FINANCIAL ACCOUNTING AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 12th Edition FINANCIAL ACCOUNTING AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 12th Edition Chapter 9 -- Liabilities: Introduction Clyde P. Stickney and Roman L. Weil

Learning Objectives 1. Understand and apply the concept of an accounting liability to obligations with uncertain payment dates and amounts. 2. Develop the skills to compute the issue price, book value, and current market value of various debt obligations in an amount equal to the present value of the future cash flows. 3. Understand the effective interest method and apply it to debt amortization for various long-term debt obligations. 4. Understand the accounting procedures for debt retirements, whether at or before maturity. 1. Understand and apply the concept of an accounting liability to obligations with uncertain payment dates and amounts. 2. Develop the skills to compute the issue price, book value, and current market value of various debt obligations in an amount equal to the present value of the future cash flows. 3. Understand the effective interest method and apply it to debt amortization for various long-term debt obligations. 4. Understand the accounting procedures for debt retirements, whether at or before maturity.

Chapter Outline 1. Basic concepts of liabilities 2. Current liabilities 3. Long-term liabilities Chapter Summary Appendix 9.1: Effects on Cash Flow Statement of Transactions Involving Long-Term Liabilities 1. Basic concepts of liabilities 2. Current liabilities 3. Long-term liabilities Chapter Summary Appendix 9.1: Effects on Cash Flow Statement of Transactions Involving Long-Term Liabilities

Basic Concepts of Liabilities a. Liability recognition -- when is the liability recorded? b. Contingencies: potential liabilities -- under what conditions are potential contingencies booked as a liability? c. Liability valuation -- for what amount is the liability recorded? d. Liability classification –Current liability –Noncurrent liability a. Liability recognition -- when is the liability recorded? b. Contingencies: potential liabilities -- under what conditions are potential contingencies booked as a liability? c. Liability valuation -- for what amount is the liability recorded? d. Liability classification –Current liability –Noncurrent liability

Discuss Liability Recognition  An obligation is a liability if: 1. It involves a probably future sacrifice of resources 2. There is little or no discretion to avoid the transfer 3. The transaction or event that gives rise to the obligation has already occurred  A mutual promise (or executory contract) is not a liability because of item 3 above.  An obligation is a liability if: 1. It involves a probably future sacrifice of resources 2. There is little or no discretion to avoid the transfer 3. The transaction or event that gives rise to the obligation has already occurred  A mutual promise (or executory contract) is not a liability because of item 3 above.

Discuss Liability Recognition (cont.)  An example of a mutual promise is the customer promises to pay and the firm promises to deliver goods at a date. If this promise is in the form of a legal contract, it may give both parties rights but the rights are not yet considered assets and the obligations are not yet considered liabilities.

Contingencies: Potential Liabilities  Contingent liabilities are potential liabilities.  The more probable the potential to become a legal obligation, the greater the rationale for recognizing it as a liability.  Probability of a potential liability is very difficult to measure.  In general, an obligation should be recognized as a liability if it is probable that the firm will have make future sacrifices of resources.  Contingent liabilities are potential liabilities.  The more probable the potential to become a legal obligation, the greater the rationale for recognizing it as a liability.  Probability of a potential liability is very difficult to measure.  In general, an obligation should be recognized as a liability if it is probable that the firm will have make future sacrifices of resources.

Contingencies: Potential Liabilities (cont.)  Of course, the word probable is also difficult to measure.  FASB and IASC require the recognition of a loss and a contingent liability when –It is probable that an asset has been impaired or a liability incurred, and –The amount of the loss can be reasonably estimated.  Of course, the word probable is also difficult to measure.  FASB and IASC require the recognition of a loss and a contingent liability when –It is probable that an asset has been impaired or a liability incurred, and –The amount of the loss can be reasonably estimated.

What is a constructive liability?  New concept not yet finalized by FASB.  A constructive liability arises not from an obligation, but from management intent. –A firm may record a liability based on future plans (or intent). –This gives management a lot of flexibility in reporting because they may easily change their intent.  New concept not yet finalized by FASB.  A constructive liability arises not from an obligation, but from management intent. –A firm may record a liability based on future plans (or intent). –This gives management a lot of flexibility in reporting because they may easily change their intent.

What is a constructive liability? (cont.)  Example: Management makes a decision to close a plant. At the time of the decision and before any actual transaction, management may decide to record the cost of the plant closing as a liability.

Liability Valuation  In general, liabilities are presented on the balance sheet at the present value of payments needed to fulfill the obligation.  Present value refers to discounting the nominal payments by an interest rate appropriate for the firm.  Discounting is a mathematical computation whereby future flows are reduced to reflect the concept that money has time value. (See Appendix A at the back of the text.)  Current liabilities are not generally discounted because of the short period of time until they are to be resolved. The any discount for the short time period would so small to be considered immaterial.  In general, liabilities are presented on the balance sheet at the present value of payments needed to fulfill the obligation.  Present value refers to discounting the nominal payments by an interest rate appropriate for the firm.  Discounting is a mathematical computation whereby future flows are reduced to reflect the concept that money has time value. (See Appendix A at the back of the text.)  Current liabilities are not generally discounted because of the short period of time until they are to be resolved. The any discount for the short time period would so small to be considered immaterial.

Discuss Liability Classification  Liabilities are separated into current and noncurrent based on the length of time that will elapse before the obligation must be fulfilled.  Current liabilities are obligations that must be fulfilled within the current operating cycle which is almost always one year.  Noncurrent liabilities are obligations that need not be fulfilled within the current operating cycle.  Obligations calling for periodic payments such as a mortgage may be noncurrent but have a current portion; that is, the payments due within the operating cycle are current but the remaining payments are noncurrent.  Liabilities are separated into current and noncurrent based on the length of time that will elapse before the obligation must be fulfilled.  Current liabilities are obligations that must be fulfilled within the current operating cycle which is almost always one year.  Noncurrent liabilities are obligations that need not be fulfilled within the current operating cycle.  Obligations calling for periodic payments such as a mortgage may be noncurrent but have a current portion; that is, the payments due within the operating cycle are current but the remaining payments are noncurrent.

Rapid Review – True False 1. Probable liabilities are the same thing as contingent liabilities. 2. A warranty is a promise to repair or replace the good but is limited by time. 3. Bonds sold for more than face value are sold at a discount.