,000,000 To record the payments of the semiannual interest Interest expense 500,000 Cash (($10,000,000 x 10%) / 2) 500,000 To record the repayment of principal at maturity Bonds payable 10,000,000 Cash 10,000,000 06/04/16 NGUYEN TAN BINH - PH 22 Debt Ratios and Interest-Coverage Ratios  Debt ratios are used to measure the extent to which a company has used borrowing to finance its activities  The more borrowing, and the less equity, the riskier it is to lend money to a firm 06/04/16 NGUYEN TAN BINH - PH 23 Debt Ratios and Interest-Coverage Ratios Total liabilities Debt-to= equity ratio Total shareholders' equity Long-termTotal long-term debt debt-to-total- = Total shareholders’ equity + long-term debt capital ratio 06/04/16 NGUYEN TAN BINH - PH 24 Debt Ratios and Interest-Coverage Ratios Debt-toTotal liabilities total-assets = Total assets ratio InterestPretax income + Interest expense coverage = Interest expense ratio 06/04/16 NGUYEN TAN BINH - PH 25 Debt Ratios and Interest-Coverage Ratios   The first three ratios are alternative ways of expressing what part of a firm’s resources is obtained by borrowing and what part is invested by owners The interest-coverage ratio measures the firm’s ability to meet its interest obligations References: Horngren, Introduction to financial accounting 06/04/16 NGUYEN TAN BINH - PH 26 [...]... days 06/04/16 NGUYEN TAN BINH - PH 13 Current Portion of Long-Term Debt   If long-term liabilities are paid gradually, the portion that comes due within the year becomes a current liability The journal entry to reclassify a liability is: Long-term debt Current portion of long-term debt xxxx 06/04/16 NGUYEN TAN BINH - PH xxxx 14 Internal Controls Over Payables  Since huge sums of money flow through payables... a longer term As time passes, payments of interest and principal eliminate the loan obligation 06/04/16 NGUYEN TAN BINH - PH 17 Long-Term Liabilities  Illustration and analysis of a loan:   Assume that $10,000 is borrowed at 10% interest The yearly payment is to be $3,154 .71 for four years on December 31 of each year The total repayment amount is $12,618.83, which consists of the $10,000 principal