Measuring and Recording Liabilities
Liabilities are generally recorded and disclosed at the present value of the future payments computed using a realistic interest rate. The existence of a nominal interest rate that is unrealistic makes the measurement task more difficult. The effect of complying with the rule is the description of the proper relationship between the amount actually borrowed and the amount of interest incurred during the life of the liability.
As an example of the use of present value computations, consider the facts about this asset acquisition:
The amount of the debt is as follows:
This entry would be made at the time of the purchase:
This journal entry would be recorded on December 31, 20×1, when the first payment is made:
The balance sheet would report the note balance of $44,580 on December 31, 20×1. The following example shows the calculation of the annual interest expense and the amount that would be disclosed for the note for each year in its life.
An alternate approach to recordkeeping would have recognized the difference between the present value of the note ($57,661) and the sum of the future payments ($75,000) as a discount of $17,339. Then, subsequent entries would have credited the discount instead of the note payable. While GAAP call for disclosure of the amount of the discount, it need not be recorded formally in the accounts. However, as a practical matter, recording the discount would virtually assure its disclosure in the balance sheet.
As exceptions to this general treatment, GAAP does not require that present value measurements be applied to trade receivables or payables that are due within “approximately one year” or to deposits that are to be applied to the purchase or sale of goods. The apparent reason for the exceptions is the probable immateriality of the amounts.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.