1 CHAPTER 14 EXPENSES AND CASH PAYMENTS

2 Chapter Overview  Why does a large company make purchases on credit, and how should it manage and record accounts payable?  How does an exchange gain (loss) arise from a credit purchase made from a company in another country?  What are accrued liabilities, and what type does a company often have?  What type of taxes do an employee and a company incur, and how does the company record them?

3  How is accounting for a short-term note payable similar to accounting for a short- term note receivable?  What are prepaid items, and how does a company account for them?  What are loss contingencies, and how does a company report or disclose them?  What can external users learn from analyzing a company’s liquidity? Chapter Overview

4 Accounts Payable Management Separating these duties adds internal control to accounts payable to prevent one employee from making a purchase and stealing for personal use. A purchasing department should oversee purchases, taking time to investigate suppliers, prices and payment terms to meet company criteria. Since duties are separated, proper documentation must be provided before payment is authorized, such as a supplier’s invoice that has been matched with the purchase order and receiving report. Without receipt of accounts payable documents timely, the company is unable to take advantage of purchase discounts.

5  Assume Unlimited Decadence orders $35,000 of cocoa from Cool Cocoa, Inc. Cool Cocoa offers credit terms on the purchase of 2/10, n/30. How is this transaction recorded? Recording Credit Purchases and Discounts Assets = Liabilities + Stockholders’ Equity +$35,000 (Raw Materials Inventory) +$35,000 (Accounts payable) Before this purchase was made, a purchase order was approved by the purchasing dept. and send to the supplier.

6  When Unlimited Decadence takes advantage of the credit terms offered by Cool Cocoa of 2/10, n/30, how is the transaction recorded? Recording Purchase Discounts and Returns Assets = Liabilities + Stockholders’ Equity -$34,300 (Cash) -$700 (Raw Materials Inventory) -$35,000 (Accounts payable) Before this payment was authorized, the purchase order was matched to the supplier invoice and receiving report for the cocoa. Under the gross method, the purchase discount (2% X $35,000) is not recorded until taken, and then it reduces the cost of the inventory.

7  A 2% discount may not sound like much, but in annual terms it is very significant.  If a company takes advantage of 2/10 credit terms, it pays 2% less by paying 20 days earlier (the 30 days allowed for payment less the 10-day discount period).  If the discount is not taken, the purchaser pays 2% more to the supplier for borrowing just 20 days. This equates to a 36% annual interest cost! The Cost of Not Taking Discounts [2% x (360 days/20 days)] = 36%!!

8  Suppose Unlimited Decadence discovered that the cocoa was of a lesser quality than ordered, even though it was still acceptable. Cool Cocoa agrees to grant a $1,000 allowance on the purchase for the error.  This is a purchase allowance, which reduces the amount of the inventory purchased and the amount due to the supplier. Recording Purchase Discounts and Returns Assets = Liabilities + Stockholders’ Equity -$1,000 (Raw Materials Inventory) -$1,000 (Accounts payable) Any subsequent purchase discount available would then be made on the adjusted invoice price of $34,000 ($35,000 - $1,000 allowance).

9 Foreign Exchange Gains/Losses  Exchange gains or loss result from change in the exchange rate between the date that a company records an event and the date of actual payment.  An exchange gain occurs when the exchange rate decreases between the date a payable is recorded and the date of payment.  An exchange loss occurs when the exchange rate increases between the date a payable is recorded and the date of payment.

10 Recording Foreign Exchange Events  If Unlimited Decadence purchases sugar from a Brazilian company on credit for an agreed price of 400,000 Brazilian Reals when the exchange rate is $0.40 (1 Brazilian Real = $0.40), how would the transaction be recorded?  400,000 Brazilian Reals X 0.40 = $160,000, the amount of the transaction recorded by Unlimited Decadence. Assets = Liabilities + Stockholders’ Equity +$160,000 (Raw materials inventory) +$160,000 (Accounts payable)

11 Recording Foreign Exchange Events  Unlimited Decadence has the obligation to pay 400,000 Brazilian Reals regardless of exchange rate differences. What happens when the exchange rate falls to $0.38 on the date of payment?  400,000 Brazilian Reals X 0.38 = $152,000, the amount of the cash paid by Unlimited Decadence. This results in an $8,000 exchange gain. Assets = Liabilities + Stockholders’ Equity -$152,000 (Cash) +$8,000 (Exchange gain) -$160,000 (Accounts payable)

12 Accrued Liabilities  Accrued liabilities is a common caption on the balance sheet. What does it mean? What does it include?  Accrued liabilities are short-term obligations (other than merchandise accounts payable) that company owes at the end of an accounting period. These obligations arise from operating activities.  Common examples of accrued liabilities include unpaid utility bills, salaries (wages) and warranties.

13  Accrued salaries arise when pay periods cross over an accounting period, such as December 31.  If employees of Unlimited Decadence earn $400,000 for the last 2 days of December, that fall in the next pay period, $400,000 is accrued on December 31. How is this entry recorded? -$400,000 (+Salaries expense) Assets = Liabilities + Stockholders’ Equity +$400,000 (Salaries payable) Accrued Salaries

14 Analysis of the Salaries Payable Account Exhibit 14-1

15  Warranty liabilities arise when a company offers a warranty when goods are purchased, such as “30 days parts and labor” or 3 years bumper to bumper.”  Since GAAP requires a company to match the revenues with the cost of producing revenues, companies must estimate their future warranty obligation for goods sold during the period.  When the cost of warranties is estimated, the warranty liability is recorded. Warranty Liabilities

16  Assume you purchase a new Ford in 2004 with a 36,000 mile warranty. Based on its prior experience and other data, Ford estimates that the future warranty liability associated with your purchase is $900. How is this recorded in 2004? -$900 (+Warranty expense) Assets = Liabilities + Stockholders’ Equity +$900 (Warranty liability) Warranty Liabilities A warranty claim will ultimately reduce the warranty liability and either cash or inventory, depending on the warranty claim.

17  A tax is an amount of money that a government requires a taxable entity (i.e., an individual or company) to pay. Companies incur many different type of taxes, depending on the nature of their business.  Taxes that a company owes but has not yet paid at the balance sheet date are referred to as Accrued Taxes, or Taxes Payable.  The three most common type of taxes are payroll, income, and sales taxes. Taxes

18  Payroll taxes come in two forms: the amount the company takes out of your paycheck (the difference between your gross and net pay) – these are payroll withholding taxes that represent the employees’ liabilities.  The second type is called payroll tax expense, additional taxes due by a company because of the employees on its payroll. These represent employer liabilities.  Each pay period, a company must account for payroll withholding and payroll tax expense. Payroll Taxes

19  As an employer, Unlimited Decadence must withhold certain taxes from employees’ paychecks, as a collection agent for the governmental unit.  These are employee obligations not Unlimited Decadence’s obligations, although the company is required, by law, to pay over these liabilities within certain time frames. Payroll Withholding Taxes Federal income tax withholding Social Security/Medicare tax withholding 7.65% State and local income tax withholding

20 Illustration of Employee Payroll Taxes

21  In addition, Unlimited Decadence must pay over additional amounts, over and above what is withheld from employees’ paychecks.  These payroll taxes are obligations of the company, not the employee. Unlimited Decadence is also required, by law, to pay these liabilities within certain time frames. Addition Employer Payroll Taxes Social Security/Medicare taxes 7.65% (matches employee contribution dollar for dollar up to pre-established wage ceiling) Federal /state unemployment insurance taxes 6.2% (contribution up to a pre-established wage ceiling)

22 Illustration of Employer Payroll Taxes

23  Since corporations are separate entities under the law, they pay income taxes.  Under GAAP, a corporation must provide for the amount of estimated taxes due based on profits earned in the accounting period, even thought the taxes may not be paid until a later time.  Income taxes are included as an expense on the income statement because it is a cost of doing business. Income taxes payable is a liability on the balance sheet. Income Taxes

24  Accrued Taxes or Taxes Payable are calculated on a corporation’s pretax net income during an accounting period.  If Unlimited Decadence reports $4.9 million in pre- tax income, and is subject to a 40% tax rate, how is the tax recorded?  $4.9 million X 40% = $1.96 million in tax expense. -$1.96 million (+Income tax expense) Assets = Liabilities + Stockholders’ Equity +$1.96 million (Income taxes payable) Accrued Taxes

25  Most states and local communities in the U.S. require customers to pay a sales tax on many type of products purchased.  A company is require to collect state and local sales taxes from its retail customers at the time its product are sold, if the sale is a covered taxable sale.  Like payroll withholding taxes, a company is acting as a collection agent for the governmental unit in this regard. Sales Taxes

26  If Unlimited Decadence makes a $10,000 credit sale to a customer that is subject to a 5% sales tax, how is the tax recorded? +$10,000 (Sales revenue) +$500 (Sales tax payable) Sales Taxes Payable Assets = Liabilities + Stockholders’ Equity +$10,500 (Accounts receivable)

27 Notes Payable  As we discussed in Chapter 13, some companies sell goods to customers in return for a promissory note. When a company is the maker of the promissory note, it records a short-term note payable.  Because the purchaser expects to pay cash in the future based on a written commitment, the amount owed to the supplier is called a note payable.  The accounting treatment mirrors that for a note receivable. Over time, the obligation to pay interest expense arises rather than interest revenue.

28 Prepaid items  In some industries, it is common for the buying company to pay cash before the selling company delivers the goods or provides the service that the buying company purchased.  For example, landlords require tenants to pay rent in advance and insurance companies require policyholders to pay premiums before a policy is effective.  When a company pays for goods and services before using them, it creates an expense with a future benefit (i.e., an asset). These are called prepaid items.

29  If Unlimited Decadence pays $12,000 for a one-year insurance policy on October 1, 2004, how is this recorded?  As the insurance is “used” how is this recognized in the financial statements at the end of 2004? Prepaid Items Assets = Liabilities + Stockholders’ Equity +$12,000 (Prepaid insurance -$12,000 (Cash) -$3,000 (+Insurance expense) -$3,000 (Prepaid insurance Record purchase (Asset) Transaction on October 1, 2004 Record expiration (Expense) Adjusting entry on December 31, 2004

30 Loss Contingencies  A loss contingencies is an existing condition (based on a past event that has occurred) that may have an adverse impact on a company, depending on the outcome of a future event.  A common example of a loss contingency would be a pending lawsuit against a company.  GAAP has certain criteria that must be examined when a loss contingency exist to determine how the contingency is to be reflected in the financial statements.

31 Loss Contingency Decision Grid Probable means the chance that the future event will occur is likely. Remote means the chance that the future event will occur is slight. Reasonably possible means the chance that the future event will occur is more than remote but less than probable. This means the company records an estimated loss from a contingency as a reduction of income (expense or loss) and a related liability (or reduction of an asset).

32 Evaluation of Liquidity Position  Assessing a company’s liquidity is important to determine its ability to meet short-term obligations. A company risks going out of business if it cannot meet its obligations or obtain additional resources.  In addition, a company’s liquidity is important to financial flexibility. A company with a good liquidity position can take advantage of business opportunities and invest for growth.  Intracompany and intercompany financial analysis can provide helpful information.

33 Intracompany Analysis of Rocky Mountain Chocolate Factory

34 Intercompany Analysis of Rocky Mountain Chocolate Factory