and Reporting Interpreting Liabilities
Chapter 9
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
9-2
Understanding the Business
The acquisition of assets is financed from two sources:
Debt - funds from creditors
Equity - funds from owners
9-3
Understanding the Business
Debt is considered riskier than equity.
Interest is a legal obligation. Creditors can force bankruptcy.
9-4
Learning Objectives
Define, measure, and report current liabilities.
9-5
Liabilities Defined and Classified
Defined as probable debts or obligations of the entity that result from past transactions, which will be paid with assets or services.
Maturity = 1 year or less
Maturity > 1 year
Current Liabilities
Noncurrent Liabilities
9-6
Liabilities Defined and Classified
Liabilities are measured at their current cash equivalent (the amount a creditor would accept to cancel the debt) at the time incurred.
9-7
Current Liabilities
Account Name Accounts Payable Accrued Liabilities Notes Payable Deferred Revenues Definition Obligations to pay for goods and services used in the basic operating activities of the business. Obligations related to expenses that Accrued have been incurred, but will not be Expenses paid until the subsequent period. Obligations due supported by a formal N/A written contract. Obligations arising when cash is Unearned received prior to the related revenue Revenues being earned. Also Called Trade Accounts Payable
9-8
Payroll Taxes
Gross Pay
Net Pay
Less Deductions:
Social Security Tax
Medicare Tax
Federal Income Tax
State and Voluntary Local Income Deductions Taxes
9-9
Learning Objectives
Use the current ratio.
9-10
Current Ratio
An important indicator of a company's ability to meet its current obligations. Current Ratio = Current Assets Current Liabilities
Starbucks has current assets of $924 and current liabilities of $608.7.
Current = Ratio 1.52 =
Current Assets
Current Liabilities $608.70
$924.00
2003 Current Ratios Panera Krispy Starbucks Bread Kreme 1.52 1.53 1.94
9-11
Learning Objectives
Analyze the accounts payable turnover ratio.
9-12
Accounts Payable Turnover Ratio
Measures how quickly management is paying trade accounts.
Accounts Payable = Turnover Cost of Goods Sold Average Accounts Payable
Average Accounts Payable $1,685.90 $152.50 Cost of Goods Sold
Starbucks has cost of goods sold of $1,685.9 and average accounts payable of $152.5.
Accounts Payable = Turnover 11.06 =
2003 Accounts Payable Turnover Ratios
Starbucks 11.00
Panera Bread 9.29
Krispy Kreme N/A
9-13
Learning Objectives
Report notes payable and explain the time value of money.
9-14
Notes Payable
A note payable specifies the interest rate associated with the borrowing.
the lender, interest is a revenue. To the borrower, interest is an expense.
To
Interest = Principal Interest Rate Time
When computing interest for one year, "Time" equals 1. When the computation period is less than one year, then "Time" is a fraction.
9-15
Notes Payable
Starbucks borrows $100,000 for 2 months at an annual interest rate of 12%. Compute the interest on the note for the loan period.
Interest Interest Interest
= Principal = $ 100,000 = $ 2,000
Interest Rate 12%
Time 2 /12
9-16
Learning Objectives
Report contingent liabilities.
9-17
Contingent Liabilities
Potential liabilities that arise because of events or transactions that have already occurred.
Probability of future sacrifice . . . Reasonably Probable Possible Remote Amount Can be Estimated Amount Cannot be Estimated
Record contingent liability. Disclose liability in the notes to the Disclose liability in the notes to the financial stmts. Disclose liability in the notes to the No action.
No action.
financial stmts. financial stmts.
9-18
Learning Objectives
Explain the importance of working capital and its impact on cash flows.
9-19
Working Capital Management
Working Capital = Current Assets - Current Liabilities Changes in working capital accounts affect cash flows as indicated in the following table.
Change in Account Balance During Year Increase Decrease Reduce cash Increase cash flows. flows. Increase cash Reduce cash flows. flows.
Current Assets Current Liabilities
9-20
Learning Objectives
Report long-term liabilities.
9-21
Long-Term Liabilities
Creditors often require the borrower to pledge specific assets as security for the long-term liability.
Maturity = 1 year or less
Maturity > 1 year
Current Liabilities
Long-term Liabilities
9-22
Long-Term Notes Payable and Bonds
Relatively small debt needs can be filled from single sources.
Banks
Insurance Companies
or
Pension Plans
9-23
Long-Term Notes Payable and Bonds
Significant debt needs are often filled by issuing bonds to the public.
Bonds Cash
9-24
Borrowing in Foreign Currencies
When a company has operations in a foreign country, it often borrows in the local currency. This reduces exchange rate risk. Because interest rates vary from country to country, companies may borrow in the foreign market with the lowest interest rate.
9-25
Operating and Capital Leases
Operating Lease Capital Lease
Long-term lease; Short-term lease; No Meets one of 4 liability or asset criteria; Results in Capital Lease Criteria recorded recording an asset 1. Lease term is 75% or more of the asset's expected economic life. 2. Ownership of asset is transferred to lessee at endand a liability of lease.
3. Lease permits lessee to purchase the asset at a price that is lower than its fair market value. 4. The present value of the lease payments is 90% or more of the fair market value of the asset when the lease is signed.
9-26
Learning Objectives
Compute present values.
Apply present value concepts to liabilities.
9-27
Present Value Concepts
$1,000 invested today at 10%.
In 5 years it will be worth $1,610.51.
In 25 years it will be worth $10,834.71!
Money can grow over time, because it can earn interest.
9-28
Present Value Concepts
1. 2. 3. 4.
The growth is a mathematical function of four variables: The value today (present value). The value in the future (future value). The interest rate. The time period.
9-29
Present Value Concepts
Most analysts use present value tables, calculators, or Excel to solve time value of money problems. We will use the present value tables in our illustrations (an explanation of how to use Excel is included in the supplement to this chapter).
9-30
Present Value of a Single Amount The present value of a single amount is the worth to you today of receiving that amount some time in the future.
Present compounding Value
Interest periods
Future Value
Today
Future
9-31
Present Value of a Single Amount
How much do we need to invest today at 10% interest, compounded annually, if we need $1,331 in three years? a. $1,000.00 b. $ 990.00 c. $ 751.30 d. $ 970.00
9-32
Present Value of a Single Amount
How much do we need to invest today at 10% interest, compounded annually, if we need $1,331 in three years? a. $1,000.00 b. $ 990.00 The required future amount is $1,331. c. $ 751.30 i = 10% & n = 3 years Using the present value of a single d. $ 970.00
amount table, the factor is .7513. $1,331 .7513 = $1,000 (rounded)
9-33
Present Values of an Annuity
An annuity is a series of consecutive equal periodic payments.
Today
9-34
Present Values of an Annuity
What is the value today of a series of payments to be received or paid out in the future?
Payment 1 Present Value Payment 2 Payment 3
Interest compounding periods
Today
9-35
Present Values of an Annuity
What is the present value of receiving $1,000 each year for three years at an interest rate of 10%, compounded annually? a. $3,000.00 b. $2,910.00 c. $2,700.00 d. $2,486.90
9-36
Present Values of an Annuity
What is the present value of receiving $1,000 each year for three years at an interest rate of 10%, compounded annually? a. $3,000.00 b. $2,910.00 c. $2,700.00 The consecutive equal payment amount is $1,000. d. $2,486.90
i = 10% & n = 3 years Using the present value of an annuity table, the factor is 2.4869. $1,000 2.4869 = $2,486.90
9-37
Accounting Applications of Present Values
On January 1, 2006, Starbucks bought some new delivery trucks. The company signed a note agreeing to pay $200,000 on December 31, 2007. The market interest rate for this note is 12%.
Future value PV of $1 (i=12%, n=2) Present value $ 200,000
0.79720 $ 159,440
Let's prepare the journal entry to record the purchase.
9-38
Accounting Applications of Present Values
GENERAL JOURNAL
Date Description Jan. 1 Delivery trucks Notes payable Debit 159,440 Credit 159,440
Present at the Interest Rate December Now, let's look Value journal entry at = Interest 31, $159,440 2006. = $19,133 12%
GENERAL JOURNAL
Date Description Dec. 31 Interest expense Notes payable Debit 19,133 Credit 19,133
9-39
Accounting Applications of Present Values
Now, let's look at the journal entries at December 31, 2007.
GENERAL JOURNAL
Date Description Dec. 31 Interest expense Notes payable 31 Notes payable Cash Debit 21,429 Credit 21,429 200,000 200,000
Present Value Interest Rate = Interest ($159,440 + $19,133) 12% = $21,429
9-40
Chapter Supplement A
Income Taxes and Retirement Benefits
9-41
Income Taxes and Retirement Benefits
Exist because of timing differences caused by reporting revenues and expenses according to GAAP on a company's income statement and according to the Internal Revenue Code on the tax return.
Deferred Taxes
Temporary Differences
Timing differences that cause deferred income taxes and will reverse, or turn around, in the future.
9-42
Income Taxes and Retirement Benefits
Some pension plans create obligations during employees' service periods that must be paid during their retirement periods. The amounts contributed during the employment period are determined using present value computations of the estimate of the future amount to be paid during retirement.
9-43
Chapter Supplement B
Federal Income Tax Concepts
9-44
Federal Income Tax Concepts
Are separate legal entities and are required to pay income taxes.
Corporations
Tax Obligation
Determined by multiplying taxable income by the corporate tax rate.
9-45
Revenue and Expense Recognition for Income Tax Purposes
1. Interest revenue on state and municipal bonds is generally excluded from taxable income although it is included in accounting income.
2. Revenue collected in advance is included in taxable income when it is collected and in accounting income when it is earned.
3. Proceeds from life insurance policies are excluded from taxable income but included in accounting income. 4. Corporations that own less than 20% of another corporation's stock may exclude 70% of the dividends received from taxable income, although all dividends are included in accounting income. 5. For tax purposes, depreciation expense is generally based on the Accelerated Cost Recovery System (ACRS) or on the Modified Accelerated Cost Recovery System (MACRS).
9-46
Tax Minimization Versus Tax Evasion
9-47
Chapter Supplement C
Present Value Computations Using Excel
9-48
Present Value Computations Using Excel
Present Value of A Single Amount Formula = Payment/(1 + i)^n Present Value of An Annuity Formula Use the present value of an annuity formula programmed in Excel by selecting the function button (fx ). In the drop down menu, under the Select Category heading, pick "Financial" and scroll down under Select Function and click on "PV." In the new drop down box, enter the specific information for your problem and click "OK."
9-49
Chapter Supplement D
Future Value Concepts
9-50
Future Value of a Single Amount
Future value is the sum to which an amount will increase as the result of compound interest.
How much will an amount today be worth in the future?
Present Value
Interest compounding periods
Future Value
Today
9-51
Future Value of a Single Amount
If we invest $1,000 today earning 10% interest, compounded annually, how much will it be worth in three years? $1,000 $1,010 $1,100 $1,331
a. b. c. d.
9-52
Future Value of a Single Amount
If we invest $1,000 today earning 10% interest, compounded annually, how much will it be worth in three years? $1,000 $1,010 The invested amount is $1,000. $1,100 i = 10% & n = 3 years $1,331 Using the future value of a single
amount table, the factor is 1.331. $1,000 1.331 = $1,331
a. b. c. d.
9-53
Future Value of an Annuity
Equal payments are made each period. The payments and interest accumulate over time.
Payment 1 Payment 2 Payment 3
Interest compounding periods
Today
9-54
Future Value of an Annuity
If we invest $1,000 each year at an interest rate of 10%, compounded annually, how much will we have at the end of three years? $3,000 $3,090 $3,300 $3,310
a. b. c. d.
9-55
Future Value of an Annuity
If we invest $1,000 each year at an interest rate of 10%, compounded annually, how much will we have at the end of three years? $3,000 $3,090 $3,300 The annual investment amount is $1,000. $3,310 i = 10% & n = 3 years
Using the future value of an annuity table, the factor is 3.3100. $1,000 3.3100 = $3,310
a. b. c. d.
9-56
End of Chapter 9