McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. CURRENT LIABILITIES AND CONTINGENCIES...

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

CURRENT LIABILITIES CURRENT LIABILITIES AND CONTINGENCIESAND CONTINGENCIES

Chapter 13

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Characteristics of LiabilitiesCharacteristics of Liabilities

. . . Resulting from past

transactions or events.

. . . Resulting from past

transactions or events.

. . . Arising from

present obligations

to other entities . . .

. . . Arising from

present obligations

to other entities . . .

Probable future

sacrifices of economic

benefits . . .

Probable future

sacrifices of economic

benefits . . .

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What is a Current Liability?What is a Current Liability?

LIABILITIESLIABILITIES

Long-term LiabilitiesLong-term Liabilities

Expected to be satisfied with current assets or by

the creation of other current liabilities.

Expected to be satisfied with current assets or by

the creation of other current liabilities.

Current LiabilitiesCurrent Liabilities

Obligations payable within one year or one operating cycle, whichever is longer.

Obligations payable within one year or one operating cycle, whichever is longer.

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Current LiabilitiesCurrent Liabilities

Current Liabilities

Short-term notes payable

Accrued expenses

Cash dividends payable

Taxes payable

Accounts payable

Unearned revenues

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Open Accounts and NotesOpen Accounts and NotesAccounts Payable

Obligations to suppliers for goods purchased on open account.

Trade Notes PayableSimilar to accounts payable, but recognized by a written promissory note.

Short-term Notes PayableCash borrowed from the bank and recognized by a promissory note.

• Credit linesPrearranged agreements with a bank that allow a company to borrow cash without following normal loan procedures and paperwork.

Accounts PayableObligations to suppliers for goods purchased on open account.

Trade Notes PayableSimilar to accounts payable, but recognized by a written promissory note.

Short-term Notes PayableCash borrowed from the bank and recognized by a promissory note.

• Credit linesPrearranged agreements with a bank that allow a company to borrow cash without following normal loan procedures and paperwork.

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InterestInterest

Interest on notes is calculated as follows:

Amount borrowed

Amount borrowed

Interest rate is always stated as an annual

rate.

Interest rate is always stated as an annual

rate.

Interest owed is adjusted for the

portion of the year that the face

amount is outstanding.

Interest owed is adjusted for the

portion of the year that the face

amount is outstanding.

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Interest-Bearing NotesInterest-Bearing Notes

On September 1, Eagle Boats borrows $80,000 from Cooke Bank. The note is due in 6 months and has a

stated interest rate of 9%.Record the borrowing on September 1.

On September 1, Eagle Boats borrows $80,000 from Cooke Bank. The note is due in 6 months and has a

stated interest rate of 9%.Record the borrowing on September 1.

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How much interest is due to Cooke Bank at year-end, on December 31?

a. $2,400

b. $3,600

c. $7,200

d. $87,200

How much interest is due to Cooke Bank at year-end, on December 31?

a. $2,400

b. $3,600

c. $7,200

d. $87,200

Interest-Bearing NotesInterest-Bearing Notes

Interest is calculated as: Face Annual Time to Amount Rate maturity

$80,000 9% 4/12

$2,400 interest due to Cooke Bank.

Interest is calculated as: Face Annual Time to Amount Rate maturity

$80,000 9% 4/12

$2,400 interest due to Cooke Bank.

× ×

× ×

=

=

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Interest-Bearing NotesInterest-Bearing Notes

Assume Eagle Boats’ year-end is December 31.

Record the necessary adjustment at year-end.

Assume Eagle Boats’ year-end is December 31.

Record the necessary adjustment at year-end.

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Interest-bearing NotesInterest-bearing Notes

Assume Eagle Boats’ year-end is December 31.

Record the necessary journal entry whenthe note matures on February 28.

Assume Eagle Boats’ year-end is December 31.

Record the necessary journal entry whenthe note matures on February 28.

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Noninterest-Bearing NotesNoninterest-Bearing Notes

Notes without a stated interest rate carry an implicit, or effective rate.

The face of the note includes the amount borrowed and the interest.

Notes without a stated interest rate carry an implicit, or effective rate.

The face of the note includes the amount borrowed and the interest.

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On May 1, Batter-Up, Inc. issued a one-year, noninterest-bearing note with a face amount

of $10,600 in exchange for equipmentvalued at $10,000.

How much interest will Batter-Up pay on the note?

On May 1, Batter-Up, Inc. issued a one-year, noninterest-bearing note with a face amount

of $10,600 in exchange for equipmentvalued at $10,000.

How much interest will Batter-Up pay on the note?

Interest = Face Amount - Amount Borrowed

= $10,600 - $10,000

= $600

Interest = Face Amount - Amount Borrowed

= $10,600 - $10,000

= $600

Noninterest-Bearing NotesNoninterest-Bearing Notes

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Noninterest-Bearing NotesNoninterest-Bearing Notes

On May 1, Batter-Up, Inc. issued a one-year, noninterest-bearing note with a face amount

of $10,600 in exchange for equipmentvalued at $10,000.

What is the effective interest rate on the note?

On May 1, Batter-Up, Inc. issued a one-year, noninterest-bearing note with a face amount

of $10,600 in exchange for equipmentvalued at $10,000.

What is the effective interest rate on the note?

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Commercial PaperCommercial Paper

Commercial paper is a term used for unsecured notes issued in minimum

denominations of $25,000 with maturities ranging from 30 days to 270 days.

Commercial paper is a term used for unsecured notes issued in minimum

denominations of $25,000 with maturities ranging from 30 days to 270 days.

Normally, commercial paper is issued directly to the lender and is backed by a line of credit with a bank.Normally, commercial paper is issued directly to the lender and is backed by a line of credit with a bank.

Commercial paper is recorded in thesame manner as notes payable.

Commercial paper is recorded in thesame manner as notes payable.

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Salaries, Commissions, and BonusesSalaries, Commissions, and Bonuses

Compensation expenses such as salaries, commissions, and bonuses

are liabilities at the balance sheet date if earned but unpaid.

These accrued expenses/accrued liabilities

are recorded with an adjusting entry prior to

preparing financial statements.

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Liabilities from Advance CollectionsLiabilities from Advance Collections

Refundable DepositsAdvances from CustomersCollections for Third Parties

Refundable DepositsAdvances from CustomersCollections for Third Parties

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A Closer Look at the Current andA Closer Look at the Current andNoncurrent ClassificationNoncurrent Classification

Current maturities of long-term obligations are usually reclassified and reported as current

liabilities if they are payable within the upcoming year (or operating cycle, if longer than a year).

Current maturities of long-term obligations are usually reclassified and reported as current

liabilities if they are payable within the upcoming year (or operating cycle, if longer than a year).

Debt that is callable (due on demand) by the lender in the coming year, (or operating cycle, if

longer than a year) should be classified as a current liability, even if the debt is not expected to

be called.

Debt that is callable (due on demand) by the lender in the coming year, (or operating cycle, if

longer than a year) should be classified as a current liability, even if the debt is not expected to

be called.

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The ability to refinance on a long-term basiscan be demonstrated by an: existing refinancing agreement, or actual financing prior to issuance of the financial statements.

The ability to refinance on a long-term basiscan be demonstrated by an: existing refinancing agreement, or actual financing prior to issuance of the financial statements.

Short-Term Obligations ExpectedShort-Term Obligations Expectedto be Refinancedto be Refinanced

A company may reclassify a short-term liability as long-term only if two conditions are met:

A company may reclassify a short-term liability as long-term only if two conditions are met:

It has the intent to refinance on a long-term basis.

It has the intent to refinance on a long-term basis.

It has demonstrated the ability to refinance.

It has demonstrated the ability to refinance.

and

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ContingenciesContingencies

A loss contingency is an existing uncertain situation

involving potential loss depending on whether

some future event occurs.

A loss contingency is an existing uncertain situation

involving potential loss depending on whether

some future event occurs.

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ContingenciesContingencies

Two factors affect whether a loss contingency must be accrued and

reported as a liability:1. the likelihood that the confirming event

will occur.2. whether the loss amount can be

reasonably estimated.

Two factors affect whether a loss contingency must be accrued and

reported as a liability:1. the likelihood that the confirming event

will occur.2. whether the loss amount can be

reasonably estimated.

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Contingencies – Likelihood of OccurrenceContingencies – Likelihood of Occurrence

ProbableA confirming event is likely to occur.

Reasonably PossibleThe chance the confirming event will occur is more than remote, but less than likely.

RemoteThe chance the confirming event will occur is slight.

ProbableA confirming event is likely to occur.

Reasonably PossibleThe chance the confirming event will occur is more than remote, but less than likely.

RemoteThe chance the confirming event will occur is slight.

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KnownReasonably

PossibleNot Reasonably

Estimable

Liability accrued and disclosure note

Liability accrued and disclosure note

Disclosure note only

Disclosure note only

Disclosure note only

Disclosure note only

No disclosure required

No disclosure required

No disclosure required

Dollar Amount of Potential Loss

Likelihood

Probable

Reasonably possible

Remote

ContingenciesContingencies

A loss contingency is accrued only if a loss is probable and the amount can reasonably be estimated.

A loss contingency is accrued only if a loss is probable and the amount can reasonably be estimated.

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Product Warranties and GuaranteesProduct Warranties and Guarantees

Product warranties inevitably entail costs.The amount of those costs can be reasonably

estimated using commonly available estimation techniques.

The estimate requires the following entry:

Product warranties inevitably entail costs.The amount of those costs can be reasonably

estimated using commonly available estimation techniques.

The estimate requires the following entry:

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Extended WarrantiesExtended Warranties

Extended warranties are sold separately from the product.

The related revenue is not earned until: Claims are made against the extended

warranty, or The extended warranty period expires.

Extended warranties are sold separately from the product.

The related revenue is not earned until: Claims are made against the extended

warranty, or The extended warranty period expires.

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PremiumsPremiums

Premiums included with the product are expensed in the period of sale.

Premiums that are contingent on action by the customer require accounting similar to warranties.

Premiums included with the product are expensed in the period of sale.

Premiums that are contingent on action by the customer require accounting similar to warranties.

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Litigation ClaimsLitigation Claims

The majority of medium and large-size corporations annually report loss contingencies due to litigation.

The most common disclosure is a note to the financial statements.

The majority of medium and large-size corporations annually report loss contingencies due to litigation.

The most common disclosure is a note to the financial statements.

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Subsequent EventsSubsequent Events

Events occurring between the year-end date and report date can affect the appearance of disclosures on the

financial statements.

Events occurring between the year-end date and report date can affect the appearance of disclosures on the

financial statements.

Fiscal Year Ends Financial Statements

ClarificationCause of Loss Contingency

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Unasserted Claims and AssessmentsUnasserted Claims and Assessments

Is a claimIs a claimor assessmentor assessment

probable?probable?

Is a claimIs a claimor assessmentor assessment

probable?probable?No

Yes

NoNodisclosuredisclosure

neededneeded

NoNodisclosuredisclosure

neededneeded

UnassertedUnassertedclaimclaim

UnassertedUnassertedclaimclaim

Evaluate (a) the likelihood of an unfavorable outcome andEvaluate (a) the likelihood of an unfavorable outcome and(b) whether the dollar amount can be estimated.(b) whether the dollar amount can be estimated.

An estimated loss and contingent liability would beaccrued if an unfavorable outcome is probable and the

amount can be reasonably estimated.

Evaluate (a) the likelihood of an unfavorable outcome andEvaluate (a) the likelihood of an unfavorable outcome and(b) whether the dollar amount can be estimated.(b) whether the dollar amount can be estimated.

An estimated loss and contingent liability would beaccrued if an unfavorable outcome is probable and the

amount can be reasonably estimated.

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Gain ContingenciesGain Contingencies

As a general rule, we As a general rule, we never record never record GAINGAIN

contingenciescontingencies..

Note that the prior rules have Note that the prior rules have supported the recording of supported the recording of LOSSLOSS

contingencies.contingencies.

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Employers incur several expenses

and liabilities from having employees.

Appendix 13 ─ Payroll-Related LiabilitiesAppendix 13 ─ Payroll-Related Liabilities

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FICA Taxes

Medicare Taxes

Federal Income Tax

State and Local Income Taxes

Voluntary Deductions

Gross Pay

Net Pay

Payroll-Related LiabilitiesPayroll-Related Liabilities

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Amounts withheld depend on the employee’s earnings, tax rates, and number of withholding allowances.

Employers must pay the taxes withheldfrom employees’ gross pay to the appropriate government agency.

Employers must pay the taxes withheldfrom employees’ gross pay to the appropriate government agency.

Federal Income Tax

State and Local Income Taxes

Employees’ Withholding TaxesEmployees’ Withholding Taxes

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FICA Taxes Medicare Taxes

6.2% of the first $108,000earned in the year.

1.45% of all wagesearned in the year.

Employers must pay withheld taxesto the Internal Revenue Service (IRS).Employers must pay withheld taxes

to the Internal Revenue Service (IRS).

Employees’ Withholding TaxesEmployees’ Withholding Taxes

Federal Insurance Contributions Act (FICA)

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Amounts withheld depend on the employee’s request.

Employers owe voluntary amounts withheld from employees’ gross pay to the designated agency.Employers owe voluntary amounts withheld from employees’ gross pay to the designated agency.

Voluntary Deductions

Examples include union dues, savings accounts, pension contributions, insurance premiums, charities.

Examples include union dues, savings accounts, pension contributions, insurance premiums, charities.

Voluntary DeductionsVoluntary Deductions

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FICA TaxesMedicare

TaxesFederal and

State Unemployment

Taxes

Employers pay amounts equal to that withheld from the employee’s gross pay.

Employers pay amounts equal to that withheld from the employee’s gross pay.

Employers’ Payroll TaxesEmployers’ Payroll Taxes

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6.2% on the first $7,000 of wages paid to each employee (A credit up to 5.4% is

given for SUTA paid.)

Federal Unemployment Tax

Act (FUTA)

Basic rate of 5.4% on the first $7,000 of

wages paid to each employee (Merit

ratings may lower SUTA rates.)

StateUnemployment Tax

Act (SUTA)

Federal and StateFederal and StateUnemployment TaxesUnemployment Taxes

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Fringe BenefitsFringe Benefits

In addition to salaries and wages,withholding taxes, and payroll taxes, most companies provide a variety

of fringe benefits.

In addition to salaries and wages,withholding taxes, and payroll taxes, most companies provide a variety

of fringe benefits.

Healthinsurancepremiums

Healthinsurancepremiums

Lifeinsurancepremiums

Lifeinsurancepremiums

Retirementplan

contributions

Retirementplan

contributions

Employers must pay the amounts promised to fund employee fringe benefits to the designated agency.Employers must pay the amounts promised to fund employee fringe benefits to the designated agency.

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

End of Chapter 13End of Chapter 13