Chapter 9 Notes

Liabilities Review
 Liabilities are probable future sacrifices of economic benefits arising from past transactions
 Liabilities are recorded in the balance sheet at their current cash equivalent (i.e., the cash
amount a creditor would accept to settle the debt immediately  present value!)
 Interest accrues over time and therefore is not included in the initial value of the liability
 Liabilities are classified as current (expected to be paid within one year of the balance sheet
date) or noncurrent (expected to be paid after one year)
 Types of liabilities on the balance sheet:
- Accounts Payable – obligations to pay suppliers in the near future (also called trade A/P)
- Accrued Liabilities – obligations from expenses that have been incurred but not paid
 Examples: Accrued Taxes; Accrued Compensation; Accrued Utilities
- Deferred Revenue – obligations resulting from the receipt of cash prior to providing
goods or services (i.e., revenue has not yet been earned, like gift cards)
- Notes Payable – obligations resulting from a written formal contract
 The current portion of long-term debt (the amount due within one year) is
reported in the current liability section of the balance sheet
- Lease Liabilities – obligations resulting from long-term leases (renting assets); amount
of expense recognized over the lease depends on how close the lease looks to ownership
- Contingent Liabilities – potential liabilities resulting from a past event; not a definitive
liability until some future event occurs (e.g., lawsuits; warranties)
 Example: A company may get sued for a past event (e.g., data leak), but they will
not know definitely until the lawsuit is settled or a judgment is rendered whether
they have an actual obligation to pay anything

Accounting for Liabilities

 Contingent Liabilities
- Companies must determine whether these liabilities should be recorded or reported
- This decision is based on two factors:
 Probability of future economic sacrifice – by definition, it’s only recorded as a
liability if the sacrifice is probable
 Ability of management to estimate the amount of the liability – if management
cannot estimate the amount, it cannot be recorded in the balance sheet
 If the contingency does not currently fit the definition of a liability, but it is still
reasonably possible to become a future liability, then that information needs to be
disclosed to the financial statement users in the Notes
 Use the following table to determine recognition vs. reporting (disclosure)

Probable Reasonably Possible Remote

(Likely to occur) (> Slight; < Likely) (Slight chance)
Amount can be Record as liability Disclose in footnotes Disclosure is not
reasonably estimated required
Amount cannot be Disclose in footnotes Disclose in footnotes Disclosure is not
reasonably estimated required

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 Notes Payable
- Notes may be short-term (≤ 1 year) or long-term (>1 year)
- Notes require a formal written contract specifying:
 Principal – the amount borrowed
 Maturity date – date the note (i.e., principal) must be repaid
 Interest rate – cost of borrowing/time value of money
- Interest for a given period is calculated using the following formula:
¿ of months∈ period
 Interest for the period=Principal x Annual Interest Rate x
12months
- Notes Payable are typically recorded in three stages
1. Loan issuance: Dr Cash / Cr Notes Payable
2. Interest accruals: Dr Interest Expense / Cr Interest Payable
3. Maturity date: Dr Notes Payable; Dr Interest Payable; Dr Interest Expense / Cr Cash
- There will be differences in these entries as calculations depending on the timing of when
the principal and interest are paid (discussed below)

Accounting for Short-Term Notes Payable when Interest is paid at maturity

1. Loan issuance: Dr Cash / Cr Notes Payable
 Amount recorded = Principal
ref Cash (+A) $Principal
Notes Payable (+L) $Principal

2. Interest accruals: Dr Interest Expense / Cr Interest Payable

 Amount recorded is calculated using the interest formula
ref Interest Expense (+E, -SE) $Principal*i*(#mo/12)
Interest Payable (+L) $Principal*i*(#mo/12)

3. Maturity date: Dr Notes Payable; Dr Interest Payable; Dr Interest Expense / Cr Cash

 First - catch up on Interest Expense through the maturity date
ref Interest Expense (+E, -SE) $Principal*i*(#mo/12)
Interest Payable (+L) $Principal*i*(#mo/12)

 Second – record payment of the Note and Interest Payable with cash
ref Notes Payable (-L) $Principal
Interest Payable (-L) Principal*i*N
Cash (-A) $Principal + Principal*i*N

Accounting for Long-Term Non-Interest-Bearing Notes Payable

 This type of loan is referred to as non-interest-bearing because it does not require interest
payments over the life of the note (similar to zero coupon bonds in Ch. 10)
 The interest is built into the single final payment of the note
1. Loan issuance: Dr Asset / Cr Notes Payable
 Amount recorded = Principal = PV of final payment at market interest rate
 N = # periods until maturity; I/Y = Market Rate; FV = -Final payment
ref Asset (+A) $Principal
Notes Payable (+L) $Principal

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 2. Interest accruals: Dr Interest Expense / Cr Interest Payable
 Year 1: Amount recorded is calculated using the interest formula
Yr1 Interest Expense (+E, -SE) $Principal*I/Y
Interest Payable (+L) $Principal*I/Y
 Year 2: Since interest is not paid at the end of Year 1, it adds to what the
borrower owes the lender. Therefore, interest for Year 2 is computed as
I/Y*(Principal + Year 1 Interest) or Principal*I/Y*(1+I/Y)
Yr2 Interest Expense (+E, -SE) $Principal*I/Y*(1+I/Y)
Interest Payable (+L) $Principal*I/Y*(1+I/Y)

3. Maturity date: Dr Notes Payable; Dr Interest Payable; Dr Interest Expense / Cr Cash

 First - catch up on Interest Expense through the maturity date
ref Interest Expense (+E, -SE) $Principal*I/Y*(1+I/Y)t-1
Interest Payable (+L) $Principal*I/Y*(1+I/Y)t-1

 Second – record payment of the Note and Interest Payable with cash
ref Notes Payable (-L) $Principal
Interest Payable (-L) Final Payment - Principal
Cash (-A) Final Payment

Accounting for Installment Loans (Notes Payable with an annuity)

 This type of loan consists of consecutive equal payments (i.e., installments) that include
both principal and interest
1. Loan issuance: Dr Asset / Cr Notes Payable
 Amount recorded = Principal = PV of payments at market interest rate
 N = # periods until maturity; I/Y = Market Rate; PMT = -Payment amount
ref Asset (+A) $Principal
Notes Payable (+L) $Principal

2. Installment Payments: Dr Notes Payable; Dr Interest Expense / Cr Cash

 Year 1: Amount recorded is calculated using the interest formula
Yr1 Interest Expense (+E, -SE) $Principal*I/Y
Notes Payable (-L) Payment - Principal*I/Y
Cash (+A) $Payment
 Year 2: Since a portion of the principal is paid at the end of Year 1, it reduces
what the borrower owes the lender. You can use a chart to keep track of
interest expense and principal paid per year.
(a) (b) (c) (d)
Beginning Interest Principal Ending
Period
Balance Expense Paid Balance
1 PV at Issuance (a)*I/Y Payment – (b) (a) – (c)
2 (d1) (d1)*I/Y Payment – (b) (d1) – (c)
3 (d2) (d2)*I/Y Payment – (b) (d2) – (c)

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 Yr2 Interest Expense (+E, -SE) $(d1)*I/Y
Notes Payable (-L) Payment - $(d1)*I/Y
Cash (-A) $Payment

3. Maturity date: Dr Notes Payable; Dr Interest Expense / Cr Cash

 Once the final installment is paid, the final journal entry will eliminate any
remaining Notes Payable

Some notes on the time value of money

 Cash today is worth more than cash tomorrow because you can deposit that cash today and
earn interest over time
Future Value (FV)
Single Amount
 If you deposit cash today, the amount of cash you have in the future (i.e., its future value
(FV)) depends on three variables:
1. Present value (PV) – how much cash you deposit
2. Interest rate (I/Y or i) – how much interest is earned as a percent of the amount deposited
3. Number of periods (N or t) – how often interest is calculated
 These variables relate to each other in the formula: Future Value=Present Value×(1+i)t
 In the calculator, input PV, N, and I/Y  CPT FV (future value of a single amount)
Annuity
 An annuity is a series of consecutive payments characterized by:
1. Equal dollar amount each period
2. Interest periods of equal length (e.g., annual, semi-annual, quarterly)
3. Same interest rate each period
 If you make several consecutive payments (i.e., an annuity), the future value becomes the
sum of the future values of each of those individual payments
- In an ordinary annuity, payments are made at the end of each period
- When you want to know the value of the annuity t periods from today, use the following:
 Payment at the end of year 1: FV of Payment 1=Payment ×(1+i)t−1
 Payment at the end of year 2: FV of Payment 2=Payment ×(1+i)t−2
 Payment at the end of year X: FV of Payment X=Payment ×(1+i)t −X
- The exponent is “t-period#” because that is the number of periods between that payment
and the future date you want to know the value for
- The last payment will not be discounted because t=X at the end of the payment stream
 In the calculator, input PMT, N, and I/Y  CPT FV (future value of an annuity)

Present Value (PV)

Single Amount
 The present value of a future amount of money is equal to what you would need to invest
today to earn that future value given a specific interest rate and time period
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 PV of a single amount formula: Present Value= × Future Value
(1+i)t
- FV is equal to the lump-sum amount to be paid or received one time in the future
 In the calculator, input FV, N, and I/Y  CPT PV (present value of a single amount)

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Annuity
 You can find the PV of a stream of equal future payments as the sum of the PV of each of the
individual payments
1
- Payment at the end of year 1: PV of Payment 1= 1
× Payment
(1+i)
1
- Payment at the end of year 2: PV of Payment 2= × Payment
(1+i)2
1
- Payment at the end of year X: PV of Payment X= X
× Payment
(1+ i)
 The exponent is equal to the payment number since that number also represents how many
years in the future the payment is made and therefore, needs to be discounted back
 In the calculator, input PMT, N, and I/Y  CPT PV (present value of an annuity)
 Note: You can also calculate the PV of a liability involving an annuity and lump-sum
payment (input N, I/Y, PMT, and FV  CPT PV), which is equal to computing the PV of
each separately and adding them (use the same N and I/Y)
Compounding Interest
 If interest is calculated/paid more often than annually, then N and I/Y need to be adjusted
 N should equal the number of periods interest is calculated or paid
- If semiannual  multiply length in years by 2
- If quarterly  multiply length in years by 4
 The given interest rate is usually an annual rate  must be adjusted to fit the interest period
- If semiannual  divide annual rate by 2
- If quarterly  divide annual rate by 4

Analysis of Current Liabilities

Accounts Payable Turnover Ratio
 Question: How quickly does management pay its suppliers?
Cost of Goods Sold
 Formula: Accounts Payable turnover=
Average Accounts Payable
 Alternative calculation: Average # of Days Payable are Outstanding = 365 / A/P Turnover
- If calculating for a quarter, use COGS for one quarter and 90 days as the numerator
 Interpretation: The number of times per period the company pays off its accounts payable
- Higher ratio  paying off payables in a timely manner
 Cautions: Still possible that some suppliers are being paid slowly; if paying too quickly, may
not be taking advantage of low-cost financing

Working Capital
 Question: Is the company able to pay off its current obligations (i.e., is it liquid)?
 Formula: Working Capital=Current Assets−Current Liabilities
 Interpretation: What is left after a company pays all its current liabilities with its current
assets
- Broad interpretation is similar to the current ratio
- Too little  company may not be able to meet its short-term obligations
- Too much  resources may be tied up in unproductive assets (e.g., excess inventory)