PRINCIPLES of ACCOUNTING II (AC202) ___________ CHAPTER 12 CURRENT AND LONG-TERM LIABILITIES LIABILITIES DEFINED: A probable future payment of assets or services a company is presently obligated to make as a result of past transactions or events. Fundamentally liabilities are measured by the "cost principle" however: Liabilities are comprised of known obligations of a definite amount and known obligations of an estimated amount (i.e. warranties) CURRENT LIABILITIES: Obligations expected to be paid using current assets or by creating other current liabilities LONG-TERM LIABILITIES: Obligations not expected to be paid within one year. Includes long-term notes payable; mortgages payable; warranty liabilities; lease liabilities; and bonds payable. MEASUREMENT OF LIABILITIES Conceptually, the dollar amount of a liability, at any point in time, is the "present value" of the future outlays of assets required to pay the debt in full. i.e. the present value of principal plus all future interest payments The present value amount may be called the "current cash equivalent amount" -What both parties would settle for today! A liability that requires the "going rate of interest" will always have a present value equal to its maturity amount (i.e. interest bearing notes) When the required rate of interest is different from the going rate, or interest is unspecified, the present value will be different from the maturity amount. (i.e. bonds sold at a premium or discount) As such liabilities approach maturity, the current cash equivalent amount approaches the maturity amount CURRENT LIABILITIES Accounts Payable Short-term Notes Payable Unearned (deferred) Revenues Payroll Liabilities -Employee Payroll Deductions -Employer Payroll Taxes Warranty Liabilities Employee Health/Pension Benefits Payable Vacation Pay (employee benefits) Tax Liabilities for Businesses (Federal Income Tax - Corporation only; State and/or local income taxes - Corporation only; property taxes; sales taxes; etc.) Deferred Income Taxes for Corporations Contingent Liabilities -Legal Claims (Potential) -Debt Guarantees -Other Contingencies INTEREST & NON-INTEREST NOTES Interest Bearing Notes: Specifies: -A stated rate of interest -Interest is to be paid at maturity in addition to the face or principal amount of the note. Non-Interest Bearing Notes: Does not specify a rate of interest Includes the interest in the face amount of the note An overdue non-interest bearing note immediately draws interest at a legal rate (usually specified by law) from the due date. EXAMPLE: The business needs to borrow $2,000 cash from the bank for 60 days on December 16, 1999 a. interest bearing note, 6% b. non-interest bearing note, $2,040 UNEARNED REVENUES Arise from revenues that have been collected in advance during the current period but will not be earned until a later accounting period. -Also called; Deferred Revenue, Revenue collected in Advance, or Precollected Revenue Unearned Revenues constitute a liability since cash has been collected but the goods or services have not been provided (i.e. the revenue has not been earned) -There is a "present obligation" to render, in the future, the product or services. EXAMPLE: Textbook, page 499 PAYROLL LIABILITIES Recording Employee salary expense and amounts withheld. -Textbook, page 507 Recording Employer Payroll taxes -Textbook, page 508 Payroll Reports, Records and Procedures -Appendix 12A, page 523 Payroll reports are filed within one month after the end of each calendar quarter Payments: -Less than $500, pay with report -Most companies are required to pay monthly or semiweekly -If taxes are over $100,000 they must be paid at the end of the next business day Employers are required to provide employees with a W-2 before January 31 of the following year Companies with many employees often use a special "payroll bank account" to pay employees. CONTINGENT LIABILITIES A contingent liability is not a legal or effective debt -- rather it is a potential future liability It is a potential liability that has arisen as a result of an event that "already has occurred" but its conversion to an effective liability is dependent upon the occurrence of one or more "future events" REPORTING: -A contingent liability is not recorded in the accounting records unless there is a high probability of loss. -They are generally reported in a footnote(s) to the financial statements An example is a pending lawsuit. Before recording in the financial records work with the legal representation to insure proper recording CURRENT LIABILITIES Working Capital: The difference between total current assets and total current liabilities Current Ratio or Workinng Capital Ratio: ______Current Assets_____ Current Liabilities Example: The balance sheet for ABC Company, December 31, 2000, reported total current assets of $900,000 and total current liabilities of $300,000. Working Capital: $900,000 - $300,000 = $600,000 Current Ratio: $ 900,000__ 300,000 = 3.00 or 3 to 1 LONG-TERM LIABILITIES Includes ALL obligations of the entity not properly classified as current liabilities. Generally arise from the purchase of fixed assets or borrowing on large sums of money -Long-term Notes Payable -Bonds Payable -Mortgages Payable Frequently, a long term liability is supported by a mortgage on specified assets of the borrower which are "pledged" as security for the liability. Secured debt -- a liability (i.e. Mortgage Payable) supported by a building/land Unsecured debt -- Creditor relies on the integrity and general earning power of the borrower As a long-term debt approaches the maturity date, the portion of it that is to be paid in the next current period is reclassified as a current liability Notes Payable Defined: A written promise to pay a stated sum at one or more specified dates in the future Notes Payable require the payment of interest and the recording of interest expense. Interest expense is incurred on liabilities because of the "time value of money" In calculating interest we must consider -Principal -Interest rate -Duration of time Interest formula is: Interest = Principal x Rate x Time The accounting for a note payable is the same whether it is classified as a current or as a long-term liability. Balance sheet presentation is different.