1. Current Liabilities and the Time Value of Money
Chapter 8
Current Liabilities and the Time Value of Money
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2. Management Current Liabilities
Objective 1
Identify the management issues related to current liabilities.
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3. Incurred to meet cash needs during the operating cycle
Current Liabilities
Incurred to meet cash needs during the operating cycle
Managers must understand how current liabilities are:
Recognized
Valued
Classified
Disclosed
Current liabilities typically equal from 25 to 50 percent of total assets for a business.
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4. 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
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5. 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 liabilities are a key component in each of these three measures
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6. Working Capital
Microsoft (in millions)
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.
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7. 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 Inventory
Average Accounts Payable
Microsoft’s Payables
Turnover =
$10,693 - $351
($3,247 + $2,909) ÷ 2
= times
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8. Payable Turnover for Selected Industries
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9. Days’ Payable
How long, on average, a company takes to pay its accounts payables
Days’ Payable =
365
Payables Turnover
Microsoft’s
Days’ Payable =
365
3.4
= days
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10. Average Days’ Payable for Selected Industries
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11. 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.
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12. 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
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13. Classification of Liabilities
Directly 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
It is important to distinguish between current and long-term liabilities because of the effect on liquidity.
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14. 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
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15. Common Types of Current Liabilities
Objective 2
Identify, compute, and record definitely determinable and estimated current liabilities.
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16. 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
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17. 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
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18. Short-term obligations to suppliers for goods and services
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.
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19. 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.
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20. 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.
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21. Promissory Note
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22. Recording Notes Payable
Issuance of 60-day, 12 percent on August 31
Payment of note
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23. Accrued Liabilities
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.
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24. Accrued Liabilities Illustrated
Example:
A $10, 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 x 30/365 = $98.63
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25. Dividends that have been declared but not yet paid
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.
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26. 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.
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27. Recording Sales and Excise Taxes Payable
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.
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28. 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.
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29. Include the cost of labor and related taxes for a company
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
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30. 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.
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31. Payroll Liabilities Payroll liabilities include: Cost of labor
Salaries & Wages
Payroll taxes
Federal income taxes, state and local taxes, FICA, Medicare, insurance, pension contributions, FUTA, SUTA
Employers are responsible to various government agencies and other entities for amounts withheld
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32. Note that employees earned $65,000 but take home pay was only $42,428.
Recording Payroll
Feb. 15: Record payroll, total employee wages, $65,000
Note that employees earned $65,000 but take home pay was only $42,428.
Feb. 15: Record payroll taxes & benefits
Payroll taxes and benefits increase the total cost of payroll to $83,802.
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33. 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
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34. Recording Unearned Revenues
Microsoft bills for annual subscription service totaling $3,600.
Microsoft now has a liability that will be reduced gradually as service is provided.
Monthly revenue recognition:
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35. 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.
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36. 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.
Sole proprietorships and partnerships do not pay income taxes; their owners pay on their individual tax returns
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37. 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.
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38. 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.
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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.
Copyright © Houghton Mifflin Company. All rights reserved.
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40. 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.
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 = 42 units
42 x $50 = $2,100
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41. Stop & Review Q. Indicate whether each of the following is a(n)
(a) Definitely determinable liability
(b) Estimated liability
Dividends payable a
Income taxes payable b
Current portion of long-term debt a
Vacation pay liability b
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42. Contingent Liabilities and Commitments
Objective 3
Distinguish contingent liabilities from commitments.
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43. Contingent Liabilities
Potential liabilities that depend on future events arising out of past transactions.
Not an existing obligation
Past transaction – building of a bridge
Future 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
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44. 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.
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45. 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.
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46. Interest Two types of interest: Simple Compound
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.
In other words, the principal sum is increased at the end of each period by the interest of that period.
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47. Simple Interest Illustrated
Willy Wang accepts an 8 percent, $15,000 note due in 90 days. How much will he receive at that time?
The total that Wang will receive is $15, ($15,000 principal + $ interest).
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48. 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?
Soma would have $11, in her account 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.
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49. 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
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50. Computing Present Value
When only one time period is involved
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?
Kelly needs to invest $9, today to have $10,000 one year from now.
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51. Present Value of a Single Sum Due in the Future
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?
More would need to invest $6, today to have
$8, three years from now.
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52. Present Value of a Single Sum Due in the Future (using table)
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
Except for a difference of $1.30, the answer is the same as the earlier one.
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53. 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?
Year 3
$6,000
Year 2
Year 1
Present value $16,338
Using the table factor, the calculation is:
Periodic payment × Factor = Present Value
$6, × = $16,338
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54. 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.
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55. Applications of the Time Value of Money
Objective 5
Apply present value to simple valuation situations.
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56. 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
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57. 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.
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58. 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
Using Table 2, the factor for 10 percent and 8 periods is 5.335
Yeboah should not pay more than $7,469 for the new machine.
This amount equals the present value of the benefits that he will receive from owning the machine.
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59. Determining the Sales Price When Payment Is Deferred
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
12% annual rate ÷ 12 periods per year = 1 percent
12 periods per year x 8/12 of a year = 8 periods
The sale price of the tractor is $90,500.
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60. 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
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61. Chapter Review
Identify the management issues related to current liabilities.
Identify, compute, and record definitely determinable and estimated current liabilities.
Distinguish contingent liabilities from commitments.
Identify the valuation approaches to fair value accounting, and define time value of money and interest and apply them to present values.
Apply present value to simple valuation situations.
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