Chapter 13: Current Liabilities and Contingencies

Sid Glandon, DBA, CPAAssistant Professor of Accounting

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Liability

FASB Concepts Statement #6– Present obligation

Probable future transfer or use of cash, goods, or services

– Unavoidable obligation– Transaction or event has already occurred

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Current Liabilities

Obligations whose liquidation will require– Use of current assets or – Creation of other current liabilities

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Examples of Current Liabilities

Accounts payable– Purchases on open account in the normal course

of business

Notes payable– Interest bearing– Zero-interest-bearing

Current maturities of long-term debt

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Line of Credit (Interest-Bearing Note)

Spencer Company took out a line of credit with the Bank of the West on April 1, 2004 for $100,000. The term is six months and the interest rate is 9%.

Prepare the journal entries to record:– The issuance of the line of credit– The payment of the line of credit

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Line of Credit (Interest-Bearing Note)

DATE ACCOUNT DEBIT CREDIT4/1/04 Cash 100,000

Notes payable 100,000

10/1/04 Interest expense 4,500Notes payable 100,000 Cash 104,500

Analysis of interest expense:Face amount of note 100,000Interest rate 9%Annual interest 9,000Short period 6/12Interest expense 4,500

To record the issuance of a line of credit for six months at 9% interest

To record the payment of principal and interest on the line of credit

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Noninterest-Bearing Note

Spencer Company took out borrowed $100,000 from Bank of the West on April 1, 2004. The instrument was a zero-interest bearing note for six months at 9% interest.

Prepare the journal entries to record:– The issuance of the zero-interest bearing note– The payment of the zero-interest bearing notes

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Noninterest-Bearing Note

DATE ACCOUNT DEBIT CREDIT4/1/04 Cash 95,500

Discount on notes payable 4,500Notes payable 100,000

Analysis of discount on notes payable:Face amount of note 100,000Interest rate 9%Annual interest 9,000Short period 6/12Discount on notes payable 4,500

10/1/04 Interest expense 4,500 Discount on notes payable 4,500Notes payable 100,000 Cash 100,000

To record the issuance of a zero-interest-bearing note for six months at 9% interest

To record the payment of the zero-interest-bearing note

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Short-Term Obligations Expected to be Refinanced

Refinancing criteria– Must intend to refinance the obligation on a long-

term basis, and– Must demonstrate an ability to consummate the

refinancing Actual refinancing after balance sheet date Entering into a financing agreement

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Other Current Liabilities

Dividends payable Returnable deposits Unearned revenues Sales taxes payable Property taxes payable Income taxes payable

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Sales Taxes Payable

Spencer Company has sales for the month of March 2004 of $150,000. All sales are subject to a 6.5% state sales tax and a 0.5% local sales tax.

Prepare the journal entries:– To record sales– To record the payment of sales taxes

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Sales Taxes Payable

DATE ACCOUNT DEBIT CREDIT3/31/04 Accounts receivable 160,500

Sales 150,000 Sales taxes payable 10,500

Analysis of sales taxes payable:Gross sales 150,000State sales tax rate 6.50%Local sales tax rate 0.50%Combined rate 7%Discount on notes payable 10,500

4/15/04 Sales tax payable 10,500 Cash 10,500

To record sales and sales tax collected for the month of March 2004

To record payment of sales taxes collected in March 2004

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Contingencies, SFAS #5

“An existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur”

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Gain Contingencies

Based on the constraint of conservatism gain contingencies are not recorded until resolved

Under certain circumstances such contingencies may be disclosed in the notes to the financial statements

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Loss Contingencies

Likelihood that liability exists– Probable

confirming event is likely to occur

– Reasonably possible the chance that a confirming event will occur is more

than remote but less than likely

– Remote The chance the confirming event will occur is slight.

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Loss Contingencies

Criteria for recording– It is probable that a liability has been incurred at

the balance sheet date, and– The loss is reasonably estimated

Criteria for disclosing– If it is reasonably possible that a liability has

been incurred at the balance sheet date, and– The loss is reasonably estimated

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Contingent Liability

On October 2, 2003, a company truck was involved in an accident with a car driven by Alexander. On January 12, 2004 the company was notified that Alexander had filed a lawsuit seeking damages for personal injuries in the amount of $800,000. The company's counsel believes it is reasonably possible that Alexander will be awarded between $250,000 and $500,000 and the $400,000 is a better estimate of potential liability than any other amount. The company's financial statements were issued on March 1, 2004.

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What amount of loss should the company accrue at December 31, 2003?

A.$0B.$250,000C.$400,000D.$500,000

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What amount of loss should the company accrue at December 31, 2003?

A) $0

SFAS 5 requires that a contingent loss be accrued when it is probable that, at a balance sheet date, an asset is overstated or a liability has been incurred and the amount of the loss can be reasonably estimated. If both conditions are not met but the probability of the loss is at least reasonably possible, the amount of the loss must be disclosed. This loss is reasonably possible and reasonably estimable. Hence, it should be disclosed but not accrued.

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Guarantee and Warranty Costs

Cash basis– Not GAAP but used for tax purposes

Accrual basis– Expense warranty approach

Integral part of the sale transaction Accrue warranty in year of sale

– Sales warranty approach Sold as a separate contract Extended warranties-deferred revenue

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Warranty Expense

Spencer Company sells 100 pet video units for $500 per unit during 2003. The video units have a three-year warranty covering parts and labor. Based on past experience management estimates that warranty costs will be $10 in the first year, $20 in the second year and $25 in the third year. During 2003 the company incurs $900 in warranty costs.

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Prepare the Journal Entry to Record Sales and Warranty Expense for 2003

ACCOUNT DEBIT CREDITAccounts receivable 50,000 Sales 50,000To record sales for 2003

Warranty expense 5,500 Estimated liability under warranties 5,500To record warranty expense on 2003 sales

Analysis of warranty expense:Estimated warranty cost per unit $55Units sold 100Warranty expense $5,500

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ACCOUNT DEBIT CREDITEstimated liability under warranties 900 Cash, payroll, parts 900To record warranty costs incurred during 2003 on 2003 sales

Prepare the Journal Entry to Record Warranty Costs Incurred During 2003

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Employee-Related Liabilities

Payroll deductions– Payroll expense– Payroll tax expense

Compensated absences– Services already rendered– Rights vested or accumulated– Compensation is probable– Amount is reasonably estimated

Bonus Agreements

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Gross Payroll

Percentage Amount TotalsGross salaries and wages $100,000Income tax withheld 15.0% $15,000Social security tax withheld 7.5% 7,500Union dues withheld 2,500Total withheld 25,000Net payroll $75,000

For the month of March 2004 Spencer Company had the following

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Journal Entry to Record Gross Payroll

ACCOUNT DEBIT CREDITSalaries and wages $100,000 Income taxes payable 15,000 Social security payable 7,500 Union dues payable 2,500 Cash 75,000To record payroll for the month of March 2004

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Payroll Taxes

Gross Payroll Percentage TotalsGross salaries and wages $100,000Social security (FICA) 7.50% $7,500State unemployment (SUTA) 9.00% 9,000Federal unemployment (FUTA) 0.80% 800Workmen's comp. 2.75% 2,750Total payroll taxes $20,050

Employer Payroll Taxes Associated with the March 2004 Payroll

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Journal Entry to Record Payroll Taxes

ACCOUNT DEBIT CREDITPayroll taxes 20,050 Social security payable 7,500 State unemployment payable 9,000 Federal unemployment payable 800 Workmen's comp. Payable 2,750To record payroll taxes associated with March 2004 payroll