Chapter Summary

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 assets.

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.

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.)

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.

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.

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.

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 funded.)

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.

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.

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.

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.