11 Current Liabilities and Fair Value Accounting C H A P T E R Current Liabilities and Fair Value Accounting Principles of Accounting 12e Needles Powers Crosson ©human/iStockphoto

Concepts Underlying Current Liabilities Current liabilities are debts and obligations that a company expects to satisfy within one year or within its normal operating cycle. Timing is important in the recognition of liabilities. Failure to record a liability often means failure to record an expense. The two errors lead to an under-statement of expense and an overstatement of income. Generally accepted accounting principles require that a liability be recorded when an obligation occurs, such as when goods are bought on credit. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Valuation On the balance sheet, a liability is generally valued at the amount of money needed to pay the debt or reported at the fair market value of the goods or services to be delivered. Some liabilities must be estimated. For example, if an automobile dealer sells a car with a one-year warranty on parts and service, the obligation is definite because the sale has occurred; but the amount of the obligation can only be estimated. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Classification Current liabilities are due in the next year or within the normal operating cycle, whichever is longer, and are normally paid out of current assets or with cash generated by operations. They contrast with long-term liabilities, which are liabilities due beyond one year or beyond the normal operating cycle. The distinction between current and long-term liabilities affects the evaluation of a company’s liquidity. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Disclosure In addition to reporting liabilities on the balance sheet, a company may need to include additional explanation in the notes to its financial statements. If a company’s Notes Payable account is large, it should disclose the features of the debts in an explanatory note. Any special credit arrangements, such as a line of credit, should also be disclosed. A line of credit with a bank allows a company to borrow funds on short notice up to the credit limit, with little or no negotiation. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Definitely Determinable Liabilities Current liabilities that are set by contract and that can be measured exactly are called definitely determinable liabilities. These include: Accounts payable, which are short-term obligations to suppliers for goods and services Short-term notes payable, which are represented by promissory notes A promissory note is a written agreement to pay according to certain terms. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Bank Loans and Commercial Paper Although a company signs a promissory note for the full amount of a line of credit, it can increase its borrowing up to the limit when it needs cash and reduce the amount borrowed when it generates enough cash on its own. Companies with excellent credit ratings can borrow short-terms funds by issuing commercial paper—unsecured loans that are sold to the public, usually investment firms. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accrued Liabilities A key reason for making adjusting entries is to recognize accrued liabilities that are not already in the accounting records. These may include estimated liabilities. Interest payable, a definitely determinable liability, is an accrued liability. Interest accrues daily on interest-bearing notes. An adjusting entry is made at the end of each period to record the interest obligation up to that point. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Dividends Payable Cash dividends are a distribution of earnings to a corporation’s stockholders. A corporation’s board of directors has the sole authority to declare them. A corporation has no liability for dividends until the date of declaration. During the brief period between that date and the date of payment, the dividends declared are considered current liabilities of the corporation. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Sales and Excise Taxes Payable Most states and many cities levy a sales tax on retail transactions. The federal government imposes an excise tax on some products, such as gasoline. A merchant that sells goods subject to these taxes must collect the taxes and forward them periodically to the appropriate agency. Until the merchant remits the amount it has collected, that amount represents a current liability. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Current Portion of Long-Term Debt The portion of long-term debt that is due within the next year and is to be paid from current assets is classified as a current liability. No journal entry is necessary when this is the case. The total debt is simply reclassified as short-term and long-term when the company prepares its balance sheet and other financial statements. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Payroll Liabilities Employers are liable to employees for wages and salaries and to various agencies for withholdings from wages and salaries and related taxes. Wages are compensation at an hourly rate. Salaries are compensation at a monthly or yearly rate. An employee is paid a wage or salary by an organization and is under its direct supervision and control. Payroll accounting applies only to employees. An independent contractor offers services for a fee but is not under the organization’s direct control or supervision. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Illustration of Payroll Costs The amount payable to employees is less than the amount of their earnings because employers are required by law or are requested by employees to withhold certain amounts from wages. An employer’s total liabilities exceed employee’s earnings because the employer must pay additional taxes and make other contributions (such as for pensions and medical care) that increase payroll costs. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Withholdings, Taxes, and Other Payroll Costs (slide 1 of 2) The most common withholdings, taxes, and other payroll costs are: Federal income taxes—Employers are required to withhold these and pay them to the U.S. Treasury. State and local income taxes—Most states and some local governments require that these taxes be withheld. Social security (FICA) tax: Paid by both the employee and the employer; both the rate and base may change. Medicare tax: 1.45 percent of gross income, with no limit, paid by both the employee and the employer ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Withholdings, Taxes, and Other Payroll Costs (slide 2 of 2) Medical insurance—The employee often contributes a portion of the cost through withholdings, and the employer pays the rest to the insurance company. Pension contributions—A portion of the contribution is withheld from the employee’s income, and the employer pays the rest of the amount into the pension fund. Federal unemployment insurance (FUTA) tax and state unemployment insurance tax: These taxes are paid only by employers; the FUTA tax may be reduced by the amount of unemployment tax paid to the state. Vacation pay: The cost of accrued vacation should be allocated as an expense over the year. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Unearned Revenues and Estimated Liabilities Unearned revenues are advance payments for goods or services that a company must provide in the future. Estimated liabilities are definite debts or obligations whose exact dollar amount cannot be known until a later date. Examples include: Income taxes payable—taxes on a corporation’s income (not owed by sole proprietorships or partnerships) Property taxes payable—taxes on real property and personal property, such as inventory and equipment Promotional costs—coupons, rebates, and other marketing programs, such as frequent flyer programs Product warranty liability ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Contingent Liabilities and Commitments (slide 1 of 2) A contingent liability is a potential liability because it depends on a future event arising out of a past transaction. Contingent liabilities often involve: Lawsuits Income tax disputes Discounted notes receivable Guarantees of debt Failure to follow government regulations The FASB requires that contingent liabilities be disclosed in a note to the financial statements. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Contingent Liabilities and Commitments (slide 2 of 2) A contingent liability should be entered in the accounting records if it meets two conditions: The liability must be probable. The liability can be reasonably estimated. A commitment is a legal obligation that does not meet the technical requirements for recognition as a liability and so is not recorded. Examples include purchase agreements, leases, and commitments for construction or acquisition of assets. Commitments must also be disclosed in notes to the financial statements. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Valuation Approaches to Fair Value Accounting Fair value is the price for which an asset or liability could be sold or exit the company. Three approaches to measurement of fair value are: Market approach—ideal for valuing investments and liabilities for which there is an active market and quoted prices are available for the specific asset or liability Income (or cash flow) approach—converts future cash flows to a single present value; used when there are no identical or comparable quoted prices available Cost approach—based on the amount that currently would be required to replace an asset with a comparable asset; must be adjusted to take into account the asset’s age, condition, etc. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Interest, the Time Value of Money, and Future Value The time value of money refers to the costs or benefits of holding or not holding money over time. Interest is the cost of using money for a specific period. Simple interest is the interest cost for one or more periods when the principal stays the same from period to period. Compound interest is the interest cost for two or more periods when the principal sum is increased at the end of each period by the interest earned in that period. The amount of principal plus interest after one or more periods is known as future value. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Present Value Present value is the amount that must be invested today at a given rate of interest to produce a given future value. The concept of present value is widely used in business decision making and financial reporting. The value of a long-term note receivable or payable can be determined by calculating the present value of the future interest payments. The FASB has made present value an important component of its approach in determining the fair value of assets and liabilities when a market price is not available. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Business Issues Related to Current Liabilities The primary reason a company incurs current liabilities is to meet its needs for cash during the operating cycle. To evaluate a company’s ability to pay its current liabilities, analysts use two measures of liquidity: Working Capital = Current Assets − Current Liabilities Current Ratio = Current Assets ÷ Current Liabilities Measurements commonly used to assess a company’s ability to pay within a certain time frame are payables turnover and days’ payable. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Payables Turnover Payables turnover is the number of times, on average, that a company pays its accounts payable in an accounting period. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Days’ Payable Day’s payable shows how long, on average, a company takes to pay its accounts payable. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.