Professional Documents
Culture Documents
CHAPTER 7
ACCOUNTING FOR LIABILITIES
CHAPTER OVERVIEW
The chapter begins with a discussion of types of liabilities: definitely determinable and
estimated. Accounting for payroll, warranties, long-term notes payable, and mortgages are
presented.
The next part of the chapter introduces bonds. Examples are provided that show how bonds are
issued and how periodic interest payments are made (including the effects of these transactions
on the financial statement accounts). Issuing bonds at par, premium, or discount is also covered.
Next, the chapter presents the calculation of bond proceeds from bonds issued at a premium or
discount. Finally, this section includes a discussion of amortizing the bond discount or premium
(effective interest method), pointing out that the amortization is a natural process of the
difference between the interest payments (based on face value and stated rate) and interest
expense (based on carrying value and market rate).
The chapter includes a summary problem that continues the Team Sports example from previous
chapters and presents the student with transactions for the seventh month of business. The
student is then shown how to record the transactions, make adjusting entries at the end of July,
and prepare the four financial statements for the business.
The debt-to-equity ratio is discussed. At the end of the chapter there is a section covering the
major risks associated with debt.
LEARNING OBJECTIVES
After completing Chapter 7, your students should be able to answer these questions:
Payroll (LO 1)
I. Payroll is a definitely determinable liability.
a. Gross pay is not the amount that an employee takes home.
b. Gross pay – deductions = net pay
c. Net pay is the amount that an employee takes home.
d. Deductions are withholdings a company makes.
e. Examples of deductions include federal and state taxes, social security, and Medicare.
f. Social security taxes (FICA) are currently 6.2%.
g. Medicare taxes are currently 1.45%.
h. When payroll is recorded, salary expense is increased. The deductions are increases
to individual payable accounts. The net pay is a decrease to cash.
i. Later, the deductions are paid. The payables and cash are decreased.
Teaching Tip
Use Exhibit 7.2 to illustrate the relationship among gross pay, deductions, and net pay.
Use Exhibit 7.3, Payments Comprised of Principal and Interest, to illustrate the payment on a
note payable.
Teaching Tip
Use the example that begins on page 324 and Exhibit 7.4, Amortization Schedule for a Mortgage,
to show how payments reduce the outstanding principal.
Teaching Tip
Teaching Tip
What factors cause a bond to sell at a discount? Initially, the underwriters try to estimate the
interest rate the market will be willing to accept. But the bonds are trading long after the
contract rate is set. There is lag time between when the interest rate is set and when the bonds
are actually issued. Many other factors may cause the bond to sell at a discount: the interest rate
on other investments available on the market; the rating of the bond; the interest rate on treasury
notes and bonds; general economic and political conditions; the supply of investment capital and
the demand for those funds; the nature of the business issuing the bonds; and specific events that
occur in the business’s operations. (Note: These same factors also can have the opposite effect
on the price of a bond and cause it to sell at a premium.)
Teaching Tip
Refer to Exhibit 7.7 for an example of how cash flows are discounted to calculate the price of a
bond.
Teaching Tip
Point out that in all cases, the market (investors) is getting the return (interest rate) that it wants.
Regardless of what is printed on the bond, the market will determine the issue price, giving the
investors the return they desire. The price is equal to the sum of the present value of the series of
interest payments (annuity) and the present value of the maturity value (lump sum).
Teaching Tip
Exhibits 7.8 and 7.9 provide examples of amortization schedules for bonds issued at a discount
and at a premium.
Teaching Tip
The amortization table can be very intimidating to students. One way to help overcome the
intimidation factor is to demonstrate how to prepare a table by walking them through it with their
calculators. This is a tedious exercise, but it can help to alleviate some of the anxiety about
producing a table.
______________________________________________________________________________
_____ 7. If bonds are issued at a premium, the stated rate of interest will be:
a. Greater than the market rate of interest
b. Equal to the market rate of interest
c. Less than the market rate of interest
d. Unrelated to the market rate of interest
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 7-8
Solution Manual for Financial Accounting: A Business Process Approach, 3/E 3rd Edition Jane
_____ 8. If bonds are issued at a discount, the bonds will sell for an amount:
a. More than face amount
b. Equal to face amount
c. Less than face amount
d. To be determined by the Securities and Exchange Commission
_____ 9. Company A has a debt-to-equity ratio of 20% and Company B has a debt-to-
equity ratio of 40%. Which of the following statements is true?
a. Company A has more debt than Company B.
b. Company B is more highly leveraged than Company A.
c. Company B has more debt than Company A.
d. Company B is more profitable than Company A.
1. A
2. B
3. B
4. C
5. C
6. A
7. A
8. C
9. B
10. A