Libby, Libby and Short

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REPORTING and INTERPRETING LIABILITIES
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Business Background

• The acquisition of assets is financed from two
  sources

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Business Background

• The mix of debt and equity for a company is
  called the capital structure

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Business Background
Debt is considered more risky than equity.
Creditors can force bankruptcy.
Interest is a legal obligation.
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Business Background

• Financial Leverage - Borrowing at one rate and
  investing at a higher rate.

MIf we borrow 1,000,000 at 8 and invest it at
10, we will clear 20,000 profit!
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Liabilities Defined and Classified
Defined as probable future sacrifices of economic
benefits.
Maturity 1 year or less
Maturity gt 1 year
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Liabilities Defined and Classified

• Liabilities are measured at their current cash
  equivalent at the time of recording.
• i.e., the amount of cash the creditor would
  accept to cancel the debt.

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LiabilitiesQuestion
Devon Mfg. borrows 100,000 from First Bank. The
loan will be repaid in 20 years and has an annual
interest rate of 8. Is this a current liability
or a noncurrent liability?
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LiabilitiesQuestion
Devon Mfg. borrows 100,000 from First Bank. The
loan will be repaid in 20 years and has an annual
interest rate of 8. Is this a current liability
or a noncurrent liability?
The obligation will not be paid within one year
or one operating cycle, so it is a noncurrent
liability.
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LiabilitiesQuestion
Devon Mfg. borrows 100,000 from First Bank. The
loan will be repaid in 20 years and has an annual
interest rate of 8. How much will the liability
be recorded for on Devons books?
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LiabilitiesQuestion
Devon Mfg. borrows 100,000 from First Bank. The
loan will be repaid in 20 years and has an annual
interest rate of 8. How much will the liability
be recorded for on Devons books?
The current cash equivalent of the liability is
100,000.
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Evaluating Liquidity

• An important indicator of a companys ability to
  meet its current obligations.
• Two commonly used measures

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LiabilitiesQuestion
Devon Mfg. has current liabilities of 230,000
and current assets of 322,000. What is Devons
current ratio?
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LiabilitiesQuestion
Devon Mfg. has current liabilities of 230,000
and current assets of 322,000. What is Devons
current ratio?
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Current Liabilities
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Current Liabilities

• Accrued Payroll Payable
• Payroll earned by employees, but not yet paid.
• Record liabilities for withholdings from
  employees paychecks that must be forwarded to
  third parties.
• Record liabilities for employer-provided benefits.

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Current Liabilities
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Deferred Revenues and Service Obligations

• Cash is collected from the customer before the
  revenue is actually earned.

Cash is received in advance.
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Deferred Revenues and Service Obligations

• Cash is collected from the customer before the
  revenue is actually earned.

Deferred revenue is a liability account.
Cash is received in advance.
Deferred revenue is recorded.
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Deferred Revenues and Service Obligations

• Cash is collected from the customer before the
  revenue is actually earned.

As the earnings process is completed . . .
Cash is received in advance.
Earned revenue is recorded.
Deferred revenue is recorded.
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Deferred Revenues and Service Obligations -
Example

• On May 31, BIG CAR Magazine receives 120 for a
  12-month subscription. Year-end is December 31.
• How much revenue is recognized on December 31?

Cash is received in advance.
Earned revenue is recorded.
Deferred revenue is recorded.
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Deferred Revenues and Service Obligations -
Example

• On May 31, BIG CAR Magazine receives 120 for a
  12-month subscription. Year-end is December 31.

By Dec. 31, year-end, seven months of magazines
have been delivered.
Because subscription is collected in advance
120 of deferred revenue is recorded on May 31.
70 of magazine revenue is recorded on Dec. 31.
120 is received from customer.
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Current Liabilities
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Current Portion of Long-Term Payable

• Any portion of a note payable that is due within
  one year, or one operating cycle, whichever is
  longer.

Current Notes Payable
Total Notes Payable
Noncurrent Notes Payable
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Interest Payable

• Interest is the compensation to the lender for
  giving up the use of their money for a period of
  time.
• To the lender, interest is a revenue.

Interest Rates Up!
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Interest Payable

• Interest is the compensation to the lender for
  giving up the use of their money for a period of
  time.
• To the lender, interest is a revenue.
• To the borrower, interest is an expense.

Interest Rate Up!
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Interest Payable

• The interest formula includes three variables
  that must be considered when computing interest

Interest Principal Interest Rate Time
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Interest Payable

• The interest formula includes three variables
  that must be considered when computing interest

Interest Principal Interest Rate Time
When computing interest for one year, Time
equals 1. When the computation period is less
than one year, then Time is a fraction.
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Interest Payable

• The interest formula includes three variables
  that must be considered when computing interest

Interest Principal Interest Rate Time
For example, if we needed to compute interest for
3 months, Time would be 3/12.
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Interest Payable
Cyber Corp. borrows 300,000 for 6 months at an
annual interest rate of 9. Compute the interest
on the note for the loan period.
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Interest Payable
Cyber Corp. borrows 300,000 for 6 months at an
annual interest rate of 9. Compute the interest
on the note for the loan period.
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Long-Term Liabilities

• Creditors often require the borrower to pledge
  specific assets as security for the long-term
  liability.

Maturity 1 year or less
Maturity gt 1 year
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Long-Term Debt
Its going to take me years to pay for this
project!
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Sources for Long-Term Loans
Relatively small debt needs can be filled from
single sources.
or
or
Insurance Companies
Pension Plans
Banks
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Sources for Publicly Issued Debt
Large debt needs are often filled by issuing
bonds.
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Borrowing in Foreign Currencies

• When a company has operations in a foreign
  country, it often borrows in the local currency.
• Reduces exchange rate risk.
• Because interest rates vary from country to
  country, companies may borrow in the foreign
  market with the lowest interest rate.

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Borrowing in Foreign Currencies

• Exchange rates are published daily in the Wall
  Street Journal.
• Eurodollars are U.S. dollars that are deposited
  in the European banking system.
• The European Currency Unit is an index of 10
  European currencies that is used for borrowing.

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Deferred Taxes
The Internal Revenue Code is the set of rules for
preparing tax returns.
GAAP is the set of rules for preparing financial
statements.
Results in . . .
Results in . . .
Usually. . .
Financial statement income tax expense.
IRS income taxes payable.
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Deferred Taxes
The Internal Revenue Code is the set of rules for
preparing tax returns.
GAAP is the set of rules for preparing financial
statements.
Results in . . .
Results in . . .
Usually. . .
Financial statement income tax expense.
IRS income taxes payable.
The difference between tax expense and tax
payable is recorded in an account called deferred
taxes.
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Deferred Taxes - Example
Examine the December 31, 1999 information for
X-Off Inc.
X-Off uses straight-line depreciation for
financial reporting and accelerated depreciation
for income tax reporting. X-Offs tax rate is
30.
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Deferred Taxes - Example
Compute X-Offs income tax expense and income tax
payable.
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Deferred Taxes - Example
Compute X-Offs income tax expense and income tax
payable.
The income tax amount computed based on financial
statement income is income tax expense for the
period.
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Deferred Taxes - Example
Compute X-Offs income tax expense and income tax
payable.
Income taxes based on tax return income are the
taxes payable for the period.
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Deferred Taxes - Example
The deferred tax for the period of 36,000 is the
difference between income tax expense of 45,000
and income tax payable of 9,000.
Compute X-Offs income tax expense and income tax
payable.
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Accrued Retirement Benefits

• Two basic types of employer provided retirement
  plans.
• Defined contribution plans.
• Defined benefit plans.

Transfer of contributions
Pension payments
Employer
Retirement Plan Trustee
Retirees
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Accrued Retirement Benefits Defined Contribution
Plans

• Regular, defined payments to the fund.
• The fund balance changes in value with the
  accumulation of contributions and earnings.
• The employees retirement benefit is based on the
  fund balance available at retirement.

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Accrued Retirement Benefits Defined Benefit Plans

• Retirement benefits are defined by the company
  retirement plan.
• Contributions to the plan must be made so as to
  insure the availability of funds to pay the
  defined benefits.

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Contingent Liabilities

• Potential liabilities that arise because of
  events or transactions that have already
  occurred.
• When potential liabilities meet certain
  conditions, they must be reported in the
  financial statements.

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Contingent Liabilities
Amount . . .
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Contingent Liabilities
Requires a credit to a contingent liability
account and a debit to an estimated loss or
expense account.
Amount . . .
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Contingent Liabilities
Does not require a journal entry.
Amount . . .
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Contingent Liabilities
Amount . . .