1 Module 8: Liabilities What is a liability? – “Probable future sacrifice of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” – Future sacrifice of economic benefits. – Present obligations. – Past transactions or events.

2 Current Liabilities Classification – expected to require the use of current assets (or the creation of other current liabilities) to settle the obligation. Valuing current liabilities on the balance sheet – Ignore present value – Report at face value Reporting current liabilities – Primary problem is ensuring that all existing current liabilities are reported on the balance sheet.

3 Current Operating Liabilities 1.Accounts payable - for purchase of goods and services (usually no interest). A/P Turnover = COGS/Avg. Acct. Pay A/P Days Out. =Acct. Pay./Avg. Daily COGS 2. Accrued liabilities - short-term payables usually settled with cash in the near future. Ex: Wages, Interest, Income Tax, Utilities, Vacation Pay, Bonuses, Property Taxes. 3. Unearned revenues - usually settled with delivery of goods and services. 4. Estimated accruals - amounts not known at the end of the period and must be estimated. Ex: Warranties.

4 Warranties Companies generate sales revenue when they sell products; offering warranties is part of the cost of selling the product; the amount of the future warranty costs is not known, but may be estimated. – Record estimated expense and liability when products are sold (matching concept): Warranty Expensexx Estimated Warranty Liabilityxx – As costs are incurred (usually in subsequent periods), charge expenditure to warranty liability: Estimated Warranty Liabilityxx Cash, etc.xx Note: warranties, like other estimates, may be subject to manipulation.

5Lawsuits What about lawsuits where the company is the defendant? Should we accrue for the possible future liability? Only if the settlement is “probable” and “reasonably estimable”. Since the criteria are vague, and legal staff can usually find sufficient evidence to indicate some level of probability that the defendant will prevail, estimated liabilities for lawsuits are rarely recorded. However, most lawsuits meet the minimum requirement of “reasonably possible” and must be disclosed in the notes to the financials; these disclosures inform investors as to the potential exposure. Most companies have a section for “Contingencies” in their footnotes.

6 Current Non-Operating Liabilities Short-Term Interest-Bearing Debt - borrowing from bank is a financing activity, and not part of operations. Current Portion of Long-Term Debt - the portion of long-term liabilities, like bonds and mortgages, that will come due within the next 12 months (as of the financial statement date), will require the use of current assets (specifically cash) to settle the liabilities; these liabilities must be classified as current liabilities.

7 Long-Term Liabilities: Bonds Payable Long-term liabilities are initially recorded at the present value of the future cash flows. The subject of calculation of present value is covered in Appendix 8A, and present value tables are included in Appendix A at the back of the book.

8 Bonds Payable Bonds payable are issued by a company (usually to the marketplace) to generate cash flow. The bonds represent a promise by the company to pay a stated interest each period (yearly, semiannually, quarterly), and pay the face amount of the bond at maturity. The marketplace values bonds by discounting the cash flows using the market rate of interest. This is also called the yield rate, discount rate, or effective rate. The interest rate offered on the bonds is usually fairly close to the market rate of interest at the date of issue, but may alternatively be “zero coupon bonds.”

9 Disclosure of Long-Term Liabilities The details concerning long-term liabilities (specifically the contractual arrangements with banks or the public) are disclosed in the notes to the financial statements. Disclosure includes the principal amounts of the various notes and bonds, and usually indicates the interest rates and maturity dates.