Current Liabilities and Fair Value Accounting

Current Liabilities and Fair Value Accounting10

Management Issues Related to Current Liabilities

OBJECTIVE 1: Identify the management issues related to current liabilities.

Key Ratios

• Payables turnover

• Days’ payable

Figure 1: Payables Turnover for Selected Industries

Figure 2: Days’ Payable for Selected Industries

Management Issues Related to Current Liabilities

• Liabilities are legal obligations that must be satisfied through the future payment of assets or performance of services.– A liability should be recognized when it is

incurred; end-of-period adjustments may be necessary.

• Failure to record a liability often results in an understatement of expenses.

Management Issues Related to Current Liabilities

• Liabilities are legal obligations that must be satisfied through the future payment of assets or performance of services.(cont.)– Liabilities are valued at the amount due or at

the fair market value of goods or services to be delivered.

Management Issues Related to Current Liabilities

• Liabilities are legal obligations that must be satisfied through the future payment of assets or performance of services.(cont.)– Liabilities are classified as current or long-

term.• A current liability is a liability due within one year

or within the normal operating cycle, whichever is longer.

• A long-term liability is a liability due beyond the normal operating cycle.

Management Issues Related to Current Liabilities

• Two common measures of the length of time creditors allow for payment are the payables turnover and the days’ payable.– The payables turnover is the average number of

times that accounts payable are paid in an accounting period and shows the relative size of a company’s accounts payable.

– The days’ payable shows the average length of time a company takes to pay its accounts payable.

Management Issues Related to Current Liabilities

• Required disclosures for liabilities include the following:– Balances– Maturity dates– Interest rates– Lines of credit– Other special credit arrangements

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Common Types of Current Liabilities

OBJECTIVE 2: Identify, compute, and record definitely determinable and estimated current liabilities.

Figure 3: Promissory Note

Figure 4: Illustration of Payroll Costs

Common Types of Current Liabilities

• Current liabilities consist of definitely determinable liabilities and estimated liabilities.

Common Types of Current Liabilities

• A definitely determinable liability can be measured precisely.– Accounts payable– Bank loans and commercial paper

Common Types of Current Liabilities

• A definitely determinable liability can be measured precisely. (cont.)– Notes Payable

• Notes payable with interest stated separately.– Issue note.– Accrue interest.– Pay note.

• Notes payable with interest included in the face amount.

– Issue note.– Accrue interest.– Pay note.

Common Types of Current Liabilities

• A definitely determinable liability can be measured precisely.(cont.)– Accrued liabilities (such as interest payable)– Dividends payable– Sales and excise taxes.– Current portion of long-term debt

Common Types of Current Liabilities

• A definitely determinable liability can be measured precisely.(cont.)– Payroll liabilities

• Record the payroll.

• Record employer payroll taxes.

– Unearned revenues• Receipt of revenues in advance.

• Performance of services for revenues received in advance.

Common Types of Current Liabilities

• Estimated liabilities are definite obligations whose exact amounts cannot be known until a later date. – Record estimated income taxes.– Property taxes

• Estimated expense.

• Payment of property taxes.

Common Types of Current Liabilities

• Estimated liabilities are definite obligations whose exact amounts cannot be known until a later date. (cont.)– Promotion costs

• Examples: coupons, rebate, frequent flyer programs

• Usually recorded as a reduction in revenue (contra-sales account)

Common Types of Current Liabilities

• Estimated liabilities are definite obligations whose exact amounts cannot be known until a later date. (cont.)– Product warranties

• Estimated expense.

• Replacement of product under warranty.

– Vacation pay• Estimated vacation pay expense.

• Payment of vacation pay.

Common Types of Current Liabilities

Common Types of Current Liabilities

Common Types of Current Liabilities

Common Types of Current Liabilities

Common Types of Current Liabilities

Common Types of Current Liabilities

Common Types of Current Liabilities

Common Types of Current Liabilities

Common Types of Current Liabilities

Common Types of Current Liabilities

Common Types of Current Liabilities

Common Types of Current Liabilities

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Contingent Liabilities and Commitments

OBJECTIVE 3: Distinguish contingent liabilities from commitments.

Contingent Liabilities and Commitments

• A contingent liability is a potential liability that may or may not become an actual liability. Examples are as follows:– Pending lawsuits– Tax disputes– Failure to comply with government regulations

Contingent Liabilities and Commitments

• There are two criteria for recording a contingent liability:– Occurrence is probable.– The amount can be reasonably estimated.

Contingent Liabilities and Commitments

• A commitment is a legal obligation that does not meet the technical requirements for recognition as a liability. Examples are as follows:– Purchase agreements– Leases

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Valuation Approaches to Fair Value Accounting

OBJECTIVE 4: Identify the valuation approaches to fair value accounting, and define time value of money and interest and apply them to present values.

Table 1: Present Value of $1 to Be Received at the End of a Given Number of Periods

Table 2: Present Value of an Ordinary $1 Annuity Received in Each Period for a Given Number of Periods

Valuation Approaches to Fair Value Accounting

• Fair value is the price for which an asset or liability could be sold.– Market approach

• Involves identical or comparable assets or liabilities.

• Ready market not as available, as in case of special-purpose equipment.

Valuation Approaches to Fair Value Accounting

• Fair value is the price for which an asset or liability could be sold.(cont.)– Income (or cash flow) approach

• Converts future cash flows into a single present value.

• Based on reasonable internally generated information.

Valuation Approaches to Fair Value Accounting

• Fair value is the price for which an asset or liability could be sold.(cont.)– Cost approach

• The amount that currently would be required to replace an asset.

• Inventory usually valued at lower of cost or market.

• Plant value would take into account asset’s age, condition, depreciation, and obsolescence.

Valuation Approaches to Fair Value Accounting

• Interest and the time value of money– Time value of money is the effects of the

passage of time on holding or not holding money.

Valuation Approaches to Fair Value Accounting

• Interest and the time value of money (cont.)– Interest is the cost of using money.

• With simple interest, interest is not computed on accrued interest.

• With compound interest, interest is computed on accrued interest.

Valuation Approaches to Fair Value Accounting

• Calculating present value– Illustrate the computation of the present value

of an amount, using Table 1 in the text.– Illustrate the computation of the present value

of an annuity, using Table 2 in the text.

Valuation Approaches to Fair Value Accounting

• Calculating present value (cont.)– Discuss time periods of less than one year for

which interest is compounded.• Some savings accounts can record interest

quarterly.

• Some bonds pay interest semiannually.

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Applications Using Present Value

OBJECTIVE 5: Apply the present value to simple accounting situations.

Applications Using Present Value

• Present value has several applications in accounting:– Determine the value of an asset considered for

purchase.– Calculate deferred payments.– Account for idle cash invested.

Applications Using Present Value

• Present value has several applications in accounting: (cont.)– Accumulate funds to pay off a loan.– Other applications, such as imputing interest

on non-interest-bearing notes, accounting for installment notes, determining the value of a bond, pension and lease obligations, and depreciation of property, plant, and equipment.

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