FINANCIAL ACCOUNTING

1
Chapter 9 -- Liabilities Introduction

• FINANCIAL ACCOUNTING
• AN INTRODUCTION TO CONCEPTS,
• METHODS, AND USES
• 11th Edition

Clyde P. Stickney and Roman L. Weil
2
Learning Objectives

• 1. Understand and apply the concept of an
  accounting liability to obligations with
  uncertain payment dates and amounts.
• 2. Develop the skills to compute the issue
  price, book value, and current market value of
  various debt obligations in an amount equal to
  the present value of the future cash flows.
• 3. Understand the effective interest method and
  apply it to debt amortization for various
  long-term debt obligations.
• 4. Understand the accounting procedures for debt
  retirements, whether at or before maturity.

3
Chapter Outline

• 1. Basic concepts
• a. Liability recognition
• b. Contingencies potential liabilities
• c. Constructive liability
• d. Liability valuation
• e. Liability classification
• 2. Current liabilities
• a. Short-term notes and interest payable
• b. Wages payable and other payroll items
• c. Deferred performance liabilities advances
  from customers
• d. Deferred performance liabilities product
  warranties

4
Chapter Outline (cont.)

• 3. Long-term liabilities
• a. Procedures for recording long-term
  liabilities
• b. Mortgages and notes
• c. Contracts and long term notes interest
  imputation
• d. Bonds
• e. Unifying principles of accounting for
  long-term liabilities
• Chapter Summary
• Appendix 9.1 Effects on Cash Flow Statement of
  Transactions Involving Long-Term Liabilities

5
Basic Concepts of Liabilities

• a. Liability recognition -- when is the liability
  recorded?
• b. Contingencies potential liabilities -- under
  what conditions are potential contingencies
  booked as a liability?
• c. Liability valuation -- for what amount is the
  liability recorded?
• d. Liability classification
• Current liability
• Noncurrent liability

6
Discuss Liability Recognition

• An obligation is a liability if
• 1. It involves a probably future sacrifice of
  resources
• 2. There is little or no discretion to avoid the
  transfer
• 3. The transaction or event that gives rise to
  the obligation has already occurred
• A mutual promise (or executory contract) is not a
  liability because of item 3 above.

7
Discuss Liability Recognition (cont.)

• An example of a mutual promise is the customer
  promises to pay and the firm promises to deliver
  goods at a date. If this promise is in the form
  of a legal contract, it may give both parties
  rights but the rights are not yet considered
  assets and the obligations are not yet considered
  liabilities.

8
Exhibit 9.1 -- Classifications of Accounting
Liabilities by Degree of Certainty
most certain
least certain
Not generally recognized as accounting liabilities
Recognized as accounting liabilities
9
Define Contingencies Potential Liabilities

• Contingent liabilities are potential liabilities.
• The more probable the potential to become a legal
  obligation, the greater the rationale for
  recognizing it as a liability.
• Probability of a potential liability is very
  difficult to measure.
• In general, an obligation should be recognized as
  a liability if it is probable that the firm will
  have make future sacrifices of resources.

10
Contingencies Potential Liabilities (cont.)

• Of course, the word probable is also difficult to
  measure.
• FASB and IASC require the recognition of a loss
  and a contingent liability when
• It is probable that an asset has been impaired or
  a liability incurred, and
• The amount of the loss can be reasonably
  estimated.

11
What is a constructive liability?

• New concept not yet finalized by FASB.
• A constructive liability arises not from an
  obligation, but from management intent.
• A firm may record a liability based on future
  plans (or intent).
• This gives management a lot of flexibility in
  reporting because they may easily change their
  intent.

12
What is a constructive liability? (cont.)

• Example Management makes a decision to close a
  plant. At the time of the decision and before
  any actual transaction, management may decide to
  record the cost of the plant closing as a
  liability.

13
Comment on Liability Valuation

• In general, liabilities are presented on the
  balance sheet at the present value of payments
  needed to fulfill the obligation.
• Present value refers to discounting the nominal
  payments by an interest rate appropriate for the
  firm.
• Discounting is a mathematical computation whereby
  future flows are reduced to reflect the concept
  that money has time value. (See Appendix A at
  the back of the text.)
• Current liabilities are not generally discounted
  because of the short period of time until they
  are to be resolved. The short period of time
  would cause the amount of any discount to be
  small enough to be considered immaterial.

14
Discuss Liability Classification

• Liabilities are separated into current and
  noncurrent based on the length of time that will
  elapse before the obligation must be fulfilled.
• Current liabilities are obligations that must be
  fulfilled within the current operating cycle
  which is almost always one year.
• Noncurrent liabilities are obligations that need
  not be fulfilled within the current operating
  cycle.
• Obligations calling for periodic payments such as
  a mortgage may be noncurrent but have a current
  portion that is, the payments due within the
  operating cycle are current but the remaining
  payments are noncurrent.

15
Review Current Liabilities

• a. Accounts payable
• b. Short-term notes and interest payable
• c. Wages, salaries and other payroll items
• d. Income taxes payable
• e. Deferred performance liabilities advances
  from customers
• f. Deferred performance liabilities product
  warranties

16
Define Accounts Payable to Creditors

• Business firms often buy and sell to each other
  on credit.
• Amounts owed to other businesses for services or
  goods are called trade accounts payable.
• Typically these are short-term liabilities.
• Typically, a payment grace period is allowed
  before these obligations must be fulfilled (or
  paid).
• A grace period may be 30 days or more.

17
Define Accounts Payable to Creditors (cont.)

• Because such a grace period represents
  interest-free borrowing, the prudent firm takes
  advantage by paying exactly on time but not
  before.
• Rarely, a firm is more aggressive and always pays
  late, but a late charge may be assessed and such
  a firm will develop a reputation which may affect
  the terms they can negotiate.

18
What are short-term notes and related interest
payable?

• A note payable is a form of short term borrowing.
• The note accrues interest at a stated rate over
  time.
• The total amount of the note and the interest may
  be due as one payment upon maturity of the note,
• Or periodic payment may be required.

19
What are short-term notes and related interest
payable? (cont.)

• The journal entry for a cash payment of a note
  requires that first the interest payable be
  calculated based on the interest rate and the
  time interest accrued (typically a fraction of a
  year for notes).

20
Discuss Wages, Salaries and Other Payroll Items

• Employers pay workers directly in cash and in the
  form of benefits -- this gives rise to payroll
  expense (or work-in-process if a manufacturing
  firm).
• For example, vacation time may be earned over
  time. The firm pays taxes on this benefit as it
  is earned and a liability to the worker is
  recorded. When vacation is taken, the liability
  is reduced.

21
Discuss Wages, Salaries and Other Payroll Items
(cont.)

• Employers also pay some taxes that relate to the
  workers -- these are tax expenses.
• Also, employers serve as collector of some taxes,
  union dues and insurance payments -- these are
  not transactions of the firm and should not be
  included in the financial statements, however,
  the firm must keep careful records and does
  maintain accounts payable to the government,
  union or insurance company.

22
Comment on Income Taxes Payable

• U.S. and most countries tax business income.
• Corporations are taxed directly.
• Partnerships and sole proprietorships are not
  taxed but the income is assigned to the partners
  or proprietor who must then pay the tax.
• Income taxes are assumed to accrue that is, the
  income tax liability increases as the firm earns
  income.
• Tax rules also call for periodic payments to the
  IRS.

23
Comment on Income Taxes Payable (cont.)

• So that business income taxes are estimated and
  paid throughout the year.
• The annual filing deadline is a reporting
  deadline and not a payment deadline payment in
  many cases is required earlier.
• In addition, GAAP allows for differences between
  income tax expense (an accrual concept) and
  income tax liability (the amount owed to IRS).
  This is covered in a later chapter under deferred
  tax accounting.

24
Review Deferred Performance Liabilities
Advances from Customers

• A mutual promise (the customer promises to pay
  and the firm promises to deliver) is not
  recorded.
• However, if the customer pays in advance, then
  there is an obligation that arises and the firm
  records this as an increase in an asset (cash)
  and an increase in a liability (advances from
  customers).

25
Review Deferred Performance Liabilities
Advances from Customers (cont.)

• The obligation is for the firm to either fulfill
  its promise to deliver goods or services within
  the specifications of the contract or return the
  cash.
• An example is a magazine subscription which is
  typically paid in advance. The subscription is
  an obligation to produce and deliver the
  magazine. When a magazine is delivered, the
  obligation can be reduced (debited) and revenue
  can be recognized (credited) because it is then
  earned.

26
Define Deferred Performance Liabilities Product
Warranties

• A warranty is a promise to repair or replace the
  good but is limited by time.
• When goods with a warranty are sold revenue, the
  warranty expense, and the warranty liability are
  recognized. The amount of the liability must be
  estimated.

27
Define Deferred Performance Liabilities Product
Warranties (cont.)

• When a claim is made, the warranty liability is
  reduced (debited) and what is given to fulfill
  the claim (cash or new goods or parts and labor)
  are credited.
• Any unused portion of the warranty expires at the
  end of the warranty period reducing the liability
  and creating a gain.

28
Long-Term Liabilities

• a. Procedures for recording long-term liabilities
• b. Mortgages and notes
• c. Contracts and long-term notes interest
  imputation
• d. Bonds
• e. Unifying principles of accounting for
  long-term liabilities

29
Review Procedures for Recording Long-Term
Liabilities

• Whereas short term liabilities may be paid at
  maturity, long-term liabilities are more commonly
  paid in installments.
• Also, the general rule is that long-term
  liabilities are recorded at the present value of
  the payments.
• The accountant distinguishes between payment of
  the liability (the principle) and payment of
  interest (an expense of financing).

30
Review Procedures for Recording Long-Term
Liabilities (cont.)

• Commonly, the principle, the periodic payments
  and the interest rates are explicitly stated in
  the debt contract.
• If not, then discounted cash flow methods may be
  used to separate out the interest payment.
• The rate of interest that equated the present
  value of a given set of periodic payments with
  the principle is called the internal rate of
  return. (See Appendix A.)

31
Discuss Mortgages and Notes

• Mortgages follow the general rule for long-term
  liabilities.
• A mortgage contract typically allows some
  recourse to the lender in the event of default
  this might be a lien on property or collateral.
• When the loan is made, the firm receives cash and
  a liability is created, mortgage payable. The
  liability is recorded at the present value of the
  periodic payments.

32
Discuss Mortgages and Notes (cont.)

• As periodic payments are made cash is returned,
  the liability is reduced and interest expense is
  recognized using discounted cash flow methods.
• The convention presently in the U.S. for
  mortgages calls for equal payments over the life
  of the loan. Since the liability decreases over
  the life of the loan, the interest expense also
  decreases and a greater amount of cash goes to
  reducing the principle.

33
Exhibit 9.2 -- Mortgages (Cont.)

• Consider a 5 year mortgage for 125,000 to be
  repaid in 10 installments of 17,000 per semester
  with 12 percent interest compounded semiannually.
• The repayment schedule is given below.
• Notice that even though the cash payments are
  equal the balance owed and the interest expense
  decrease over time. The last payment is a little
  less than 17,000 due to rounding effects.

34
Exhibit 9.2 -- Mortgages (Cont.)
35
Review Contracts and Long-Term Notes Interest
Imputation

• Some contracts do not explicitly state interest
  payments, instead the purchase price may include
  carrying charges.
• There is no economic concept of an interest-free
  loan. The interest may not be expressed, but it
  is there.
• The IRS agrees and will require the tax payer to
  calculate interest payments even if the contract
  does not specifically state a rate of interest
  (called implicit or imputed interest).

36
Review Contracts Long-Term Notes Interest
Imputation (cont.)

• GAAP agrees and requires that long term
  liabilities be recorded at their present value
  and that repayments be separated into interest
  expense and reduction of the liability.
• Where interest rates are not stated, they can be
  computed using present value methods and using
  the know payments with
• An estimate of market value (which becomes the
  PV), or
• An estimate of the interest rate for similar debt.

37
Define and Discuss Bonds

• Bonds are debt instruments similar to a mortgage
  except mortgages are generally issued by banks
  while bonds are sold to the investing public.
• Some bonds carry no collateral and are called
  debenture bonds.
• Bonds backed by collateral are called collateral
  trust bonds.
• Bonds are recorded as a long-term liability.

38
Define and Discuss Bonds (cont.)

• The periodic payments for a bond are intended to
  be only for the interest at the rate that is
  given by the bond contract (called the face rate
  of interest). The principal is repaid in total
  at the maturity of the bond.
• The holder has rights to two cash inflows
  periodic interest payments and a lump sum
  repayment of the principal at maturity.
• The present value of a bond is the sum of the PV
  of the interest payments plus the PV of the
  maturity payment.

39
Bonds -- Define a Premium

• While bonds are intended to be issued for exactly
  the amount of the principal with interest paid at
  exactly the face rate, changing markets cause the
  bond to change in value during the short interval
  of time after the face rate is set and before the
  bond goes to market.
• If demand for the bond is great, the price may
  rise as people bid up the price. Such a bond is
  said to have sold at a premium.

40
Bonds Define a Discount

• If demand for the bond is less, the price may
  have to be reduced to encourage buyers. Such a
  bond is said to have sold at a discount.
• A premium or discount changes the amount of cash
  the bond issuer receives.
• Since the principal of the bond is changed, the
  actual interest rate is also changed because cash
  payments are based on the face rate, not the
  market rate.

41
Discount or Premium Example

• Consider a 20-year bond for 250 which pays
  periodic interest payment at 10 semiannually.
• The purchaser of such a bond gets 40 equal
  payments of 12.5 plus a return of the principal
  (250) at the end.
• An economically rational purchaser would pay 250
  for this bond only if he or she required exactly
  10 return on his or her investment given the
  risks.

42
Discount or Premium (Cont.)

• If the rational investor required a greater
  return, he or she might still be willing to buy
  the bond at a reduced price (a discount).
• If the rational investor required less return, he
  or she might be willing to pay more (a premium).

buy bond 12.5 12.5 12.5 12.5 .
25012.5 0 1 2 3 4 . 40
43
Discount or Premium

• Consider a 15-year bond which pays semiannual
  interest payment of 13.1 and no extra payment in
  the last year.
• Consider that the purchaser required 10 annual
  return.
• How much should he or she pay so that the return
  on the bond is exactly 10?

44
Discount or Premium (cont.)

• The rate of return can be solved using present
  value calculations
• PV(bond) PV(annuity) periodic payment ?
  present value factor
• where the present value factor for 30 periods
  and 5 percent per
• period is 15.372
• PV(bond) 13.1 ? 15.372 201.4 price of the
  bond

45
Discuss Unifying Principles of Accounting for
Long-Term Liabilities

• Long-term liabilities obligate the borrowing firm
  to pay specified amounts at definite times more
  than one year in the future.
• All long-term liabilities appear on the balance
  sheet at the present value of the remaining
  future payments.

46
Discuss Unifying Principles of Accounting for
Long-Term Liabilities (cont.)

• Process
• 1. Record the liability at the cash or
  cash-equivalent value received. This amount is
  the present value of the liability.
• 2. At any subsequent time when the firm makes a
  cash payment or an adjusting entry for interest,
  it computes interest as the book value of the
  liability multiplies by the interest rate (not
  necessarily the face rate of interest).

47
Chapter Summary

• A liability obligates a firm to make a probably
  future sacrifice of resources.
• Conditions to record a liability are (1) it is a
  probability and (2) the amount can reasonably be
  estimated.
• Current liabilities are obligations due within
  the current accounting cycle and are recorded at
  actual cash value that is, not discounted.

48
Chapter Summary (cont.)

• Long-term liabilities are recorded at the present
  value of future payments. Periodic payments
  reduce the liability. Periodic adjusting entries
  recognize interest expense.
• Bonds are special debt instruments that require
  present value calculations in order to compute
  the liability.

49
Appendix 9.1 Effects on Cash Flow Statement of
Transactions Involving Long-Term Liabilities

• Recognizing interest expense on bonds issued at
  less than par (or face value) may require special
  treatment in computing cash flows from
  operations.
• When a firm retires a bond for cash, it reports
  that cash in the financing section as a
  nonoperating use, Cash Used to Reduce Debt. In
  most cases, the amount of cash the firm uses to
  retire a liability differs from the book value of
  the liability at the time of retirement. In such
  cases, an adjusting entry is required to adjust
  for accrued interest.

50
Appendix 9.1 Effects on Cash Flow Statement of
Transactions Involving Long-Term
Liabilities(cont.)

• In addition, a realized gain or loss may occur if
  there are penalties for early retirement or if
  the bond can be retired at a discount (early
  extinguishment of debt).