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

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 portion of long-term debt Taxes payable Other accrued liabilities LO 1

Accounts Payable Amounts owed for inventory, goods, or services acquired in the normal course of business Usually do not require the payment of interest, but terms may be given to encourage early payment Example: 2/10, n/30 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

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 for notes depends on whether the interest is paid on the note’s due date or is deducted before the borrower receives the loan proceeds

Example 9.1—Recording the Interest on Notes Payable Assume that Hot Coffee Inc. receives a one-year loan from First National Bank on January 1. The face amount of the note of $1,000 must be repaid on December 31 along with interest at the rate of 12%

Example 9.1—Recording the Interest on Notes Payable (continued) The company could identify and analyze the effect of the repayment as follows:

Example 9.2—Discounting a Note Suppose that on January 1, 2014, First National Bank granted to Hot Coffee a $1,000 loan, due on December 31, 2014, 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)

Example 9.2—Discounting a Note (continued) The Discount on Notes Payable account should be treated as a reduction of Notes Payable. If a balance sheet was developed immediately after the January 1 loan, the note would appear in the Current Liability category as follows:

Example 9.2—Discounting a Note (continued) The original balance in the Discount on Notes Payable account represents interest that must be transferred to interest expense over the life of the note. Refer to Example 9-2. Before Hot Coffee presents its year-end financial statements, it must make an adjustment to transfer the discount to interest expense

Example 9.2—Discounting a Note (continued) Thus, the balance of the Discount on Notes Payable account is zero and $120 has been transferred to interest expense. When the note is repaid on December 31, 2014, Hot Coffee must repay the full amount of the note

Recording Current Maturities of Long-Term Debt The portion of a long-term liability that will be paid within one year

Example 9.3—Recording Current Maturities of Long-Term Debt Assume that on January 1, 2014, 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, 2015. On December 31, 2014, an entry should be made to classify a portion of the balance as a current liability

Recording Current Maturities of Long-Term Debt Refer to the information in Example 9-3. On January 1, 2015, the company must pay $1,000

Current Liabilities—Accruals 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 LO 2

Current Liabilities—Other Accrued Liabilities Include any amount that has been incurred but has not yet been paid

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

Recording Accrued Liabilities Assume that you received a one-year loan of $10,000 on December 1. The loan carries a 12% interest rate. On December 31, an accounting entry must be made to record interest even though the money may not actually be due.

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

Exhibit 9.2—Current Liabilities on the Statement of Cash Flows

Exhibit 9.3—Starbucks Corporation Partial Consolidated Statement of Cash Flows (In millions)

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 Examples: Premiums or coupons Lawsuits and legal claims Warranties and guarantees LO 4

Example 9.5—Recording a Liability for Warranties Assume that Quickkey Computer sells a computer product for $5,000 with a one-year warranty in case the product must be repaired. Assume that in 2014, Quickkey sold 100 computers for a total sales revenue of $500,000 Using an analysis of past warranty records, Quickkey estimates that repairs will average 2% of total sales

Exhibit 9.4—Note Disclosure of Contingencies for Burger King Corporation

Contingent Liabilities versus Contingent Assets 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

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

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 LO 5

Exhibit 9.5—Importance of the Time Value of Money

Simple Interest Calculated on the principal amount only

Compound Interest Calculated on the principal plus previous amounts of 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 Compounding Future value of a single amount Present value of a single amount Future value of an annuity Present value of an annuity LO 6

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

Future Value of a Single Amount (continued)

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

Future Value of an Annuity The amount accumulated in the future when a series of payments is invested and accrues interest Annuity: series of payments of equal amounts Using Future Value of Annuity of $1 Table

Future Value of an Annuity (continued) Using future value of $1 table:

Present Value of an Annuity The amount at a present time that is equivalent to a series of payments and interest in the future Using Present Value of Annuity of $1 Table

Present Value of an Annuity (continued) Using present value of $1 table:

Example 9.13—Solving for an Interest Rate Assume that you have just purchased an automobile for $14,419 and must decide how to pay for it. Your local bank has graciously granted you a five-year loan. Because you are a good credit risk, the bank will allow you to make annual payments on the loan at the end of each year. The amount of the loan payments, which include principal and interest, is $4,000 per year. You are concerned that your total payments will be $20,000 ($4,000 per year for five years) and want to calculate the interest rate that is being charged on the loan Because the market or present value of the car, as well as the loan, is $14,419, a time diagram of the example would appear as follows: LO 7

Example 9.13—Solving for an Interest Rate (Continued) The interest rate we must solve for represents the discount rate that was applied to the $4,000 payments to result in a present value of $14,419. Therefore, the applicable formula is the following: In this case, PV is known, so the formula can be rearranged as follows:

Table 9.4— Present Value of Annuity of $1

Example 9.14—Solving for the Number of Years Assume that you want to accumulate $12,000 as a down payment on a home. You believe that you can save $1,000 per semiannual period, and your bank will pay interest of 8% per year, or 4% per semiannual period. How long will it take you to accumulate the desired amount? The future value is known to be $12,000, and we must solve for the interest factor or table factor. Therefore, we can rearrange the formula as follows:

Table 9.3—Future Value of Annuity of $1

End of Chapter 9