Current Liabilities and Contingencies

1. C 12 hapter Current Liabilities and Contingencies An electronic presentation by Douglas Cloud Pepperdine University

2. Objectives 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. Continued

3. Objectives 7. Explain the terms “probable,” “reasonably possible,” and “remote” related to contingencies. 8. Record and report a loss contingency. 9. Disclose a gain contingency.

4. 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.

5. 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 assetsat 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 avoidthe future sacrifice. 3.The transaction or other event obligating the company has already happened.

6. Primary Liabilities Issues 1.Identification of liabilities—the detection of a company’s obligations. 2. Measurement or valuationof 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.

7. Current Liabilities …or the creation of other current liabilities within one year or an operating cycle, whichever is longer. Current liabilities are obligations whose liquidation is expected to require the used of existing current assets...

8. Inventory Receivables Cash Operating Cycle

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

10. Ways 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.

11. Liquidity 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.

12. Accounts payable Notes payable Currently maturing portion of long-term debt Dividends payable Advances and refundable deposits Accrued items Unearned items Types of Current Liabilities Having Contractual Amount

13. Sales (use) taxes Payroll taxes Income taxes Bonuses Types of Current Liabilities Amount Depends on Operations

14. Property taxes Warranties Premiums and coupons Other contingencies Types of Current Liabilities Amount Must Be Estimated

15. Current Liabilities HavingA Contractual Amount Trade accounts payable arise from the purchase of inventory, supplies, or services on an open charge-account basis.

16. Current Liabilities HavingA Contractual Amount A note payable is an unconditional written agreement to pay a sum of money to the bearer on a specific date.

17. Current Liabilities HavingA Contractual Amount 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, 2004 Inventory 7,000 Notes Payable 7,000 October 1, 2004 Interest Expense ($7,000 x 0.12 x30/360) 70 Notes Payable 7,000 Cash 7,070

18. Current Liabilities HavingA Contractual Amount 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, 2004 Cash 9,700 Discount on Notes Payable 300 Notes Payable 10,000 Continued

19. Current Liabilities HavingA Contractual Amount December 31, 2004 Interest Expense 100 Discount on Notes Payable 100 March 1, 2005 Interest Expense 200 Discount on Notes Payable 200 Notes Payable 10,000 Cash 10,000

20. December 31, 2004 Balance Sheet Current liability: Bonds Payable, due July, 2005 $100,000 Long-term liability: Bonds payable $900,000 Current Liabilities HavingA Contractual Amount 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.

21. Compensated Absences A company recognizes an expense and accrues a liability for employees’ compensation for future absences if allthe following conditions are met: 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.

22. Compensated Absences 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.

23. Compensated Absences 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.

24. March 31, 2005 Sales Salaries Exp. Compensated Absences 15,000 Office Salaries Exp. Compensated Absences 15,000 Liability for Employees’ Compensation for Future Absences (3/12 x $120,000) 30,000 Compensated Absences 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.

25. Payroll for Time Worked Vacation Taken Sales staff $97,000 $3,000 Office staff 96,500 3,500 Compensated Absences The $200,000 April 30, 2005 payroll, including paid vacation time taken by the sales and office staff, is as follows: Continued

26. Compensated Absences April 30, 2005 Sales Salaries Expense 97,000 Office Salaries Expense 96,500 Liability for Employees’ Compen- sation for Future Absences 6,500 Cash 200,000

27. 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.

28. Disclosure of Off-Balance Sheet Obligations 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.

29. Current Liabilities Whose Amounts Depend on Operations

30. Sales and Use Taxes Typical Situation 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

31. Sales and Use Taxes The Sales Tax is Included in the Price Charged to the Customer Cash 53,000 Sales 53,000 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. Sales 3,000 Sales Taxes Payable 3,000

32. Involuntary Taxes Withheld from Employees Involuntary Taxes Withheld from Employers F.I.C.A. taxes: O.A.S.D.I. Medicare Federal unemploy-ment tax State unemployment tax Federal income tax State income tax F.I.C.A. taxes: O.A.S.D.I. Medicare Liabilities Related to Payrolls

33. Liabilities Related to Payrolls Voluntary Payroll Deductions Withheld from Employees Union dues Government bonds Group hospital insurance Accident insurance Life insurance Others

34. Accounting for Payroll Taxes and Deductions To record salaries and employee withholding items: Sales Salaries Expense 10,000 Office Salaries Expense 4,000 F.I.C.A. Taxes Payable (8% x $14,000) 1,120 Employee Federal Income Taxes Withholding Payable 990 Employee State Income Taxes Withholding Payable 500 Employee Union Dues Withholding Payable 180 Cash 11,210

35. Accounting for Payroll Taxes and Deductions To record employer payroll taxes: Payroll Taxes Expense 1,988 F.I.C.A. Taxes Payable (8% x $14,000) 1,120 Federal Unemployment Taxes Payable ((0.8% x $14,000) 112State Unemployment Taxes Payable (5.4% x $14,000) 756

36. Bonus 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.

37. Bonus Obligations 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%.

38. Bonus Obligations 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 ÷ 0.97 B = $18,763 (rounded)

39. Bonus Obligations 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 ÷ 1.07 B = $17,009 (rounded)

40. Current Liability Current Liability Bonus Obligations To record the bonus: Salaries Expense (Officer’s Bonus) 17,009 Officer’s Bonus Payable 17,009 To record the income tax expense: Income Tax Expense 72,897 Income Taxes Payable 72,897

41. Current Liabilities Requiring Amounts to be Estimated

42. Property 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.

43. Property Taxes Three Monthly Entries July 31–September 30, 2004 Property Tax Expense ($7,200 ÷ 12) 600 Property Taxes Payable 600 October 31, 2004: Payment of Property Taxes Property Tax Payable 1,800 Prepaid Property Taxes 5,490 Cash 7,290 Three Monthly Entries: October 31–December 31, 2004 Property Tax Expense 610 Prepaid Property Taxes 610

44. Expense Warranty Accrual Method

45. Warranty Obligations 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. Cash or Accounts Receivable 1,200,000 Sales 1,200,000 Warranty cost per machine is estimated at $150. Warranty Expense 30,000 Estimated Liability under Warranties 30,000 Continued

46. Warranty Obligations The corporation spent $5,000 in 2004 to fulfill warranty agreements for the 200 machines. Estimated Liability under Warranties 5,000 Cash (or other assets) 5,000 The corporation spent $25,150 in 2005 to fulfill warranty agreements for the two machines. Estimated Liability under Warranties 25,000 Warranty Expense 150 Cash (or other assets) 25,150

47. Warranty Obligations 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. Sales Warranty Accrual Method Cash or Accounts Receivable 1,200,000 Sales ($5,850 x 200) 1,170,000 Unearned Warranty Revenue 30,000 Continued

48. Warranty Obligations Recognition of warranty expense for period, April–December, 2004. Warranty Expense 5,000 Cash (or other assets) 5,000 Recognition of warranty revenue for period, April–December, 2004. Unearned Warranty Revenue 5,000 Warranty Revenue 5,000 Continued

49. Warranty Obligations Recognition of warranty expense during 2005. Warranty Expense 25,150 Cash (or other assets) 25,150 Recognition of warranty revenue during 2005. Unearned Warranty Revenue 25,000 Warranty Revenue 25,000

50. Premium and Coupon Obligations 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.