Liabilities

ACCOUNTING FOR CURRENT LIABILITIES

Accounting for Notes Payable

  • The previous discussion in Chapter 5 focused on the payee of notes, while this chapter emphasizes the maker of notes payable.

  • The maker (issuer) borrows money, and as evidence of the debt, issues a promissory note.

  • Example:

    • Herrera Supply Company (HSC) borrows $90,000 from the National Bank with a one-year term and annual interest rate of 9%.

    • As a result of issuing the note,

    • The liability account, Notes Payable, increases.

    • The asset account, Cash, increases.

    • This is classified as an asset source transaction and does not affect the income statement.

    • The statement of cash flows indicates a cash inflow of $90,000 from financing activities.

Financial Statements Effects

  • Cash Flow = Liabilities + Stockholders' Equity

    • Cash: $90,000

    • Notes Payable: +$90,000

    • Income Statement: Not affected

Accrued Interest Expense

  • On December 31, 2014, HSC recognizes 4 months of accrued interest expense:

    • Accrued Interest = $2,700 (calculated as $90,000 x 0.09 x (4/12)).

  • This increases the liability account, Interest Payable, and decreases Retained Earnings.

  • The income statement includes interest expense even if no cash has been paid in 2014.

Financial Statements Effects for Accrued Interest Expense

  • Cash Flow = Liabilities + Stockholders' Equity

    • Notes Payable: +$90,000

    • Interest Payable: +$2,700

    • Retained Earnings: -$2,700

    • Income Statement: Expense of $2,700

Maturity Date Entries (August 31, 2015)

  • HSC records three events on the maturity date:

    1. Recognition of interest expense accrued in 2015:

      • Interest = $5,400 (calculated as $90,000 x 0.09 x (8/12)).

    2. Cash payment for interest ($8,100 total paid, combining 2014 and 2015).

      • Cash payment reduces both Cash and Interest Payable.

      • This is classified as an asset use transaction.

    3. Repayment of principal ($90,000).

      • This is also an asset use transaction and classified as financing activities in cash flow.

Financial Statements Effects for Maturity Transactions

  • Asset and liability changes for the mentioned events are as follows:

Event

Cash Flow

Assets

Liabilities

Stockholders' Equity

Recognition of Interest

NA

NA

Int. Payable: +$5,400

-$5,400

Cash Payment

-$8,100

Cash: -$8,100

Int. Payable: -$8,100

NA

Repayment of Principal

-$90,000

Cash: -$90,000

Notes Payable: -$90,000

NA

CHECK YOURSELF 7.1

  • Example:

    • On October 1, 2014, Mellon Company issued a note payable for $24,000 at an interest rate of 4% with a four-month term.

    • Interest Expense for 2014:

    • $240 = $24,000 x 0.04 x (3/12)

    • Interest Expense for 2015:

    • $80 = $24,000 x 0.04 x (1/12)

    • Total cash outflow from operating activities in 2015: $320

Accounting for Sales Tax

  • Retail companies typically collect sales tax on items sold, which creates a current liability for the sales tax collected but not yet remitted to the state.

  • Example:

    • When HSC sells merchandise for $2,000 with a 6% sales tax:

    • Cash increases to $2,120, and Sales Tax Payable increases by $120.

Remitting Sales Tax

  • Remitting the tax represents an asset use transaction affecting Cash and Sales Tax Payable.

Contingent Liabilities

  • Defined as potential obligations from past events; their existence or amount depends on future events (e.g. lawsuits).

  • Categories include:

    1. Probable and estimable: Liability recognized in financial statements (e.g., warranties).

    2. Reasonably possible: Liability disclosed in notes but not recognized. (e.g., legal challenges)

    3. Remote: No recognition or disclosure required.

Determination of Contingent Liabilities

  • Professional judgment is needed to classify as probable, possible, or remote.

  • Differentiate contingent liabilities from general uncertainties.

Accounting for Warranty Obligations

  • Warranties ensure product quality and may require future payment for defects.

  • Event examples for warranty obligations include:

    1. Sale of merchandise under warranty increases both cash and inventory.

    2. Recognition of warranty expense increases liabilities and decreases retained earnings.

    3. Settlement of warranty claims results in cash outflow.

Financial Statements Effects for Warranty Obligations

  • Effect of warranty transactions on the balance sheet and cash flows need proper recognition throughout the year.

Summary of Current Liabilities and Long-term Debt

  • This chapter demonstrates recording both current liabilities and long-term debt, highlighting the importance of cash management and transaction types in financial statements.

Appendix: Amortization Using the Effective Interest Rate Method

  • Discusses the straight-line method versus the effective interest rate method for amortizing bond premiums and discounts.

  • Importance of using the correct method for accurate expense recognition.

Key Terms

  • Amortization, Bond discount, Bond premium, Contingent liability, Current liabilities, Warranty obligations, Effective interest rate.

Questions

  • Series of questions to encourage deeper understanding of the material covered.

Key Terms

  • Amortization: The gradual reduction of a debt by periodic payments.

  • Bond discount: The difference between the face value of a bond and its market price when the bond is sold for less than its face value.

  • Bond premium: The difference between the face value of a bond and its market price when the bond is sold for more than its face value.

  • Contingent liability: A potential obligation that may occur, depending on the outcome of a future event.

  • Current liabilities: Obligations that are due to be settled within one year.

  • Warranty obligations: Legal commitments made by a seller regarding the quality and performance of a product, requiring potential future payments for repairs or replacements.