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1 Chapter 9 Current Liabilities, Contingencies, and the Time Value of Money Financial Accounting, Alternate 4e by Porter and Norton

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2 Liabilities and shareholders' equity Current liabilities: Notes payable $.3 Accounts payable635.8 Income taxes 16.3 Other taxes191.8 Accrued interest199.4 Accrued restructuring and restaurant closing costs328.5 Accrued payroll and other liabilities774.7 Current maturities of long-term debt 275.5 Total current liabilities $2,422.3 McDonald's Corporation 2002 Consolidated Balance Sheet (partial) (in millions) Require payment within one year Listed in order of liquidity

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3 Selected 2002 Liquidity Ratios Current Quick Ratio Ratio Georgia-Pacific 1.16 0.64 J. C. Penney 2.00 0.76 Johnson Controls 1.03 0.82 McDonald's 0.71 0.49 Pfizer 1.34 1.09 123 45678910 11121314151617 18192021222324 25262829303127

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4 Accounts Payable Purchase of inventory, goods or services on credit 2/10, n30 Discount payment terms offered to encourage early payment

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5 Promissory Note S.J.Devona I promise to pay $1,000 plus 12% annual interest on December 31, 2004. Date: January 1, 2004 Signed:_________ Lamanski Co. Total repayment = $1,120 $1,000 + ($1,000 x 12%)

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6 Discounted Promissory Note In exchange for $880 received today, I promise to pay $1,000 on December 31, 2004. Date: January 1, 2004 Signed:_________ Lamanski Co. Effective interest rate on note = 13.6% ($120 interest / $880 proceeds)

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7 1/1/0412/31/04 Notes Payable$ 1,000 $ 1,000 Less: Discount on Notes Payable 120 - 0 - Net Liability$ 880 $ 1,000 Balance Sheet Presentation of Discounted Notes Discount transferred to interest expense over life of note

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8 8 Current Maturities of Long-Term Debt Principal repayment on borrowings due within one year of balance sheet date Due in upcoming year 123 45678910 11121314151617 18192021222324 25262829303127 123 45678910 11121314151617 18192021222324 25262829303127 123 45678910 11121314151617 18192021222324 25262829303127

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9 Taxes Payable Record expense when incurred; not when paid Record 2004 tax expense Taxes Paid 12/31/043/15/05

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10 Current Liabilities on the Statement of Cash Flows Operating Activities Net income xxx Increase in current liability + Decrease in current liability – Investing Activities Financing Activities Increase in notes payable + Decrease in notes payable –

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11 Contingent Liability Obligation involving existing condition Outcome not known with certainty Dependent upon some future event Actual amount is estimated

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12 Accrue estimated amount if: Liability is probable Amount can be reasonably estimated Contingent Liability Record in year criteria are met: Assets = Liab. + O/E + Rev. – Exp. Est. Liab. For Warranty Exp. 10,000 Warranty 10,000 Balance Sheet Income Statement

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13 Warranties Premium or coupon offers Lawsuits Typical Contingent Liabilities

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14 Recording Contingent Liabilities Quickkey Computer sells a computer product for $5,000 with a one-year warranty. In 2004, 100 of these products were sold for a total sales revenue of $500,000. Analyzing past records, Quickkey estimates that repairs will average 2% of total sales. Example:

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15 Recording Contingent Liabilities Probable liability has been incurred? Amount reasonably estimable? Estimated Liability for Warranty $100,000 Warranty Expense $100,000 YES Record in 2004:

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16 Disclosing Contingent Liabilities IF not probable but reasonably possible OR amount not estimable Disclose in footnotes

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17 Contingent Assets Contingent gains and assets are not recorded but may be disclosed in footnotes Conservatism principle applies

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18 Time Value of Money Prefer payment now vs. in future due to interest factor Applicable to both personal and business decisions

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19 Simple Interest I = P x R x T Principal amount Dollar amount of interest per year Time in years Interest rate as a percentage

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20 Example of Simple Interest Given following data: principal amount = $ 3,000 annual interest rate = 10% term of note = 2 years Calculate interest on the note.

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21 Example of Simple Interest Given following data: principal amount = $ 3,000 annual interest rate = 10% term of note = 2 years Calculate interest on the note. Px R x T $ 3,000 x.10 x 2 = $ 600

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22 Compound Interest Interest is calculated on principal plus previously accumulated interest Compounding can occur annually, semi-annually, quarterly, etc.

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23 Example of Compound Interest Given following data: principal amount = $ 3,000 annual interest rate = 10% term of note = 2 years semiannual compounding of interest Calculate interest on note.

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24 Compound Interest Periods Year 1Year 2 10% annually 5% + 5% semiannually 5% + 5% semiannually 4 periods @ 5% semi-annual interest

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25 Example of Compound Interest Period BeginningInterest Ending Principal at 5% Balance 1 $ 3,000 $ 150 $ 3,150 2 3,150 158 3,308 3 3,308 165 3,473 4 3,473 174 3,647

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26 Comparing Interest Methods Simple annual interest: $3,000 x.10 x 2 = $ 600 Semiannual compounding: 1 $ 150 2 158 3 165 4 174 Total $ 647

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27 Compound Interest Computations Present value of an annuity Future value of an annuity Present value of a single amount Future value of a single amount

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28 Future Value of Single Amount Known amount of single payment or deposit Future Value + Interest =

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29 Future Value of a Single Amount Example If you invest $10,000 today @ 10% compound interest, what will it be worth 3 years from now? invest $10,000 Future Value? + Interest @ 10% per year Yr. 1Yr. 2Yr. 3

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30 Future Value of a Single Amount Example - Using Formulas n FV = p (1 + i) 3 = $10,000 (1.10) = $13,310

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31 FV = Present Value x FV Factor = $ 10,000 X (3 periods @ 10%) Future Value of a Single Amount Example - Using Tables FV?? $10,000 PV Yr. 1Yr. 2Yr. 3

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32 (n) 2% 4% 6% 8% 10% 11.020 1.0401.0601.0801.10 21.0401.082 1.124 1.1661.210 3 1.0611.1251.1911.260 1.331 41.0821.1701.2621.3601.464 51.1041.2171.3381.4701.611 61.1261.2651.4191.5871.772 71.1491.3161.5041.7141.949 81.1721.3691.5941.8512.144 Future Value of $1

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33 FV = Present Value x FV Factor = $ 10,000 X (3 periods @ 10%) = $ 10,000 X 1.331 = $ 13,310 Future Value of a Single Amount Example - Using Tables FV = $13,310 $10,000 PV Yr. 1Yr. 2Yr. 3

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34 Present Value of Single Amount Discount Known amount of single payment in future Present Value

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35 Present Value of a Single Amount Example If you will receive $10,000 in three years, what is it worth today (assuming you could invest at 10% compound interest)? Present Value? $ 10,000 Discount @ 10% Yr. 1Yr. 2Yr. 3

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36 Present Value of a Single Amount Example - Using Formulas -n PV = payment x (1 + i) -3 = $10,000 x (1.10) = $7,513

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37 PV = Future Value x PV Factor = $ 10,000 X (3 periods @ 10%) Present Value of a Single Amount Example - Using Tables FV=$10,000 PV ?? Yr. 1Yr. 2Yr. 3

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38 Present Value of $1 (n) 2% 4% 6% 8% 10% 1.9804.9615.9434.9259.9090 2.9612.9246.8900.8573.8265 3.9423.8890.8396.7938.7513 4.9238.8548.7921.7350.6830 5.9057.8219.7473.6806.6209

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39 PV = Future Value x PV Factor = $ 10,000 X (3 periods @ 10%) = $ 10,000 X.7513 = $ 7,513 Present Value of a Single Amount Example - Using Tables FV=$10,000 PV = $7,513 Yr. 1Yr. 2Yr. 3

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40 Periods Future Value? +Interest Future Value of an Annuity 1 2 3 4 $0 $3,000$3,000$3,000 $3,000

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41 If we invest $3,000 each year for four years at 10% compound interest, what will it be worth 4 years from now? Future Value of Annuity Example $0 $3,000 $3,000 $3,000 $3,000 Yr. 1Yr. 2Yr. 3Yr. 4 FV ??

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42 $0 $3,000 $3,000 $3,000 $3,000 Yr. 1Yr. 2Yr. 3Yr. 4 FV ?? FV = Payment x FV Factor = $ 3,000 x (4 periods @ 10%) Future Value of Annuity Example

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43 Future Value of Annuity of $1 (n) 2% 4% 6% 8% 10% 12% 1 1.000 1.000 1.000 1.000 1.000 1.000 22.020 2.040 2.060 2.080 2.100 2.120 3 3.060 3.122 3.184 3.246 3.310 3.374 4 4.122 4.246 4.375 4.506 4.641 4.779 55.204 5.416 5.637 5.867 6.105 6.353

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44 FV = Payment x FV Factor = $ 3,000 x (4 periods @ 10%) = $ 3,000 x 4.641 = $ 13,923 $0 $3,000 $3,000 $3,000 $3,000 Yr. 1Yr. 2Yr. 3Yr. 4 FV = $13,923 Future Value of Annuity Example

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45 Present Value of an Annuity Periods 12341234 Present Value ? Discount $0 $500 $500 $500 $500

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46 Present Value of an Annuity Example What is the value today of receiving $4,000 at the end of the next 4 years, assuming you can invest at 10% compound annual interest? PV ?? Yr. 1Yr. 2 Yr. 3 Yr. 4 $0 $4,000 $4,000 $4,000 $4,000

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47 Present Value of an Annuity Example Yr. 1Yr. 2 Yr. 3 Yr. 4 PV ?? $0 $4,000 $4,000 $4,000 $4,000 PV = Payment x PV Factor = $ 500 x (4 periods @ 10%)

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48 Present Value of Annuity of $1 (n) 2% 4% 6% 8% 10% 10.980 0.962 0.943 0.926 0.909 21.942 1.886 1.833 1.783 1.735 3 2.884 2.775 2.673 2.577 2.487 4 3.808 3.630 3.465 3.312 3.170 54.713 4.452 4.212 3.992 3.791

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49 Present Value of an Annuity Example Yr. 1Yr. 2 Yr. 3 Yr. 4 P.V. = $12,680 $0 $4,000$4,000 $4,000 $4,000 PV = Payment x PV Factor = $ 4,000 x (4 periods @ 10%) = $ 4,000 x 3.170 = $ 12,680

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50 Solving for Unknowns Assume that you have just purchased a new car for $14,420. Your bank has offered you a 5-year loan, with annual payments of $4,000 due at the end of each year. What is the interest rate being charged on the loan?

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51 Solving for Unknowns Yr. 1Yr. 2 Yr. 3 Yr. 4 Yr. 5 discount discount discount discount discount PV = $14,420 PV = Payment x PV factor PV factor = PV / Payment rearrange equation to solve for unknown

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52 Solving for Unknowns Yr. 1Yr. 2 Yr. 3 Yr. 4 Yr. 5 discount discount discount discount discount PV = $14,420 PV factor = PV / Payment = $14,420 / $4,000 = 3.605

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53 Present Value of an Annuity Table (n) 10% 11% 12% 15% 10.909 0.901 0.893 0.870 21.736 1.713 1.690 1.626 32.487 2.444 2.402 2.283 43.170 3.102 3.037 2.855 5 3.791 3.696 3.605 3.352 PV factor of 3.605 equates to an interest rate of 12%.

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54 Appendix A Accounting Tools: Payroll Accounting

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55 Calculation of Gross Wages Hourly Multiply the number of hours worked times employee’s hourly rate Salaried Paid at a flat rate per week, month, or year, regardless of hours

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56 Calculation of Net Pay Gross wages - Income tax (federal, state, local) - FICA - Voluntary deductions (includes health insurance, retirement contributions, savings plans, charitable contributions, union dues) = Net pay

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57 Employer Payroll Taxes Not deducted from paycheck – employer pays taxes per employee, in addition to salary FICA – employer’s share Unemployment tax

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58 Payroll Accounting Example: Gross wages for Kori Company for July are $100,000. The following amounts have been withheld from employees’ paychecks: Kori Company’s unemployment tax rate is 6%. Show the effects of these transactions on the accounting equation. Income Tax$20,000 FICA 7,650 United Way contributions 5,000 Union dues 3,000

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59 Payroll Accounting Record July salary and deductions: Assets = Liab. + O/E + Rev. – Exp. Salary Pay. 64,350 Salary Exp. (100,000) Inc. Tax Pay. 20,000 FICA Pay. 7,650 United Way Pay. 5,000 Union Dues Pay. 3,000

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60 Payroll Accounting Record payment of employee salaries: Assets = Liab. + O/E + Rev. – Exp. Cash (64,350) Salary Pay. (64,350) Record employer’s payroll taxes: Assets = Liab. + O/E + Rev. – Exp. FICA Pay. 7,650 Payroll Tax Exp. (13,650) Unemploy. Tax Pay. 6,000

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61 Compensated Absences Employee absences for which the employee will be paid Vacation, illness, holidays Accrued as a liability if The services have been rendered The rights (days) accumulate Payment is probable and can be reasonably estimated

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62 Appendix B Accounting Tools: Using Excel for Problems Involving Interest Calculations

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63 Using Excel Functions Many functions built into Excel, including PV and FV calculations Click on Paste or Insert button for list

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64 FV Function in Excel Find the FV of a 10% note payable for $2,000, due in 2 years and compounded annually Example: Answer: $2,420

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65 PV Function in Excel How much should you invest now at 10% (compounded annually) in order to have $2,000 in 2 years? Example: Answer: $1,653 (rounded)

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66 End of Chapter 9

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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Reporting and Interpreting Liabilities Chapter 9.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Reporting and Interpreting Liabilities Chapter 9.

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