copyright © cengage learning. all rights reserved. chapter 8 current liabilities and the time value...

Copyright © Cengage Learning. All rights reserved.

Chapter 8

Current Liabilities and the Time Value of Money

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

Management Current Liabilities

• Objective 1– Identify the management issues related to current

liabilities.


Current liabilities typically equal from 25 to 50

percent of total assets for a business.

Current Liabilities

Incurred to meet cash needs during the operating cycle

• Managers must understand how current liabilities are: – Recognized

– Valued

– Classified

– Disclosed


Managing Liquidity and Cash Flows

• The operating cycle converts cash to purchases, to sales, to accounts receivable, and back to cash– Most current liabilities support this cycle

• Failure to manage related cash flows can have serious consequences– If suppliers are not paid, they may not ship

– A continued inability to meet payments when due can lead to bankruptcy


Current liabilities are a key component in each of these three measures

Managing Liquidity and Cash Flows (cont’d)

• Factors to consider– Ability to pay current liabilities

• Evaluate using three measures of liquidity– Working capital

– Current ratio

– Amount of time creditors are willing to give a company to pay its accounts payable

• Common measures of this time– Payables turnover

– Days’ payable


Current Assets - Current Liabilities = Working Capital 2006 $49,010 - $22,442 = $26,568 2007 $40,168 - $23,754 = $16,414

Microsoft (in millions)

Working Capital

• Microsoft is in a strong current situation and exercises very good management of its cash flow.

• The decline in Microsoft’s working capital from 2006 to 2007 was caused primarily by a large increase in cash purchases of its own stock.


Microsoft’s Payables Turnover =

Payables Turnover = Cost of Goods Sold + Change in Inventory

Average Accounts Payable

$10,693 - $351

($3,247 + $2,909) ÷ 2

= 3.4 times

Payables TurnoverNumber of times, on average, that a company pays its accounts payables in an accounting period


Payable Turnover for Selected Industries


Microsoft’s Days’ Payable =

Days’ Payable = 365

Payables Turnover

365

3.4

= 107.4 days

Days’ Payable

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


Average Days’ Payable for Selected Industries


Recognition of Liabilities

• Timing is important.• Record when an obligation exists.

– A transaction obligates a company to make future payments.

– Some current liabilities often are not represented by a direct transaction.

• Record adjusting entries to recognize unrecorded liabilities– Known amounts such as salaries payable

– Estimated amounts such as taxes payable

• Transactions or commitments where no current obligation exists are not recognized as liabilities.


Valuation of Liabilities

• On the balance sheet, liabilities are generally valued at– The amount of money needed to pay the debt, or

– The fair market value of goods or services to be delivered


It is important to distinguish between current and long-term liabilities because of the effect on liquidity.

Classification of LiabilitiesDirectly matches the classification of assets

• Current liabilities– Expected to be satisfied within one year or within the normal

operating cycle, whichever is longer

– Paid out of current assets or with cash generated from operations

• Long-term liabilities– Due beyond one year or beyond the normal operating cycle

– Used to finance long-term assets


Disclosure of Liabilities

• Supplemental disclosure may be required in the notes to the financial statements– Large amount of notes payable

– Commercial paper

– Lines of credit


Common Types of Current Liabilities

• Objective 2– Identify, compute, and record definitely determinable and

estimated current liabilities.


Two Types of Current Liabilities

1. Definitely determinable liabilities– Set by contract or by statute and can be measured exactly

2. Estimated liabilities– Definite debts or obligations of which the exact dollar

amount cannot be known until a later date


Definitely Determinable Liabilities

• Accounts payable• Bank loans and commercial paper• Notes payable• Accrued liabilities• Dividends payable• Sales and excise taxes payable• Current portions of long-term debt• Payroll liabilities• Unearned or deferred revenues


Accounts Payable

Short-term obligations to suppliers for goods and services

• Also called trade accounts payable• Amount in Accounts Payable account in the general

ledger is generally supported by an Accounts Payable subsidiary ledger– Accounts Payable subsidiary ledger contains an

individual account for each person or company to which money is owed.


Commercial Paper

A way to borrow money by using unsecured short-term loans sold directly to the public

• The portion of the line of credit borrowed and the amount of commercial paper issued are usually combined with notes payable in the current liabilities section of the balance sheet.

• Details are disclosed in a note to the financial statements.


Short-Term Notes Payable

Obligations represented by promissory notes• Can be used to

– Secure bank loans

– Pay suppliers

– Obtain other credit

• Interest is usually stated separately on the face of the note.


Promissory Note


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

promissory note

Issuance of 60-day, 12 percent on August 31

Payment of note

Oct. 30 Notes Payable 10,000.00 Interest Expense 197.26 Cash 10,197.26

26.197$12.000,10$ 36560

Recording Notes Payable


Existing liabilities that have not yet been recorded • Include

– Interest payable

– Wages payable

– Income taxes payable

• Adjusting entries are required to recognize and record accrued liabilities

Accrued liabilities can include estimated liabilities.

Accrued Liabilities


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

Accrued Liabilities Illustrated


Dividends Payable

Dividends that have been declared but not yet paid

• Cash dividends are a distribution of earnings by a corporation .

• During the time between the date of declaration and the date of payment, dividends are a current liability.

• There is no liability until the date of declaration .• The decision to pay dividends is solely up to the

board of directors.


Sales and Excise Taxes Payable

Taxes collected by businesses that must be forwarded to the appropriate government agencies

• Most states and many cities levy a sales tax on retail transactions.

• The amount of tax collected is a current liability until remitted to the government.


June 1 Cash 230 Sales 200 Sales Tax Payable 10 Excise Tax Payable 20 Sale of merchandise and collection of

sales and excise taxes

June 1: Sold merchandise for $200; subject to 5 percent sales tax and 10 percent excise tax.

The taxes are collected and recorded as liabilities to be remitted at the proper times to the appropriate

government agencies.

Recording Sales and Excise Taxes Payable


Current Portions of Long-Term Debt

Include the portions of long-term debt that are due within the next year and are to be paid

from current assets• Are classified as current liabilities• No journal entry is required

– Debt is reclassified when financial statements are prepared.


Payroll Liabilities

Include the cost of labor and related taxes for a company

• The employer is liable to employees for wages and salaries – Wages

• Payment for the services of employees at an hourly rate

– Salaries• Compensation of employees who are paid at a monthly or

yearly rate


Payroll Liabilities (cont’d)

• Payroll accounting is important because complex laws and significant liabilities are involved.

• The employer is responsible to various government and other agencies for amounts withheld and related taxes.

• It is important to distinguish between employees and independent contractors.

• The journal entry to record payroll is lengthy.


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 Federal income taxes, state and local taxes, FICA, Medicare, insurance, pension contributions, FUTA, SUTA


Feb.15 Payroll Taxes and Benefits Expense 18,802 Social Security Tax Payable 4,030 Medicare Tax Payable 942 Medical Insurance 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

8-32

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 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 & benefits

Note that employees earned $65,000 but take home pay was

only $42,428.

Payroll taxes and benefits increase the total cost of payroll

to $83,802.

Recording Payroll


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 are also considered current liabilities


Unearned Revenue 300 Service Revenues 300 Delivery of subscription service.

8-34

Accounts Receivable 3,600 Unearned Revenue 3,600 Subscriptions billed in advance

Microsoft bills for annual subscription service totaling $3,600.

Monthly revenue recognition:

Microsoft now has a liability that will be reduced gradually as service is provided.

Recording Unearned Revenues


Estimated Liabilities

Definite debts or obligations of which the exact dollar amount cannot be

known until a later date• There is no doubt about the existence of the legal

obligation.• The primary accounting problem is to estimate and

record the amount of the liability.• Types of estimated liabilities include income taxes,

property taxes, product warranties, and vacation pay.


Dec. 31 Income Taxes Expense 53,000 Estimated Income Taxes Payable 53,000 To record estimated federal income taxes

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

Income Taxes

• 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.


Property Taxes Payable

• Property taxes are levied on real and personal property.

• They are assessed annually, but the government unit’s fiscal year and the company’s may not correspond.

• The company must estimate the amount of property tax that applies to each month of the year.


Promotional Costs

• These are associated with coupons or rebates offered by companies’ marketing programs .

• Promotional costs are usually recorded as a reduction in sales (contra-sales account) rather than as an expense with a corresponding current liability.

• Promotional costs are difficult to estimate.

Copyright © Cengage Learning. All rights reserved.Copyright © Houghton Mifflin Company. All rights reserved. 8-39

Product Warranty Liability

• A liability exists for the length of time specified in the terms of the warranty.

• A company can estimate the future cost of the liability:– Based on past experience with claims for the product or

services.

– An average cost is usually used.

• The estimated cost of the warranty is debited to an expense account in the period of sale.


Illustration: A muffler company guarantees that it will replace free of charge any muffler it sells 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 units 42 x $50 = $2,100

Product Warranty Liability Illustrated

When a firm sells a product or service with a warranty, it has a liability for the length of the warranty.


2. Income taxes payable3. Current portion of long-term debt4. Vacation pay liability

1. a2. b3. a4. b

1. Dividends payable

Stop & Review

Q. Indicate whether each of the following is a(n) – (a) Definitely determinable liability

– (b) Estimated liability


Contingent Liabilities and Commitments

• Objective 3– Distinguish contingent liabilities from commitments.


Past transaction – building of a bridgeFuture event – outcome of a lawsuit

Two conditions for determining when a contingency should be entered in the accounting records The liability must be probable It can be reasonably estimated

Examples: Vacation pay, income taxes, and warranty liability

Contingent Liabilities

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

• Not an existing obligation


The Time Value of Money

• Objective 4– Identify the valuation approaches to fair value

accounting, and define time value of money and interest and apply them to present values.


Time Value of Money

• Refers to the effects of the passage of time on holding or not holding money.

• Interest is the specific cost measure of these effects for a given period of time.

• The timing of receipt and payment of cash is important to business decisions.


In other words, the principal sum is increased at the end of each period by the interest of that period.

Interest

• Two types of interest:– Simple

• The interest cost for one or more periods where the amount on which the interest is computed stays the same from period to period.

– Compound• The interest cost for two or more periods where, after each

period, the interest of that period is added to the amount on which interest is computed for future periods.


Willy Wang accepts an 8 percent, $15,000 note due in 90 days. How much will he receive at that time?

Time Rate Principal Interest

365

90

100

8 $15,000

$295.89

The total that Wang will receive is $15,295.89. ($15,000 principal + $295.89 interest).

Simple Interest Illustrated


Compound Interest Illustrated

Terry Soma deposits $10,000 in a savings 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. How much will her account total at the end of three years?

(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 10,600.00 636.00 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 would have $11,910.16 in her account at the end of three years.


Present Value

The amount that must be invested now at a given rate of interest to produce a given future value

• Calculation is simplified using present value tables


Rate)Interest (1.0

Value Future ValuePresent

Kelly Fontaine needs $10,000 one year from now. She can earn 5 percent interest on her investment today. What amount should she invest today to achieve her goal?

$9,523.81 (1.05)

$10,000

.05) (1.0

$10,000 ValuePresent

Kelly needs to invest $9,523.81 today to have

$10,000 one year from now.

Computing Present Value

When only one time period is involved


Ron More wants to be sure of having $8,000 at the end of three years. His savings account earns 5 percent at the end of each year. How much must he invest today to achieve this goal?

Year Amount at

End of Year

Divided by Present Value at

Beginning of Year 3 $8,000.00 ÷ 1.05 = $7,619.05 2 7,619.05 ÷ 1.05 = 7,256.24 1 7,256.24 ÷ 1.05 = 6,910.70

More would need to invest $6,910.70 today to have $8,000.00 three years from now.

Present Value of a Single Sum Due in the Future


Table 3. Present Value of $1 to be Received at the End of Given Number of Time Periods

Periods 1% 2% 3% 4% 5% 6% 7% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713

Ron More wants to be sure of having $8,000 at the end of three years. His savings account earns 5 percent at the end of each year.

Use Table 1 to compute the amount More must invest today.

Look down the 5 percent column and across the row for 3 periods to find the factor 0.864.

ValuePresent Factor Value Future

$6,912 0.864 000,8$ Except for a difference of $1.30, the answer is the same as the earlier one.

Present Value of a Single Sum Due in the Future (using table)


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, 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

Present Value of an Ordinary Annuity


Time Periods

• The left-hand column of the future and present value tables refers to time periods.– This accommodates compounding periods of less than

one year.

– To use the tables for periods of less than one year• Divide the annual interest rate by the number of periods in

the year

• Multiply the number of periods in one year by the number of years.


Applications of the Time Value of Money

• Objective 5– Apply present value to simple valuation situations.


Time Value of Money

How is the time value of money applied in accounting?

– Valuing an asset

– Deferred payment

– Investment of idle cash

– Accumulation of a fund for loan repayment

– Other accounting applications


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 5.335 $1,400.00

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

the machine.

Yeboah should not pay more than $7,469 for the new machine.

Evaluating the Proposed Purchase Price of an Asset


Field Helpers Corp. 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 periods per year = 1 percent12 periods per year x 8/12 of a year = 8 periods

The sale price of the tractor is $90,500.

Determining the Sales Price When Payment Is Deferred


Other Applications

• Present value may also be used when:– Imputing interest on non-interest-bearing notes

– Accounting for installment notes

– Valuing bonds

– Recording lease obligations

– Determining• Pension obligations

• Premium and discount on debt

• Depreciation of property, plant, and equipment

– Making capital expenditure decisions

– Any problem in which time is a factor


Chapter Review

1. Identify the management issues related to current liabilities.

2. Identify, compute, and record definitely determinable and estimated current liabilities.

3. Distinguish contingent liabilities from commitments.

4. Identify the valuation approaches to fair value accounting, and define time value of money and interest and apply them to present values.

5. Apply present value to simple valuation situations.

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