Chapter 10 - Summary
Define liabilities and distinguish between current and long-term liabilities.
Liabilities are debts arising from past transactions or events and that require
payment (or the rendering of services) at some future date. Current liabilities
are those maturing within one year or the company's operating cycle (whichever
is longer) and that are expected to be paid from current assets. Liabilities
classified as long-term include obligations maturing more than one year in the
future and shorter-term obligations that will be refinanced or paid from noncurrent
Account for notes payable and interest expense.
Initially, a liability is recorded only for the principal amount of a note--that
is, the amount owed before including any interest charges. Interest expense
accrues over time. Any accrued interest expense is recognized at the end of
an accounting period in an adjusting entry that records both the expense and
a short-term liability for accrued interest payable.
Describe the costs relating to payrolls.
The basic cost of payrolls is, of course, the salaries and wages earned by
employees. However, all employers also incur costs for various payroll taxes,
such as the employer's share of Social Security and Medicare, workers' compensation
premiums, and unemployment insurance. Many employers also incur costs for various
employee benefits, such as health insurance and postretirement benefits. (These
additional payroll related costs often amount to 30% to 40% of the basic wages
and salaries expense.)
Prepare an amortization table allocating payments between interest and principal.
An amortization table includes four money columns, showing (1) the amount
of each payment, (2) the portion of the payment representing interest expense,
(3) the portion of the payment that reduces the principal amount of the
loan, and (4) the remaining unpaid balance (or principal amount). The table
begins with the original amount of the loan listed in the unpaid balance column.
A separate line then is completed showing the allocation of each payment between
interest and principal reduction and indicating the new unpaid balance subsequent
to the payment.
Describe corporate bonds and explain the tax advantage of debt financing.
Corporate bonds are transferable long-term notes payable. Each bond usually
has a face value of $1,000 (or a multiple of $1,000), calls for interest payments
at a contractual rate, and has a stated maturity date. By issuing thousands
of bonds to the investing public at one time, the corporation divides a very
large and long-term loan into many transferable units.
The principal advantage of issuing bonds instead of capital stock is that interest
payments to bondholders are deductible in determining taxable income, whereas
dividend payments to stockholders are not.
Explain the concept of present value.
The basic concept of present value is that an amount of money that will not
be paid or received until some future date is equivalent to a smaller amount
of money today. This is because the smaller amount available today could be
invested to earn interest and thereby accumulate over time to the larger future
amount. The amount that, if available today, is considered equivalent to the
future amount is termed the present value of that future amount.
The concept of present value is used in the valuation of all long-term liabilities
except deferred taxes. It also determines the current values of financial instruments
and is widely used in investment decisions. Readers who are not familiar with
this concept are encouraged to now read Appendix C at the end of this textbook.
Account for postretirement costs.
The annual expense for postretirement costs is the present value of the future
benefits earned by employees as a result of their services during the current
year. This amount is estimated by an actuary. To the extent that the employer
funds this expense each year--that is, contributes cash to a pension plan--no
liability arises. However, the employer must report a liability for any unfunded
postretirement obligations. (Pension plans usually are fully funded, meaning
that the employer reports no liability for pension payments. But other postretirement
benefits, such as health insurance for retired workers, normally are not fully
Describe and account for deferred income taxes.
Timing differences sometimes exist between the dates that certain revenue or
expense items are recognized in financial statements and the dates these items
are reported in tax returns. Most of these timing differences result in postponing
(deferring) the recognition of income for tax purposes. That portion of the
income taxes expense that is deferred to future tax returns is credited to a
liability account entitled Deferred Income Taxes.
Evaluate the safety of creditors' claims.
Short-term creditors may evaluate the safety of their claims using such measures
of solvency as the current ratio, quick ratio, the available lines of credit,
and the debtor's credit rating. Long-term creditors look more to signs of stability
and long-term financial health, including the debt ratio, interest coverage
ratio, and the trends in net income and net cash flow from operating activities.
Define loss contingencies and explain their presentation in financial
A loss contingency is a possible loss (or expense) stemming from past events
that will be resolved as to existence and amount by some future event. Loss
contingencies are accrued (recorded) if (1) it is probable that a loss has been
incurred and (2) the amount of loss can be estimated reasonably. Even if these
conditions are not met, loss contingencies should be disclosed if it is reasonably
possible that a material loss has been incurred.
Account for bonds issued at a discount or premium.
When bonds are issued at a discount, the borrower must repay more than the
amount originally borrowed. Thus any discount in the issuance price becomes
additional cost in the overall borrowing transaction. The matching principle
requires that the borrower recognize this cost gradually over the life of the
bond issue as interest expense.
If bonds are issued at a premium, the borrower will repay an amount less than
the amount originally borrowed. Thus the premium serves to reduce the overall
cost of the borrowing transaction. Again, the matching principle requires that
this reduction in interest expense be recognized gradually over the life of
the bond issue.
Businesses have two basic means of financing their assets and business operations:
with liabilities or with owners' equity. In the next two chapters, we turn our
attention to the owners' equity in various types of business organizations.