Reporting and Interpreting

Liabilities
Chapter 9

McGraw-Hill/Irwin

2009 The McGraw-Hill Companies, Inc.

Understanding the Business

The acquisition of assets is

financed from two sources:

Debt - funds
from creditors

Equity - funds
from owners

9-2

Understanding the Business

Debt is considered riskier than equity.
Interest
Interest is
is
aa legal
legal
obligation.
obligation.

Creditors
Creditors
can
can force
force
bankruptcy.
bankruptcy.

9-3

Liabilities Defined and Classified

Defined
Definedas
asprobable
probabledebts
debtsor
orobligations
obligationsof
ofthe
the
entity
entitythat
that result
resultfrom
frompast
past transactions,
transactions,which
whichwill
will
be
bepaid
paidwith
with assets
assets or
or services.
services.
Maturity = 1 year or less

Maturity > 1 year

Current
Liabilities

Noncurrent
Liabilities

9-4

Liabilities Defined and Classified

Liabilities are
measured at
their current
cash equivalent
(the amount a
creditor would
accept to cancel
the debt) at the
time incurred.
9-5

Current Liabilities

9-6

Payroll Taxes
Gross Pay
Net Pay
Less Deductions:

Social
Security
Tax

Medicare
Tax

Federal
Income
Tax

State and
Voluntary
Local Income Deduction
Taxes
s
9-7

Working Capital and Cash Flows

Working Capital = Current Assets - Current Liabilities

Changes in working capital accounts are

important to managers and analysts
because they have a direct impact on cash
flows from operating activities reported on
the statement of cash flows.
9-8

Notes Payable
A
A note
note payable
payable specifies
specifies the
the interest
interest
rate
rate associated
associated with
with the
the borrowing.
borrowing.

To
Tothe
the lender,
lender, interest
interest is
is aa revenue.
revenue.

To
Tothe
the borrower,
borrower,interest
interest is
is an
an expense
expense..

Interest = Principal Interest Rate Time

When
Whencomputing
computinginterest
interest for
for one
oneyear,
year,
Time
Timeequals
equals1.
1. When
Whenthe
thecomputation
computation
period
periodis
isless
lessthan
thanone
oneyear,
year,then
thenTime
Time
is
isaafraction.
fraction.
9-9

Notes Payable
Toyota
Toyota borrows
borrows
$100,000
$100,000 for
for 22 months
months at
at
an
an annual
annual interest
interest rate
rate
of
of 12%.
12%. Compute
Compute the
the
interest
interest on
on the
the note
note for
for
the
the loan
loan period.
period.

9-10

Estimated Liabilities
Contingent Liability Examples

Lawsuits

Environmental
Problems

Product
Warranties

9-11

Long-Term Liabilities
Creditors often require the borrower to
pledge specific assets as security for
the long-term liability.

Maturity = 1 year or less

Maturity > 1 year

Current
Liabilities

Long-term
Liabilities
9-12

Long-Term Notes Payable and Bonds

Relatively
Relatively small
small debt
debt
needs
needs can
can be
be filled
filled from
from
single
single sources.
sources.

Banks

Insurance
Companies

Pension
Plans
9-13

Long-Term Notes Payable and Bonds

Significant
Significant debt
debt needs
needs are
are
often
often filled
filled by
by issuing
issuing
bonds
bonds to
to the
the public.
public.
Bonds

Cash

9-14

Borrowing in Foreign Currencies

When
When aa company
company has
has operations
operations in
in aa foreign
foreign

country,
country,itit often
often borrows
borrows in
in the
the local
local currency.
currency.
This
This reduces
reduces exchange
exchange rate
rate risk.
risk.

Because
Because interest
interest rates
rates vary
vary from
from country
country to
to
country,
country,companies
companies may
may borrow
borrow in
in the
the foreign
foreign
market
market with
with the
the lowest
lowest interest
interest rate.
rate.

9-15

Lease Liabilities
Operating
Lease

Capital
Lease

Long-term lease;
Short-term lease; No
Meets one of 4
liability or asset
criteria; Results in
Capital Lease
Criteria
recorded
recording an asset
1. Lease term is 75% or more of the assets expected economic life.
a liability
2. Ownership of asset is transferred to lessee at endand
of lease.
3. Lease permits lessee to purchase the asset at a price that is lower than its
fair market value.
4. The present value of the lease payments is 90% or more of the fair market
value of the asset when the lease is signed.

9-16

Present Value Concepts

$1,000
invested
today at 10%.

In 5 years it
will be worth
$1,610.51.

In 25 years it
will be worth
$10,834.71!

Money can grow over time, because it

can earn interest.
9-17

Present Value Concepts

1.
1.
2.
2.
3.
3.
4.
4.

The
The growth
growth is
is aa mathematical
mathematical
function
function of
of four
four variables:
variables:
The
The value
value today
today (present
(present value).
value).
The
The value
value in
in the
the future
future (future
(future
value).
value).
The
The interest
interest rate.
rate.
The
The time
time period.
period.

9-18

Present Value Concepts

Most
Most analysts
analysts use
use present
present value
value
tables,
tables, calculators,
calculators, or
or Excel
Excel to
to
solve
solve time
time value
value of
of money
money
problems.
problems.
We
We will
will use
use the
the present
present value
value tables
tables
in
in our
our illustrations
illustrations (an
(an explanation
explanation
of
of how
how to
to use
use Excel
Excel is
is included
included in
in
the
the supplement
supplement to
to this
this chapter).
chapter).
9-19

Present Value of a Single Amount

The present value of a single amount is
the worth to you today of receiving that
amount some time in the future.
Present
Value

Future
Value
Interest compounding periods

Today

Future

9-20

Present Value of a Single Amount

How
How much
much do
do we
we need
need to
to invest
invest today
today at
at
10%
10% interest,
interest, compounded
compounded annually,
annually, if
if we
we
need
need $1,331
$1,331 in
in three
three years?
years?
a.
a. $1,000.00
$1,000.00
b.
b. $$ 990.00
990.00 The
The required
required future
futureamount
amountis
is$1,331.
$1,331.
c.
c. $$ 751.30
751.30 ii==10%
10%&&nn==33 years
years
d.
d. $$ 970.00
970.00 Using
Usingthe
thepresent
presentvalue
valueof
of aasingle
single
amount
amounttable,
table,the
thefactor
factoris
is.7513.
.7513.
$1,331
$1,331 .7513
.7513 == $1,000
$1,000 (rounded)
(rounded)

9-21

Present Values of an Annuity

An annuity is a series of
consecutive equal periodic
payments.

Today

9-22

Present Values of an Annuity

What is the value today of a

series of payments to be
received or paid out in the
future?
Payment 1
Present
Value

Payment 2

Payment 3

Interest compounding periods

Today
9-23

Present Values of an Annuity

What
What is
is the
the present
present value
value of
of receiving
receiving
$1,000
$1,000 each
each year
year for
for three
three years
years at
at an
an
interest
interest rate
rate of
of 10%,
10%, compounded
compounded annually?
annually?
a.
a. $3,000.00
$3,000.00
b.
b. $2,910.00
$2,910.00
The
consecutive
equal
payment
The
consecutive
equal
payment
c.
$2,700.00
c. $2,700.00
amount
amountis
is$1,000.
$1,000.
d.
d. $2,486.90
$2,486.90
ii== 10%
10%&&nn ==33 years
years
Using
Using the
thepresent
present value
valueof
ofan
an
annuity
annuitytable,
table, the
thefactor
factor is
is 2.4869.
2.4869.
$1,000
$1,000 2.4869
2.4869 == $2,486.90
$2,486.90

9-24

Accounting Applications of Present

Values

On January 1, 2009, Starbucks bought some new

delivery trucks. The company signed a note
agreeing to pay $200,000 on December 31, 2010.
The market interest rate for this note is 12%.

Lets prepare the journal entry to record the purchase.

9-25

Accounting Applications of Present

Values

Present
Interest
Rate
Interest 31,
Now, lets
look Value
at the journal
entry
at =December
$159,440 2009.
12% = $19,133

9-26

Accounting Applications of Present

Values
Now, lets look at the journal entries at
December 31, 2010.

Present Value Interest Rate = Interest

($159,440 + $19,133) 12% = $21,429
9-27

Supplement A: Income Taxes and

Retirement Benefits

Deferred Taxes

Exist because of timing differences

caused by reporting revenues and
expenses according to GAAP on a
companys income statement and
according to the Internal Revenue
Code on the tax return.

Temporary
Differences

Timing differences that cause

deferred income taxes and will
reverse, or turn around, in the
future.

9-28

Income Taxes and Retirement Benefits

Some pension plans create
obligations during
employees service periods
that must be paid during their
retirement periods. The
amounts contributed during
the employment period are
determined using present
value computations of the
estimate of the future amount
to be paid during retirement.
9-29

Supplement B: Federal Income Tax

Concepts

Corporations

Are separate legal entities and

are required to pay income
taxes.

Tax Obligation

Determined by multiplying
taxable income by the corporate
tax rate.

9-30

Revenue and Expense Recognition for

Income Tax Purposes
1. Interest revenue on state and municipal bonds is generally
excluded from taxable income although it is included in
accounting income.
2. Revenue collected in advance is included in taxable income when
it is collected and in accounting income when it is earned.
3. Proceeds from life insurance policies are excluded from taxable
income but included in accounting income.
4. Corporations that own less than 20% of another corporations
stock may exclude 70% of the dividends received from taxable
income, although all dividends are included in accounting income.
5. For tax purposes, depreciation expense is generally based on the
Accelerated Cost Recovery System (ACRS) or on the Modified
Accelerated Cost Recovery System (MACRS).
9-31

Tax Minimization Versus Tax Evasion

9-32

Supplement C: Present Value

Computations Using Excel
Present Value of A Single Amount Formula
= Payment/(1 + i)^n
Present Value of An Annuity Formula
Use the present value of an annuity formula
programmed in Excel by selecting the
function button (fx ). In the drop down
menu, under the Select Category heading,
pick "Financial" and scroll down under
Select Function and click on "PV." In the
new drop down box, enter the specific
information for your problem and click
"OK."

9-33

Supplement D: Future Value Concepts

Future value is the sum to which an amount will
increase as the result of compound interest.
How much will an amount today be worth
in the future?

Present
Value

Interest compounding periods

Future
Value

Today
9-34

Future Value of a Single Amount

If
If we
we invest
invest $1,000
$1,000 today
today earning
earning 10%
10%
interest,
interest, compounded
compounded annually,
annually, how
how much
much
will
will it
it be
be worth
worth in
in three
three years?
years?
a.
a. $1,000
$1,000
b.
b. $1,010
$1,010
The
Theinvested
invested amount
amountis
is$1,000.
$1,000.
c.
c. $1,100
$1,100
ii ==10%
10%&&nn== 33years
years
d.
d. $1,331
$1,331
Using
Using the
the future
futurevalue
value of
of aasingle
single
amount
amount table,
table, the
thefactor
factoris
is1.331.
1.331.
$1,000
$1,000 1.331
1.331 == $1,331
$1,331

9-35

Future Value of an Annuity

Equal payments are made each period.

The payments and interest accumulate over
time.
Payment 1

Payment 2

Payment 3

Interest compounding periods

Today

9-36

Future Value of an Annuity

a.
a.
b.
b.
c.
c.
d.
d.

If
If we
we invest
invest $1,000
$1,000 each
each year
year at
at an
an
interest
interest rate
rate of
of 10%,
10%, compounded
compounded
annually,
annually, how
how much
much will
will we
we have
have at
at the
the
end
end of
of three
three years?
years?
$3,000
$3,000
$3,090
$3,090
The
Theannual
annualinvestment
investmentamount
amount is
is $1,000.
$1,000.
$3,300
$3,300
ii== 10%
10%&&nn== 33years
years
$3,310
$3,310
Using
Usingthe
thefuture
futurevalue
valueof
ofan
anannuity
annuity
table,
table, the
thefactor
factoris
is3.3100.
3.3100.
$1,000
$1,000 3.3100
3.3100 == $3,310
$3,310

9-37

End of Chapter 9

McGraw-Hill/Irwin

2009 The McGraw-Hill Companies, Inc.