Chapter 8: Current and Contingent Liabilities Financial Accounting: The Cornerstone of Business Decisions, 2e © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Current and Contingent Liabilities 1 Current and Contingent Liabilities Current liabilities are those obligations that are (1) expected to be retired with existing current assets or creation of new current liabilities, and (2) due within one year or one operating cycle, whichever is longer. All other liabilities are considered long-term. Contingent liabilities can be either current or long-term, but they are ‘‘iffy’’ in two ways. They may or may not turn into actual obligations and, for those contingencies that do become obligations, the timing and amount of the required payment is uncertain. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2

Recognition and Measurement of Liabilities 1 Liabilities are probable future sacrifices of economic benefits. These commitments, which arise from activities that have already occurred, require the business to transfer assets or provide services to another entity sometime in the future. Liabilities have a wide variety of characteristics. The future outflow associated with a liability may or may not involve the payment of cash; may or may not be known with certainty; may or may not be legally enforceable; and may or may not be payable to a known recipient. When a liability depends on a future event (i.e., a contingent liability), such as the outcome of a lawsuit, recognition depends on how likely the occurrence of the event is and whether a good estimate of the payment amount can be made. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3

Recognition of Current Liabilities 1 Recognition of Current Liabilities © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4

Measurement of Liabilities 1 When you owe money you typically pay interest, based on the following equation: Total payment = Principal + (Principal x Interest Rate x Period) Sometimes companies will appear to give you a zero percent interest loan. This really means that the ‘‘interest’’ is included in the sales price because no business is going to truly provide zero percent interest. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5

Current Liabilities 2 Current liabilities are obligations that require the firm to pay cash or another current asset, create a new current liability, or provide goods or services within the longer of one year or one operating cycle. Since most firms have operating cycles shorter than one year, the one-year rule usually applies. Some firms combine their current liabilities into a very short list, while others provide considerable detail. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6

Accounts Payable 2 An account payable arises when a business purchases goods or services on credit. It is really just the flip side of an account receivable—when you have a payable, the business you owe has a receivable. Credit terms generally require that the purchaser pay the amount due within 30 to 60 days and seldom require the payment of interest. Accounts payable do not require a formal agreement or contract. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7

Accrued Liabilities 2 Unlike accounts payable, which are recognized when goods or services change hands, accrued liabilities are recognized by adjusting entries. They usually represent the completed portion of activities that are in process at the end of the period. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8

Notes Payable 2 A note payable typically arises when a business borrows money or purchases goods or services from a company that requires a formal agreement or contract (like when you sign a contract to lease an apartment or buy a car). This formal agreement or contract is what distinguishes the note payable from an account payable. Notes payable normally specify the amount to be repaid indirectly, by stating the amount borrowed (the principal) and an interest rate. These notes are called interest-bearing notes because they explicitly state an interest rate. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9

Notes Payable from a Payment Extension 2 Notes Payable from a Payment Extension In addition to short-term borrowings, notes payable are often created when a borrower is unable to pay an account payable in a timely manner. Rolling an account payable into a short-term note payable would be an example of this. For example, on March 8, 2011, Gibson Shipping orders $25,000 of packing materials from Ironman Enterprises on account. This amount is due on May 15, 2011. Gibson’s entry is: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Notes Payable from a Payment Extension (continued) 2 Notes Payable from a Payment Extension (continued) On May 15, Gibson cannot make the $25,000 payment. Ironman grants the extension on the condition that Gibson sign a note that specifies 7 percent interest beginning on May 15, 2011, with a due date of November 15, 2011, Gibson’s entry is: Finally, on November 15, 2011, when Gibson pays the amount in full, the journal entry would be as follows: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11

Current Portion of a Long-Term Debt 2 The current portion of long-term debt is the amount of long-term debt principal that is due within the next year. At the end of each accounting period, the long-term debt that is due during the next year is reclassified as a current liability. Since the reclassification of most long-term debt as current does not usually change the accounts or amounts involved, journal entries are not required. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Other Payables 2 Other payables for most retail companies include sales taxes, usage taxes, or excise taxes for various state, local, and federal taxing authorities. These taxes, although collected as part of the total selling price, are not additions to revenue. Instead, they are money collected from the customer for the governmental unit levying the tax. These tax collections are liabilities until they are paid to the taxing authority. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13

Withholding and Payroll Taxes 2 Businesses are required to withhold taxes from employees’ earnings and to pay taxes based on wages and salaries paid to employees. These withholding and payroll taxes are liabilities until they are paid to the taxing authority. Two sources for these taxes are: Employees, that must pay certain taxes that are ‘‘withheld’’ from their paycheck. This is the difference between gross pay and net pay. The business itself, which must pay certain taxes based on employee payrolls, like matching contributions of Social Security and Medicare and fringe benefits. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14

Unearned Revenues 2 Unearned revenue is the liability created when customers pay for goods or services in advance. In such instances, the amount of the prepayment is a liability for the seller. This liability is discharged either by providing the goods or services purchased (at which time revenue is recognized) or by refunding the amount of the prepayment. A similar long-term liability, called customer deposits, is recorded when customers make advance payments or security deposits that are not expected to be earned or returned soon enough to qualify as current liabilities. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15

Contingent Liabilities 3 Measurement of the liabilities described so far was not affected by uncertainties about the amount, timing, or recipient of future asset outflows. A contingent liability is not recognized in the accounts unless: the event on which it is contingent is probable and a reasonable estimate of the loss can be made. Lawsuits filed against a business are classic examples of contingent liabilities. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16

Warranties 4 When goods are sold, the customer is often provided with a warranty against certain defects. A warranty usually guarantees the repair or replacement of defective goods during a period (ranging from a few days to several years) following the sale. The matching concept requires that all expenses required to produce sales revenue for a given period be recorded in that period. The recognition of warranty expense and (estimated) warranty liability is normally recorded by an adjustment at the end of the accounting period. As warranty claims are paid to customers or related expenditures are made, the liability is reduced. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17

Analyzing Current Liabilities 5 Both investors and creditors are interested in a company’s liquidity—that is, its ability to meet its short-term obligations. The following ratios are often used to analyze a company’s ability to meet its current obligations: Notice that the first three ratios compare all or parts of current assets to current liabilities. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18