8–18–1 Chapter 8 Current Liabilities and the Fair Value of Accounting.

8–1

Chapter 8

Current Liabilities and the Fair Value of Accounting

8–2Copyright © Cengage Learning. All rights reserved.

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

© Royalty Free PhotoDisc/ Getty Images


Microsoft’s 2007 Payables Turnover =

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

$10,693 + $351

($3,247 + $2,909) ÷ 2

= 3.4 times


Payables Turnover for Selected Industries


Microsoft’s Days’ Payable =

Days’ Payable

How long, on average, a company takes to pay its accounts payables

365 days

3.4

= 107.4 days

Days’ Payable =

Payables Turnover

365 days

example SE2, hwk E 4


Days’ Payable for Selected Industries


Recognition of Liabilities

Timing is important when recognizing liabilitiesFailure to record a liability often means that an

expense has also not been recorded

When an obligation occurs, a liability

should be recorded.

When an obligation occurs, a liability

should be 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


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



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

Long-Term LiabilitiesDue beyond one year or beyond the normal operating cycle

Maturity dates, interest rates, special credit agreements


Common Types of Current Liabilities

© Royalty Free/ Corbis


Definitely Determinable Liabilities

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

Current liabilities that are set by contract or statute and that can be measured exactly



Accounts Payable

Also called trade accounts payable

Amount in Accounts Payable account is generally supported by an accounts payable (A/P) subsidiary ledger

Short-term obligations to suppliers for goods and services

A/P Subsidiary LedgerIndividual accounts for each person or business to which money is owed

A/P Subsidiary LedgerIndividual accounts for each person or business to which money is owed


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



Commercial Paper

Short-term unsecured loans available to firms with excellent credit ratings

Usually issued to the public through professionally managed investment firms

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

categories and terms example SE3, hwk P1


Short-Term Notes Payable

Obligations represented by promissory notes

Used to:Secure bank loans Pay suppliersObtain more credit

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Aug. 31 Cash 10,000 Notes Payable 10,000 Issued 60-day, 12 percent

promissory note

Issuance of 60-day, 12 percent promissory note on August 31

Payment of note

Oct. 30 Notes Payable 10,000.00 Interest Expense 197.26 Cash 10,197.26 Payment of promissory note with $100

interest

Recording Notes Payable

26.197$12.000,10$ 36560

example SE4, hwk E5


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

Sept. 30 Interest Expense 98.63 Interest Payable 98.63 To record 30 days’ interest

expense on promissory note


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


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

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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.

Current Portion of Long-Term Debt


Payroll Liabilities

Payroll liabilities include:

Employers are responsible to various government agencies and other entities for amounts withheld

Cost of labor

Salaries & Wages

Payroll taxes

FICA, Medicare, FUTA, and SUTA


Payroll Costs


Feb.15 Wages Expense 65,000 Employees’ Federal Income Taxes Payable 10,800 Employees’ State Income Taxes Payable 2,400 Social Security Tax Payable 4,030 Medicare Tax Payable 942 Medical Insurance Premiums Payable 1,800 Pension Contributions Payable 2,600 Wages Payable 42,428 To record payroll

Feb. 15: Record payroll, total employee wages, $65,000

Feb. 15: Record payroll taxes and benefit costsFeb.15 Payroll Taxes and Benefits Expense 18,802 Social Security Tax Payable 4,030 Medicare Tax Payable 942 Medical Insurance Premiums Payable 7,200 Pension Contributions Payable 2,600 Federal Unemployment Tax Payable 520 State Unemployment Tax Payable 3,510 To record payroll taxes and other costs

Note that employees earned $65,00 but their take home pay was only $42,428

Payroll taxes and benefits increase the total cost of payroll to $83,802

Recording Payrollexample SE5 , hwk E7


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

8–25

Unearned Subscriptions 300 Subscription Revenues 300 Delivery of monthly magazine issues

Copyright © Cengage Learning. All rights reserved.

Cash 3,600 Unearned Subscriptions 3,600 Receipt of annual subscriptions in advance

Received advanced one year subscription totaling $3,600

Monthly Service Performed

Microsoft now has a liability that will be reduced gradually as monthly services are provided

Recording Unearned Revenues

8–26Copyright © Houghton Mifflin Company. 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 taxesProperty taxesPromotional costsProduct warrantiesVacation pay


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

Dec. 31 Income Taxes Expense 1,040* Estimated Income Taxes Payable 1,040 To record estimated federal income taxes *Numbers in millions

Sole proprietorships and partnerships do not pay income taxes; their owners pay on their individual tax returns


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


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

8–30

Dec. 5 Cash 30 Estimated Product Warranty Liability 60 Service Revenue 30 Merchandise Inventory 60 Replacement of muffler under warranty


Recording Product Warranty Liabilities

July 31 Product Warranty Expense 2,100 Estimated Product Warranty Liability 2,100 To record estimated product warranty

expense

Record warranty expense:

Record replacement of a defective muffler, which cost $60, and receipt of $30 service fee to have it replaced:

example SE6, hwk E8


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)


8–32

Apr. 20 Estimated Liability for Vacation Pay 2,000 Cash (or Wages Payable) 2,000 Wages of employees on vacation


Vacation Pay Liability: Illustrated

Apr. 20 Vacation Pay Expense 1,200 Estimated Liability for Vacation Pay 1,200 Estimated vacation pay expense

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?

$1,200 .75 .04 $2,000)– ($42,000

The computation of vacation pay expense is based on the payroll of employees not on vacation

8–33

Contingent Liabilities

Potential liabilities that depend on future events arising out of past transactions

Conditions for determining when a contingency should be entered in the accounting records:

1. The liability must be probable2. The liability can be reasonably estimated

(Vacation pay, income taxes, and warranty liability)

Past Transaction: Building of a

bridge

Future Event: Outcome of a

lawsuit


8–34

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

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Valuation Approaches to Fair Value Accounting



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


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


Simple Interest Illustrated

Willy Wang accepts an 8 percent, $15,000 note due in 90 days. What total amount will Sanchez receive?

Time Rate Principal Interest

365

90

100

8 $15,000

$295.89

The total that Sanchez will receive is $15,295.89.($15,000.00 principal + $295.89 interest)


Compound Interest Illustrated

(1)

Year

(2) Principal Amount

at Beginning of Year

(3) Annual Amount

of Interest (Col. 2 x 6%)

(4) Accumulated Amount

at End of Year (Col. 2 + Col. 3)

1 $10,000.00 $600.00 $10,600.00 2 10,600.00 63.6.00 11,236.00 3 11,236.00 674.16 11,910.16

Note that the annual amount of interest increases each year by the interest rate times the interest of the previous year.

Soma will have $11,910.16 at the end of three years.

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?


Present Value

Way of valuing future cash flowsAmount that must be invested today at a

given rate to produce a given future value Present value and future value are closely

related

8–41

Present Value

• It depends upon...

– the amount of the future receipt.

– the length of time to the future receipt.

– interest rate for the period.

8–42

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.

8–43

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.

8–44

EXHIBIT B-1

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12%1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.893

2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.797

3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 0.712

4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 0.636

5 0.951 0.906 0.883 0.822 0.784 0.747 0.713 0.681 0.650 0.621 0.567

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 0.507

7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 0.452

8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 0.404

9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 0.361

10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 0.322

11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 0.287

12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 0.257

13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 0.229

14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 0.205

15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 0.183

16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 0.163

17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 0.146

18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 0.130

19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 0.116

20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149 0.104

21 0.811 0.660 0:5-38 0.439 0.359 0.294 0.242 0.199 0.164 0.135 0.093

22 0.803 0.647 0.522 0.422 0.342 0.278 0.226 0.184 0.150 0.123 0.083

23 0.795 0.634 0.507 0.406 0.326 0.262 0.211 0.170 0.138 0.112 0.074

24 0.788 0.622 0.492 0.390 0.310 0.247 0.197 0.158 0.126 0.102 0.066

25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092 0.059

26 0.772 0.598 0.464 0.361 0.281 0.220 0.172 0.135 0.106 0.084 0.053

27 0.764 0.586 0.450 0.347 0.268 0.207 0.161 0.125 0.098 0.076 0.047

28 0.757 0.574 0.437 0.333 0.255 0.196 0.150 0.116 0.090 0.069 0.042

29 0.749 0.563 0.424 0.321 0.243 0.185 0.141 0.107 0.082 0.063 0.037

30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057 0.033

40 0.672 0.453 0.307 0.208 0.142 0.097 0.067 0.046 0.032 0.022 0.011

50 0.608 0.372 0.228 0.141 0.087 0.054 0.034 0.021 0.013 0.009 0.003

Present Value of $1


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 2Year 1

Present value $6,910

Using tables (Table 1), the calculation is: Future Value × Factor = Present Value $8,000 × .864 = $6,910

8–46

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)

8–47

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).

8–48

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12%1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.893

2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 1.690

3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 2.402

4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 3.037

5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 3.605

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 4.111

7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 4.564

8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 4.968

9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 5.328

10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 5.650

11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 5.938

12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 6.194

13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 6.424

14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 6.628

15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 6.811

16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 6.974

17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 7.120

18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 7.250

19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 7.366

20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514 7.469

21 18.857 17.011 15.415 14.029 12.821 11.764 10.836 10.017 9.292 8.649 7.562

22 19.660 17.658 15.937 14.451 13.163 12.042 11.061 10.201 9.442 8.772 7.645

23 20.456 18.292 16.444 14.857 13.489 12.303 11.272 10.371 9.580 8.883 7.718

24 21.243 18.914 16.936 15.247 13.799 12.550 11.469 10.529 9.707 8.985 7.784

25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077 7.843

26 22.795 20.121 17.877 15.983 14.375 13.003 11.826 10.810 9.929 9.161 7.896

27 23.560 20.707 18.327 16.330 14.643 13.211 11.987 10.935 10.027 9.237 7.943

28 24.316 21.281 18.764 16.663 14.898 13.406 12.137 11.051 10.116 9.307 7.984

29 25=066 21.844 19.189 16.984 15.141 13.591 12.278 11.158 10.198 9.370 8.022

30 25.808 22.396 19.600 17.292 15.373 13.765 12.409 11.258 10.274 9.427 8.055

40 32.835 27.355 23.115 19.793 17.159 15.046 13.332 11.925 10.757 9.779 8.244

50 39.196 31.424 25.730 21.482 18.256 15.762 13.801 12.234 10.962 9.915 8.305

EXHIBIT B-2

Present Value of Annuity of $1


Present Value of an Ordinary Annuity

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?

Using the table factor (Table 2), the calculation is: Periodic payment × Factor = Present Value $6,000 × 2.723 = $16,338

Year 3

$6,000

Year 2Year 1

Present value $16,338

$6,000$6,000

Example SE7-8, hwk E13


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


Applications Using Present Values



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


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

The proposed purchase price can be evaluated by comparing it with the present value of the asset to the company



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

Using Table 2, the factor for 10 percent and 8 periods is 5.335

ValuePresent Factor Savings Periodic $7,469.00 5.335 $1,400.00

This amount equals the present value of the benefits that he will receive from owning

the machine.

Evaluating the Proposed Purchase Price of an Asset

Yeboah should not pay more than $7,469.00 for the new machine.

Example SE9, hwk E14


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

ValuePresent Factor Payment Future $90,500 .905 $100,000

12% annual rate ÷ 12 months per year = 1 percent per month12 months per year x 10/12 of a year = 10 months

The sale price of the tractor is $90,500

Determining the Sales Price When Payment Is Deferred


Feb. 1 Accounts Receivable 100,000 Sales 100,000 Sale of Tractor

Recording Deferred Sales

Feb. 1 Tractor 100,000 Accounts Payable 100,000 Purchase of Tractor

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)


Dec. 1 Cash 100,000 Accounts Receivable 100,000 Interest Income 9,500 Receipt on account from

Washington, including imputed interest earned

Recording Deferred Sales

Dec. 1 Accounts Payable 100,000 Interest Expense 9,500 Cash 100,000 Payment on account, including

imputed interest expense

When Ptak pays for the tractor, the entries are as follows:

Ptak’s Journal (Purchaser)

Helpers’ Journal (Seller)

8–18–1 Chapter 8 Current Liabilities and the Fair Value of Accounting.

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Transcript of 8–18–1 Chapter 8 Current Liabilities and the Fair Value of Accounting.