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Bring your financial calculator to the next class session and following sessions.

Chapter 9: Liabilities
Definition of liability
Probable future sacrifice of resources Represents an existing obligation Based on a past event or transaction Liability recognition often depends on the degree of uncertainty that the liability will be paid.

Liability Recognition
Obligations with fixed payment dates and amounts have very low uncertainty of future cash payment. Recognized as liabilities Examples: Notes payable, Bonds payable Obligations with fixed payment amounts but estimated payment dates have slightly higher uncertainty. Recognized as liabilities Examples: Accounts payable, Taxes payable

Liability Recognition
Obligations for which company must estimate both timing and amount of payment. A bit higher uncertainty. Recognized as liabilities Examples: Warranties obligations; pension obligations Obligations under mutually unexecuted contracts (executory contracts). Higher level of uncertainty. Not recognized as liabilities Examples: Purchase commitments Employment commitments

Liability Recognition
Some contingent obligations (cash outflows dependent on some future event that may not occur) have a great deal of uncertainty (probability of future cash outflow is reasonably possible but not likely. ) Not recognized as liability, discussed in notes Examples: Unsettled lawsuits Environmental clean up costs * * However, if probability of future cash outflow is likely and the amount can be estimated, a liability must be recognized. We will discuss the treatment of various contingent obligations.

Contingent Liability Example

Exxon Valdez oil spill in 1989 Initially $5 billion in punitive damages Reduced to $2.5 billion on by Court of Appeals Reduced to $507.5 million by Supreme Court in 2008 19 years after the incident In addition, Exxon spent $3.4 billion for cleaning and compensation.

Current Liabilities
Obligations which will be paid within one year or the operating cycle, whichever is longer, are classified as Current Liabilities. Accounts Payable Accrued Liabilities (e.g., rent payable, interest payable) Income Taxes Payable Payroll Liabilities Unearned Revenues Note Payable Current Portion of Long-term debt

Current Portion of Long-Term Debt

Any portion of a note payable or bond liability that is due within one year, or one operating cycle, whichever is longer.
Total Notes Payable Current Notes Payable Noncurrent Notes Payable

Liabilities Example
On January 1, Year 1, Devon Mfg. borrows $25,000 cash from First Texas Bank and will repay the loan in three (3) equal payments of $10,053 per year each 12/31, beginning 12/31/Year 1. The loan has an annual interest rate of 10%.
At what amount should the loan be initially recognized on the balance sheet? 1/1/Yr 1 Cash 25,000 Note payable 25,000 What is the amount of the interest expense that will be recognized for the first year? How much of the note is a current liability on 12/31/Yr 1?

Liabilities Example: Year 1

On January 1, Year 1, Devon Mfg. borrows $25,000 cash from First Texas Bank and will repay the loan in 3 equal payments of $10,053 per year each 12/31, beginning 12/31/Year 1. The loan has an annual interest rate of 10%.

Interest expense for Year 1 Interest expense = beginning BV of note interest rate Year 1 interest expense = $25,000 10% = $2,500 12/31/Yr1 Interest expense Note payable Cash 2,500 7,553 10,053

Liability at 12/31/Yr1 = $25,000 - $7,553 = $17,447

How much is current and how much is noncurrent? Calculations below.

Liabilities Example: Year 1

Notes Payable 1/1/Yr1 12/31/Yr1 payment 7,553 12/31/Yr1 balance 17,447 25,000

Liabilities Example: Years 2 & 3

On January 1, Year 1, Devon Mfg. borrows $25,000 cash from First Texas Bank and will repay the loan in three (3) equal payments of $10,053 per year each 12/31, beginning 12/31/Year 1. The loan has an annual interest rate of 10%.

What is the amount of the interest expense that will be recognized for the second and third years? What is the total amount of interest that Devon will pay over the life of the loan?

Liabilities Example: Year 2

What is the amount of the interest expense that will be recognized for the second year? Interest expense = book value of the note interest rate Year 2 interest expense = ($25,000 - $7,553) 10% = $1,745 12/31/Yr2 Interest expense Note payable Cash 1,745 8,308 10,053

Liabilities Example: Year 2

Notes Payable 1/1/Yr1 12/31/Yr1 payment 12/31/Yr2 payment 7,553 12/31/Yr1 balance 8,308 12/31/Yr2 balance 9,139 17,447 25,000

Liabilities Example: Year 3

What is the amount of the interest expense that will be recognized for the third year? Interest expense = book value of the note interest rate Year 3 interest expense = ($25,000 $7,553 $8,308 ) 10% = $914 12/31/Yr3 Interest expense Note payable Cash 914 9,139 10,053

Liabilities Example: Year 3

Notes Payable 1/1/Yr1 loan 12/31/Yr1 payment 12/31/Yr2 payment 12/31/Yr3 payment 7,553 12/31/Yr1 balance 8,308 12/31/Yr2 balance 9,139 12/31/Yr3 balance -09,139 17,447 25,000

Long-term Liabilities
Long-term portion of: Long-term debt borrow from a bank or issue bonds Deferred Taxes Accrued Retirement Benefits (Pensions) Lease obligations (if a capital lease)

Lease Obligations Recognition

Operating lease no asset or liability recognized; lease payments are expensed when incurred Capital lease when lease agreement is signed and leased asset is received, recognize a leased asset and a lease liability on the balance sheet if any of the following criteria are met: 1. Lease term > 75% of useful life 2. Ownership transfers at end of lease term 3. Can purchase asset for a bargain price at end of lease term 4. Present value of lease payments > 90% of market value of asset

Lease Obligations Recognition

Operating lease when lease agreement is signed and leased asset is received, no asset or liability recognized; lease payments are expensed when incurred Capital lease when lease agreement is signed and leased asset is received, recognize the value of the leased asset (or, equivalently, the value of the lease obligation): Leased asset Lease obligation XX XX

Contingent Liabilities
Probability of future sacrifice . . . Reasonably Probable Possible Remote Can be Estimated
Record the contingent liability. Disclose the liability in the notes to the financial stmts. Disclose the est. liability in the notes to the financial stmts. Disclose the liability in the notes to the financial stmts. No action.

Amount . . .

Cannot be Estimated

No action.

Examples: Bad debts, warranties, pensions, litigation

Contingent Liability: Warranty Example

Jane s Music World makes sales of $280,000 during the accounting period and estimates that it will eventually use an amount equal to 4 percent of the sales revenue to satisfy warranty claims. Actual warranty expenditures during the period totaled $2,000. What entries should Jane s make related to the sales and the related warranty?

Warranty Example
During the year: Accounts receivable 280,000 Revenue 280,000 Warranty expense 2,000 Cash (or other assets)

2,000

At year end (adjusting entry): Total warranty expense = $280,000 x 4% = $11,200 Expense to be accrued = $11,200 $2,000 = $9,200 Warranty expense 9,200 Warranty liability 9,200

Current Ratio Chapter 2

Current assets Current ratio = Current liabilities
Measures ability of a company to pay its current obligations Liquidity Risk Netflix current ratio = 1.67 in 2008 (2.07 in 2007) Blockbuster current ratio = 1.00 in 2008 (1.02 in 2007)

Current Ratio
Current assets Current ratio = Current liabilities
$130,000 Suppose our current ratio is 1.3 = $100,000

How can we improve it? If we have an extra $30,000 in cash or highly liquid investments, we could pay off some current liabilities. And the current ratio would increase to: $100,000 1.43 =
$70,000

Quick Ratio Chapter 9

Cash + Marketable Securities + Accounts Receivable Current Liabilities
Another measure of the ability of a company to pay its current obligations very quickly Liquidity Risk Netflix quick ratio = 1.38 in 2008 (1.84 in 2007) Blockbuster quick ratio = 0.22 in 2008 (0.23 in 2007)

Accounts Payable Turnover

Cost of goods sold Accounts payable turnover = Average accounts payable
Measures how quickly a company pays its creditors. A decline in the ratio may indicate that the company is having trouble paying creditors.

Average Days AP Outstanding

= Average Accounts Payable Average Daily COGS = Avg AP (COGS/365) = 365 (Avg AP COGS)

= 365 AP Turnover

Accounts Payable Turnover

Netflix AP turnover = 9.09 Average days AP outstanding = 40 Blockbuster AP turnover = 5.70 Average days AP outstanding = 64

Present and Future Value Concepts

The

value of money changes over time because money can earn interest. The growth is a mathematical function of three variables:
The value today or amount invested. The growth rate, or interest rate. The length of time for growth.

Present and Future Value Concepts

Future

value concept

The sum to which an amount will increase as the result of compound interest. Compounding (adding in the interest)
Present

value concept

The current value of an amount to be received in the future. Discounting (backing out the interest)

Present and Future Value Concepts

Two types of cash flows can be involved
Single

payment

One payment that will grow over time.

Annuities

A series of equal payments that accumulate over time and that each earn interest.

Future Value of a Single Amount

How much will an amount invested today be worth in the future?

Present Value

Interest compounding periods

Future Value?

Today

Future Value of a Single Amount

How much will an amount today be worth in the future? Three pieces of information must be known to answer the question:
The current amount or present value: PV The interest rate: i The number of periods the amount will be invested: n

Future Value of a Single Amount

If we invest $1,000 today earning 10% interest, compounded annually, how much will it be worth in three (3) years? PV=($1,000), i = 10%, n = 3 FV = $1,331
$1,000 1.103 = $1,331 Year 1: $1,000 x 1.10 = $1,100 Year 2: $1,100 x 1.10 = $1,210 Year 3: $1,210 x 1.10 = $1,331

Present Value of a Single Amount

How much is a future amount worth today?
(discounting)
Interest compounding periods

Present Value?

Future Value

Today

Present Value of a Single Amount

How much is a future amount worth today? Three pieces of information must be known to solve a present value problem:
The future amount or future value: FV The interest rate: i The number of periods the amount will be invested: n

Present Value of a Single Amount

How much do we need to invest today at 10% interest, compounded annually, if we want to accumulate to $1,331 in three (3) years?

FV = $1,331, i = 10%, n = 3 PV = ($1,000) $1,331 1.103 = $1,000

Annuities
Equal payments each period Note that payments can be made at the beginning or end of a period (your calculator has a BEG or END option)
End of period called an ordinary annuity
Beginning of period an annuity due

Future Value of an Ordinary Annuity

Equal

payments are made each period. The payments and interest accumulate over time.

Interest compounding periods

Future Value?

Payment 1

Payment 2

Payment 3

Payment 4

Future value is computed on the date of the last payment.

Future Value of an Ordinary Annuity If we invest $1,000 each year on December 31 at interest of 10%, compounded annually, how much will we have on December 31, Year 3?
Interest compounding periods Future Value?

($1,000)

($1,000)

($1,000)

Future value is computed on the date of the last payment.

Future Value of an Ordinary Annuity

If we invest $1,000 each year on December 31 at interest of 10%, compounded annually, how much will we have on December 31, Year 3? PV=0, PMT=($1,000), n = 3, i = 10%, END FV = $3,310
Year 1: $1,000 Year 2: ($1,000 x 1.10) + $1,000 = $2,100 Year 3: ($2,100 x 1.10) + $1,000 = $3,310

Using END computes FV on date of last payment. Using BEG computes FV one period beyond last payment.

Future Value of an Annuity Due

Equal

payments are made each period. The payments and interest accumulate over time.

Interest compounding periods

Future Value?

Payment 1

Payment 2

Payment 3

Future value is computed one period after the last rent.

Future Value of an Annuity Due

If we invest $1,000 each year on January 1 at interest of 10%, compounded annually, how much will we have on December 31, Year 3?
Interest compounding periods Future Value?

($1,000)

($1,000)

($1,000)

Future value is computed one period after the last rent.

Future Value of an Annuity Due

If we invest $1,000 each year on January 1 at interest of 10%, compounded annually, how much will we have on December 31, Year 3? PV=0, PMT=($1,000), n = 3, i = 10%, BEG FV = $3,641
Year 1: $1,000 x 1.10 = $1,100 Year 2: ($1,100 + $1,000) x 1.10 = $2,310 Year 3: ($2,310 + $1,000) x 1.10 = $3,641

Using BEG computes FV one period beyond last payment. Using END computes FV on date of last payment.

Present Value of an Ordinary Annuity What is the value today of a series of payments to be received or paid out in the future?
Present Value? Interest compounding periods

Today

Payment 1

Payment 2

Payment 3

Present value is computed one period before the first payment.

Present Value of an Ordinary Annuity What is the present value on 1/1/Year 1 of receiving $1,000 each year at 12/31 for three years at interest of 10%, compounded annually?
Present Value? Interest compounding periods

Today

$1,000

$1,000

$1,000

Present value is computed one period before the first payment.

Present Value of an Ordinary Annuity

What is the present value on 1/1/Year 1 of receiving $1,000 each year at 12/31 for three years at interest of 10%, compounded annually? PMT = $1,000, i = 10%, n = 3, FV=0, END PV = ($2,487) Using END computes PV one period before first payment.

Present Value of an Annuity Due

What is the value today of a series of payments to be received or paid out in the future?
Present Value Interest compounding periods

Payment 1

Payment 2

Payment 3

Payment 4

Present value is computed on the date of the first payment.

Present Value of an Annuity Due

What is the present value on 1/1/Year 1 of receiving $1,000 each year at 1/1 (beginning immediately) for three years at interest of 10%, compounded annually?
Present Value Interest compounding periods

$1,000

$1,000

$1,000

Present value is computed on the date of the first payment.

Present Value of an Annuity Due

What is the present value on 1/1/Year 1 of receiving $1,000 each year at 1/1 (beginning immediately) for three years at interest of 10%, compounded annually? PMT = $1,000, i = 10%, n = 3, FV=0, BEG PV = ($2,736) Using BEG computes PV on date of first payment.

Practice Future Value

If $10,000 was invested today at a 10% rate of interest per year what would the amount be worth after 10 years? PV=($10,000), i=10%, PMT=0, n = 10 FV = $25,937

Practice Present Value

If $20,000 is to be received in 10 years, what is the value of the amount today assuming a 10% interest rate? FV = $20,000, i = 10%, PMT=0, n = 10 PV = ($7,711)

Practice FV of an Ordinary Annuity

If $5,000 is invested at the end of each year for 10 years at a 12% rate of interest what will the amount be worth at the end of the 10 years?
PV=0, PMT = ($5,000), i = 12%, n = 10, END FV = $87,744

Practice PV of an Ordinary Annuity

If you will receive $50,000 on 12/31 of each year for 3 years what is the value of this receivable on 1/1/Yr 1 assuming an 8% interest rate?
PMT = $50,000, i = 8%, n = 3, FV=0, END PV = ($128,855)

Practice Lump Sum vs Annuity

You won the lottery! The grand prize is $20 million, payable at $1 million per year for 20 years (assume at year-end). Or, alternatively, you can take an immediate payment of $12,462,200. You believe you can invest your winnings and earn 6% annually if you take the lump sum amount. What should you do?

Practice Lump Sum vs Annuity

You won the lottery! The grand prize is $20 million, payable at $1 million per year for 20 years (assume at year-end). Or, alternatively, you can take an immediate payment of $12,462,200. You believe you can invest your winnings and earn 6% annually if you take the lump sum amount. What should you do?

What interest rate are you earning if you take the long term payout?
PV = ($12,462,200), PMT = $1,000,000, n = 20, FV=0, END

i=5%
You should take the lump sum payment and invest at 6%.
With a 6% return, the lump sum would provide higher annual payments. PV = ($12,462,200), i = 6%, n = 20, END PMT = $1,086,511

Practice Ordinary Annuity

You are buying a house and its cost is $100,000. The bank charges an annual interest rate of 8%. If you want to pay the loan off over a period of 20 years (making equal payments at the end of each year), what is the amount of the yearly payment that will be made?

Practice Ordinary Annuity

You are buying a house and its cost is $100,000. The bank charges an annual interest rate of 8%. If you want to pay the loan off over a period of 20 years (making equal payments at the end of each year), what is the amount of the yearly payment that will be made?

PV = $100,000, i = 8%, n = 20, END, FV = 0 PMT = ($10,185)

Practice Installment Purchase [END]

ABC Company purchases a new machine for its business. The seller of the machine agrees to be paid over a 3 year period. Each payment is $2,000 and is made at the end of the year. Assume the market rate of interest is 14%. At what amount should the company record the machine in its books at the purchase date? {Cost Principle: Cash Equivalent Value} What amount of interest expense should be recognized in Year 1? Year 2?

Practice Installment Purchase [END]

PMT = ($2,000), i = 14%, n = 3, END, FV = 0 PV = $4,643 1/1/Yr1 Equipment 4,643 Note payable 4,643 Interest for year 1: $4,643 x 14% = $650 12/31/Yr 1 Interest expense 650 Note payable 1,350 Cash 2,000

Practice Installment Purchase [END]

Interest for year 2: ($4,643 $1,350) x 14% = $461 12/31/Yr 2 Interest expense Note payable Cash 461 1,539 2,000

Practice Installment Purchase [BEG]

ABC Company purchases a new machine for its business. The seller of the machine agrees to be paid over a 3 year period. Each payment is $2,000 and is made on 1/1, beginning on 1/1/Year 1. Assume the market rate of interest is 14%. At what amount should the company record the machine in its books at the purchase date? What amount of interest expense should be recognized in Year 1? Year 2?

Practice Installment Purchase [BEG]

PMT = ($2,000), i = 14%, n = 3, BEG, FV = 0 PV = $5,293 1/1/Yr1 Equipment 5,293 Cash 2,000 Note payable 3,293 Interest for year 1: $3,293 x 14% = $461 12/31/Yr 1 Interest expense 461 Note payable 461

Practice Installment Purchase [BEG]

1/1/Yr 2 Note payable Cash 2,000 2,000

Interest for year 2: ($3,293+$461-$2,000) x 14% = $246

12/31/Yr 2 1/1/Yr 3

Interest expense 246 Note payable 246 Note payable 2,000 Cash 2,000

Note payable balance is now $0.