BIOM 121 1nd Edition Lecture 10 Outline of Last Lecture I Long lived assets a Acquisition i Example b Use Over Multiple Years i Methods ii Example II Disposal III Natural Resources IV Intangible assets V Current Liabilities Overview VI Short Term Notes Payable VII Discounted Notes Payable Outline of Current Lecture VIII Commitments IX Contingent Liabilities a Example X Quick Ratio XI Compound Interest a Example XII Compound Interest and Present Value of an Annuity a Example XIII Debt financing Vs Equity Financing Borrowing VS Ownership Current Lecture Current Liabilities Continued Commitments Unexecuted contract Is reported Contingent Liabilities Based on a past event Outcome is uncertain Common Examples of Contingencies These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute Lawsuits Product warranties and defects Embedded vs extended Guarantees of debts of others Accounting for contingent liabilities Record if Probable More than 50 likely to occur and amount can be estimated Means increase loss from lawsuit and increase lawsuit payable Footnote disclosure if Reasonable possible But not probable and or amount can t be reasonably estimated Remite disclosure not required If it is not probable Example 3 Warranty Expense Piper Company is a new company that sells sewing machines All machines are sold with a 4 yar warranty Based on engineering studies Piper estimates that its warranty costs will amount to approximately 6 of sales each year During 20X4 Piper s sales totaled 200 000 Determine the estimated warranty expense and the warranty liability that should appear on Piper s 20X4 financial statements Note Warranties are almost always probable Sale Warranty Estimated warranty Exp 200 000 0 06 12 000 Financial statement analysis Quick ratio Also called Acid Test Ratio Similar to current ratio Liquidity measurement More strict than Current ratio Current Ratio Current Assets Current Liabilities Quick Ratio Quick Assets Current Liabilities Quick Assets Cash Market securities Compound Interest and Long term Liabilities Time value of money concept idea that money received today is worth more than the same amount of money to be received in the future money received today can be invested to earn a return Simple interest interest is computed on the principal amount only interest is stated as an annual percentage rate I Principle P Annual Rate R Time T Compound interest interest is computed on both the principal and on previously earned interest that has not been paid or withdrawn the more frequently interest is compounded calculated and added to the principal the higher the effective interest rate SIMPLE VS COMPOUND INTEREST Assume you deposited 1 000 into First National Bank and another 1 000 into First State Bank First National pays 5 simple interest and First State pays 5 interest compounded annually No money is withdrawn until three years from the date of the initial deposit What is the balance of each account at the end of three years SIMPLE INTEREST COMPOUND INTEREST End of Interest calculation Balance Year 1 1000 05 50 1 050 1000 05 50 1 050 Year 2 1000 05 50 1 100 1050 05 52 50 1 102 50 Year 3 1000 05 50 1 150 1102 50 05 55 125 Total interest 150 Interest calculation Balance 1 157 625 Total interest 157 625 Future value is the amount an investment will be worth at some future date In accounting we often are concerned with determining present value Present value is the amount needed today to achieve some known future value or the value today of some known future amount The process of determining present value is called discounting CALCULATING PRESENT VALUE To calculate present value PV we must know 1 the amount to be paid or received in the future FV 2 the interest rate i 3 the number of periods of compounding n 1 We can use the following formula to calculate present value PV FV 1 1 i n Example 1 You want to buy a new car in three years and believe that you will need 20 000 at that time How much must you deposit today in an account earning 6 interest compounded annually to have 20 000 three years from today PV 20 000 1 1 0 06 3 20 000 1 1 191 20 000 0 8396 16 793 Example 2 You want to buy a new car in three years and believe that you will need 20 000 at that time How much must you deposit today in an account earning 6 interest compounded semi annually to have 20 000 three years from today Since compounded twice a year N 2 3 6 Rate I 0 06 2 0 03 Per 6 Month period PV 20 000 1 1 0 03 3 20 000 1 1 194 20 000 0 8375 16 750 2 Instead of using formulas to calculate present value difficult to do with a simple calculator we can use present value tables Present value tables are provided at the end of these notes PRESENT VALUE TABLES Tables have been developed to help in calculating present values Using the information from example 1 above we want to find the present value of an amount to be received in three years earning 6 compounded annually Solving the problem mathematically we multiply 20 000 by 1 1 i n or in this case 1 1 06 3 which equals 8396 Instead of calculating 1 1 i n we can use a present value table See Table 1 in the text page 10 A6 Looking across the columns for 6 then down to 3 periods we find the same amount 8396 The PV Factor PV FV PV Factor PRESENT VALUE OF AN ANNUITY Often business decisions involve a series of cash flows to be received or paid in the future An annuity is a series of equal payments made at regular intervals To find the present value of an annuity we could calculate the present value of each individual payment then sum the amounts Example 3 You are planning to begin college in one year and your grandparents want to give you 10 000 each year for the four years that you will be in school How much would they need to deposit today in a savings account paying 5 interest compounded annually so that they could withdraw exactly 10 000 each year for four years In this problem we need to find the present value of four payments of 10 000 each to be received at a different time in the future We could find the present value of each individual payment as shown below Year Amount Factor 1 10 000 1 1 05 9524 9 524 2 10 000 1 1 05 2 9070 9 070 3 10 000 1 1 05 3 8638 8 638 4 10 000 1 1 05 4 8227 8 227 Total present value Present value 35 459 Alternatively we could simply sum the present value factors and multiply In the example above 9524 9070 8638 8227 3 5459 Then 3 5459 10 000