1 Chapter 9 Current Liabilities, Contingencies, and the Time Value of Money Financial Accounting, Alternate 4e by Porter and Norton.

1

Chapter 9

Current Liabilities,Contingencies, and the Time Value of Money

A

FEDERAL RESERVE NOTE

THE UNITED STATES OF AMERICATHE UNITED STATES OF AMERICA

L70744629F

12

1212

12

L70744629F

ONE DOLLARONE DOLLAR

WASHINGTON, D.C.

THIS NOTE IS LEGAL TENDER

FOR ALL DEBTS, PUBLIC AND PRIVATE

SERIES

1985

H 293

Financial Accounting, Alternate 4e by Porter and Norton

2

Liabilities and shareholders' equityCurrent liabilities:

Notes payable $ .3Accounts payable 635.8Income taxes 16.3Other taxes 191.8Accrued interest 199.4Accrued restructuring and restaurant closing costs 328.5Accrued payroll and other liabilities 774.7Current maturities of long-term debt 275.5

Total current liabilities $2,422.3

McDonald's Corporation2002 Consolidated Balance Sheet (partial)

(in millions)

Require paymentwithin

one year

Listed in order of liquidity

3

Selected 2002 Liquidity Ratios

Current Quick Ratio Ratio

Georgia-Pacific 1.16 0.64J. C. Penney 2.00 0.76Johnson Controls 1.03 0.82McDonald's 0.71 0.49Pfizer 1.34 1.09

1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 28 29 30 3127

4

Accounts Payable

Purchase of inventory, goods or services on credit

2/10,n30

Discount payment terms offered to encourage early payment

5

Promissory Note

S.J.Devona

I promise to pay $1,000 plus 12% annualinterest on December 31, 2004.

Date: January 1, 2004

Signed:_________Lamanski Co.

Total repayment = $1,120 $1,000 + ($1,000 x 12%)

6

Discounted Promissory Note

In exchange for $880 received today, I promise to pay $1,000 on December 31, 2004. Date: January 1, 2004

Signed:_________Lamanski Co.

Effective interest rate on note = 13.6% ($120 interest / $880 proceeds)

7

1/1/04 12/31/04

Notes Payable $ 1,000 $ 1,000

Less: Discount on

Notes Payable 120 - 0 -

Net Liability $ 880 $ 1,000

Balance Sheet Presentation of Discounted Notes

Discount transferred to interest expense

over life of note

88

Current Maturities of Long-Term Debt

Principal repayment on borrowings due within one year of balance sheet date

Due in upcoming year

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4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 28 29 30 3127

1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 28 29 30 3127

1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 28 29 30 3127

9

Taxes Payable

Record expense when incurred; not when paid

Record 2004 taxexpense

Taxes Paid

12/31/04 3/15/05

10

Current Liabilities on the Statement of Cash Flows

Operating Activities Net income xxx Increase in current liability + Decrease in current liability –

Investing Activities

Financing Activities Increase in notes payable + Decrease in notes payable –

1111

Contingent Liability

Obligation involving existing condition

Outcome not known with certainty

Dependent upon some future event

Actual amount is estimated

12

Accrue estimated amount if: Liability is probable Amount can be reasonably estimated

Contingent Liability

Record in year criteria are met:

Assets = Liab. + O/E + Rev. – Exp. Est. Liab. For Warranty Exp. 10,000 Warranty 10,000

Balance Sheet Income Statement

1313

Warranties

Premium or coupon offers

Lawsuits

Typical Contingent Liabilities

14

Recording Contingent Liabilities

Quickkey Computer sells a computer product for $5,000 with a one-year warranty. In 2004, 100 of these products were sold for a total sales revenue of $500,000.

Analyzing past records, Quickkey estimates that repairs will average 2% of total sales.

Example:

15

Recording Contingent Liabilities

Probable liability has been incurred?

Amount reasonably estimable?

Estimated Liability for Warranty $100,000

Warranty Expense $100,000

YES

YES

Record in 2004:

16

Disclosing Contingent Liabilities

IF not probable

but reasonably possible

ORamount not estimable

Disclose in footnotes

1717

Contingent Assets

Contingent gains and assets are not recorded but may be disclosed in footnotes

Conservatism principle applies

1818

Time Value of Money

Prefer payment now vs. in future due to interest factor

Applicable to both personal and business decisions

19

Simple Interest

I = P x R x T

Princi

pal a

mount

Dollar a

mount o

f

inte

rest

per

yea

r

Time

in y

ears

Inte

rest

rate

as

a per

centa

ge

2020

Example of Simple Interest

Given following data:principal amount = $ 3,000annual interest rate = 10%term of note = 2 years

Calculate interest on the note.

2121

Example of Simple Interest

Given following data:principal amount = $ 3,000annual interest rate = 10%term of note = 2 years

Calculate interest on the note.

P x R x T $ 3,000 x .10 x 2 = $ 600

2222

Compound Interest

Interest is calculated on principal plus previously accumulated interest

Compounding can occur annually, semi-annually, quarterly, etc.

23

Example of Compound Interest

Given following data:

principal amount = $ 3,000

annual interest rate = 10%

term of note = 2 years

semiannual compounding of interest

Calculate interest on note.

24

Compound Interest Periods

Year 1 Year 2

10% annually 10% annually

5% + 5%semiannually

5% + 5%semiannually

4 periods @ 5% semi-annual interest

25

Example of Compound Interest

Period Beginning Interest Ending Principal at 5% Balance

1 $ 3,000 $ 150 $ 3,150

2 3,150 158 3,308

3 3,308 165 3,473

4 3,473 174 3,647

26

Comparing Interest Methods

Simple annual interest: $3,000 x .10 x 2 = $ 600Semiannual compounding:

1 $ 150 2 158 3 165 4 174

Total $ 647

27

Compound Interest Computations

Present value of an

annuity

Future value of an

annuity

Present value of a

single amount

Future value of a

single amount

28

Future Value of Single Amount

Known amount of single payment or deposit Future Value

+ Interest =

29

Future Value of a Single Amount Example

If you invest $10,000 today @ 10% compound interest, what will it be worth 3 years from now?

invest

$10,000 Future Value?

+ Interest @ 10% per year

Yr. 1 Yr. 2 Yr. 3

30

Future Value of a Single Amount Example - Using Formulas

nFV = p (1 + i)

3 = $10,000 (1.10)

= $13,310

31

FV = Present Value x FV Factor = $ 10,000 X (3 periods @ 10%)

Future Value of a Single Amount Example - Using Tables

FV??$10,000 PV

Yr. 1 Yr. 2 Yr. 3

32

(n) 2% 4% 6% 8% 10% 1 1.020 1.040 1.060 1.080 1.10 2 1.040 1.082 1.124 1.166 1.210

3 1.061 1.125 1.191 1.260 1.3314 1.082 1.170 1.262 1.360 1.464

5 1.104 1.217 1.338 1.470 1.611 6 1.126 1.265 1.419 1.587 1.772 7 1.149 1.316 1.504 1.714 1.949 8 1.172 1.369 1.594 1.851 2.144

Future Value of $1

33

FV = Present Value x FV Factor = $ 10,000 X (3 periods @ 10%) = $ 10,000 X 1.331 = $ 13,310

Future Value of a Single Amount Example - Using Tables

FV = $13,310$10,000 PV

Yr. 1 Yr. 2 Yr. 3

3434

Present Value of Single Amount

Discount

Known amount of single paymentin futurePresent Value

35

Present Value of a Single Amount Example

If you will receive $10,000 in three years, what is it worth today (assuming you could invest at 10% compound interest)?

Present Value? $ 10,000

Discount @ 10%

Yr. 1 Yr. 2 Yr. 3

36

Present Value of a Single Amount Example - Using Formulas

-nPV = payment x (1 + i)

-3 = $10,000 x (1.10)

= $7,513

37

PV = Future Value x PV Factor = $ 10,000 X (3 periods @ 10%)

Present Value of a Single Amount Example - Using Tables

FV=$10,000PV ??

Yr. 1 Yr. 2 Yr. 3

38

Present Value of $1

(n) 2% 4% 6% 8% 10%

1 .9804 .9615 .9434 .9259 .9090 2 .9612 .9246 .8900 .8573 .8265 3 .9423 .8890 .8396 .7938 .7513 4 .9238 .8548 .7921 .7350 .6830 5 .9057 .8219 .7473 .6806 .6209

39

PV = Future Value x PV Factor = $ 10,000 X (3 periods @ 10%)

= $ 10,000 X .7513 = $ 7,513

Present Value of a Single Amount Example - Using Tables

FV=$10,000 PV = $7,513

Yr. 1 Yr. 2 Yr. 3

40

Periods

FutureValue?

+Interest

Future Value of an Annuity

1 2 3 4

$0 $3,000 $3,000 $3,000 $3,000

41

If we invest $3,000 each year for four years at 10% compound interest, what will it be worth 4 years from now?

Future Value of Annuity Example

$0 $3,000 $3,000 $3,000 $3,000

Yr. 1 Yr. 2 Yr. 3 Yr. 4

FV ??

42

$0 $3,000 $3,000 $3,000 $3,000

Yr. 1 Yr. 2 Yr. 3 Yr. 4

FV ??

FV = Payment x FV Factor = $ 3,000 x (4 periods @ 10%)

Future Value of Annuity Example

43

Future Value of Annuity of $1

(n) 2% 4% 6% 8% 10% 12% 1 1.000 1.000 1.000 1.000 1.000 1.000 2 2.020 2.040 2.060 2.080 2.100 2.120 3 3.060 3.122 3.184 3.246 3.310 3.374 4 4.122 4.246 4.375 4.506 4.641 4.779 5 5.204 5.416 5.637 5.867 6.105 6.353

44

FV = Payment x FV Factor = $ 3,000 x (4 periods @ 10%) = $ 3,000 x 4.641 = $ 13,923

$0 $3,000 $3,000 $3,000 $3,000

Yr. 1 Yr. 2 Yr. 3 Yr. 4

FV = $13,923

Future Value of Annuity Example

45

Present Value of an Annuity

Periods1 2 3 4

PresentValue ?

Discount$0 $500 $500 $500 $500

A

FEDERAL RESERVE NOTE

THE UNITED STATES OF AMERICATHE UNITED STATES OF AMERICA

L70744629F

12

1212

12

L70744629F

ONE DOLLARONE DOLLAR

WASHINGTON, D.C.

THIS NOTE IS LEGAL TENDER

FOR ALL DEBTS, PUBLIC AND PRIVATE

SERIES

1985

H 293

A

FEDERAL RESERVE NOTE

THE UNITED STATES OF AMERICATHE UNITED STATES OF AMERICA

L70744629F

12

1212

12

L70744629F

ONE DOLLARONE DOLLAR

WASHINGTON, D.C.

THIS NOTE IS LEGAL TENDER

FOR ALL DEBTS, PUBLIC AND PRIVATE

SERIES

1985

H 293

A

FEDERAL RESERVE NOTE

THE UNITED STATES OF AMERICATHE UNITED STATES OF AMERICA

L70744629F

12

1212

12

L70744629F

ONE DOLLARONE DOLLAR

WASHINGTON, D.C.

THIS NOTE IS LEGAL TENDER

FOR ALL DEBTS, PUBLIC AND PRIVATE

SERIES

1985

H 293

A

FEDERAL RESERVE NOTE

THE UNITED STATES OF AMERICATHE UNITED STATES OF AMERICA

L70744629F

12

1212

12

L70744629F

ONE DOLLARONE DOLLAR

WASHINGTON, D.C.

THIS NOTE IS LEGAL TENDER

FOR ALL DEBTS, PUBLIC AND PRIVATE

SERIES

1985

H 293

46

Present Value of an Annuity Example

What is the value today of receiving $4,000 at the end of the next 4 years, assuming you can invest at 10% compound annual interest?

PV ??

Yr. 1 Yr. 2 Yr. 3 Yr. 4

$0 $4,000 $4,000 $4,000 $4,000

47

Present Value of an Annuity Example

Yr. 1 Yr. 2 Yr. 3 Yr. 4

PV ??

$0 $4,000 $4,000 $4,000 $4,000

PV = Payment x PV Factor = $ 500 x (4 periods @ 10%)

48

Present Value of Annuity of $1

(n) 2% 4% 6% 8% 10%

1 0.980 0.962 0.943 0.926 0.909 2 1.942 1.886 1.833 1.783 1.735 3 2.884 2.775 2.673 2.577 2.487 4 3.808 3.630 3.465 3.312 3.170 5 4.713 4.452 4.212 3.992 3.791

49

Present Value of an Annuity Example

Yr. 1 Yr. 2 Yr. 3 Yr. 4

P.V. = $12,680

$0 $4,000 $4,000 $4,000 $4,000

PV = Payment x PV Factor = $ 4,000 x (4 periods @ 10%)

= $ 4,000 x 3.170 = $ 12,680

50

Solving for Unknowns

Assume that you have just purchased a new car for $14,420. Your bank has offered you a 5-year loan, with annual payments of $4,000 due at the end of each year. What is the interest ratebeing chargedon the loan?

51

Solving for Unknowns

Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5

discount discount discount discount discount

PV = $14,420

PV = Payment x PV factor

PV factor = PV / Payment rearrange equation to solve for unknown

52

Solving for Unknowns

Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5

discount discount discount discount discount

PV = $14,420

PV factor = PV / Payment = $14,420 / $4,000 = 3.605

5353

Present Value of an Annuity Table

(n) 10% 11% 12% 15% 1 0.909 0.901 0.893 0.870 2 1.736 1.713 1.690 1.626 3 2.487 2.444 2.402 2.283 4 3.170 3.102 3.037 2.855 5 3.791 3.696 3.605 3.352

PV factor of 3.605 equates to an interest rate of 12%.

54

Appendix A

Accounting Tools:

Payroll Accounting

55

Calculation of Gross Wages

Hourly Multiply the number of

hours worked times employee’s hourly rate

Salaried Paid at a flat rate per

week, month, or year, regardless of hours

56

Calculation of Net Pay

Gross wages- Income tax (federal, state, local)- FICA - Voluntary deductions

(includes health insurance, retirement contributions, savings plans, charitable contributions, union dues)

= Net pay

57

Employer Payroll Taxes

Not deducted from paycheck – employer pays taxes per employee, in addition to salary FICA – employer’s share Unemployment tax

58

Payroll Accounting

Example:

Gross wages for Kori Company for July are $100,000. The following amounts have been withheld from employees’ paychecks:

Kori Company’s unemployment tax rate is 6%. Show the effects of these transactions on the accounting equation.

Income Tax $20,000FICA 7,650United Way contributions 5,000Union dues 3,000

59

Payroll Accounting

Record July salary and deductions:

Assets = Liab. + O/E + Rev. – Exp. Salary Pay. 64,350 Salary Exp.

(100,000) Inc. Tax Pay. 20,000

FICA Pay. 7,650 United Way Pay. 5,000 Union Dues Pay. 3,000

60

Payroll Accounting

Record payment of employee salaries:

Assets = Liab. + O/E + Rev. – Exp.Cash (64,350) Salary Pay. (64,350)

Record employer’s payroll taxes:

Assets = Liab. + O/E + Rev. – Exp. FICA Pay. 7,650 Payroll Tax Exp.

(13,650) Unemploy.

Tax Pay. 6,000

61

Compensated Absences

Employee absences for which the employee will be paid Vacation, illness, holidays

Accrued as a liability if The services have been rendered The rights (days) accumulate Payment is probable and can be

reasonably estimated

62

Appendix B

Accounting Tools:Using Excel for Problems

Involving Interest Calculations

63

Using Excel Functions

Many functions built into Excel, including PV and FV calculations

Click on Paste or Insert button for list

64

FV Function in Excel

Find the FV of a 10% note payable for $2,000, due in 2 years and compounded annually

Example:

Answer:$2,420

65

PV Function in Excel

How much should you invest now at 10% (compounded annually) in order to have $2,000 in 2 years?

Example:

Answer:$1,653

(rounded)

66

End of Chapter 9

A

FEDERAL RESERVE NOTE

THE UNITED STATES OF AMERICATHE UNITED STATES OF AMERICA

L70744629F

12

1212

12

L70744629F

ONE DOLLARONE DOLLAR

WASHINGTON, D.C.

THIS NOTE IS LEGAL TENDER

FOR ALL DEBTS, PUBLIC AND PRIVATE

SERIES

1985

H 293