BIOM 121 1nd Edition Lecture 10 Outline of Last Lecture I. Long-lived assetsa. Acquisitioni. Exampleb. Use Over Multiple Yearsi. Methodsii. ExampleII. DisposalIII. Natural ResourcesIV. Intangible assetsV. Current Liabilities OverviewVI. Short Term Notes PayableVII. Discounted Notes PayableOutline of Current Lecture VIII. CommitmentsIX. Contingent Liabilitiesa. ExampleX. Quick RatioXI. Compound Interest a. ExampleXII. Compound Interest and Present Value of an Annuity a. ExampleXIII. Debt-financing Vs. Equity-Financing (Borrowing VS. Ownership)Current LectureCurrent Liabilities ContinuedCommitments – Unexecuted contract; Is reportedContingent Liabilities – Based on a past event; Outcome is uncertain.Common Examples of ContingenciesThese 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.LawsuitsProduct warranties and defects (Embedded vs. extended)Guarantees of debts of othersAccounting for contingent liabilitiesRecord if: Probable (More than 50% likely to occur) and amount can be estimated. Means increase loss from lawsuit and increase lawsuit payableFootnote 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 ExpensePiper Company is a new company that sells sewing machines. All machines are sold with a 4-yarwarranty. 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 probableSale * Warranty % = Estimated warranty Exp 200,000 * 0.06 = 12,000Financial statement analysis: Quick ratio – Also called Acid-Test RatioSimilar to current ratio: Liquidity measurement; More strict than Current ratioCurrent Ratio = Current Assets / Current LiabilitiesQuick Ratio = Quick Assets / Current Liabilities; Quick Assets = Cash Market securitiesCompound Interest and Long-term LiabilitiesTime 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 returnSimple interest – interest is computed on the principal amount only; interest is stated as an annual percentage rateI = 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 rateSIMPLE VS. COMPOUND INTERESTAssume 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 INTERESTEnd of Interest calculation Balance Interest calculation BalanceYear 1 1000 * .05 = 50 $1,050 1000 * .05 = 50 $1,050Year 2 1000 * .05 = 50 $1,100 1050 * .05 = 52.50 $1,102.50Year 3 1000 * .05 = 50 $1,150 1102.50 * .05 = 55.125 $1,157.625Total interest = $150 Total interest = $157.625Future 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 todayto 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 VALUETo 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 n1. We can use the following formula to calculate present value:PV = FV * 1/(1+i)nExample #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 = 16,793Example #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 = 6Rate = I =0.06/ 2 = 0.03 Per 6 Month periodPV = 20,000 * 1/ (1 + 0.03)^3 = 20,000 * 1/(1.194) = 20,000 * 0.8375 = 16,7502. 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 TABLESTables 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 FactorPRESENT VALUE OF AN ANNUITYOften, 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 needto 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