REPORTING AND INTERPRETING LIABILITIES
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1 REPORTING AND INTERPRETING LIABILITIES Chapter 9 McGraw-Hill/Irwin 2009 The McGraw-Hill Companies, Slide Inc. 1
2 UNDERSTANDING THE BUSINESS The acquisition of assets is financed from two sources: Debt - funds from creditors Equity - funds from owners McGraw-Hill/Irwin Slide 2
3 UNDERSTANDING THE BUSINESS Debt is considered riskier than equity. Interest is a legal obligation. Creditors can force bankruptcy. McGraw-Hill/Irwin Slide 3
4 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 Current Liabilities Maturity > 1 year Noncurrent Liabilities McGraw-Hill/Irwin Slide 4
5 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. McGraw-Hill/Irwin Slide 5
6 CURRENT LIABILITIES Account Also Name Called Accounts Payable Accrued Liabilities Notes Payable Deferred Revenues Trade Accounts Payable Accrued Expenses N/A Unearned Revenues Definition Obligations to pay for goods and services used in the basic operating activities of the business. Obligations related to expenses that have been incurred, but will not be paid until the subsequent period. Obligations due supported by a formal written contract. Obligations arising when cash is received prior to the related revenue being earned. McGraw-Hill/Irwin Slide 6
7 ACCOUNTS PAYABLE Payments for goods and services: Normal course of business Regular extension of credit No specific signed agreement McGraw-Hill/Irwin Slide 7
8 CURRENT LIABILITIES Account Also Name Called Accounts Payable Accrued Liabilities Notes Payable Deferred Revenues Trade Accounts Payable Accrued Expenses N/A Unearned Revenues Definition Obligations to pay for goods and services used in the basic operating activities of the business. Obligations related to expenses that have been incurred, but will not be paid until the subsequent period. Obligations due supported by a formal written contract. Obligations arising when cash is received prior to the related revenue being earned. McGraw-Hill/Irwin Slide 8
9 ACCRUED EXPENSES Usually amounts paid rapidly: Salaries payable Utilities payable Rent payable Insurance payable McGraw-Hill/Irwin Slide 9
10 CURRENT LIABILITIES Account Also Name Called Accounts Payable Accrued Liabilities Notes Payable Deferred Revenues Trade Accounts Payable Accrued Expenses N/A Unearned Revenues Definition Obligations to pay for goods and services used in the basic operating activities of the business. Obligations related to expenses that have been incurred, but will not be paid until the subsequent period. Obligations due supported by a formal written contract. Obligations arising when cash is received prior to the related revenue being earned. McGraw-Hill/Irwin Slide 10
11 NOTES PAYABLE Formal signed document with: Payment schedule Interest rates Default procedures Other terms and conditions No interest for 36 months on all plasma TVs $999 & up Qualifying purchase price determined after discount. This is a Deferred Interest/Interest Free Special Purchase Promotion with payments. Purchase price must be paid in full within 36 billing cycles of the purchase date, minimum monthly payments must be made and account must not otherwise be in default during the promotional period or finance charges will be assessed at the Deferred/Accumulated Finance Charge APR from the purchase date. Promotional financing is available with approved Circuit City credit cards from Chase Bank USA, N.A. Minimum payments will be determined in accordance with your Circuit City credit card agreement ( agreement ). Promotional period could be shorter depending upon the timing and amount of your payments and the type of other account balances (see the Application of Payments or Payment Allocation section of your agreement for details). Existing cardmembers must have adequate available credit and not be in default to qualify for promotional financing (see your agreement for other terms, rates, costs and fees). As of 10/13/08, the rates for new Circuit City Rewards Card accounts are: Purchase APR=20.49% variable; Deferred/Accumulated Finance Charge APR=20.99% variable; Default APR=26.90% variable; Minimum Finance Charge $1.00 and for new Circuit City Rewards Visa Card accounts: Purchase and Balance Transfer APR=13.99% or 15.99% variable (depending on your application and credit history); Cash Advance APR= 20.24% variable; Deferred/Accumulated Finance Charge APR= 20.99% variable; Default APR=26.49% variable; Overdraft Advance APR= 13.99% fixed; Transaction fee for Balance Transfers and Cash Advances: 3% of the amount of the transaction (minimum $10); Minimum Finance Charge $1 and for International Transactions 3% of the U.S. dollar amoun of the transaction, whether originally made in U.S. dollars or converted from a foreign currency. Offer expires 10/25/08. McGraw-Hill/Irwin Slide 11
12 CURRENT LIABILITIES Account Also Name Called Accounts Payable Accrued Liabilities Notes Payable Deferred Revenues Trade Accounts Payable Accrued Expenses N/A Unearned Revenues Definition Obligations to pay for goods and services used in the basic operating activities of the business. Obligations related to expenses that have been incurred, but will not be paid until the subsequent period. Obligations due supported by a formal written contract. Obligations arising when cash is received prior to the related revenue being earned. McGraw-Hill/Irwin Slide 12
13 UNEARNED REVENUES 2008 Football Season Tickets Catch all the excitement of Sacred Heart Footballl for one low price! You'll get a ticket to every home game for the entire season! (6 games) QUANTITY: PRICE: $36.00 TICKET TYPE: McGraw-Hill/Irwin Slide 13
14 PAYROLL COSTS Payroll (employee compensation) is A major expense of most businesses Includes Salaries - pay stated at a yearly or monthly rate Wages - pay stated at hourly rates Commissions - a percentage of the sales the employee has made Bonuses - rewards for excellent performance Salary expense represents employees gross pay and includes several payroll liabilities McGraw-Hill/Irwin Slide 14
15 PAYROLL TAXES Gross Pay Net Pay Less Withholdings and Deductions: Social Security Tax Medicare Tax Federal Income Tax State and Local Income Taxes Voluntary Deductions McGraw-Hill/Irwin Slide 15
16 McGraw-Hill/Irwin Slide 16
17 WORKING CAPITAL AND CASH FLOWS Working Capital = Current Assets - Current Liabilities Changes in working capital accounts are important to managers and analysts because they have a direct impact on cash flows from operating activities reported on the statement of cash flows. McGraw-Hill/Irwin Slide 17
18 NOTES PAYABLE A note payable specifies the interest rate associated with the borrowing. To the lender, interest is a revenue. To the borrower, interest is an expense. 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. McGraw-Hill/Irwin Slide 18
19 NOTES PAYABLE Toyota borrows $100,000 for 2 months at an annual interest rate of 12%. Compute the interest on the note for the loan period. Interest = Principal Interest Rate Time Interest = $ 100,000 12% Interest = $ 2,000 2 / 12 McGraw-Hill/Irwin Slide 19
20 Estimated warranty payable Arises when a company warranties its product Is recorded in the same period that the business recognizes sales revenue Is estimated because the exact amount of warranty expense cannot be known with certainty McGraw-Hill/Irwin Slide 20
21 ESTIMATED LIABILITIES Contingent Liability Examples Lawsuits Environmental Problems Product Warranties Probable Reasonably Possible Remote Subject to estimate Record as liability Disclose in note Disclosure not required Not subject to estimate Disclose in note Disclose in note Disclosure not required McGraw-Hill/Irwin Slide 21
22 LONG-TERM LIABILITIES Creditors often require the borrower to pledge specific assets as security for the long-term liability. Maturity = 1 year or less Current Liabilities Maturity > 1 year Long-term Liabilities McGraw-Hill/Irwin Slide 22
23 LONG-TERM NOTES PAYABLE AND BONDS Relatively small debt needs can be filled from single sources. Banks Insurance Companies Pension Plans McGraw-Hill/Irwin Slide 23
24 LONG-TERM NOTES PAYABLE AND BONDS Significant debt needs are often filled by issuing bonds to the public. Bonds Cash McGraw-Hill/Irwin Slide 24
25 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. McGraw-Hill/Irwin Slide 25
26 LEASE LIABILITIES Operating Lease Short-term lease; No liability or asset recorded McGraw-Hill/Irwin Slide 26
27 LEASE LIABILITIES Capital Lease Long-term lease; Meets one of 4 criteria; Results in recording an asset and a liability McGraw-Hill/Irwin Slide 27
28 LEASE LIABILITIES Operating Lease Capital Lease Short-term lease; No liability or asset recorded Long-term lease; Meets one of 4 criteria; Results in recording an asset Capital Lease Criteria 1. Lease term is 75% or more of the asset s expected economic life. 2. Ownership of asset is transferred to lessee at end and of lease. a liability 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. McGraw-Hill/Irwin Slide 28
29 PRESENT VALUE CONCEPTS $1,000 invested today at 10%. In 5 years it will be worth $1, In 25 years it will be worth $10,834.71! Money can grow over time, because it can earn interest. McGraw-Hill/Irwin Slide 29
30 PRESENT VALUE CONCEPTS The growth is a mathematical function of four variables: 1. The value today (present value). 2. The value in the future (future value). 3. The interest rate. 4. The time period. McGraw-Hill/Irwin Slide 30
31 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). McGraw-Hill/Irwin Slide 31
32 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 Value Future Value Interest compounding periods Today Future McGraw-Hill/Irwin Slide 32
33 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, b. $ c. $ d. $ The required future amount is $1,331. i = 10% & n = 3 years Using the present value of a single amount table, the factor is $1, = $1,000 (rounded) McGraw-Hill/Irwin Slide 33
34 PRESENT VALUES OF AN ANNUITY An annuity is a series of consecutive equal periodic payments. Today McGraw-Hill/Irwin Slide 34
35 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 Payment 2 Payment 3 Present Value Interest compounding periods Today McGraw-Hill/Irwin Slide 35
36 Millions of Americans are injured in accidents each year often the injured opt for compensation through a structured settlement. This type of settlement provides a stream of payments over many years. While this option works well for some, many people find that they need larger sums of cash in the near term to pay for things such as college tuition for a family member, a down payment for the purchase of a home, debt reduction, medical expenses, or perhaps to start a business. That's where J.G. Wentworth steps in. McGraw-Hill/Irwin Slide 36
37 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, b. $2, c. $2, d. $2, The consecutive equal payment amount is $1,000. i = 10% & n = 3 years Using the present value of an annuity table, the factor is $1, = $2, McGraw-Hill/Irwin Slide 37
38 ACCOUNTING APPLICATIONS OF PRESENT VALUES On January 1, 2009, Starbucks bought some new delivery trucks. The company signed a note agreeing to pay $200,000 on December 31, The market interest rate for this note is 12%. Future value $ 200,000 PV of $1 (i=12%, n=2) Present value $ 159,440 Let s prepare the journal entry to record the purchase. McGraw-Hill/Irwin Slide 38
39 ACCOUNTING APPLICATIONS OF PRESENT VALUES GENERAL JOURNAL Date Description Debit Credit Jan. 1 Delivery trucks 159,440 Notes payable 159,440 Now, let s Present look Value at the journal Interest entry Rate = December Interest 31, $159, % = $19,133 GENERAL JOURNAL Date Description Debit Credit Dec. 31 Interest expense 19,133 Notes payable 19,133 McGraw-Hill/Irwin Slide 39
40 ACCOUNTING APPLICATIONS OF PRESENT VALUES Now, let s look at the journal entries at December 31, GENERAL JOURNAL Date Description Debit Credit Dec. 31 Interest expense 21,429 Notes payable 21, Notes payable 200,000 Cash 200,000 Present Value Interest Rate = Interest ($159,440 + $19,133) 12% = $21,429 McGraw-Hill/Irwin Slide 40
41 SUPPLEMENT A: INCOME TAXES AND RETIREMENT BENEFITS Deferred Taxes 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. Temporary Differences Timing differences that cause deferred income taxes and will reverse, or turn around, in the future. McGraw-Hill/Irwin Slide 41
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. McGraw-Hill/Irwin Slide 42
43 END OF CHAPTER The McGraw-Hill Companies, Inc.
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