Week 13, Chap 9 Accounting 1A, Financial Accounting

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1 Week 13, Chap 9 Accounting 1A, Financial Accounting Reporting and Interpreting Liabilities Instructor: Michael Booth

2 Understanding the Business Debt is considered riskier than equity. Interest is a legal obligation. Creditors can force bankruptcy.

3 Define, measure, and report current liabilities.

4 Liabilities Defined and Classified Defined as probable debts or obligations of the entity that result from past transactions, which will be paid with assets or services. Maturity = 1 year or less Current Liabilities Maturity > 1 year Noncurrent Liabilities

5 Liabilities Defined and Classified Liabilities are measured at their current cash equivalent (the amount a creditor would accept to cancel the debt) at the time incurred.

6 Current Liabilities

7 Payroll Taxes Gross Pay Net Pay Less Deductions: Social Security Tax Medicare Tax Federal Income Tax State and Local Income Taxes Voluntary Deductions

8 Use the current ratio.

9 Current Ratio An important indicator of a company s ability to meet its current obligations. Current Ratio = Current Assets Current Liabilities Starbucks has current assets of $924 and current liabilities of $ Current Ratios Starbucks Panera Bread Krispy Kreme

10 Analyze the accounts payable turnover ratio.

11 Accounts Payable Turnover Ratio Measures how quickly management is paying trade accounts. Accounts Payable Turnover Cost of = Goods Sold Average Accounts Payable Starbucks has cost of goods sold of $1,685.9 and average accounts payable of $ Accounts Payable Turnove r Ratios Panera Krispy Starbucks Bread Kreme N/A Days = 365/11.06 Days= 33

12 Report notes payable and explain the time value of money.

13 Notes Payable

14 Notes Payable A note payable specifies the interest rate associated with the borrowing. To the lender, interest is a revenue. To the borrower, interest is an expense. Interest = Principal Interest Rate Time When computing interest for one year, Time equals 1. When the computation period is less than one year, then Time is a fraction.

15 Notes Payable Starbucks borrows $100,000 for 2 months at an annual interest rate of 12%. Compute the interest on the note for the loan period.

16 Learning Objectives Compute present values. Apply present value concepts to liabilities.

17 Present Value Concepts $1,000 invested today at 10%. In 5 years it will be worth $1, In 25 years it will be worth $10,834.71! Money can grow over time, because it can earn interest.

18 Present Value Concepts The growth is a mathematical function of four variables: 1. The value today (present value). 1. The value in the future (future value). 1. The interest rate. 1. The time period.

19 Present Value Concepts Most analysts use calculators or Excel to solve time value of money problems. Note: use of present value tables is also acceptable

20 Present Value Formula for Single Amount P = F / (1 + r) ^n Discount Factor = 1 / (1 + r) ^n P = Present Value F= Future Value r = interest rate n = number of periods

21 Present Value of a Single Amount The present value of a single amount is the worth to you today of receiving that amount some time in the future. Present Value Future Value Interest compounding periods Today Future

22 Present Value of a Single Amount How much do we need to invest today at 10% interest, compounded annually, if we need $1,331 in three years? The required future amount is $1,331. i = 10% & n = 3 years Using the present value of a single amount table (A.1), the factor is $1, = $1,000 (rounded)

23 Present Values of an Annuity An annuity is a series of consecutive equal periodic payments. Today

24 Present Value Formula for multiple future payments Amount P = C 1 / (1 + r) ^1 + C 2 / (1 + r) ^2 + C 3 / (1 + r) ^ Discount Factor = 1 / (1 + r) ^n P = Present Value F= Future Value r = interest rate n = number of periods C = cash payment

25 Present Values of an Annuity What is the value today of a series of payments to be received or paid out in the future? Payment 1 Payment 2 Payment 3 Present Value Interest compounding periods Today

26 Present Values of an Annuity What is the present value of receiving $1,000 each year for three years at an interest rate of 10%, compounded annually? The consecutive equal payment amount is $1,000. i = 10% & n = 3 years Using the Present value of an annuity table,(a.2), the factor is $1, = $2,486.90

27 Accounting Applications of Present Values On January 1, 2006, Starbucks bought some new delivery trucks. The company signed a note agreeing to pay $200,000 on December 31, The market interest rate for this note is 12%. Interest 12% Future Value 200,000 =pv(rate,nper,pmt,fv) Present value $ 159,439 Period 1 Interest$ 19,133 Period 2 Interest$ 21,429 Total $ 200,000 Let s prepare the journal entry to record the purchase.

28 Accounting Applications of Present Values Now, let s Present look Value at the journal Interest entry Rate = December Interest 31, $159, % = $19,133

29 Accounting Applications of Present Values The journal entries at December 31, 2007(year 2). Present Value Interest Rate = Interest ($159,440 + $19,133) 12% = $21,429

30 Present Value Computations Using Excel

31 Present Value Computations Using Excel Present Value of A Single Amount Formula = Payment/(1 + i)^n Interest 12% Future Value 200,000 Number of Periods 2 Interest Calc =pv(rate,nper,pmt,fv) Present value $ 159,439 Period 1 Interest $ 19,133 =FV(rate,NPer,,159439) Period 2 Interest $ 21,429 =FV(rate,NPer,,178572) Total $ 200,000

32 Report contingent liabilities.

33 Contingent Liabilities Potential liabilities that arise because of events or transactions that have already occurred.

34 Importance of working capital and its impact on cash flows.

35 Working Capital Management Working Capital = Current Assets - Current Liabilities Changes in working capital accounts affect cash flows as indicated in the following table.

36 Report long-term liabilities.

37 Long-Term Liabilities Creditors often require the borrower to pledge specific assets as security for the long-term liability. Maturity = 1 year or less Current Liabilities Maturity > 1 year Long-term Liabilities

38 Long-Term Notes Payable and Bonds Relatively small debt needs can be filled from single sources. Banks Insurance Companies or Pension Plans

39 Long-Term Notes Payable and Bonds Significant debt needs are often filled by issuing bonds to the public. Bonds Cash

40 Borrowing in Foreign Currencies When a company has operations in a foreign country, it often borrows in the local currency. This reduces exchange rate risk. Because interest rates vary from country to country, companies may borrow in the foreign market with the lowest interest rate.

41 Operating & Capital Leases

42 Operating vs. Capital lease Understand the rationale for leasing and the distinction between operating and capital leases Understand the income statement and the balance sheet differences between operating and capital leases from lessee s perspective

43 The nature of leases A lease is an agreement conveying the right to use property, plant or equipment usually for a stated period of time, in exchange for periodic cash payments The owner of the property is referred to as the lessor, and the renter is the lessee

44 Economic substance of leases Operating lease Lessee rents the property Lessee accrues rent expense Capital lease Lessee economically owns the property Lessee records the leased asset in the balance sheet (i.e. capitalizes the asset) and reflects the corresponding lease obligation

45 Economic Rational for lease Operational advantages to lease Leasing ready-to-use equipment can be more attractive if the asset requires lengthy preparation and set-up Leasing avoids having to own the asset that will be required only seasonally, temporarily or sporadically (leasing contract can be tailored) Leasing for short periods protects against obsolescence But lease payments are accordingly higher

46 Economic Rationale for Leases Financial advantages to the leases Lease payments can be tailored to suit the lessee s cash flows (up to 100% financing, instead of the 80% limit by banks) Properly structured leases may be off-balance sheet, avoiding debt-covenant restrictions Leasing can be tax advantageous when the lessee is unable to take the depreciation tax advantage of owning

47 Disadvantages to Leasing Disadvantages to lessee Leased ready-to-use equipment may be of lower quality than custom built (resulting in lower quality products and lower sales) Seasonal leasing may affect equipment availability and pricing Premium must be paid against obsolenscence Disadvantages to financial statement users: Off-balance sheet financing can hide the true leverage (debt obligations) of the firm

48 Operating and Capital Leases Operating Lease Capital Lease Short-term lease; No liability or asset recorded Long-term lease; Meets one of 4 criteria; Results in recording an asset Capital Lease Criteria 1. Lease term is 75% or more of the asset s expected economic life. 2. Ownership of asset is transferred to lessee at end and of lease. a liability 3. Lease permits lessee to purchase the asset at a price that is lower than its fair market value. 4. The present value of the lease payments is 90% or more of the fair market value of the asset when the lease is signed.

49 Accounting for operating leases (Lessee s Ledger) An operating lease is recorded as a rental of an asses in the financial statements When the lease agreement is signed and the lessee begins using the asset: A = L + SE (no entry) During the Lease (as payments are made): Cash = L + Retained Earnings (PP) = (PP), as rent expense PP = Periodic lease payment

50 Accounting for capital leases Lessee s Ledger A capital lease is recorded as an asset acquisition with 100% debt financing in the financial statements When the lease agreement is signed and lessee begins using the asset: Leased Property = Lease Obligation PVL = PVL During the lease (as payments are made) Cash + leased property acc depr. = lease obligation + RE - PP (PP Int expense) - Int Exp - Depr. -Depr Expense PVL = Present Value of Leas PP = Periodic lease payment Int Exp = beginning lease liability * %int, where beginning lease liability = present value remaining payment at int% Depr. Expense = depreciation expense

51 Operating and Capital Leases: An Example Delta transactions if treated as an capital lease: Leased Property = Lease Obligation $30,000 = $30,000 When the lease agreement is signed and lessee begins using the asset During the lease (as payments are made): Y1 Cash - Acc Depr = Lease oblig + RE - $ Int Exp Depr Exp (Depr=(30,000-0)/20) (Dec LO = ) (Int = * 16%) Y2 Cash - Acc Depr = Lease Oblig + Re -$ int Exp Depr Exp (Dec LO = ) (Int = (30, ) * 16%

52 Federal Income Tax Concepts

53 Federal Income Tax Concepts Corporations Are separate legal entities and are required to pay income taxes. Tax Obligation Determined by multiplying taxable income by the corporate tax rate.

54 Revenue and Expense Recognition for Income Tax Purposes 1. Interest revenue on state and municipal bonds is generally excluded from taxable income although it is included in accounting income. 2. Revenue collected in advance is included in taxable income when it is collected and in accounting income when it is earned. 3. Corporations that own less than 20% of another corporation s stock may exclude 70% of the dividends received from taxable income, although all dividends are included in accounting income. 4. For tax purposes, depreciation expense is generally based on the Accelerated Cost Recovery System (ACRS) or on the Modified Accelerated Cost Recovery System (MACRS).

55 Tax Minimization Versus Tax Evasion

56 Assignments: See web: http// This will be updated weekly as required Update your weekly journal for the Final Journal Work weekly on your final project, do the analysis with information learned during the week Note: Use McGrawHill HOMEWORK manager to submit assignments

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