Chapter 9

1. Chapter 9 Current Liabilities

2. Conceptual Learning Objectives C1:Describe current and long-term liabilities and their characteristics. C2: Identify and describe known current liabilities. C3:Explain how to account for contingent liabilities. 9-2

3. Analytical Learning Objectives A1: Compute the times interest earned ratio and use it to analyze liabilities. 9-3

4. Procedural Learning Objectives P1: Prepare entries to account for short-term notes payable. P2: Compute and record employee payroll deductions and liabilities. P3: Compute and record employer payroll expenses and liabilities. P4: Account for estimated liabilities, including warranties and bonuses. NOT COVERED P5: Appendix 9A: Identify and describe the details of payroll reports, records, and procedures. 9-4

5. Defining Liabilities A liability is a probable future payment of assets or services that a company is presently obligated to make as a result of a past transaction or event. Examples: TRANSACTIONS: Accounts payable: Purchase of Inventory; Wages payable: Employee Services; Utilities payable: Utility consumption. EVENTS: Unearned revenue: Received up-front payments for goods and services to be provided in the near future.

6. Liability --Three crucial factors: 1. Past transaction or event. 2. Present obligation. 3. Future payment of assets or services. Thecompanyhas a presentobligation Because of apast event . . . . . . For futuresacrifices Past Present Future 9-6

7. Long-Term Liabilities Expected not to be paid within one year or the company’s operating cycle, whichever is longer. Expected to be paid within one year or the company’s operating cycle, whichever is longer. Classifying Liabilities C 1 Current Liabilities 9-7

8. Uncertainty in Whom to Pay Uncertainty in Whento Pay OR to Provide services Uncertainty in How Much to Pay Uncertainty in Liabilities (pages 357 -58) Answers to the following questions are often decided when a liability is incurred; however, one or more may be uncertain for some liabilities. 9-8

9. Known Liabilities C 2 Accounts Payable Sales Taxes Payable Unearned Revenues Short-Term Notes Payable Payroll Liabilities Multi-Period Known Liabilities 9-9

10. Quick Study 1 Exercise 1

11. $7,500 × 6% = $450 Sales Taxes Payable On May 15, 2009, Max Hardware sold building materials for $7,500 that are subject to a 6% sales tax. 9-11

12. Quick Study 2

13. Unearned Revenues C 2 On May 1, 2009, A-1 Catering received $3,000 in advance for catering a wedding party to take place on July 12, 2009. 9-13

14. Quick Study 3 Exercise 2

15. Note Given to Extend Credit Period P1 On August 1, 2009, Matrix, Inc. asked Carter, Co. to accept a 90-day, 12% note to replace its existing $5,000 account payable to Carter. Matrix would make the following entry: 9-15

16. Interest expense = $5,000 × 12% × (90 ÷ 360) = $150 Note Given to Extend Credit Period P1 On October 30, 2009, Matrix, Inc. pays the note plus interest to Carter. 9-16

17. PROMISSORY NOTE Face Value Date after date promise to pay to the order of American Bank Nashville, TN Dollars plus interest at the annual rate of . $20,000 Sept. 1, 2009 Ninety days I Twenty thousand and no/100 - - - - - - - - - - - - - - - - - 6% Jackson Smith Note Given to Borrow from Bank P1 9-17

18. Face Value Equals Amount Borrowed P1 On September 1, 2009, Jackson Smith borrows $20,000 from American Bank. The note bears interest at 6% per year. Principal and interest are due in 90 days (November 30, 2009). 9-18

19. $20,000 × 6% × (90 ÷ 360) = $300 Face Value Equals Amount Borrowed P1 On November 30, 2009, Smith wouldmake the following entry: 9-19

20. An adjusting entry is required to record interest expense incurred to date. End-of-Period Adjustment to Notes P1 Note Date End of Period Maturity Date 9-20

21. End-of-Period Adjustment to Notes P1 Dec. 31, 2009 Dec. 16, 2009 Feb. 14, 2010 Note Date End of Period Maturity Date James Burrows borrowed $8,000 on Dec. 16, 2009, by signing a 12%, 60-day note payable. 9-21

22. End-of-Period Adjustment to Notes P1 On December 16, 2009, James Burrows would make the following entry: On December 31, 2009, the adjustment is: $8,000 × 12% × (15 ÷ 360) = $40 9-22

23. $8,000 × 12% × (45 ÷ 360) = $120 End-of-Period Adjustment to Notes P1 On February 14, 2010, James Burrows would make the following entry. 9-23

24. Quick Study 5Exercise 4 Exercise 5

25. Payroll Liabilities Employers incur expenses and liabilities from having employees. 9-25

26. Net Pay ($3,126) Employee Payroll Deductions P2 Gross Pay ($4,000) Medicare Taxes Federal Income Tax State and Local Income Taxes Voluntary Deductions FICA Taxes 9-26

27. Employee FICA Taxes P2 Federal Insurance Contributions Act (FICA) FICA Taxes — Soc. Sec. FICA Taxes —Medicare 2010: 6.2% of the first $106,800 earned in the year ( Max = $6,621.60). 2010: 1.45% of all wages earned in the year. Employers must pay withheld taxes to the Internal Revenue Service (IRS). 9-27

28. Employee Income Tax P2 State and Local Income Taxes Federal Income Tax Amounts withheld depend on the employee’s earnings, tax rates, and number of withholding allowances. Employers must pay the taxes withheld from employees’ gross pay to the appropriate government agency. 9-28

29. Employee Voluntary Deductions P2 Voluntary Deductions Amounts withheld depend on the employee’s request. Examples include union dues, savings accounts, pension contributions, insurance premiums, and charities Employers owe voluntary amounts withheld from employees’ gross pay to the designated agency. 9-29

30. $4,000 ´ 6.2% = $248 $4,000 ´ 1.45% = $58 Recording Employee Payroll Deductions P2 The entry to record payroll expenses and deductions for an employee might look like this. 9-30

31. Employers pay amounts equal to that withheld from the employee’s gross pay. Employer Payroll Taxes P3 Medicare Taxes1.45% FICA Taxes6.2% Federal and State Unemployment Taxes 9-31

32. 2008: 6.2% on the first $7,000 of wages paid to each employee (A credit up to 5.4% is given for SUTA paid, therefore the net rate is .8%.) Federal Unemployment Tax (FUTA) 2008: Basic rate of 5.4% on the first $7,000 of wages paid to each employee (Merit ratings may lower SUTA rates.) State Unemployment Tax (SUTA) Federal and State Unemployment Taxes P3 9-32

33. Recording Employer Payroll Taxes P3 The entry to record the employer payroll taxes for January might look like this: FICA amounts are the same as that withheld from the employee’s gross pay. SUTA: $4,000 ´ 5.4% = $216 FUTA: $4,000 ´ (6.2% - 5.4%) = $32 9-33

34. Quick Study 5 Exercise 6 Exercise 7 Problem 5A

35. Multi-Period Known Liabilities P3 Often include unearned revenues and notes payable. Unearned revenues from magazine subscriptions often cover more than one accounting period.A portion of the earned revenue is recognized each period and the unearned revenue account is reduced. Quick Study 3 Notes payable often extend over more than one accounting period. A three-year note payable would be classified as a current liability for one year and a long-term liability for two years. 9-35

36. Estimated Liabilities P4 An estimated liability is a known obligationof an uncertain amount, but one that can be reasonably estimated. A. Health and Pension Benefits B. Vacation Benefits C. Bonus Plans D. Warranty Liabilities 9-36

37. Health and Pension Benefits P4 Employer expenses for pensions or medical, dental, life and disability insurance Assume an employer agrees to pay an amount for medical insurance equal to $8,000, and contribute an additional 10% of the employees’ $120,000 gross salary to a retirement program. 9-37

38. $62,400 ÷ 52 weeks = $1,200 $62,400 ÷ 50 weeks = $1,248 $ 48 Annual vacation benefit Vacation Benefits Employer expenses for paid vacation by employees Assume an employee earns $62,400 per year and earns two weeks of paid vacation each year. Quick Study 10 9-38

39. Bonus Plans P4 Many bonuses paid to employees are based on reported net income. Assume the annual yearly bonus (B) to the store manager is equal to 10% of the company’s annual net income minus the bonus. The store earned $100,000 net income (Pre-bonus) this year. (100,000 – 9,091) = 90,909 * 10% = 9,091 9-39

40. Bonus Plans P4 Many bonuses paid to employees are based on reported net income. Assume the annual yearly bonus to the store manager is equal to 10% of the company’s annual net income minus the bonus. The store earned $100,000 net income this year. 9-40

41. Quick Study 9 Exercise 9

42. Warranty Liabilities P4 Seller’s obligation to replace or correct a product (or service) that fails to perform as expectedwithin a specified period. To conform with the matching principle, the seller ESTIMATES (reports) expected warranty expense in the period when revenue from the sale is reported. A dealer sells a car for $32,000, on December 1, 2009, with a warranty for parts and labor for 12 months, or 12,000 miles. The dealership experiences an average warranty cost of 3% of the selling price of each car. 9-42

43. Warranty Liabilities P4 Adealer sells a car for $32,000, on December 1, 2009, with a warranty for parts and labor for 12 months, or 12,000 miles. The dealership experiences an average warranty cost of 3% of the selling price of each car. On February 15, 2010, parts of $200 and labor of $250 covered under warranty were incurred. 9-43

44. Quick Study 8 Exercise 11

45. Contingent Liabilities Potential obligation that depends on a future event arising out of a past transaction or event. 1. Potential legal claims (lawsuits) 2. Debt guarantees (of a debt owed by another company) 3.Other contingencies: -Warranty Liability; -Environmental damages (Oil Spill & BP); -Possible tax assessments (IRS Audits); -Insurance losses (Flood Damage); -Government investigations (BP & TOYOTA). 9-45

46. Amount . . . Contingent Liabilities Potential obligation that depends on a future event arising out of a past transaction or event. 9-46

47. Reasonably Possible Contingent Liabilities C3 Potential Legal Claims– A potential claim is recorded if the amount can be reasonably estimated and payment for damages is probable. Debt Guarantees– The guarantor usually discloses the guarantee in its financial statement notes. If it is probable that the debtor will default, the guarantor should record and report the guarantee as a liability. 9-47

48. Quick Study 9 Exercise 2

49. Income before interestand income taxes Times interestearned = Interest expense Times Interest Earned A1 If income before interest and taxes varies greatly from year to year, fixed interest charges can increase the risk that an owner will not earn a positive return and be unable to pay interest charges. 9-49