1. Current Liabilities, Contingencies, and the Time Value of Money
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 Contingent Liabilities
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 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
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 ( )15
= $50,000 x ( )
= $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 ( )8
= $2,000 x ( )
= $2,534
Future Value of $1 Table:
FV = $2,000 x (interest factor)
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 ( )2
= $2,000 x ( )
= $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 ( )
= $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 ( )
= $13,923
Module 4: LO 6

49. Future Value of an Annuity (continued)
$3,000 x Interest for 3 Periods $3,993
3, x Interest for 2 Periods 3,630
3, x Interest for 1 Period 3,300
3, x 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

51. Present Value of an Annuity (continued)
You will receive an annuity of $4,000 per year for four years, with the first received one year from today
The amounts received can be invested at a rate of 10% compounded annually
What amount would you need at the present time to have an amount equivalent to the series of payments and interest in the future?
Present Value of Annuity of $1:
PV = $4,000 x (table factor)
= $4,000 x ( )
= $12,679
Module 4: LO 6

52. Present Value of an Annuity (continued)
$4,000 x Factor for 4 Periods $2,732
4, x Factor for 3 Periods 3,005
4, x Factor for 2 Periods 3,306
4, x Factor for 1 Period 3,636
Total Present Value $12,679
Module 4: LO 6

53. Example 9-12—Calculating Present Value of an Annuity
You just won the lottery and can take your $1 million in a lump sum today, or you can receive $100,000 per year over the next 12 years
Assuming a 5% interest rate, which would you prefer, ignoring tax considerations?
The present value of the series of payments can be calculated as follows:
PV = $100,000 x (table factor)
= $100,000 x ( )
= $886,325
Module 4: LO 6

54. Solving for Unknowns
In some cases, the present value or future value amounts will be known but the interest rate or the number of payments must be calculated
The formulas for present value and future value be used for such calculations
Module 4: LO 7

55. Example 9-13—Solving for an Interest Rate
Assume that you have just purchased an automobile for $14,419
The amount of the loan payments, which include principal and interest, is $4,000 annual payments on the loan at the end of each 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
The market or present value of the car, as well as the loan, is $14,419
The interest rate that must be solved for represents the discount rate that was applied to the $4,000 payments to result in a present value of $14,419
Module 4: LO 7

56. Example 9-13—Solving for an Interest Rate (continued)
The applicable formula is the following:
PV = $4,000 x (table factor)
In this case, PV is known, so the formula can be rearranged as follows:
Table factor = PV/$4,000
= $14,419/$4,000
= 3.605
Present Value of Annuity of $1:
Table factor of is found in the 12% column
Therefore, the rate of interest being paid on the auto loan is approximately 12%
Module 4: LO 7

57. 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 accumulated amount of $12,000 represents the future value of an annuity of $1,000 per semiannual period
Module 4: LO 7

58. Example 9-14—Solving for the Number of Years (continued)
Using Future Value of Annuity of $1 the applicable formula is the following:
FV = $1,000 x (table factor)
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 factor = FV/$1,000
= $12,000/$1,000
= 12.00
Future Value of Annuity of $1 :
The closest table value is and corresponds to ten periods
Therefore, if $1,000 is deposited per semiannual period and the money is invested at 4% per semiannual period, it will take ten semiannual periods (five years) to accumulate $12,000
Module 4: LO 7

59. Appendix Accounting Tools: Using Excel for Problems Involving Interest Calculations
The purpose of this appendix is to illustrate how the functions built in to the Excel spreadsheet can be used to calculate future value and present value amounts
Appendix

60. Example 9-15—Using Excel for Future Values
Your three-year-old son 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 when Robert starts college?
Appendix

61. Example 9-16—Using Excel for Annual Compounding
Consider a $2,000 note payable that carries interest at the rate of 10% compounded annually and is due in two years, when the principal and interest must be paid at that time
What amount must be paid in two years?
Appendix

62. Example 9-17—Using Excel for Quarterly Compounding
Suppose we want to 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
What future amount must be paid in two years?
Appendix

63. Example 9-18—Using Excel for Present Values
Suppose you know that you will receive $2,000 in two years
If you had the money now, you could invest it at 10% compounded annually
What is the present value of the $2,000?
Appendix

64. Example 9-19—Using Excel for Future Value of an Annuity
Suppose you are to receive $3,000 per year at the end of each of the next four years and assume that 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?
Appendix

65. Example 9-20—Using Excel for Semiannual Compounding Annuities
Your cousin had a baby girl two weeks ago and is already thinking about sending her to college
When the girl is 15, how much money would be in her college account if your cousin deposited $2,000 into it on each of her 15 birthdays? The interest rate is 10%
Appendix

66. Example 9-20—Using Excel for Semiannual Compounding Annuities (continued)
What if the scenario was modified so that $1,000 was deposited semiannually and the interest rate was 10% compounded semiannually (or 5% per period) for 15 years?
Appendix

67. Example 9-21—Using Excel for Present Value of an Annuity
You just won the lottery and can take your $1 million in a lump sum today, or you can receive $100,000 per year over the next 12 years
Assuming a 5% interest rate, which would you prefer, ignoring tax considerations?
Appendix

68. Review
LO1 Identify the components of the Current Liability category of the balance sheet.
Current liabilities are obligations of a company that generally must be satisfied within one year. Some companies list them in the balance sheet in order of the account that requires payment first.
Current liability accounts include Accounts Payable, Notes Payable, Current Portion of Long-Term Debt, Taxes Payable, and Accrued Liabilities.
LO2 Examine how accruals affect the Current Liability category.
Accrued liabilities result from expenses that are incurred but have not yet been paid.
Common accrued liabilities include taxes payable, salaries payable, and interest payable.

69. Review
LO3 Explain how changes in current liabilities affect the statement of cash flows.
Most current liabilities are directly related to the ongoing operations of a company.
Decreases in current liabilities indicate that cash has been used to satisfy obligations and are cash outflows not represented by some expenses on the income statement.
Increases in current liabilities indicate that some expenses on the income statement have not been paid in cash and are not cash outflows represented by some expenses on the income statement.

70. Review
LO4 Determine when contingent liabilities should be presented on the balance sheet or disclosed in notes and how to calculate their amounts.
Contingent liabilities should be accrued and disclosed only when the event they depend on is probable and the amount can be reasonably estimated.
The amount of a contingent liability is often an estimate made by experts both inside the firm (managers for amounts of warranty expenses) and outside the firm (e.g., attorneys for amounts in a lawsuit).

71. Review
LO5 Explain the difference between simple and compound interest.
Simple interest is earned only on the principal amount, whereas compound interest is earned on the principal plus previous amounts of accumulated interest.
LO6 Calculate amounts using the future value and present value concepts.
Present and future value calculations are made for four different scenarios:
Future value of a single amount
Present value of a single amount
Future value of an annuity
Present value of an annuity

72. Review
LO7 Apply the compound interest concepts to some common accounting situations.
Often, all of the variables necessary to calculate amounts related to present and future value concepts will be available except for one unknown amount that can be solved for.
Financial calculators allow for these situations and easily solve for unknown values such as present or future value, payments, and interest rate.

73. End of Chapter 9