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Financial Accounting Unit 9: Liabilities, Bonds and Stockholders' Equity

Companies finance their assets with debt and with owners' money. This unit covers current liabilities and payroll, contingencies, bonds and their amortization, and the parts of stockholders' equity including stock issues, treasury stock and dividends.

Covers: Current liabilities and notes payable, Payroll liabilities, Contingent liabilities, Bond pricing, discounts and premiums, Bond amortization and retirement, Issuing common and preferred stock, Treasury stock, Dividends and stock splits

Study guide

Current liabilities are obligations due within a year. They include accounts payable, short-term notes payable with accrued interest, unearned revenue, the current portion of long-term debt, sales tax collected from customers, and payroll liabilities. Payroll creates two layers. Employee withholdings, such as federal and state income tax and the employee's share of FICA (Social Security and Medicare, 7.65% in total), are taken out of gross pay, and the employee receives net pay. On top of gross pay, the employer pays its own matching FICA plus federal and state unemployment taxes, which are recorded as payroll tax expense. All of these amounts are liabilities until they are paid to the government.

A contingent liability depends on a future event, such as a lawsuit or a product warranty. GAAP requires a company to record a liability when a loss is probable and the amount can be reasonably estimated; warranties are a common example, accrued in the year of the sale. If the loss is only reasonably possible, or probable but not estimable, it is disclosed in the notes. Remote possibilities generally need no disclosure. Long-term liabilities include notes, mortgages, leases and bonds. A bond is a promise to pay a face value at maturity plus periodic interest at the stated (contract) rate, sold to many investors.

Bond prices depend on the relationship between the stated rate and the market rate. If they are equal, bonds sell at face value. If the stated rate is below market, the bonds sell at a discount; if above, at a premium. The price is the present value of the interest payments plus the present value of the face amount, both discounted at the market rate. The discount or premium is amortized over the bond's life. Under the effective-interest method, preferred by GAAP, interest expense equals carrying value times the market rate per period, and the difference from the cash paid is the amortization. Straight-line amortization spreads the discount or premium evenly and is allowed when the result is not materially different.

Stockholders' equity has two sources: paid-in capital and retained earnings. When a corporation issues stock, Common Stock is credited at par value, a legal amount per share, and any excess is credited to Paid-in Capital in Excess of Par. Preferred stock has priority over common for dividends and in liquidation, usually with a fixed dividend rate; if it is cumulative, missed dividends become dividends in arrears that must be paid before common stockholders receive anything. Treasury stock is the company's own stock bought back. It is recorded at cost as a contra-equity account, and reissuing it above or below cost changes paid-in capital or retained earnings, never income.

Dividends distribute earnings to owners. A cash dividend becomes a liability on the declaration date; the record date determines who receives it; the payment date settles it. A stock dividend gives shareholders more shares instead of cash. Small stock dividends (below about 20–25%) are recorded at market value, and large ones at par, moving amounts from retained earnings to paid-in capital without changing total equity. A stock split increases shares and reduces par per share proportionally, with no journal entry beyond a memo. Retained earnings may also be restricted by loan agreements, and corrections of prior-period errors are recorded as adjustments to beginning retained earnings.

Key ideas

• Employee withholdings reduce net pay; employer payroll taxes are an added expense.
• Contingent losses are accrued if probable and estimable, and disclosed if reasonably possible.
• Bonds sell at a discount when the stated rate is below the market rate, and at a premium when above.
• Effective-interest expense equals carrying value times the market rate per period.
• Common stock is credited at par, with the excess going to additional paid-in capital.
• Treasury stock is a contra-equity account; trading in a company's own shares never creates gains or losses.
• Stock dividends and splits do not change total stockholders' equity; cash dividends reduce it.

Formulas and rules

Common mistakes

• Using the stated rate instead of the market rate to compute effective-interest expense.
• Forgetting dividends in arrears on cumulative preferred stock.
• Recording sales tax collected as revenue instead of a liability.
• Reporting treasury stock as an asset or recording a gain on its reissue.
• Recording a small stock dividend at par instead of market value.

Before the test, make sure you can

• Record notes payable, accrued interest, sales tax and unearned revenue.
• Calculate net pay and the employer's payroll tax expense.
• Decide whether a contingency is recorded, disclosed or ignored.
• Explain why bonds sell at a discount or premium and compute a bond's price.
• Prepare effective-interest and straight-line amortization for the first periods.
• Record bond retirement and compute any gain or loss.
• Journalize stock issuances, treasury stock purchases and reissues.
• Allocate dividends between cumulative preferred and common, and record cash dividends, stock dividends and splits.

Words to know

Current liability

An obligation expected to be paid within one year or the operating cycle.

Note payable

A written promise to repay a borrowed amount, usually with interest, by a specific date.

FICA taxes

Social Security and Medicare taxes, withheld from employees and matched by employers.

Net pay

Gross pay minus all employee withholdings; the amount of the paycheck.

Contingent liability

A possible obligation that depends on a future event, such as a lawsuit outcome.

Warranty liability

An estimated liability, accrued in the year of sale, for future repair or replacement costs.

Bond

A long-term debt security that pays periodic interest and repays face value at maturity.

Stated (contract) rate

The interest rate printed on a bond, used to compute cash interest payments.

Market (effective) rate

The rate investors demand for bonds of similar risk; it determines the bond's price.

Bond discount

The amount by which face value exceeds the issue price; added to interest expense over the life.

Bond premium

The amount by which the issue price exceeds face value; reduces interest expense over the life.

Effective-interest method

Amortizes a discount or premium so interest expense is a constant rate of carrying value.

Par value

A legal per-share amount assigned to stock; credited to the Common Stock account.

Paid-in capital in excess of par

Amounts received from stockholders above par value.

Cumulative preferred stock

Preferred stock whose unpaid dividends accumulate and must be paid before common dividends.

Treasury stock

A company's own issued shares that it has reacquired; a contra-equity account.

Stock dividend

A distribution of additional shares to stockholders, moving amounts from retained earnings to paid-in capital.

Stock split

Increasing shares outstanding and lowering par per share proportionally, with no change in total equity.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.