Act 211, Chapter 8

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Chapter 08 :

Chapter 08 Current Liabilities and Contingencies

Part A:

Part A Current Liabilities 8- 2

Current Liabilities:

Current Liabilities Liability - A present responsibility to sacrifice assets in the future due to a transaction or other event that happened in the past. Current liabilities are usually, but not always, due within one year . Notes payable, accounts payable, and payroll liabilities are the three main categories. 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. Current liabilities are also sometimes called short-term liabilities . 8- 3

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Operating Cycle

LO1 Distinguish between current and long-term liabilities:

LO1 Distinguish between current and long-term liabilities Three characteristics of liabilities: probable future sacrifices of economic benefits. arising from present obligations to other entities. resulting from past transactions or events. Reporting Liabilities 8- 5

Current vs. Long-Term Liabilities:

Current vs. Long-Term Liabilities LIABILITIES Payable within one year With in the company LONG-TERM Payable more than one year CURRENT 8- 6

Reporting Current Liabilities:

Reporting Current Liabilities Distinguishing between current and long-term liabilities helps investors and creditors assess risk. If a company has to have a liability, it often prefers 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. 8- 7

LO2 Account for Notes Payable and Interest Expense:

LO2 Account for Notes Payable and Interest Expense Notes Payable 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. Notes payable is a liability that creates interest expense Small firms rely heavily on short-term financing. Large companies also use short-term debt as a significant part of their capital structure. 8- 8

Notes Payable (Notes Receivable earlier):

Illustration 8-9 Notes Payable ( Notes Receivable earlier ) To the Maker , the promissory note is a note payable. To the Payee , the promissory note is a note receivable.

Example of Southwest Airlines:

Example of Southwest Airlines Southwest Airlines borrows $100,000 from Bank of America on September 1, 2012. Signing a 6%, six-month note for the amount borrowed plus accrued interest due six months later on March 1, 2013. On September 1, 2012, Southwest will receive $100,000 in cash and record the following entry: September 1, 2012 Debit Credit Cash 100,000 Notes Payable 100,000 (Issue notes payable) 8- 10

Measuring Interest:

Measuring Interest Interest is stated in terms of an annual percentage rate to be applied to the face value of the loan. Interest rate is almost always 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 = Principal x Interest rate (annual) x Fraction of the Year How much interest cost does Southwest incur for the six-month period of the note from September 1, 2012 to March 1, 2013? $3,000 = $100,000 x 6% x 6/12 8- 11

Interest Accrued and Repayment of Note:

Interest Accrued and Repayment of Note On maturity, Southwest Airlines will pay the face value of the loan plus the entire interest incurred. It makes the following journal entry If Southwest’s reporting period ends on December 31, 2012, company records the four months’ interest incurred during 2012 in an adjusting entry prior to preparing the 2012 financial statements: December 31, 2012 Debit Credit Interest Expense ($100,000 x 6% x 4/12) 2,000 Interest Payable 2,000 ( Record interest incurred, but not paid ) March 1, 2013 Debit Credit Notes Payable (face value) 100,000 Interest Expense ($100,000 x 6% x 2/12) 1,000 Interest Payable ($100,000 x 6% x 4/12) 2,000 Cash 103,000 (Pay notes payable and interest ) 8- 12

Flip Side: Bank of America :

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: 8- 13

Line of Credit:

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 except the company is able to borrow without having to go through a formal loan approval process each time it borrows money. Many short-term loans are arranged under an existing line of credit with a bank, or for larger corporations in the form of commercial paper, a loan from one company to another. 8- 14

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Current Liabilities:

The term “payroll” pertains to both: Salaries - managerial, administrative, and sales personnel (monthly or yearly rate). Wages - store clerks, factory employees, and manual laborers (rate per hour). Determining the payroll involves computing three amounts: ( 1) gross earnings , (2) payroll deductions , and (3) net pay . Payroll and Payroll Taxes Payable Current Liabilities 8- 16

LO3 Account for Employee and Employer Payroll Liabilities:

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 (FICA), 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 (FICA), Employer contributions for health, dental, disability, and life insurance, Employer contributions to retirement or savings plans. 8- 17

Summary of Payroll Costs:

Summary of Payroll Costs 8- 18

Employee Costs:

Employee Costs Employers 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 (recently reduced to 4.2% as part of “tax holiday”) 1.45% Medicare tax with no maximum. Total FICA tax is 7.65% (6.2% + 1.45%) on income up to a base amount ($110,100 in 2012) and 1.45% on all income above the base amount. Employees may opt to have additional amounts withheld from their paychecks. 8- 19

Current Liabilities:

Illustration: Assume Cargo Corporation records its payroll for the week of March 7 as follows: Salaries and wages expense 100,000 Federal tax payable 21,864 FICA tax payable 7,650 State tax payable 2,922 Salaries and wages payable 67,564 Cash 67,564 Salaries and wages payable 67,564 Mar. 7 Record the payment of this payroll on March 7. Mar. 7 Current Liabilities 8- 20

Current Liabilities:

Payroll tax expense results from three taxes that governmental agencies levy on employers . These taxes are: FICA tax Federal unemployment tax State unemployment tax Current Liabilities 8- 21

Current Liabilities:

Illustration: Based on Cargo Corp.’s $100,000 payroll, the company would record the employer’s expense and liability for these payroll taxes as follows. Payroll tax expense 13,850 State unemployment tax payable 5,400 FICA tax payable 7,650 Federal unemployment tax payable 800 Current Liabilities 8- 22

Employer Costs (contd.):

Employer Costs (contd.) 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. 8- 23

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LO4 Demonstrate the Accounting for other Current Liabilities :

LO4 Demonstrate the Accounting for other Current Liabilities Additional current liabilities companies report: Unearned revenues Sales taxes payable The current portion of long-term debt Deferred taxes We explore each of these in more detail in the following slides. 8- 25

Unearned Revenues:

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. 8- 26

Sales Taxes Payable :

Sales Taxes Payable Company selling products subject to sales tax is responsible for collecting the sales tax directly from customers and periodically sending the sales taxes collected to the state and local governments. When the company collects the sales taxes, it increases cash (a debit) and increases sales taxes payable (a credit). Suppose you buy lunch in the airport for $15 plus 9% sales tax. The airport restaurant records the transaction this way: 8- 27

Current Portion of Long-Term Debt:

Current Portion of Long-Term Debt Currently maturing portion of a long-term debt is reported as a current liability on the balance sheet. Assume Southwest Airlines had total borrowings of $3,515 million at December 31, 2012, of which $190 million was payable in 2013 and the remaining $3,325 million is due after 2013. In its 2012 balance sheet, the company records the $3,515 million in current and long-term debt, as shown below 8- 28

Deferred taxes:

Deferred taxes Net income and taxable income often differ because of differences in financial accounting and tax accounting rules. These differences can result in deferred tax liabilities, in which income is reported now but the tax on the income will not be paid until future years. 8- 29

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Part B:

Part B Contingencies 8- 31

LO5 Apply the appropriate accounting treatment for contingencies:

LO5 Apply the appropriate accounting treatment for contingencies Contingent liability: An existing, uncertain situation that might result in a loss. Examples: Lawsuits, product warranties, environmental problems, and premium offers A contingent liability may not be a liability at all. Whether it is, depends on whether an uncertain event that might result in a loss occurs or not. 8- 32

Litigations and Other Causes:

Litigations and Other Causes Deloitte & Touche 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 Deloitte’s 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, DaimlerChrysler , 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. Legal counsel representing Jeeps, Inc. indicated that the possibility of payment was remote and that if the case went to trial, Jeeps would almost surely win. As the auditor, you could choose one of three options to report the situation: (1) report a liability for the full $100 million or for some lesser amount, (2) provide full disclosure in a financial statement footnote but not report a liability in the balance sheet, or (3) provide no disclosure at all. 8- 33

Contingent Liabilities:

Contingent Liabilities Whether we report a loss contingent liability depends on two criteria: The likelihood of payment can be: Probable—likely to occur Reasonably possible—more than remote but less than probable; or Remote—the chance is slight The ability to estimate the payment 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 contingent liability requires a debit to a loss (or expense) account and a credit to a liability. 8- 34

Contingent Liabilities:

Contingent Liabilities If the likelihood of payment is probable and if one amount within a range appears more likely , 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 payment is remote , disclosure usually is not required. 8- 35

Accounting Treatment of Contingent Liabilities – Summary Table:

Accounting Treatment of Contingent Liabilities – Summary Table 8- 36

Contingent Liabilities:

Contingent Liabilities Back to Jeeps, Inc. How do you think Deloitte , as the auditor of Jeeps, Inc., treated the litigation described earlier? Based on the response of legal counsel, the likelihood of the payment 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. 8- 37

Warranties:

Warranties When you buy a new Dell notebook, it comes with a warranty covering the hardware from defect for either a 90-day, one-year, or two-year period depending on the product. 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 contingent liability . Even though Dell doesn’t know exactly at the time of the sale what that warranty expense will be, it can, based on experience, reasonably estimate the amount. 8- 38

Guarantees, Warranties, Premiums, Coupons, etc.:

39 Guarantees, Warranties, Premiums, Coupons, etc. For illustrative purposes, let’s look at a Warranty example… 1/1/12 Cash or A/R 5,000,000 Sales (w/3-year warranty) 5,000,000 1/1/12 Warranty Expense 50,000 Estimated Warranty Liability 50,000 Accrual Basis Method (based on 1%...and good GAAP!) Over next 3 Years: Est. Warr . Liab . 5 0,000 Cash (or Inventory) 50,000

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Contingent Gains:

Contingent Gains Is an existing uncertain situation that might result in a gain, which often is the flip side of contingent liabilities. In a pending lawsuit, one side—the defendant—faces a contingent liability, while the other side—the plaintiff—has a contingent gain. We record contingent liabilities when the loss is probable and the amount is reasonably estimable. We do not record contingent gains until the gain is certain. Though firms do not record contingent gains in the accounts, they sometimes disclose them in notes to the financial statements 8- 41

LO6 Assess liquidity using current liability ratios:

LO6 Assess liquidity using current liability ratios Liquidity Analysis (Liquidity refers to having sufficient cash to pay currently maturing debts.) Working Capital : It is the difference between current assets and current liabilities. Current ratio : We calculate it by dividing current assets by current liabilities. Acid-test ratio/Quick ratio : We calculate it by dividing “quick assets” by current liabilities. Quick assets include cash, short-term investments, and accounts receivable. 8- 42

Let’s Review:

Let’s Review Calculate working capital for United Airlines and Southwest Airlines. Calculate the current ratio for United Airlines and Southwest Airlines. Calculate the acid-test (quick) ratio for United Airlines and Southwest Airlines. Selected financial data regarding current assets and current liabilities for United and Southwest Airlines are as follows 8- 43

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Solution: 3. ($ in millions) Total Current Assets ÷ Total Current Liabilities = Current Ratio United $4,861 ÷ $7,281 = 0.67 Southwest $2,893 ÷ $2,806 = 1.03 ($ in millions) Quick Assets ÷ Total Current Liabilities = Acid-Test Ratio United $4,023 ÷ $7,281 = 0.55 Southwest $2,377 ÷ $2,806 = 0.85 Let’s Review ($ in millions) Total Current Assets - Total Current Liabilities = Working Capital United $4,861 - $7,281 = $(2,420) Southwest $2,893 - $2,806 = $ 87 2. 1. 8- 44

Effect of Transactions on Liquidity Ratios:

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, current investments, and accounts receivable, so an increase in any of those 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. 8- 45

Liquidity Management:

Liquidity Management Can management influence the ratios that measure liquidity? Yes, at least to some extent . A company can 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 . (A debt covenant is an agreement between a borrower and a lender that requires certain minimum financial measures be met or the lender can recall the debt .) 8- 46

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Good Luck on the Chapter 8 Homework!

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