Chapter 9 Reporting and Interpreting Liabilities LIABILITIES DEFINED AND CALSSIFIED Liabilities probable debts or obligations of the entity that result from past transactions which will be paid with assets or services Current liabilities short term obligations that will be paid within the current operating cycle of the business or within one year of the balance sheet date whichever is longer Analysts say that a company has liquidity if it has the ability to meet its current obligations In contract the current ratio includes all current assets in the numerator of the ratio o Quick Ratio Quick Assets Current Liabilities Accounts Payable Accounts payable are also called trade accounts payable From many companies trade credit is a relatively inexpensive way to finance the purchase of inventory because interest does not normally accrue on accounts payable A positive relationship can be destroyed by slow payment of debt o Accounts Payable Turnover Cost of goods sold Av Acc Payable Accrued Liabilities Accrued liabilities are expenses that have been incurred before the end of an accounting period but have not been paid Accrued liabilities are recorded as adjusting entries at year end Accrued Compensation and Related Costs In addition to reporting salaries that have been earned but not paid companies must report the cost of unpaid benefits including retirement programs vacation time and health insurance Payroll Taxes Federal Income Tax Withheld is often referred to as FITW The Social Security taxes often are called FICA taxes because they are required by the Federal Insurance Contributions Act Employers are charged unemployment taxes through the Federal Unemployment Tax Act FUTA and State Unemployment Tax Acts SUTA The cost of hiring employees is much more than the amount that those employees actually receive in cash Notes Payable A note payable specifies the amount borrowed the date by which it must be repaid and the interest rate associated with the borrowing Will earn interest in return for giving up the use of their money for a period This simple concept is called the time value of money To the borrower interest is an expense to the creditor it is revenue o Interest Principal x Interest Rate x Time Current Portion of Long Term Debt To provide accurate information on its current liabilities a company must reclassify its long term debt as a current liability within a year of its maturity date Deferred Revenues When a company collects cash before the related revenue has been earned the cash is called deferred revenues Under the revenue principle revenue cannot be recorded until it ahs been earned Deferred revenues are reported as a liability because cash has been collected by the related revenue has not been earned by the end of the accounting period Estimated Liabilities Reported on the Balance Sheet The cost of providing future repair work must be estimated and recorded as a liability in the period in which the product is sold The estimated amount of product that will be returned is reported as a reduction from sales revenue in the year the sales are recorded Estimated Liabilities Reported in the Notes These situations create contingent liabilities which are potential liabilities that are created as a result of a past event A situation that produces a contingent liability also causes a contingent The probabilities of occurrence are defined in the following manner 1 Probable the chance that the future event or events will occur is 2 Reasonable possible the chance that the future event or events will occur is more than remote but less than likely 3 Remote the chance that the future event or events will occur is loss high slight Working Capital Management Working capital the dollar difference between current assets and current liabilities Has a significant impact on the health and profitability of a company If a business has too little working capital it runs the risk of not being able to meet its obligations to creditors Too much working capital may tie up resources in unproductive assets and incur additional costs LONG TERM LIABILITIES Long term liabilities all obligations that are not classified as current liabilities such as long term notes payable and bonds payable to reduce risk for creditors some companies agree to use specific assets as security A liability supported by this type of agreement is called a secured debt An unsecured debt is one for which the creditor relies primarily on the borrower s integrity and general earning power Long Term Notes Payable and Bonds Because bonds provide liquidity to investors they are more likely to lend money to a company A liability is recorded when the debt is incurred and interest expense is recorded with the passage of time Borrowing money in a foreign currency raises some interesting accounting and management issues Lease Liabilities Companies often lease assets rather than purchase them When a company leases an asset on a short term basis the agreement is called an operating lease No liability is recorded when an operating lease is created Instead they record rent expense as it uses the asset For a number of reasons a company may prefer to lease an asset on a long term basis rather than purchase it This type of lease is called a capital lease A capital lease contract represents the purchase and financing of an asset even though it is legally a lease agreement If a lease meets any of the following four criteria it is considered a capital lease o The lease term is 75 or more of the asset s expected economic o Ownership of the asset is transferred to the lessee at the end of the life lease term o The lease contract permits the lessee to purchase the asset at a price that is lower than its fair market value o The present value of the lease payments is 9 or more of the fair market value of the asset when the lease is signed If managers have a choice of recording a lease as an operating or a capital lease most would prefer to record it as an operating lease To record a capital lease it is necessary to determine the current cash equivalent of the required lease payments PRESENT VALUE CONCEPTS Present value is based on the time value of money In present value problems you are told a dollar amount to be received in the future and are asked to determine the present value of the amount The opposite situation occurs when you know the dollar amount of cash flow that occurs today and need to determine its value at some point in the future These
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