Chapter 8 Current Liabilities and the Time Value

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Chapter 8 Current Liabilities and the Time Value of Money Skyline College Lecture Notes

Chapter 8 Current Liabilities and the Time Value of Money Skyline College Lecture Notes

Managing Liquidity and Cash Flows ü Current liabilities arise to support the operating cycle

Managing Liquidity and Cash Flows ü Current liabilities arise to support the operating cycle or to raise cash during periods of inventory build up ü Companies must be able to pay debts ü Measurements like working capital and the current ratio depend on current liabilities ü The amount of time suppliers give a company to pay for purchases is also a factor in managing cash flow and liquidity Copyright © Houghton Mifflin Company. All rights reserved. 8– 2

Payables Turnover Number of times, on average, that a company pays its accounts payables

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 Merchandise Inventory Average Accounts Payable Amazon. com’s 2004 Payables Turnover = $5, 319, 127 + $185, 792 ($1, 141, 733 + $819, 811) ÷ 2 = Copyright © Houghton Mifflin Company. All rights reserved. 5. 6 times 8– 3

Payables Turnover for Selected Industries Copyright © Houghton Mifflin Company. All rights reserved. 8–

Payables Turnover for Selected Industries Copyright © Houghton Mifflin Company. All rights reserved. 8– 4

Days’ Payable How long, on average, a company takes to pay its accounts payables

Days’ Payable How long, on average, a company takes to pay its accounts payables Days’ Payable = Amazon. com’s Days’ Payable = = Copyright © Houghton Mifflin Company. All rights reserved. 365 days Payables Turnover 365 days 5. 6 65. 2 days 8– 5

Days’ Payable for Selected Industries Copyright © Houghton Mifflin Company. All rights reserved. 8–

Days’ Payable for Selected Industries Copyright © Houghton Mifflin Company. All rights reserved. 8– 6

Recognition of Liabilities ü Timing is important when recognizing liabilities ü Failure to record

Recognition of Liabilities ü Timing is important when recognizing liabilities ü Failure to record a liability often means that an expense has also not been recorded When an obligation occurs, a liability should be recorded. üTransaction obligates company to make future payments üAccrue liabilities like salaries or interest payable üEstimate and accrue liabilities like taxes payable üAgreements for future transactions do not have to be recognized Copyright © Houghton Mifflin Company. All rights reserved. 8– 7

Valuation of Liabilities Balance Sheet Liabilities Valued at the amount needed to pay off

Valuation of Liabilities Balance Sheet Liabilities Valued at the amount needed to pay off the debt, or at the fair market value of the goods or services to be delivered Copyright © Houghton Mifflin Company. All rights reserved. 8– 8

Classification and Disclosure Current Liabilities Debts and obligations that a company expects to satisfy

Classification and Disclosure Current Liabilities Debts and obligations that a company expects to satisfy within one year or within its normal operating cycle, whichever is longer Long-Term Liabilities Due beyond one year or beyond the normal operating cycle Copyright © Houghton Mifflin Company. All rights reserved. Companies may be required to include additional explanation of liability accounts in the notes to the financial statements ü Maturity dates, interest rates, special credit agreements 8– 9

Discussion: Ethics on the Job Trimble Company accepts delivery of 20, 000 units of

Discussion: Ethics on the Job Trimble Company accepts delivery of 20, 000 units of product that it intends to resell to its customers. The invoice for $12, 384. 89 is delivered to the accounts payable clerk. Since the amount is not due until next month, she decides not to record the amount in the books this month. This will help the company’s financial position as it seeks to secure a long-term loan for the purchase of a new building. Q. If you were the accountant for this company, what position would you take on this issue? Copyright © Houghton Mifflin Company. All rights reserved. 8– 10

Definitely Determinable Liabilities Current liabilities that are set by contract or statute and that

Definitely Determinable Liabilities Current liabilities that are set by contract or statute and that can be measured exactly ü Accounts Payable ü Bank loans and commercial paper ü Notes payable ü Accrued liabilities ü Dividends payable ü Sales and excise taxes payable ü Current portion of long-term debt ü Payroll liabilities ü Unearned revenues Copyright © Houghton Mifflin Company. All rights reserved. 8– 11

Accounts Payable Short-term obligations to suppliers for goods and services ü Also called trade

Accounts Payable Short-term obligations to suppliers for goods and services ü Also called trade accounts payable ü Amount in Accounts Payable account is generally supported by an accounts payable (A/P) subsidiary ledger Copyright © Houghton Mifflin Company. All rights reserved. A/P Subsidiary Ledger Individual accounts for each person or business to which money is owed 8– 12

Bank Loans Companies often borrow funds when they are needed using a line of

Bank Loans Companies often borrow funds when they are needed using a line of credit ü Company signs a note for the full amount of a line of credit ü Company may use all or only some of funds ü Interest rate may change daily ü Bank may require firm to meet certain financial goals to retain its line of credit Copyright © Houghton Mifflin Company. All rights reserved. 8– 13

Commercial Paper ü Short-term unsecured loans available to firms with excellent credit ratings ü

Commercial Paper ü Short-term unsecured loans available to firms with excellent credit ratings ü Usually issued to the public through professionally managed investment firms Copyright © Houghton Mifflin Company. All rights reserved. On the Balance Sheet: Current Liabilities: The line of credit currently borrowed and the amount of commercial paper issued are usually combined with notes payable in the current liabilities section of the balance sheet 8– 14

Short-Term Notes Payable Obligations represented by promissory notes Used to: üSecure bank loans üPay

Short-Term Notes Payable Obligations represented by promissory notes Used to: üSecure bank loans üPay suppliers üObtain more credit Copyright © Houghton Mifflin Company. All rights reserved. 8– 15

Recording Notes Payable Issuance of 60 -day, 12 percent promissory note on August 31

Recording Notes Payable Issuance of 60 -day, 12 percent promissory note on August 31 Payment of note Copyright © Houghton Mifflin Company. All rights reserved. 8– 16

Accrued Liabilities Adjusting entries recognize liabilities that are not already in the accounting records

Accrued Liabilities Adjusting entries recognize liabilities that are not already in the accounting records Example: A $5, 000, 60 -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: $5, 000 x. 12 x 30/365 = $49. 32 Copyright © Houghton Mifflin Company. All rights reserved. 8– 17

Sales and Excise Taxes Payable ü Sales taxes are often levied on retail transactions

Sales and Excise Taxes Payable ü Sales taxes are often levied on retail transactions ü Excise taxes are imposed on certain goods like gasoline ü Merchants collect the sales taxes from customers and pay them over to the appropriate taxing authority Copyright © Houghton Mifflin Company. All rights reserved. 8– 18

Current Portion of Long-Term Debt If a portion of long-term debt (principle portion) is

Current Portion of Long-Term Debt If a portion of long-term debt (principle portion) is due within the next year and is to be paid from current assets, that portion is classified as a current asset. Copyright © Houghton Mifflin Company. All rights reserved. 8– 19

Unearned Revenues Obligations for goods or services that the company must provide or deliver

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, gift certificates, and subscriptions are all current liabilities Copyright © Houghton Mifflin Company. All rights reserved. 8– 20

Recording Unearned Revenues Received annual subscriptions totaling $240 The publisher now has a liability

Recording Unearned Revenues Received annual subscriptions totaling $240 The publisher now has a liability that will be reduced gradually as monthly issues of the magazine are mailed Monthly issue of magazine mailed Copyright © Houghton Mifflin Company. All rights reserved. 8– 21

Estimated Liabilities Definite obligations whose exact dollar amount cannot be known until a later

Estimated Liabilities Definite obligations whose exact dollar amount cannot be known until a later date Estimate and record these types of liabilities ü Income taxes ü Property taxes ü Promotional costs ü Product warranties ü Vacation pay Copyright © Houghton Mifflin Company. All rights reserved. 8– 22

Income Taxes Payable Ø A corporation’s income is taxed by the federal government and

Income Taxes Payable Ø A corporation’s income is taxed by the federal government and most state governments Ø 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 Copyright © Houghton Mifflin Company. All rights reserved. 8– 23

Property Tax Payable ü Property taxes are levied on real and personal property ü

Property Tax Payable ü Property taxes are levied on real and personal property ü The fiscal years of local governments and of businesses rarely correspond ü Companies must estimate the amount of property tax applicable to each month until the tax bill arrives Copyright © Houghton Mifflin Company. All rights reserved. 8– 24

Product Warranty Liabilities When a firm sells a product or service with a warranty,

Product Warranty Liabilities When a firm sells a product or service with a warranty, it has a liability for the length of the warranty Illustration: Midas Muffler guarantees that it will replace free of charge any muffler it sells that fails 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 350 mufflers during July, what is the amount of liability to be accrued? 350 X. 06 = 21 x $50 = $1, 050 Copyright © Houghton Mifflin Company. All rights reserved. 8– 25

Recording Product Warranty Liabilities Record warranty expense: Record replacement of a defective muffler, which

Recording Product Warranty Liabilities Record warranty expense: Record replacement of a defective muffler, which cost $40, and receipt of $20 service fee to have it replaced: Copyright © Houghton Mifflin Company. All rights reserved. 8– 26

Vacation Pay Liability ü Vacation pay is often accrued as employees work during the

Vacation Pay Liability ü Vacation pay is often accrued as employees work during the year ü The cost should be allocated over the entire year so that month-to-month costs will not be distorted (applies to bonus plans and pension plan contributions as well) Copyright © Houghton Mifflin Company. All rights reserved. 8– 27

Vacation Pay Liability: Illustrated April 20: Employees earn two weeks paid vacation for every

Vacation Pay Liability: Illustrated April 20: Employees earn two weeks paid vacation for every 50 weeks worked, and it is assumed only 75 percent of employees will ultimately collect vacation pay. The weekly payroll is $21, 000, of which $1, 000 is paid to employees on vacation. How is estimated vacation pay liability recorded? The computation of vacation pay expense is based on the payroll of employees not on vacation Copyright © Houghton Mifflin Company. All rights reserved. 8– 28

Contingent Liabilities Potential liabilities that depend on future events arising out of past transactions

Contingent Liabilities Potential liabilities that depend on future events arising out of past transactions Past Transaction: Building of a bridge Future Event: Outcome of a lawsuit Conditions for determining when a contingency should be entered in the accounting records: 1. The liability must be probable 2. The liability can be reasonably estimated (Vacation pay, income taxes, and warranty liability) Copyright © Houghton Mifflin Company. All rights reserved. 8– 29

Commitments ü Legal obligations that do not meet the technical requirements for recognition as

Commitments ü Legal obligations that do not meet the technical requirements for recognition as a liability and so are not recorded ü Examples include purchase agreements and leases (unless unusual) Copyright © Houghton Mifflin Company. All rights reserved. 8– 30

Does Time Affect Money? Time Value of Money Effects of the passage of time

Does Time Affect Money? Time Value of Money Effects of the passage of time on holding or not holding money Interest Measures these effects for a given period of time Copyright © Houghton Mifflin Company. All rights reserved. 8– 31

Interest Simple Interest Compound Interest ü return on principal for one or more periods

Interest Simple Interest Compound Interest ü return on principal for one or more periods ü return on principal for two or more periods ü principal sum stays the same from period to period Copyright © Houghton Mifflin Company. All rights reserved. ü computed by adding the interest earned in one period to the amount on which interest is computed in future periods 8– 32

Simple Interest Illustrated Joe Sanchez accepts an 8 percent, $30, 000 note due in

Simple Interest Illustrated Joe Sanchez accepts an 8 percent, $30, 000 note due in 90 days. What total amount will Sanchez receive? The total that Sanchez will receive is $30, 591. 78. ($30, 000. 00 principal + $591. 78 interest) Copyright © Houghton Mifflin Company. All rights reserved. 8– 33

Compound Interest Illustrated Anna Wang deposits $5, 000 in an account that pays 6

Compound Interest Illustrated Anna Wang deposits $5, 000 in an 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. What total amount will be in the account at the end of three years? Wang will have $5, 955. 08 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. Copyright © Houghton Mifflin Company. All rights reserved. 8– 34

Future Value Tables The amount an investment will be worth at a future date

Future Value Tables The amount an investment will be worth at a future date if invested at compound interest Instead of calculating interest period by period, future value tables may be used Copyright © Houghton Mifflin Company. All rights reserved. 8– 35

Future Value of Single Sum Using Tables Anna Wang deposits $5, 000 in an

Future Value of Single Sum Using Tables Anna Wang deposits $5, 000 in an 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. What total amount will be in the account at the end of three years? ü Look down the 6 percent column of Table 1 to the 3 period row and find the factor of 1. 191. ü $5, 000 x 1. 191 = $5, 955 future value ü The answer is the same as the earlier calculation except for a rounding difference of $0. 08 Copyright © Houghton Mifflin Company. All rights reserved. 8– 36

Future Value an Ordinary Annuity An ordinary annuity is a series of equal payments

Future Value an Ordinary Annuity An ordinary annuity is a series of equal payments made at the end of equal intervals of time with compound interest on these payments Payment Year 1 Payment Year 2 Payment Year 3 ü Use the percentage interest and the number of payments to find the factor in the future value for ordinary annuity (Table 2). Copyright © Houghton Mifflin Company. All rights reserved. 8– 37

Present Value ü Way of valuing future cash flows ü Amount that must be

Present Value ü Way of valuing future cash flows ü Amount that must be invested today at a given rate to produce a given future value ü Present value and future value are closely related Sample Question Concerning Present Value and Future Value: You need $500 one year from now for tuition. How much do you need to invest today to generate that amount if the interest rate is 3 percent? Copyright © Houghton Mifflin Company. All rights reserved. 8– 38

Present Value of a Single Sum Due in the Future Don Riley wants to

Present Value of a Single Sum Due in the Future Don Riley wants to have $4, 000 at the end of three years. How much must he invest today in a 5 percent savings account to achieve this goal? Future value $4, 000 Year 1 Year 2 Year 3 Present value $3, 456 Using tables (table 3), the calculation is: Future Value × Factor = Present Value $4, 000 ×. 864 = $3, 456 Copyright © Houghton Mifflin Company. All rights reserved. 8– 39

Present Value of an Ordinary Annuity Kathy Casal sold a piece of property and

Present Value of an Ordinary Annuity Kathy Casal sold a piece of property and is to receive $15, 000 in three equal payments of $5, 000 beginning one year from today. What is the present value of this sale if the current interest rate is 5 percent? $5, 000 Year 1 $5, 000 Year 2 $5, 000 Year 3 Present value $13, 615 Using the table factor (Table 4), the calculation is: Periodic payment × Factor = Present Value $5, 000 × 2. 723 = $13, 615 Copyright © Houghton Mifflin Company. All rights reserved. 8– 40

How Is the Time Value of Money Used in Accounting? Valuing an asset: ü

How Is the Time Value of Money Used in Accounting? Valuing an asset: ü ü Deferred payment Investment of idle cash Accumulation of a fund for loan repayment Other applications Copyright © Houghton Mifflin Company. All rights reserved. 8– 41

Valuing an Asset ü An asset is something that will provide future benefits to

Valuing an Asset ü An asset is something that will provide future benefits to the company that owns it ü The purchase price of an asset represents the present value of these future benefits ü The purchase price is the present value of expected cash flows Copyright © Houghton Mifflin Company. All rights reserved. 8– 42

Evaluating the Proposed Purchase Price of an Asset Sam Hurst is thinking about buying

Evaluating the Proposed Purchase Price of an Asset Sam Hurst is thinking about buying a new machine that will reduce his annual labor cost by $700 per year. The machine will last for 8 years. The interest rate used for management decisions is 10 percent. What is the maximum amount Hurst should pay for the machine? The present value of the machine is equal to the present value of an ordinary annuity of $700 per year for 8 years at compound interest of 10 percent Using Table 4, the factor for 10 percent and 8 periods is 5. 335 Hurst should not pay more than $3, 734. 50 for the new machine. This amount equals the present value of the benefits that he will receive from owning the machine. 8– 43

Determining the Sales Price When Payment Is Deferred Plains Implement Corporation sells a tractor

Determining the Sales Price When Payment Is Deferred Plains Implement Corporation sells a tractor to Dana Washington for $50, 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 3, the factor for 1 percent and 10 periods is. 905 12% annual rate ÷ 12 months per year = 1 percent per month 12 months per year x 10/12 of a year = 10 months The sale price of the tractor is $45, 250 8– 44

Recording Deferred Sales The transaction is recorded in both the seller’s and purchaser’s books

Recording Deferred Sales The transaction is recorded in both the seller’s and purchaser’s books at the present value, $45, 250. Washington’s Journal (Purchaser) Plains’s Journal (Seller) Copyright © Houghton Mifflin Company. All rights reserved. 8– 45

Recording Deferred Sales When Washington pays for the tractor, the entries are as follows:

Recording Deferred Sales When Washington pays for the tractor, the entries are as follows: Washington’s Journal (Purchaser) Plains’s Journal (Seller) Copyright © Houghton Mifflin Company. All rights reserved. 8– 46

Accumulation of a Fund for Loan Repayment Aloha Corporation agrees to set aside cash

Accumulation of a Fund for Loan Repayment Aloha Corporation agrees to set aside cash at the end of each year to pay off a $100, 000 note due in 5 years. The fund is projected to earn 8 percent, compounded annually. What would be the amount of Aloha Corporation’s annual payments? The loan amount of $100, 000 is equal to the future value of the annual payments Using Table 2, the factor for 8 percent and 5 periods is 5. 867 The required annual payment to the fund is $17, 044 Copyright © Houghton Mifflin Company. All rights reserved. 8– 47