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Reporting and 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 Also Called Trade Accounts Payable 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. 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 $924.00 ÷ $608.70 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 Average Goods ÷ Accounts Sold Payable Starbucks has cost of goods sold of $1,685.9 and average accounts payable of $152.5. Accounts Payable = Turnover 11.06 = Cost of Goods Sold Average ÷ Accounts Payable $1,685.90 ÷ $152.50 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. 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. 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 Disclose liability in the No liability. notes to the action. Disclose liability in the financial stmts. Disclose liability in the No notes to the notes to the 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. Current Assets Current Liabilities Change in Account Balance During Year Increase Decrease Reduce cash Increase cash flows. flows. Increase cash Reduce cash flows. flows. 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. a liability 2. Ownership of asset is transferred to lessee at endand 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 Value Future Value Interest compounding periods Today Future 9-31 Present Value of a Single Amount a. b. c. d. How much do we need to invest today at 10% interest, compounded annually, if we need $1,331 in three years? $1,000.00 $ 990.00 $ 751.30 $ 970.00 9-32 Present Value of a Single Amount a. b. c. d. How much do we need to invest today at 10% interest, compounded annually, if we need $1,331 in three years? $1,000.00 $ 990.00 The required future amount is $1,331. $ 751.30 i = 10% & n = 3 years Using the present value of a single $ 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 Today Payment 2 Interest compounding periods Payment 3 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 $ 200,000 PV of $1 (i=12%, n=2) Present value × 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 Interest Rate Interest 31, Now, let’s look Value at the ×journal entry at =December $159,440 2006. × 12% = $19,133 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 Description Date 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 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. 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 Corporations Are separate legal entities and are required to pay income taxes. 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 Today Interest compounding periods Future Value 9-51 Future Value of a Single Amount a. b. c. d. 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 9-52 Future Value of a Single Amount a. b. c. d. 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 9-53 Future Value of an Annuity Equal payments are made each period. The payments and interest accumulate over time. Payment 1 Payment 2 Interest compounding periods Today Payment 3 9-54 Future Value of an Annuity a. b. c. d. 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 9-55 Future Value of an Annuity a. b. c. d. 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 9-56 End of Chapter 9