Chapter 09 – Reporting and Interpreting Liabilities
9-1
CHAPTER 9
REPORTING AND INTERPRETING LIABILITIES
Learning Objectives and Related Assignment Materials
Learning Objectives
Mini-
Exercises
Exercises
Problems
Alternate
Problems
Cases and
Projects
1. Define, measure, and report current
liabilities.
3, 4, 5
1, 2, 3, 4,
5, 6, 7, 8
1, 2, 3, 4,
5, 6
1, 2, 3
1, 2, 6
2. Analyze the accounts payable turnover
ratio.
3
3, 6
3. Report notes payable and explain the
time value of money.
9
5
4. Report contingent liabilities.
1, 2, 6
1, 4, 5, 8
6, 7
3, 5
6
5. Explain the importance of changes in
working capital and its impact on cash
flows.
3
1
2, 3, 8
1, 2, 4
1, 2, 6
6. Report long-term liabilities.
8, 9, 10
10
1, 2, 6
7. Compute present values.
7, 8, 9
14, 15,
16, 17,
18, 19,
20, 21
11, 12
6, 7
4, 5
8. Apply present value concepts to
liabilities.
11
6
Chapter Supplement A: Present value
computations using Excel
Chapter Supplement B: Deferred taxes
12, 13,
14
Chapter Supplement C: Future value
concepts
10, 11
22, 23,
24, 25
13, 14
8
Synopsis of Chapter Revisions
Focus Company: Starbucks
▪ Focus and contrast company data updated.
▪ Quick ratio coverage removed.
▪ New GUIDED HELP feature provides free access to step-by-step video instruction on present value.
▪ New CONTINUING CASE added to the end-of-chapter problems. Students are asked to record and
report liabilities for Pool Corporation, a public company.
▪ New and updated real companies, as well as modified accounts, names, and amounts for fictional
companies in end-of-chapter exercises, problems, and cases.
Chapter 09 – Reporting and Interpreting Liabilities
PowerPoint Slides
Learning Objectives
PowerPoint® Slides
1. Define, measure, and report current liabilities.
9-1 through 9-7 and 9-9
2. Analyze the accounts payable turnover ratio.
9-8
3. Report notes payable and explain the time value of money.
9-10 through 9-12
4. Report contingent liabilities.
9-13 through 9-14
5. Explain the importance of changes in working capital and its impact on
cash flows.
9-15
6. Report long-term liabilities.
9-16 through 9-21
7. Compute present values.
9-22 through 9-28
8. Apply present value concepts to liabilities.
9-29 through 9-31
Chapter Supplement A: Present value computations using Excel
9-32
Chapter Supplement B: Deferred taxes
9-33
Chapter Supplement C: Future value concepts
9-34 through 9-37
Related Video Programs
Chapter 09 – Reporting and Interpreting Liabilities
9-3
Chapter Take-Aways
1. Define, measure, and report liabilities.
Strictly speaking, accountants define liabilities as probable future sacrifices of economic benefits that
arise from past transactions. They are classified on the balance sheet as either current or long-term.
Current liabilities are 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. Long-term liabilities are all
obligations not classified as current.
2. Analyze the accounts payable turnover ratio.
This ratio is computed by dividing cost of goods sold by accounts payable. It shows how quickly
management is paying its trade creditors and is considered to be a measure of liquidity.
3. Report notes payable and explain the time value of money.
A note payable specifies the amount borrowed, when it must be repaid, and the interest rate
associated with the debt. Accountants must report the debt and the interest as it accrues. The time
value of money refers to the fact that interest accrues on borrowed money with the passage of time.
4. Report contingent liabilities.
A contingent liability is a potential liability that has arisen as the result of a past event. Such liabilities
are disclosed in a note if the obligation is reasonably possible.
5. Explain the importance of working capital and its impact on cash flows.
Working capital is used to fund the operating activities of a business. Changes in working capital
accounts affect the statement of cash flows. Cash flows from operating activities are increased by
decreases in current assets (other than cash) or increases in current liabilities. Cash flows from
operating activities are decreased by increases in current assets (other than cash) or decreases in
current liabilities.
6. Report long-term liabilities.
Usually, long-term liabilities will be paid more than one year in the future. Accounting for long-term
debt is based on the same concepts used in accounting for short-term debt.
7. Compute present values.
The present value concept is based on the time value of money. Simply stated, a dollar to be received
in the future is worth less than a dollar available today (present value). This concept can be applied
either to a single payment or multiple payments called annuities. Either tables or Excel can be used to
determine present values.
8. Apply present value concepts to liabilities.
Accountants use present value concepts to determine the reported amounts of liabilities. A liability
involves the payment of some amount at a future date. The reported liability is not the amount of the
future payment. Instead, the liability is reported at the amount of the present value of the future
payment.
Chapter 09 – Reporting and Interpreting Liabilities
9-4
Key Ratios
Accounts payable turnover is a measure of how quickly a company pays its creditors. It is computed as
follows:
Accounts Payable Turnover = Cost of Goods Sold ÷ Average Accounts Payable
Finding Financial Information
Balance Sheet
Under Current Liabilities
Liabilities listed by account title, such as:
Accounts payable
Accrued liabilities
Notes payable
Current portion of long-term debt
Under Noncurrent Liabilities
Liabilities listed by account title, such as:
Long-term debt
Deferred taxes
Bonds
Income Statement
Liabilities are shown only on the balance sheet,
never on the income statement. Transactions
affecting liabilities often affect an income
statement account. For example, accrued salary
compensation affects an income statement account
(compensation expense) and a balance sheet
account (salaries payable).
Statement of Cash Flows
Under Operating Activities (indirect method)
Net income
+ Increases in most current liabilities
− Decreases in most current liabilities
Under Financing Activities
+ Increase in long-term liabilities
− Decreases in long-term liabilities
Notes
Under Summary of significant accounting
policies
Description of pertinent information concerning
accounting treatment of liabilities. Normally, there
is minimal information.
Under a Separate Note
If not listed on the balance sheet, a listing of the
major classifications of liabilities with information
about maturities and interest rates. Information
about contingent liabilities is reported in the notes.
Chapter 09 – Reporting and Interpreting Liabilities
9-5
Chapter Outline
Teaching Notes
LO 1 – Define, measure, and report current liabilities.
I. Liabilities Defined and Classified
Show Video Program #11
A. Liabilities – Probable debts or obligations that result from
past transactions, which will be paid with assets or services
1. When recorded, a liability at its current cash equivalent
(i.e., the cash amount a creditor would accept to settle the
liability immediately)
2. Classifications of liabilities on the balance sheet:
a. 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.
b. Noncurrent liabilities – All other liabilities
3. Liquidity – Ability to pay current obligations
LO 2 – Analyze the accounts payable turnover ratio.
II. Current Liabilities
A. Accounts Payable (or Trade Accounts Payable)
1. Created when goods and services are provided on credit
2. Trade credit is a relatively inexpensive way to finance the
purchase of inventory because interest does not normally
accrue on accounts payable
B. Key Ratio Analysis: Accounts Payable Turnover Ratio
1. Accounts Payable Turnover Ratio = Cost of Goods Sold ÷
Average Accounts Payable
2. Quick Assets – Cash, marketable securities, and accounts
receivable
3. Measures how quickly management is paying trade
accounts
4. High ratio normally suggests that a company is paying its
suppliers in a timely manner
a. Might not reflect reality if a company pays some
creditors on time but is late with others
b. Subject to manipulation; managers could be late in
paying creditors during the entire year but catch up at
year-end so that the ratio is at an acceptable level
5. Can be stated more conservatively as:
Average Age of Payables = 365 Days ÷ Turnover Ratio
C. Accrued Liabilities – Expenses that have been incurred but
have not been paid at the end of the accounting period
1. Accrued Taxes Payable
a. Like individuals, corporations must pay taxes on the
income they earn
b. Corporate tax rates are graduated; large corporations
paying a top federal tax rate of 35%
c. Corporations may also pay state and local income
taxes and, in some cases, foreign income taxes
Chapter 09 – Reporting and Interpreting Liabilities
9-6
2. Accrued Compensation and Related Costs
a. At the end of each accounting period, there are usually
salaries not yet paid
b. Companies must also report the cost of unpaid
benefits, including retirement programs, vacation time,
and health insurance
c. Accrued Vacation Liability
i. Starbucks estimates the cost of accrued vacation
time to be $125,000
dr Compensation Expense
(+E, –SE)
125,000
cr Accrued Vacation
Liability (+L)
125,000
Assets = Liabilities + Stockholders’ Equity
0 = Accrued Vacation Liability (L) + 125,000 +
Compensation Expense (E) – 125,000
ii. The vacations are taken
dr Accrued Vacation
Liability (–L)
125,000
cr Cash (–A)
125,000
Assets = Liabilities + Stockholders’ Equity
Cash (A) – 125,000 = Accrued Vacation Liability
(L) – 125,000
3. Payroll Taxes
a. All payrolls are subject to a variety of taxes, including
federal, state, and local income taxes, Social Security
taxes, and federal and state unemployment taxes
i. Employees pay some; employers pay others
ii. Reporting is similar for each type of payroll tax
b. Employee Income Taxes
i. Employers are required to withhold income taxes
for each employee
ii. Amount tax withheld is recorded by the employer
as a current liability until remitted to government
c. Employee and Employer FICA Taxes
i. Social Security taxes are required by the Federal
Insurance Contributions Act (FICA)
ii. FICA taxes are imposed in equal amounts on both
the employee and the employer
iii. Effective 1/1/10, the Social Security tax rate was
6.2% on the first $106,800 paid to each employee
during the year
iv. Separate 1.45% Medicare tax applies to all income
v. Total FICA tax rate is 7.65% on wages up to
$106,800 and 1.45% on all wages above $106,800
Chapter 09 – Reporting and Interpreting Liabilities
9-7
d. Employer Unemployment Taxes
i. Employers pay unemployment taxes through the
Federal Unemployment Tax Act (FUTA) and State
Unemployment Tax Acts (SUTA)
ii. The SUTA rate and specified amount of wages
vary by state
As such, focus is just on
FUTA
iii. FUTA:
• FUTA federal tax rate is 6.2% percent on
taxable wages up to the first $7,000 for each
employee
• Certain employers may receive a credit for
SUTA taxes paid, up to 5.4%
• For most large employers, FUTA rate is
0.8% of wages up to $7,000 for each
employee
e. Starbucks accumulated the following information in
its records for the first two weeks of June 2015:
Salaries and wages earned
$1,800,000
Income taxes withheld
275,000
FICA taxes (employees’ share)
105,000
FUTA taxes
2,300
i. First entry records amounts paid to employees or
withheld from amounts they have earned:
dr Compensation Expense
(+E, −SE)
1,800,000
cr Liability for Income
Taxes Withheld (+L)
275,000
cr FICA Payable (+L)
105,000
cr Cash (−A)
1,420,000
Assets = Liabilities + Stockholders’ Equity
Cash (A) – 1,420,000 = Liability for Income Taxes
Withheld ( L) + 275,000 + FICA Payable (L) +
105,000 + Compensation Expense (E) – 1,800,000
Use Supplemental
Enrichment Activity #1
ii. Second entry records the taxes that employers must
pay:
dr Compensation Expense
(+ E, −SE)
107,300
cr FICA Payable (+L)
105,000
cr FUTA Payable (+L)
2,300
Assets = Liabilities + Stockholders’ Equity
0 = FICA Payable (L) + 105,000 + FUTA Payable
(L) + 2,300 + Compensation Expense (E)
– 107,300
Chapter 09 – Reporting and Interpreting Liabilities
9-8
LO 3 – Report notes payable and explain the time value of money.
D. Notes Payable
Show Video Program #12
1. Notes Payable – Formal written contract that specifies the
amount borrowed, repayment date, and the interest rate
2. Formula to calculate interest:
Interest = Principal × Interest Rate × Time
3. On 11/1/14, Starbucks borrows $100,000 cash on a one-
year, 12% note payable with interest is payable on
3/31/15 and 10/31/15
dr Cash (+A)
100,000
cr Note Payable (+L)
100,000
Assets = Liabilities + Stockholders’ Equity
Cash (A) + 100,000 = Note Payable (L) + 100,000
4. Interest in the amount of 2,000 (or $100,000 x 12% x
2/15) is owed as of 12/31/14
dr Interest Expense (+E, –SE)
2,000
cr Interest Payable (+L)
2,000
Assets = Liabilities + Stockholders’ Equity
0 = Interest Payable (L) + 2,000 + Interest Expense (E)
– 2,000
5. On 3/31/15, Starbucks pays $5,000 in interest ($2,000
accrued at 12/31/15 + $3,000 for first 3 months of 2016)
dr Interest Expense (+E, –SE)
3,000
cr Interest Payable (–L)
2,000
cr Cash (–A)
5,000
Assets = Liabilities + Stockholders’ Equity
Cash (A) – 5,000 = Interest Payable (L) – 3,000 + Interest
Expense (E) – 2,000
Use Supplemental
Enrichment Activity #2
E. Current Portion of Long-Term Debt
1. A company must reclassify its long-term debt as a current
liability within a year of its maturity date
2. In some cases, companies will refinance debt when it
comes due rather than pay out cash currently on hand
a. Under IFRS, the actual refinancing must take place by
the balance sheet date
See Financial Analysis
feature “Refinanced Debt:
Current or Noncurrent?”
b. Under GAAP, the ability to refinance must be in place
before the financial statements are issued.
F. Deferred Revenues
1. Deferred Revenues – Revenues that have been collected
but not earned; they are liabilities until the goods or
services have been provided
2. Under the revenue principle, revenue cannot be recorded
until it has been earned
a. Deferred revenues are reported as a liability because
cash has been collected but the related revenue has not
been earned by the end of the accounting period
b. These obligations are classified as current or long-
term, depending on when they must be satisfied
Use Supplemental
Enrichment Activity #3
Chapter 09 – Reporting and Interpreting Liabilities
9-9
E. Estimated Liabilities Reported on the Balance Sheet
1. Some recorded liabilities are based on estimates because
the exact amount will not be known until a future date
2. Warranties
a. An estimated liability is created when a company
offers a warranty with the products it sells
b. The cost of providing future repair work must be
estimated and recorded as a liability (and expense) in
the period in which the product is sold
LO 4 – Report contingent liabilities.
F. Estimated Liabilities Reported in the Notes
1. Contingent liability – A potential liability that has arisen
as the result of a past event; it is not an effective liability
until some future event occurs
2. Whether situation produces a recorded or contingent
liability depends on two factors:
a. Probability of future economic sacrifice
i. Probable—the chance that the future event or
events will occur is high
ii. Reasonably possible—the chance that the future
event or events will occur is more than remote but
less than likely
iii. Remote—the chance that the future event or events
will occur is slight
b. Ability of management to estimate the amount of the
liability
3. Possibilities:
a. Subject to estimate
i. Probable – record as liability
ii. Reasonably possible – disclose in note
iii. Remote – disclosure not required
b. Not subject to estimate
i. Probable – disclose in note
See International Perspective
feature “It’s a Matter of
Degree”
ii. Reasonably possible – disclose in note
iii. Remote – disclosure not required
LO 5 – Explain the importance of changes in working capital and its impact on cash flows.
III. Working Capital Management
A. Working Capital = Current Assets – Current Liabilities
1. Business with too little working capital runs risk of not
meeting obligations to creditors
2. Too much working capital may tie up resources in
unproductive assets
B. Focus on Cash Flows – Working Capital and Cash Flows
1. A net decrease in current liabilities is subtracted in
computing cash flows from operations
2. A net increase in current liabilities is added in computing
cash flows from operations
Refer students to Pause for
Feedback – Self-Study Quiz
Chapter 09 – Reporting and Interpreting Liabilities
9-10
LO 6 – Report long-term liabilities.
III. Long-Term Liabilities
A. Long-Term Liabilities
1. Secured debt – Specific assets are pledged as collateral
2. Unsecured debt – Creditor relies primarily on the
borrower’s integrity and general earning power
B. Long-Term Notes Payable and Bonds
1. Private placement – Long-term debt raised directly from
financial service organizations
2. Bonds – Publicly traded debt
Discussed in chapter 10
a. Bondholders can sell their bonds to other investors
prior to maturity
b. Because bonds provide liquidity to investors, they are
more likely to lend money to company
3. Generally, accounting for long-term debt is same as for
short-term notes payable; liability is recorded when the
debt is incurred and interest expense is recorded
See International Perspective
feature “Borrowing in
Foreign Currencies”
C. Lease Liabilities
1. Operating lease – Does not meet any of the four criteria
(see below) established by GAAP and does not cause the
recording of an asset and liability
a. No liability is recorded when operating lease created
b. Instead, company records rent expense as it uses the
asset
2. Capital lease – Meets at least one of the four criteria
established by GAAP; results in an asset and a liability
a. Criteria:
i. The lease term is 75% or more of the asset’s
expected economic life
ii. Ownership of the asset is transferred to the lessee
at the end of the lease term.
iii. The lease contract permits the lessee to purchase
the asset at a price that is lower than its fair market
value
iv. The present value of the lease payments is 90% or
more of the fair market value of the asset when the
lease is signed
b. To record a capital lease, it is necessary to determine
the current cash equivalent of the required lease
payments
c. Starbucks signs a lease for new delivery trucks; the
lease is a capital lease with a current cash equivalent
of $250,000
dr Leased Equipment (+A)
250,000
cr Lease Payable (+L)
250,000
Assets = Liabilities + Stockholders’ Equity
Leased Equipment (A) + 250,000 = Lease Payable (L)
+ 250,000
Chapter 09 – Reporting and Interpreting Liabilities
9-11
LO 7 – Compute present values.
IV. Present Value Concepts
A. Present Value
1. Present value – Current value of an amount to be received
in the future; a future amount discounted for compound
interest
2. In a present value problem, you know the dollar amount
of a cash flow that will occur in the future and need to
determine its value now
B. Present Value of a Single Amount
1. Formula to compute the present value of a single amount:
Present value = 1 ÷ (1 + i )n x Amount
2. Formula is not difficult to use; however, most analysts
use present value tables, calculators, or Excel
3. Today is 1/1/14 and you have the opportunity to receive
$1,000 cash on 12/31/16. At an interest rate of 10% per
year, how much is the $1,000 payment worth today?
Use Supplemental
Enrichment Activity #4
a. Present value factor – For i = 10%, n = 3, present
value of $1 is 0.7513
Refer students to Pause for
Feedback – Self-Study Quiz
b. Present value = $1,000 × 0.7513 = $751.30
C. Present Value of an Annuity
1. Annuity – A series of periodic cash receipts or payments
that are equal in amount each interest period
2. You are to receive $1,000 cash on each December 31,
2014, 2015, and 2016. How much would the sum of these
three $1,000 future amounts be worth on January 1, 2014,
assuming an interest rate of 10% per year?
Use Supplemental
Enrichment Activity #4
a. Present value factor – For i = 10%, n = 3, present
value of an annuity of $1 is 2.4869
b. Present value = $1,000 × 2.4869 = $2,486.80
D. Interest Rates and Interest Periods
1. When interest periods are less than a year, the values of n
and i must be restated to be consistent with the length of
the interest period
2. If compounding is quarterly:
a. The interest period is one quarter of a year (i.e., four
periods per year), and the quarterly interest rate is one
quarter of the annual rate (i.e., 3 percent per quarter)
See A Question of Ethics
feature “Truth in
Advertising”
b. 12% interest compounded quarterly for five years
requires use of n = 20 and i = 3%.