1. Chapter 8 Current Liabilities The chapter is divided into two parts.
Part A: Current Liabilities
Part B: Loss Contingencies

2. Current Liabilities Usually, but not always, due within one year.
Note: If a company has an operating cycle longer than one year, its current liabilities are defined by the operating cycle rather than by the length of a year.
Liability:
A present responsibility to sacrifice assets in the future due to a transaction or other event that happened in the past.
In this chapter, we focus on Current Liabilities and Loss Contingencies.
Current liabilities are usually, but not always, due within one year. For example, if a company has an operating cycle longer than one year (a winery, for example), its current liabilities are defined by the operating cycle rather than by the length of a year. For now, remember that in most cases (but not all) current liabilities are due within one year.
Liability: A present responsibility to sacrifice assets in the future due to a transaction or other event that happened in the past.

3. Part A Current Liabilities
In Part A of this chapter, we focus on current liabilities and their essential characteristics.

4. LO1 Distinguish between current and long-term liabilities
Reporting Liabilities
Three characteristics of liabilities:
Probable future sacrifices of economic benefits.
Arising from present obligations to other entities.
Resulting from past transactions or events.
Liabilities have three essential characteristics. Liabilities are: (1) probable future sacrifices of economic benefits; (2) arising from present obligations to other entities; (3) resulting from past transactions or events.
The definition of liabilities touches on the present, the future, and the past. A liability is a present responsibility to sacrifice assets in the future due to a transaction or other event that happened in the past.
Recall that assets represent probable future benefits. In contrast, liabilities represent probable future sacrifices of benefits.

5. Current vs. Long-Term Liabilities
In a classified balance sheet, we categorize liabilities as either current or long-term. In most cases, current liabilities are payable within one year and long-term liabilities are payable more than one year from now.
With in the
company
Payable more than
one year
Payable within one
year

6. Reporting Current Liabilities
Distinguishing between current and long-term liabilities helps investors and creditors assess risk.
Companies often prefer to report a liability as long-term because it may cause the firm to appear less risky.
Many companies list notes payable first, followed by accounts payable, and then other current liabilities from largest to smallest.
The obligations firms most frequently report as current liabilities are notes payable, accounts payable, salaries payable, and other current liabilities such as unearned revenue, sales taxes, and current maturities of long-term debt.
There is no prescribed order for presenting accounts within the current liabilities section of the balance sheet. However, many companies list notes payable first, followed by accounts payable, and then other current liabilities from largest to smallest.

7. LO2 Account for Notes Payable and Interest Expense
A company borrowing cash (borrower) from a bank is required to sign a note promising to repay the amount borrowed plus interest.
The borrower reports its liability as notes payable.
Small firms rely heavily on short-term financing.
Large companies also use short-term debt as a significant part of their capital structure.
When a company borrows cash from a bank, the bank requires the firm to sign a note (essentially an IOU) promising to repay the amount borrowed plus interest. The borrower reports its liability as notes payable.
Very often, small firms are unable to tap into the major sources of long-term financing to the extent necessary to provide for their capital needs. So they must rely heavily on short-term financing.
Even large companies use short-term debt as a significant part of their capital structure. A major reason is that short-term funds usually offer lower interest rates than long-term debt.

8. Example of Southwest Airlines
Southwest Airlines borrows $100,000 from Bank of America on September 1, 2010.
Signing a 6%, six-month note with the amount borrowed plus accrued interest due six months later on March 1, 2011.
On September 1, 2010, Southwest will receive $100,000 in cash and record the following entry:
Southwest Airlines borrows $100,000 from Bank of America on September 1, 2010, signing a 6%, six-month note with the amount borrowed plus accrued interest due six months later on March 1, On September 1, 2010, Southwest will receive $100,000 in cash and record the entry debiting Cash account for $100,000 and crediting Notes payable account for $100,000.

9. Measuring Interest $3,000 = $100,000 x 6% x 6/12
Interest is stated in terms of a percentage rate to be applied to the face value of the loan.
Interest rate is stated as an annual rate.
When calculating interest for a period less than one year adjust for the fraction of the annual period the loan spans.
Interest = Face value x Annual rate x Fraction of the Year
When a company borrows money, it pays the lender interest in return for using the lender’s money during the term of the loan. Interest is stated in terms of a percentage rate to be applied to the face value of the loan. Because the stated interest rate is an annual rate, when calculating interest for a current note payable we must adjust for the fraction of the annual period the loan spans.
We calculate interest on notes as:
Interest = Face value x Annual interest rate x Fraction of the year
In the example, how much interest cost does Southwest incur for the six-month period of the note from September 1, 2010 to March 1, 2011?
$3,000 = $100,000 x 6% x 6/12
How much interest cost does Southwest incur for the six-month period of the note from September 1, 2010 to March 1, 2011?
$3,000 = $100,000 x 6% x 6/12

10. Interest Accrued and Repayment of Note
If Southwest’s reporting period ends on December 31, 2010, it records the four months’ interest incurred during 2010 in an adjusting entry prior to preparing the 2010 financial statements:
On maturity, Southwest Airlines will pay the face value of the loan plus the entire interest incurred. It makes the following journal entry
The purpose of the adjusting entry is to report four months’ interest in Southwest will report the remaining $1,000 in Since the firm won’t actually pay the 2010 interest until March 1, 2011, its financial statements for the year ended December 31, 2010, will show interest payable of $2,000 along with notes payable of $100,000 as a current liability on the balance sheet, and the “other expenses” section of the income statement will report interest expense of $2,000.
When the note comes due on March 1, 2011, Southwest Airlines will pay the face value of the loan plus the entire interest incurred. The $3,000 represents six months of interest—four months of interest ($2,000) in 2010 that we previously recorded and two months of interest ($1,000) in Southwest makes the following journal entry on March 1, 2011:
The journal entry on March 1 removes the note payable ($100,000), records interest expense for January and February, 2011 ($1,000), removes the interest payable recorded in the December 31, 2010 entry ($2,000), and reduces cash ($103,000). Notice that we record interest expense incurred for four months in 2010 and two months in 2011, rather than recording all six month’s interest expense in 2011 when we pay it. This is consistent with the matching principle.

11. Flip Side Bank of America
How would the lender, Bank of America, record this note?
For the bank it’s a note receivable rather than a note payable.
It generates interest revenue rather than interest expense.
The entries are as follows:
How would the lender, Bank of America, record this note? For the bank it’s a note receivable rather than a note payable, and it generates interest revenue rather than interest expense. You may want to review the discussion on notes receivable in Chapter 5.

12. Line of Credit
An informal agreement that permits a company to borrow up to a prearranged limit without having to follow formal loan procedures and prepare paperwork.
Similar to notes payable.
Company is able to borrow without having to go through a formal loan approval process each time it borrows money.
Rather than wait until borrowing becomes necessary, many companies prearrange the terms of a loan by establishing a line of credit with a bank. A line of credit is an informal agreement that permits a company to borrow up to a prearranged limit without having to follow formal loan procedures and prepare paperwork.
The line of credit works like a note payable except the company is able to borrow without having to go through a formal loan approval process each time it borrows money.
Banks sometimes require the company to maintain a cash balance on deposit with the bank, say, 5% of the line of credit.

13. LO3 Account for Employee and Employer Payroll Liabilities
Prior to depositing a monthly payroll check, an employer withholds
Federal and state income taxes,
Social Security and Medicare,
Health, dental, disability, and life insurance premiums, and
Employee investments to retirement or savings plans.
As an employer, the costs of hiring an employee are higher than the salary.
Significant costs include
Federal and state unemployment taxes,
The employer portion of Social Security and Medicare,
Employer contributions for health, dental, disability, and life insurance,
Employer contributions to retirement or savings plans.
Let’s assume you are hired at a $60,000 annual salary with salary payments of $5,000 per month. Unfortunately, your monthly payroll deposit will be much less than $5,000 a month. Prior to depositing your monthly payroll check, your employer will withhold amounts for (1) federal and state income taxes; (2) Social Security and Medicare; (3) health, dental, disability, and life insurance premiums; and (4) employee investments to retirement or savings plans. Realistically, then, your $5,000 monthly salary translates to less than $4,000 in actual take-home pay.
Now assume you are an employer. You hire an employee at a starting annual salary of $60,000. Unfortunately, your costs for this employee will be much more than $5,000 per month. Besides the $5,000 salary, you will have significant costs for (1) federal and state unemployment taxes, ; (2) the employer portion of Social Security and Medicare, ; (3) employer contributions for health, dental, disability, and life insurance, ; and (4) employer contributions to retirement or savings plans. With theses additional costs, a $5,000 monthly salary could very easily create total costs in excess of $6,000 per month.

14. Summary of Payroll Costs
A summary of payroll costs is provided.

15. Employee Costs
Companies are required by law to withhold federal and state income taxes from employees’ paychecks and remit these taxes to the government.
FICA taxes - Collectively, Social Security and Medicare taxes.
FICA Act requires employers to withhold:
6.2% Social Security tax up to a maximum base amount.
1.45% Medicare tax with no maximum.
Total FICA tax is 7.65% (6.2% %) on income up to a base amount ($102,000 in 2008) and 1.45% on all income above the base amount.
Employees may opt to have additional amounts withheld from their paychecks.
The amount withheld varies according to the amount the employee earns and the number of exemptions the employee claims. The IRS furnishes tax tables that assist in determining the amount withheld. If you are able to claim more exemptions, you will have less tax withheld from your paycheck.
FICA act requires employers to withhold a 6.2% Social Security tax up to a maximum base amount and a 1.45% Medicare tax with no maximum. Therefore, the total FICA tax is 7.65% (6.2% %) on income up to a base amount ($102,000 in 2008) and 1.45% on all income above the base amount. For example, if you earn less than $102,000 you will have 7.65% withheld from your check all year. However, if you earn, let’s say, $152,000 you would have 7.65% withheld for FICA on the first $102,000 of your annual salary and then only 1.45% withheld on the remaining $50,000 earned during the rest of the year.
Besides the required deductions for income tax and FICA taxes, employees may opt to have additional amounts withheld from their paychecks. These might include the employee portion of insurance premiums, employee investments in retirement or savings plans, and contributions to charitable organizations such as United Way.

16. Employer Costs
Employer pays an additional (matching) FICA tax on behalf of the employee.
Employer’s limits on FICA tax are the same as employee’s.
Employer must also pay federal and state unemployment taxes on behalf of the employees.
FUTA requires a tax of 6.2% on the first $7,000 earned by each employee. This amount is reduced by a 5.4% (maximum) credit for contributions to state unemployment programs, so the net federal rate often is 0.8%.
The employer pays an additional (matching) FICA tax on behalf of the employee. The employer’s limits on FICA tax are the same as the employee’s. So the government actually collects 15.3% (7.65% employee % employer) on each employee’s salary. In addition to FICA, the employer also must pay federal and state unemployment taxes on behalf of its employees. FUTA requires a tax of 6.2% on the first $7,000 earned by each employee. This amount is reduced by a 5.4% (maximum) credit for contributions to state unemployment programs, so the net federal rate often is 0.8%.

17. Employer Costs (cont.)
SUTA, in many states the maximum state unemployment tax rate is 5.4%, but many companies pay a lower rate based on past employment history.
Fringe benefits: Additional employee benefits paid by the employer include
All or part of employees’ insurance premiums.
Contributions to retirement or savings plans.
Many companies provide additional fringe benefits specific to the company or the industry. An important additional fringe benefit in the airline industry is the ability for the employee and family to fly free.
Under SUTA, in many states the maximum state unemployment tax rate is 5.4%, but many companies pay a lower rate based on past employment history.
Additional employee benefits paid for by the employer are often referred to as fringe benefits. Employers often pay all or part of employees’ insurance premiums and make contributions to retirement or savings plans. Many companies provide additional fringe benefits specific to the company or the industry. For instance, an important additional fringe benefit in the airline industry is the ability for the employee and family to fly free.

18. Payroll Costs
Payroll example to demonstrate the recording of employee and employer payroll costs.

19. Payroll Costs (cont.)
Notice that Hawaiian Travel Agency incurred an additional $28,850 ($15,000 for fringe benefits plus $13,850 for employer payroll taxes) in expenses beyond the $100,000 salary expense. The FICA taxes payable in part 1 is the same amount as in part 3. The employee pays 7.65% and the employer matches this amount with an additional 7.65%.

20. LO4 Demonstrate the Accounting for other Current Liabilities
Three additional current liabilities companies report:
Unearned revenues
Sales taxes payable
The current portion of long-term debt
We explore each of these in more detail in the following slides.
Three additional current liabilities companies report include:
Unearned revenues,
Sales taxes payable, and
The current portion of long-term debt.
We explore each of these in more detail in the following slides.

21. Unearned Revenues Companies account for cash received in advance by:
Increasing (debit) cash and increasing (credit) a current liability account called unearned revenue.
Decreasing (debit) unearned revenue and increasing (credit) revenue once revenue is earned.
Companies account for cash received in advance by increasing (debit) cash and increasing (credit) a current liability account called unearned revenue.
Later, when they earn the revenue, they decrease (debit) unearned revenue and increase (credit) revenue.
While it may seem unusual for an account called unearned revenue to be a liability, think of it this way: having already collected the cash, the company now has the obligation to earn it.

22. Sales Taxes Payable
Company selling products subject to sales taxes are responsible for collecting, and remitting sales taxes to state and local governments.
Suppose you buy lunch in the airport for $15 plus 9% sales tax. The airport restaurant should record the transaction this way:
Each company selling products subject to sales taxes is responsible for collecting the sales tax directly from customers and periodically remitting the sales taxes collected to the state and local governments. The selling company records sales revenue in one account and sales taxes payable in another. When the company collects the sales taxes, the debit is to cash and the credit is to sales taxes payable.
Some companies don’t separately record sales and sales taxes with each sale, choosing instead to separate the two amounts later. Suppose you buy lunch in the airport for $21.80 that includes a 9% sales tax. How much did the restaurant charge you for the lunch and how much do they owe the state for sales taxes? If we divide the total cash paid by 1.09 (1 + 9% sales tax rate), we get $20 (= $21.80 / 1.09) as the sales price, leaving $1.80 as sales taxes payable. If the entire amount collected is recorded initially as sales, at some point, the sales tax portion will be removed from sales and properly recorded as sales tax payable.

23. Current Portion of Long-Term Debt
Distinguishing between current portion of long-term debt and long-term debt is important to management, investors, and lenders.
Long-term obligations are reclassified and reported as current liabilities when they become payable within the upcoming year.
Assume Southwest Airlines has a $100 million liability at December 31, 2010, of which $5 million is payable in In its 2010 balance sheet, the company records the $100 million debt as shown below
Distinguishing between the current portion of long-term debt and long-term debt is important to management, investors, and lenders. Management needs to be aware of debt requiring payment in the next year in order to budget the cash flow necessary to pay it as it becomes due. Investors and lenders also pay attention to current debt because it provides information about a company’s liquidity, a useful indicator of risk.
Long-term obligations usually are reclassified and reported as current liabilities when they become payable within the upcoming year.

24. Part B Loss Contingencies Part B: Loss Contingencies
In Part B of this chapter, we focus on loss contingencies.

25. LO5 Apply the appropriate accounting treatment for loss contingencies
Loss contingency:
An existing, uncertain situation that might result in a loss.
Examples:
Lawsuits, product warranties, environmental problems, and premium offers
Loss contingency is an existing, uncertain situation that might result in a loss.
Examples include lawsuits, product warranties, environmental problems, and premium offers.

26. Loss Contingency for Jeeps, Inc.
Deloitte was the auditor for a client we’ll call Jeeps, Inc. The client sold accessories for jeeps such as tops, lights, cargo carriers, and hitches. One of the major issues in the audit of Jeeps, Inc., was outstanding litigation. Several lawsuits against the company alleged that the jeep top (made of vinyl) did not hold during a major collision. The jeep manufacturer, Chrysler, also was named in the lawsuits. The damages claimed were quite large, about $100 million.
Although the company had litigation insurance, there was some question whether the insurance company could pay because the insurance carrier was undergoing financial difficulty. The auditor discussed the situation carefully with the outside legal counsel representing Jeeps, Inc. Legal counsel indicated that the possibility of loss was remote and that if the case went to trial, Jeeps would almost assuredly win.
If you were the auditor, how would you report this situation? Consider four options. You could (1) report a liability for the full $100 million, (2) report a liability for less than $100 million based on estimated outcomes, (3) provide full disclosure in one of the financial statements’ footnotes and not report any liability in the balance sheet, or (4) provide no disclosure at all since the possibility of loss is remote.
Which approach did Deloitte take?
Loss Contingency for Jeeps, Inc.

27. Loss Contingencies
Whether we report a loss contingency as a liability depends on two criteria:
The likelihood of the loss occurring can be
Probable—likely to occur
Reasonably possible—more than remote but less than likely, or
Remote—the chance is slight
The ability to estimate the loss amount is either:
Known or reasonably estimable or
Not reasonably estimable.
We record a liability if the loss is probable and the amount is at least reasonably estimable.
The journal entry to record a loss contingency requires a debit to a loss (or expense) account and a credit to a liability.
Whether we report a loss contingency as a liability depends on two criteria:
(1) The likelihood of the loss occurring can be
a. Probable—likely to occur
b. Reasonably possible—more than remote but less than likely, or
c. Remote—the chance is slight
(2) The ability to estimate the loss amount is either:
a. Known or reasonably estimable or
b. Not reasonably estimable.
We record a liability if the loss is probable and the amount is at least reasonably estimable. The journal entry to record a loss contingency requires a debit to a loss (or expense) account and a credit to a liability.

28. ESTIMABLE WITHIN A RANGE
If one amount within a range of potential losses appears more likely than other amounts within the range, we record that amount.
When no amount within the range appears more likely than others, we record the minimum amount and disclose the potential additional loss.
If the likelihood of loss is reasonably possible rather than probable, we record no entry but make full disclosure in a footnote to the financial statements to describe the contingency.
If the likelihood of loss is remote, disclosure usually is not required.
If one amount within a range of potential losses appears more likely than other amounts within the range, we record that amount. When no amount within the range appears more likely than others, we record the minimum amount and disclose the potential additional loss.
If the likelihood of loss is reasonably possible rather than probable, we record no entry but make full disclosure in a footnote to the financial statements to describe the contingency. Finally, if the likelihood of loss is remote, disclosure usually is not required.

29. Accounting Treatment of Loss Contingencies

30. Back to Jeeps, Inc.
Now how do you think Deloitte, the auditor of Jeeps, Inc., treated the litigation described earlier?
Based on the response of legal counsel, the likelihood
of the loss occurring was considered to be remote, so
disclosure was not required.
However, because the amount was so large, and
because there were concerns about the firm’s primary
insurance carrier undergoing financial difficulty,
Deloitte insisted on full disclosure of the litigation in
the footnotes to the financial statements.
Back to Jeeps, Inc.

31. WARRANTY LIABILITY
When you buy a new Dell notebook, it comes with a warranty.
Why does Dell offer a warranty? To increase sales, of course.
Based on the matching principle, the company needs to record warranty expense in the same accounting period as the sale.
A warranty represents an expense and a liability at the time of the sale, because it meets the criteria for recording a loss contingency.
Even though Dell doesn’t know exactly at the time of the sale what that warranty expense will be, based on experience, the company can reasonably estimate the amount.
Warranties are perhaps the most common example of loss contingencies. When you buy a new Dell notebook, it comes with a warranty. Why does Dell offer a warranty? To increase sales, of course. And based on the matching principle, it needs to record the warranty expense in the same accounting period in which it sells you the notebook. The warranty represents an expense and a liability for Dell at the time of the sale because it meets the criteria for recording a loss contingency. Because warranties almost always entail an eventual expenditure, it’s probable that a cost will be incurred. And even though Dell doesn’t know exactly what that cost will be, based on experience, the company can reasonably estimate the amount.

32. GAIN CONTINGENCIES
Is an existing uncertain situation that might result in a gain, which often is the flip side of loss contingencies.
In a lawsuit, one side—the defendant—faces a loss contingency, while the other side—the plaintiff—has a gain contingency.
We record loss contingencies when the loss is probable and the amount is reasonably estimable.
We do not record gain contingencies of this type until the gain is certain.
Though firms do not record gain contingencies in the accounts, they sometimes disclose them in notes to the financial statements
A gain contingency is an existing uncertain situation that might result in a gain, which often is the flip side of loss contingencies. In a pending lawsuit, one side—the defendant—faces a loss contingency, while the other side—the plaintiff—has a gain contingency. As we discussed earlier, we record loss contingencies when the loss is probable and the amount is reasonably estimable. However, we do not record gain contingencies of this type until the gain is certain. The nonparallel treatment of gain contingencies follows the same conservative reasoning that motivates reporting some assets (like inventory) at lower-of-cost-or-market. Specifically, it’s desirable to anticipate losses, but recognizing gains should await their final settlement. Though firms do not record gain contingencies in the accounts, they sometimes disclose them in notes to the financial statements.

33. LO6 Assess liquidity using current liability ratios
Liquidity Analysis
A company is said to be liquid if it has sufficient cash to pay currently maturing debts.
Lack of liquidity can result in financial difficulties or even bankruptcy.
Liquidity Ratios
Current ratio:
We calculate it by dividing current assets by current liabilities.
Acid-test ratio:
Similar to the current ratio but is based on a more conservative measure of current assets available to pay current liabilities.
We calculate it by dividing “quick assets” by current liabilities.
Quick assets include cash, short-term investments, and accounts receivable.
The current ratio is intended as a way to assess liquidity. We calculate it by dividing current assets by current liabilities. A current ratio greater than 1 implies more current assets than current liabilities. As a rule of thumb, a current ratio of 1 or higher often reflects an acceptable level of liquidity, but we should evaluate the current ratio, like other ratios, in the context of the industry in which the company operates and other specific circumstance.
The acid-test ratio, is similar to the current ratio but is based on a more conservative measure of current assets available to pay current liabilities. We calculate it by dividing “quick assets” by current liabilities. Quick assets include only cash, short-term investments, and accounts receivable. By eliminating current assets, such as inventories and prepaid expenses, that are less readily convertible into cash, the acid-test ratio may provide a better indication of a company’s liquidity than does the current ratio.

34. STOP AND REVIEW
Selected financial data regarding current assets and current liabilities for United and Southwest Airlines are as follows.
Selected financial data regarding current assets and current liabilities for United and Southwest Airlines is provided in the slide.
1. Calculate the current ratio for United Airlines and Southwest Airlines. Which has the better current ratio?
2. Calculate the acid-test (quick) ratio for United Airlines and Southwest Airlines. Which has the better acid-test ratio?

35. STOP AND REVIEW Solution: 1. 2.
As expected, Southwest Airlines has a stronger current ratio, but current liabilities exceed current assets (current ratio is less than 1) for both airlines.
By eliminating less-liquid current assets such as inventory, the acid-test ratio often provides a better indicator of liquidity. Once again, Southwest Airlines wins with an acid-test ratio of 0.72 compared to 0.63 for United Airlines. 2.

36. LIQUIDITY MANAGEMENT
Can management influence the ratios that measure liquidity?
Yes, at least to some extent.
A large auto manufacturer like General Motors or Ford might use its economic muscle or persuasive powers to influence the timing of accounts payable recognition by asking suppliers to change their delivery schedules.
The timing of accounts payable recognition could mean the difference between an unacceptable ratio and an acceptable one, or between violating and complying with a debt covenant.
Can management influence the ratios that measure liquidity?
Yes, at least to some extent.
A large auto manufacturer like General Motors or Ford might use its economic muscle or persuasive powers to influence the timing of accounts payable recognition by asking suppliers to change their delivery schedules.
The timing of accounts payable recognition could mean the difference between an unacceptable ratio and an acceptable one, or between violating and complying with a debt covenant.

37. EFFECT OF TRANSACTIONS ON LIQUIDITY RATIOS
It is important to understand the effect of specific transactions on the current ratio and acid-test ratio.
Both ratios have the same denominator, current liabilities, so a decrease in current liabilities will increase the ratios and an increase in current liabilities will decrease the ratios.
Both ratios include cash, short-term investments, and accounts receivable, so an increase in any of those accounts will increase both ratios.
Only the current ratio includes inventory and other current assets, so an increase in these accounts will increase the current ratio, but not the acid-test ratio.
It also is important to understand the effect of specific transactions on the current ratio and acid-test ratio. Both ratios have the same denominator, current liabilities, so a decrease in current liabilities will increase the ratios (dividing by a smaller number makes a bigger ratio). Likewise, an increase in current liabilities will decrease the ratios (dividing by a bigger number makes the ratio smaller).
How are the ratios affected by changes in current assets? It depends on which current asset changes. Both ratios include cash, short-term investments, and accounts receivable. An increase in any of those will increase both ratios. However, only the current ratio includes inventory and other current assets. An increase to inventory or other current assets will increase the current ratio, but not the acid-test ratio.

38. End of chapter 8