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

2. 2 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. Objectives ContinuedContinued

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

4. 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. 5 Three Essential Characteristics of 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.

6. 6 Primary 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.

7. 7 Current Liabilities 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.

8. 8 Operating Cycle Cash Inventory Receivables

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

10. 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. 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. 12 Types of Current Liabilities Having Contractual Amount Accounts payable Notes payable Currently maturing portion of long- term debt Dividends payable Advances and refundable deposits Accrued items Unearned items

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

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

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

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

17. 17 Current Liabilities Having A 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 Inventory7,000 Notes Payable7,000 October 1, 2004 Interest Expense ($7,000 x 0.12 x30/360) 70 Notes Payable7,000 Cash7,070

18. 18 Current Liabilities Having A 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 Cash9,700 Discount on Notes Payable300 Notes Payable10,000 ContinuedContinued

19. 19 Current Liabilities Having A Contractual Amount December 31, 2004 Interest Expense100 Discount on Notes Payable100 March 1, 2005 Interest Expense200 Discount on Notes Payable200 Notes Payable10,000 Cash10,000

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

21. 21 Compensated 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:

22. 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. 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. 24 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. Sales Salaries Exp. Compensated Absences15,000 Office Salaries Exp. Compensated Absences15,000 Liability for Employees’ Compensation for Future Absences (3/12 x $120,000)30,000 March 31, 2005

25. 25 Compensated Absences 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$3,000 Office staff96,5003,500 ContinuedContinued

26. 26 Sales Salaries Expense97,000 Office Salaries Expense 96,500 Liability for Employees’ Compen- sation for Future Absences 6,500 Cash200,000 April 30, 2005 Compensated Absences

27. 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. 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. 29 Current Liabilities Whose Amounts Depend on Operations

30. 30 Sales 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. Cash53,000 Sales50,000 Sales Taxes Payable3,000 Typical Situation

31. 31 Sales 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. Cash53,000 Sales53,000 The Sales Tax is Included in the Price Charged to the Customer Sales3,000 Sales Taxes Payable3,000

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

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

34. 34 Accounting for Payroll Taxes and Deductions To record salaries and employee withholding items: Sales Salaries Expense10,000 Office Salaries Expense4,000 F.I.C.A. Taxes Payable (8% x $14,000)1,120 Employee Federal Income Taxes Withholding Payable990 Employee State Income Taxes Withholding Payable500 Employee Union Dues Withholding Payable180 Cash11,210

35. 35 To record employer payroll taxes: Payroll Taxes Expense1,988 F.I.C.A. Taxes Payable (8% x $14,000)1,120 Federal Unemployment Taxes Payable ((0.8% x $14,000)112 State Unemployment Taxes Payable (5.4% x $14,000)756 Accounting for Payroll Taxes and Deductions

36. 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. 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. 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. 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 0.97B = $18,200 B = $18,200 ÷ 0.97 B = $18,763 (rounded)

39. 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. 40 Bonus Obligations Salaries Expense (Officer’s Bonus)17,009 Officer’s Bonus Payable17,009 To record the bonus: Income Tax Expense72,897 Income Taxes Payable72,897 To record the income tax expense: Current Liability

41. 41 Current Liabilities Requiring Amounts to be Estimated

42. 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. 43 Property Taxes Three Monthly Entries July 31–September 30, 2004 Property Tax Expense ($7,200 ÷ 12)600 Property Taxes Payable600 October 31, 2004: Payment of Property Taxes Property Tax Payable1,800 Prepaid Property Taxes5,490 Cash7,290 Three Monthly Entries: October 31–December 31, 2004 Property Tax Expense610 Prepaid Property Taxes610

44. 44 Expense Warranty Accrual Method

45. 45 Warranty Obligations Cash or Accounts Receivable1,200,000 Sales1,200,000 Warranty cost per machine is estimated at $150. Warranty Expense30,000 Estimated Liability under Warranties30,000 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. ContinuedContinued

46. 46 Warranty Obligations The corporation spent $5,000 in 2004 to fulfill warranty agreements for the 200 machines. Estimated Liability under Warranties5,000 Cash (or other assets)5,000 The corporation spent $25,150 in 2005 to fulfill warranty agreements for the two machines. Estimated Liability under Warranties25,000 Warranty Expense150 Cash (or other assets)25,150

47. 47 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 Receivable1,200,000 Sales ($5,850 x 200)1,170,000 Unearned Warranty Revenue30,000 Sales Warranty Accrual Method Warranty Obligations ContinuedContinued

48. 48 Warranty Obligations Recognition of warranty expense for period, April– December, 2004. Warranty Expense5,000 Cash (or other assets)5,000 Recognition of warranty revenue for period, April– December, 2004. Unearned Warranty Revenue5,000 Warranty Revenue5,000 ContinuedContinued

49. 49 Warranty Obligations Recognition of warranty expense during 2005. Warranty Expense25,150 Cash (or other assets)25,150 Recognition of warranty revenue during 2005. Unearned Warranty Revenue25,000 Warranty Revenue25,000

50. 50 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

51. 51 Premium and Coupon Obligations Purchased 12,000 serving dishes at $2 each. Inventory of Premium Serving Dishes24,000 Cash (or Accounts Payable)24,000 Sold 300,000 cans of meatball at $1.80 each... Cash (or Accounts Receivable)540,000 Sales540,000 ContinuedContinued

52. 52 Premium and Coupon Obligations Received 105,000 labels from customers:. Premium Expense7,000 Inventory of Premium Serving Dishes7,000 Estimated that 75,000 labels will be submitted next year: Premium Expense5,000 Estimated Premium Claims Outstanding5,000 (105,000 ÷ 30) x $2) Estimated labels that will be redeemed (300,000 x.60)180,000 Deduct labels redeemed during 2004(105,000) Estimated number of future label redemptions75,000 Premium expense for estimated future redemptions: [(75,000 ÷ 30) x $2)$5,000

53. 53 Contingencies A contingency is an existing condition involving uncertainty as to possible gain or loss that will ultimately be resolved.

54. 54 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. Contingencies

55. 55 Contingencies Criteria Disclosure No Future event probable? Yes No Amount reasonably estimated? Yes Report amount in financial statements YesNo Reasonable possibility of loss Disclose in notes to financial statements or and Disclose in notes to financial statements Not required to disclose

56. 56 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.

57. 57 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... ContinuedContinued

58. 58 Short-Term Debt Expected to be Refinanced 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.

59. 59 C hapter 12 The End

60. 60