Chapter 10 Summary

Outcome #10: REPORTING AND ANALYZING LIABILITIES

10.1     Describe current and long-term liabilities and their characteristics.
10.2     Prepare entries to account for short-term notes payable.
10.3     Explain how to account for contingencies.
10.4     Prepare entries to record bond issuance and interest expense.
10.5     Compute and record amortization of bond discount using the straight
line method.
10.6     Compute and record amortization of bond premium using the straight
line method.
10.7     Record the redemption of bonds at maturity.
10.8     Calculate and record amounts related to mortgage note payments and
interest.

Liabilities are classified on the Balance Sheet as Either:

1. Current Liabilities – debts/obligations that a company expects to settle usually with assets within 1 year, or the
operating cycle, whichever is longer. (Examples: short term notes payable, A/P, Unearned Revenue, and Wages
Payable)
2. Long-Term Liabilities – debts/obligations that a company expects to settle more than 1 year into the future.
(Examples: Bonds Payable, Long Term Notes Payable)

Notes Payable
A written promissory agreement to pay a specific amount at a specific point in the future. There is interest (expense)
associated with notes payable that must be recognized and paid.

Borrowing Cash and receipt of a Note

Example 1: On September 1st, ABC borrows $50,000 from DC Bank on a 6 month, $50,000, 5% note.

Debit Cash $50,000

Credit Notes Payable $50,000

Recognition of Unpaid Interest at the end of the Year:

Debit: Interest Expense (50,000 X 5% X 4/12) $833

Credit: Interest Payable $833

Payment of Note Principal Plus Interest in Period FOLLOWING the above entry

Debit: Notes Payable $50,000

Debit: Interest Payable (for interest expense previously recorded) $833

Debit: Interest Expense (for current period) (50,000 x 5% x 2/12) $417

Credit: Cash $51,250

Example 2: Using the same information, except assume it was a 3 month note:

Issuance is the same entry as above

Payment of Note Principal Plus Interest in the SAME Period as the issuance

Debit: Notes Payable $50,000

Debit: Interest Expense (for current period) (50,000 x 5% x 3/12) $625

Credit: Cash $50,625

LONG TERM NOTES (Periodic principal and interest payments)

These notes are a common form of financing for purchases of land, buildings, improvements and vehicles and each
payment made on a periodic basis includes a portion that goes towards the debt (principal) and some portion towards
interest.

Example: On 1/1, Porter Tech borrows $500,000, 12%, 20 year installment note to finance an expansion. Terms provide
for annual payments of $66,462.

Journal Entry for the Loan

Debit: Cash $500,000

Credit: Long Term Installment Note Payable $500,000

Perio Cash Principal

d Payment Interest Expense Reduction of Principal Balance
Principal X
    Interest Cash Payment - Interest Expense 500000
1 66462 60000 6462 493538
2 66462 59225 7237 486301
BONDS
Bonds are a form of interest bearing notes payable. Bonds result from the borrowing of cash from multiple sources (i.e.
investors) as opposed to a single source (i.e. bank). Principal (face value) is always paid in full at the end (maturity) of
the bond term. Interest is usually paid annually OR semi-annually and is calculated based on the contract rate (not the
market rate).

Disadvantages of Bonds:

1. Interest must be paid on a periodic basis regardless (of earnings).

2. Bond Principal (face value) must be paid at maturity regardless of financial position.

Issuance of Bonds

The cash received on the issuance date is determined by a % of bond face value.

For example: a bond issued at 100 is 100% of face value, 98 is 98% of face value, 110 is 110% of face value.

The bonds issued are recorded at either:

1. Face Value – if contract rate = market rate

2. Discount – if contract rate < market rate
3. Premium – if contract rate > market rate

*Because market interest rates change daily, there is often a difference between the two rates when bonds are issued.
The difference between the two interest rates results in a discount or premium that must be recognized.

Discount on Bond Payable – contra liability account whose balance communicates an increase to interest expense
recognized over the bond term. LESS collected up front, MORE paid back at maturity. The difference is an INCREASE to
interest expense which is recognized over the bond term when interest is paid.

Premium on Bond Payable – liability account whose balance communicates a decrease to interest expense recognized
over the bond term. MORE collected up front, LESS paid back at maturity. The difference is a DECREASE to interest
expense which is recognized over the bond term when interest is paid.

Bond Journal Entries

Issuance of a $100,000, 8%, 15 year bond at 100 or Face Value (par):

Debit: Cash $100,000

Credit: Bonds Payable $100,000

Issuance

Issuance of a $100,000, 8%, 15 year bond at 98 or Discount:

Debit: Cash $98,000

Debit: Discount on Bonds Payable $2,000

Credit: Bonds Payable $100,000

Issuance of a $100,000, 8%, 15 year bond at 103 or Premium:

Debit: Cash $103,000

Credit: Premium on Bonds Payable $3,000

Credit: Bonds Payable $100,000

Balance Sheet Presentation at Date of Issuance:

Long Term
Liabilities

Issued at Issued at Issued at

  Face Value   Discount   Premium
Bonds Payable 100,000 Bonds Payable 100,000 Bonds Payable 100,000
Discount on Premium on
Bonds Payable (2000) Bonds Payable 3000
Carrying (Book) Carrying
Value 98,000 (Book) Value 103,000

Recording Interest Payments

Issued at Face Par/Face Value - Interest Payment (no previous accrual of interest – assuming 12 months of interest):

Debit: Interest Expense (100,000 x 8%) $8,000

Credit: Cash $8,000

Issued at Discount – Interest Payment (no previous accrual of interest – assuming 12 months of interest):

Debit:

Credit:

Credit:

Interest Interest to Interest Discount Unamortized Carrying (Book)

Periods be Paid Expense Amortization Discount Value)
Interest Paid -
Discount
100,000 X Amortization
  8% (2000/15) 2000/15 2000 98000
1/1/2015          
1/1/2016          
1/1/2017          
1/1/2018          
1/1/2019          
1/1/2020          
1/1/2021          
1/1/2022          
1/1/2023          
1/1/2024          
1/1/2025          
1/1/2026          
1/1/2027          
1/1/2028          
1/1/2029          
1/1/1930       0 100000
Issued at Premium – Interest Payment (no previous accrual of interest – assuming 12 months of interest):

Debit: Interest Expense $7800

Debit: Premium on Bonds Payable $200

Credit: Cash $8,000

BOND AMORTIZATION SCHEDULE

Interest Interest to Interest Premium Unamortized Carrying (Book)
Periods be Paid Expense Amortization Premium Value)
Interest Paid -
Premium
100,000 X Amortization
  8% (3000/15) 3000/15 3000 103000
1/1/2015          
1/1/2016 8,000 7,800 200 2800 102800
1/1/2017 8,000 7,800 200 2600 102600
1/1/2018 8,000 7,800 200 2400 102400
1/1/2019 8,000 7,800 200 2200 102200
1/1/2020 8,000 7,800 200 2000 102000
1/1/2021 8,000 7,800 200 1800 101800
1/1/2022 8,000 7,800 200 1600 101600
1/1/2023 8,000 7,800 200 1400 101400
1/1/2024 8,000 7,800 200 1200 101200
1/1/2025 8,000 7,800 200 1000 101000
1/1/2026 8,000 7,800 200 800 100800
1/1/2027 8,000 7,800 200 600 100600
1/1/2028 8,000 7,800 200 400 100400
1/1/2029 8,000 7,800 200 200 100200
1/1/1930 8,000 7,800 200 0 100000

Return of Bond Principal and Interest at Maturity (not including last interest payment):

Debit: Bonds Payable $100,000

Credit: Cash $100,000