Intermediate Financial Accounting I Current Liabilities and Contingencies

Current Liabilities and Contigencies2 Objectives of the Chapter 1. Accounting for current liabilities with definite amount (i.e., trade related liabilities, employee payroll related liabilities and accrued liabilities.) 2. Accounting for estimated liabilities (i.e., warranty obligations, coupons and premiums obligations). 3. Accounting for contingent liabilities.

Current Liabilities and Contigencies3 Liabilities n Legal obligations require future payments of cash or services or the creation of other liabilities as a result of past transactions. n Current liabilities: Obligations must be fulfilled in one year or one operating cycle, whichever is longer.

Current Liabilities and Contigencies4 Current Liabilities n Examples of current liabilities with definite amount as a result of a business transaction: u A/P (accounts payable) u N/P (notes payable including commercial paper issued) u Current maturity portion of a long-term debt u Sales taxes payable u Accrued liabilities u Payroll taxes withholdings

Current and Long-Term Liabilities5 Sales Taxes Payable n Sales taxes are taxes levied by states on retail sales, not on manufacturers (i.e., GE, GM, etc). n Every state, except Alaska, Delaware, Montana, New Hampshire, and Oregon, levies state sales taxes on retail sales. n The rate varies state by state ( for example, Starting 4/1/2009, California has a statewide sales tax at 8.25% with a local supplementary tax for up to 10.75%).

Current and Long-Term Liabilities6 Sales Taxes Payable (contd.) n Retailers charge their customers the sales taxes in addition to the price of the merchandise. n The retailers have to forward the collected sales taxes to the state at regular intervals.

Current and Long-Term Liabilities7 Example n Assume that the 12/22/x9 sales of Macy’s in California totaled $2,000,000. The state tax rate is 8.25%. The business would record the day’s sales as follows: Cash2,165,000 Sales Revenue 2,000,000 Sales Taxes Payable165,000

Current Liabilities and Contigencies8 Accrued Liabilities n Obligations accumulated on a daily basis but not recorded until the end of period through adjusting entries (i.e., Interest payable, salaries payable, rent payable…)

Current Liabilities and Contigencies9 Employee Related Liabilities: FICA, Federal I/T, state I/T, Medical Insurance Premiums… Salaries Expense50,000 Employee F.I.C.A. Taxes Payable* 3,825 Federal I/T Payable 10,000 State I/T Payable2,500 Cash32,675 *(6.2% +1.45%) *$50,000 or 7.65% x $50,000 F.I.C.A. taxes include Social Security tax of 6.2% (max earnings taxable is $106,800 for 2009) and 1.45% of Medicare tax (no limit on maximum earnings taxable).

Current Liabilities and Contigencies10 Employee Related Liabilities (contd.) n Employer payroll taxes: Payroll Taxes Expense6,925 Employer F.I.C.A. Taxes Payable3,825 F.U.T.A. Taxes Payable a 400 State Unemployment Tax Payable b 2,700 a. 6.2% of the first $7,000 of salaries paid to employees. b. assuming a state unemployment tax = 5.4%.

Current Liabilities and Contigencies11 n Refundable Deposits Cashxxx Refund Deposit Liabilitiesxxx n Dividends Payable n Unearned Revenue Other Current Liabilities

Current Liabilities and Contigencies12 Estimated Liabilities n Liabilities exist but the amount is unknown: A. Property taxes B. Warranty obligations C. Coupon and premium obligations D. Compensated absences E. Environmental liabilities

Current Liabilities and Contigencies13 A. Property Taxes n Property taxes are assessed by local governments (city, state …) on the value of properties. The assessed property taxes become a lien on the properties on a day specified by law (i.e., July 1) n In general, the bills of the property taxes are not received until a few months after the lien day. The property taxes must be estimated and recognized on a monthly basis (recommended by the AICPA) starting the lien day.

Current Liabilities and Contigencies14 A. Property Taxes (contd.) n Also, the property taxes expenses should be allocated over the fiscal year of the local government (i.e., 7/1/x1 ~ 6/30/x2). n If there are differences between the estimates and the actual taxes, the adjustments are considered as an estimate change and are spread to the remaining tax period (no retroactive effect).

Current Liabilities and Contigencies15 Example The fiscal year of the local government => 7/1/x8 - 6/31/x9 The property tax becomes a lien on the property on => 7/1/x8 Estimated property tax expenses (for 7/1/x8 - 6/30/x9) =>$12,000 Tax bill received on=> 10/29/x8 Actual tax expense=> $13,800 Tax paid on=>11/30/x8

Current Liabilities and Contigencies16 Example (contd.) Prepare journal entries regarding the property tax for the period of 7/1/x8 - 6/30/x9: 7/1/x8 No journal entry (accrued the liability, on a monthly basis) 7/31/x8 Property Tax Expenses1,000 Property Tax Payable1,000  ($12,000/12=$1,000) 8/31/x8 P/T Exp1,000 P/T Payable1,000 9/30/x8 P/T Exp1,000 P/T Payable1,000 10/31/x8 P/T Exp1,200 P/T Payable1,200 F (($13,800 -$3,000)/(12-3) = $1,200 the difference is treated as changes in estimates; no retroactive effect. (APB 20))

Current Liabilities and Contigencies17 Prepare journal entries regarding the property tax for the period of 7/1/x8 - 6/30/x9: (contd.) 11/30/x8P/T Payable4,200 Prepaid P/T9,600 Cash13,800 P/T Expense1,200 Prepaid P/T1,200 12/31/x8P/T Exp1,200 Prepaid P/T1,200 : : 6/30/x9P/T Exp1,200 Prepaid P/T1,200

Current Liabilities and Contigencies18 B. Warranty Obligations (Product Warranty) 1. Cash basis (for Income Tax Filing Purposes, not GAAP) 2. Expense warranty using accrued method (GAAP)

Current Liabilities and Contigencies19 1. Cash Basis (for tax filing) (Not Acceptable for Financial Reporting Purpose) n Warranty expenses are recognized when these expenses are paid for (violating the matching principle) n Journal Entry: Warranty Expxxx Cashxxx (only for I/T filling)

Current Liabilities and Contigencies20 2. Expense Warranty Using Accrued Method (for financial Reporting Purposes) n Estimate the warranty exp. associated with the sales (of the period) at the end of the period and recognize it.

Current Liabilities and Contigencies21 2. Expense Warranty Using Accrued Method (contd.) n Journal Entry: Warranty Expensesxxx Estimated Warranty Liabilitiesxxx When warranty services provided: Estimated warranty liabilitiesxxx Cash (or Inventory)xxx If the estimated warranty liabilities are not enough to cover the current year’s warranty services, treat it as a change in accounting estimates (i.e., no retroactive effect).

Current Liabilities and Contigencies22 Example The estimated warranty liabilities account has an ending balance of $2,000 before the following year end adjustment: 12/31/x2Warranty Expenses3,000 Estimated Warranty Liability3,000 During 20x3, the actual warranty expenses amounted to $5, x3: Estimated warranty liability5,000 * Warranty Expenses 800 Cash (or Inventory)5,800 22

Current Liabilities and Contigencies23 C. Premiums and Coupons Obligations n Liabilities of premiums and coupons should be estimated and recognized in the year when sales are made. n Journal Entry Premium (or Coupon) Expensexxx Estimated Premium Claims (or coupon) outstandingxxx

Current Liabilities and Contigencies24 C. Premiums and Coupons Obligations (contd.) n When premiums (or coupons) are claimed: Journal Entry Estimated Premium Claims (coupon) outstandingxxx Inventoryxxx * If the actual redemption of coupons (or premiums) is greater than the estimated liabilities, the underestimated amount would be recognized as the expense of the current year.

D. Compensated Absences  Compensation for vacation, illness and holidays.  Companies should estimate the amount of liabilities and recognize them at the end of the reporting period if: a. Employee’s services needed to receive these rights have been rendered. b. The obligation relates to these rights are vested. c. Payment of the compensation is probable. d. The amount of liabilities can be reasonably estimated. Current Liabilities and Contigencies25

E. Environmental Liabilities (SFAS 143)  A company must recognize an asset retirement obligation (ARO) when 1) it has an existing legal obligation associated with the retirement of a long- lived asset, and 2) the liability can be reasonably estim ated. Examples of obligating events: decommissioning nuclear facilities, dismantling, restoring and reclamation of oil and gas properties, etc. Current Liabilities and Contigencies26

Recognition and Allocation of ARO  The estimated fair value of ARO is capitalized on 1/1/2002 : Nuclear Plant 50,000 Asset Retirement Obligation 50,000  The cost of ARO will be subsequently allocated as depre. expense over the life of the asset (i.e., 5 years): Depre. Expense 10,000 Acc. Depre. – Nuclear Plant 10,000 Current Liabilities and Contigencies27

Recognition and Allocation of ARO (contd.) The accrued interest of ARO should be recognized periodically (assuming 10% interest): 12/31/2002 Interest expense (10% x50,000) 5,000 ARO 5,000 On 1/1/2008, the decommissioning cost amounted to $78,000, the following will be recorded: ARO 80,525 Cash 78,000 Gain on Settlement of ARO 2,525 Current Liabilities and Contigencies28

Current Liabilities and Contigencies29 Contingencies u Contingent Liabilities u Contingent Losses u Contingent Gains

Current Liabilities and Contigencies30 Contingent Liabilities n Obligations may arise because of the occurrence or not occurrence of future event(s). (i.e., warranty obligations)

Current Liabilities and Contigencies31 Contingent Liabilities n Liabilities may arise because of the occurrence or not occurrence of future event(s). (i.e., guarantee and warranty costs, litigation and claims, premiums and coupons, environment al liabilities, etc.)

Current Liabilities and Contigencies32 Contingent Gains n Gains may arise because of the occurrence or not occurrence of future events). (i.e., pending lawsuit gains)

Current Liabilities and Contigencies33 Accounting Treatments of Contingencies The accounting treatments of the contingencies depend on the occurrence probability of the related future event(s).(FASB 5) 1. Probable: The future event(s) is(are) likely to occur. 2. Reasonably possible: The chance for the future event(s) to occur is less than probable but greater than remote 3. Remote: The chance of the future event to occur is unlikely (slight).

Current Liabilities and Contigencies34 Accounting Treatments of Contingencies (contd.) n If the future event(s) is(are) a. Probable, and b. amount of liability can be estimated The loss (liability) should be estimated, and recognized (accrued).

Current Liabilities and Contigencies35 Accounting Treatments of Contingencies (contd.) n Examples: Warranty Expense xxx Estimated Warranty Liabilities xxx Lawsuit Expensesxxx Estimate Liability under litigation xxx

Current Liabilities and Contigencies36 Accounting Treatments of Contingencies (contd.) n If the future event is probable, but the amount of loss (or liability) cannot be estimated, the contingent loss (or liability) should only be footnoted (not accrued). n Contingent gains: u If the event is probable and the amount of contingent gains is determinable, only footnote the information. No unrealized gain can be recognized under the current accounting standards (conservatism!!!)

Current Liabilities and Contigencies37 Additional Notes For Current Liabilities 1. Obligations that are callable by the creditors within the longer period of one year or one operating cycle: reported as current liabilities. 2. Obligation that matures in one year or one operating cycle, whichever is longer: reported as current liabilities. 3. Short-term obligations that are expected to be refinanced by a long-term debt: reported as a long-term debt if conditions (i.e., intention and ability to do so) are met.