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Accounting
Lecture no 7
Prepared by:
Jan Hájek
The Nature of Liabilities
Defined as debts or obligations
arising from past transactions or
events.
Maturity = 1 year or less
Maturity > 1 year
Current
Liabilities
Non-current/longterm Liabilities
I.O.U.
Distinction Between
Debt and Equity
The acquisition of assets is financed from
two sources:
DEBT
Funds from creditors, with
a definite due date, and
sometimes bearing
interest.
EQUITY
Funds from
owners
ACCOUNTING FOR
CURRENT LIABILITIES
A current liability is a debt that can
reasonably be expected to be paid
1. from existing current assets or
in the creation of other
current liabilities and
2. within one year or the
operating cycle, whichever
is longer.
ACCOUNTING FOR CURRENT
LIABILITIES

Types of liabilities
1)
2)
3)
Definitely determinable
Estimated
Contingent
ACCOUNTING FOR
CURRENT LIABILITIES
Definitely determinable current
liabilities include:
1. Operating line of credit
2. Accounts and notes payable
3. Sales tax payable
4. Payroll and employee benefits
5. Unearned revenues
6. Current maturities of
long-term debt
OPERATING LINE OF CREDIT
A pre-authorized demand loan, allowing the
company to write cheques up to a preset limit
when needed.
 Disclosed by footnote and by reporting
any resulting bank overdraft
as a current liability.

NOTES PAYABLE
Notes
Payable are obligations in the form of
written promissory notes that usually require
the borrower to pay interest.
Notes payable may be used instead of
accounts payable because it supplies
documentation of the obligation in case legal
remedies are needed to collect the debt.
Notes due for payment within one year
of the balance sheet date are usually
classified as current liabilities.
SALES TAXES PAYABLE
Sales tax is expressed as a stated percentage
of the sales price of goods sold to customers
by a retailer.
 Sales tax includes the goods and service tax
(GST), provincial sales tax (PST) or
harmonized sales taxes (GST and PST
combined).
 The retailer (or selling company) collects the
tax from the customer when the sale occurs,
and periodically (usually monthly)
remits the collections to the government.

PAYROLL AND EMPLOYEE BENEFITS
Salaries or wages payable represent the
amounts owed to employees for a pay
period.
 Payroll withholdings include federal and
provincial income taxes, Canada Pension
Plan (CPP) contributions, and employment
insurance (EI) premiums.
 Employees may also voluntarily authorize
withholdings for charity, retirement, medical,
or other purposes.
 Payroll withholdings are remitted to
governmental taxing authorities.

UNEARNED REVENUES
Unearned Revenues (advances from
customers) occur when a company receives
cash before a service is rendered.
 Examples are when an airline sells a ticket for
future flights or when a lawyer receives legal
fees before work is done.

CURRENT MATURITIES OF
LONG-TERM DEBT
Another item classified as a current liability is
current maturities of long-term debt.
 Current maturities of long-term debt are often
identified on the balance sheet as long-term
debt due within one year.

ESTIMATED LIABILTIES
Obligation that exists but for which the
amount and timing is uncertain.
 However, the company can reasonably
estimate the liability.
 Examples include property taxes and
warranty liabilities.

PROPERTY TAXES
Property taxes are accrued monthly
based on the prior year’s tax bill.
 When the property tax bill for the current
year is received, the company will adjust
its monthly expense for the remainder of
the year.

PRODUCT WARRANTIES
Warranty contracts may lead to future
costs for replacement or repair of
defective units.
 Using prior experience with the product,
the company estimates what the cost of
servicing the warranty will be.
 Estimated warranty costs are accrued with
a debit to warranty expense and a credit
to estimated warranty liability.

CONTINGENT LIABILITIES
Contingent liabilities exist when there is
uncertainty about the outcome.
 Contingencies are accrued by a debit to
an expense account and a credit to a
liability account if both of the following
conditions are met:
1. The contingency is likely, and
2. The amount of the contingency can
be reasonably estimated.

FINANCIAL STATEMENT
PRESENTATION


Each major type of current liability is listed
separately.
Often list bank loans, notes payable, and
accounts payable first, then other liabilities.
COMINCO LTD.
Current liabilities (Millions)
Bank loans and notes payable
Accounts payable and accrued liabilities
Income and resource taxes
Long-term debt due within one year
$ 5
230
36
30
$301
INTERNAL CONTROLS FOR PAYROLL
 The
objectives of internal accounting control
concerning payroll are
1. to safeguard company assets from
unauthorized payrolls and
2. to assure the accuracy and reliability of the
accounting records pertaining to payrolls.
 Payroll activities include:
1. hiring employees
2. timekeeping
3. preparing the payroll
4. paying the payroll
4
Functions
 These functions should be assigned to
of Payroll
different departments or individuals.
HIRING EMPLOYEES
The human resources department is responsible for:
1.
Posting job openings
2.
Screening and interviewing applicants
3.
Hiring of employees
4.
Authorizing changes in pay rates during
employment
5.
Terminations of employment
TIMEKEEPING
Hourly employees are usually required to
record time worked by “punching” a time
clock – the time of arrival and departure are
automatically recorded by the employee
when he/she inserts a time card into the
clock.
 The employee’s supervisor must:
1. approve the hours shown by signing the
time card at the end of the pay period
2. authorize any overtime hours for an
employee.

PREPARING THE PAYROLL
The payroll department prepares the payroll
on the basis of two sources of input:
1. human resource department
authorizations, and
2. approved time cards.
PAYING THE PAYROLL
The comptroller’s department is responsible
for the payment of the payroll.
1. Payment by direct deposit, or by
cheque, minimizes the risk of loss
from theft.
2. All direct deposit lists and cheques
must be signed by the comptroller and
their distribution protected by the
comptroller’s department.
DETERMINING AND PAYING THE
PAYROLL
Determining the payroll involves calculating
1. gross earnings,
2. payroll deductions, and
3. net pay.
GROSS EARNINGS
Gross earnings is the total compensation
earned by an employee.
 There are three types of gross earnings:
1. wages
2. salaries
3. bonuses
 Total wages are determined by applying the
hourly rate of pay to the hours worked.
 Most companies are required to pay a
minimum of one and one-half times the
regular hourly rate for overtime work.

PAYROLL DEDUCTIONS
The difference between gross pay and
the amount actually received is
attributable to payroll deductions.
 Mandatory deductions consist of Canada
Pension Plan (CPP, or QPP in Quebec),
employment insurance (EI) and personal
income tax.

PAYROLL DEDUCTIONS
Voluntary deductions pertain to
withholdings for charitable causes,
retirement, and other purposes.
 All voluntary payroll deductions should be
authorized in writing by the employee.
 Voluntary payroll deductions do not result
in a payroll expense to the employer.
 Net pay is determined by subtracting
payroll deductions from gross earnings.

EMPLOYER PAYROLL COSTS
CPP
• The employer must match each employee’s
CPP contribution.
 EI
• The employer is required to contribute 1.4
times each employee’s EI deductions.
 Workplace Health, Safety, and Compensation
• Employers pay a specified percentage of their
gross payroll to provide supplemental benefits
for workers who are injured or disabled in the
workplace.

ADDITIONAL FRINGE BENEFITS
PAID ABSENCES
Employees may have the right to
receive compensation for future benefits
when certain conditions of employment
are met.
 The compensation may pertain to:
1. Paid vacation
2. Sick pay benefits
3. Paid holidays

ADDITIONAL FRINGE BENEFITS
PAID ABSENCES
When the payment of compensation is
probable and can reasonably be
determined, a liability should be
accrued.
 When the amount can not be reasonably
estimated, the potential liability should
be disclosed.

RECORDING THE PAYROLL
Many companies use a payroll register to
accumulate the gross earnings, deductions,
and net pay by employee for each period.
 In some cases, this record is a journal or
book of original entry.
 The typical entry to record the employee
costs in a payroll is to debit Salaries or
Wages expense and to credit a variety of
liability accounts.
 When the payroll is paid, the liability
accounts are debited and Cash is credited.

RECOGNIZING PAYROLL
EXPENSES AND LIABILITIES
Date Date
June 15
GENERAL JOURNAL
Account
titles
and
explanation
Account
Titles
and
Explanation
Office Salaries Expense
Wages Expense
CPP Payable
EI Payable
Income Tax Payable
United Way Payable
Union Dues Payable
Salaries and Wages Payable
To record payroll for the week ending
June 15.
Debit Credit
Credit
Debit
5,200.00
12,010.00
654.03
387.23
5,646.90
421.50
215.00
9,885.34
Academy Company records its payroll for the week ending June 15, 2002
with the journal entry above. Office Salaries Expense ($5,200) and Wages
Payable ($12,010) are debited in total for $17,210 in gross earnings.
Specific liability accounts are credited for the deductions made during the
pay period. Salaries and Wages Payable is credited for $9,885.34 in net
RECORDING EMPLOYER
PAYROLL COSTS
GENERAL JOURNAL
Date
Account Titles and Explanation
June 15 Employee Benefits Expense
CPP Payable
EI Payable
Workers’ Compensation Payable
Vacation Pay Payable
To record employer payroll costs on
June 15 payroll.
Debit
Credit
2,056.65
654.03
542.12
172.10
688.40
The entry to record the payroll costs associated with the Academy Company
payroll results in a debit to Employee Benefits Expense for $2,056.65, a credit
to CPP Payable for $654.03 ($654.03 x 1) and a credit to EI Payable for
$542.12 ($387.23 x 1.4). Assuming a worker’s compensation rate of 1
percent, the comp-ensation payable liability would be for $172.10 ($17,210 x
1%). Vacation pay accrues at 4% and therefore the vacation payable will be
RECORDING PAYMENT
OF THE PAYROLL
GENERAL JOURNAL
Date
Account Titles and Explanation
June 15 Salaries and Wages Payable
Cash
To record payment of payroll.
Debi
Credit
9,885.34
9,885.34
The entry to record payment of the Academy
Company payroll is a debit to Salaries and
Wages Payable and a credit to Cash.
LONG-TERM LIABILITIES
Long-term liabilities are obligations that
are expected to be paid after one year.
 Long-term liabilities include bonds,
long-term notes, and lease obligations.

BOND BASICS
Bonds are a form of interest-bearing
notes payable issued by corporations,
governments, and governmental
agencies.
 Bonds, like common shares, can be sold
in small denominations (usually a
thousand dollars), and as a result they
attract investors.

WHY ISSUE BONDS?

From the standpoint of the
corporation seeking long-term
financing, bonds offer the following
advantages over common shares:
1. Shareholder control is not
affected.
2. Income tax savings result.
3. Earnings per share may be
higher.
DISADVANTAGES OF BONDS

The major disadvantages resulting from
the use of bonds are that
 interest must be paid on a periodic basis,
and
 principal (face value) of the bonds must be
paid at maturity.
TYPES OF BONDS
SECURED AND UNSECURED
Secured bonds have specific assets of
the issuer pledged as collateral for the
bonds. A bond can be secured by real
estate or other assets.
 Unsecured bonds are issued
against the general credit of
No ASSET
the borrower; they are also
as Collateral
called debenture bonds.

TYPES OF BONDS
TERM AND SERIAL BONDS

Bonds that mature at a single specified
future date are called term bonds.
2000

2001
2002
2003
In contrast, bonds that mature in
instalments are called serial bonds.
2000
2003
2001
2002
TYPES OF BONDS
REGISTERED AND BEARER
Registered bonds are issued in the
name of the owner and have interest
payments made by cheque to
bondholders of record.
 Bearer or coupon bonds are not
registered; thus bondholders must send
in coupons to receive interest payments.

TYPES OF BONDS
CONVERTIBLE,
REDEEMABLE, AND RETRACTABLE
Convertible bonds permit bondholders to
convert the bonds into common shares at
their option.
 Redeemable (callable) bonds are subject
to call and retirement at a stated dollar
amount prior to maturity at the option of the
issuer.
 Retractable bonds are subject to
redemption prior to maturity at the option of
the holder.

ISSUING PROCEDURES
The face value is the amount of principal
due at the maturity date.
 The contractual interest rate, often referred
to as the stated rate, is the rate used to
determine the amount of cash interest the
borrower pays and the investor receives.
 Bond certificates, which provide information
such as name of issuer, face value,
contractual interest rate and maturity date,
are authorized by the Board and printed.

DETERMINING THE
MARKET VALUE OF BONDS

The market value (present value) of a bond
is a function of three factors:
 the dollar amounts to be received,
 the length of time (n) until the amounts are
received, and
 the market rate of interest (i) which is the rate
investors demand for loaning funds to the
corporation.

The process of finding the present value is
referred to as discounting the future
amounts.
TIME DIAGRAM DEPICTING CASH
FLOWS
$100,000
Principal
$2,000 $2,000 $2,000 $2,000 $2,000 $2,000 $2,000 $2,000 $2,000
0
1
2
3
4
5
6
10 semi-annual interest payments
7
8
9
CALCULATING THE PRESENT
VALUE OF BONDS
 The market value of a bond is equal to
the present value of all the future cash
payments promised by the bond.
Present value of $100,000 received in 10 periods
$100,000 x 0.82035 (Table B-1: n=10, i=2%)
$ 82,035
Present value of $2,000 received annually for 10 periods
$2,000 x 8.98259 (Table B-2: n=10, i=2%)
$ 17,965
Present (market) value of bonds
$100,000
ACCOUNTING FOR BOND ISSUES
Bonds may be issued at:
 Face value
 Below face value (discount) or
 Above face value (premium).
ISSUING BONDS AT FACE VALUE
 Bonds payable are reported in the long-term
liability section of the balance sheet because the
maturity date (January 1, 2008 in this case) is
more than one year away.
Date Account Titles and Explanation
Debit Credit
Jan.1 Cash
1,000,000
Bonds Payable
1,000,000
To record sale of bonds at face value.
ISSUING BONDS AT FACE VALUE
Assuming that interest is payable semi-annually on
January 1 and July 1 on the bonds, interest of
$25,000 ($1,000,000 x 5% x 6/12) must be paid on
July 1, 2003. The entry for the payment is:
Date Account Titles and Explanation
Debit Credit
July 1 Bond Interest Expense
25,000
25,000
Cash
To record payment of bond interest.
DISCOUNT OR PREMIUM ON
BONDS
Bonds may be issued below or above face
value.
 If the market (effective) rate of interest is
higher than the contractual (coupon) rate,
the bonds will sell at less than face value,
or at a discount.
 If the market rate of interest is less than the
contractual rate on the bonds, the bonds
will sell above face value, or at a premium.

INTEREST RATES AND BOND
PRICES
Bond
Issued
Contractual when
Interest
Rate
5%
Market Interest
Rates
Bonds Sell
at
4%
Premium
5%
Face Value
6%
Discount
ISSUING BONDS AT A DISCOUNT
Assume that on January 1, 2003, Candlestick Inc.
sells $1 million, 5-year, 5 percent bonds at 95.7345
(95.7345 percent of face value) with interest payable
on July 1 and January 1. The entry to record the
issue is:
Date
Account Titles and Explanation
Debit
Credit
957,345
Jan. 1 Cash
42,655
Discount on Bonds Payable
1,000,000
Bonds Payable
To record payment of bond interest.
STATEMENT PRESENTATION OF
BOND DISCOUNT
The Discount on Bonds Payable account has a
debit balance and is deducted from Bonds Payable
on the balance sheet, as illustrated below:
Long-term liabilities
Bonds payable
Less: Discount on bonds payable
$1,000,000
42,655
$ 957,345
The $957,345 represents the carrying (or book)
value of the bonds. On the date of issue, this
amount equals the market price of the bonds.
STRAIGHT-LINE METHOD OF
BOND DISCOUNT AMORTIZATION
To comply with the matching principle, it
follows that bond discount should be
allocated systematically to each
accounting period benefiting from the
use of the cash proceeds.
 The straight-line method of amortization
of bond discount allocates the same
amount to interest expense each
interest period.

FORMULA FOR STRAIGHT-LINE
METHOD OF BOND DISCOUNT
AMORTIZATION
Bond
Discount

Number of
Interest
Periods
=
Bond Discount
Amortization
Bond Discount Amortization
Entries
The entry to record the payment of bond interest and
the amortization of bond discount on the first interest
date (July 1, 2003) is:
Date Account Titles and Explanation
Debit Credit
29,265.50
July 1 Bond Interest Expense
4,265.50
Discount on Bonds Payable
25,000.00
Cash
To record payment of bond interest
and amortization of bond discount.
Over the term of the bonds, the balance in Discount on Bonds
Payable will decrease annually by the same amount until it
reaches zero at the maturity date of the bonds. Thus, the
carrying value of the bonds at maturity will be equal to the face
EFFECTIVE INTEREST METHOD
OF AMORTIZATION
The effective interest method is an alternative to
the straight-line method of amortization.
 Bond interest expense is calculated by
multiplying the carrying value of the bonds at the
beginning of the period by the effective interest
rate.
 The credit to Cash (or Bond Interest Payable) is
calculated by multiplying the face value of the
bonds by the contractual interest rate.
 The bond discount or premium amortization
amount is then determined by comparing bond
interest expense with the interest paid or
accrued.

EFFECTIVE INTEREST METHOD
OF AMORTIZATION
(2)
Bond Interest
Paid
(1)
Bond Interest
Expense
Carrying
Market
value 
(Effective)
of Bonds at
Beginning of Interest
Rate
Period

Face Contractua
Amount l Interest
of Bonds
Rate
(3)

Amortization
Amount
BOND DISCOUNT AMORTIZATION
ENTRIES
The entry to record the payment of bond interest and the
amortization of bond discount on the first interest date (July
1, 2003) is:
Date
Account Titles and Explanation
Debit
Credit
July 1 Bond Interest Expense
28,720
Discount on Bonds Payable
3,720
Cash
25,000
To record payment of bond interest
and amortization of bond discount.
Over the term of the bonds, the balance in Discount on Bonds
Payable will decrease annually by the same amount until it
reaches zero at the maturity date of the bonds. Thus, the
carrying value of the bonds at maturity will be equal to the
face value of the bonds.
ISSUING BONDS AT A PREMIUM
To illustrate issuing bonds at a premium, assume
that on January 1, 2003, Candlestick Inc. sells $1
million, 5-year, 5 percent bonds at 104.4915
(104.4915 percent of face value) with interest
payable on July 1 and January 1. The entry to
record the issue is:
Date
Account Titles and Explanation
Debit
Credit
Jan. 1 Cash
1,044,915
Bonds Payable
1,000,000
Premium on Bonds Payable
44,915
To record sale of bonds at a premium.
STATEMENT PRESENTATION OF
BONDS PREMIUM
Premium on Bonds Payable has a credit balance
and therefore is added to Bonds Payable on the
balance sheet, as illustrated below:
Long-term liabilities
$1,000,000
Bonds payable
44,915
Add: Premium on bonds payable
$1,044,915
The $1,044,915 represents the carrying (or book)
value of the bonds. On the date of issue, this
amount equals the market price of the bonds.
BOND PREMIUM AMORTIZATION
ENTRIES
The entry to record the payment of bond interest and the
amortization of bond premium using the straight-line method
on the first interest date (July 1, 2003) is:
Date
Account Titles and Explanation
Debit
Credit
July 1 Bond Interest Expense
20,508.50
Premium on Bonds Payable ($44,91510) 4,491.50
25,000.00
Cash
To record payment of bond interest
and amortization of bond premium.
Over the term of the bonds, the balance in Premium on Bonds
Payable will decrease annually by the same amount until it
reaches zero at the maturity date of the bonds. Thus, the
carrying value of the bonds at maturity will be equal to the face
EFFECTIVE INTEREST METHOD
OF AMORTIZATION
(2)
Bond Interest
Paid
(1)
Bond Interest
Expense
Carrying
Market
value 
(Effective)
of Bonds at
Beginning of Interest
Rate
Period

Face Contractua
Amount l Interest
of Bonds
Rate
(3)

Amortization
Amount
BOND PREMIUM AMORTIZATION
ENTRIES
The entry to record the payment of bond interest and the
amortization of bond premium on the first interest date
(July 1, 2003) using the effective interest method is:
Date
Account Titles and Explanation
Debit
Credit
July 1 Bond Interest Expense
20,898
Premium on Bonds Payable
4,102
Cash
25,000
To record payment of bond interest
and amortization of bond premium.
Over the term of the bonds, the balance in Premium on Bonds
Payable will decrease annually by the same amount until it
reaches zero at the maturity date of the bonds. Thus, the
carrying value of the bonds at maturity will be equal to the face
value of the bonds.
ISSUING BONDS BETWEEN
INTEREST DATES
When bonds are issued between interest payment dates, the
investor must pay the market price for the bonds plus accrued
interest since the last interest date.
Assume that on March 1 Candlestick Inc. sells $1,000,000 of
5-year, 5 percent bonds at face value plus accrued interest.
Interest is payable semi-annually on July 1 and January 1.
The accrued interest is $8,333 ($1,000,000 x 5% x 2/12). The
total proceeds on the sale of bonds is $1,008,333. The entry
to record the sale is:
Date Account Titles and Explanation
Debit Credit
Mar. 1 Cash
1,008,333
1,000,000
Bonds Payable
8,333
Bond Interest Payable
To record sale of bonds at face value
plus accrued bond interest.
ISSUING BONDS BETWEEN
INTEREST DATES
At the first interest date, it is necessary to eliminate the bond
interest payable balance and to recognize the bond interest
expense for the four months (March 1 to July 1) that the
bonds have been outstanding.
Interest expense in this example is $16,667 ($1,000,000 x 5%
x 4/12). The entry on July 1 to record the first interest payment
is:
Date
Account Titles and Explanation
Debit
July 1 Bond Interest Payable
8,333
Bond Interest Expense
16,667
Cash
To record payment of bond interest.
Credit
25,000
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 interest for the last interest period
is paid and recorded separately, the entry to record the
redemption of the Candlestick bonds at maturity is:
Date
Account Titles and Explanation
Debit
Credit
1,000,000
Jan. 1 Bonds Payable
1,000,000
Cash
To record redemption of bonds
at maturity.
BOND RETIREMENTS
Bonds may be redeemed before maturity
because a company may decide to reduce
interest cost and remove debt from its
balance sheet.
 When bonds are retired before maturity it is
necessary to

 eliminate the carrying value of the bonds at the
redemption date after updating interest,
 record the cash paid, and
 recognize the gain or loss on redemption and
report as other gains or other losses in the
income statement.
ACCOUNTING FOR OTHER
LONG-TERM LIABILITIES
Long-term notes payable are similar to shortterm interest-bearing notes payable except
that the term of the note exceeds one year.
 A long-term note may be secured by a
mortgage that pledges title to specific assets
as security for a loan.
 Mortgage notes payable are widely used in
the purchase of homes by individuals and in
the acquisition of capital assets by many
small and some large companies.

MORTGAGE NOTES PAAYBLE

Mortgage notes payable are recorded
initially at face value and entries are
required subsequently for each instalment
payment.
 Fixed principal payment
 Blended principal and interest

In the balance sheet, the reduction in
principal for the next year is reported as a
current liability, and the remaining unpaid
principal balance is classified as a longterm liability.
INSTALMENT PAYMENT SCHEDULE FIXED
PRINCIPAL PAYMENT
To illustrate, assume that Belanger Ltd. issues a $120,000, 7
percent, 5-year note on January 1, 2003, to obtain needed
financing for the construction of a new research laboratory.
The terms provide for monthly instalment payments of
$2,000 ($120,000/60). The instalment payment schedule for
the first few months is shown below:
Interest
Period
Issue date
1
2
3
(A)
Cash
Payment
(B + C)
$2,700
2,688
2,677
(B)
Interest
Expense
(D x 7% x 1/12)
$ 700
688
677
(C)
Reduction
of Principal
(120,000/60)
$2,000
2,000
2,000
(D)
Principal
Balance
(D-C)
$120,000
118,000
116,000
114,000
INSTALMENT PAYMENT SCHEDULE BLENDED
PAYMENT
To illustrate, assume that Belanger Ltd. issues a $120,000, 7
percent, 5-year note on January 1, 2003, to obtain needed
financing for the construction of a new research laboratory. The
terms provide for monthly instalment payments of $2,376. The
instalment payment schedule for the first few months is shown
below:
Interest
Period
Issue date
1
2
3
(A)
Cash
Payment
$2,376
2,376
2,376
(B)
Interest
Expense
(D x 7% x 1/12)
$ 700
690
680
(C)
Reduction
of Principal
(A - B)
$1,676
1,686
1,696
(D)
Principal
Balance
(D-C)
$120,000
118,324
116,638
114,942
LEASE LIABILITIES
OPERATING LEASE
In an operating lease the intent is
temporary use of the property by the
lessee with continued ownership of the
property by the lessor.
 The lease (rental) payments are
recorded as an expense by the lessee
and as revenue by the lessor.

Car rental is an
example of an
operating lease
LEASE LIABILITIES
CAPITAL LEASES
A capital lease transfers substantially all
the benefits and risks of ownership from
the lessor to the lessee.
 In a capital lease, the present value of
the cash payments for the lease are
capitalized and recorded as an asset.

LEASE LIABILITIES
CAPITAL LEASES

The lessee must record the lease as an
asset (a capital lease) if any one of the
following conditions exist:
 the lease transfers ownership of the property to
the lessee (e.g., contains a bargain purchase
option).
 The lease term is equal to 75% or more of the
economic life of the leased property.
 The present value of the lease payments equals
or exceeds 90% of the fair market value of the
leased property.
CAPITAL LEASE ENTRIES
The leased asset is reported on the
balance sheet under capital assets.
 The portion of the lease liability expected to
be paid in the next year is reported as a
current liability.
 The remainder is classified as a long-term
liability.
 If none of the four conditions for capitalizing
a lease are met, the company does not
report an asset. This procedure is referred
to as off-balance sheet financing.
