Current Liabilities and Contingencies

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Current Liabilities and Contingencies
An electronic presentation by Douglas Cloud
Pepperdine University
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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
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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.
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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.
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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 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.

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Primary Liabilities Issues
1. Identification of liabilitiesthe detection of
a companys obligations. 2. Measurement or
valuation of the liabilities and the related
expensethe determination of an amount to attach
to each obligation and to match as an expense
against revenues. 3. Reporting on the financial
statementsthe specific disclosures in both the
companys financial statements and the related
notes.
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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.
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Operating Cycle
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Liquidity
Liquidity refers to how quickly a liability can
be paid, or its nearness to cash.
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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.

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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.

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Types of Current Liabilities
Having Contractual Amount
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Types of Current Liabilities
Amount Depends on Operations
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Types of Current Liabilities
Amount Must Be Estimated
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Current Liabilities HavingA Contractual Amount
Trade accounts payable arise from the purchase of
inventory, supplies, or services on an open
charge-account basis.
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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.
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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
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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
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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
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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.
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Compensated Absences
A company recognizes an expense and accrues a
liability for employees compensation for future
absences if all the following conditions are met

• 1. The companys obligation relating to the
  employees rights to receive compensation for
  future absences is attributed to the employees
  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.

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Compensated Absences
A vested right exists when an employer has an
obligation to make payments to an employee that
is not contingent on the employees future
services.
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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.
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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.
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Compensated Absences
The 200,000 April 30, 2005 payroll, including
paid vacation time taken by the sales and office
staff, is as follows
Continued
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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
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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.
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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.
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Current Liabilities Whose Amounts Depend on
Operations
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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
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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
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Liabilities Related to Payrolls
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Liabilities Related to Payrolls
Voluntary Payroll Deductions Withheld from
Employees
Union dues Government bonds Group hospital
insurance Accident insurance Life insurance Others
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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
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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) 112 State Unemployment Taxes
Payable (5.4 x 14,000) 756
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Bonus Obligations

• 1) The bonus is based on the corporations income
  after deducting income taxes, but before
  deducting the bonus.
• 2) The bonus is based on the corporations net
  income after deducting both the bonus and the
  income tax.

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Bonus Obligations
Bonex Corporations 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.
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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)
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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 0.10260,000 B .30(260,000
-B) B 0.10260,000 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)
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Bonus Obligations
To record the bonus
Salaries Expense (Officers Bonus) 17,009
Officers Bonus Payable 17,009
To record the income tax expense
Income Tax Expense 72,897 Income Taxes
Payable 72,897
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Current Liabilities Requiring Amounts to be
Estimated
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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.
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Property Taxes
Three Monthly Entries July 31September 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 31December 31,
2004
Property Tax Expense 610 Prepaid Property
Taxes 610
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Expense Warranty Accrual Method
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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 1,20
0,000
Warranty cost per machine is estimated at 150.
Warranty Expense 30,000 Estimated Liability
under Warranties 30,000
Continued
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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 Warra
nty Expense 150 Cash (or other assets) 25,150
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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
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Warranty Obligations
Recognition of warranty expense for period,
AprilDecember, 2004.
Warranty Expense 5,000 Cash (or other
assets) 5,000
Recognition of warranty revenue for period,
AprilDecember, 2004.
Unearned Warranty Revenue 5,000 Warranty
Revenue 5,000
Continued
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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
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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.
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Premium and Coupon Obligations
Continued
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Premium and Coupon Obligations
(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
redemptions 75,000
Premium expense for estimated future
redemptions (75,000 30) x 2) 5,000
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Contingencies
A contingency is an existing condition involving
uncertainty as to possible gain or loss that will
ultimately be resolved.
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Contingencies

• 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.

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Contingencies
Disclosure
Criteria
No
Future event probable?
Yes
and
or
Amount reasonably estimated?
No
Yes
and
Reasonable possibility of loss
Yes
No
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Disclosure of Gain Contingencies
FASB Statement No. 5 requires that these gains be
disclosed in the notes to the companys financial
statements.

• (a) Contingencies that might result in gains
  usually are not reflected in a companys
  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.

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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...
Continued
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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.
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