Current Liabilities, Contingencies, and the Time Value of Money

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Chapter 9
Current Liabilities, Contingencies, and the Time
Value of Money
Financial Accounting, Alternate 4e by Porter and
Norton
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McDonald's Corporation2002 Consolidated Balance
Sheet (partial)
Listed in order of liquidity
(in millions)

• Liabilities and shareholders' equity
• Current liabilities
• Notes payable .3
• Accounts payable 635.8
• Income taxes 16.3
• Other taxes 191.8
• Accrued interest 199.4
• Accrued restructuring and restaurant
• closing costs 328.5
• Accrued payroll and other liabilities 774.7
• Current maturities of long-term debt
  275.5
• Total current liabilities 2,422.3

Require payment within one year
3
Selected 2002 Liquidity Ratios

• Current Quick
• Ratio Ratio
• Georgia-Pacific 1.16 0.64
• J. C. Penney 2.00 0.76
• Johnson Controls 1.03 0.82
• McDonald's 0.71 0.49
• Pfizer 1.34 1.09

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Accounts Payable

• Purchase of inventory, goods or services on credit

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Promissory Note
I promise to pay 1,000 plus 12 annual interest
on December 31, 2004. Date January 1,
2004 Signed_________
Lamanski Co.
S.J.Devona
Total repayment 1,120 1,000 (1,000 x 12)
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Discounted Promissory Note
Effective interest rate on note 13.6 (120
interest / 880 proceeds)
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Balance Sheet Presentation of Discounted Notes
Discount transferred to interest expense over
life of note

• 1/1/04 12/31/04
• Notes Payable 1,000 1,000
• Less Discount on
• Notes Payable 120 - 0 -
• Net Liability 880 1,000

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Current Maturities of Long-Term Debt

• Principal repayment on borrowings due within one
  year of balance sheet date

Due in upcoming year
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Taxes Payable

• Record expense when incurred not when paid

12/31/04
3/15/05
Record 2004 tax expense
Taxes Paid
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Current Liabilities on the Statement of Cash
Flows

• Operating Activities
• Net income xxx
• Increase in current liability
• Decrease in current liability
• Investing Activities
• Financing Activities
• Increase in notes payable
• Decrease in notes payable

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Contingent Liability

• Obligation involving existing condition
• Outcome not known with certainty
• Dependent upon some future event
• Actual amount is estimated

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Contingent Liability

• Accrue estimated amount if
• Liability is probable
• Amount can be reasonably estimated

Record in year criteria are met Assets
Liab. O/E Rev. Exp.
Est. Liab. For Warranty Exp.
10,000 Warranty 10,000
Balance Sheet
Income Statement
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Typical Contingent Liabilities

• Warranties
• Premium or coupon offers
• Lawsuits

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Recording Contingent Liabilities
Example

• Quickkey Computer sells a computer product for
  5,000 with a one-year warranty. In 2004, 100 of
  these products were sold for a total sales
  revenue of 500,000.
• Analyzing past records, Quickkey estimates that
  repairs will average 2 of total sales.

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Recording Contingent Liabilities
Probable liability has been incurred? Amount
reasonably estimable?
YES
YES
Record in 2004
Estimated Liability for Warranty 100,000
Warranty Expense 100,000
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Disclosing Contingent Liabilities
IF not probable but reasonably
possible OR amount not estimable
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Contingent Assets

• Contingent gains and assets are not recorded but
  may be disclosed in footnotes

• Conservatism principle applies

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Time Value of Money

• Prefer payment now vs. in future due to interest
  factor

• Applicable to both personal and business decisions

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Simple Interest
I P x R x T
Dollar amount of interest per year
Time in years
Principal amount
Interest rate as a percentage
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Example of Simple Interest
Given following data principal amount
3,000 annual interest rate
10 term of note 2
years Calculate interest on the note.
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Example of Simple Interest
Given following data principal amount
3,000 annual interest rate
10 term of note 2
years Calculate interest on the note. P x R
x T 3,000 x .10 x 2 600
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Compound Interest

• Interest is calculated on principal plus
  previously accumulated interest

Compounding can occur annually, semi-annually,
quarterly, etc.
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Example of Compound Interest
Given following data principal amount
3,000 annual interest rate
10 term of note 2
years semiannual compounding of interest
Calculate interest on note.
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Compound Interest Periods
Year 1 Year 2 10 annually 10
annually
5 5 semiannually
5 5 semiannually
4 periods _at_ 5 semi-annual interest
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Example of Compound Interest
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Comparing Interest Methods
Simple annual interest 3,000 x .10 x
2 600 Semiannual compounding 1
150 2 158 3 165
4 174 Total 647
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Compound Interest Computations
Present value of a single amount
Future value of a single amount
Present value of an annuity
Future value of an annuity
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Future Value of Single Amount
Known amount of single payment or deposit
Future Value
Interest
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Future Value of a Single Amount Example

• If you invest 10,000 today _at_ 10 compound
  interest, what will it be worth 3 years from now?

invest 10,000
Future Value?
Yr. 1
Yr. 2
Yr. 3
Interest _at_ 10 per year
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Future Value of a Single Amount Example - Using
Formulas
n FV p (1 i) 3 10,000
(1.10) 13,310
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Future Value of a Single Amount Example - Using
Tables
Yr. 1
Yr. 2
Yr. 3

• FV Present Value x FV Factor
• 10,000 X (3 periods _at_ 10)

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Future Value of 1

• (n) 2 4 6 8 10
• 1 1.020 1.040 1.060 1.080 1.10
• 2 1.040 1.082 1.124 1.166 1.210
• 3 1.061 1.125 1.191 1.260 1.331
• 4 1.082 1.170 1.262 1.360 1.464
• 5 1.104 1.217 1.338 1.470 1.611
• 6 1.126 1.265 1.419 1.587 1.772
• 7 1.149 1.316 1.504 1.714 1.949
• 8 1.172 1.369 1.594 1.851 2.144

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Future Value of a Single Amount Example - Using
Tables
Yr. 1
Yr. 2
Yr. 3
10,000 PV
FV 13,310

• FV Present Value x FV Factor
• 10,000 X (3 periods _at_ 10)
• 10,000 X 1.331
• 13,310

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Present Value of Single Amount
Known amount of single payment in future
Present Value
Discount
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Present Value of a Single Amount Example

• If you will receive 10,000 in three years, what
  is it worth today (assuming you could invest at
  10 compound interest)?

Present Value?
10,000
Yr. 1
Yr. 2
Yr. 3
Discount _at_ 10
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Present Value of a Single Amount Example - Using
Formulas
-n PV payment x (1 i) -3
10,000 x (1.10) 7,513
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Present Value of a Single Amount Example - Using
Tables
Yr. 1
Yr. 2
Yr. 3

• PV Future Value x PV Factor
• 10,000 X (3 periods _at_ 10)

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Present Value of 1

• (n) 2 4 6 8 10
• 1 .9804 .9615 .9434 .9259 .9090
• 2 .9612 .9246 .8900 .8573 .8265
• 3 .9423 .8890 .8396 .7938 .7513
• 4 .9238 .8548 .7921 .7350 .6830
• 5 .9057 .8219 .7473 .6806 .6209

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Present Value of a Single Amount Example - Using
Tables
Yr. 1
Yr. 2
Yr. 3
PV 7,513
FV10,000

• PV Future Value x PV Factor
• 10,000 X (3 periods _at_ 10)
• 10,000 X .7513
• 7,513

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Future Value of an Annuity
Periods
1 2 3 4
0 3,000 3,000 3,000 3,000
Interest
Future Value?
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Future Value of Annuity Example

• If we invest 3,000 each year for four years at
  10 compound interest, what will it be worth 4
  years from now?

Yr. 1 Yr. 2 Yr. 3 Yr. 4
0 3,000 3,000 3,000
3,000
FV ??
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Future Value of Annuity Example
Yr. 1 Yr. 2 Yr. 3 Yr. 4
0 3,000 3,000 3,000
3,000
FV ??

• FV Payment x FV Factor
• 3,000 x (4 periods _at_ 10)

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Future Value of Annuity of 1

• (n) 2 4 6 8 10 12
• 1 1.000 1.000 1.000 1.000 1.000
  1.000
• 2 2.020 2.040 2.060 2.080 2.100 2.120
• 3 3.060 3.122 3.184 3.246 3.310 3.374
• 4 4.122 4.246 4.375 4.506 4.641 4.779
• 5 5.204 5.416 5.637 5.867 6.105 6.353

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Future Value of Annuity Example
FV 13,923

• FV Payment x FV Factor
• 3,000 x (4 periods _at_ 10)
• 3,000 x 4.641
• 13,923

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Present Value of an Annuity
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Present Value of an Annuity Example

• What is the value today of receiving 4,000 at
  the end of the next 4 years, assuming you can
  invest at 10 compound annual interest?

PV ??
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Present Value of an Annuity Example

• PV Payment x PV Factor
• 500 x (4 periods _at_ 10)

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Present Value of Annuity of 1

• (n) 2 4 6 8 10
• 1 0.980 0.962 0.943 0.926 0.909
• 2 1.942 1.886 1.833 1.783 1.735
• 3 2.884 2.775 2.673 2.577 2.487
• 4 3.808 3.630 3.465 3.312 3.170
• 5 4.713 4.452 4.212 3.992 3.791

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Present Value of an Annuity Example
Yr. 1 Yr. 2 Yr. 3 Yr. 4
0 4,000 4,000 4,000 4,000
P.V. 12,680

• PV Payment x PV Factor
• 4,000 x (4 periods _at_ 10)
• 4,000 x 3.170
• 12,680

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Solving for Unknowns

• Assume that you have just purchased a new car for
  14,420. Your bank has offered you a 5-year
  loan, with annual payments of 4,000 due at the
  end of each year. What is the interest rate
• being charged
• on the loan?

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Solving for Unknowns
Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5
discount discount discount discount
discount PV 14,420

• PV Payment x PV factor
• PV factor PV / Payment

rearrange equation to solve for unknown
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Solving for Unknowns
Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5
discount discount discount discount
discount PV 14,420

• PV factor PV / Payment
• 14,420 / 4,000
• 3.605

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Present Value of an Annuity Table

• (n) 10 11 12 15
• 1 0.909 0.901 0.893 0.870
• 2 1.736 1.713 1.690 1.626
• 3 2.487 2.444 2.402 2.283
• 4 3.170 3.102 3.037 2.855
• 5 3.791 3.696 3.605 3.352

PV factor of 3.605 equates to an interest rate of
12.
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Appendix A

• Accounting Tools
• Payroll Accounting

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Calculation of Gross Wages

• Hourly
• Multiply the number of hours worked times
  employees hourly rate
• Salaried
• Paid at a flat rate per week, month, or year,
  regardless of hours

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Calculation of Net Pay

• Gross wages
• - Income tax (federal, state, local)
• - FICA
• - Voluntary deductions
• (includes health insurance, retirement
  contributions, savings plans, charitable
  contributions, union dues)
• Net pay

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Employer Payroll Taxes

• Not deducted from paycheck employer pays taxes
  per employee, in addition to salary
• FICA employers share
• Unemployment tax

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Payroll Accounting

Example
Gross wages for Kori Company for July are
100,000. The following amounts have been
withheld from employees paychecks Kori
Companys unemployment tax rate is 6. Show the
effects of these transactions on the accounting
equation.
Income Tax 20,000 FICA 7,650 United
Way contributions 5,000 Union dues 3,000
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Payroll Accounting

• Record July salary and deductions
• Assets Liab. O/E Rev.
  Exp.
• Salary Pay. 64,350
  Salary Exp. (100,000)
• Inc. Tax Pay. 20,000
• FICA Pay. 7,650
• United Way Pay. 5,000
• Union Dues Pay. 3,000

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Payroll Accounting

• Record payment of employee salaries
• Assets Liab. O/E Rev.
  Exp.
• Cash (64,350) Salary Pay. (64,350)
• Record employers payroll taxes
• Assets Liab. O/E Rev.
  Exp.
• FICA Pay. 7,650
  Payroll Tax Exp. (13,650)
• Unemploy.
• Tax Pay. 6,000

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Compensated Absences

• Employee absences for which the employee will be
  paid
• Vacation, illness, holidays
• Accrued as a liability if
• The services have been rendered
• The rights (days) accumulate
• Payment is probable and can be reasonably
  estimated

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Appendix B

• Accounting Tools
• Using Excel for Problems Involving Interest
  Calculations

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Using Excel Functions

• Many functions built into Excel, including PV and
  FV calculations
• Click on Paste or Insert button for list

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FV Function in Excel
Example

• Find the FV of a 10 note payable for 2,000,
  due in 2 years and compounded annually

Answer 2,420
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PV Function in Excel
Example

• How much should you invest now at 10
  (compounded annually) in order to have 2,000 in
  2 years?

Answer 1,653 (rounded)
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End of Chapter 9