current liabilities and contingencies

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Current Current Liabilities and Liabilities and ContingenciesContingencies

Current Current Liabilities and Liabilities and ContingenciesContingencies

Chapter12

An electronic presentation by Douglas Cloud

Pepperdine University

An electronic presentation by Douglas Cloud

Pepperdine University

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1. Explain the characteristics of a liability.2. Define current liabilities.3. Account for compensated absences.4. Understand and record payroll taxes and

deductions.5. Record property taxes.6. Account for warranty costs.

ObjectivesObjectives

ContinuedContinuedContinuedContinued

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7. Explain the terms “probable,” “reasonably possible,” and “remote” related to contingencies.

8. Record and report a loss contingency.

9. Disclose a gain contingency.

ObjectivesObjectives

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Conceptual Overview of Liabilities

Conceptual Overview of Liabilities

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.

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Three Essential Characteristicsof a Liability

Three Essential Characteristicsof a Liability

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.

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Primary Liabilities IssuesPrimary Liabilities Issues

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.

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Current LiabilitiesCurrent Liabilities

Current liabilities are obligations whose

liquidation is expected to require the used of

existing current assets...

Current liabilities are obligations whose

liquidation is expected to require the used of

existing current assets...

…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.

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Operating CycleOperating Cycle

Cash

Inventory

Receivables

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LiquidityLiquidity

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.

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Ways of Reporting LiquidityWays of Reporting Liquidity

1. Classify current liabilities and assets (mixture of operating-cycle and maturity-date approach).

2. Classify current liabilities and assets using the “pure” operating-cycle approach.

3. Classify current liabilities and assets under the maturity-date approach only.

4. Adopt a different classification scheme, possibly using more classes.

5. Leave the balance sheet unclassified but arranging items in order of liquidity.

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Liquidity RatiosLiquidity Ratios

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.

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Types of Current LiabilitiesTypes of Current Liabilities

Having Contractual Amount

Having Contractual Amount

Accounts payableNotes payableCurrently maturing portion of long-term debt

Dividends payableAdvances and refundable depositsAccrued itemsUnearned items

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Amount Depends on Operations

Amount Depends on Operations

Sales (use) taxesPayroll taxesIncome taxesBonuses


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Amount Must Be Estimated

Amount Must Be Estimated

Property taxesWarrantiesPremiums and coupons

Other contingencies


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Current Liabilities HavingA Contractual Amount


Trade accounts payable arise from the purchase of inventory, supplies, or services on an open charge-account

basis.

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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.

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Trishan Corporation uses a perpetual inventory system and purchases merchandise for $7,000 on September 1, 2004 by

issuing a $7,000, 12%, 30-day note to the supplier.

Trishan Corporation uses a perpetual inventory system and purchases merchandise for $7,000 on September 1, 2004 by

issuing a $7,000, 12%, 30-day note to the supplier.

September 1, 2004Inventory 7,000 Notes Payable 7,000October 1, 2004Interest Expense ($7,000 x 0.12 x30/360) 70Notes Payable 7,000 Cash 7,070

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On December 1, 2004, the Trollingwood Corporation borrows money at First National Bank by issuing a $10,000, 90 -day, non-interest-bearing note that is

discounted on a 12% basis.

On December 1, 2004, the Trollingwood Corporation borrows money at First National Bank by issuing a $10,000, 90 -day, non-interest-bearing note that is

discounted on a 12% basis.

December 1, 2004Cash 9,700Discount on Notes Payable 300 Notes Payable 10,000


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December 31, 2004Interest Expense 100 Discount on Notes Payable 100

March 1, 2005Interest Expense 200 Discount on Notes Payable 200

Notes Payable 10,000 Cash 10,000

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On July 1, 2003, Rexlow Corporation issues 13% serial bonds with a face value of $1 million.

These bonds are to be retired in installments of $100,000, beginning on July 1, 2005.

On July 1, 2003, Rexlow Corporation issues 13% serial bonds with a face value of $1 million.

These bonds are to be retired in installments of $100,000, beginning on July 1, 2005.

Current liability:Bonds Payable, due July, 2005 $100,000

Long-term liability:Bonds payable $900,000

December 31, 2004 Balance SheetDecember 31, 2004 Balance Sheet

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Compensated AbsencesCompensated Absences

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.

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:

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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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Milton Company has 100 employees who are paid an average of $100 per day. Company policy

allows each employee 12 days of paid vacation per year. Assume no vacation days were taken.

Milton Company has 100 employees who are paid an average of $100 per day. Company policy

allows each employee 12 days of paid vacation per year. Assume no vacation days were taken.

Sales Salaries Exp. Compensated Absences 15,000Office Salaries Exp. Compensated Absences 15,000 Liability for Employees’ Compensation for Future Absences (3/12 x $120,000) 30,000

March 31, 2005March 31, 2005

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The $200,000 April 30, 2005 payroll, including paid vacation time taken by the

sales and office staff, is as follows:

The $200,000 April 30, 2005 payroll, including paid vacation time taken by the

sales and office staff, is as follows:

Payroll for

Time Worked Vacation Taken

Sales staff $97,000 $3,000Office staff 96,500 3,500


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Sales Salaries Expense 97,000Office Salaries Expense 96,500Liability for Employees’ Compen- sation for Future Absences 6,500

Cash 200,000

April 30, 2005April 30, 2005


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Disclosure of Off-Balance Sheet Obligations


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.

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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.

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Current Liabilities Whose Amounts Depend on

Operations

Current Liabilities Whose Amounts Depend on

Operations

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Sales and Use TaxesSales and Use Taxes

Selleroy Company sells merchandise for cash with a retail sales price of $50,000 on which a sales tax of 6% is levied. The company collects $53,000.

Selleroy Company sells merchandise for cash with a retail sales price of $50,000 on which a sales tax of 6% is levied. The company collects $53,000.

Cash 53,000 Sales 50,000 Sales Taxes Payable 3,000

Typical SituationTypical SituationTypical SituationTypical Situation

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Sales and Use TaxesSales and Use Taxes

At the end of January the Sales account is adjusted to record the tax on all goods sold [$53,000 –

($53,000 ÷ 1.06)] = $3,000.

At the end of January the Sales account is adjusted to record the tax on all goods sold [$53,000 –

($53,000 ÷ 1.06)] = $3,000.

Cash 53,000 Sales 53,000

The Sales Tax is Included in the Price The Sales Tax is Included in the Price Charged to the CustomerCharged to the Customer

The Sales Tax is Included in the Price The Sales Tax is Included in the Price Charged to the CustomerCharged to the Customer

Sales 3,000 Sales Taxes Payable 3,000

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Liabilities Related to PayrollsLiabilities Related to Payrolls

Involuntary Taxes Involuntary Taxes Withheld from Withheld from

EmployeesEmployees


EmployeesEmployees

Federal income taxState income taxF.I.C.A. taxes: O.A.S.D.I. Medicare

Federal income taxState income taxF.I.C.A. taxes: O.A.S.D.I. Medicare


EmployersEmployers


EmployersEmployers

F.I.C.A. taxes: O.A.S.D.I. MedicareFederal unemploy-

ment taxState unemployment

tax

F.I.C.A. taxes: O.A.S.D.I. MedicareFederal unemploy-

ment taxState unemployment

tax

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Liabilities Related to PayrollsLiabilities Related to Payrolls

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

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Accounting for Payroll Taxes and Deductions


To record salaries and employee withholding items:

Sales Salaries Expense 10,000Office Salaries Expense 4,000 F.I.C.A. Taxes Payable (8% x $14,000) 1,120

Employee Federal Income Taxes Withholding Payable 990Employee State Income Taxes Withholding Payable 500Employee Union Dues Withholding Payable 180Cash 11,210

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To record employer payroll taxes:

Payroll Taxes Expense 1,988F.I.C.A. Taxes Payable (8% x $14,000) 1,120Federal Unemployment Taxes Payable ((0.8% x $14,000) 112State Unemployment Taxes Payable (5.4% x $14,000) 756



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Bonus ObligationsBonus Obligations

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.

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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%.

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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 – 0.03B = $18,200 0.97 B = $18,200

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

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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

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

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

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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

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Current Liabilities Current Liabilities Requiring Amounts to be Requiring Amounts to be

EstimatedEstimated

Current Liabilities Current Liabilities Requiring Amounts to be Requiring Amounts to be

EstimatedEstimated

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Property TaxesProperty Taxes

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, 2004 to June 30, 2005 are $7,200. The tax bill is mailed in October with a requirement that

the tax be paid before December 31, 2004. The tax bill reported an actual tax of $7,290, and the

corporation pays this amount on October 31, 2004.

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, 2004 to June 30, 2005 are $7,200. The tax bill is mailed in October with a requirement that

the tax be paid before December 31, 2004. The tax bill reported an actual tax of $7,290, and the

corporation pays this amount on October 31, 2004.

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Property TaxesProperty TaxesThree Monthly Entries July 31–September 30, 2004

Property Tax Expense ($7,200 ÷ 12) 600Property Taxes Payable 600

October 31, 2004: Payment of Property Taxes

Property Tax Payable 1,800Prepaid Property Taxes 5,490

Cash 7,290Three Monthly Entries: October 31–December 31, 2004

Property Tax Expense 610Prepaid Property Taxes 610

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Expense Warranty Expense Warranty Accrual MethodAccrual Method

Expense Warranty Expense Warranty Accrual MethodAccrual Method

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Warranty ObligationsWarranty Obligations

Cash or Accounts Receivable 1,200,000Sales 1,200,000

Warranty cost per machine is estimated at $150.Warranty cost per machine is estimated at $150.

Warranty Expense 30,000Estimated Liability under Warranties 30,000

Anglee Machinery Corporation begins production on a new machine in April 2004 and sells 200 of these

machines at $6,000 each by December 31, 2004.

Anglee Machinery Corporation begins production on a new machine in April 2004 and sells 200 of these

machines at $6,000 each by December 31, 2004.


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The corporation spent $5,000 in 2004 to fulfill warranty agreements for the 200 machines.

The corporation spent $5,000 in 2004 to fulfill warranty agreements for the 200 machines.

Estimated Liability under Warranties 5,000Cash (or other assets) 5,000

The corporation spent $25,150 in 2005 to fulfill warranty agreements for the two machines.

The corporation spent $25,150 in 2005 to fulfill warranty agreements for the two machines.

Estimated Liability under Warranties 25,000Warranty Expense 150

Cash (or other assets) 25,150

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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 Sales Warranty Accrual MethodAccrual MethodSales Warranty Sales Warranty Accrual MethodAccrual Method



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Recognition of warranty expense for period, April–December, 2004.

Recognition of warranty expense for period, April–December, 2004.

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

Recognition of warranty revenue for period, April–December, 2004.

Recognition of warranty revenue for period, April–December, 2004.

Unearned Warranty Revenue 5,000Warranty Revenue 5,000


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Recognition of warranty expense during 2005.Recognition of warranty expense during 2005.

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

Recognition of warranty revenue during 2005.Recognition of warranty revenue during 2005.

Unearned Warranty Revenue 25,000Warranty Revenue 25,000

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On October 1, 2004, the American Meatball Corporation began offering to customers a serving disk in return for 30 meatball can labels. The offer

expires on April 1, 2005. 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 24,000Cash (or Accounts Payable) 24,000

Sold 300,000 cans of meatball at $1.80 each...

Cash (or Accounts Receivable) 540,000Sales 540,000


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Received 105,000 labels from customers:.

Premium Expense 7,000Inventory of Premium Serving Dishes 7,000

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

Premium Expense 5,000Estimated Premium Claims Outstanding 5,000

(105,000 (105,000 ÷÷ 30) 30) x $2)x $2)

Estimated labels that will be redeemed (300,000 x .60) 180,000Deduct labels redeemed during 2004 (105,000)Estimated number of future label redemptions 75,000

Premium expense for estimated future redemptions:

[(75,000 ÷ 30) x $2) $5,000

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ContingenciesContingencies

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.

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• 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? Yes

NoNoAmount reasonably

estimated? Yes

Report amount in financial statements

Report amount in financial statements

Yes NoNoReasonable possibility

of loss

Disclose in notes to financial statementsDisclose in notes to financial statements

or and

and

Disclose in notes to financial statements

Not required to disclose

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Disclosure of Gain Contingencies

Disclosure of Gain Contingencies

(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.

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Short-Term Debt Expected to be Refinanced


When a company relies on a financing agreement to

demonstrate the ability to refinance, the amount of the short-

term debt that it excludes from current liabilities is reduced to an

amount that is the lesser of...

When a company relies on a financing agreement to

demonstrate the ability to refinance, the amount of the short-

term debt that it excludes from current liabilities is reduced to an

amount that is the lesser of...


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1. The amount available for refinancing under the agreement, or

2. The amount obtainable under the agreement after considering the restrictions included in other agreements, or

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

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Chapter12

The EndThe EndThe EndThe End

current liabilities and contingencies

Documents

existing current assets

total assets ratio

primary liabilities

assets mixture of operating

total debt

specific date

maturitydate approach

probable future transfer