Understanding Liabilities in Financial Accounting

1. Chapter 9 -- Liabilities: Introduction FINANCIAL ACCOUNTING AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 10th Edition Clyde P. Stickney and Roman L. Weil

2. Learning Objectives 1. Understand and apply the concept of an accounting liability to obligations whose certainty of payment dates and amounts vary. 2. Develop the skills to compute the issue price, book value, and current market value of various debt obligations in an amount equal to the present value of the future cash flows. 3. Understand the effective interest method and apply it to debt amortization for various long-term debt obligations. 4. Understand the accounting procedures for debt retirements, whether at or before maturity.

3. Chapter Outline 1. Basic concepts a. Liability recognition b. Contingencies: potential liabilities c. Constructive liability d. Liability valuation e. Liability classification 2. Current liabilities a. Short-term notes and interest payable b. Wages payable and other payroll items c. Deferred performance liabilities: advances from customers d. Deferred performance liabilities: product warranties 3. Long-term liabilities a. Procedures for recording long-term liabilities b. Mortgages and notes c. Contracts and long term notes: interest imputation d. Bonds e. Unifying principles of accounting for long-term liabilities Chapter Summary Appendix 9.1: Effects on Cash Flow Statement of Transactions Involving Long-Term Liabilities

4. 1. Basic Concepts of Liabilities a. Liability recognition -- when is the liability recorded? b. Contingencies: potential liabilities -- under what conditions are potential contingencies booked as a liability? c. Liability valuation -- for what amount is the liability recorded? d. Liability classification • Current liability • Noncurrent liability

5. 1.a. Liability Recognition • An obligation is a liability if: 1. It involves a probably future sacrifice of resources 2. There is little or no discretion to avoid the transfer 3. The transaction or event that gives rise to the obligation has already occurred • A mutual promise (or executory contract) is not a liability because of item 3 above. • An example of a mutual promise is the customer promises to pay and the firm promises to deliver goods at a date. If this promise is in the form of a legal contract, it may give both parties rights but the rights are not yet considered assets and the obligations are not yet considered liabilities.

6. Exhibit 9.1 -- Classifications of Accounting Liabilities by Degree of Certainty most certain least certain Not generally recognized as accounting liabilities Recognized as accounting liabilities

7. 1.b. Contingencies: Potential Liabilities • Contingent liabilities are potential liabilities. • The more probable the potential to become a legal obligation, the greater the rationale for recognizing it as a liability. • Probability of a potential liability is very difficult to measure. • In general, an obligation should be recognized as a liability if it is probable that the firm will have make future sacrifices of resources. • Of course, the word probable is also difficult to measure. • FASB and IASC require the recognition of a loss and a contingent liability when • It is probable that an asset has been impaired or a liability incurred, and • The amount of the loss can be reasonably estimated.

8. 1.c. Constructive Liability • New concept not yet finalized by FASB. • A constructive liability arises not from an obligation, but from management intent. • A firm may record a liability based on future plans (or intent). • This gives management a lot of flexibility in reporting because they may easily change their intent. • Example: Management makes a decision to close a plant. At the time of the decision and before any actual transaction, management may decide to record the cost of the plant closing as a liability.

9. 1.d. Liability Valuation • In general, liabilities are presented on the balance sheet at the present value of payments needed to fulfill the obligation. • Present value refers to discounting the nominal payments by an interest rate appropriate for the firm. • Discounting is a mathematical computation whereby future flows are reduced to reflect the concept that money has time value. (See Appendix A at the back of the text.) • Current liabilities are not generally discounted because of the short period of time until they are to be resolved. The short period of time would cause the amount of any discount to be small enough to be considered immaterial.

10. 1.e. Liability Classification • Liabilities are separated into current and noncurrent based on the length of time that will elapse before the obligation must be fulfilled. • Current liabilities are obligations that must be fulfilled within the current operating cycle which is almost always one year. • Noncurrent liabilities are obligations that need not be fulfilled within the current operating cycle. • Obligations calling for periodic payments such as a mortgage may be noncurrent but have a current portion; that is, the payments due within the operating cycle are current but the remaining payments are noncurrent.

11. 2. Current Liabilities a. Accounts payable b. Short-term notes and interest payable c. Wages, salaries and other payroll items d. Income taxes payable e. Deferred performance liabilities: advances from customers f. Deferred performance liabilities: product warranties

12. 2.a. Accounts Payable to Creditors • Business firms often buy and sell to each other on credit. • Amounts owed to other businesses for services or goods are called trade accounts payable. • Typically these are short-term liabilities. • Typically, a payment grace period is allowed before these obligations must be fulfilled (or paid). • A grace period may be 30 days or more. • Because such a grace period represents interest-free borrowing, the prudent firm takes advantage by paying exactly on time but not before. • Rarely, a firm is more aggressive and always pays late, but a late charge may be assessed and such a firm will develop a reputation which may affect the terms they can negotiate.

13. 2.b. Short-Term Notes and Interest Payable • A note payable is a form of short term borrowing. • The note accrues interest at a stated rate over time. • The total amount of the note and the interest may be due as one payment upon maturity of the note, • Or periodic payment may be required. • The journal entry for a cash payment of a note requires that first the interest payable be calculated based on the interest rate and the time interest accrued (typically a fraction of a year for notes). Interest expense (calculated) nnn Note Payable (balance) nnn Cash (amount paid) nnn

14. 2.c. Wages, Salaries and Other Payroll Items • Employers pay workers directly in cash and in the form of benefits -- this gives rise to payroll expense (or work-in-process if a manufacturing firm). • For example, vacation time may be earned over time. The firm pays taxes on this benefit as it is earned and a liability to the worker is recorded. When vacation is taken, the liability is reduced. • Employers also pay some taxes that relate to the workers -- these are tax expenses. • Also, employers serve as collector of some taxes, union dues and insurance payments -- these are not transactions of the firm and should not be included in the financial statements, however, the firm must keep careful records and does maintain accounts payable to the government, union or insurance company.

15. 2.d. Income Taxes Payable • U.S. and most countries tax business income. • Corporations are taxed directly. • Partnerships and sole proprietorships are not taxed but the income is assigned to the partners or proprietor who must then pay the tax. • Income taxes are assumed to accrue; that is, the income tax liability increases as the firm earns income. • Tax rules also call for periodic payments to the IRS. • So that business income taxes are estimated and paid throughout the year. • The annual filing deadline is a reporting deadline and not a payment deadline; payment in many cases is required earlier. • In addition, GAAP allows for differences between income tax expense (an accrual concept) and income tax liability (the amount owed to IRS). This is covered in a later chapter under deferred tax accounting.

16. 2.e. Deferred Performance Liabilities: Advances from Customers • A mutual promise (the customer promises to pay and the firm promises to deliver) is not recorded. • However, if the customer pays in advance, then there is an obligation that arises and the firm records this as an increase in an asset (cash) and an increase in a liability (advances from customers). • The obligation is for the firm to either fulfill its promise to deliver goods or services within the specifications of the contract or return the cash. • An example is a magazine subscription which is typically paid in advance. The subscription is an obligation to produce and deliver the magazine. When a magazine is delivered, the obligation can be reduced (debited) and revenue can be recognized (credited) because it is then earned.

17. 2.f. Deferred Performance Liabilities: Product Warranties • A warranty is a promise to repair or replace the good but is limited by time. • When goods with a warranty are sold: revenue, the warranty expense, and the warranty liability are recognized. The amount of the liability must be estimated. Accounts receivable (or cash) 280,000 Sales revenue 280,000 Warranty expense (estimated at 4% of sales) 11,200 Warranty liability11,200 • When a claim is made, the warranty liability is reduced (debited) and what is given to fulfill the claim (cash or new goods or parts and labor) are credited. • Any unused portion of the warranty expires at the end of the warranty period reducing the liability and creating a gain.

18. 3. Long-Term Liabilities a. Procedures for recording long-term liabilities b. Mortgages and notes c. Contracts and long-term notes: interest imputation d. Bonds e. Unifying principles of accounting for long-term liabilities

19. 3.a. Procedures for Recording Long-Term Liabilities • Whereas short term liabilities may be paid at maturity, long-term liabilities are more commonly paid in installments. • Also, the general rule is that long-term liabilities are recorded at the present value of the payments. • The accountant distinguishes between payment of the liability (the principle) and payment of interest (an expense of financing). • Commonly, the principle, the periodic payments and the interest rates are explicitly stated in the debt contract. • If not, then discounted cash flow methods may be used to separate out the interest payment. • The rate of interest that equated the present value of a given set of periodic payments with the principle is called the internal rate of return. (See Appendix A.)

20. 3.b. Mortgages and Notes • Mortgages follow the general rule for long-term liabilities. • A mortgage contract typically allows some recourse to the lender in the event of default; this might be a lien on property or collateral. • When the loan is made, the firm receives cash and a liability is created, mortgage payable. The liability is recorded at the present value of the periodic payments. • As periodic payments are made: cash is returned, the liability is reduced and interest expense is recognized using discounted cash flow methods. • The convention presently in the U.S. for mortgages calls for equal payments over the life of the loan. Since the liability decreases over the life of the loan, the interest expense also decreases and a greater amount of cash goes to reducing the principle.

21. 3.b. Exhibit 9.2 -- Mortgages (Cont.) • Consider a 5 year mortgage for $125,000 to be repaid in 10 installments of $17,000 per semester with 12 percent interest compounded semiannually. • The repayment schedule is given below. • Notice that even though the cash payments are equal; the balance owed and the interest expense decrease over time. The last payment is a little less than $17,000 due to rounding effects.

22. 3.c. Contracts and Long-Term Notes: Interest Imputation • Some contracts do not explicitly state interest payments, instead the purchase price may include carrying charges. • There is no economic concept of an interest-free loan. The interest may not be expressed, but it is there. • The IRS agrees and will require the tax payer to calculate interest payments even if the contract does not specifically state a rate of interest (called implicit or imputed interest). • GAAP agrees and requires that long term liabilities be recorded at their present value and that repayments be separated into interest expense and reduction of the liability. • Where interest rates are not stated, they can be computed using present value methods and using the know payments with • An estimate of market value (which becomes the PV), or • An estimate of the interest rate for similar debt.

23. 3.d. Bonds • Bonds are debt instruments similar to a mortgage except mortgages are generally issued by banks while bonds are may sold to the investing public. • Some bonds carry no collateral and are called debenture bonds. • Bonds backed by collateral are called collateral trust bonds. • Bonds are recorded as a long-term liability. • The periodic payments for a bond are intended to be only for the interest at the rate that is given by the bond contract (called the face rate of interest). The principal is repaid in one lump sum at the maturity of the bond. • So the holder of a bond has rights to two cash inflows: periodic interest payments over time and a lump sum repayment of the principal at maturity. • The present value of a bond is the sum of the PV of the interest payments plus the PV of the maturity payment.

24. 3.d. Bonds -- Discount or Premium • While bonds are intended to be issued for exactly the amount of the principal with interest paid at exactly the face rate, changing market forces sometimes cause the bond to rise or fall in value during the short interval of time after the face rate is set and before the bond goes to market. • If demand for the bond is great, the price may rise as people bid up the price. Such a bond is said to have sold at a premium. • If demand for the bond is less, the price may have to be reduced to encourage buyers. Such a bond is said to have sold at a discount. • A premium or discount changes the amount of cash the bond issuer receives. • Since the principal of the bond is changed, the actual interest rate is also changed because cash payments are based on the face rate, not the market rate.

25. 3.d. Discount or Premium (Cont.) Example18 buy bond $12.5 $12.5 $12.5 $12.5 .… $250+$12.5 0 1 2 3 4 …. 40 • Consider a 20-year bond for $250 which pays periodic interest payment at 10% semiannually. • The purchaser of such a bond gets 40 equal payments of $12.5 plus a return of the principal ($250) at the end. • An economically rational purchaser would pay $250 for this bond only if he or she required exactly 10% return on his or her investment given the risks. • If the rational investor required a greater return, he or she might still be willing to buy the bond at a reduced price (a discount). • If the rational investor required less return, he or she might be willing to pay more (a premium).

26. 3.d. Discount or Premium (Cont.) Ex. 19 • Consider a 15-year bond which pays semiannual interest payment of $13.1 and no extra payment in the last year. • Consider that the purchaser required 10% annual return. • How much should he or she pay so that the return on the bond is exactly 10%? • The rate of return can be solved using present value calculations: PV(bond) = PV(annuity) = periodic payment  present value factor where the present value factor for 30 periods and 5 percent per period is 15.372 PV(bond) = $13.1  15.372 = $201.4 = price of the bond

27. 3.e. Unifying Principles of Accounting for Long-Term Liabilities • Long-term liabilities obligate the borrowing firm to pay specified amounts at definite times more than one year in the future. • All long-term liabilities appear on the balance sheet at the present value of the remaining future payments. • Process: 1. Record the liability at the cash or cash-equivalent value received. This amount is the present value of the liability. 2. At any subsequent time when the firm makes a cash payment or an adjusting entry for interest, it computes interest as the book value of the liability multiplies by the interest rate (not necessarily the face rate of interest).

28. Chapter Summary • A liability obligates a firm to make a probably future sacrifice of resources. • Conditions to record a liability are: (1) it is a probability and (2) the amount can reasonably be estimated. • Current liabilities are obligations due within the current accounting cycle and are recorded at actual cash value; that is, not discounted. • Long-term liabilities are recorded at the present value of future payments. Periodic payments reduce the liability. Periodic adjusting entries recognize interest expense. • Bonds are special debt instruments that require present value calculations in order to compute the liability.

29. Appendix 9.1: Effects on Cash Flow Statement of Transactions Involving Long-Term Liabilities • Recognizing interest expense on bonds issued at less than par (or face value) may require special treatment in computing cash flows from operations. • When a firm retires a bond for cash, it reports that cash in the financing section as a nonoperating use, Cash Used to Reduce Debt. In most cases, the amount of cash the firm uses to retire a liability differs from the book value of the liability at the time of retirement. In such cases, an adjusting entry is required to adjust for accrued interest. • In addition, a realized gain or loss may occur if there are penalties for early retirement or if the bond can be retired at a discount (early extinguishment of debt).