Chapter 9 Reporting and Interpreting

Liabilities

Financial Accounting
10e
Libby • Libby • Hodge
Liabilities Defined and Classified

Defined
Definedas
asthe
theprobable
probablefuture
futuresacrifice
sacrificeof
ofeconomic
economicbenefits
benefitsthat
that
arise
arisefrom
frompast
pasttransactions.
transactions.

Maturity = 1 year or less Maturity > 1 year

Current Liabilities Long-Term Liabilities

(to be paid with current assets)

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9-2
 Notes Payable (1 of 2)

AAnote
notepayable
payableisisaaformal
formalwritten
writtencontract
contractthat
thatspecifies:
specifies:
• • The amount borrowed
The amount borrowed
• • The repayment date
The repayment date
• • The annual interest rate associated with the borrowing
The annual interest rate associated with the borrowing

To the lender, interest is a revenue.

To the lender, interest is a revenue.
To the borrower, interest is an expense.
To the borrower, interest is an expense.

Interest = Principal × Annual Interest Rate × Number of Months / 12 Months

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9-3
Notes Payable (2 of 2)

 Interest is an expense incurred when companies borrow money.

 Companies record interest expense for a given accounting period,
regardless of when they actually pay the bank cash for interest.

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9-4
Notes Payable, illustration (1 of 2)

Assume that on November 1, a company with a December 31 fiscal

year-end borrows $100,000 cash for one year.
• The annual interest rate is 12%.
• The interest is payable on April 30 and October 31 of the following
year.
• The principal ($100,000) is payable at the maturity date, October
31 of next year.

On November 1, the note is recorded in the accounts as follows:

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9-5
Notes Payable, illustration (2 of 2)
By the end of the fiscal year, December 31, the company incurred two months of
interest, $2,000 ($100,000 × 0.12 × 2/12 months = $2,000). The entry to record
interest expense and interest payable for the two months is:

On April 30, the company has incurred an additional four months of interest
expense for the period January–April. The entry to record the interest is:

Also on April 30, the company pays the bank $6,000 cash for six months of
interest:

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Current Portion of Long-Term Debt
To provide accurate information on how much of its long-term debt is
due in the current year, a company must reclassify its long-term debt as
a current liability within a year of its maturity date.
Assume that a company signed a note to borrow $5 million at the end of
December 2018. Half of the loan must be repaid in January 2020 and the
other half is due in January 2021. The 2019 Balance Sheet would report
the following:

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9-7
Contingent Liabilities

A contingent liability is a potential liability that has arisen as the result of a

past event; it is not a definitive liability until some future event occurs.

PROBABILITY OF OCCURRENCE
Probable Reasonably Possible Remote
Amount can be
reasonably estimated Record as liability Disclose in footnotes Disclosure not required
Amount cannot be
reasonably estimated Disclose in footnotesDisclose in footnotes Disclosure not required

The probabilities of occurrence are defined in the following manner:

• Probable—The future event or events are likely to occur.
• Reasonably possible—The chance of the future event or events
occurring is more than remote but less than likely.
• Remote—The chance of the future event or events occurring is
slight.

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9-8
International Perspective: It’s a Matter of Degree

Under US GAAP, “probable” has been defined as likely to occur,

which is interpreted as having a greater than 70 percent chance
of occurring.

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 Example: Contingent Liabilities

Simon Company was in a lawsuit filed by its customers due to the danger of its
products on 15 December 2020. The lawyer advised that the probability of
losing the case is 80% on 31 December. The results of the lawsuit will only be
known in March 2021. The loss would be 5m which can be reasonably
estimated. The year end of Simon Company is on 31 December.

Date: 31 December 2020 Dr Cr

Loss on lawsuit 5m
Contingent liability - lawsuit 5m

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9-10
Long-Term Liabilities
Long-term liabilities include all obligations not classified as current
liabilities, such as long-term notes payable and bonds payable.

Maturity = 1 year or less Maturity > 1 year

Current Liabilities Long-Term Liabilities

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9-11
Present Value Concepts

$1,000 In one year, it will In five years, it will

invested be worth $1,100. be worth $1,610!
today at 10
percent.

The value of money can grow over time because money can earn interest.

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9-12
Future Value of a Single Amount

If you deposited $100 today in a savings account that earns 10%

interest, how much would you have after one year?

Answer: $110

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9-13
Present Value of a Single Amount (1 of 2)

If you needed $110 in one year, how much would you need to deposit
in a savings account today if the savings account earns 10% interest?

Answer: $100

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9-14
Present Value of a Single Amount (2 of 2)

Assume that you need to make a $1,000 cash payment in

three years.
At an interest rate of 10% per year, how much would you
need to deposit today to have exactly $1,000 at the end
of three years?
a. $1,000.00
b. $ 990.00
c. $ 751.31
d. $ 970.00

The
Thefuture
futureamount
amountisis$1,000.
$1,000.
i i==10%
10%&&nn==33years
years
Using
Usingthe
thePresent
PresentValue
Valueofof$1
$1table,
table,the
thefactor
factorisis0.75131.
0.75131.
$1,000
$1,000 ×× 0.75131
0.75131 == $751.31
$751.31

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9-15
Exhibit 9.2
How a Deposit Grows to $1,000

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9-16
Present Value of an Annuity (1 of 2)
An annuity is a series of consecutive payments:
1. An equal dollar amount each period
2. Interest periods of equal length (e.g., a year, half a year, quarterly, or
monthly)
3. The same interest rate each period.

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9-17
Present Value of an Annuity (2 of 2)
Assume
Assumeyou youpurchase
purchaseaapiece
pieceofofequipment
equipmentand andagree
agreeto
topay
pay
$1,000
$1,000cash
casheach
eachDecember
December3131forforthree
threeyears.
years.
How
Howmuchmuchwould
wouldyouyouneed
needto
todeposit
deposittoday
todayatatananannual
annual
interest
interestrate
rateofof10%
10%to
tomake
makeeach
each$1,000
$1,000payment?
payment?
a.a. $3,000.00
$3,000.00
b.b. $2,910.00 The
The consecutive
consecutive equal
equal payment
payment amount
amountisis
$2,910.00 $1,000.
c.c. $2,700.00 $1,000.
$2,700.00 i i==10% &&nn==33years
d.d. $2,486.85 10% years
$2,486.85 Discount
Discountfactor
factorisis2.48685.
2.48685.
$1,000
$1,000 ×× 2.48685
2.48685 == $2,486.85
$2,486.85

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9-18
Illustration of an Annuity over Time
Assume you purchase a piece of equipment and agree to pay $1,000 cash
each December 31 for three years. How much would you need to deposit
today at an annual interest rate of 10% to make each $1,000 payment?

The amount of the deposit, which is the present value of the annuity, is
$2,486.85.

The following chart shows the balance in the account as the $1,000
payment is made each year:

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9-19
Accounting Applications of Present Values (1 of 3)
• On January 1, 2019, Starbucks bought new delivery trucks by
signing a note and agreeing to pay $200,000 on December 31,
2020.
• This note is a “non-interest-bearing-note” because no interest
payments are required over the life of the note. The interest is
built into the final payment (All interest will be paid on the due
date).
• Assume that the market interest rate applicable to the note is
12%.

Compute the present value of the single amount to be paid in the

future:

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9-20
Accounting Applications of Present Values (2 of 3)

Record the purchase of the delivery trucks: Debit Credit

Delivery trucks (+A) 159,438
Note payable (+L) 159,438

At the end of each year, record the implied interest expense.

December 31, 2019 Debit Credit
$159,438 * 12% = $19,133
Interest expense (+E, -SE) 19,133
Note payable (+L) 19,133

December 31, 2020 Debit Credit

$159,438 + $19,133 = $178,571*12% = $21,429
Interest expense (+E, -SE) 21,429
Note payable (+L) 21,429

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9-21
Accounting Applications of Present Values (3 of 3)

Initial loan balance $ 159,438

Interest added 12/31/2019 19,133
Interest added 12/31/2020 21,429
Loan balance at end of loan $ 200,000

At the end of two years, repay the loan amount.

Debit Credit
Note payable (-L) 200,000
Cash (-A) 200,000

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9-22
Accounts Payable Turnover
KEY RATIO ANALYSIS

Accounts Payable = Cost of Goods ÷ Average Accounts

$$$
Turnover Sold Payable

Measures how quickly management is paying its suppliers.

A high accounts payable ratio normally suggests that a
company is paying its suppliers in a timely manner.

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9-23