Liabilities. Liabilities. What are they? Theoretically: probable future sacrifices of economic benefits
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A non-interest bearing note is given to a vendor in exchange for goods and services. The note’s face value is $ 10,000. The note is due in 1 year. The typical interest charged in such a transaction would be 10%.
1000/1.10 = $ 9091.
Thus interest must be $ 909, with principle borrowed (and thus sale price) = $ 9091.
Defined benefit- The employer agrees to give the employee a set amount per year, usually based on a formula, when the employee retires. The amount of expense will vary as a function of many uncertainties, including:
The length of service
The number of employees that actually retire
The extent to which any benefit is vested.
The amount agreed to.
How long the employee lives
The yield on investments made to pay the expense someday.
A special note: when return on plan assets is a lot less than expected, the difference increases the cost companies incur in providing defined benefit plans. To smooth out the impact, this difference is only gradually charged to earnings.
As a result, because of the stock market crash, many companies experienced major shortfalls in pension funding from 2001-2003 that are only slowly being recognized.
A lot of important pension info is not booked but simply disclosed in footnotes.
When bonds are sold, they are booked at the amount that was exchanged by investors in return for the paper.
Subsequently, any discount or premium is amortized, thus adjusting cash payments (the coupon) for differences between the face amount due at maturity and what investors actually received when they lent the firm money.
An important note: Amortization causes the interest recongized to be based on the effective rate at the time bonds were issued.
Interest rates change constantly. As they do, the value of bonds change. This is not recognized in financial reports.
Can a liability be a liability if it is never paid?
Example: deferred taxes. Timing differences create deferrals that delay tax payments into future years.
To better match tax expense with the revenues that create it, these deferrals are recognized when the associated income is recognized. They are booked as an expense, with an offsetting liability called “deferred tax”.
If a firm is constantly growing (at least nominally), the deferrals to the IRS also keep growing. Thus, the balance in deferred taxes keeps growing and never gets paid.