Reporting and Interpreting Liabilities

1. Reporting and Interpreting Liabilities Chapter 9

2. The acquisition of assets is financed from two sources: Understanding the Business Equity - funds from owners Debt - funds from creditors

3. Understanding the Business Debt is considered riskier than equity. Creditors can force bankruptcy. Interest is a legal obligation.

4. Learning Objectives Define, measure, and report current liabilities. LO1

5. Current Liabilities Noncurrent Liabilities 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

6. Liabilities are measured at their current cash equivalent (the amount a creditor would accept to cancel the debt) at the time incurred. Liabilities Defined and Classified

7. Current Liabilities

8. Net Pay State and Local Income Taxes Voluntary Deductions Medicare Tax Federal Income Tax Social Security Tax Payroll Taxes Gross Pay Less Deductions:

9. Learning Objectives Use the current ratio. LO2

10. An important indicator of a company’s ability to meet its current obligations. Current Ratio Current Ratio = Current Assets÷ Current Liabilities Starbucks has current assets of $924 and current liabilities of $608.7.

11. Learning Objectives Analyze the accounts payable turnover ratio. LO3

12. Accounts Payable Turnover Ratio Measures how quickly management is paying trade accounts. AccountsPayableTurnover Cost of Goods Sold Average Accounts Payable = ÷ Starbucks has cost of goods sold of $1,685.9 and average accounts payable of $152.5.

13. Learning Objectives Report notes payable and explain the time value of money. LO4

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.

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.

16. Learning Objectives Report contingent liabilities. LO5

17. Contingent Liabilities Potential liabilities that arise because of events or transactions that have already occurred.

18. Learning Objectives Explain the importance of working capital and its impact on cash flows. LO6

19. Working Capital Management Working Capital = Current Assets- Current Liabilities Changes in working capital accounts affect cash flows as indicated in the following table.

20. Learning Objectives Report long-term liabilities. LO7

21. Current Liabilities Long-term Liabilities 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

22. or Insurance Companies Pension Plans Banks Long-Term Notes Payable and Bonds Relatively small debt needs can be filled from single sources.

23. Long-Term Notes Payable and Bonds Significant debt needs are often filled by issuing bonds to the public. Bonds Cash

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.

25. Operating and Capital Leases Operating Lease CapitalLease Short-term lease; No liability or asset recorded Long-term lease; Meets one of 4 criteria; Results in recording an asset and a liability • Capital Lease Criteria • Lease term is 75% or more of the asset’s expected economic life. • Ownership of asset is transferred to lessee at end of lease. • Lease permits 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.

26. Learning Objectives Compute present values. LO8 Apply present value concepts to liabilities. LO9

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.

28. 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. Present Value Concepts

29. 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). Present Value Concepts

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

31. 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. $1,000.00 b. $ 990.00 c. $ 751.30 d. $ 970.00

32. 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. $1,000.00 b. $ 990.00 c. $ 751.30 d. $ 970.00 The required future amount is $1,331. i = 10% & n = 3 years Using the present value of a single amount table, the factor is .7513. $1,331 × .7513 = $1,000 (rounded)

33. Present Values of an Annuity An annuity is a series of consecutive equal periodic payments. Today

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 Payment 2 Payment 3 Present Value Interest compounding periods Today

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

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 d. $2,486.90 The consecutive equal payment amount is $1,000. 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

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%. Let’s prepare the journal entry to record the purchase.

38. Accounting Applications of Present Values Present Value × Interest Rate = Interest $159,440 × 12% = $19,133 Now, let’s look at the journal entry at December 31, 2006.

39. Accounting Applications of Present Values Now, let’s look at the journal entries at December 31, 2007. Present Value × Interest Rate = Interest ($159,440 + $19,133) × 12% = $21,429

40. Chapter Supplement A Income Taxes and Retirement Benefits

41. Income Taxes and Retirement Benefits 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. Deferred Taxes Timing differences that cause deferred income taxes and will reverse, or turn around, in the future. Temporary Differences

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.

43. Chapter Supplement B Federal Income Tax Concepts

44. Federal Income Tax Concepts Are separate legal entities and are required to pay income taxes. Corporations Determined by multiplying taxable income by the corporate tax rate. Tax Obligation

45. Revenue and Expense Recognition for Income Tax Purposes • Interest revenue on state and municipal bonds is generally excluded from taxable income although it is included in accounting income. • Revenue collected in advance is included in taxable income when it is collected and in accounting income when it is earned. • Proceeds from life insurance policies are excluded from taxable income but included in accounting income. • 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. • For tax purposes, depreciation expense is generally based on the Accelerated Cost Recovery System (ACRS) or on the Modified Accelerated Cost Recovery System (MACRS).

46.  Tax Minimization Versus Tax Evasion Tax Minimization Tax Evasion

47. Chapter Supplement C Present Value Computations Using Excel

48. Present Value Computations Using Excel

49. Chapter Supplement D Future Value Concepts

50. How much will an amount today be worth in the future? Future Value of a Single Amount Future value is the sum to which an amount will increase as the result of compound interest. Present Value FutureValue Interest compounding periods Today