current liabilities and contingencies c hapter 13 an electronic presentation by norman sunderman...

Current Liabilities and Contingencies

Chapter 13

An electronic presentation by Norman Sunderman Angelo State University

An electronic presentation by Norman Sunderman Angelo State University

COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Intermediate AccountingIntermediate Accounting 10th edition 10th edition

Nikolai Bazley JonesNikolai Bazley Jones

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Liabilities are probable future sacrifices of

economic benefits arising from present obligations of a company to transfer assets or provide services

to other entities in the future as a result of past transactions or events.

Conceptual Overview of Liabilities

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1. It involves a present duty or responsibility of the company to one or more entities that will be settled by the probable future transfer or use of assets at a specified or determinable date, on occurrence of a specific event, or on demand.

2. The duty or responsibility obligates the company, leaving it little or no discretion to avoid the future sacrifice.

3. The transaction or other event obligating the company has already happened.

Three Essential Characteristics of a Liability

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1. Identification of liabilities— the detection of a company’s obligations.

2. Measurement or valuation of the liabilities and the related expense— the determination of an amount to attach to each obligation and to match as an expense against revenues.

3. Reporting on the financial statements— the specific disclosures in both the company’s financial statements and the related notes.

Primary Liability Issues

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Current liabilities are obligations whose

liquidation is expected to require the use of

existing current assets...

Current liabilities are obligations whose

liquidation is expected to require the use of

existing current assets...

Current Liabilities

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…or the creation of other current liabilities within one year or an operating

cycle, whichever is longer.

…or the creation of other current liabilities within one year or an operating

cycle, whichever is longer.

Current Liabilities

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Cash

Inventory

Receivables

Operating Cycle

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Liquidity refers to how quickly a liability can be paid, or its nearness to

cash.

Liquidity refers to how quickly a liability can be paid, or its nearness to

cash.

Liquidity

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1. Cash flows to total debt.

2. Net income to total assets (return on total assets ratio).

3. Total debt to total assets.

4. Current assets to current liabilities (current ratio).

5. Cash to current liabilities.

Liquidity Ratios

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Having Contractual Amount

Having Contractual Amount

Accounts payableNotes payableCurrently maturing portion of long-term debtDividends payableAdvances and refundable depositsAccrued itemsUnearned items

Accounts payableNotes payableCurrently maturing portion of long-term debtDividends payableAdvances and refundable depositsAccrued itemsUnearned items

Types of Current Liabilities

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Amount Depends on Operations

Amount Depends on Operations

Sales (use) taxesPayroll taxesIncome taxesBonuses

Sales (use) taxesPayroll taxesIncome taxesBonuses


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Amount Must Be Estimated

Amount Must Be Estimated

Property taxesWarrantiesPremiums and couponsOther contingencies

Property taxesWarrantiesPremiums and couponsOther contingencies


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Trade accounts payable arise from the purchase of inventory, supplies, or services on

an open charge-account basis.

Current Liabilities Having a Contractual Amount

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A note payable is an unconditional

written agreement to pay a sum of money to the bearer on a

specific date.

Current Liabilities Having a Contractual Amount

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Cash (Dividends Payable)

Property (Property Dividends Payable)

Scrip (Dividends Payable)

Cash (Dividends Payable)

Property (Property Dividends Payable)

Scrip (Dividends Payable)

Dividends Payable

Declaration of a dividend reduces retained earnings and creates a

current liability.

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1. The company’s obligation relating to the employee’s rights to receive compensation for future absences is attributed to the employee’s services already rendered.

2. The obligation relates to rights that vest or accumulate.

3. Payment of the compensation is probable.

4. The amount can be reasonably estimated.

A company recognizes an expense and accrues a liability for employees’ compensation for future absences if all the following conditions are met:

Compensated Absences

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A vested right exists when an employer has an obligation to make payments to an employee that is not contingent on the employee’s future

services.

A vested right exists when an employer has an obligation to make payments to an employee that is not contingent on the employee’s future

services.


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Accumulated rights are those that can be carried forward by the employee to future periods if not taken in the

period in which they are earned.

Accumulated rights are those that can be carried forward by the employee to future periods if not taken in the

period in which they are earned.


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FASB Statement No. 47 requires that if a company enters into an unconditional

purchase obligation that (1) is noncancellable, (2) is negotiated as part of arranging financing

for facilities to provide the contracted items, and (3) contains a term in excess of one year,

the company must make certain disclosures in the notes to its financial statements.

FASB Statement No. 47 requires that if a company enters into an unconditional

purchase obligation that (1) is noncancellable, (2) is negotiated as part of arranging financing

for facilities to provide the contracted items, and (3) contains a term in excess of one year,

the company must make certain disclosures in the notes to its financial statements.

Disclosure of Off-Balance Sheet Obligations

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FASB Statement No. 107 requires a company to disclose the fair value of all its financial instruments (both assets and liabilities),

whether recognized or not on the balance sheet.

FASB Statement No. 107 requires a company to disclose the fair value of all its financial instruments (both assets and liabilities),

whether recognized or not on the balance sheet.

FASB Statement No. 131 requires a company to recognize as liabilities any “derivative”

financial instruments that are obligations of the company, based on their fair value.

FASB Statement No. 131 requires a company to recognize as liabilities any “derivative”

financial instruments that are obligations of the company, based on their fair value.

Disclosure of Off-Balance Sheet Obligations

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Definition of Derivatives

Derivatives are financial instruments, such as forwards and options whose value

depends upon the value of an underlying instrument (asset or liability) such as a

security, commodity, currency or interest rate. Hence, they are "derived" from these

underlying instruments.

Derivatives are financial instruments, such as forwards and options whose value

depends upon the value of an underlying instrument (asset or liability) such as a

security, commodity, currency or interest rate. Hence, they are "derived" from these

underlying instruments.

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Current Liabilities Whose Amounts Depend upon

Operations

Current Liabilities Whose Amounts Depend upon

Operations

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Involuntary Taxes Involuntary Taxes Withheld from Withheld from

EmployeesEmployees


EmployeesEmployees

Federal income taxState income taxF.I.C.A. taxesMedicare

Federal income taxState income taxF.I.C.A. taxesMedicare


EmployersEmployers


EmployersEmployers

F.I.C.A. taxesMedicareFederal unemploy-

ment taxState unemployment

tax

F.I.C.A. taxesMedicareFederal unemploy-

ment taxState unemployment

tax

Liabilities Related to Payrolls

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Voluntary Payroll Voluntary Payroll Deductions Withheld Deductions Withheld

from Employeesfrom Employees

Voluntary Payroll Voluntary Payroll Deductions Withheld Deductions Withheld

from Employeesfrom Employees

Union duesGovernment bondsGroup hospital insurance

Accident insuranceLife insuranceOthers

Union duesGovernment bondsGroup hospital insurance

Accident insuranceLife insuranceOthers

Liabilities Related to Payrolls

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To record salaries and employee withholding items:

Sales Salaries Expense 20,000Office Salaries Expense 8,000 F.I.C.A. Taxes Payable (8% x $14,000) 2,240

Employee Federal Income Taxes Withholding Payable 1,980Employee State Income Taxes Withholding Payable 1,000Employee Union Dues Withholding Payable 360Cash 22,420

Accounting for Payroll Taxes and Deductions

The actual FICA rate is 6.2% and Medicare is 1.45% for a total of The actual FICA rate is 6.2% and Medicare is 1.45% for a total of 7.65%. Together these taxes are referred to as social security. For 7.65%. Together these taxes are referred to as social security. For

simplicity, an assumed rate of 8% is used for both these taxes.simplicity, an assumed rate of 8% is used for both these taxes.

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1. The bonus is based on the corporation’s income after deducting income taxes, but before deducting the bonus.

2. The bonus is based on the corporation’s net income after deducting both the bonus and the income tax.

1. The bonus is based on the corporation’s income after deducting income taxes, but before deducting the bonus.

2. The bonus is based on the corporation’s net income after deducting both the bonus and the income tax.

Alternative Methods

Bonus Obligations

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1. The word “after” means deduction in the bonus equation.

2. The bonus is always a deduction for the calculation of income taxes.

1. The word “after” means deduction in the bonus equation.

2. The bonus is always a deduction for the calculation of income taxes.

Bonus Obligations

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Bonex Corporation’s reported income for the current year is $260,000 before deducting income

taxes and bonus. The effective tax rate is 30% and the bonus is 10%.

Bonex Corporation’s reported income for the current year is $260,000 before deducting income

taxes and bonus. The effective tax rate is 30% and the bonus is 10%.

Bonus Obligations

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Method 1: Bonus computed on income after deducting taxes but before deducting the bonus:

B = 0.10($260,000 - T)T = 0.30($260,000 - B)B = 0.10[($260,000 - .30($260,000 - B)]

B = 0.10($260,000 - $78,000 + 0.30B) B = $26,000 - $7,800 + 0.03B

B - 0.03 B = $18,200 0.97 B = $18,200

B = $18,200 ÷ 0.97B = $18,763 (rounded)

Bonus Obligations

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Method 2: Bonus computed on income after deducting both taxes and the bonus:

B = 0.10($260,000 - B - T)T = 0.30($260,000 - B)

B = 0.10[$260,000 - B - .30($260,000 -B)] B = 0.10[$260,000 - B - $78,000 + 0.30B]B = $26,000 - 0.10B - $7,800 + 0.03B

B+0.10B-0.03B = $18,200 1.07B = $18,200

B = $18,200 ÷ 1.07B = $17,009 (rounded)

Bonus Obligations

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Salaries Expense (Officer’s Bonus) 17,009 Officer’s Bonus Payable 17,009

To record the bonus:

Income Tax Expense 72,897 Income Taxes Payable 72,897

To record the income tax expense: Current Liability

Current Liability

Bonus Obligations

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Current Liabilities Requiring Amounts to

be Estimated

Current Liabilities Requiring Amounts to

be Estimated

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Ezzell Company closes its books annually each December 31. The fiscal year for the town and

county in which the firm is located ends on June 30. The estimated property taxes for the period July 1, 2007, to June 30, 2008, are $7,200. The

tax bill is mailed in October with a requirement that the tax be paid before December 31, 2007.

The tax bill reported an actual tax of $7,290, and the corporation pays this amount on

October 31, 2007.

Ezzell Company closes its books annually each December 31. The fiscal year for the town and

county in which the firm is located ends on June 30. The estimated property taxes for the period July 1, 2007, to June 30, 2008, are $7,200. The

tax bill is mailed in October with a requirement that the tax be paid before December 31, 2007.

The tax bill reported an actual tax of $7,290, and the corporation pays this amount on

October 31, 2007.

Property Taxes

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Anglee Machinery Corporation sells 200 machines for $6,000. This amount includes a service contract

sale of $150 and a machine sale of $5,850.

Anglee Machinery Corporation sells 200 machines for $6,000. This amount includes a service contract

sale of $150 and a machine sale of $5,850.

Cash or Accounts Receivable 1,200,000Sales ($5,850 x 200) 1,170,000Unearned Warranty Revenue 30,000

Sales Warranty Accrual MethodSales Warranty Accrual MethodSales Warranty Accrual MethodSales Warranty Accrual Method

ContinuedContinuedContinuedContinued

Warranty Obligations

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Recognition of warranty expense for period, April-December, 2007.

Recognition of warranty expense for period, April-December, 2007.

Warranty Expense 5,000Cash (or other assets) 5,000

Recognition of warranty revenue for period, April-December, 2007.

Recognition of warranty revenue for period, April-December, 2007.

Unearned Warranty Revenue 5,000Warranty Revenue 5,000



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Recognition of warranty expense during 2008.Recognition of warranty expense during 2008.

Warranty Expense 25,150Cash (or other assets) 25,150

Recognition of warranty revenue during 2008.Recognition of warranty revenue during 2008.

Unearned Warranty Revenue 25,000Warranty Revenue 25,000


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On October 1, 2007, the American Meatball Corporation began offering to customers a serving disk in return for 30 meatball can labels. The offer expires on April 1, 2008. The cost of each premium serving disk is $2. It is estimated that 60% of the

labels will be redeemed.

Premium and Coupon Obligations

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Purchased 12,000 serving dishes at $2 each.Inventory of Premium Serving Dishes 24,000

Cash (or Accounts Payable) 24,000

Sold 300,000 cans of meatball at $1.80 each...Cash (or Accounts Receivable) 540,000

Sales 540,000


Premium and Coupon Obligations

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Received 105,000 labels from customers:.Premium Expense 7,000

Inventory of Premium Serving Dishes 7,000

Estimated that 75,000 labels will be submitted next year:Premium Expense 5,000

Estimated Premium Claims Outstanding 5,000

Estimated labels that will be redeemed (300,000 x .60)Estimated labels that will be redeemed (300,000 x .60) 180,000180,000Deduct labels redeemed during 2007Deduct labels redeemed during 2007 (105,000(105,000))Estimated number of future label redemptionsEstimated number of future label redemptions 75,00075,000

Premium expense for estimated future redemptions:Premium expense for estimated future redemptions:

(75,000 (75,000 ÷ 30) x $2÷ 30) x $2 $5,000$5,000

Premium expense for estimated future redemptions:Premium expense for estimated future redemptions:

(75,000 (75,000 ÷ 30) x $2÷ 30) x $2 $5,000$5,000

Premium and Coupon Obligations(105,000 ÷ 30)(105,000 ÷ 30)

x $2x $2

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A contingency is an existing condition involving uncertainty as to possible gain or loss that

will ultimately be resolved.

A contingency is an existing condition involving uncertainty as to possible gain or loss that

will ultimately be resolved.

Contingencies

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Contingencies

Probable. The future event or events is likely to occur.

Reasonably possible. The chance of the future event occurring is more than remote but less than likely.

Remote. The chance of the future event occurring is slight.

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Criteria Disclosure

NoNo Future event probable? YesYes

NoNoAmount reasonably

estimated? YesYes

Report amount in financial statements



Yes NoNoNoNoReasonable possibility

of loss

Disclose in notes to financial statementsDisclose in notes to financial statementsDisclose in notes to financial statementsDisclose in notes to financial statements

or and

and

Disclose in notes to financial statementsDisclose in notes to financial statements

Not required to disclose

Not required to disclose

Contingencies

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a. Contingencies that might result in gains usually are not reflected in [a company’s] accounts since to do so might be to recognize revenue prior to its realization.

b. Adequate disclosure shall be made of contingencies that might result in gains, but care shall be exercised to avoid misleading implications as to the likelihood of realization.

FASB Statement No. 5 requires that these gains be disclosed in the notes to the company’s financial statements.

Disclosure of Gain Contingencies

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A company may reclassify current liabilities to long-term to improve its working capital

and current ratio.

A company may reclassify current liabilities to long-term to improve its working capital

and current ratio.

Short-Term Debt Expected to be Refinanced

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1. The company intends to refinance the obligation on a long-term basis, and

2. The company can demonstrate the ability to consummate the refinancing.

3. A reasonable estimate of the minimum amount expected to be available for future refinancing if the amount that could be obtained fluctuates.

Short-Term Expected to be Refinanced

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Ability must be demonstrated by the fact that the company

1. Has issued long-term obligations or equity securities after the date of its balance sheet but before it issues its balance sheet, or

2. has entered into a bona fide long-term financing agreement before it issues its balance sheet that clearly permits the company to refinance the short-term obligations on a long-term basis.

Short-Term Debt Expected to be Refinanced

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Chapter13

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current liabilities and contingencies c hapter 13 an electronic presentation by norman sunderman...

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