FINANCIAL ACCOUNTING 2

LIABILITIES
A liability is a present obligation of an enterprise arising from past event, the settlement of
which is expected to result in an outflow of resources from the enterprise embodying economic
benefit.
From the definition given, a liability possesses the following essential characteristics:

1. Present obligation
2. Past event
3. Probable outflow of resources embodying economic benefits

An obligation is a duty or responsibility to act or perform in a certain way which may be

legally enforceable as a consequence of a binding contract or statutory requirement.

An obligating event is an event that creates a legal obligation or a constructive obligation that
results in an enterprise having no realistic alternative to settling that obligation. It may be
classified in one of the following:

1. Legal obligation – one that derives from a contract (through its explicit or implicit
terms), legislation, or other operation of law. Examples of which are accounts payable
(arising from a contract with a supplier), withholding taxes payable and value added tax
payable (arising from legislation and other operation of law)
2. Constructive obligation – one that derives from an enterprise’s actions where an
established pattern of past practice, published policies, or a sufficiently specific current
statement, the enterprise has indicated to other parties that it will accept certain
responsibilities, and as a result, the enterprise has created a valid expectation on the part
of those parties that it will discharge those responsibilities. An example of which is
provision for clean-up costs where the enterprise has a widely published policy of
cleaning up all contamination that it causes.

The settlement of a present obligation involves the enterprise giving up resources embodying
economic benefits in order to satisfy the claim of the other party. Settlement of a present
obligation may occur in a number of ways, such as by:

1. Payment of cash.
2. Transfer of other assets.
3. Provision of services.
 4. Replacement of an obligation with another obligation.
5. Conversion of the obligation to equity.
In some exceptional cases, an obligation is settled through condonation by the creditor.

On the Balance Sheet, liabilities are classified either as Current Liabilities or Non-Current
Liabilities. A liability should be classified as a current liability when it satisfies any of the
following criteria:

1. It is expected to be settled in the entity’s normal operating cycle.

2. It is due to be settled within twelve months after the balance sheet date.
3. It is held primarily for the purpose of being traded.
4. The entity, as of the balance sheet date, does not have an unconditional right to defer
settlement of the liability for at least twelve months after the balance sheet date.

ACCOUNTS PAYABLE

Accounts Payable is a liability arising from the purchase of goods, materials, supplies, or
services on an open charge account basis. The credit time period generally varies from 30 to
120 days without any interest being charges on the deferred payment.

Shipment Terms

Most accounting systems are designed to record liabilities for purchases of goods when the
goods are received, or practically, when the invoices are received from the supplier. The
recognition of the liability depends on the terms of purchase, which could either be FOB
Shipping Point or FOB Destination. A purchase made towards the end of the accounting
period, where goods are still in transit, should be recognized as a liability when the term of
shipment is FOB Shipping Point. The cost of the goods, likewise, is included in the ending
inventory. The record of goods received (inclusion in ending inventory) should be in agreement
with the liability (recognition of accounts payable) and that both are reflected in the proper
reporting period.
FOB Shipping Point – ownership of the goods or merchandise is transferred from the seller to
the buyer upon shipment, or once the goods or merchandise is brought or loaded to the common
carrier. It is very important to take note of the shipment date under this shipment term.

Illustration: Goods worth PhP100,000 were shipped FOB Shipping Point on December 28,
2013. The goods were received on January 3, 2014.

Assuming that both the buyer and the seller use the Periodic Method, the following journal
entries shall be prepared:
Seller’s point of view:

12/28/13 Accounts Receivable 100,000

Sales 100,000
Buyer’s point of view:

12/28/13 Purchases 100,000

Accounts Payable 100,000

The buyer should recognize a liability on December 28, 2013 (date of the shipment), even if the
goods were received on January 3, 2014 (date of receipt).
FOB Destination – ownership of the goods or merchandise is transferred from the seller to the
buyer once the goods or merchandise is received at the point of destination. It is very important
to take note of the date when the goods or merchandise is received under this shipment term.

Illustration: Goods worth PhP100,000 were shipped FOB Shipping Point on December 28,
2013. The goods were received on January 3, 2014.

Assuming that both the buyer and the seller use the Periodic Method, the following journal
entries shall be prepared:
Seller’s point of view:

01/03/14 Accounts Receivable 100,000

Sales 100,000
Buyer’s point of view:

01/03/14 Purchases 100,000

Accounts Payable 100,000

Notice that the journal entries were prepared by the seller and the buyer on January 3, 2014
(date of receipt), instead of December 28, 2013 (date of the shipment).

Discounts

The agreement for the purchase of goods usually includes incentives for early payment of the
account, hence, cash discounts are offered. The purchase transaction may be recorded using
either the gross method or the net method.

Under the gross method, the Purchases account and the Accounts Payable are recorded at the
gross invoice price. A cash discount taken on purchases is recorded upon payment as Purchase
Discounts. Any balance of the Purchase Discounts is reported on the income statement as a
deduction from gross purchases.
Illustration: Bought merchandise of PhP100,000 terms 5/10, n/30

Purchases 100,000
Accounts Payable 100,000
Assuming that payment is made within the discount period, the journal entry will be:

Accounts Payable 100,000

Cash 95,000
Purchase Discount 5,000
Assuming that payment is made beyond the discount period, the journal entry will be:

Accounts Payable 100,000

Cash 100,000

Under the net method, both the Purchases account and the Accounts Payable are initially
recorded at invoice price less the cash discounts available. A cash discount not taken is
recorded as Purchase Discount Lost, which is reported on the income statement as part of
finance cost.

Illustration: Bought merchandise of PhP100,000 terms 5/10, n/30

Purchases 95,000
Accounts Payable 95,000
Assuming that payment is made within the discount period, the journal entry will be:

Accounts Payable 95,000

Cash 95,000
Assuming that payment is made beyond the discount period, the journal entry will be:

Accounts Payable 95,000

Purchase Discount Lost 5,000
Cash 100,000
DEFERRED REVENUES

Deferred revenues, or Unearned revenues, are amounts already collected in advance but not yet
earned. This is peculiar to a service concerned business. Examples are collections in advance
for rent, interest, subscriptions, royalties, and service contracts.
There are two approaches of recording deferred revenues:

1. Income, or Nominal, approach

2. Liability approach
For the income approach, the entry upon receipt of the advance payment is as follows:

Cash XXX
Revenue/Income XXX
For the liability approach, the entry upon receipt of the advance payment is as follows:

Cash XXX
Deferred (Unearned) Revenue/Income XXX

Whichever method is used, it is important that adjusting journal entry (AJE) be prepared at the
end of the accounting period.

For the income approach, the AJE would be to debit the Revenue account and to credit Deferred
(Unearned) Revenue/Income account. While for the liability approach, the AJE would be to
debit the Deferred (Unearned) Revenue/Income account and to credit the Revenue account.

Illustration: On March 1, 2010, Peter Pan Bookstore entered into a lease agreement with
Tinkerbelle Publishing. Monthly rental calls for PhP18,000 cash payment, while the term of the
lease is for two (2) years. On the same date, Peter Pan paid Tinkerbelle PhP180,000 in advance.
 FINANCIAL ACCOUNTING 2
In the books of Tinkerbelle, the following journal entry shall be prepared using the Income
Approach:

03/01/10 Cash 180,000

Rent Income 180,000

On March 31, 2010, Tinkerbelle shall prepare the following adjusting journal entry to update its
income account:

03/31/10 Rent Income 162,000

Deferred Rent Income 162,000

In the books of Tinkerbelle, the following journal entry shall be prepared using the Liability
Approach:

03/01/10 Cash 180,000

Deferred Rent Income 180,000

On March 31, 2010, Tinkerbelle shall prepare the following adjusting journal entry to update its
liability account:

03/31/10 Deferred Rent Income 18,000

Rent Income 18,000

ACCRUED LIABILITIES

Accrued Liabilities consist of obligations for expenses incurred on or before the balance sheet
date but payable at a later date. Common examples of this nature are accrued salaries, accrued
interest, and accrued taxes.

The pro-forma entry to record accrued liabilities would be a Debit to an appropriate Expense
Account and a Credit to Accrued Expenses Payable.
 FINANCIAL ACCOUNTING 2
TAXES AND EMPLOYEE-RELATED LIABILITES

Value Added Taxes are levied on the transfer of tangible property and on certain services.
Withholding Taxes on compensation are deducted from the employees’ compensation, and
eventually remitted to the government.

Other related liabilities that are deducted from the compensation of the employees are for the
Social Security System (SSS), Philippine Health Insurance Corporation, (Philhealth), and Home
Development Mutual Fund (HDMF).

The pro-forma entry for an employee’s compensation (or wages), be it monthly, bi-monthly,
weekly, or daily is as follows:
Salaries & Wages XXX
SSS Premium Contribution XXX
SSS EC Contribution XXX
Philhealth Medicare Contribution XXX
HDMF Contribution XXX
Cash in Bank XXX
Withholding Tax Payable XXX
SSS Premium Payable XXX
SSS EC Payable XXX
Philhealth Medicare Payable XXX
HDMF Payable XXX

At times, the account title Advances to Officers & Employees is credited if an employee has a
loan deductible from his or her salaries.

Value Added Tax (VAT) is an indirect tax levied on the buyer or services, or on the transferee
or lessee of properties. The VAT rate is fixed at 12%. The VAT on the sale or lease of taxable
goods, properties, or services is called Output Tax. The VAT on the purchase or lease of
taxable goods, properties, or services is called Input Tax. The difference between Output Tax
and Input Tax is remitted to the Bureau of Internal Revenue on or before the 20 th day of the
month following the applicable month. The journal entry for such remittance is:
 FINANCIAL ACCOUNTING 2
Output Tax XXX
Input Tax XXX
Cash in Bank XXX

LIABILITY FOR BONUSES

Bonuses are incentives given by companies to officers and managers, and are usually paid after
the end of the year or end of the accounting cycle. The pro-forma entry for bonuses is as
follows:
Bonus Expense XXX
Bonus Payable XXX

The following situations may happen in the computation of bonus:

1. Bonus is based on income before deducting bonus and income tax.

2. Bonus is based on income after deducting bonus but before deducting income tax.
3. Bonus is based on income before deducting bonus but after deducting income tax.
4. Bonus is based on income after deducting bonus and income tax.
Illustration:

Income before bonus and income tax PhP2,000,000

Bonus Rate 10%
Income Tax Rate 30%
Before deducting bonus and income tax
Bonus = PhP2,000,000 X 10% = PhP200,000

After deducting bonus; Before deducting income tax

Bonus = Bonus Rate X (Net income before bonus & tax – Bonus)
B = .10 X (2,000,000 – B)
B = 200,000 – .10B
B + .10B = 200,000
1.10B = 200,000
B = 200,000/1.10
B = 181,818
 FINANCIAL ACCOUNTING 2
Before deducting bonus; After deducting income tax

Bonus= Bonus Rate X (Net income before bonus & tax – Income Tax)
Tax = Tax Rate X (Net income before bonus & tax – Bonus)
B = .10[2,000,000 - .30(2,000,000 – B)]
B = .10(2,000,000 – 600,000 + .30B)
B = .10(1,400,000 + .30B)
B = 140,000 + .03B
B - .03B = 140,000
.97B = 140,000
B = 140,000/.97
B = 144,330

After deducting bonus and income tax

Bonus = Bonus Rate X (Net income before bonus & tax – Bonus - Income Tax)
Tax = Tax Rate X (Net income before bonus & tax – Bonus)
B = .10[2,000,000 – B - .30(2,000,000 – B)]
B = .10(2,000,000 – B - 600,000 + .30B)
B = .10(1,400,000 - .70B)
B = 140,000 - .07B
B + .07B = 140,000
1.07B = 140,000
B = 140,000/1.07
B = 130,841

DIVIDENDS PAYABLE

Dividends are distribution of earnings to the shareholders in proportion to the number of shares
held by them. Ordinary dividends are dividends distributed periodically based on
accumulated earnings of the corporation, or Retained Earnings account; hence it is debited
whenever an ordinary dividend is declared. Liquidating dividends are distribution of net
assets or return of shareholders’ investment which takes place when the corporation is
terminated.
 FINANCIAL ACCOUNTING 2
Forms of Ordinary Dividend

Cash dividend is a dividend in the form of cash. It is usually expressed at a certain amount of
peso per share, or at a certain percentage of the par value.

Property dividend is in the form of property, or other company assets, such as merchandise or
acquired shares of stock from other corporations.

Liability dividend is a deferred cash dividend payable in some future time, because at the time
of dividend declaration, cash is unavailable. Usually, additional interest is paid for the waiting
period from the date of declaration to the date of payment.

Stock dividend is a distribution of the corporation’s own stock coming from the unissued
shares. Valuation of the stock dividend depends on the following:

1. If the stock dividend is less than 20% of the total outstanding shares, the dividend, as well
as the corresponding liability, should be valued at the fair market value of the stock.
2. If the stock dividend is more than 20% of the total outstanding shares, the dividend, as
well as the corresponding liability, should be valued at the par value of the stock.

NOTES PAYABLE

A promissory note is a written promise to pay a certain sum of money to the bearer at a
designated future time. The notes may arise out of either a trade situation (purchase of goods or
services on credit) or the borrowing of money from a bank, or other transactions.
 FINANCIAL ACCOUNTING 2
Interest bearing note

Accounting for the issuance of interest bearing note is relatively straightforward. Since the note
is interest bearing, the present value of the note at the time of its issuance is its face value. The
issuance of the note is recorded as a credit to Notes Payable account. At maturity date, payment
is made for the principal amount plus interest for the entire term of the note. If the note is still
outstanding at the end of the accounting period, an accrued interest should be recorded for the
period from the date of issuance of the note to the end of the accounting period. Such accrual
may be reversed at the beginning of the new accounting period so that the subsequent payment
of the note and the interest may be recorded in the usual manner, debiting Notes Payable for the
principal and Interest Expense for the total interest paid.

Illustration: On January 1, 2009, ABC Co. sold an equipment costing PhP800,000 and with
accumulated depreciation of PhP450,000 to XYZ Co. ABC received a consideration of
PhP100,000 and a 15% interest bearing note for PhP400,000 due on December 31, 2011. The
interest on the note is payable annually every December 31.
Seatwork: Formulate all indicated journal entries
Non-Interest bearing note

Accounting for a non-interest bearing note is more complex. A non-interest bearing note does
not explicitly state an interest rate on the face of the note. However, it does not mean that there
is no interest imputed on the original obligation. A non-interest bearing note is simply written
in a form where the interest is imputed on the face value of the note. Hence, the face value of
the note represents the present value of the obligation plus the imputed interest for the term of
the note. The discounted amount (face value of the note less the imputed interest) of the note
should be used initially to record the liability. Interest expense is then recognized over the term
of the note, using the effective interest method, as an adjustment of this discounted amount.
Discount on Notes Payable is reported on the balance sheet as contra-account to Notes Payable.
 FINANCIAL ACCOUNTING 2
Illustration A: On January 1, 2009, ABC Co. sold an equipment costing PhP800,000 and with
accumulated depreciation of PhP450,000 to XYZ Co. ABC received a consideration of
PhP100,000 and a non-interest bearing note for PhP400,000 due on December 31, 2011. The
prevailing interest for a note of this type is 15%.
Seatwork: Formulate all indicated journal entries

Illustration B: On January 1, 2009, ABC Co. sold an equipment costing PhP800,000 and with
accumulated depreciation of PhP450,000 to XYZ Co. ABC received a consideration of
PhP100,000 and a non-interest bearing note for PhP300,000 due in equal amounts of
PhP100,000 every December 31, starting December 31, 2009. The prevailing interest for a note
of this type is 15%.
Seatwork: Formulate all indicated journal entries

BONDS PAYABLE

A bond is a kind of loan that makes interest only payments until they mature. On the maturity
date, the bond’s life ends, and both the final interest payment and original principal amount are
due.
Principal – amount of money in which interest is paid.

Maturity date – the date when a bond’s life ends and the borrower must make the final interest
payment plus the principal.
Par Value – face value of the bond which the borrower repays at maturity.
Coupon – a fixed amount of interest that a bond promises to pay investors.

Indenture – a legal document stating the conditions under which a bond has been issued.
Coupon Rate – the rate derived by dividing the bond’s annual coupon payment by its par value.
 FINANCIAL ACCOUNTING 2
Coupon Yield – the amount obtained by dividing the bond’s coupon by its current market price.
It is also called current yield.

Yield to Maturity – the bond’s internal rate of return; the return investors will get when the
bond matures.

Basic Equation in Bond Pricing

Bond Price = Present value of coupons + present value of principal

Types of Bonds by Issuer

Bonds that mature on a single date are called term bonds, while bonds that mature in
installments are called serial bonds. Secured bonds provide security and protection to
investors in the form of specific assets of the issuer, such as real estate or other collateral. On
the other hand, unsecured bonds, frequently termed as debentures, are not protected by the
pledge of any specific asset of the issuing corporation. The issue of this kind of bonds is
generally based on the credit rating of the company, as these bonds are backed only by the
issuer’s general favorable credit standing. Registered bonds are bonds whose owners’ names
are registered in the books of the issuing corporation. Bearer bonds are not recorded in the
name of the owner. Callable bonds are those that can give the issuing company the right to call
or retire the bonds before maturity date, usually specified on the bond indenture. Convertible
bonds are those that can give the bondholders the right to exchange their bond holdings into a
specified or predetermined number of the issuing corporation’s shares of stock. Zero-rated
bonds, also known as deep-discount bonds, are issued at significantly lower than their face
value. The total interest on these bonds during their entire term is paid together with the
principal amount on maturity date.
 FINANCIAL ACCOUNTING 2
Issuance of Bonds
When bonds are sold at face value, the journal entry is simply to debit Cash acco unt and credit
Bonds Payable account at the proceeds which equals the face value.

If the required rate is higher than the coupon rate, the bond will sell at a discount. The journal
entry will have an additional debit to Discount on Bonds Payable account, which is reported as
a direct deduction from the face value of the bonds payable.

If the required rate is lower than the coupon rate, the bond will sell at a premium. The journal
entry will have an additional credit to Premium on Bonds Payable account, which is reported as
an addition to the face value of the bonds payable.

When bonds are issued at a premium or discount, the periodic interest payments made over the
bond life by the issuer to the investors do not represent the complete interest expense for the
periods involved. In order to reflect the total interest cost of the bonds, bond premium or
discount should be allocated over the life of the bonds as a deduction or addition to interest
expense using the effective interest method.

Bond issuance costs are expenditures incurred by the issuing company for legal and accounting
fees, printing and engraving of bond certificates, taxes, commissions, and similar charges.
These costs form part of the initial carrying amount of the bond liability.
 FINANCIAL ACCOUNTING 2
Bonds with Equity characteristics
Corporations may issue bonds that allow creditors to become shareholders, either by attaching
warrants or conversion features in the bond indenture. When bonds are issued with warrants
attached, the bondholders are given the right to acquire a specified number of ordinary or
common shares of the issuing corporation at a given price within a certain time period, known
as exercise period. The warrant may either be detachable or non-detachable. For bonds with
detachable warrants, the right can be exercised by the bondholder or another party or investor,
because these warrants can be traded separately in the capital market. For bonds with non-
detachable warrants, the right can only be exercised by the bondholder.
TROUBLED-DEBT RESTRUCTURING
Companies get into financial difficulty for various reasons:

1. Continued losses from operations

2. Poor management
3. Over-extended credit to customers
4. Failure to react to changes in economic conditions

Financial difficulty may lead to insolvency. A debtor corporation is considered insolvent when
it is unable to pay its debt as they come due. When this happens, the corporation may take on
any of the following:
1. Liquidation – stop operating; sell the assets

2. Reorganization – continue operating but under new management. A trustee, usually

appointed by the Securities & Exchange Commission (SEC), is appointed to take over.
3. Debt restructuring
 FINANCIAL ACCOUNTING 2
Debt Restructuring

This occurs when a debtor having debt-related financial distress is granted concession
pertaining to debt by the related creditor. Troubled debt restructuring involves one of three
forms:
1. Asset Swap – a transfer of non-cash assets can be used to settle a debt.

2. Equity Swap – the issuance of the debtor’s shares of stock can also be used to settle a
debt.

3. Modification of Terms – may take the form of one or a combination of the following:

➢ Reduction of stated interest rate

➢ Reduction of the face amount of debt
➢ Reduction or condonation of accrued interest
➢ Extension of the maturity date
➢ Moratorium on the payment of interest and/or principal