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McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 10
Reporting and Interpreting
Liabilities

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Fred Phillips, Ph.D., CA

Learning Objective 1

Explain the role of liabilities in


financing a business.

10-3

The Role of Liabilities


Liabilities are created when a company:
Buys goods
and services
on credit

Obtains
short-term
loans

Issues
long-term
debt

Current liabilities are short-term obligations that will


be paid with current assets within the companys
current operating cycle or within one year of the
balance sheet date, whichever is longer.
10-4

The Role of Liabilities


The liability section of the General Mills 2007 and 2008
comparative balance sheets.

10-5

Learning Objective 2

Explain how to account for


common types of current
liabilities.

10-6

Measuring Liabilities
Initial Amount of the Liability

Cash Value

Additional Liability Amounts

Increase Liability

Cash Payments Made

10-7

Decrease Liability

Current Liabilities
Accounts Payable
Decreases
Decreases
(Debited)
(Debited)

Increases
Increases
(Credited)
(Credited)

when a company
pays on its account

when a company
receives goods or
services on credit

Accrued Liabilities
Liabilities that have been incurred but not yet paid.

10-8

Calculating Payroll
Payroll Deductions
Payroll
Liabilities
Payroll deductions are either required by law or voluntarily

1.Payroll
requested byDeductions
employees and create a current liability for the
company. Examples include:
1.Income tax
2.Employer
Payroll Taxes
2.FICA tax
3.Other deductions (charitable donations, union dues, etc.)

10-9

Calculating Payroll

10-10

Recording Payroll
Adam Palmer earned gross pay of $600 in the current payroll period.
General Mills withheld $58 in Federal income taxes, $48.80 for FICA, and
$10 for United Way, resulting in net pay of $483.20.
1 Analyze

2 Record

10-11

Payroll Taxes
Employer Payroll Taxes
Employers have other liabilities related to payroll.
1.FICA tax (a matching contribution)
2.Federal unemployment tax
3.State unemployment tax

Assume General Mills was required to contribute $16,400 for FICA, $250
for federal unemployment tax, and $1,350 for state unemployment tax.
1 Analyze

2 Record

10-12

Accrued Income Taxes


Corporations calculate taxable income by subtracting tax-allowed
expenses from revenues. This taxable income is then multiplied by a tax
rate, which for most large corporations is about 35 percent.
General Mill calculated taxable income to be $1,000,000, and is subject to
a 35% tax rate, so income taxes owed are $350,000 ($1,000,000 35%)
1 Analyze

2 Record

10-13

Notes Payable
Four key events occur with any note payable:
1.establishing the note,
2.accruing interest incurred but not paid,
3.recording interest paid, and
4.recording principal paid.

10-14

Notes Payable
1. Establish the note on November 1, 2009.
Assume
Assume that
that on
on November
November 1,
1, 2009,
2009, General
General Mills
Mills borrowed
borrowed $100,000
$100,000 cash
cash
on
on aa one-year
one-year note
note that
that required
required General
General Mills
Mills to
to pay
pay 66 percent
percent interest
interest and
and
$100,000
$100,000 principal,
principal, both
both on
on October
October 31,
31, 2010.
2010.
1 Analyze

2 Record

10-15

Notes Payable
Accrue interest owed but not paid on December 31, 2009.
$100,000
$100,000 6%
6% 2/12
2/12 == $1,000
$1,000 accrued
accrued interest
interest
P
xx II
xx TT
P
1 Analyze

10-16

Record

Notes Payable
Record interest accrued in 2010
$100,000
$100,000 6%
6% 10/12
10/12 == $5,000
$5,000 interest
interest
P
xx II
xx
T
P
T
1 Analyze

10-17

Record

Notes Payable
4. Record principal paid of $100,000 on October 31, 2010.
1 Analyze

2 Record

10-18

Current Portion of
Long-Term Debt
Long-Term Debt

Current Portion of
Long-term Debt

Noncurrent Portion
of Long-term Debt

Borrowers must report in Current Liabilities the portion of


long-term debt that is due to be paid within one year.

10-19

Additional Current Liabilities

10-20

Sales Tax
Payable

Payments collected from


customers at time of sale create
a liability that is due to the state
government.

Unearned
Revenue

Cash received in advance of


providing services creates a
liability of services due to the
customer .

Additional Current Liabilities


Best
Best Buy
Buy sells
sells aa television
television for
for $1,000
$1,000 cash
cash plus
plus 55 percent
percent sales
sales tax.
tax.
$1,000 5% = $50 sales tax collected
1 Analyze

2 Record

When Best Buy pays the sales tax to the state government, its accountants
will reduce Sales Tax Payable (with a debit) and reduce Cash (with a credit).
10-21

Additional Liabilities
On
On October
October 11 IAC,
IAC, an
an internet
internet provider,
provider, received
received $30
$30 cash
cash for
for threethreemonths
months of
of internet
internet access,
access, paid
paid in
in advance.
advance.
1 Analyze

2 Record

10-22

Additional Liabilities
At
At the
the end
end of
of October,
October, IAC
IAC provided
provided one
one month
month of
of internet
internet service
service
to
to its
its customer.
customer.
$30 3 months = $10 per month
1 Analyze

2 Record

10-23

Learning Objective 3

Analyze and record bond


liability transactions.

10-24

Long-Term Liabilities
Common Long-Term Liabilities
1. Long-term notes payable
2. Deferred income taxes
3. Bonds payable
Bonds are financial instruments that outline the
future payments a company promises to make
in exchange for receiving a sum of money now.

10-25

Bonds
Key Elements of a Bond
1. Maturity date
2. Face value
3. Stated interest rate
Interest Computation
12
$1,000 6% 12 = $60

Bond Pricing
The bond price involves present value computations and is the amount
that investors are willing to pay on the issue date for the bonds.
10-26

Bonds
Balance Sheet Reporting of Bond Liability

Relationships between Interest Rates and Bond Pricing

10-27

Bonds
Bonds Issued at Face Value
General
receives $100,000
cash in
in exchange
General Mills
Mills receives
$100,000 cash
exchange for
for issuing
issuing
100
100 bonds
bonds at
at their
their $1,000
$1,000 face
face value,
value, so
so the
the bonds
bonds are
are issued
issued at
at
total
total face
face value
value (1,000
(1,000 $1,000
$1,000 == $100,000).
$100,000).
1 Analyze

2 Record

10-28

Bonds
Bonds Issued at a Premium
General
General Mills
Mills issues
issues 100
100 of
of its
its $1,000
$1,000 bonds
bonds at
at aa price
price of
of
107.26
107.26 (percent)
(percent) of
of face
company will
will receive
receive
face value,
value, the
the company
$107,260
$107,260 (100
(100 $1,000
$1,000 1.0726).
1.0726).
1 Analyze

10-29

Record

Bonds
Bonds Issued at a Discount
General
General Mills
Mills receives
receives $93,376
$93,376 for
for bonds
bonds with
with aa total
total face
face value
value of
of
$100,000,sold
$100,000,sold at
at 93.376
93.376 the
the cash-equivalent
cash-equivalent amount
amount is
is $93,376,
$93,376, which
which
represents
represents the
the liability
liability on
on that
that date.
date. These
These bonds
bonds are
are issued
issued at
at aa
discount
discount because
because the
the cash
cash received
received is
is less
less than
than the
the face
face value
value of
of the
the
bonds.
bonds.
1 Analyze

$100,000
$100,000 -- $93,376
$93,376 == $6,624
$6,624 discount
discount

2 Record

10-30

Interest on Bonds Issued at Face Value


General Mills issues bonds on January 1, 2010, at their total face
value of $100,000. The bonds have an annual stated interest rate of
6 percent payable in cash on December 31 of each year, General
Mills will need to accrue an expense and liability for interest at the
end of each accounting period. The end of the first accounting
period is January 31, 2010.
1 Analyze

2 Record

10-31

$100,000
$100,000 6%
6% 1/12
1/12 == $500
$500 interest
interest

Interest on Bonds Issued at a Premium


Cash proceeds > Face value
Cash proceeds Face value = Premium
Interest expense < Cash interest paid
Interest expense = Cash interest paid Premium amortization

10-32

Interest on Bonds Issued at a Discount


Cash proceeds < Face value
Face value Cash proceeds = Discount
Interest expense > Cash interest paid
Interest expense = Cash interest paid+ Discount amortization

10-33

Bond Retirement
The early retirement of bonds has three financial effects. The company
1. pays cash,
2. eliminates the bond liability, and
3. reports either a gain or a loss.
Assume
Assume that
that in
in 2000,
2000, General
General Mills
Mills issued
issued $100,000
$100,000 of
of bonds
bonds at
at face
face value.
value.
Ten
Ten years
years later,
later, in
in 2010,
2010, the
the company
company retired
retired the
the bonds
bonds early.
early. At
At the
the time,
time,
the
the bond
bond price
price was
was 103,
103, so
so General
General Mills
Mills made
made aa payment
payment of
of $103,000.
$103,000.
1 Analyze

2 Record

10-34

Cash Payment
$103,000
Carrying Value
100,000
Loss on Retirement
$3,000

Learning Objective 4

Describe how to account for


contingent liabilities.

10-35

Contingent Liabilities
Contingent liabilities are potential liabilities that arise from past
transactions or events, but their ultimate resolution depends
(is contingent) on a future event.

10-36

Learning Objective 5

Calculate and interpret the


quick ratio and the times
interest earned ratio.

10-37

Evaluate the Results


Two financial ratios are commonly used to assess a
companys ability to generate resources to pay
future amounts owed:
1.Quick ratio
2.Times interest earned ratio
Quick Ratio =

10-38

(Cash + Short-term Investments + Accounts Receivable, Net)


Current Liabilities

Evaluate the Results


In
In 2008,
2008, General
General Mills
Mills reported
reported $661
$661 million
million of
of cash
cash and
and cash
cash equivalents,
equivalents,
no
no short-term
short-term investments,
investments, and
and $1,082
$1,082 million
million of
of net
net accounts
accounts receivable.
receivable.
The
The company
company reported
reported $4,856
$4,856 million
million in
in total
total current
current liabilities.
liabilities.

Quick Ratio =

(Cash + Short-term Investments + Accounts Receivable, Net)


Current Liabilities

$661 + 0 + 1,082
4,856

0.359

A
A quick
quick ratio
ratio of
of 0.359
0.359 implies
implies that
that General
General Mills
Mills would
would
be
be able
able to
to pay
pay only
only 35.9
35.9 percent
percent of
of its
its current
current
liabilities,
liabilities, ifif forced
forced to
to pay
pay them
them immediately.
immediately. However,
However,
not
not all
all current
current liabilities
liabilities are
are to
to be
be paid
paid immediately.
immediately.
10-39

Evaluate the Results


In
In 2008,
2008, General
General Mills
Mills reported
reported net
net income
income of
of $290
$290 million
million and
and interest
interest
expense
expense of
of $100
$100 million,
million, and
and income
income tax
tax expense
expense of
of $230
$230 million.
million. Lets
Lets
calculate
calculate the
the times
times interest
interest earned
earned for
for 2008.
2008.

$290 + $100 + $230


$100

6.20 times

The
The ratio
ratio means
means that
that General
General Mills
Mills generates
generates $6.20
$6.20 of
of income
income
(before
(before the
the costs
costs of
of financing
financing and
and taxes)
taxes) for
for each
each dollar
dollar of
of
interest
interest expense.
expense. No
No doubt
doubt this
this ratio
ratio is
is part
part of
of the
the reason
reason that
that
General
General Mills
Mills has
has earned
earned aa favorable
favorable credit
credit rating
rating of
of BBB+.
BBB+.
10-40

Chapter 10
Supplement 10A
Straight-Line Method of
Amortization

Bond Premium
Bond premium
premium or
or discount
discount decreases
decreases each
each year,
year, until
until itit is
is completely
completely
Bond
eliminated on
on the
the bonds
bonds maturity
maturity date.
date. This
This process
process is
is called
called amortizing
amortizing
eliminated
the bond
bond premium
premium or
or discount.
discount. The
The straight-line
straight-line method
method of
of amortization
amortization
the
reduces the
the premium
premium or
or discount
discount by
by an
an equal
equal amount
amount each
each period.
period.
reduces
Recall
Recall our
our example
example when
when General
General Mills
Mills received
received $107,260
$107,260 on
on the
the issue
issue date
date
(January
(January 1,
1, 2010)
2010) but
but repays
repays only
only $100,000
$100,000 at
at maturity
maturity (December
(December 31,
31, 2013).
2013).
Under
Under the
the straight-line
straight-line method,
method, this
this $7,260
$7,260 is
is spread
spread evenly
evenly as
as aa reduction
reduction in
in
interest
interest expense
expense over
over the
the four
four years
years ($7,260
($7,260 44 == $1,815
$1,815 per
per year).
year).
1 Analyze

2 Record

10-42

Cash
$6,000
Cash Interest
Interest
$6,000
Amortization
Amortization of
of Premium
Premium (1,815)
(1,815)
Interest
$4,185
Interest Expense
Expense
$4,185

Bond Premium
Amortization Schedule of Bonds Issued at a Premium

$7,260
$7,260 -- $1,815
$1,815 == $5,445
$5,445
$7,260
$7,260 44 == $1,815
$1,815
$100,000
$100,000 6%
6% 12/12
12/12 == $6,000
$6,000
face
face value
value xx stated
stated int
int xx TT

$107,260
$107,260 $1,815
$1,815 == $105,445
$105,445
$6,000
$6,000 -- $1,815
$1,815 == $4,185
$4,185

Notice that each of these amounts would plot as a straight-line!


10-43

Bond Discount
Recall
Recall our
our example
example where
where General
General Mills
Mills received
received $93,376
$93,376 for
for four-year
four-year
bonds
bonds with
with aa total
total face
face value
value of
of $100,000,
$100,000, implying
implying aa discount
discount of
of $6,624.
$6,624.
The
The annual
annual amortization
amortization of
of the
the discount
discount is
is $1,656
$1,656 ($6,624
($6,624 4).
4).
1 Analyze

2 Record

10-44

Cash
Cash Interest
Interest
Amortization
Amortization of
of Discount
Discount
Interest
Interest Expense
Expense

$6,000
$6,000
1,656
1,656
$7,656
$7,656

Bond Discount
Amortization Schedule of Bonds Issued at a Discount

$6,624
$6,624 44 == $1,656
$1,656
$100,000
$100,000 6%
6% 12/12
12/12 == $6,000
$6,000
Face
Face value
value xx stated
stated int
int xx TT

10-45

$6,624
$6,624 -- $1,656
$1,656 == $4,968
$4,968
$93,376
$93,376 ++ $1,656
$1,656 == $95,032
$95,032

$6,000
$6,000 ++ $1,656
$1,656 == $7,656
$7,656

Chapter 10
Supplement 10B
Effective-Interest Method of
Amortization

Effective Interest Amortization


The
The effective-interest
effective-interest method
method of
of amortization
amortization is
is considered
considered aa conceptually
conceptually superior
superior
method
method of
of accounting
accounting for
for bonds
bonds because
because itit correctly
correctly calculates
calculates interest
interest expense
expense by
by
multiplying
multiplying the
the market
market interest
interest rate
rate times
times the
the carrying
carrying value
value of
of the
the bonds.
bonds.
When
When General
General Mills
Mills adds
adds this
this $7,260
$7,260 premium
premium to
to the
the $100,000
$100,000 face
face value,
value,
itit reports
reports aa carrying
carrying value
value of
of $107,260
$107,260 ($100,000
($100,000 ++ $7,260)
$7,260) on
on January
January 1,
1,
2010.
2010. The
The proceeds
proceeds indicates
indicates that
that the
the market
market interest
interest rate
rate was
was 44 percent.
percent.
Interest (I) = Principal (P) Rate (R) Time (T)
Interest Expense = Carrying Value Market Rate n/12
$4,290 = $107,260 4% 12/12

10-47

Effective Interest Amortization


General
General Mills
Mills issued
issued 6%
6% stated
stated rate
rate bonds
bonds for
for $107,260.
$107,260. The
The market
market
rate
rate of
of interest
interest on
on these
these bonds
bonds is
is 4%.
4%. The
The face
face amount
amount of
of the
the bonds,
bonds,
$100,000,
$100,000, results
results in
in cash
cash interest
interest is
is $6,000
$6,000 ($100,000
($100,000 6%).
6%). Lets
Lets
amortize
amortize the
the premium
premium on
on the
the bonds
bonds at
at the
the first
first interest
interest payment
payment date.
date.
1 Analyze

Interest (I) = Principal (P) Rate (R) Time (T)


Interest Expense = Carrying Value Market Rate n/12
$4,290 = $107,260 4% 12/12

2 Record

10-48

Cash
$$ 6,000
Cash Interest
Interest
6,000
Effective
4,290
Effective Interest
Interest
4,290
Amortization
Amortization of
of Premium
Premium $1,710
$1,710

Effective Interest Amortization


$6,000
$6,000 -- $4,290
$4,290 == $1,710
$1,710

$7,290
$7,290 -- $1,710
$1,710 == $5,550
$5,550

Effective Interest Amortization of Bonds Issued at a Premium

$107,260
$107,260 4%
4% 12/12
12/12 == $4,290
$4,290
$100,000
$100,000 6%
6% 12/12
12/12 == $6,000
$6,000
Face
Face value
value xx stated
stated int
int xx time
time

$107,260
$107,260 -- $1,710
$1,710 == $105,550
$105,550

Interest Expense decreases and Premium Amortization


increases each period. Cash interest is unchanged.
10-49

Effective Interest Amortization


General
General Mills
Mills issued
issued $100,000
$100,000 face
face value,
value, 6%,
6%, 4-year
4-year bonds
bonds at
at aa market
market
price
price to
to yield
yield investors
investors 8%.
8%. The
The bonds
bonds were
were issued
issued at
at aa discount
discount of
of $6,624.
$6,624.
Lets
Lets determine
determine the
the effective
effective interest
interest for
for the
the first
first interest
interest payment
payment period.
period.
1 Analyze

Interest (I) = Principal (P) Rate (R) Time (T)


Interest Expense = Carrying Value Market Rate n/12
$7,470 = $93,376 8% 12/12

2 Record

10-50

Cash
$$ 6,000
Cash Interest
Interest
6,000
Effective
7,470
Effective Interest
Interest
7,470
Amortization
Amortization of
of Discount
Discount $$ 1,470
1,470

Effective Interest Amortization


$7,470
$7,470 -- $6,000
$6,000 == $1,470
$1,470

$7,470
$7,470 -- $1,470
$1,470 == $5,154
$5,154

Effective Interest Amortization of Bonds Issued at a Discount

$93,376
$93,376 8%
8% 12/12
12/12 == $7,470
$7,470
$100,000
$100,000 6%
6% 12/12
12/12 == $6,000
$6,000
Face
Face value
value xx stated
stated int
int xx time
time

$93,376
$93,376 ++ $1,470
$1,470 == $94,846
$94,846

Both Interest Expense and Discount Amortization


increase each period. Cash interest is unchanged.
10-51

Chapter 10
Solved Exercises
M10-5, E10-2, E10-3, E10-8, E10-10,
PA10-3

M10-5 Reporting Current and Noncurrent Portions of Long-Term


Debt
Assume that on December 1, 2010, your company borrowed $14,000, a
portion of which is to be repaid each year on November 30.
Specifically, your company will make the following principal payments:
2011, $2,000; 2012, $3,000; 2013, $4,000; and 2014, $5,000. Show how
this loan will be reported in the December 31, 2011 and 2010 balance
sheets, assuming that principal payments will be made when required.

10-53

E10-2 Recording a Note Payable through Its Time to Maturity


Many businesses borrow money during periods of increased business
activity to finance inventory and accounts receivable. Target
Corporation is one of Americas largest general merchandise retailers.
Each Christmas, Target builds up its inventory to meet the needs of
Christmas shoppers. A large portion of Christmas sales are on credit.
As a result, Target often collects cash from the sales several months
after Christmas. Assume that on November 1, 2010, Target borrowed
$6 million cash from Metropolitan Bank and signed a promissory note
that matures in six months. The interest rate was 7.5 percent payable
at maturity. The accounting period ends December 31.
Required:
1.Give the journal entry to record the note on November 1, 2010.
2.Give any adjusting entry required on December 31, 2010.
3.Give the journal entry to record payment of the note and interest on
the maturity date, April 30, 2011, assuming that interest has not been
recorded since December 31, 2010.

10-54

E10-2 Recording a Note Payable through Its Time to Maturity


November 1, 2010:

Borrowed on 6-month, 7.5%, note payable.

December 31, 2010 (end of the accounting period):

Adjusting entry for 2 months accrued interest ($6,000,000 x 7.5% x 2/12 = $75,000).

April 30, 2011 (maturity date):

Paid note plus interest at maturity.

10-55

E10-3 Recording Payroll Costs with Discussion


McLoyd Company completed the salary and wage payroll for March
2010. The payroll provided the following details:

Required:
1.Considering both employee and employer payroll taxes, use the
preceding information to calculate the total labor cost for the company.
2.Prepare the journal entry to record the payroll for March, including
employee deductions (but excluding employer payroll taxes).
3.Prepare the journal entry to record the employers FICA taxes and
unemployment taxes.

10-56

E10-3 Recording Payroll Costs with Discussion


Req. 1 The total labor cost was $248,045, made up of the $230,000 in gross
salaries and wages plus the $16,445 for employer FICA taxes and
$1,600 for unemployment taxes.
Req. 2 March 31, 2010
dr Salaries and Wages Expense (+E, -SE) 230,000
cr Withheld Income Taxes Payable (+L)
50,200
cr FICA Taxes Payableemployees (+L)
16,445
cr Cash (-A)
163,355
Payroll for March including employee deductions.

Req. 3 March 31, 2010


dr Payroll Tax Expense (+E,-SE)
cr FICA Taxes Payableemployer (+L)
cr Unemployment Taxes Payable (+L)
Employer payroll taxes on March payroll.

10-57

18,045
16,445
1,600

E10-8 Preparing Journal Entries to Record Issuance of


Bonds at Face Value, Payment of Interest, and Early
Retirement
On January 1, 2010, Innovative Solutions, Inc., issued
$200,000 in bonds at face value. The bonds have a stated
interest rate of 6 percent. The bonds mature in 10 years and
pay interest once per year on December 31.
Required:
1.Prepare the journal entry to record the bond issuance.
2.Prepare the journal entry to record the interest payment on
December 31, 2010. Assume no interest has been accrued
earlier in the year.
3.Assume the bonds were retired immediately after the first
interest payment at a quoted price of 102. Prepare the journal
entry to record the early retirement of the bonds.

10-58

E10-8 Preparing Journal Entries to Record Issuance of Bonds


at Face Value, Payment of Interest, and Early Retirement
Req. 1 dr Cash (+A)
200,000
cr Bonds Payable (+L)
200,000

Req. 2

dr Interest Expense (+E, -SE)


cr Cash (-A)

12,000
12,000

($200,000 x 6% x 12/12) = $12,000

Req. 3

dr Bonds Payable (-L)


200,000
dr Loss on Bonds Retired (+E, -SE) 4,000
cr Cash (-A)
204,000
($200,000 x 102%) = $204,000

10-59

E10-10 Calculating and Interpreting the Quick Ratio and Times


Interest Earned Ratio
According to its Web site, Kraft Foods Inc. sells enough Kool-Aid mix to
make 1,000 gallons of the drink every minute during the summer and over
560 million gallons each year. At December 31, 2008, the company
reported no short-term investments but did report the following amounts (in
millions) in its financial statements:

Required:
1.Compute the quick ratio and times interest earned ratio (to two decimal
places) for 2008 and 2007.
2.Did Kraft appear to have increased or decreased its ability to pay current
liabilities and future interest obligations as they become due? How can you
explain the seemingly conflicting findings of your ratio analysis?

10-60

E10-10 Calculating and Interpreting the Quick Ratio and Times


Interest Earned Ratio
Req. 1

Req. 2

10-61

E10-10 Calculating and Interpreting the Quick Ratio and Times


Interest Earned Ratio
Req. 3 The times interest earned ratio has decreased from 6.95 to 3.93,

suggesting a decline in Krafts ability to cover its interest through


profitable operations. The quick ratio has increased from 0.34 in
2007 to 0.54 in 2008, suggesting Kraft is in a better position to
quickly pay its current liabilities at the end of 2008. These findings
seem to conflict, but can be explained as follows. In 2008, when the
economy was suffering, Kraft realized that it could no longer rely as
much on obtaining short-term financing to cover cash needs.
Consequently, Kraft borrowed more funds through long-term debt,
which doubled the amount the company held in Cash and Cash
Equivalents. Obtaining more long-term debt financing came at a
cost, however, as indicated by the doubling of Interest Expense. The
results of these shifts were an increase in the quick ratio (associated
with the increase in Cash) and a decrease in the times interest
earned ratio (associated with the increase in Interest Expense).

10-62

PA10-3 Recording and Reporting Current Liabilities


During 2010, Lakeview Company completed the following two transactions. The annual
accounting period ends December 31.
a.On December 31, 2010, calculated the payroll, which indicates gross earnings for
wages ($80,000), payroll deductions for income tax ($8,000), payroll deductions for
FICA ($6,000), payroll deductions for American Cancer Society ($2,000), employer
contributions for FICA (matching), state unemployment taxes ($500), and federal
unemployment taxes ($100). Employees were paid in cash, but these payments and the
corresponding payroll deductions and employer taxes have not yet been recorded.
b.Collected rent revenue of $3,600 on December 10, 2010, for office space that
Lakeview rented to another business. The rent collected was for 30 days from
December 11, 2010, to January 10, 2011, and was credited in full to Rent Revenue.
Required:
1.Give the journal entries to record payroll on December 31, 2010.
2.Give ( a ) the journal entry for the collection of rent on December 10, 2010, and ( b )
the adjusting journal entry on December 31, 2010.
3.Show how any liabilities related to these items should be reported on the companys
balance sheet at December 31, 2010.
4.Explain why the accrual basis of accounting provides more relevant information to
financial analysts than the cash basis.

10-63

PA10-3 Recording and Reporting Current Liabilities

Req. 1 dr Wage Expense (+E, -SE)


80,000
cr Withheld Income Tax Payable (+L)
8,000
cr FICA Payable (+L)
6,000
cr American Cancer Society Payable (+L)
2,000
cr Cash (-A)
64,000
dr Payroll Tax Expense (+E, -SE)
6,600
cr FICA Payable (+L)
cr State Unemployment Tax Payable (+L)
cr Federal Unemployment Tax Payable (+L)
December 10, 2010:
Req. 2 (a)
dr Cash (+A)
cr Rent Revenue (+R, +SE)

6,000
500
100

3,600
3,600

Collection of rent revenue for one month.

(b)
December 31, 2010:
dr Rent Revenue (-R, -SE)
cr Unearned Rent Revenue (+L)

1,200
1,200

Earned 20 days of rent but initially recorded as if all was earned. Need to
reduce revenue for 10 days unearned (10/30 x $3,600 = $1,200).
10-64

PA10-3 Recording and Reporting Current Liabilities

Req. 3 Balance sheet at December 31, 2010:


Current Liabilities:
Withheld Income Taxes Payable
8,000
FICA Payable
12,000
American Cancer Society Payable
2,000
State Unemployment Tax Payable 500
Federal Unemployment Tax Payable
100
Unearned Rent Revenue
1,200

Req. 4 Accrual basis accounting is beneficial to financial analysts because it


records revenues when they are earned and expenses when they are
incurred, regardless of when the related cash is received or paid. Cash
basis accounting only records revenues when they are received and
expenses when they are paid. A financial analyst is looking towards the
future of the company, so it is helpful to know how much cash will be
coming into and out of the company at later dates. Cash basis
accounting limits financial analysts to only what has happened in prior
periods and tells them very little about future events and cash flows that
will affect the financial health of the company.
10-65

End of Chapter 10

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