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

2. Part A Current Liabilities 8-2

3. 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

4. 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

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

6. 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

7. 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

8. Example of Southwest Airlines oSouthwest Airlines borrows $100,000 from Bank of America on September 1, 2012. oSigning a 6%, six-month note for the amount borrowed plus accrued interest due six months later on March 1, 2013. oOn September 1, 2012, Southwest will receive $100,000 in cash and record the following entry: September 1, 2012DebitCredit Cash100,000 Notes Payable 100,000 (Issue notes payable) 8-8

9. Measuring Interest oInterest is stated in terms of an annual percentage rate to be applied to the face value of the loan. oInterest rate is stated as an annual rate. oWhen calculating interest for a period less than one year adjust for the fraction of the annual period the loan spans. Interest = Face value x Annual interest rate x Fraction of the Year oHow much interest cost does Southwest incur for the six-month period of the note from September 1, 2012 to March 1, 2013? $3,000 = $100,000 x 6% x 6/12 8-9

10. Interest Accrued and Repayment of Note On maturity, Southwest Airlines will pay the face value of the loan plus the entire interest incurred. It makes the following journal entry If Southwest’s reporting period ends on December 31, 2012, company records the four months’ interest incurred during 2012 in an adjusting entry prior to preparing the 2012 financial statements: December 31, 2012DebitCredit Interest Expense ($100,000 x 6% x 4/12)2,000 Interest Payable 2,000 (Record interest incurred, but not paid ) March 1, 2013DebitCredit Notes Payable (face value)100,000 Interest Expense ($100,000 x 6% x 2/12)1,000 Interest Payable ($100,000 x 6% x 4/12)2,000 Cash 103,000 (Pay notes payable and interest ) 8-10

11. Flip Side: Bank of America How would the lender, Bank of America, record this note? oFor the bank it’s a note receivable rather than a note payable. oIt generates interest revenue rather than interest expense. oThe entries are as follows: 8-11

12. Line of Credit oAn informal agreement that permits a company to borrow up to a prearranged limit without having to follow formal loan procedures and prepare paperwork. oSimilar to notes payable except the company is able to borrow without having to go through a formal loan approval process each time it borrows money. oMany short-term loans are arranged under an existing line of credit with a bank, or for larger corporations in the form of commercial paper, a loan from one company to another. 8-12

13. 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. 8-13

14. Summary of Payroll Costs 8-14

15. Employee Costs oEmployers are required by law to withhold federal and state income taxes from employees’ paychecks and remit these taxes to the government. oFICA taxes - Collectively, Social Security and Medicare taxes. oFICA Act requires employers to withhold: o6.2% Social Security tax up to a maximum base amount. o1.45% Medicare tax with no maximum. oTotal FICA tax is 7.65% (6.2% + 1.45%) on income up to a base amount ($106,800 in 2010) and 1.45% on all income above the base amount. oEmployees may opt to have additional amounts withheld from their paychecks. 8-15

16. Employer Costs oEmployer pays an additional (matching) FICA tax on behalf of the employee. oEmployer’s limits on FICA tax are the same as employee’s. oEmployer must also pay federal and state unemployment taxes on behalf of the employees. oFUTA requires a tax of 6.2% on the first $7,000 earned by each employee. This amount is reduced by a 5.4% (maximum) credit for contributions to state unemployment programs, so the net federal rate often is 0.8%. oSUTA, in many states the maximum state unemployment tax rate is 5.4%, but many companies pay a lower rate based on past employment history. 8-16

17. Employer Costs (contd.) oFringe benefits: Additional employee benefits paid by the employer include oAll or part of employees’ insurance premiums. oContributions to retirement or savings plans. oMany companies provide additional fringe benefits specific to the company or the industry. An important additional fringe benefit in the airline industry is the ability for the employee and family to fly free. 8-17

18. Payroll Costs Hawaiian Travel Agency oPayroll information is provided in the speaker notes. oRecords the employee salary expense, withholdings, and salaries payable on January 31 as follows: 8-18

19. Payroll Costs (contd.) Hawaiian Travel Agency pays employer’s FICA taxes at the same rate that the employees pay (7.65%) and also pays unemployment taxes at the rate of 6.2%. The agency records its employer’s payroll taxes as follows: Hawaiian Travel Agency records its employer-provided fringe benefits as follows: 8-19

20. LO4 Demonstrate the Accounting for other Current Liabilities oAdditional current liabilities companies report: oUnearned revenues oSales taxes payable oThe current portion of long-term debt oDeferred taxes oWe explore each of these in more detail in the following slides. 8-20

21. Unearned Revenues Companies account for cash received in advance by: oIncreasing (debit) cash and increasing (credit) a current liability account called unearned revenue. oDecreasing (debit) unearned revenue and increasing (credit) revenue once revenue is earned. 8-21

22. Sales Taxes Payable oCompany selling products subject to sales taxes is responsible for collecting the sales tax directly from customers and periodically sending the sales taxes collected to the state and local governments. oWhen the company collects the sales taxes, it increases cash (a debit) and increases sales taxes payable (a credit). Suppose you buy lunch in the airport for $15 plus 9% sales tax. The airport restaurant records the transaction this way: 8-22

23. Current Portion of Long-Term Debt oCurrently maturing portion of a long-term debt is reported as a current liability on the balance sheet. oAssume Southwest Airlines had total borrowings of $3,515 million at December 31, 2009, of which $190 million was payable in 2010 and the remaining $3,325 million is due after 2010. In its 2009 balance sheet, the company records the $3,515 million in current and long-term debt, as shown below 8-23

24. Deferred taxes oNet income and taxable income often differ because of differences in financial accounting and tax accounting rules. oThese differences can result in deferred tax liabilities, in which income is reported now but the tax on the income will not be paid until future years. 8-24

25. Part B Contingencies 8-25

26. 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. 8-26

27. 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. 8-27

28. Contingent Liabilities oWhether we report a loss contingent liability depends on two criteria: oThe likelihood of payment can be: oProbable—likely to occur oReasonably possible—more than remote but less than probable; or oRemote—the chance is slight oThe ability to estimate the payment amount is either: oKnown or reasonably estimable; or oNot reasonably estimable. oWe record a liability if the loss is probable and the amount is at least reasonably estimable. oThe journal entry to record a contingent liability requires a debit to a loss (or expense) account and a credit to a liability. 8-28

29. Contingent Liabilities oIf the likelihood of payment is probable and if one amount within a range appears more likely, we record that amount. oWhen no amount within the range appears more likely than others, we record the minimum amount and disclose the potential additional loss. oIf the likelihood of loss is reasonably possible rather than probable, we record no entry but make full disclosure in a footnote to the financial statements to describe the contingency. oIf the likelihood of payment is remote, disclosure usually is not required. 8-29

30. Accounting Treatment of Contingent Liabilities 8-30

31. 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. 8-31

32. Warranties oWhen you buy a new Dell notebook, it comes with a warranty covering the hardware from defect for either a 90-day, one- year, or two-year period depending on the product. oWhy does Dell offer a warranty? oTo increase sales, of course. oBased on the matching principle, the company needs to record warranty expense in the same accounting period as the sale. oA warranty represents an expense and a liability at the time of the sale, because it meets the criteria for recording a contingent liability. oEven though Dell doesn’t know exactly at the time of the sale what that warranty expense will be, it can, based on experience, reasonably estimate the amount. 8-32

33. Contingent Gains oIs an existing uncertain situation that might result in a gain, which often is the flip side of contingent liabilities. oIn a pending lawsuit, one side—the defendant— faces a contingent liability, while the other side—the plaintiff—has a contingent gain. oWe record contingent liabilities when the loss is probable and the amount is reasonably estimable. oWe do not record contingent gains until the gain is certain. oThough firms do not record contingent gains in the accounts, they sometimes disclose them in notes to the financial statements 8-33

34. 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. 8-34

35. Let’s Review 1.Calculate working capital for United Airlines and Southwest Airlines. 2.Calculate the current ratio for United Airlines and Southwest Airlines. 3.Calculate the acid-test (quick) ratio for United Airlines and Southwest Airlines. Selected financial data regarding current assets and current liabilities for United and Southwest Airlines are as follows 8-35

36. Solution: 3. ($ in millions) Total Current Assets÷ Total Current Liabilities= Current Ratio United$4,861÷$7,281=0.67 Southwest$2,893÷$2,806=1.03 ($ in millions)Quick Assets÷ Total Current Liabilities= Acid-Test Ratio United$4,023÷$7,281=0.55 Southwest$2,377÷$2,806=0.85 Let’s Review ($ in millions)Total Current Assets- Total Current Liabilities= Working Capital United$4,861-$7,281=$(2,420) Southwest$2,893-$2,806=$ 87 2. 1. 8-36

37. Effect of Transactions on Liquidity Ratios oIt is important to understand the effect of specific transactions on the current ratio and acid-test ratio. oBoth ratios have the same denominator, current liabilities, so a decrease in current liabilities will increase the ratios and an increase in current liabilities will decrease the ratios. oBoth ratios include cash, current investments, and accounts receivable, so an increase in any of those will increase both ratios. oOnly the current ratio includes inventory and other current assets, so an increase in these accounts will increase the current ratio, but not the acid-test ratio. 8-37

38. Liquidity Management oCan management influence the ratios that measure liquidity? oYes, at least to some extent. oA company can influence the timing of accounts payable recognition by asking suppliers to change their delivery schedules. oThe timing of accounts payable recognition could mean the difference between an unacceptable ratio and an acceptable one, or between violating and complying with a debt covenant. oA debt covenant is an agreement between a borrower and a lender that requires certain minimum financial measures be met or the lender can recall the debt. 8-38

39. End of chapter 08 8-39