E10-2 recording a note payable through its time to maturity [lo 10-2]

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&conte… 1/101

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&conte… 2/101

10

Reporting and Analyzing Liabilities

 CHAPTER PREVIEW 

The Feature Story suggests that General Motors (GM) and Ford accumulated tremendous amounts of debt in their pursuit of auto industry dominance. It is unlikely that they could have grown so large without this debt, but at times the debt threatened their very existence. Given this risk, why do com panies borrow money? Why do they sometimes borrow short-term and other times long-term? Besides bank borrowings, what other kinds of debts do companies incur? In this chapter, we address these issues.

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&conte… 3/101

And Then There Were Two

Debt can help a company acquire the things it needs to grow. But, it is often the very thing that can also kill a company. A brief history of Maxwell Car Company illustrates the role of debt in the U.S. auto industry. In 1920, Maxwell Car Company was on the brink of �inancial ruin. Because it was unable to pay its bills, its creditors stepped in and took over. They hired a former General Motors (GM) executive named Walter Chrysler to reorganize the company. By 1925, he had taken over the company and renamed it Chrysler. By 1933, Chrysler was booming, with sales surpassing even those of Ford.

But the next few decades saw Chrysler make a series of blunders. By 1980, with its creditors pounding at the gates, Chrysler was again on the brink of �inancial ruin.

At that point, Chrysler brought in a former Ford executive named Lee Iacocca to save the company. Iacocca argued that the United States could not afford to let Chrysler fail because of the loss of jobs. He convinced the federal government to grant loan guarantees—promises that if Chrysler failed to pay its creditors, the government would pay them. Iacocca then streamlined operations and brought out some pro�itable products. Chrysler repaid all of its government-guaranteed loans by 1983, seven years ahead of the scheduled �inal payment.

To compete in today's global vehicle market, you must be big—really big. So in 1998, Chrysler merged with German automaker Daimler-Benz to form DaimlerChrysler. For a time, this left just two U.S.-based auto manufacturers—GM and Ford. But in 2007, DaimlerChrysler sold 81% of Chrysler to Cerberus, an investment group, to provide much-needed cash infusions to the automaker. In 2009, Daimler turned over its remaining stake to Cerberus. Three days later, Chrysler �iled for bankruptcy. But by 2010, it was beginning to show signs of a turnaround.

The car companies are giants. GM and Ford typically rank among the top �ive U.S. �irms in total assets. But GM and Ford accumulated truckloads of debt on their way to getting big. Although debt made it possible to get so big, the Chrysler story, and GM's recent bankruptcy, make it clear that debt can also threaten a company's survival.

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&conte… 4/101

LEARNING OBJECTIVE 1

 Explain how to account for current liabilities. 

WHAT IS A CURRENT LIABILITY? Liabilities are often de�ined as “creditors' claims on total assets” and as “existing debts and obligations.” Companies must settle or pay these claims, debts, and obligations at some time in the future by transferring assets or services. The future date on which they are due or payable (the maturity date) is a signi�icant feature of liabilities.

As explained in Chapter 2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02#ch02) , a current liability is a debt that a company reasonably expects to pay (1) from existing current assets or through the creation of other current liabilities, and (2) within one year or the operating cycle, whichever is longer. Debts that do not meet both criteria are long-term liabilities.

Financial statement users want to know whether a company's obligations are current or long-term. A company that has more current liabilities than current assets often lacks liquidity, or short-term debt- paying ability. In addition, users want to know the types of liabilities a company has. If a company declares bankruptcy, a speci�ic, predetermined order of payment to creditors exists. Thus, the amount and type of liabilities are of critical importance.

The different types of current liabilities include notes payable, accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest. In the sections that follow, we discuss a few of the common types of current liabilities.

▼ HELPFUL HINT

In previous chapters, we explained the entries for accounts payable and the adjusting entries for some current liabilities.

NOTES PAYABLE Companies record obligations in the form of written notes as notes payable. They often use notes payable instead of accounts payable because notes payable provide written documentation of the obligation in case legal remedies are needed to collect the debt. Companies frequently issue notes payable to meet short-term �inancing needs. Notes payable usually require the borrower to pay interest.

Notes are issued for varying periods of time. Those due for payment within one year of the balance sheet date are usually classi�ied as current liabilities.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch02#ch02

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&conte… 5/101

To illustrate the accounting for notes payable, assume that on September 1, 2017, Cole Williams Co. signs a $100,000, 12%, four-month note maturing on January 1 with First National Bank. When a company issues an interest-bearing note, the amount of assets it receives generally equals the note's face value. Cole Williams Co. therefore will receive $100,000 cash and will make the following journal entry.

Interest accrues over the life of the note, and the issuer must periodically record that accrual. (You may �ind it helpful to review the discussion of interest computations that was provided in Chapter 8 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch08#ch08) , page 388, with regard to notes receivable.) If Cole Williams Co. prepares �inancial statements annually, it makes an adjusting entry at December 31 to recognize four months of interest expense and interest payable of $4,000 ($100,000×12%×412):

In the December 31 �inancial statements, the current liabilities section of the balance sheet will show notes payable $100,000 and interest payable $4,000. In addition, the company will report interest expense of $4,000 under “Other expenses and losses” in the income statement.

At maturity (January 1), Cole Williams Co. must pay the face value of the note ($100,000) plus $4,000 interest ($100,000×12%×412). It records payment of the note and accrued interest as follows.

Appendix 10C at the end of this chapter discusses the accounting for long-term installment notes payable.

SALES TAXES PAYABLE Many of the products we purchase at retail stores are subject to sales taxes. Many states are now implementing sales taxes on purchases made on the Internet as well. Sales taxes are expressed as a percentage of the sales price. The selling company collects the tax from the customer when the sale occurs and periodically (usually monthly) remits the collections to the state's department of revenue. Collecting sales taxes is important. For example, the State of New York recently sued Sprint Corporation for $300 million for its alleged failure to collect sales taxes on phone calls.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch08#ch08

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&conte… 6/101

Under most state laws, the selling company must enter separately on the cash register the amount of the sale and the amount of the sales tax collected. (Gasoline sales are a major exception.) The company then uses the cash register readings to credit Sales Revenue and Sales Taxes Payable. For example, if the March 25 cash register readings for Cooley Grocery show sales of $10,000 and sales taxes of $600 (sales tax rate of 6%), the journal entry is as follows.

When the company remits the taxes to the taxing agency, it decreases (debits) Sales Taxes Payable and decreases (credits) Cash. The company does not report sales taxes as an expense. It simply forwards to the government the amount paid by the customer. Thus, Cooley Grocery serves only as a collection agent for the taxing authority.

Sometimes companies do not enter sales taxes separately on the cash register. To determine the amount of sales in such cases, divide total receipts by 100% plus the sales tax percentage. For example, assume that Cooley Grocery enters total receipts of $10,600. Because the amount received from the sale is equal to the sales price (100%) plus 6% of sales, or 1.06 times the sales total, we can compute sales as follows: $10,600÷1.06=$10,000. Thus, we can �ind the sales tax amount of $600 by either (1) subtracting sales from total receipts ($10,600−$10,000) or (2) multiplying sales by the sales tax rate ($10,000×6%).

▼ HELPFUL HINT

Check your sales receipts from local retailers to see whether the sales tax is computed separately.

UNEARNED REVENUES A magazine publisher such as Sports Illustrated collects cash when customers place orders for magazine subscriptions. An airline company such as American Airlines often receives cash when it sells tickets for future �lights. Season tickets for concerts, sporting events, and theatre programs are also paid for in advance. How do companies account for unearned revenues that are received before goods are delivered or services are performed?

1. When the company receives an advance, it increases (debits) Cash and increases (credits) a current liability account identifying the source of the unearned revenue.

2. When the company recognizes revenue, it decreases (debits) the unearned revenue account and increases (credits) a revenue account.

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&conte… 7/101

To illustrate, assume that Superior University sells 10,000 season football tickets at $50 each for its �ive- game home schedule. The university makes the following entry for the sale of season tickets.

As each game is completed, Superior records the recognition of $100,000 ($500,000÷5) of revenue with the following entry.

The account Unearned Ticket Revenue represents unearned revenue, and Superior reports it as a current liability. As the school recognizes revenue, it reclassi�ies the amount from unearned revenue to Ticket Revenue. Unearned revenue is material for some companies. In the airline industry, tickets sold for future �lights often represent almost 50% of total current liabilities. At United Air Lines, unearned ticket revenue is its largest current liability, recently amounting to more than $1 billion.

Illustration 10-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo1#c10-�ig-0001) shows speci�ic unearned revenue and revenue accounts used in selected types of businesses.

ILLUSTRATION 10-1 Unearned revenue and revenue accounts

CURRENT MATURITIES OF LONG-TERM DEBT Companies often have a portion of long-term debt that comes due in the current year. As an example, assume that Wendy Construction issues a �ive-year, interest-bearing $25,000 note on January 1, 2016. This note speci�ies that each January 1, starting January 1, 2017, Wendy should pay $5,000 of the note. When the company prepares �inancial statements on December 31, 2016, it should report $5,000 as a current liability and $20,000 as a long-term liability. (The $5,000 amount is the portion of the note that is due to be paid within the next 12 months.) Companies often identify current maturities of long-term debt on the balance sheet as long-term debt due within one year. In a recent year, General Motors had $724 million of such debt.

It is not necessary to prepare an adjusting entry to recognize the current maturity of long-term debt. At the balance sheet date, all obligations due within one year are classi�ied as current, and all other obligations are long-term.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo1#c10-fig-0001

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&conte… 8/101

DO IT! 1a

Current Liabilities

You and several classmates are studying for the next accounting examination. They ask you to answer the following questions.

1. If cash is borrowed on a $50,000, 6-month, 12% note on September 1, how much interest expense would be incurred by December 31?

2. The cash register total including sales taxes is $23,320, and the sales tax rate is 6%. What is the sales taxes payable?

3. If $15,000 is collected in advance on November 1 for 3 months' rent, what amount of rent revenue should be recognized by December 31?

Action Plan ✓ Use the interest formula: Face value of note×Annual interest

rate×Time in terms of one year.

✓ Divide total receipts by 100% plus the tax rate to determine sales; then subtract sales from the total receipts.

✓ Determine what fraction of the total unearned rent should be recognized this year.

SOLUTION

1. $50,000×12%×4/12=$2,000

2. $23,320÷1.06=$22,000;$23,320−$22,000=$1,320

3. $15,000×2/3=$10,000

Related exercise material: BE10-2, BE10-3, BE10-4, DO IT! 10-1a, E10-1, E10-2, E10-3, E10-4, E10-6, and E10-7.

PAYROLL AND PAYROLL TAXES PAYABLE

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&conte… 9/101

Assume that Susan Alena works 40 hours this week for Pepitone Inc., earning a wage of $10 per hour. Will Susan receive a $400 check at the end of the week? Not likely. The reason: Pepitone is required to withhold amounts from her wages to pay various governmental authorities. For example, Pepitone will withhold amounts for Social Security taxes1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10ifrs#c10-note- 0009) and for federal and state income taxes. If these withholdings total $100, Susan will receive a check for only $300. Illustration 10-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo1#c10-�ig-0002) summarizes the types of payroll deductions that normally occur for most companies.

ILLUSTRATION 10-2 Payroll deductions

As a result of these deductions, companies withhold from employee paychecks amounts that must be paid to other parties. Pepitone therefore has incurred a liability to pay these third parties and must report this liability in its balance sheet.

As a second illustration, assume that Cargo Corporation records its payroll for the week of March 7 with the journal entry shown below.

In this case, Cargo reports $100,000 in salaries and wages expense. In addition, it reports liabilities for the salaries and wages payable as well as liabilities to governmental agencies. Rather than pay the employees

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10ifrs#c10-note-0009

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo1#c10-fig-0002

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 10/101

$100,000, Cargo instead must withhold the taxes and make the tax payments directly. In summary, Cargo is essentially serving as a tax collector.

In addition to the liabilities incurred as a result of withholdings, employers also incur a second type of payroll-related liability. With every payroll, the employer incurs liabilities to pay various payroll taxes levied upon the employer. These payroll taxes include the employer's share of Social Security (FICA) taxes and state and federal unemployment taxes. Based on Cargo's $100,000 payroll, the company would record the employer's expense and liability for these payroll taxes as follows.

Companies classify the payroll and payroll tax liability accounts as current liabilities because they must be paid to employees or remitted to taxing authorities periodically and in the near term. Taxing authorities impose substantial �ines and penalties on employers if the withholding and payroll taxes are not computed correctly and paid on time.

ANATOMY OF A FRAUD

Art was a custodial supervisor for a large school district. The district was supposed to employ between 35 and 40 regular custodians, as well as 3 or 4 substitute custodians to �ill in when regular custodians were absent. Instead, in addition to the regular custodians, Art “hired” 77 substitutes. In fact, almost none of these people worked for the district. Instead, Art submitted time cards for these people, collected their checks at the district of�ice, and personally distributed the checks to the “employees.” If a substitute's check was for $1,200, that person would cash the check, keep $200, and pay Art $1,000.

Total take: $150,000

THE MISSING CONTROLS

Human resource controls. Thorough background checks should be performed. No employees should begin work until they have been approved by the Board of Education and entered into the payroll system. No employees should be entered into the payroll system until they have been approved by a supervisor. All paychecks should be distributed directly to employees at the of�icial school locations by designated employees or direct-deposited into approved employee bank accounts.

Independent internal veri�ication. Budgets should be reviewed monthly to identify situations where actual costs signi�icantly exceed budgeted amounts.

Source: Adapted from Wells, Fraud Casebook (2007), pp. 164–171.

DO IT! 1b

Wages and Payroll Taxes

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 11/101

During the month of September, Lake Corporation's employees earned wages of $60,000. Withholdings related to these wages were $3,500 for Social Security (FICA), $6,500 for federal income tax, and $2,000 for state income tax. Costs incurred for unemployment taxes were $90 for federal and $150 for state.

Prepare the September 30 journal entries for (a) salaries and wages expense and salaries and wages payable, assuming that all September wages will be paid in October, and (b) the company's payroll tax expense.

Action Plan ✓ Remember that wages earned are an expense to the company,

but withholdings reduce the amount due to be paid to the employee.

✓ Payroll taxes are taxes the company incurs related to its employees.

SOLUTION (a) To determine wages payable, reduce wages expense by the withholdings for

FICA, federal income tax, and state income tax.

(b) Payroll taxes would be for the company's share of FICA, as well as for federal and state unemployment tax.

Related exercise material: BE10-5, BE10-6, DO IT! 10-1b, and E10-5.

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 12/101

LEARNING OBJECTIVE 2

Describe the major characteristics of bonds. 

Long-term liabilities are obligations that a company expects to pay more than one year in the future. In this section, we explain the accounting for the principal types of obligations reported in the long-term liabilities section of the balance sheet. These obligations often are in the form of bonds or long-term notes.

Bonds are a form of interest-bearing note payable issued by corporations, universities, and governmental agencies. Bonds, like common stock, are sold in small denominations (usually $1,000 or multiples of $1,000). As a result, bonds attract many investors. When a corporation issues bonds, it is borrowing money. The person who buys the bonds (the bondholder) is investing in bonds.

TYPES OF BONDS Bonds may have different features. In the following sections, we describe some commonly issued types of bonds.

Secured and Unsecured Bonds

Secured bonds have speci�ic assets of the issuer pledged as collateral for the bonds. Unsecured bonds are issued against the general credit of the borrower. Large corporations with good credit ratings use unsecured bonds extensively. For example, at one time DuPont reported more than $2 billion of unsecured bonds outstanding.

Convertible and Callable Bonds

Bonds that can be converted into common stock at the bondholder's option are convertible bonds. Bonds that the issuing company can redeem (buy back) at a stated dollar amount prior to maturity are callable bonds. Convertible bonds have features that are attractive both to bondholders and to the issuer. The conversion feature often gives bondholders an opportunity to bene�it if the market price of the common stock increases substantially. Furthermore, until conversion, the bondholder receives interest on the bond. For the issuer, the bonds sell at a higher price and pay a lower rate of interest than comparable debt securities that do not have a conversion option. Many corporations, such as USAir, United States Steel Corp., and General Motors Corporation, have issued convertible bonds.

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 13/101

ISSUING PROCEDURES A bond certi�icate is issued to the investor to provide evidence of the investor's claim against the company. As Illustration 10-3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo2#c10-�ig-0003) (page 487) shows, the bond certi�icate provides information such as the name of the company that issued the bonds, the face value of the bonds, the maturity date of the bonds, and the contractual interest rate. The face value is the amount of principal due at the maturity date. The maturity date is the date that the �inal payment is due to the investor from the issuing company. The contractual interest rate is the rate used to determine the amount of cash interest the issuer pays and the investor receives. Usually, the contractual rate is stated as an annual rate.

ALTERNATIVE TERMINOLOGY

The contractual rate is often referred to as the stated rate.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo2#c10-fig-0003

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 14/101

DETERMINING THE MARKET PRICE OF BONDS If your company needed �inancing and wanted to attract investors to purchase its bonds, how would the market set the price for these bonds? To be more speci�ic, assume that Coronet, Inc. issues a zero-interest (pays no interest) bond with a face value of $1,000,000 due in 20 years. For this bond, the only cash Coronet pays to bond investors is $1 million at the end of 20 years. Would investors pay $1 million for this bond? We hope not because $1 million received 20 years from now is not the same as $1 million received today.

ILLUSTRATION 10-3 Bond certi�icate

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 15/101

The term time value of money is used to indicate the relationship between time and money—that a dollar received today is worth more than a dollar promised at some time in the future. If you had $1 million today, you would invest it and earn interest so that at the end of 20 years, your investment would be worth much more than $1 million. Thus, if someone is going to pay you $1 million 20 years from now, you would want to �ind its equivalent today, or its present value. In other words, you would want to determine the value today of the amount to be received in the future after taking into account current interest rates.

The current market price (present value) of a bond is therefore a function of three factors: (1) the dollar amounts to be received, (2) the length of time until the amounts are received, and (3) the market interest rate. The market interest rate is the rate investors demand for loaning funds.

To illustrate, assume that Acropolis Company on January 1, 2017, issues $100,000 of 9% bonds, due in �ive years, with interest payable annually at year-end. The purchaser of the bonds would receive the following two types of cash payments: (1) principal of $100,000 to be paid at maturity, and (2) �ive $9,000 interest payments ($100,000×9%) over the term of the bonds. Illustration 10-4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo2#c10-�ig-0004) shows a time diagram depicting both cash �lows.

ILLUSTRATION 10-4 Time diagram depicting cash �lows

The current market price of a bond is equal to the present value of all the future cash payments promised by the bond. Illustration 10-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo2#c10-�ig-0005) lists and totals the present values of these amounts, assuming the market rate of interest is 9%.

ILLUSTRATION 10-5 Computing the market price of bonds

Tables are available to provide the present value numbers to be used, or these values can be determined mathematically or with �inancial calculators.2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10ifrs#c10-note-0016) Appendix G (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a07#a07) , near the end of the textbook, provides further discussion of the concepts and the mechanics of the time value of money computations.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo2#c10-fig-0004

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo2#c10-fig-0005

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10ifrs#c10-note-0016

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/a07#a07

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 16/101

INVESTOR INSIGHT

Running Hot!

Recently, the market for bonds was running hot. For example, consider these two large deals: Apple Inc. sold $17 billion of debt, which at the time was the largest corporate bond ever sold. But shortly thereafter, it was beat by Verizon Communications Inc., which sold $49 billion of debt. The following chart highlights the increased issuance of bonds.

As one expert noted about these increases, “Companies are taking advantage of this lower- rate environment in the limited period of time it is going to be around.” An interesting aspect of these bond issuances is that companies, like Philip Morris International, Medtronic, Inc., and Simon Properties, are even selling 30-year bonds. These bond issuers are bene�itting from “a massive sentiment shift,” says one bond expert. The belief that the economy will recover is making investors more comfortable holding longer-term bonds, as they search for investments that offer better returns than U.S. Treasury bonds.

Sources: Vipal Monga, “The Big Number,” Wall Street Journal (March 20, 2012), p. B5; and Mike Cherney, “Renewed Embrace of Bonds Sparks Boom,” Wall Street Journal (March 8–9, 2014), p. B5.

What are the advantages for companies of issuing 30-years bonds instead of 5-year bonds? (Go to WileyPLUS for this answer and additional questions.)

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 17/101

DO IT! 2

Bond Terminology

State whether each of the following statements is true or false. If false, indicate how to correct the statement.

______ 1. Secured bonds have speci�ic assets of the issuer pledged as collateral.

______ 2. Callable bonds can be redeemed by the issuing company at a stated dollar amount prior to maturity.

______ 3. The contractual interest rate is the rate investors demand for loaning funds.

______ 4. The face value is the amount of principal the issuing company must pay at the maturity date.

______ 5. The market price of a bond is equal to its maturity value.

Action Plan ✓ Review the types of bonds and the basic terms associated with

bonds.

SOLUTION

1. True.

2. True.

3. False. The contractual interest rate is used to determine the amount of cash interest the borrower pays.

4. True.

5. False. The market price of a bond is equal to the present value of all the future cash payments promised by the bond.

Related exercise material: DO IT! 10-2.

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 18/101

LEARNING OBJECTIVE 3

Explain how to account for bond transactions. 

A corporation records bond transactions when it issues (sells) or redeems (buys back) bonds and when bondholders convert bonds into common stock. If bondholders sell their bond investments to other investors, the issuing corporation receives no further money on the transaction, nor does the issuing corporation journalize the transaction (although it does keep records of the names of bondholders in some cases).

Bonds may be issued at face value, below face value (discount), or above face value (premium). Bond prices for both new issues and existing bonds are quoted as a percentage of the face value of the bond. Face value is usually $1,000. Thus, a $1,000 bond with a quoted price of 97 means that the selling price of the bond is 97% of face value, or $970.

ISSUING BONDS AT FACE VALUE To illustrate the accounting for bonds issued at face value, assume that Devor Corporation issues 100, �ive- year, 10%, $1,000 bonds dated January 1, 2017, at 100 (100% of face value). The entry to record the sale is as follows.

Devor reports bonds payable in the long-term liabilities section of the balance sheet because the maturity date is January 1, 2022 (more than one year away).

Over the term (life) of the bonds, companies make entries to record bond interest. Interest on bonds payable is computed in the same manner as interest on notes payable, as explained earlier. If we assume that interest is payable annually on January 1 on the bonds described above, Devor accrues interest of $10,000 ($100,000×10%×1212) on December 31. At December 31, Devor recognizes the $10,000 of interest expense incurred with the following adjusting entry.

The company classi�ies interest payable as a current liability because it is scheduled for payment within the next year. When Devor pays the interest on January 1, 2018, it decreases (debits) Interest

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 19/101

Payable and decreases (credits) Cash for $10,000. Devor records the payment on January 1 as follows.

DISCOUNT OR PREMIUM ON BONDS The previous example assumed that the contractual (stated) interest rate and the market (effective) interest rate paid on bonds were the same. Recall that the contractual interest rate is the rate applied to the face (par) value to arrive at the interest paid in a year. The market interest rate is the rate investors demand for loaning funds to the corporation. When the contractual interest rate and the market interest rate are the same, bonds sell at face value.

However, market interest rates change daily. The type of bond issued, the state of the economy, current industry conditions, and the company's individual performance all affect market interest rates. As a result, the contractual and market interest rates often differ. To make bonds salable when the two rates differ, bonds sell below or above face value.

To illustrate, suppose that a company issues 10% bonds at a time when other bonds of similar risk are paying 12%. Investors will not be interested in buying the 10% bonds, so their value will fall below their face value. When a bond is sold for less than its face value, the difference between the face value of a bond and its selling price is called a discount. As a result of the decline in the bonds' selling price, the actual interest rate incurred by the company increases to the level of the current market interest rate.

Conversely, if the market rate of interest is lower than the contractual interest rate, investors will have to pay more than face value for the bonds. That is, if the market rate of interest is 8% but the contractual interest rate on the bonds is 10%, the price on the bonds will be bid up. When a bond is sold for more than its face value, the difference between the face value and its selling price is called a premium. Illustration 10-6 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo3#c10-�ig-0006) shows these relationships graphically.

ILLUSTRATION 10-6 Interest rates and bond prices

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo3#c10-fig-0006

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 20/101

Issuance of bonds at an amount different from face value is quite common. By the time a company prints the bond certi�icates and markets the bonds, it will be a coincidence if the market rate and the contractual rate are the same. Thus, the issuance of bonds at a discount does not mean that the �inancial strength of the issuer is suspect. Conversely, the sale of bonds at a premium does not indicate that the �inancial strength of the issuer is exceptional.

▼ HELPFUL HINT

Bond prices vary inversely with changes in the market interest rate. As market interest rates decline, bond prices increase. When a bond is issued, if the market interest rate is below the contractual rate, the bond price is higher than the face value.

▼ HELPFUL HINT

Some bonds are sold at a discount by design. “Zero-coupon” bonds, which pay no interest, sell at a deep discount to face value.

ISSUING BONDS AT A DISCOUNT To illustrate the issuance of bonds at a discount, assume that on January 1, 2017, Candlestick Inc. sells $100,000, �ive-year, 10% bonds at 98 (98% of face value) with interest payable on January 1. The entry to record the issuance is as follows.

Although Discount on Bonds Payable has a debit balance, it is not an asset. Rather it is a contra account, which is deducted from bonds payable on the balance sheet as shown in Illustration 10-7 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo3#c10-�ig-0007) . The $98,000 represents the carrying (or book) value of the bonds. On the date of issue, this amount equals the market price of the bonds.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo3#c10-fig-0007

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 21/101

ILLUSTRATION 10-7 Statement presentation of discount on bonds payable

The issuance of bonds below face value causes the total cost of borrowing to differ from the bond interest paid. That is, the issuing corporation not only must pay the contractual interest rate over the term of the bonds but also must pay the face value (rather than the issuance price) at maturity. Therefore, the difference between the issuance price and the face value of the bonds—the discount—is an additional cost of borrowing. The company records this cost as interest expense over the life of the bonds. The total cost of borrowing $98,000 for Candlestick Inc. is $52,000, computed as shown in Illustration 10-8 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo3#c10-�ig-0008) .

ILLUSTRATION 10-8 Computation of total cost of borrowing—bonds issued at discount

Alternatively, we can compute the total cost of borrowing as shown in Illustration 10-9 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo3#c10-�ig-0009) .

ILLUSTRATION 10-9 Alternative computation of total cost of borrowing— bonds issued at discount

To follow the expense recognition principle, companies allocate bond discount to expense in each period in which the bonds are outstanding. This is referred to as amortizing the discount. Amortization of the discount increases the amount of interest expense reported each period. That is, after the company amortizes the discount, the amount of interest expense it reports in a period will exceed the contractual amount. As shown in Illustration 10-8 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo3#c10-�ig-0008) , for the bonds issued by Candlestick Inc., total interest expense will exceed the contractual interest by $2,000 over the life of the bonds.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo3#c10-fig-0008

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo3#c10-fig-0009

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo3#c10-fig-0008

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 22/101

As the discount is amortized, its balance declines. As a consequence, the carrying value of the bonds will increase, until at maturity the carrying value of the bonds equals their face amount. This is shown in Illustration 10-10 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo3#c10-�ig- 0010) . Appendices 10A and 10B at the end of this chapter discuss procedures for amortizing bond discount.

ILLUSTRATION 10-10 Amortization of bond discount

▼ HELPFUL HINT

The carrying value (book value) of bonds issued at a discount is determined by subtracting the balance of the discount account from the balance of the Bonds Payable account.

ISSUING BONDS AT A PREMIUM We can illustrate the issuance of bonds at a premium by now assuming the Candlestick Inc. bonds described above sell at 102 (102% of face value) rather than at 98. The entry to record the sale is as follows.

Candlestick adds the premium on bonds payable to the bonds payable amount on the balance sheet, as shown in Illustration 10-11 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo3#c10-�ig-0011) .

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo3#c10-fig-0010

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo3#c10-fig-0011

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 23/101

ILLUSTRATION 10-11 Statement presentation of bond premium

The sale of bonds above face value causes the total cost of borrowing to be less than the bond interest paid because the borrower is not required to pay the bond premium at the maturity date of the bonds. Thus, the premium is considered to be a reduction in the cost of borrowing that reduces bond interest expense over the life of the bonds. The total cost of borrowing $102,000 for Candlestick Inc. is $48,000, computed as in Illustration 10-12 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo3#c10-�ig-0012) .

ILLUSTRATION 10-12 Computation of total cost of borrowing—bonds issued at a premium

Alternatively, we can compute the cost of borrowing as shown in Illustration 10-13 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo3#c10-�ig-0013) .

ILLUSTRATION 10-13 Alternative computation of total cost of borrowing— bonds issued at a premium

Similar to bond discount, companies allocate bond premium to expense in each period in which the bonds are outstanding. This is referred to as amortizing the premium. Amortization of the premium decreases the amount of interest expense reported each period. That is, after the company amortizes the premium, the amount of interest expense it reports in a period will be less than the contractual amount. As shown in Illustration 10-12 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo3#c10-�ig- 0012) , for the bonds issued by Candlestick Inc., contractual interest will exceed the interest expense by $2,000 over the life of the bonds.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo3#c10-fig-0012

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo3#c10-fig-0013

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo3#c10-fig-0012

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 24/101

As the premium is amortized, its balance declines. As a consequence, the carrying value of the bonds will decrease, until at maturity the carrying value of the bonds equals their face amount. This is shown in Illustration 10-14 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo3#c10-�ig- 0014) . Appendices 10A and 10B at the end of this chapter discuss procedures for amortizing bond premium.

ILLUSTRATION 10-14 Amortization of bond premium

▼ HELPFUL HINT

Both a discount and a premium account are valuation accounts. A valuation account is one that is needed to value properly the item to which it relates.

DO IT! 3a

Bond Issuance

Giant Corporation issues $200,000 of bonds for $189,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the balance sheet at the date of issuance.

Action Plan ✓ Record cash received, bonds payable at face value, and the

difference as a discount or premium.

✓ Report discount as a deduction from bonds payable and premium as an addition to bonds payable.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo3#c10-fig-0014

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 25/101

SOLUTION

Related exercise material: BE10-8, BE10-9, BE10-10, DO IT! 10-3a, E10-8, E10-9, and E10-10.

REDEEMING BONDS AT MATURITY Regardless of the issue price of bonds, the book value of the bonds at maturity will equal their face value. Assuming that the company pays and records separately the interest for the last interest period, Candlestick records the redemption of its bonds at maturity as follows.

REDEEMING BONDS BEFORE MATURITY Bonds may be redeemed before maturity. A company may decide to redeem bonds before maturity in order to reduce interest cost and remove debt from its balance sheet. A company should redeem debt early only if it has suf�icient cash resources.

When bonds are redeemed before maturity, it is necessary to (1) eliminate the carrying value of the bonds at the redemption date, (2) record the cash paid, and (3) recognize the gain or loss on redemption. The carrying value of the bonds is the face value of the bonds less unamortized bond discount or plus unamortized bond premium at the redemption date.

To illustrate, assume at the end of the fourth period, Candlestick Inc., having sold its bonds at a premium, redeems the $100,000 face value bonds at 103 after paying the annual interest. Assume that the carrying value of the bonds at the redemption date is $100,400 (principal $100,000 and premium $400). Candlestick records the redemption at the end of the fourth interest period (January 1, 2021) as follows.

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 26/101

Note that the loss of $2,600 is the difference between the $103,000 cash paid and the $100,400 carrying value of the bonds.

PEOPLE, PLANET, AND PROFIT INSIGHT

Unilever

How About Some Green Bonds?

Unilever recently began producing popular frozen treats such as Magnums and Cornettos, funded by green bonds. Green bonds are debt used to fund activities such as renewable-energy projects. In Unilever's case, the proceeds from the sale of green bonds are used to clean up the company's manufacturing operations and cut waste (such as related to energy consumption).

The use of green bonds has taken off as companies now have guidelines as to how to disclose and report on these green-bond proceeds. These standardized disclosures provide transparency as to how these bonds are used and their effect on overall pro�itability.

Investors are taking a strong interest in these bonds. Investing companies are installing socially responsible investing teams and have started to integrate sustainability into their investment processes. The disclosures of how companies are using the bond proceeds help investors to make better �inancial decisions.

Source: Ben Edwards, “Green Bonds Catch On.” Wall Street Journal (April 3, 2014), p. C5.

Why might standardized disclosure help investors to better understand how proceeds from the sale or issuance of bonds are used? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 3b

Bond Redemption

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 27/101

R & B Inc. issued $500,000, 10-year bonds at a discount. Prior to maturity, when the carrying value of the bonds is $496,000, the company redeems the bonds at 98. Prepare the entry to record the redemption of the bonds.

Action Plan ✓ Determine and eliminate the carrying value of the bonds.

✓ Record the cash paid.

✓ Compute and record the gain or loss (the difference between the �irst two items).

SOLUTION

There is a gain on redemption. The cash paid, $490,000 ($500,000×98%), is less than the carrying value of $496,000. The entry is:

Related exercise material: BE10-11, DO IT! 10-3b, E10-13, and E10-14.

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 28/101

LEARNING OBJECTIVE 4

Discuss how liabilities are reported and analyzed. 

PRESENTATION Current liabilities are the �irst category under “Liabilities” on the balance sheet. Companies list each of the principal types of current liabilities separately within the category. Within the current liabilities section, companies often list notes payable �irst, followed by accounts payable.

Companies report long-term liabilities in a separate section of the balance sheet immediately following “Current liabilities.” Illustration 10-15 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo4#c10-�ig-0015) shows an example.

ILLUSTRATION 10-15 Balance sheet presentation of liabilities

Disclosure of debt is very important. Failures at Enron, WorldCom, and Global Crossing have made investors very concerned about companies' debt obligations. Summary data regarding debts may be presented in the balance sheet with detailed data (such as interest rates, maturity dates, conversion privileges, and assets pledged as collateral) shown in a supporting schedule in the notes. Companies should report current maturities of long-term debt as a current liability.

ETHICS NOTE

Some companies try to minimize the amount of debt reported on their balance sheet by not reporting certain types of commitments as liabilities. This subject is of intense interest in the �inancial community.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo4#c10-fig-0015

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 29/101

KEEPING AN EYE ON CASH

The balance sheet presents the balances of a company's debts at a point in time. The statement of cash �lows also presents information about a company's debts. Information regarding cash in�lows and out�lows during the year that resulted from the principal portion of debt transactions appears in the “Financing activities” section of the statement of cash �lows. Interest expense is reported in the “Operating activities” section even though it resulted from debt transactions.

The following statement of cash �lows shown below presents the cash �lows from �inancing activities for General Motors Company. From this we learn that the company issued new debt of $31,373 million and repaid debt of $19,524 million.

ANALYSIS Careful examination of debt obligations helps you assess a company's ability to pay its current and long- term obligations. It also helps you determine whether a company can obtain debt �inancing in order to grow. We will use the following information from the �inancial statements of General Motors to illustrate the analysis of a company's liquidity and solvency.

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 30/101

ILLUSTRATION 10-16 Simpli�ied balance sheets for General Motors

Liquidity

Liquidity ratios measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash. A commonly used measure of liquidity is the current ratio (presented in Chapter 2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02#ch02) ). The current ratio is calculated as current assets divided by current liabilities. Illustration 10-17 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo4#c10-�ig-0017) presents the current ratio for General Motors along with the industry average.

ILLUSTRATION 10-17 Current ratio

General Motors' current ratio declined from 1.31:1 to 1.27:1 from 2013 to 2014. Although General Motors' ratio declined, it still exceeds the industry average current ratio for manufacturers of autos and trucks of 1.00:1.

General Motors' current ratio, like the industry average, is quite low. Many companies today minimize their liquid assets (such as accounts receivable and inventory) in order to improve pro�itability measures, such as return on assets. This is particularly true of large companies such as Ford, General Motors, and Toyota. Companies that keep fewer liquid assets on hand must rely on other sources of liquidity. One such source is a bank line of credit. A line of credit is a prearranged agreement between a company and a lender that permits the company, should it be necessary, to borrow up to an agreed-upon amount. For example, a recent disclosure regarding debt in General Motors' annual report states that it has $12 billion of unused lines of credit.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch02#ch02

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo4#c10-fig-0017

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 31/101

Solvency

Solvency ratios measure the ability of a company to survive over a long period of time. The Feature Story in this chapter mentioned that, although there once were many U.S. automobile manufacturers, only three U.S.-based companies remain today. Many of the others went bankrupt. This highlights the fact that when making a long-term loan or purchasing a company's stock, you must give consideration to a company's solvency.

To reduce the risks associated with having a large amount of debt during an economic downturn, some U.S. automobile manufacturers took two precautionary steps while they enjoyed strong pro�its. First, they built up large balances of cash and cash equivalents to avoid a cash crisis. Second, they were reluctant to build new plants or hire new workers to meet their production needs. Instead, they asked workers to put in overtime, or they “outsourced” work to other companies. In this way, when the economic downturn occurred, they hoped to avoid having to make debt payments on idle production plants and to minimize layoffs. As a result, when the crisis �irst hit, Ford had cash of $29 billion, about double the amount of cash it would expect to use over a two-year period.

In Chapter 2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02#ch02) , you learned that one measure of a company's solvency is the debt to assets ratio. This is calculated as total liabilities (debt) divided by total assets. This ratio indicates the extent to which a company's assets are �inanced with debt.

Another useful solvency measure is the times interest earned. It provides an indication of a company's ability to meet interest payments as they come due. It is computed by dividing the sum of net income, interest expense, and income tax expense by interest expense. It uses income before interest expense and taxes because this number best represents the amount available to pay interest.

DECISION TOOLS

Times interest earned helps users determine if a company can meet its obligations in the long term.

We can use the balance sheet information presented in Illustration 10-16 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo4#c10-�ig-0016) and the additional information below to calculate solvency ratios for General Motors.

($ in millions) 2014 2013 Net income $4,018 $5,331 Interest expense 403 334 Income tax expense 228 2,127

The debt to assets ratios and times interest earned for General Motors and averages for the industry are shown in Illustration 10-18 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch10lo4#c10-�ig-0018) (page 498).

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch02#ch02

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo4#c10-fig-0016

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch10lo4#c10-fig-0018

4/23/2019 Print

https://content.ashford.edu/print/Kimmel.2745.17.1?sections=cover,ch10,ch10lo1,ch10lo2,ch10lo3,ch10lo4,ch10lo5,ch10lo6,ch10lo7,ch10ifrs&cont… 32/101

ILLUSTRATION 10-18 Solvency ratios

General Motors' debt to assets ratio was 80%. The industry average for manufacturers of autos and trucks is 62%. Thus, General Motors is more reliant on debt �inancing than the average �irm in the auto and truck industry. In part, General Motors' heavy reliance on debt is due to its substantial �inance division.

General Motors' times interest earned decreased from 23.3 times in 2013 to 11.5 in 2014. This means that in 2014 General Motors had earnings before interest and taxes that were more than 11.5 times the amount needed to pay interest. The higher the multiple, the lower the likelihood that the company will default on interest payments. This suggests that while General Motors' ability to meet interest payments was high, the average company in the industry had a lower ability to meet interest payments in 2014.

INVESTOR INSIGHT

Debt Masking

In the wake of the �inancial crisis, many �inancial institutions are wary of reporting too much debt on their �inancial statements, for fear that investors will consider them too risky. The Securities and Exchange Commission (SEC) is concerned that some companies engage in “debt masking” to make it appear that they use less debt than they actually do. These companies enter into transactions at the end of the accounting period that essentially remove debt from their books. Shortly after the end of the period, they reverse the transaction and the debt goes back on their books. The Wall Street Journal reported that 18 large banks “had consistently lowered one type of debt at the end of each of the past �ive quarters, reducing it on average by 42% from quarterly peaks.”