Liabilities: Current, Contingent, and Long-Term (Bonds) – Financial Accounting Study Notes

Liabilities in Financial Accounting

Introduction to Liabilities

Liabilities represent obligations of a company to pay cash, transfer assets, or provide services in the future as a result of past transactions. They are classified as current or long-term based on their due dates.

• Current Liabilities: Obligations due within one year.

• Long-Term Liabilities: Obligations due beyond one year.

Current Liabilities

Short-Term Notes Payable

Short-term notes payable are written promises to pay a specified amount of money, usually with interest, within one year. They are often used to finance inventory purchases or other short-term needs.

• Initial Entry: When inventory is purchased by issuing a note:

Date	Account	Debit	Credit
Jan 1	Inventory	8,000
	Note Payable, Short-Term		8,000

• Accrual of Interest: At year-end, interest expense is accrued:

Date	Account	Debit	Credit
Sep 30	Interest Expense	600
	Interest Payable		600

• Payment at Maturity: On maturity, both principal and interest are paid:

Date	Account	Debit	Credit
Jan 1	Note Payable, Short-Term	8,000
	Interest Payable	600
	Interest Expense	200
	Cash		8,800

Formula for Interest:

$\text{Interest} = \text{Principal} \times \text{Rate} \times \text{Time}$

Sales Tax Payable

Sales tax payable is a liability for sales taxes collected from customers and owed to the government.

• Levied on retail sales

• Collected from customers and remitted to state

Account	Debit	Credit
Cash ($200,000 x 1.05)	210,000
Sales Revenue		200,000
Sales Tax Payable ($200,000 x .05)		10,000

Payroll Liabilities

Payroll liabilities, also called employee compensation, are major expenses for companies and include various forms:

• Salary

• Wage

• Commission

• Bonus

Accounting for payroll involves recording salary expense and related tax liabilities:

Account	Debit	Credit
Salary Expense	10,000
Employee Income Tax Payable		1,200
FICA Tax Payable		800
Salary Payable		8,000

Unearned Revenue and Sales Tax Example

When cash is received in advance for services (e.g., subscriptions), it is recorded as unearned revenue. Sales tax collected is a liability until remitted.

Date	Account	Debit	Credit
Oct 1	Cash ($2,400 x 1.09)	2,616
	Unearned Subscription Revenue		2,400
	Sales Tax Payable		216
Nov 15	Sales Tax Payable	216
	Cash		216
Dec 31	Unearned Subscription Revenue	600
	Subscription Revenue		600

Additional info: $600 = $2,400 \times 3/12$ (portion earned by year-end)

Current Portion of Long-Term Debt

The current portion of long-term debt is the amount of principal due within one year. It is reclassified from long-term to current on the balance sheet.

• Also called current maturity or current installment

• Long-term debt is often paid in installments

• Company reclassifies amount from long-term to current

Current Liabilities That Must Be Estimated

Estimated Warranty Payable

Estimated warranty payable is a liability for expected future warranty claims. Companies must estimate and record warranty expense in the same period as the related sales revenue (expense recognition principle).

• Warranty period may extend for 90 days to a year

• Expense is estimated based on historical data

Account	Debit	Credit
Warranty Expense ($100,000 x 3%)	3,000
Estimated Warranty Payable		3,000

When actual warranty claims are made:

Account	Debit	Credit
Estimated Warranty Payable	2,800
Inventory		2,800

T-account Example:

Estimated Warranty Payable
Debit: 2,800
Credit: 3,000
Balance: 200

Contingent Liabilities

Contingent liabilities are potential obligations that depend on the outcome of future events. Their accounting treatment depends on the probability of occurrence:

Probability	Accounting Treatment
Probable	Accrue
Reasonably Possible	Disclose
Remote	None

Long-Term Liabilities: Bonds Payable

Bonds: An Introduction

Bonds are long-term debt instruments issued by companies to raise capital. The bond certificate includes key information:

• Company name

• Principal (face value, maturity value, par value)

• Maturity date

• Interest rate

• Interest payment dates (typically semi-annual)

Bonds Prices

Bonds are quoted as a percentage of their maturity (face) value. The price may be at par, premium, or discount:

Quoted Price	Sold at Amount	Premium, Discount, or Par
100	$1,000	Par (face value)
101.5	$1,015	Premium
88.375	$883.75	Discount

Interest Rates Determine Bond Prices

The price of a bond is determined by two interest rates:

• Stated Interest Rate (Coupon Rate): Printed on the bond certificate; determines cash interest paid to bondholders.

• Market Interest Rate (Effective Rate): Demanded by investors; varies with market conditions.

If the market rate is below the stated rate, bonds sell at a premium; if above, at a discount; if equal, at par.

Bond Premium and Discount

Premium ($1,050)	Discount ($950)
Issuance price above face value	Issuance price below face value
Credit balance will amortize to 0	Debit balance will amortize to 0
Carrying amount decreases towards maturity value	Carrying amount increases towards maturity value

At maturity, the carrying amount equals the face value.

Issuing Bonds Payable at Par (Face Value)

When bonds are issued at par, the cash received equals the face value. Interest is paid semiannually and accrued at year-end.

Date	Account	Debit	Credit
Jan 1	Cash	50,000
	Bonds Payable		50,000
Jul 1	Interest Expense	2,250
	Cash		2,250
Dec 31	Interest Expense	2,250
	Interest Payable		2,250
Jan 1 (next year)	Interest Payable	2,250
	Cash		2,250
At maturity	Bonds Payable	50,000
	Cash		50,000

Formula for Interest Payment:

$\text{Interest Payment} = \text{Face Value} \times \text{Stated Rate} \times \text{Time}$

Issuing Bonds Payable at a Discount

Bonds issued at a discount are sold below face value when the stated rate is less than the market rate. The discount is amortized over the bond's life.

Date	Account	Debit	Credit
Jan 1	Cash	96,149
	Discount on Bonds Payable	3,851
	Bonds Payable		100,000

Balance Sheet Presentation:

Long-term liabilities	Amount
Bonds payable, 9%, due 2019	100,000
Less: Discount on bonds payable	(3,851)
Net carrying amount	96,149

Straight-Line Amortization Method

This method divides the total bond discount or premium into equal amounts over the bond's term. It is less precise but simpler than the effective interest method.

• Interest expense is the same for each period.

• Allowed if results do not differ significantly from the effective interest method.

Formula:

$\text{Amortization per period} = \frac{\text{Total Discount or Premium}}{\text{Number of Interest Periods}}$

Effective Interest Amortization Method

This method calculates interest expense by multiplying the market rate by the carrying amount of the bond. The difference between interest expense and cash payment is the amortization amount.

• Interest expense varies each period.

• More accurate; required by GAAP for significant differences.

Formula:

$\text{Interest Expense} = \text{Carrying Amount} \times \text{Market Rate} \times \text{Time}$

$\text{Discount Amortization} = \text{Interest Expense} - \text{Cash Payment}$

Bond Amortization Schedule Example

The following table shows the effective interest method for a $100,000 bond issued at a discount:

Date	Interest Payment (4.5%)	Interest Expense (5.0%)	Discount Amortization	Discount Balance	Carrying Value
1/1/2014	4,500	4,807	307	3,851	96,149
7/1/2014	4,500	4,823	323	3,528	96,472
1/1/2015	4,500	4,840	340	3,188	96,812
7/1/2015	4,500	4,857	357	2,831	97,169
1/1/2019	4,500	4,961	461	0	100,000

Key Points:

• Semiannual interest payments are constant ($4,500).

• Interest expense increases as carrying value increases.

• Discount balance decreases as it is amortized.

• At maturity, carrying value equals face value.

Summary

• Current liabilities include notes payable, sales tax payable, payroll liabilities, and estimated liabilities.

• Contingent liabilities require judgment for accounting treatment.

• Bonds payable can be issued at par, discount, or premium, with amortization methods affecting interest expense and carrying value.