9 Ch Reporting and Interpreting Liabilities
Capital structure. Risk vs, Return a. Debt is more risky than equity because principal and interest payments must be made on debt. b. Equity is less risky since dividend payments to owners are not legal obligations until declared by the board of directors.
1. 2.
A. Liabilities: Liabilities are probable future sacrifices of economic benefits that arise from past transactions. 2. A liability is measured in terms of its cash equivalent (the cash that the creditor would accept to settle the liability) to settle the liability immediately. a. Interest to be paid on the debt is not included initially because interest accrues over time. b. After it has accrued, interest becomes a liability. 3. Classification: Current vs, Long term liabilities
1.
B. Current Liabilities: 1. Current liabilities are short-term obligations that will be paid within the current operating cycle or one year, whichever is longer. 2. Current liability accounts that appear on most balance sheets: a. Accounts Payable (A/P or Trade Payable) b. Accrued Liabilities 1. Accrued liabilities are recorded for expenses that have been incurred but have not been paid by the end of the accounting period. 2. Examples of accrued expenses include: a. Accrued Taxes Payable
b. i. ii.
Accrued Compensation and Related Costs Salaries and wages payable are incurred but unpaid employee compensation..
Payroll taxes include FICA (Social Security) tax. This liability arises from two sources. This tax is withheld from employees' gross wages based on a statutory percentage. This amount is also "matched" by the employer. Both the withholding and the matching amounts are current liabilities of the company 3. Current Portion of Long-Term Debt 4. Deferred Revenues
I. CURRENT RATIO.
A. Liquidity: the ability of a company to pay current obligations. B. Current Ratio: a measure of liquidity.
1
C. Interpretation Most companies use techniques for managing working capital. This is critical for the survival of a business. 2. The Current Ratio restates Working Capital as a ratio rather than as a flat number. 3. It shows the relationship of current assets to current liabilities rather than just the net.
1. Short term Notes Payable and Simple Interest 1. To the borrower, interest
is an expense. To the lender, interest is revenue. 2. The calculation of simple interest is :
a. Principal is the amount borrowed or loaned. b. Interest Rate is the annual rate unless stated otherwise. c. Time is the term of the loan in years or part of a year.
II.
CONTINGENT LIABILITIES.
A. Estimated Liabilities on the balance Sheet 1. Whether a situation produces a contingent liability depends on two factors: a. The liability must be probable, and b. The liability must be reasonably estimated 2. Before determining if a contingent liability should be recorded, an understanding of probability of occurrence is necessary. a. Probable - the future event is likely to occur. b. Reasonably possible - the chance of the occurrence of the future event is more than remote but less than probable. 3. Remote - the chance of occurrence of the future event is slight. 4. The conditions that can exist and how they should be handled are: _____________________________________________________________________________ _ Condition ProbableReasonably Possible Remote Subject to estimation Record as liability Disclose in note Disclosure not required Not subject to estimate Disclose in note Disclose in note Disclosure not required
A. Capital Working Management and impact on Statement of Cash flows 2
A. Long-Term Liabilities 1. Noncurrent liabilities; i.e., all liabilities not properly classified as current liabilities. a. Secured vs. Unsecured debt. B. Lease Liabilities 1. Companies may lease rather than purchase assets. 2. There are two classifications of leases: a. Operating lease 1. Generally does not create an immediate liability. 2. Lease payment amounts are recorded as incurred. 3. This type of lease is on a short term basis. b. Capital lease 1. Represents the purchase and financing of the asset acquired through a lease agreement. 2. Generally recorded as an asset (for the purchase) and a liability (for the financing) if at least one of the following four criteria is met. a. The lease term is 75% or more of the asset's expected economic life.
b. c. d.
Ownership of the asset is transferred to the lessee at the end of the lease term. The lease contract permits the lessee to purchase the asset at a price that is lower than its fair market value. The present value of the lease payments is 90% or more of the fair market value of the asset when the lease is signed.
III.
PRESENT VALUES.
A. Present Value Concepts 1. Present value (PV) focuses on the time value of money. a. A dollar received today is worth more than a dollar received in the future (such as a year from now). b. A dollar can be invested today and earns interest during that future period. c. The buying power of a dollar decreases in time due to inflation. B. Present Value of a Single Amount (Table A.1), 1. The worth to you today of receiving a certain amount at some time in the future. It is a future amount discounted for compound interest.
3
2. Three items must be known to find the PV of a single amount: a. The amount to be received in the future. b. The applicable discount rate (i) to be earned. c. The number of periods (n) in which interest will be earned.
C. Present Value of an Annuity 1. Annuity a. A series of periodic cash receipts or cash payments that are characterized by 1. An equal payment (in amount) each interest period. 2. Annuities involve multiple cash flows over more than one period rather than a single amount. 3. Interest periods are of equal length 4. Interest rate remains constant over the annuity period. b. The equation for an annuity factor is:
IV.
1.
FUTURE VALUE CONCEPTS Future value of a single amount
V.
a. This calculation is appropriate if you plan to invest money today and you need to determine its value at a future date. b. Three items must be known to find FV of a single amount: 1. The amount to be invested today. 2. The applicable interest rate (i) to be earned. 3. The number of periods (n) in which interest will be earned. c. The amount of interest earned (accrued) in one period is added to the invested amount. This sum earns interest for the next period and so forth. This is referred to as compound interest. d. By using the FV tables, the amount to be invested (PV) times the appropriate FV table factor will result in the FV amount.
2.
Future Value of an Annuity
4
a. This includes compound interest on each payment from the date of payment to the end of the annuity term. Each payment accumulates less interest than the prior payments because the number of remaining periods decreases. b. Three items must be known to find it: 1. The amount of each periodic payment. 2. The applicable interest rate (i) to be earned. 3. The number of periods (n) in which payments will be made.
5