Current Liabilities and the Fair Value of Accounting Chapter 8 Current Liabilities and the Fair Value of Accounting

Managing Liquidity and Cash Flows Current liabilities arise to support the operating cycle or to raise cash during periods of inventory build up Companies must be able to pay debts Measurements like working capital and the current ratio depend on current liabilities The amount of time suppliers give a company to pay for purchases is also a factor in managing cash flow and liquidity Copyright © Cengage Learning. All rights reserved. © Royalty Free PhotoDisc/ Getty Images

Payables Turnover Number of times, on average, that a company pays its accounts payables in an accounting period Payables Turnover = Cost of Goods Sold + Change in Merchandise Inventory Average Accounts Payable Microsoft’s 2007 Payables Turnover = $10,693 + $351 ($3,247 + $2,909) ÷ 2 = 3.4 times Copyright © Cengage Learning. All rights reserved.

Payables Turnover for Selected Industries Copyright © Cengage Learning. All rights reserved.

How long, on average, a company takes to pay its accounts payables Days’ Payable example SE2, hwk E 4 How long, on average, a company takes to pay its accounts payables Days’ Payable = Payables Turnover 365 days Microsoft’s Days’ Payable = 365 days 3.4 = 107.4 days Copyright © Cengage Learning. All rights reserved.

Days’ Payable for Selected Industries Copyright © Cengage Learning. All rights reserved.

Recognition of Liabilities Timing is important when recognizing liabilities Failure to record a liability often means that an expense has also not been recorded Transaction obligates company to make future payments Accrue liabilities like salaries or interest payable Estimate and accrue liabilities like taxes payable Agreements for future transactions do not have to be recognized When an obligation occurs, a liability should be recorded. Copyright © Cengage Learning. All rights reserved.

Valuation of Liabilities Balance Sheet Liabilities Valued at the amount needed to pay off the debt, or at the fair market value of the goods or services to be delivered © Royalty Free PhotoDisc/ Getty Images Copyright © Cengage Learning. All rights reserved.

Classification and Disclosure Current Liabilities Companies may be required to include additional explanation of liability accounts in the notes to the financial statements Debts and obligations that a company expects to satisfy within one year or within its normal operating cycle, whichever is longer Maturity dates, interest rates, special credit agreements Long-Term Liabilities Due beyond one year or beyond the normal operating cycle Copyright © Cengage Learning. All rights reserved.

Common Types of Current Liabilities © Royalty Free/ Corbis Copyright © Cengage Learning. All rights reserved.

Definitely Determinable Liabilities Current liabilities that are set by contract or statute and that can be measured exactly Accounts Payable Bank loans and commercial paper Notes payable Accrued liabilities Dividends payable Sales and excise taxes payable Current portion of long-term debt Payroll liabilities Unearned revenues © Royalty Free PhotoDisc/ Getty Images Copyright © Cengage Learning. All rights reserved.

Individual accounts for each person or business to which money is owed Accounts Payable Short-term obligations to suppliers for goods and services Also called trade accounts payable Amount in Accounts Payable account is generally supported by an accounts payable (A/P) subsidiary ledger A/P Subsidiary Ledger Individual accounts for each person or business to which money is owed Copyright © Cengage Learning. All rights reserved.

Bank Loans Companies often borrow funds when they are needed using a line of credit Company signs a note for the full amount of a line of credit Company may use all or only some of funds Interest rate may change daily Bank may require firm to meet certain financial goals to retain its line of credit © Royalty Free/ Corbis Copyright © Cengage Learning. All rights reserved.

Commercial Paper categories and terms example SE3, hwk P1 Short-term unsecured loans available to firms with excellent credit ratings On the Balance Sheet: Current Liabilities: The line of credit currently borrowed and the amount of commercial paper issued are usually combined with notes payable in the current liabilities section of the balance sheet Usually issued to the public through professionally managed investment firms Copyright © Cengage Learning. All rights reserved.

Short-Term Notes Payable Obligations represented by promissory notes Used to: Secure bank loans Pay suppliers Obtain more credit © Royalty Free C Squared Studios/ Getty Images Copyright © Cengage Learning. All rights reserved.

Recording Notes Payable example SE4, hwk E5 Issuance of 60-day, 12 percent promissory note on August 31 Payment of note Copyright © Cengage Learning. All rights reserved.

Accrued Liabilities Adjusting entries recognize liabilities that are not already in the accounting records Example: A $10,000, 60-day, 12% promissory note is issued on August 31. The fiscal year ends on September 30. The interest to be accrued is calculated as follows: $10,000 x .12 x 30/365 = $98.63 Copyright © Cengage Learning. All rights reserved.

Dividends Payable Cash dividends are a distribution of earnings to a corporation’s stockholders A corporation’s board of directors has the sole authority to declare dividends A corporation has no liability for dividends until the date of declaration During the time between the date of declaration and the date of payment, the dividends declared are considered current liabilities Copyright © Cengage Learning. All rights reserved.

Sales and Excise Taxes Payable Sales taxes are often levied on retail transactions Excise taxes are imposed on certain goods like gasoline Merchants collect the sales taxes from customers and pay them over to the appropriate taxing authority © Royalty Free Stockbye/ Getty Images Copyright © Cengage Learning. All rights reserved.

Current Portion of Long-Term Debt If a portion of long-term debt is due within the next year and is to be paid from current assets, that portion is classified as a current liability. Copyright © Cengage Learning. All rights reserved.

Payroll Liabilities Payroll liabilities include: Cost of labor Salaries & Wages Payroll taxes FICA, Medicare, FUTA, and SUTA Employers are responsible to various government agencies and other entities for amounts withheld Copyright © Cengage Learning. All rights reserved.

Payroll Costs Copyright © Cengage Learning. All rights reserved.

Recording Payroll example SE5 , hwk E7 Feb. 15: Record payroll, total employee wages, $65,000 Note that employees earned $65,00 but their take home pay was only $42,428 Feb. 15: Record payroll taxes and benefit costs Payroll taxes and benefits increase the total cost of payroll to $83,802 Copyright © Cengage Learning. All rights reserved.

Unearned Revenues Obligations for goods or services that the company must provide or deliver in a future accounting period in return for an advance payment from a customer Deposits received in advance, gift certificates, and subscriptions are all current liabilities © Royalty Free C Squared Studios/ Getty Images Copyright © Cengage Learning. All rights reserved.

Recording Unearned Revenues Received advanced one year subscription totaling $3,600 Microsoft now has a liability that will be reduced gradually as monthly services are provided Monthly Service Performed Copyright © Cengage Learning. All rights reserved.

Estimated Liabilities Definite obligations whose exact dollar amount cannot be known until a later date Estimate and record these types of liabilities Income taxes Property taxes Promotional costs Product warranties Vacation pay Copyright © Houghton Mifflin Company. All rights reserved.

Income Taxes Payable A corporation’s income is taxed by the federal government and most state governments The amount of tax is not known until the end of the year, but should be accrued in an adjusting entry Sole proprietorships and partnerships do not pay income taxes; their owners pay on their individual tax returns Copyright © Cengage Learning. All rights reserved.

Property Tax Payable Property taxes are levied on real and personal property The fiscal years of local governments and of businesses rarely correspond Companies must estimate the amount of property tax applicable to each month of the year © Royalty Free Stockbye/ Getty Images Copyright © Cengage Learning. All rights reserved.

Product Warranty Liabilities When a firm sells a product or service with a warranty, it has a liability for the length of the warranty Illustration: Midas Muffler guarantees that it will replace free of charge any muffler it sells that fails during the time the buyer owns the car. In the past, 6 percent of mufflers sold have been returned for replacement. The average cost for a muffler is $50. If the company sold 700 mufflers during July, what is the amount of liability to be accrued? 700 X .06 = 42 x $50 = $2,100 Copyright © Cengage Learning. All rights reserved.

Recording Product Warranty Liabilities example SE6, hwk E8 Record warranty expense: Record replacement of a defective muffler, which cost $60, and receipt of $30 service fee to have it replaced: Copyright © Cengage Learning. All rights reserved.

Vacation Pay Liability Vacation pay is often accrued as employees work during the year The cost should be allocated over the entire year so that month-to-month costs will not be distorted (applies to bonus plans and pension plan contributions as well) © Royalty Free/ Corbis Copyright © Cengage Learning. All rights reserved.

Vacation Pay Liability: Illustrated April 20: Employees earn two weeks paid vacation for every 50 weeks worked, and it is assumed only 75 percent of employees will ultimately collect vacation pay. The weekly payroll is $42,000, of which $2,000 is paid to employees on vacation. How is estimated vacation pay liability recorded? The computation of vacation pay expense is based on the payroll of employees not on vacation Copyright © Cengage Learning. All rights reserved.

Contingent Liabilities Potential liabilities that depend on future events arising out of past transactions Past Transaction: Building of a bridge Future Event: Outcome of a lawsuit Conditions for determining when a contingency should be entered in the accounting records: The liability must be probable The liability can be reasonably estimated (Vacation pay, income taxes, and warranty liability) Copyright © Cengage Learning. All rights reserved.

Commitments Legal obligations that do not meet the technical requirements for recognition as a liability and so are not recorded Examples include purchase agreements and leases Copyright © Cengage Learning. All rights reserved. © Royalty Free Digital Vision/ Getty Images

Valuation Approaches to Fair Value Accounting © Royalty Free PhotoDisc/ Getty Images Copyright © Cengage Learning. All rights reserved.

Does Time Affect Money? Time Value of Money Effects of the passage of time on holding or not holding money Interest Measures these effects for a given period of time Copyright © Cengage Learning. All rights reserved.

Interest Simple Interest Compound Interest return on principal for one or more periods principal sum stays the same from period to period return on principal for two or more periods computed by adding the interest earned in one period to the amount on which interest is computed in future periods Copyright © Cengage Learning. All rights reserved.

Simple Interest Illustrated Willy Wang accepts an 8 percent, $15,000 note due in 90 days. What total amount will Sanchez receive? The total that Sanchez will receive is $15,295.89. ($15,000.00 principal + $295.89 interest) Copyright © Cengage Learning. All rights reserved.

Compound Interest Illustrated Terry Soma deposits $10,000 in an account that pays 6 percent interest. She expects to leave the principal and accumulated interest in the account for three years. Interest is paid at the end of each year. What total amount will be in the account at the end of three years? Soma will have $11,910.16 at the end of three years. Note that the annual amount of interest increases each year by the interest rate times the interest of the previous year. Copyright © Cengage Learning. All rights reserved.

Present Value Way of valuing future cash flows Amount that must be invested today at a given rate to produce a given future value Present value and future value are closely related Copyright © Cengage Learning. All rights reserved.

Present Value It depends upon... the amount of the future receipt. the length of time to the future receipt. interest rate for the period.

The present value (PV) is the PRESENT VALUE amount that would have to be invested now to accumulate to some specified future amount. Present Value = Future Value * Factor The process of computing present value is called discounting.

CALCULATING PRESENT VALUE The present value of a single sum can be computed using The Present Value of $1 table Find the factor in the table that corresponds with the number of interest periods and the interest rate. Multiply that factor by the future value.

Present Value of a Single Sum Due in the Future Ron More wants to have $8,000 at the end of three years. How much must he invest today in a 5 percent savings account to achieve this goal? Year 3 Future value $8,000 Year 2 Year 1 Present value $6,910 Using tables (Table 1), the calculation is: Future Value × Factor = Present Value $8,000 × .864 = $6,910 Copyright © Cengage Learning. All rights reserved.

Present Value of an Annuity An annuity is a stream of payments of equal amounts at equal time intervals. The Present Value of an Annuity: PVa = Payment (pmt) * Factor (f)

Present Value of an Annuity The present value of an annuity is determined by using the factors in the Present Value of an Annuity table. To compute the present value of an annuity, find the factor in the table that corresponds with the number of periods and the interest rate. Multiply that factor by the amount of the periodic payment (receipt).

Present Value of an Ordinary Annuity Example SE7-8, hwk E13 Vickie Long sold a piece of property and is to receive $18,000 in three equal payments of $6,000 beginning one year from today. What is the present value of this sale if the current interest rate is 5 percent? Year 3 $6,000 Year 2 Year 1 Present value $16,338 Using the table factor (Table 2), the calculation is: Periodic payment × Factor = Present Value $6,000 × 2.723 = $16,338 Copyright © Cengage Learning. All rights reserved.

Time Periods When using tables, the left-hand column refers to periods Interest can, of course, be paid on a quarterly or semiannual basis To use the tables in these cases, it is necessary to (1) divide the annual interest rate by the number of periods in the year, and (2) multiply the number of periods in one year by the number of years Copyright © Cengage Learning. All rights reserved.

Applications Using Present Values © Royalty Free PhotoDisc/ Getty Images Copyright © Cengage Learning. All rights reserved.

How Is the Time Value of Money Used in Accounting? Valuing an asset Differed payment Investment of idle cash Accumulation of a fund for loan repayment Other applications © Royalty Free PhotoDisc/ Getty Images Copyright © Cengage Learning. All rights reserved.

Valuing an Asset An asset is something that will provide future benefits to the company that owns it The purchase price of an asset represents the present value of these future benefits © Royalty Free/ Corbis The proposed purchase price can be evaluated by comparing it with the present value of the asset to the company Copyright © Cengage Learning. All rights reserved.

Evaluating the Proposed Purchase Price of an Asset Mike Yeboah is thinking about buying a new machine that will reduce his annual labor cost by $1,400 per year. The machine will last for 8 years. The interest rate used for management decisions is 10 percent. What is the maximum amount Yeboah should pay for the machine? The present value of the machine is equal to the present value of an ordinary annuity of $1,400 per year for 8 years at compound interest of 10 percent Example SE9, hwk E14 Using Table 2, the factor for 10 percent and 8 periods is 5.335 Yeboah should not pay more than $7,469.00 for the new machine. This amount equals the present value of the benefits that he will receive from owning the machine. Copyright © Cengage Learning. All rights reserved.

Determining the Sales Price When Payment Is Deferred Field Helpers Corporation sells a tractor to Sasha Ptak for $100,000 on February 1, agreeing to take payment ten months later on December 1. The prevailing annual interest rate is 12 percent. What is the actual price of the tractor? The actual price of the tractor is equal to the present value of the future payment Using Table 1, the factor for 1 percent and 10 periods is .905 12% annual rate ÷ 12 months per year = 1 percent per month 12 months per year x 10/12 of a year = 10 months The sale price of the tractor is $90,500 Copyright © Cengage Learning. All rights reserved.

Recording Deferred Sales The transaction is recorded in both the seller’s and purchaser’s books at the present value, $90,500. Ptak’s Journal (Purchaser) Helpers’ Journal (Seller) Copyright © Cengage Learning. All rights reserved.

Recording Deferred Sales When Ptak pays for the tractor, the entries are as follows: Ptak’s Journal (Purchaser) Helpers’ Journal (Seller) Copyright © Cengage Learning. All rights reserved.