2/18/2009. Reporting and CURRENT LIABILITIES. Notes Payable. Chapter 9

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1 Chapter 9 Reporting and analysing liabilities PowerPoint presentation by Anne Abraham University of Wollongong 2009 John Wiley & Sons Australia, Ltd CURRENT LIABILITIES A current liability is an obligation that can reasonably be expected to be paid within one year or within the operating cycle, whichever is the longer Liabilities that do not meet this definition are classified as non-current Examples include: notes payable accounts payable revenue received in advance accrued liabilities 2 Notes Payable Notes payable record obligations in the form of written notes Usually require borrower to pay interest or borrowing costs Frequently issued to meet short-term financing needs Issued for varying periods of time 3 1

2 Notes payable Journal entry when note issued Mar 1 Cash Notes Payable (To record issue of 12%, 4-month note to West State Bank) Journal entry to record interest Mar 1 Interest Expense Interest Payable (To accrue interest for 4 months on West State Bank note) 4 Notes payable Journal entry to settle liabilities Mar 1 Notes Payable Interest Payable Cash (To record payment of West State Bank interest-bearing note and accrued interest at maturity) 5 Payroll and payroll deductions payable Employers deduct amounts from employees wages and salaries if they are required to be paid to other parties These include deductions for: Tax (pay-as-you-go or PAYG) Superannuation Trade union fees Health insurance Employers are responsible to remit these withheld funds to the appropriate parties 6 2

3 Payroll and payroll deductions payable Entry for payroll accrual and payment Mar 7 Salaries and Wages Expense Pay-as-you-go Withheld Tax Payable Salaries and Wages Payable (To record payroll and withheld taxes for the week ending 7 March) Mar 7 Salaries and Wages Payable Cash (To record payment of 7 March payroll) 7 Payroll and payroll deductions payable Journal entry when payments are made Apr 6 Pay-as-you-go Withheld Tax Payable Cash (To record payment of withheld taxes for March) 8 Revenues received in advance Occurs when customers pay ahead of time for goods or services e.g. Purchase of plane tickets Magazine subscriptions Season passes to sporting events 9 3

4 Revenues received in advance Journal entry to record revenue received in advance Aug 6 Cash Ticket Revenue Received in Advance (To record sale of season tickets) t Journal entry when service is delivered Sep 5 Ticket Revenue Received in Advance Football Ticket Revenue (To record football ticket revenue) 10 NON-CURRENT LIABILITIES Obligations expected to be paid after 1 year or outside normal operating cycle Common forms of these obligations are: Bank loans Long-term notes Debentures are notes that are subject to a secured charge on the issuers assets Unsecured notes are not subject to a security over assets 11 Why issue long-term notes? Advantages of Debt Financing Shareholder control is not affected Current owners retain full control of company Tax savings result Interest is deductible for tax purposes; dividends on shares are not Earnings per share may be higher Although interest expense reduces net profit, earnings per share may be higher because no additional shares are issued 12 4

5 What options are available for a business requiring additional long term debt finance? 13 Why issue long-term notes? Disadvantage of Debt Financing Company is locked into fixed payments. These must be made in good and bad times Interest must be paid on periodic basis Principal must be paid at maturity Company with fluctuating earnings and relatively weak cash flow may experience difficulty in meeting interest payments in periods of low earnings 14 Determining the market value of long-term notes The face value of a note (or principal) is the amount due at maturity The issue price is the amount paid for the note by the investor at the time of issue The market value of the note is the price at which it is traded by willing parties, and may vary over time The contract interest rate is the rate used to determine the amount of interest the borrower pays and the investor receives 15 5

6 Determining the market value of long-term notes The present value of a note is the face value plus the contractual interest rate for the life of the debt, stated in today s equivalent dollar terms: affected by cash amounts to be received (face value + contractual interest rate), by length of time until investor receives cash, and by current market rates 16 Determining the market value of long-term notes Calculation of present value of future payments Present value of $ received in 5 years $ Present value of $9000 received annually for 5 years Market price of notes $ Accounting for issues of unsecured notes and debentures Journal entries are required when longterm debt is issued or repaid If one investor sells to another investor, no journal entry is required Face value of long-term debt is often different than amount of cash received from investors: premium if market rates < contract discount if market rates > contract 18 6

7 Accounting for issues of unsecured notes and debentures Journal entry to record debentures issued Jun 30 Cash Debentures Payable (To record issue of debentures at face value) Journal entry to record payment of interest Dec 31 Interest Expense (Borrowing Costs) Cash (To record payment of debenture interest) 19 Redeeming unsecured notes and debentures at maturity Notes are redeemed when they are purchased (repaid) by the issuing company Carrying amount of the notes will always equal their face value Entry to record redemption at maturity 2030 Jun 30 Debentures Payable Cash (To record redemption of debentures at maturity) 20 Redeeming unsecured notes and debentures at maturity Notes may be redeemed before maturity A company may decide to redeem notes early to reduce interest cost and remove debt from its statement of financial position Company must Eliminate carrying amount of notes at redemption date Record cash paid Recognise gain or loss on redemption 21 7

8 Redeeming unsecured notes and debentures at maturity Journal entry to record redemption before maturity at 103% of face value Jun 30 Debentures Payable Loss on Redemption of Debentures Cash (To record redemption of debentures at 103) 22 LOANS PAYABLE BY INSTALMENT Entities may borrow money from a single borrower in the form of loan It is common for such loans to be repayable by instalment, e.g. mortgages A mortgage is a loan secured by a charge over property If the borrower is unable to repay the loan, the lender may sell the property and use the proceeds to repay the loan 23 Accounting for loans payable by instalment Mortgage payments consist of: Interest expense and Reduction of loan liability Journal entry to record mortgage payment Mar 31 Interest Expense Loan Payable Cashat Bank (To record loan repayment for March) 24 8

9 Current and non-current components of long-term debt Entities often have a portion of long-term debt that falls due within the coming year This portion of the long-term debt should be classified as a current liability 25 Current and non-current components of long-term debt The remainder will be classified as a noncurrent liability An adjusting entry is not necessary to recognise the current portion of the liability. It is recognised by proper classification on the statement of financial statement 26 PROVISIONS AND CONTINGENT LIABILITIES Accruals are liabilities to pay for goods or services that have been provided but not yet invoiced e.g. next telephone or electricity account Involve a low level of uncertainty Provisions are liabilities for which the amount of the future sacrifice is still uncertain e.g. long service leave Involve significant level of uncertainty 27 9

10 PROVISIONS AND CONTINGENT LIABILITIES A warranty is an obligation of the supplier of goods or services to the purchaser that the product will be functional There is significant uncertainty in measuring the future sacrifice because: It is conditional upon the customer making a claim The costs of satisfying the claim depend on the nature of the fault 28 PROVISIONS AND CONTINGENT LIABILITIES Contingent liabilities are liabilities for which the amount of future sacrifice is so uncertain that it cannot be measured reliably e.g. an unresolved legal l action Contingent liabilities are not recognised in the accounts because they are neither probable nor able to be measured reliably However, they must be disclosed in the notes to the financial statements 29 Recording provisions for warranties Entry to record liability for outstanding warranties Jun 30 Warranty Expense Warranty Provision (To record the liability for warranty contracts outstanding at balance date) Entry to record goods replaced under warranty Jul 12 Warranty Provision Inventory (To record replacement of goods under warranty) 30 10

11 Recording provisions for warranties Entry to increase cost of servicing unexpired warranty contracts Jun 30 Warranty Expense Warranty Provision (To adjust the liability for Warranty Provision i account to total estimated liability for contracts outstanding at balance date) 31 FINANCIAL STATEMENT ANALYSIS 1. Liquidity Ratios These measure the short-term ability of an entity to pay its maturing obligations and to meet unexpected needs for cash. 3 useful measures: (a) Working capital (b) Current ratio (c) Quick ratio 32 FINANCIAL STATEMENT ANALYSIS (a) Working capital = Current assets Current liabilities Example: ($ in millions) Telstra $5513 $8123 = $2610 $5353 $9434 = $4081 Corporation 33 11

12 FINANCIAL STATEMENT ANALYSIS (b) Current ratio = Current assets Current liabilities Example: ($ in millions) Telstra $5513 = 0.68:1 $5353 = 0.57:1 Corporation $8123 $ FINANCIAL STATEMENT ANALYSIS (c) Quick ratio = Cash + Marketable securities + Net receivables Current liabilities Provides a measure of immediate short-term liquidity Example: ($ in millions) Telstra $899 + $3952 = 0.60:1 $823 + $3891 = 0.50:1 Corporation $8123 $ FINANCIAL STATEMENT ANALYSIS 2. Solvency Ratios These measure the ability of an entity to survive over a long period of time 2 useful measures: (a) Debt to total assets ratio (b) Times interest earned 36 12

13 FINANCIAL STATEMENT ANALYSIS (a) Debt to total assets ratio = Total liabilities Total assets Example: ($ in millions) Telstra $ = 0.68:1 $ = 0.67:1 Corporation $ $ FINANCIAL STATEMENT ANALYSIS (b) Times interest earned = Profit before income tax + Interest expense Interest expense Provides an indication of an entity s ability to meet interest payments as they become due Example: ($ in millions) Telstra $ $1158 = 5.4 times $ $1144 = 5.1 times Corporation $1158 $ Decision Toolkit Telecom Corporation of New Zealand Ltd Work through on your own and check your results with the suggested solution provided 39 13

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