eporting and Interpreting Liabilities

Introduction

Businesses
finance the acquisition of their assets from three sources: profits
generated through operations of the business, funds supplied by
creditors (debt), or funds provided by owners (equity). The mixture of
debt and equity that a business uses is called its capital structure. In
this module, we will examine the basic concepts that affect
liabilities.

Liabilities

Liabilities
are the debts and obligations of an entity, which will require the
probable future sacrifice of assets (Kimmel, Weygandt, & Kieso,
2009). Liabilities are classified on the balance sheet as either current
or long term, depending upon when they are due. Current liabilities are
the obligations of the organizations that are reasonably expected to be
paid within 1 year of the balance sheet date or the operating cycle,
whichever is longer. All liabilities not classified as current are considered to be long-term liabilities.

Current Liabilities

Typical
current liabilities include accounts payable, accrued expenses,
short-term notes payable, the current portion of long-term debt,
salaries and wages payable, unearned revenues, interest payable, and
taxes payable.

Long-Term Liabilities

Long-term
liabilities are all obligations that are not classified as current and
include notes payable, bonds payable, and other long-term debt
instruments. Long-term liabilities that are maturing within one year are
classified as current liabilities unless the maturing debt will be
satisfied by incurring additional long-term debt. Accountants use
present value concepts to determine the reported amounts of long-term
liabilities. The liability is not reported at the amount of the total
future payments but the amount of the present value of the future
payments.

Notes payable may be included in
current or long-term liabilities depending upon the nature of the note. A
note payable is a formal written debt instrument that specifies the
amount borrowed, when it must be repaid, and the interest rate
associated with the debt. Notes payable will be classified as either
current or long-term depending upon when they mature. Some types of
notes, such as installment notes or mortgages, may have current portions
and long-term portions shown on the balance sheet. Accountants must
report the debt when it is incurred and the related interest expense as
it accrues. Interest payable on a note is accounted for in a separate
account from the note itself; the note payable should not be affected as
interest expense accrues.

Time Value of Money

Long-term liabilities will be paid more than one year in the future and are generally subject to interest based upon the time value of money.
The concept of the time value of money is that a dollar to be received
in the future is worth less than a dollar available today (present
value) and a dollar invested today will grow to a larger amount in the
future (future value). To determine the future value of a known present
amount, interest is added to the present value. To determine the present
value of a known future amount, interest is backed out of a future
amount. These concepts are applied either to a single payment or
multiple recurring payments called annuities. Either tables or
calculators can be used to determine present and future values. Bonds
payable and some notes payable take into account the time value of
money. Current liabilities are so short term in nature that the time
value of money is not generally recognized when reporting current
liabilities.

Bonds are debt instruments that
corporations and government units issue when they borrow large amounts
of money. After bonds have been issued, some bonds can be traded on
established exchanges such as the New York Bond Exchange. The ability to
sell a bond on the bond exchange is a significant advantage for
creditors because it provides them with liquidity or the ability to
convert their investments into cash.

Three
types of events must be recorded over the life of a typical bond: (1)
the receipt of cash when the bond is first sold, (2) the periodic
payment of cash interest, and (3) the repayment of principal upon the
maturity of the bond.

Bonds are sold at a
discount whenever the coupon interest rate (stated rate) is less than
the market rate of interest. A discount is the dollar amount of the
difference between the par value of the bond and its selling price. The
discount is recorded as a contra-liability when the bond is sold and is
amortized over the life of the bond as an adjustment to interest
expense.

Bonds are sold at a premium
whenever the coupon interest rate is more than the market rate of
interest. A premium is the dollar amount of the difference between the
selling price of the bond and its par value. The premium is recorded as a
liability when the bond is sold and is amortized over the life of the
bond as an adjustment to interest expense. Bond discounts and premiums
can be amortized using either the straight-line method or the
effective-interest method. Under the straight-line method, a consistent
amount of interest expense is incurred each period from the bond’s
issuance until maturity in order to amortize the discount or premium to
zero by the maturity date. Under the effective-interest method, interest
expense is computed each period by multiplying the current amount of
the bond liability by the market rate of interest when the bond was
issued. Thus, the interest expense will change each period that the
discount or premium is amortized.

Analysis

Review the available materials for the chapters covered this week, including the lecture, reading, publisher materials, demonstration problems and exercises at the end of the chapters. After reviewing these materials and attempting the assignment for the week, what challenges did you face? Do you have any questions on the material?Analysts
use various tools to assess the financial health of corporations. One
such tool is the debt-to-equity ratio. The debt-to-equity ratio (total
liabilities divided by owners’ equity) compares the amount of capital
supplied by creditors to the amount supplied by owners. It is a measure
of a company’s debt capacity. Horngren?s Accounting, The Financial Chapters
Read chapters 11 and 14.

Liabilities and the Statement of Cash Flows

Cash
flows associated with transactions involving long-term creditors are
reported in the financing activities section of the statement of cash
flows. Interest expense is reported in the operating activities section.

Conclusion

The
sources of funds for a corporation are classified as either debt
funding or equity funding. An understanding of a company’s capital
structure provides insight into the company’s strategy, needs, and
solvency. Prior to investing in a company or lending to a company,
investors and creditors will review the capital structure of a company
and do a ratio analysis to compare the company to similar investments or
credit opportunities.

References

Kieso, D., Weygandt, J., & Warfield, T. (2009). Intermediate accounting (3rd ed.). Hoboken, NJ: John Wiley and Sons, Inc.

Kimmel, P., Weygandt, J., & Kieso, D. (2009). Accounting: Tools for business decision making (3rd ed.). Hoboken, NJ: John Wiley and Sons, Inc.

Libby, R., Libby, P., & Short, D. (2004). Financial accounting (4th ed.). New York: McGraw-Hill/Irwin.

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