1. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 8 Current Liabilities and Fair Value Accounting Financial Accounting, 11e

2. Learning Objectives 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. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Current Liabilities Current liabilities: Debts and obligations that a company expects to satisfy within one year or within its normal operating cycle, whichever is longer. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4. Managing Liquidity and Cash Flows Analysts often use two measures of liquidity to evaluate a company’s ability to pay its current liabilities:  Working Capital = Current Assets – Current Liabilities  Current Ratio = Current Assets ÷ Current Liabilities © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. Financial Ratio: Payables Turnover Payables turnover: Average number of times a company pays its accounts payable in an accounting period. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. If Microsoft’s cost of goods sold in 2009 was $12,155 million and its inventory decreased by $268 million:

6. Financial Ratio: Days’ Payable Days’ payable: How long, on average, a company takes to pay its accounts payable. Microsoft’s payables turnover was calculated as 3.2 times: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. Reporting Liabilities (slide 1 of 2) Recognition  GAAP requires a liability be recorded when an obligation occurs. Valuation  A liability is generally valued at the amount of money needed to pay the debt or at the fair market value of the goods or services to be delivered. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. Reporting Liabilities (slide 2 of 2) Classification  Current liabilities: Due in the next year or normal operating cycle, whichever is longer.  Normally paid out of current assets or with cash generated by operations.  Long-term liabilities: Liabilities due beyond one year or beyond the normal operating cycle. Disclosure  Additional explanation of some liability accounts is included in the notes to the financial statements. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9. Kate’s Cookie Company has current assets of $30,000 and current liabilities of $20,000, of which accounts payable are $15,000. Kate’s cost of goods sold is $125,000, its merchandise inventory increased by $5,000, and accounts payable were $11,000 the prior year. Calculate Kate’s current ratio, payables turnover, and days’ payable. SOLUTION © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10. Definitely Determinable Liabilities  Accounts Payable  Notes Payable  Bank Loans and Commercial Paper  Accrued Liabilities  Dividends Payable  Sales and Excise Taxes Payable  Current Portion of Long- Term Debt  Payroll Liabilities  Unearned Revenues © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Definitely determinable liabilities: Current liabilities set by contract or statute that can be measured exactly. The problems in accounting for these liabilities are to determine their existence and amount and to see that they are recorded properly. Definitely determinable liabilities include:

11. EXAMPLE: Promissory Note Payable © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12. Bank Loans and Commercial Paper Line of credit: Arrangement with a bank to allow a company to borrow funds when needed to finance current operations. Commercial paper: Unsecured loans (i.e., loans not backed by any specific assets) that are sold to the public, usually through professionally managed investment firms. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13. Payroll Liabilities Wages: Compensation of employees at an hourly rate. Salaries: Compensation of employees at a monthly or yearly rate. Employee: A person who is paid a wage or salary by the organization and is under its direct supervision and control. Independent contractor: A person who is not an employee of the organization and so is not accounted for under the payroll system. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

14. Illustration of Payroll Costs © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15. Unearned Revenues Unearned revenues: Advance payments for goods or services that a company must provide in a future accounting period. The company recognizes the revenue over the period in which it provides the products or services. Many businesses, including special-order firms, repair companies, and construction companies, ask for a deposit before they will deliver goods or services. Until they do deliver the goods or services, these deposits are current liabilities. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16. Estimated Liabilities Income Taxes Payable Property Taxes Payable Promotional Costs Product Warranty Liability  A company that sells a product or service with a warranty, has a liability for the length of the warranty.  The warranty is a feature of the product and is included in the selling price; its cost should therefore be debited to an expense account in the period of the sale. Vacation Pay Liability  In most companies, employees accrue paid vacation as they work during the year.  The cost of the vacation should be allocated as an expense over the year so that month-to-month costs will not be distorted. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. EXAMPLE: Product Warranty Liability (slide 1 of 2) A muffler company like Midas guarantees that it will replace free of charge any muffler it sells that fails during the time the buyer owns the car. The company charges a small service fee for replacing the muffler. In the past, 6 percent of the mufflers sold have been returned for replacement under the warranty. The average cost of a muffler is $50. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18. EXAMPLE: Product Warranty Liability (slide 2 of 2) If the company sold 700 mufflers during July, the accrued liability would be recorded as an adjustment at the end of July, as shown in the following journal entry: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

19. EXAMPLE: Vacation Pay Liability (slide 1 of 2) A company with a vacation policy of two weeks of paid vacation for each 50 weeks of work has a payroll of $42,000 and that it paid $2,000 of that amount to employees on vacation for the week ended April 20. Because of past experience with employee turnover, the company assumes that only 75 percent of employees will ultimately collect vacation pay. The computation of vacation pay expense based on the payroll of employees not on vacation ($42,000 - $2,000) is as follows: $40,000 x 0.04 x 0.75 = $1,200 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20. EXAMPLE: Vacation Pay Liability (slide 2 of 2) The company would the following entry make record vacation pay expense for the week ended April 20: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21. Identify each of the following as either (a) a definitely determinable liability or (b) an estimated liability. ____ 1.Bank loan ____ 2. Dividends payable ____ 3. Product warranty liabilities ____ 4. Interest payable ____ 5. Income taxes payable ____ 6. Vacation pay liability ____ 7. Notes payable ____ 8. Property taxes payable ____ 9. Commercial paper ____ 10. Gift certificate liability SOLUTION 1. a; 2. a; 3. b; 4. a; 5. b; 6. b; 7. a; 8. b; 9. a; 10. b © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22. Contingent Liabilities and Commitments (slide 1 of 2) Contingent liability: A potential liability that depends on a future event arising out of a past transaction.  Lawsuits  Income tax disputes  Discounted notes receivable  Guarantees of debt  Failure to follow government regulations © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23. Contingent Liabilities and Commitments (slide 2 of 2) The FASB has established two conditions for determining when a contingency should be entered in the accounting records:  The liability must be probable.  The liability can be reasonably estimated. Commitment: A legal obligation that does not meet the technical requirements for recognition as a liability and so is not recorded. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

25. Identify each of the following as (a) a contingent liability or (b) a commitment. ____ 1. A tax dispute with the IRS ____ 2. A long-term lease agreement ____ 3. An agreement to purchase goods in the future ____ 4. A potential lawsuit over a defective product SOLUTION 1. a; 2. b; 3. b; 4. a © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26. Valuation Approaches to Fair Value Accounting Market approach: When available, external market transactions involving identical or comparable assets or liabilities are ideal. Income (or cash flow) approach: The income approach, as defined by the FASB, converts future cash flows to a single present value. Cost approach: The cost approach is based on the amount that currently would be required to replace an asset with the same or a comparable asset. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

28. Interest, the Time Value of Money, and Future Value Time value of money: The costs or benefits of holding or not holding money over time. Interest: The cost of using money for a specific period. Future value: Amount of principal plus interest after one or more periods. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

29. EXAMPLE: Future Value Using Simple Interest Erin Burns accepts an 8 percent, $15,000 note due in 90 days. How much will she receive at that time? Interest = Principal × Rate × Time =$15,000 × 8/100 × 90/365 = $295.89 The future value that Burns will receive : Total = Principal × Interest =$15,000.00 × $295.89 =$15,295.89 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30. EXAMPLE: Future Value Using Compound Interest (slide 1 of 2) Jake Laverne deposits $10,000 in an account that pays 6 percent interest. He expects to leave the principal and accumulated interest in the account for three years. If the interest is paid at the end of each year and is then added to the principal and this amount in turn earns interest, how much will Laverne’s account total at the end of three years? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

31. EXAMPLE: Future Value Using Compound Interest (slide 2 of 2) The amount is computed as follows: Laverne will have a future value of $11,910.16 in his account at the end of three years. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

32. Calculating Present Value Present value: The amount that must be invested today at a given rate of interest to produce a given future value. Example: Debra needs $10,000 one year from now. How much does she have to invest today to achieve that goal if the interest rate is 5 percent? Present Value × (1.0 + Interest Rate)= Future Value Present Value × 1.05 = $10,000.00 Present Value = $10,000.00 ÷ 1.05 Present Value = $9,523.81 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

33. Present Value of a Single Sum Due in the Future © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

34. Present Value of $1 to Be Received at the End of a Given Number of Periods © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

35. Present Value of an Ordinary Annuity Ordinary annuity: A series of receipts or payments equally spaced over time, with compound interest. Example: Vicky has sold a piece of property and is to receive $18,000 in three equal annual payments of $6,000 beginning one year from today. What is the present value of this sale if the current value is 5 percent? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

36. EXAMPLE: Present Value of an Ordinary Annuity Vicky has sold a piece of property and is to receive $18,000 in three equal annual payments of $6,000 beginning one year from today. What is the present value of this sale if the current value is 5 percent? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

37. Present Value of an Ordinary $1 Annuity Received in Each Period for a Given Number of Periods © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

38. EXAMPLE: Time Periods Present value of a $6,000 payment to be received in two years with an annual interest rate of 8 percent and a semiannual compounding period  Interest rate: 4 percent (8% annual rate ÷ 2 periods per year).  Number of compounding periods: 4 (2 periods per year × 2 years). Principal × Factor = Present Value $6,000 × 0.855 = $5,130 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

39. Determine the present value of the following: 1.A single payment of $10,000 at 5 percent for 10 years 2.10 annual payments of $1,000 at 5 percent 3.A single payment of $10,000 at 7 percent for 5 years 4.10 annual payments of $1,000 at 9 percent SOLUTION 1.$10,000 × 0.614 = $6,140 2. $1,000 × 7.722 = $7,722 3. $10,000 × 0.713 = $7,130 4.$1,000 × 6.418 = $6,418 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

40. Applications Using Present Value (slide 1 of 3) Valuing an Asset © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

41. Applications Using Present Value (slide 2 of 3) Deferred Payment © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

42. Applications Using Present Value (slide 3 of 3) Other Applications  Computing imputed interest on non-interest-bearing notes  Accounting for installment notes  Valuing a bond  Recording lease obligations  Accounting for pension obligations  Valuing debt  Depreciating property, plant, and equipment  Making capital expenditure decisions  Accounting for any item in which time is a factor © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

43. George owns a restaurant and has the opportunity to buy a high-quality espresso coffee machine for $5,000. After carefully studying projected costs and revenues, George estimates that the machine will produce a net cash flow of $1,600 annually and will last for five years. He determines that an interest rate of 10 percent is an adequate return on investment for his business. Calculate the present value of the machine to George. Based on your calculation, do you think George would be wise to purchase the machine? Explain your answer. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

44. SOLUTION Calculation of the present value: Annual cash flow $1,600.00 Factor from Table (5 years at 10%) × 3.791 Present value of net cash flows $ 6,065.60 Less purchase price – 5,000.00 Net present value $ 1,065.60 The present value of the net cash flows from the machine exceeds the purchase price. Thus, the investment will return more than 10 percent to George’s business. A decision to purchase the machine would therefore be wise. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.