An In-Depth Look at Liabilities

1.6 Notes Payable

- Accounting Term for financing (due in less than 1 year) obtained from banks and other creditors, for which the company typically signs a promissory note - Lines of credit are also included in this category - Notes payable due on demand or within 12 months are considered current, notes payable due in greater than 12 months is considered non-current - Notes payable may not require periodic payments before the due date - When you see a notes payable, you specifically want to know: 1. To whom the debt is owed 2. When it is due and payable 3. Why the company borrowed the funds 4. How much is still available to borrow 5. Assets pledged to secure the repayment of the note 6. The terms and conditions the borrower must comply with while the note is outstanding 7. Whether the borrowings are senior to or equal to any new loans in the event the borrowing company is liquidated or goes bankrupt.

1.6 Accounts Payable

- Accounts payable are the short term obligations of a company to pay its suppliers for goods and services provided on credit. - Also known as trade payables or trade creditors. - The typical evidence of an account payable is an invoice - they are current liabilities - An account payable is evidenced by a promissory note would be included in notes payable

1.24 LT Debt

- Also called Term Debt, consists of loans from banks and other financial institutions that are repaid over several years. - For fixed asset purchases such as real estate or equipment, banks usually lend for periods as long as seven to ten years. - Payments may be based on longer amortization- For example 10, 15, or even 20 years depending on the asset - Term debt is: 1. Recorded on the borrowers balance sheet at the principle amount or face value 2. Generally governed by a written contract called a "loan agreement" containing the covenants and agreements between the borrower and lending institution 3. Unsecured or secured, depending on the financial strength of the borrower - Example: As part of its ambitious expansion plans, Scientific INC. borrowed $720,000 from the bank for a period of six years. This is a term loan for which it entered into a loan agreement with the bank for the borrowed amount

1.18 Unearned Revenue

- Also called customer advances or deferred revenues, represent the funds the company has received from customers prior to the delivery of goods or performances of services - Unearned revenue is classified as a current liability on the balance sheet if the performance will happen within the next 12 months. - Any performance expected to take place more than 12 months after the balance sheet date will be reflected as a LT liability. - Unearned revenue is an example of deferred performance liability. The cash for the performance of the activities represented by this liability has already been received (and is included in the cash account); however, the outlay of resources necessary for the deferred performance lies in the future. These represent a future drain on the company's assets and resources. - Check phone for example on balance sheet

1.11 Accrued Expenses W/ Examples

- As we know, in accrual accounting expenses are recognized on the income statement in the period in which they occur, regardless of whether they have been paid. - Accrued expenses represent the company's liability to pay those expenses at a future date. - Examples 1. Sales Tax 2. Property Taxes 3. Wages 4. Insurance Payments 5. Interest Payments 6. Pension Contributions

1.5 The Impact of Liabilities on Repayment of Loans

- As we saw, Scientific Inc requested a loan of $500,00 for production equipment. - The company already has current liabilities of $775,000 and noncurrent liabilities of $590,000 - How will these affect scientific Incs repayment capacity - As a lender, we must know how a company's liabilities can impact its ability to repay your loan. Below is what you need to determine: 1. The liabilities that need to be paid during the term of your loan 2. Assets pledged to secure repayment of any liabilities- For example, LT debt secured by the company's property, plant, and equipment 3. Terms and conditions attached to the LT debt, such as any restrictions on additional borrowing and the timing of payment 4. Liabilities that have a less certain valuation, such as pensions, and the assumptions on which those estimations were based.

1.34 Accounting for Operating Leases

- Both the asset and the liability must appear on the balance sheet - the lease payments are still recognized in full in operating expenses on the income statement. 1. Balance sheet: the leased asset- The leased assets under an operating lease must appear either: - In current assets if the initial term of the lease is 12 months or less, or - in the fixed assets section of non current assets, if the initial term of the leases is longer than 12 months. 2. Balance Sheet: The lease liability- The total liability for an operating lease is the sum of all contracted lease payments, les any payment made at the commencement of the lease. The distribution of that amount between current and noncurrent liabilities depends on the initial term of the lease. - A short term operating lease obligation is listed in current liabilities - A long term operating lease obligation is separated into a current portion of operating leases and a long term portion 3. Income Statement: Lease Expense- The lease expense shown on the income statement is the total of lease payments during that period. Unlike a finance lease, the amount is not distributed between principal, interest, and amortization

1.35 Leases and LT loans: Comparison

- Check pic of table in phone

1.33 Operating Leases

- Commonly used to acquire the use of equipment on a LT or short term basis. These leases are particularly attractive for a company that needs equipment that changes rapidly with new technology - Example: Msquare leases 25 computers from bright electronics for its offices for a period of one year. - At the end of one year, Msquare simply returns the computers to bright electronics and stops making the lease payments. - This kind of lease is considered an operating lease, where the contract allows the use of an asset, but does not convey rights similar to ownership of the asset and the company cannot depreciate the asset on its balance sheet - Payments on an operating lease are recognized as an expense on the income statement - Operating leases: 1. Are written for a term that is shorter that the expected life of the leased asset 2. Do not meet any of the four criteria for a capital lease

1.32 Finance Lease Accounting

- Generally shown on the balance sheet as if the company had purchased the asset, because the company is getting virtually all the use from that asset. - the company can realize depreciation expense, may have certain tax advantages, and may have less of an equity requirement or down payment compared to the purchase of the same asset - the first step in recording the lease obligation is to calculate the net amount (the present value of the future rental payments). - This amount will be the value of the lease as stated on the balance sheet, rather than at gross amount of the total payments. - The present value of the cash payments for the lease is recorded on the company's balance sheet as: 1. A fixed asset: the leased property 2. A liability: the finance lease 3. Payments due within 12 months of balance sheet date are reported as a current liability (CPLTD- finance lease) 4. The remaining value of the lease is reported as a long term liability (LTD- finance lease) - Finance lease payments are accounted for as principal and interest. The principal portion of each payment reduced the corresponding lease obligation, and interest is expensed along with any loan interest on the income statement - In addition, the underlying leased asset is depreciated or amortized, using the same method for similar fixed assets, and the expense is combined with any other depreciation or amortization expense on the income statement.

1.7 Notes Payable Example

- J&M Furniture, a furniture manufacturer, borrowed $50,000 from its bank to purchase components for a special order from a customer. This transaction took place on January 1, 20Y1. The company promised to repay the loan by June 30, 20Y1, at an interest rate of 10% on the unpaid balance, and signed a promissory note as evidence of the debt. - The principal amount borrowed against the promissory note appears on its balance sheet as notes payable. - Normally note payable consist primarily of bank lines of credit. They are recorded on the borrowers balance sheet at the principle amount of the obligation outstanding as of the date of the balance sheet. Any unused but available portion of the loan amount will be discussed in the footnotes to the financial statements. - In this case of J&M, notes payable typically also involve payment of interest. Interest is not included in Notes Payable on the balance sheet; it is expensed on the income statement.

1.9 Accounts Payable Example

- J&M purchased raw material on credit for $10,000, for which the supplier issued an invoice with 30-day payment terms. This transaction creates an account payable on J&M balance sheet - Account Payable is normally recorded at the face value of the bill or invoice received. For most companies, accounts payable serve as an important source for short-term financing that generally carriers no interest charge. - Sometimes the gross amount of the bill will be reduced to a net amount if any discounts are allowed on the bill, and if the company normally takes advantage of these discounts.

1.6 Typical Liabilities

- Liabilities recorded on the balance sheet are recorded at the principal amount of the obligation outstanding - Below are the liabilities you will most likely find on a balance sheet: 1. Notes Payable 2. Accounts Payable 3. Accrued Expenses 4. LT debt 5. Current Portion of LT Debt 6. Unearned Revenue

1.30 Leases (Example)

- Msquare, a company that manufactures cartons, is growing rapidly and needs additional production equipment. To support its growth, Msquare has entered into a contract with shine papers to lease packaging production equipment for a period of five years - At the end of the five year period, Msquare has the option to purchase the equipment for 5% of the original price - When a company enters into a contract to lease, it agrees to lease fixed assets (normally land, buildings, and equipment) for a specified period of time. - A lessee is the company using the asset - a Lessor is the company that owns the asset - Leases can be categorized as: 1. Finance (Capital) Leases 2. Operating Leases

1.10 Difference between Notes Payable and Accounts Payable

- Notes Payable 1. Liabilities owed to banks and other creditors to fund short-term business needs 2. Involves a written promissory note 3. Involves a payment of interest - Accounts Payable 1. Liabilities owed to creditors and vendors from which the company has made a purchase 2. Involves bills and invoices 3. Carries no interest rate, and may provide a discount for early payment

1.31 Finance Leases

- One where the lessor finances the asset but transfers substantially all of the risks and benefits of ownership (including depreciation) to the lessee. - When a lease is a finance lease, the lessee shows the asset on a separate line, such as fixed assets under finance lease, in the fixed assets section of non current assets. - Depreciation/amortization is included in accumulated depreciation. - The lease payment obligations are included in liabilities: payments due within 12 months are shown as current portion, finance leases, and the remaining liability is usually shown as finance lease liability - Accounting rules state conditions for a lease to qualify as a finance lease for financial reporting purposes. - Finance Lease criteria (must meet any) 1. The lease transfers ownership of the asset to the lessee 2. The lease contains a bargain purchase option 3. The lease term is equal to 75% or more of the estimated economic life of the asset 4. The present value of the minimum lease payments equals or exceeds 90 percent of the fair value of the leased property. - if it does not meet this criteria it is an operating lease

1.19 Deposits

- Payments that customers make to a company to guarantee one of the following: 1. The company's performance on a contract; for example, a carpet installation 2. The customer's payment on a contract; for example, rent on an apartment 3. The customer's payment for possible damage to a company property left with the customer; for example, a car rental - The company usually credits or returns these deposits when the contract is completed or the property returned - Example: Customer deposits may be segregated from cash and shown as both 1. An asset called deposits, since the money should be segregated from normal cash balances; and 2. A liability, also called deposits, since there is an obligation to return the deposit once the performance is completed. - If the deposit is returned to the customer, both the asset and the liability decrease. - If the deposit becomes earned, the liability is decreased; the deposit amount moves from the deposits account to the cash account; and revenue is recognized on the income statement.

1.22 Noncurrent Liabilities W/ Example

- Scientific Inc. has entered a 15-year mortgage on commercial property for $370,000 at an interest rate of 10 percent - The property, which includes a company office building, serves as collateral for the mortgage until its paid off. - Because the repayment begins next year an is spread over 15 years, the amount of mortgage is split into two components: 1. The amount due within 12 months following the statement date, $25,000, is classified as a current liability; CPLTD 2. The remainder of the balance due in longer than 12 months, $345,000, is a noncurrent liability; LT debt - Most commonly these include LT debt such as loans from banks, leases company issued debentures, mortgages, and deferred taxes

1.2 Liabilities

- Using example of Scientific Inc. a borrowing client - The company wants to expand its current product line and is requesting a five year term loan in the amount of $500,000 to assist with the purchase of new production equipment - First step in assessing their ability to repay the requested financing is to identify what other obligations will be competing for available cash flow to repay the loan. - It is important to understand: 1. The nature of each obligation 2. The timing of required payments in relation to your loan

1.25 Types of LT Debt

- Usually used to finance a LT asset, property, plant, equipment 1. Term Loans- form of LT debt most frequently used by businesses. In most cases, a term loan is a bank loan to finance a company's fixed assets. It has a fixed maturity date, generally five to seven years from the date of the loan. They are usually secured but can be unsecured 2. Debentures- a bond issued by the company, sold to investors unsecured 3. Mortgage Loan- similar to a term loan, however it involves a mortgage on real estate as collateral

1.17 CPLTD W/ Example

- When analyzing the liabilities of the loan applicant, you need to pay particular attention to whether the cash flows generated by the company are adequate to pay its CPLTD - Example: Scientific Inc. made ambitious plans to expand its business across the US on March 30, 20Y2, the company borrowed $720,000 from the bank, to be repaid in equal payments of principal plus interest over a period of 6 years, beginning March 20Y3. The final payment will be made 20Y8. - Check phone for Pic of repayment schedule on Balance sheet

1.36 Disclosure requirements for LT debt

- When you asses the LT debts shown on your borrowers statements, you should always read the disclosures related to the LT debt - These disclosures include: 1. Description of LT debt by type of creditor 2. Asset used as security, or collateral 3. Interest Rate 4. Schedule of payment in each of the next 5 years 5. Exposure to interest rate risk 6. Significant terms and conditions that may affect the amount, timing, and certainty of cash flow 7. Violation of any covenants

1.12 Accrued Expenses and Cash Flow Example

- When you see the accrued expenses account on the balance sheet, you will know the company has matched expenses with revenues on the income statement without paying out cash for the expenses. - The actual cash outflow occurs when the accrued expense is paid - On January 10, J&M borrowed $50,000 at an interest rate of 10% to purchase raw materials for a new customer order. This loan note matures in 6 months, but interest is due quarterly, with the first payment due on April 10 - the interest payable by the company is calculated and recorded at the end of each accounting period (Monthly), even though payment is due only on a quarterly basis

1.6 Unearned Revenue

- a liability that reports amounts received in advance for providing goods or services - When the goods or services are provided, this account balance is decreased and a revenue account is increased

1.23 Current Vs. LT Liabilities

- from the lenders perspective, how are noncurrent liabilities different from current liabilities? 1. Current Liabilities- Have implications for the company's cash flow requirements in the year following the date of the balance sheet- The same cash flow you would rely upon to repay short term loans or lines of credit as well as the current portion of an LT debt you are proposing 2. LT Liabilities- represent a claim against longer term cash flows- the same cash flows you would rely on to repay the balance of any LT debt you are proposing.

1.6 LT Debt

- generally used to finance the purchase of long-lived assets, such as property, plant, and equipment - The evidence of LT debt is usually a loan agreement or promissory note. - LT capital leases also fall in this category of debt, as do debentures or bonds issued by the company. - A mortgage loan is a type of LT debt that involves a mortgage or lien on a real estate as collateral. - All forms of LT debt are non current liabilities

1.9 Discounts

- many suppliers offer discounts to their customers in return for early payment of the invoice. - These offers are often expressed in the payment terms shown on their invoice. - For example, if the invoice shows terms of 2/10, net 30, the supplier is offering a 2% discount on the entire amount invoiced if the customer pays within 10 days. Otherwise, full payment is expected within 30 days. - On a $10,000 invoice, the purchaser could save $200 by paying early. - If the purchasing company has funds available to pay the invoice early, its gross profit upon sale of the inventory is increased

1.6 Current Portion of LT Debt (CPLTD)

- the principal portion of LT debt that must be paid within the next year - At the end of the financial reporting period, the company determines the amount of principle that will be due on the LT debt during the next 12 months. - The amount of that payment becomes a current liability, CPLTD, while the remainder of LT debt remains in noncurrent liabilities

1.6 Accrued Expenses

- those expenses recognize on the income statement before they are paid in cash. - Insurance, rent, salaries are typically accrued - they are current liabilities

1.26 Repayment of LT debt (Example)

- what would happen if Scientific Inc. repays the loan of $720,000 within 3 years instead of 6? - It is important as a lender to analyze how and why the company has made significant additional repayments of LT debt - You can detect such repayments by: 1. Analyzing the charges in the LTD on the balance sheet. If LT debt plus CPLTD is less than the prior years LTD, additional payments have been made. 2. Reading the notes on LT debt obligations 3. Reviewing the statement of cash flows, which should show you any significant repayments of debt - Look a Pic in phone on a balance sheet example

1.3 Broad Categories of Liabilities

1. Money owed to others- Businesses often engage in transactions that create an obligation to pay another party at a time in the future. (Accounts Payable, Notes Payable, and LT debt are examples of this 2. Deferred Performance Liabilities- Future obligations to perform services are called deferred performance liabilities or deferred liabilities. For example, Scientific Inc may receive a customer advance for the purchase of custom laboratory equipment over a three year period. Scientific has signed a contract, received an advance, and is obligated to perform the services. Warranties are another example of this 3. Estimated Future Payment Obligations- take pensions for example, they create liability for future payments but the amount may change over many years. Therefore, estimations are taken into account