eporting and Interpreting Liabilities
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 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.
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 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.
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.
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.
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.