Week 13, Chap 9Accounting 1A,

Financial Accounting

Reporting and Interpreting Liabilities

Instructor: Michael Booth

Understanding the Business

Debt is considered riskier than equity.

Interest is Interest is a legal a legal

obligation.obligation.

Creditors Creditors can force can force

bankruptcy.bankruptcy.

Define, measure, and report current liabilities.

Liabilities Defined and Classified

Defined as probable debts or obligations of the entity that result from past transactions, which will

be paid with assets or services.

Maturity = 1 year or less Maturity > 1 year

Current Liabilities

Noncurrent Liabilities

Liabilities Defined and Classified

Liabilities are measured at their

current cash current cash equivalentequivalent (the

amount a creditor would accept to

cancel the debt) at the time incurred.

Current Liabilities

Net Pay

Medicare Tax

State and Local Income

TaxesSocial

Security Tax

Federal Income Tax

Voluntary Deductions

Gross PayPayroll Taxes

Less Deductions:

Use the current ratio.

Current Ratio

Current RatioCurrent Ratio = Current Assets ÷ Current Liabilities

An important indicator of a company’s ability to meet its current obligations.

Starbucks has current assets of $924 and current liabilities of

$608.7.

StarbucksPanera Bread

Krispy Kreme

1.52 1.53 1.94

2003 Current Ratios

Analyze the accounts payable turnover ratio.

Accounts Payable Turnover Ratio

AccountsAccountsPayablePayable

Turnover Turnover

Measures how quickly management is paying trade accounts.

Starbucks has cost of goods sold of $1,685.9 and average accounts

payable of $152.5.

Cost of Cost of Goods Goods Sold Sold

Average Average Accounts Accounts Payable Payable

= =

÷÷

StarbucksPanera Bread

Krispy Kreme

11.00 9.29 N/A

2003 Accounts Payable Turnover RatiosDays = 365/11.06Days= 33

Report notes payable and explain the time value of money.

Notes Payable

Notes Payable

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

To the lender, interest is a revenue.To the borrower, interest is an expense..

Interest = Principal × Interest Rate × Time

When computing interest for one When computing interest for one year, “Time” equals 1. When the year, “Time” equals 1. When the computation period is less than computation period is less than

one year, then “Time” is a fraction.one year, then “Time” is a fraction.

Notes Payable

Starbucks borrows $100,000 for 2 months at an annual interest rate of 12%. Compute the

interest on the note for the loan period.

Learning Objectives

Compute present values.

Apply present value concepts to liabilities.

Present Value Concepts

Money can grow over time, Money can grow over time, because it can earn interest.because it can earn interest.

$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!

Present Value Concepts

The growth is a mathematical function of four variables:

1. The value today (present value).

1. The value in the future (future value).

1. The interest rate.1. The time period.

Present Value Concepts

Most analysts use calculators or Excel to solve time value of money problems.

Note: use of present value tables is also acceptable

Present Value Formula for Single Amount

P = F / (1 + r) ^n

Discount Factor = 1 / (1 + r) ^n

P = Present ValueF= Future Valuer = interest raten = number of periods

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.

Today

Present Value

Future

Future Value

Interest compounding periods

How much do we need to invest today at 10% interest,

compounded annually, if we need $1,331 in three years?

Present Value of a Single Amount

The required future amount is $1,331.i = 10% & n = 3 yearsUsing the present value of a single amount table (A.1), the factor is .7513.$1,331 × .7513 = $1,000 (rounded)

Present Values of an Annuity

An annuity is a series of consecutive equal periodic payments.

Today

Present Value Formula for multiple future payments Amount

P = C1 / (1 + r) ^1 + C2 / (1 + r) ^2 + C3 / (1 + r) ^3

+... Discount Factor = 1 / (1 + r) ^n

P = Present ValueF= Future Valuer = interest raten = number of periodsC = cash payment

Present Values of an Annuity What is the value today of a series of payments to be received or paid out in

the future?

Today

Present Value

Interest compounding periods

Payment 1 Payment 2 Payment 3

What is the present value of receiving $1,000 each year for three years at an

interest rate of 10%, compounded annually?

Present Values of an Annuity

The consecutive equal payment amount is $1,000.i = 10% & n = 3 yearsUsing the Present value of an annuity table,(A.2), the factor is 2.4869.$1,000 × 2.4869 = $2,486.90

Accounting Applications of Present Values

On January 1, 2006, Starbucks bought some new delivery trucks. The company signed a note

agreeing to pay $200,000 on December 31, 2007. The market interest rate for this note is 12%.

Let’s prepare the journal entry to record the purchase.

Interest 12%Future Value 200,000

=pv(rate,nper,pmt,fv)Present value 159,439$ Period 1 Interest 19,133$ Period 2 Interest 21,429$

Total 200,000$

Accounting Applications of Present Values

Now, let’s look at the journal entry at December 31, 2006.

Present Value × Interest Rate = Interest $159,440 × 12% = $19,133

Accounting Applications of Present Values

The journal entries at December 31, 2007(year 2).

Present Value × Interest Rate = Interest ($159,440 + $19,133) × 12% = $21,429

Present Value Computations Using Excel

Present Value Computations Using Excel

= Payment/(1 + i)^nPresent Value of A Single Amount Formula

Interest 12%Future Value 200,000Number of Periods 2

=pv(rate,nper,pmt,fv) Interest CalcPresent value 159,439$ Period 1 Interest 19,133$ =FV(rate,NPer,,159439)-159439Period 2 Interest 21,429$ =FV(rate,NPer,,178572)-178572

Total 200,000$

Report contingent liabilities.

Contingent Liabilities

Potential liabilities that arise because of events Potential liabilities that arise because of events or transactions that have already occurred.or transactions that have already occurred.

Importance of working capital and its impact on cash flows.

Working Capital Management

Changes in working capital accounts affect cash flows as indicated in the following

table.

Working CapitalWorking Capital = Current Assets - Current Liabilities

Report long-term liabilities.

Long-Term LiabilitiesCreditors often require the borrower to

pledgepledge specific assets as security for the long-term liability.

Maturity = 1 year or less Maturity > 1 year

Current Liabilities

Long-term Liabilities

Long-Term Notes Payable and Bonds

Relatively small debt needs can be filled from

single sources.

BanksBanksInsurance Insurance

CompaniesCompaniesPension Pension

PlansPlansoror

Long-Term Notes Payable and Bonds

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

CashBonds

Borrowing in Foreign Currencies

When a company has operations in a foreign country, it often borrows in the local currency. This reduces exchange rate risk.

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

Operating & Capital Leases

Operating vs. Capital lease Understand the rationale for leasing and the

distinction between operating and capital leases

Understand the income statement and the balance sheet differences between operating and capital leases from lessee’s perspective

The nature of leases A lease is an agreement conveying the right

to use property, plant or equipment usually for a stated period of time, in exchange for periodic cash payments

The owner of the property is referred to as the lessor, and the renter is the lessee

Economic substance of leases Operating lease

Lessee rents the property Lessee accrues rent expense

Capital lease Lessee economically owns the property Lessee records the leased asset in the balance

sheet (i.e. capitalizes the asset) and reflects the corresponding lease obligation

Economic Rational for lease Operational advantages to lease

Leasing ready-to-use equipment can be more attractive if the asset requires lengthy preparation and set-up

Leasing avoids having to own the asset that will be required only seasonally, temporarily or sporadically (leasing contract can be tailored)

Leasing for short periods protects against obsolescence But lease payments are accordingly higher

Economic Rationale for Leases Financial advantages to the leases

Lease payments can be tailored to suit the lessee’s cash flows (up to 100% financing, instead of the 80% limit by banks)

Properly structured leases may be “off-balance sheet”, avoiding debt-covenant restrictions

Leasing can be tax advantageous when the lessee is unable to take the depreciation tax advantage of owning

Disadvantages to Leasing Disadvantages to lessee

Leased ready-to-use equipment may be of lower quality than custom built (resulting in lower quality products and lower sales)

Seasonal leasing may affect equipment availability and pricing

Premium must be paid against obsolenscence Disadvantages to financial statement users:

Off-balance sheet financing can hide the true leverage (debt obligations) of the firm

Operating and Capital LeasesOperating

Lease

Short-term lease; No liability or asset

recorded

CapitalLease

Long-term lease; Meets one of 4

criteria; Results in recording an asset

and a liabilityCapital Lease Criteria1. Lease term is 75% or more of the asset’s expected economic life.2. Ownership of asset is transferred to lessee at end 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.

Accounting for operating leases(Lessee’s Ledger) An operating lease is recorded as a rental of an

asses in the financial statementsWhen the lease agreement is signed and the lessee

begins using the asset: A = L + SE (no entry)

During the Lease (as payments are made): Cash = L + Retained Earnings (PP) = (PP), as rent expense

PP = Periodic lease payment

Accounting for capital leasesLessee’s Ledger A capital lease is recorded as an asset acquisition with 100% debt

financing in the financial statementsWhen the lease agreement is signed and lessee begins using the

asset:

Leased Property = Lease Obligation PVL = PVL

During the lease (as payments are made)Cash + leased property – acc depr. = lease obligation + RE

- PP (PP – Int expense) - Int Exp - Depr. -Depr Expense

PVL = Present Value of LeasPP = Periodic lease paymentInt Exp = beginning lease liability * %int , where beginning lease liability = present value remaining payment at int%Depr. Expense = depreciation expense

Operating and Capital Leases:An Example Delta transactions if treated as an capital lease: Leased Property = Lease Obligation $30,000 = $30,000 When the lease agreement is signed and lessee begins using

the assetDuring the lease (as payments are made):

Y1 Cash - Acc Depr = Lease oblig + RE - $5060 -260 -4800 Int Exp 1500 -1500 Depr Exp (Depr=(30,000-0)/20) (Dec LO = 5060-4800) (Int = 30000 * 16%)

Y2 Cash - Acc Depr = Lease Oblig + Re -$5060 1500 -302 - 4758 int Exp

- 1500 Depr Exp (Dec LO = 5060 – 4758) (Int = (30,000-260) * 16%

Federal Income Tax Concepts

Federal Income Tax Concepts

CorporationsAre separate legal entities and

are required to pay income taxes.

Tax ObligationDetermined by multiplying

taxable income by the corporate tax rate.

Revenue and Expense Recognition for Income Tax

Purposes1. 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. Corporations that own less than 20% of another corporation’s stock may exclude 70% of the dividends received from taxable income, although all dividends are included in accounting income.

4. For tax purposes, depreciation expense is generally based on the Accelerated Cost Recovery System (ACRS) or on the Modified Accelerated Cost Recovery System (MACRS).

Tax Minimization Versus Tax Evasion

Assignments:

See web: http//www.cabrillo.edu/~mboothThis will be updated weekly as required

•Update your weekly journal for the Final Journal•Work weekly on your final project, do the analysis

with information learned during the week

Note: Use McGrawHill HOMEWORK manager to submit assignments