Chapter 08 Current Liabilities McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Part A Current Liabilities 8-2

Current Liabilities Liability - A present responsibility to sacrifice assets in the future due to a transaction or other event that happened in the past. oCurrent 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. oCurrent liabilities are also sometimes called short- term liabilities. 8-3

LO1 Distinguish between current and long-term liabilities Three characteristics of liabilities: oprobable future sacrifices of economic benefits. oarising from present obligations to other entities. oresulting from past transactions or events. Reporting Liabilities 8-4

Current vs. Long-Term Liabilities LIABILITIES Payable within one year With in the company LONG-TERM Payable more than one year CURRENT 8-5

Reporting Current Liabilities oDistinguishing between current and long-term liabilities helps investors and creditors assess risk. oCompanies often prefer to report a liability as long-term because it may cause the firm to appear less risky. oMany companies list notes payable first, followed by accounts payable, and then other current liabilities from largest to smallest. 8-6

LO2 Account for Notes Payable and Interest Expense oNotes Payable oA company borrowing cash (borrower) from a bank is required to sign a note promising to repay the amount borrowed plus interest. oThe borrower reports its liability as notes payable. oNotes payable is a liability that creates interest expense oSmall firms rely heavily on short-term financing. oLarge companies also use short-term debt as a significant part of their capital structure. 8-7

LO3 Account for Employee and Employer Payroll Liabilities oPrior to depositing a monthly payroll check, an employer withholds oFederal and state income taxes, oSocial Security and Medicare, oHealth, dental, disability, and life insurance premiums, and oEmployee investments to retirement or savings plans. oAs an employer, the costs of hiring an employee are higher than the salary. oSignificant costs include oFederal and state unemployment taxes, oThe employer portion of Social Security and Medicare, oEmployer contributions for health, dental, disability, and life insurance, oEmployer contributions to retirement or savings plans. 8-8

Summary of Payroll Costs 8-9

LO4 Demonstrate the Accounting for other Current Liabilities Additional current liabilities companies report: oUnearned revenues oSales taxes payable oThe current portion of long-term debt oDeferred taxes 8-10

Part B Contingencies 8-11

LO5 Apply the appropriate accounting treatment for contingencies oContingent liability: oAn existing, uncertain situation that might result in a loss. oExamples: Lawsuits, product warranties, environmental problems, and premium offers oA 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. 8-12

Litigations and Other Causes 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 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, 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. 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. 8-13

Accounting Treatment of Contingent Liabilities 8-14

Contingent Liabilities Back to Jeeps, Inc. How do you think Deloitte, as the auditor of Jeeps, Inc., treated the litigation described earlier? oBased on the response of legal counsel, the likelihood of the payment occurring was considered to be remote, so disclosure was not required. oHowever, 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. 8-15

LO6 Assess liquidity using current liability ratios oLiquidity Analysis oLiquidity refers to having sufficient cash to pay currently maturing debts. oWorking Capital: oIt is the difference between current assets and current liabilities. oCurrent ratio: oWe calculate it by dividing current assets by current liabilities. oAcid-test ratio/Quick ratio: oWe calculate it by dividing “quick assets” by current liabilities. oQuick assets include cash, short-term investments, and accounts receivable. 8-16

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