©2009 The McGraw-Hill Companies, Inc.

Chapter 8

Current Liabilities

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Current Liabilities

o Usually, but not always, due within one year. o 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.

o Usually, but not always, due within one year. o 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.

Liability: A present responsibility to sacrifice assets in the future due to a transaction or other event that happened in the past.

©2009 The McGraw-Hill Companies, Inc.

Part A

Current Liabilities

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LO1 Distinguish between current and long-term liabilities

o Three characteristics of liabilities:o Probable future sacrifices of economic

benefits.o Arising from present obligations to other

entities.o Resulting from past transactions or

events.

o Three characteristics of liabilities:o Probable future sacrifices of economic

benefits.o Arising from present obligations to other

entities.o Resulting from past transactions or

events.

Reporting LiabilitiesReporting Liabilities

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Current vs. Long-Term Liabilities

CURRENT

LIABILITIESLIABILITIES

Payable within oneyear

With in the company

LONG-TERM

Payable more thanone year

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Reporting Current Liabilities

o Distinguishing between current and long-term liabilities helps investors and creditors assess risk.

o Companies often prefer to report a liability as long-term because it may cause the firm to appear less risky.

o Many companies list notes payable first, followed by accounts payable, and then other current liabilities from largest to smallest.

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LO2 Account for Notes Payable and Interest Expense

o Notes Payableo A company borrowing cash (borrower) from a bank

is required to sign a note promising to repay the amount borrowed plus interest.

o The borrower reports its liability as notes payable.o Small firms rely heavily on short-term financing. o Large companies also use short-term debt as a

significant part of their capital structure.

o Notes Payableo A company borrowing cash (borrower) from a bank

is required to sign a note promising to repay the amount borrowed plus interest.

o The borrower reports its liability as notes payable.o Small firms rely heavily on short-term financing. o Large companies also use short-term debt as a

significant part of their capital structure.

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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:

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Measuring Interest

o Interest is stated in terms of a percentage rate to be applied to the face value of the loan.

o Interest rate is stated as an annual rate.o 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 YearInterest = Face value x Annual rate x Fraction of the Year

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$3,000 = $100,000 x 6% x 6/12

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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, 2010, it records the four months’ interest incurred during 2010 in an adjusting entry prior to preparing the 2010 financial statements:

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:

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Flip Side Bank of America

o How would the lender, Bank of America, record this note? o For the bank it’s a note receivable rather than a note payable.o It generates interest revenue rather than interest expense. o The entries are as follows:

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Line of Credit

o An informal agreement that permits a company to borrow up to a prearranged limit without having to follow formal loan procedures and prepare paperwork.o Similar to notes payable.o Company is able to borrow without having to go

through a formal loan approval process each time it borrows money.

o An informal agreement that permits a company to borrow up to a prearranged limit without having to follow formal loan procedures and prepare paperwork.o Similar to notes payable.o Company is able to borrow without having to go

through a formal loan approval process each time it borrows money.

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LO3 Account for Employee and Employer Payroll Liabilities

o Prior to depositing a monthly payroll check, an employer withholdso Federal and state income taxes,o Social Security and Medicare,o Health, dental, disability, and life insurance premiums, ando Employee investments to retirement or savings plans.

o As an employer, the costs of hiring an employee are higher than the salary.

o Significant costs includeo Federal and state unemployment taxes,o The employer portion of Social Security and Medicare,o Employer contributions for health, dental, disability, and life

insurance,o Employer contributions to retirement or savings plans.

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Summary of Payroll Costs

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Employee Costs

o Companies are required by law to withhold federal and state income taxes from employees’ paychecks and remit these taxes to the government.

o FICA taxes - Collectively, Social Security and Medicare taxes.o FICA Act requires employers to withhold:

o 6.2% Social Security tax up to a maximum base amount.o 1.45% Medicare tax with no maximum. o Total FICA tax is 7.65% (6.2% + 1.45%) on income up to a base

amount ($102,000 in 2008) and 1.45% on all income above the base amount.

o Employees may opt to have additional amounts withheld from their paychecks.

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Employer Costs

o Employer pays an additional (matching) FICA tax on behalf of the employee.o Employer’s limits on FICA tax are the same as

employee’s.o Employer must also pay federal and state

unemployment taxes on behalf of the employees.o 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%.

o Employer pays an additional (matching) FICA tax on behalf of the employee.o Employer’s limits on FICA tax are the same as

employee’s.o Employer must also pay federal and state

unemployment taxes on behalf of the employees.o 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%.

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Employer Costs (cont.)

o 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.

o Fringe benefits: Additional employee benefits paid by the employer includeo All or part of employees’ insurance premiums.o Contributions to retirement or savings plans.o 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.

o 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.

o Fringe benefits: Additional employee benefits paid by the employer includeo All or part of employees’ insurance premiums.o Contributions to retirement or savings plans.o 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.

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Payroll Costs

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Payroll Costs (cont.)

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LO4 Demonstrate the Accounting for other Current Liabilities

o Three additional current liabilities companies report:o Unearned revenueso Sales taxes payableo The current portion of long-term debt

o We explore each of these in more detail in the following slides.

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Unearned Revenues

o Companies account for cash received in advance by:o Increasing (debit) cash and increasing (credit)

a current liability account called unearned revenue.

o Decreasing (debit) unearned revenue and increasing (credit) revenue once revenue is earned.

o Companies account for cash received in advance by:o Increasing (debit) cash and increasing (credit)

a current liability account called unearned revenue.

o Decreasing (debit) unearned revenue and increasing (credit) revenue once revenue is earned.

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Sales Taxes Payable

o Company selling products subject to sales taxes are responsible for collecting, and remitting sales taxes to state and local governments.

o Suppose you buy lunch in the airport for $15 plus 9% sales tax. The airport restaurant should record the transaction this way:

o Company selling products subject to sales taxes are responsible for collecting, and remitting sales taxes to state and local governments.

o Suppose you buy lunch in the airport for $15 plus 9% sales tax. The airport restaurant should record the transaction this way:

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Current Portion of Long-Term Debt

o Distinguishing between current portion of long-term debt and long-term debt is important to management, investors, and lenders.

o Long-term obligations are reclassified and reported as current liabilities when they become payable within the upcoming year.

o Assume Southwest Airlines has a $100 million liability at December 31, 2010, of which $5 million is payable in 2011. In its 2010 balance sheet, the company records the $100 million debt as shown below

o Distinguishing between current portion of long-term debt and long-term debt is important to management, investors, and lenders.

o Long-term obligations are reclassified and reported as current liabilities when they become payable within the upcoming year.

o Assume Southwest Airlines has a $100 million liability at December 31, 2010, of which $5 million is payable in 2011. In its 2010 balance sheet, the company records the $100 million debt as shown below

©2009 The McGraw-Hill Companies, Inc.

Part B

Loss Contingencies

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LO5 Apply the appropriate accounting treatment for loss contingencies

Loss contingency: o An existing, uncertain situation that might

result in a loss. o Examples:

o Lawsuits, product warranties, environmental problems, and premium offers

Loss contingency: o An existing, uncertain situation that might

result in a loss. o Examples:

o Lawsuits, product warranties, environmental problems, and premium offers

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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?

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Loss Contingencies

o Whether we report a loss contingency as a liability depends on two criteria:

1. The likelihood of the loss occurring can bea. 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.

o We record a liability if the loss is probable and the amount is at least reasonably estimable.

o The journal entry to record a loss contingency requires a debit to a loss (or expense) account and a credit to a liability.

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ESTIMABLE WITHIN A RANGE

o If one amount within a range of potential losses appears more likely than other amounts within the range, we record that amount.

o When no amount within the range appears more likely than others, we record the minimum amount and disclose the potential additional loss.

o 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.

o If the likelihood of loss is remote, disclosure usually is not required.

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Accounting Treatment of Loss Contingencies

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Back to Jeeps, Inc.

Now how do you think Deloitte, the auditor of Jeeps, Inc., treated the litigation described earlier?

o Based on the response of legal counsel, the likelihood of the loss occurring was considered to be remote, so disclosure was not required.

o 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.

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WARRANTY LIABILITY

o When you buy a new Dell notebook, it comes with a warranty. o Why does Dell offer a warranty? To increase sales, of course. o Based on the matching principle, the company needs to record

warranty expense in the same accounting period as the sale.o A warranty represents an expense and a liability at the time of

the sale, because it meets the criteria for recording a loss contingency.

o 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.

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GAIN CONTINGENCIES

o Is an existing uncertain situation that might result in a gain, which often is the flip side of loss contingencies.

o In a lawsuit, one side—the defendant—faces a loss contingency, while the other side—the plaintiff—has a gain contingency.

o We record loss contingencies when the loss is probable and the amount is reasonably estimable.

o We do not record gain contingencies of this type until the gain is certain.

o Though firms do not record gain contingencies in the accounts, they sometimes disclose them in notes to the financial statements

o Is an existing uncertain situation that might result in a gain, which often is the flip side of loss contingencies.

o In a lawsuit, one side—the defendant—faces a loss contingency, while the other side—the plaintiff—has a gain contingency.

o We record loss contingencies when the loss is probable and the amount is reasonably estimable.

o We do not record gain contingencies of this type until the gain is certain.

o Though firms do not record gain contingencies in the accounts, they sometimes disclose them in notes to the financial statements

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LO6 Assess liquidity using current liability ratios

Liquidity Analysiso A company is said to be liquid if it has sufficient cash to pay

currently maturing debts.o Lack of liquidity can result in financial difficulties or even

bankruptcy.

Liquidity Ratioso Current ratio:

o We calculate it by dividing current assets by current liabilities.

o Acid-test ratio: o Similar to the current ratio but is based on a more conservative

measure of current assets available to pay current liabilities. o We calculate it by dividing “quick assets” by current liabilities.o Quick assets include cash, short-term investments, and accounts

receivable.

Liquidity Analysiso A company is said to be liquid if it has sufficient cash to pay

currently maturing debts.o Lack of liquidity can result in financial difficulties or even

bankruptcy.

Liquidity Ratioso Current ratio:

o We calculate it by dividing current assets by current liabilities.

o Acid-test ratio: o Similar to the current ratio but is based on a more conservative

measure of current assets available to pay current liabilities. o We calculate it by dividing “quick assets” by current liabilities.o Quick assets include cash, short-term investments, and accounts

receivable.

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STOP AND REVIEW

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?

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?

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 are as follows.

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STOP AND REVIEWSolution:1.

2.

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LIQUIDITY MANAGEMENT

o Can management influence the ratios that measure liquidity?

o Yes, at least to some extent. o 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.

o 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.

o Can management influence the ratios that measure liquidity?

o Yes, at least to some extent. o 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.

o 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.

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EFFECT OF TRANSACTIONS ON LIQUIDITY RATIOS

o It is important to understand the effect of specific transactions on the current ratio and acid-test ratio.

o 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.

o Both ratios include cash, short-term investments, and accounts receivable, so an increase in any of those accounts will increase both ratios.

o 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.

o It is important to understand the effect of specific transactions on the current ratio and acid-test ratio.

o 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.

o Both ratios include cash, short-term investments, and accounts receivable, so an increase in any of those accounts will increase both ratios.

o 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.

©2009 The McGraw-Hill Companies, Inc.

End of chapter 8