Chapter 10: Accounting for Liabilities Flashcards
Define liabilities
Obligations resulting from past transactions or events that require a company to pay money or provide goods or services in the future.
Define current liabilities
Liabilities that come due within the coming year or normal operating cycle
What two accounts are current liabilities?
Accounts payable and notes payable.
What is the difference between accounts payable and notes payable regarding credit periods?
Accounts payable: short-term creditors
Notes payable: Longer credit period, 30-60 days
What is the difference between accounts payable and notes payable regarding interest?
Accounts payable: Non-interest bearing
Notes payable: Interest bearing
Example of journaling interest payable: Pomona Corporation signed a 90-day note on November 1 for $10,000 with 6 percent annual interest in exchange for equipment.
How do you record the purchase of equipment?
Debit equipment 10,000
Credit notes payable 10,000
Example of journaling interest payable: Pomona Corporation signed a 90-day note on November 1 for $10,000 with 6 percent annual interest in exchange for equipment.
How do you calculate accrued interest expense for this example?
Equipment cost * interest * 2/12
10,000 * 0.6 * 2/12 = 100
(I have no idea where the 2/12 comes from)
Example of journaling interest payable: Pomona Corporation signed a 90-day note on November 1 for $10,000 with 6 percent annual interest in exchange for equipment.
How do you record the accrued interest expense (100)
Debit interest expense 100
Credit interest payable 100
Example of journaling interest payable: Pomona Corporation signed a 90-day note on November 1 for $10,000 with 6 percent annual interest in exchange for equipment.
How do you record the payment of notes and interest?
Debit interest expense 50
Debit interest payable 100
Debit Notes payable 10,000
Credit cash 10,150
Payroll expenses are a _____ cost for most firms
A. Major
B. Minor
A. Major
What 3 things are included in payroll expenses?
- Salaries and wages
- Withheld employee paychecks
- Payroll taxes/benefits
What four taxes can employers withhold from employee paychecks?
- Federal tax
- State tax
- Social Security tax
- Medicare tax
Other than taxes, what other payments can employers withhold from employee paychecks?
Health insurance, union dues, and retirement
Which payroll taxes are paid by the employer?
FICA, federal and state unemployment taxes
How do you calculate net pay?
Net pay = gross pay - amounts withheld
What 5 accounts are “amounts withheld”?
- Health insurance premiums
- FICA
- Federal income tax
- State income tax
- Union dues
Calculate net pay with the following information:
Federal income tax: 1,200
FICA: 459
Gross Pay: 6,000
Health insurance premiums: 320
State income tax: 405
Union dues: 100
Net pay = gross profit - amounts withheld
Net pay = gross profit - (health insurance premiums + FICA + Federal income tax +state income tax + union dues+
Net pay = 6,000 - (+2,484)
Net pay = 6,000 - 2,484
Net pay = 3,516
Define unearned revenue
Revenue that had not been earned
What type of account is unearned revenue?
Liability
Southwest Airlines sells a ticket on June 1 for travel on July 15 for $300.
How do you record the advance sale of the ticker?
Debit cash 300
Credit unearned revenue 300
Southwest Airlines sells a ticket on June 1 for travel on July 15 for $300.
How do you record ticked revenue earned?
Debit unearned revenue 300
Credit ticket revenue 300
Which of the following is NOT a current liability?
A. Account payable
B. Unearned revenue
C. Payroll taxes payable
D. Bonds payable
D. Bonds payable
Explanation: bonds payable is a non-current liability, not current liability, because it is payable after one accounting period. (longer credit period)
Define bond
A long-term debt instrument that promises to pay periodic interest in addition to the principal amount at maturity
What are the 5 types of bonds?
- Secured bonds
- Debenture bonds
- Serial bonds
- Convertible bonds
- Zero-coupon bonds
Define secured bond
Bonds that pledge specific property as collateral in case of default
Define debenture bond
Bonds rely on the borrower’s general creditworthiness rather than specific collateral.
Define serial bonds
Bonds that mature over a series of years
Define convertible bonds
Bonds that grant the bondholder the right to convert the bonds into the company’s common stick as a specific conversion rate
Define zero-coupon bonds
Bonds that pay no periodic interest but are issued at a large discount
What effect does “call provision” have on bonds?
Allows the issuer to pay the bond before it’s due
What is a sinking fund provision?
An account containing money set aside to pay off a debt or bond
Define face value regarding bonds.
The amount paid back was the expected amount
Ex: I lend you $1,000, you pay it back at fave value for $1,000
Define coupon rate regarding bonds.
Paying back a bond with the interest agreed upon
For example, I will lend you $1,000 with a 2% interest over 12 months. In a year, you pay me back $1,020.
Define market rate regarding bonds.
A representation of what the market will pay for similar bonds.
For example, I’m willing to sell a bond for $1,000. You offer to pay for it at a face value of $1,000 on the agreed date, but the market value is a 10% increase. That means I can likely sell the same bond for $1,000 to someone but get paid a premium value of $1,100 instead of the face value of $1,000.
If you have a bond coupon rate of 8%, what value will the bond sell if the market interest rate is 10%?
A. Discount value
B. Face value
C. Premium value
A. Discount value
Explanation: If the market sells bonds for $100 at a 10% bond coupon rate, the buyer will have to pay back $110. But if you’re selling a bond of $100 for an 8% coupon rate, your bond is sold for $108 instead, and thus at a discounted value compared to the market value of $110.
If you have a bond coupon rate of 8%, what value will the bond sell if the market interest rate is 8%?
A. Discount value
B. Face value
C. Premium value
B. Face value
Explanation: The market value and face value are the same. You sell your bond for precisely what you expected to.
If you have a bond coupon rate of 8%, what value will the bond sell if the market interest rate is 6%?
A. Discount value
B. Face value
C. Premium value
C. Premium value
Explanation: If the market has bonds of $100 selling for a 6% coupon rate, the buyer will only have to pay back $106. But if you sell a bond for 8%, you will be paid back $108, a higher (premium) value than the market value of $106.
How do you record a bond issuance of face value price? (Assume bond cost $1,000)
Debit cash 1,000
Credit bonds payable 1,000
How do you record bond issuance at a discounted value? (Assume the bond costs $1,000 for a 3% discount)
Debit cash 970
Debit discount on bonds payable 30
Credit bonds payable 1,000
How do you record a bond issuance for a premium value? (Assume the bond costs $1,000 and is sold for a 5% increase)
Debit cash 1,050
Credit bonds payable 1,000
credit premium on bonds payable 50
How long does a bond mature before it appears on the balance sheet as a long-term liability?
One year
Does a discount appear as a reduction of a bond (liability) or an addition to the bond (liability)?
Reduction
Does the premium appear as a reduction of a bond (liability) or an addition to the bond (liability)?
Addition
Define leverage regarding bonds.
When income increases by earning more on the use of bonds than the cost of those bonds
Ex: If you buy a bond for $1,000 to purchase equipment and pay the bond back for 1,000, but the equipment earns you $1,500, you gain a $500 leverage.
Three advantages of bonds
- No ownership interest dilution
- Bond interest expense is tax deductible
- Leverage to common shareholders
Define debt covenants
When a bond restricts what actions a company can take
Ex: Choosing to pay back a bond over advertising for a new product
3 disadvantages of bonds
- Bond interest must be paid (unlike dividends)
- Have a specific repayment date
- Debt covenants
Jones Co. issued a $1,000 face amount 20-year bond and received a $950 at the time of issuance. The bond sold at…
A. A premium
B. A discount
C. Face value
D. Cannot be determined without knowing interest rates
B) Discount
Would have earned $1,000 but only earned $950 instead
Define contingent liabilities
Liabilities are obligation resulting from past events BUT ALSO need a future event to take place
Ex: Lawsuits, environmental cleanup costs, credit guarantees, etc.
What is the challenge when recording contingent liabilities?
Predicting the likelihood of future events and the ability to measure the pay amount
What conditions must be met to record contingent liabilities?
- The likelihood of the event taking place is probable
- A reasonable estimate of obligation can be made
What do you do with a contingent liability whose future event is possible but not probable, and no reasonable estimation can be made?
Disclose it in the notes, but DO NOT RECORD IT
Can a contingent liability be ignored?
A. No, all liabilities must be recorded
B. No, contingent liabilities should still be recorded
C. Yes, but only if the future event is slim to occur
D. Yes, but only if the estimation couldn’t be calculated
C. Yes, but only if the future event is slim to occur
Define working capital
The estimation between the difference of current assets and current liabilities
Does a company want a high working capital or low working capital?
High, as it’s a sign of a stronger financial position
What are the 2 ways to measure working capital?
Current ratio and quick ratio
Define current ratio
The total of current assets divided by current liabilities
How do you calculate the current ratio?
Current ratio = current assets / current liabilities
Ex:
Current ratio = 10 current assets / 5 current liabilities
Current ratio = 2
Ideally, 2 or higher, but businesses with less than two have been able to stay successful
How is quick ratio different from current ratio?
Some current assets are challenging to convert to cash, and the quick ratio only contains liquid current assets instead of all assets.
How do you calculate the quick ratio?
Quick ratio = (cash/cash equivalents + short-term investments + accounts receivable) / current liabilities
What is the times-interest earned ratio?
A ratio that shows a company’s ability to pay back credits (like a business’s credit score).
Ideally, within a 3-4 range
How is the times-interest-earned ratio calculated?
Times-interest-earned ratio = (income before interest expense and income taxes) / interest expense
Norton Co. reports the following for the current year: Cash, $300; short-term investments, $500; accounts receivable, $1,000; inventory, $700, total current assets, $2,500; and total current liabilities, $1,000.
Which of the following is true regarding the current ratio and the quick ratio?
Current ratio Quick ratio
A. 1.8:1 2.5:1
B. 2.5:1 1.8:1
C. 2.5:1 0.8:1
D. 2.5:1 2.5:1
B. 2.5:1 1.8:1
(I have no idea why)
Bonds are usually sold in units of…
A. $2,000 face value
B. $1,500 face value
C. $1,000 face value
D. $500 face value
C. $1,000 face value
What is the “proper accounting term” for being paid more for a bond?
Premium value
What is the “proper accounting term” for being paid less for a bond?
Discount value
What is the “proper accounting term” for being paid face value for a bond?
Maturity value
