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Understanding Current Liabilities and Time Value of Money

Explore components of balance sheet, accruals, cash flow effects of liabilities, contingent liabilities, and compound interest concepts. Learn to calculate present and future values in common accounting scenarios.

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Understanding Current Liabilities and Time Value of Money

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  1. Chapter 9 Current Liabilities, Contingencies, and the Time Value of Money

  2. Learning Objectives LO1 Identify the components of the Current Liability category of the balance sheet. LO2 Examine how accruals affect the Current Liability category. LO3 Explain how changes in current liabilities affect the statement of cash flows. LO4 Determine when contingent liabilities should be presented on the balance sheet or disclosed in notes and how to calculate their amounts. LO5 Explain the difference between simple and compound interest.

  3. Learning Objectives (continued) LO6 Calculate amounts using the future value and present value concepts. LO7 Apply the compound interest concepts to some common accounting situations.

  4. Module 1 Current Liabilities Current liabilities appear on the balance sheet Companies account for the accrual of current liabilities Module 1

  5. Current Liabilities • Obligation that will be satisfied within one year or within current operating cycle • Normally recorded at face value and are important because they are indications of a company’s liquidity • Examples: • Accounts payable • Notes payable • Current maturities of long-term debt Module 1: LO 1

  6. Liquidity • Firms that do not have sufficient resources to pay their current liabilities are often said to have a liquidity problem • Current ratio • Ratio of current assets to current liabilities • Helps creditors determine a company’s liquidity Module 1: LO 1

  7. Exhibit 9-1—Current and Quick Ratios of Selected Companies for 2013 Module 1: LO 1

  8. Accounts Payable • Amounts owed for inventory, goods, or services acquired in the normal course of business • Usually do not require the payment of interest • Terms may be given to encourage early payment • Example: 2/10, n/30, which means that a 2% discount is available if payment occurs within the first ten days • If payment is not made within ten days, the full amount must be paid within 30 days Module 1: LO 1

  9. Notes Payable • Amounts owed that are represented by a formal contract • Formal agreement is signed by the parties to the transaction • Arise from dealing with a supplier or acquiring a cash loan from a bank or creditor • The accounting depends on whether the interest is paid on the note’s due date or is deducted before the borrower receives the loan proceeds Module 1: LO 1

  10. Example 9-1—Recording the Interest on Notes Payable Assume that Hot Coffee Inc. receives a one-year loan for $1,000 which must be repaid on December 31 along with interest at the rate of 12% Hot Coffee would make the following entries to record the loan and its repayment: Module 1: LO 1

  11. Example 9-1—Recording the Interest on Notes Payable (continued) Module 1: LO 1

  12. Example 9-2—Discounting a Note Suppose that on January 1, 2016, First National Bank granted to Hot Coffee a $1,000 loan, due on December 31, 2016, but deducted the interest in advance and gave Hot Coffee the remaining amount of $880 ($1,000 face amount of the note less interest of $120) On January 1, Hot Coffee must make the following entry: Module 1: LO 1

  13. Current Maturities of Long-Term Debt Current maturities of long-term debt: the portion of a long-term liability that will be paid within one year Module 1: LO 1

  14. Example 9-3—Recording Current Maturities of Long-Term Debt Assume that on January 1, 2016, your firm obtained a $10,000 loan from the bank. The terms of the loan require you to make payments in the amount of $1,000 per year for ten years payable each January 1 beginning January 1, 2017. On December 31, 2016, an entry should be made to classify a portion of the balance as a current liability as follows: Module 1: LO 1

  15. Example 9-3—Recording Current Maturities of Long-Term Debt (continued) On January 1, 2017, the company must pay $1,000, and the entry should be recorded as follows: Module 1: LO 1

  16. Other Accrued Liabilities Accrued liability: a liability that has been incurred but has not yet been paid Taxes payable: business make an accounting entry, usually as one of the year-end adjusting entries, to record the amount of tax that has been incurred but is unpaid Module 1: LO 2

  17. Example 9-4—Recording Accrued Liabilities Suppose that your firm has a payroll of $1,000 per day Monday through Friday and that employees are paid at the close of work each Friday Also, suppose that December 31 is the end of your accounting year and that it falls on a Tuesday Your firm will have to record the following entry as of December 31: Module 1: LO 2

  18. IFRS and Current Liabilities International accounting standards require companies to present classified balance sheets with liabilities classified as either current or long term U.S. standards do not require a classified balance sheet Module 1: LO 2

  19. Module 2 Cash Flow Effects Current liabilities impact the cash flows of the company Module 2

  20. Cash Flow Effects Change in the balance of each current liability account should be reflected in the Operating Activities in the statement of cash flows A decrease indicates that cash has been used to pay the liability and should appear as a deduction An increase indicates a recognized expense that has not yet been paid Module 2: LO 3

  21. Exhibit 9-2—Current Liabilities on the Statement of Cash Flows Module 2: LO 3

  22. Exhibit 9-3—Starbucks Corporation Partial Consolidated Statement of Cash Flows (In millions) Module 2: LO 3

  23. Module 3 ContingentLiabilities Contingent liabilities should be presented on the balance sheet or disclosed in the notes Module 3

  24. Contingent Liabilities Existing condition for which the outcome is not known but depends on some future event Recorded if the liability is probable and the amount can be reasonably estimated Accrued and reflected on the balance sheet if it is probable and if the amount can be reasonably estimated Module 3: LO 4

  25. Contingent Liabilities That Are Recorded Product Warranties and Guarantees: at the end of each period, the selling firm must estimate how many of the products sold in the current year will become defective in the future and the cost of repair or replacement Estimated Liability: A contingent liability that is accrued and reflected on the balance sheet Module 3: LO 4

  26. Contingent Liabilities That Are Recorded (continued) Premiums or Coupons: companies estimate the number of premium offers that will be redeemed and the cost involved Some Lawsuits and Legal Claims: represent a contingent liability because an event has occurred but the outcome of that event is not known Module 3: LO 4

  27. Contingent Liabilities That Are Disclosed A contingent liability must be disclosed in the financial statement notes but not reported on the balance sheet if the contingent liability is at least reasonably possible Module 3: LO 4

  28. Exhibit 9-4—Note Disclosure of Contingencies of Starbucks Corporation Module 3: LO 4

  29. Contingent Liabilities versusContingent Assets • Contingent Liabilities: • Recorded in the balance sheet if probable and can be reasonably estimated • May be accrued • Contingent Assets: • Not recorded in the balance sheet • Not accrued Module 3: LO 4

  30. IFRS and Contingencies • International standards • Not recorded in the balance sheet—only provision is recorded • Probable means—‘‘more likely than not’’ to occur • Require the amount recorded as a liability to be ‘‘discounted’’ or recorded as a present value amount • U.S. standards • Recorded in the balance sheet if it is probable and can be reasonably estimated • Has a higher threshold than this • Do not have a similar requirement Module 3: LO 4

  31. Module 4 Time Value of Money Interest rates are calculated using the time value of money concepts Module 4

  32. Time Value of Money: Compounding of Interest An immediate amount should be preferred over an amount in the future because of the interest factor The amount can be invested, and the resulting accumulation will be larger than the amount received in the future Module 4: LO 5

  33. Exhibit 9-5—Importance of the Time Value of Money Module 4: LO 5

  34. Simple Interest • Calculated on the principal amount only I = P x R x T where I = Dollar amount of interest per year P = Principal R = Interest rate as a percentage T = Time in years Module 4: LO 5

  35. Compound Interest Calculated on the principal plus previous amounts of interest Interest is compounded, or there is interest on interest Module 4: LO 5

  36. Example 9-6—Calculating Compound Interest Assume a $3,000 note payable for which interest and principal are due in two years with interest compounded annually at 10% per year Interest would be calculated as follows: Module 4: LO 5

  37. Interest Compounding • If compounding is not done annually, the interest rate must be adjusted by dividing the annual rate by the number of compounding periods per year • Four compound interest calculations: • Future value of a single amount • Present value of a single amount • Future value of an annuity • Present value of an annuity Module 4: LO 6

  38. Example 9-7—Compounding Interest Semiannually Assume that the note payable from the previous example carried a 10% interest rate compounded semiannually for two years The compounding process is as follows: Module 4: LO 6

  39. Future Value of a Single Amount Future value of a single amount: amount accumulated at a future time from a single payment or investment The future amount is always larger than the principal amount (payment) because of the interest that accumulates Module 4: LO 6

  40. Future Value of a Single Amount (continued) • The formula to calculate the future value of a single amount is as follows: FV = p(1 + i)n where FV = Future value to be calculated p = Present value or principal amount i = Interest rate n = Number of periods of compounding Module 4: LO 6

  41. Example 9-8—Calculating Future Values with Formula • Three-year-old Robert inherits $50,000 in cash and securities from his grandfather • If the funds are left in the bank and in the stock market and receive an annual return of 10%, how much will be available in 15 years? FV = $50,000 x (1 + 0.10)15 = $50,000 x (4.17725) = $208,863 Module 4: LO 6

  42. Example 9-9—Calculating Future Values with Quarterly Compounding • Find the future value of a $2,000 note payable due in two years which requires interest to be compounded quarterly at the rate of 12% per year • To calculate the future value, adjust the interest rate to a quarterly basis by dividing the 12% rate by four compounding periods per year: 12%/4 quarters = 3% per quarter Module 4: LO 6

  43. Example 9-9—Calculating Future Values with Quarterly Compounding (continued) • The number of compounding periods is eight—four per year times two years • The future value of the note can be found in two ways as follows: FV = $2,000 x (1 + 0.03)8 = $2,000 x (1.26677) = $2,534 • Future Value of $1 Table: FV = $2,000 x (interest factor) = $2,000 x (1.26677) = $2,534 Module 4: LO 6

  44. Present Value of a Single Amount • The amount at a present time that is equivalent to a payment or an investment at a future time PV = Future Value x (1 + i)n where PV = Present value amount in dollars Future value = Amount to be received in the future i = Interest rate or discount rate n = Number of periods Module 4: LO 6

  45. Example 9-10—Calculating Present Value of a Single Amount • You will receive $2,000 in two years and you could invest it at 10% compounded annually • What is the present value of the $2,000? • Use the present value formula to solve for the present value of the $2,000 note as follows: PV = $2,000 x (1 + 0.10)2 = $2,000 x (0.82645) = $1,653 Module 4: LO 6

  46. Example 9-10—Calculating Present Value of a Single Amount (continued) • Present Value of $1 Table: PV = $2,000 x (discount factor) = $2,000 x (0.82645) = $1,653 Module 4: LO 6

  47. Future Value of an Annuity Annuity: series of payments of equal amounts Future value of an annuity: amount accumulated in the future when a series of payments is invested and accrues interest Module 4: LO 6

  48. Future Value of an Annuity (continued) • You are to receive $3,000 per year at the end of each of the next four years and each payment could be invested at an interest rate of 10% compounded annually • How much would be accumulated in principal and interest by the end of the fourth year? • Future Value of Annuity of $1: FV = $3,000 x (table factor) = $3,000 x (4.64100) = $13,923 Module 4: LO 6

  49. Future Value of an Annuity (continued) • Future Value of $1: $3,000 x 1.33100 Interest for 3 Periods $3,993 3,000 x 1.21000 Interest for 2 Periods 3,630 3,000 x 1.10000 Interest for 1 Period 3,300 3,000 x 1.00000 Interest for 0 Periods 3,000 Total Future Value $13,923 Module 4: LO 6

  50. Present Value of an Annuity The amount at a present time that is equivalent to a series of payments and interest in the future Module 4: LO 6

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