1. Current Liabilities and Contingencies
Chapter 13
Current Liabilities and Contingencies
Chapter 13: Current Liabilities and Contingencies.

2. Characteristics of Liabilities
Probable future sacrifices of economic benefits . . .
. . . Arising from present obligations to other entities . . .
. . . Resulting from past transactions or events.
Most liabilities obligate the debtor to pay cash at specified times and result from legally enforceable agreements. Liabilities have three essential characteristics. Liabilities:
 Are probable, future sacrifices of economic benefits.
 Arise from present obligations to transfer goods or provide services to other entities.
 Result from past transactions or events.

3. What is a Current Liability?
LIABILITIES
Current Liabilities
Long-term Liabilities
Obligations payable within one year or one operating cycle, whichever is longer.
In a classified balance sheet, we categorize liabilities as either current liabilities or long-term liabilities. The general definition of a current liability is an obligation payable within one year or within the company’s operating cycle, whichever is longer. Another more discriminating definition identifies a current liability as an obligation expected to be satisfied with current assets or by the creation of other current liabilities.
Expected to be satisfied with current assets or by the creation of other current liabilities.

4. Short-term notes payable Cash dividends payable
Current Liabilities
Current Liabilities
Short-term notes payable
Accrued expenses
Cash dividends payable
Taxes payable
Accounts payable
Unearned revenues
Examples of obligations reported as current liabilities are:
Accounts payable.
Taxes payable.
Unearned revenues.
Cash dividends payable.
Accrued expenses.
Short-term notes payable.

5. Open Accounts and Notes
Accounts Payable
Obligations to suppliers for goods purchased on open account.
Trade Notes Payable
Similar to accounts payable, but recognized by a written promissory note.
Short-term Notes Payable
Cash borrowed from the bank and recognized by a promissory note.
Credit lines
Prearranged agreements with a bank that allow a company to borrow cash without following normal loan procedures and paperwork.
Accounts payable are obligations to suppliers for goods purchased on open account.
Trade notes payable are similar to accounts payable but are recognized by a written promissory note.
Short-term notes payable are cash borrowings from a bank that are recognized by promissory notes.
Credit lines are prearranged agreements with a bank that allow a company to borrow cash without following normal loan procedures and paperwork.

6. Interest rate is always stated as an annual rate.
Interest on notes is calculated as follows:
Amount borrowed
Interest rate is always stated as an annual rate.
Interest owed is adjusted for the portion of the year that the face amount is outstanding.
When a company borrows money, it pays the lender interest for the term of the loan. The interest on short-term loans is calculated by multiplying the amount borrowed times the annual interest rate times the fraction of the year the loan is outstanding.
Let’s look at an example where we will record a short-term loan and compute the amount of interest.

7. Interest-Bearing Notes
On September 1, Eagle Boats borrows $80,000 from Cooke Bank. The note is due in 6 months and has a stated interest rate of 9%.
Record the borrowing on September 1.
Part I.
On September 1, Eagle Boats borrows $80,000 from Cooke Bank. The note is due in six months and has a stated interest rate of nine percent.
Record the borrowing on September 1.
Part II.
We record the borrowing on books of Eagle Boats with a debit to cash and a credit to notes payable for $80,000. The borrowing increased the asset cash and also increased the liability notes payable.
Now let’s compute the interest.

8. Interest-Bearing Notes
How much interest is due to Cooke Bank at year-end, on December 31?
a. $2,400
b. $3,600
c. $7,200
d. $87,200
Interest is calculated as:
Face Annual Time to
Amount Rate maturity
$80, % /12
$2,400 interest due to Cooke Bank. × =
Part I.
How much interest is owed to the bank at the end of the year?
Part II.
To answer this question we will use the interest computation formula, multiplying the amount borrowed times the annual interest rate times the fraction of the year that the loan is outstanding. The amount borrowed is $80,000. The annual interest rate is nine percent. The loan has been outstanding for four months, or four-twelfths of a year. Eighty thousand dollars times nine percent times four-twelfths equals $2,400.

9. Interest-Bearing Notes
Assume Eagle Boats’ year-end is December 31.
Record the necessary adjustment at year-end.
Part I.
Next let’s record the adjusting entry on December 31 to recognize the interest obligation to the bank.
Part II.
We debit interest expense and credit the liability interest payable for $2,400.

10. Interest-bearing Notes
Assume Eagle Boats’ year-end is December 31.
Record the necessary journal entry when the note matures on February 28.
Part I.
The loan matures six months from the date of borrowing on February 28 of the next year. Let’s record the loan repayment. Don’t forget that we need to recognize additional interest for the two months since the last entry on December 31.
Part II.
The total amount of interest for the six months from September 1 until February 28 is $3,600 — $2,400 for the four months from September 1 until December 31, and $1,200 for the two months from December 31 until February 28.
The $2,400 interest obligation for the first four months was recorded as an interest payable in the adjusting entry made on December 31. Since we are now repaying the bank, we remove this liability with a debit to interest payable for $2,400. In addition, we debit interest expense for the $1,200 of interest for the two months from December 31 until February 28. Also, we debit note payable to remove the $80,000 for the original amount borrowed.
The total amount owed to the bank is the $80,000 originally borrowed plus the $3,600 of interest. We credit cash for $83,600 to record this payment.

11. Noninterest-Bearing Notes
Notes without a stated interest rate carry an implicit, or effective rate.
The face of the note includes the amount borrowed and the interest.
On occasion, a bank might make a loan with a noninterest-bearing note. Even though the note is called a noninterest-bearing note, the note actually does bear interest. The face amount of the note includes both the amount borrowed and the interest.
Let’s look at an example to see how we might determine the amount of interest on a noninterest-bearing note.

12. Noninterest-Bearing Notes
On May 1, Batter-Up, Inc. issued a one-year, noninterest-bearing note with a face amount of $10,600 in exchange for equipment valued at $10,000.
How much interest will Batter-Up pay on the note?
Part I.
On May 1, Batter-Up, Inc. issued a one-year, noninterest-bearing note with a face amount of $10,600 in exchange for equipment valued at $10,000.
How much interest will Batter-Up pay on the note?
Part II.
The actual amount borrowed is $10,000, the value of the equipment. The amount that Batter-Up will repay is $10,600, the face amount of the note. To compute the amount of interest on the note, we subtract the amount borrowed from the face amount to get $600 of interest.
Interest = Face Amount - Amount Borrowed
= $10, $10,000
= $600

13. Noninterest-Bearing Notes
On May 1, Batter-Up, Inc. issued a one-year, noninterest-bearing note with a face amount of $10,600 in exchange for equipment valued at $10,000.
What is the effective interest rate on the note?
Part I.
The information is the same.
On May 1, Batter-Up, Inc. issued a one-year, noninterest-bearing note with a face amount of $10,600 in exchange for equipment valued at $10,000.
What is the effective interest rate on the note?
Part II.
We divide the amount of interest, $600, by the $10,000 borrowed to get a six percent effective interest rate.

14. Commercial paper is recorded in the same manner as notes payable.
Commercial paper is a term used for unsecured notes issued in minimum denominations of $25,000 with maturities ranging from 30 days to 270 days.
Normally, commercial paper is issued directly to the lender and is backed by a line of credit with a bank.
Commercial paper is a term used for unsecured notes issued in minimum denominations of $25,000 with maturities ranging from 30 days to 270 days. Normally commercial paper is issued directly to the lender and is backed by a line of credit with a bank.
Commercial paper is recorded in the same manner as notes payable.
Commercial paper is recorded in the same manner as notes payable.

15. Salaries, Commissions, and Bonuses
Compensation expenses such as salaries, commissions, and bonuses are liabilities at the balance sheet date if earned but unpaid.
These accrued expenses/accrued liabilities are recorded with an adjusting entry prior to preparing financial statements.
Accrued liabilities arise in connection with compensation expense when employee services have been performed as of a financial statement date, but employees have yet to be paid. These accrued expenses/accrued liabilities are recorded by adjusting entries at the end of the reporting period, prior to preparing financial statements.

16. Liabilities from Advance Collections
Refundable Deposits
Advances from Customers
Collections for Third Parties
Liabilities are created when amounts are received that will be returned or remitted to others. Examples are:
Refundable deposits
Advances from customers
Collections for third parties

17. A Closer Look at the Current and Noncurrent Classification
Current maturities of long-term obligations are usually reclassified and reported as current liabilities if they are payable within the upcoming year (or operating cycle, if longer than a year).
Debt that is callable (due on demand) by the lender in the coming year, (or operating cycle, if longer than a year) should be classified as a current liability, even if the debt is not expected to be called.
Current maturities of long-term obligations are usually reclassified and reported as current liabilities if they are payable within the upcoming year (or operating cycle, if longer than a year). Likewise, debt that is callable (due on demand) by the lender in the coming year, (or operating cycle, if longer than a year) should be classified as a current liability, even if the debt is not expected to be called.

18. Short-Term Obligations Expected to be Refinanced
A company may reclassify a short-term liability as long-term only if two conditions are met:
It has the intent to refinance on a long-term basis.
It has demonstrated the ability to refinance.
and
The ability to refinance on a long-term basis can be demonstrated by an:
existing refinancing agreement, or
actual financing prior to issuance of the financial statements.
Part I.
A company may reclassify a short-term liability as long-term only if two conditions are met:
It has the intent to refinance on a long-term basis.
It has demonstrated the ability to refinance.
Part II.
The ability to refinance on a long-term basis can be demonstrated by:
An existing refinancing agreement, or
By actual financing prior to issuance of the financial statements.

19. Contingencies
A loss contingency is an existing uncertain situation involving potential loss depending on whether some future event occurs.
A loss contingency is an existing uncertain situation involving potential loss depending on whether some future event occurs.

20. Contingencies
Two factors affect whether a loss contingency must be accrued and reported as a liability:
the likelihood that the confirming event will occur.
whether the loss amount can be reasonably estimated.
Two factors affect whether a loss contingency must be accrued and reported as a liability:
 The likelihood that the confirming event will occur.
 Whether the loss amount can be reasonably estimated.

21. Contingencies – Likelihood of Occurrence
Probable
A confirming event is likely to occur.
Reasonably Possible
The chance the confirming event will occur is more than remote, but less than likely.
Remote
The chance the confirming event will occur is slight.
Accounting standards require that the likelihood that the future event(s) will confirm the incurrence of a liability be categorized as:
probable, meaning that the confirming event is likely to occur.
reasonably possible, meaning that the chance the confirming event will occur is more than remote, but less than likely.
remote, meaning that the chance the confirming event will occur is slight.

22. Contingencies
The table on this screen summarizes the accounting and reporting for loss contingencies. The information presented here should provide you with a quick reference and a very useful study guide for loss contingencies.
In summary, a loss contingency is accrued only if a loss is probable and the amount can reasonably be estimated.
A loss contingency is accrued only if a loss is probable and the amount can reasonably be estimated.

23. Product Warranties and Guarantees
Product warranties inevitably entail costs.
The amount of those costs can be reasonably estimated using commonly available estimation techniques.
The estimate requires the following entry:
Product warranties inevitably entail costs. Since the amounts of those future costs can be reasonably estimated, usually based on past experience, we should accrue a liability for the estimated cost of the warranty obligation.
To accrue the warranty liability, we debit warranty expense and credit estimated warranty liability.

24. Extended Warranties
Extended warranties are sold separately from the product.
The related revenue is not earned until:
Claims are made against the extended warranty, or
The extended warranty period expires.
Extended warranties are sold separately from the product.
Even though cash is received at the time the warranty contract is sold, revenue is not recognized until it is earned. At the time of the sale, an entry is made to record a liability for the deferred revenue. Revenue is earned when claims are made against the extended warranty, or when the extended warranty period expires. In most cases, the deferred revenue (liability) is recognized as revenue on a straight-line basis over the life of the extended warranty.

25. Premiums
Premiums included with the product are expensed in the period of sale.
Premiums that are contingent on action by the customer require accounting similar to warranties.
Premiums are promotional items provided with a product to enhance the sale of the product. Premiums included with the product are expensed in the period of sale. Premiums that are contingent on action by the customer require accounting similar to warranties. Mail-in, cash rebate offers are an example of the second type of premium. The cost of the cash rebates, based on estimated redemptions, is recognized as an expense in the period of sale, and as an estimated liability.

26. Litigation Claims
The majority of medium and large-size corporations annually report loss contingencies due to litigation.
The most common disclosure is a note to the financial statements.
The majority of medium and large-size corporations annually report loss contingencies due to litigation. The most common disclosure is a note to the financial statements. Accrual of a loss due to pending or actual litigation is extremely rare.

27. Subsequent Events
Events occurring between the year-end date and report date can affect the appearance of disclosures on the financial statements.
Cause of Loss Contingency
Clarification
Events occurring between a company’s fiscal year-end date and the financial statement issue date are called subsequent events. These subsequent events can be used to determine how contingencies, existing before the fiscal year end are reported.
Fiscal Year Ends
Financial Statements

28. Unasserted Claims and Assessments
 Is a claim or assessment probable?
No disclosure needed No
Yes
An unasserted claim or assessment need not be disclosed unless it is probable that the claim or assessment will occur. If it is probable, then the likelihood of an unfavorable outcome and the feasibility of estimating a dollar amount should be considered in deciding whether and how to report the probable loss.
Evaluate (a) the likelihood of an unfavorable outcome and (b) whether the dollar amount can be estimated. An estimated loss and contingent liability would be accrued if an unfavorable outcome is probable and the amount can be reasonably estimated.

29. As a general rule, we never record GAIN contingencies.
Note that the prior rules have supported the recording of LOSS contingencies.
As a general rule, we never record GAIN contingencies.
A gain contingency is an uncertain situation that might result in a gain. Although loss contingencies are accrued when certain conditions are met, gain contingencies are not accrued. The practice of conservatism accounts for the difference in treatment of loss contingencies and gain contingencies.

30. Appendix 13 ─ Payroll-Related Liabilities
Employers incur several expenses and liabilities from having employees.
Appendix 13—Payroll-Related Liabilities
Most of you have probably worked at some time in your life. You know that amounts are withheld from your paycheck and you may have wondered how this money is handled by your employer. In addition to remitting amounts withheld from your paycheck, your employer also pays payroll tax expenses in connection with having you on the payroll. These are not amounts withheld from your paycheck but are costs to your employer.

31. Payroll-Related Liabilities
Gross Pay
Gross pay is the amount you actually earn during a pay period. Out of your gross pay, amounts are withheld for social security (FICA) taxes, Medicare taxes, and federal income taxes. If you live in a state or locality that has an income tax, additional amounts will be withheld. In addition to these mandatory withholdings, you may elect to have amounts withheld from your gross pay. For example, if you are eligible to participate in a contributory retirement plan or a medical savings plan, your employer may withhold amounts from your pay to contribute to these plans for you.
Your gross pay less all withholdings, mandatory and voluntary, results in the net pay that you receive.
FICA Taxes
Medicare Taxes
Federal Income Tax
State and Local Income Taxes
Voluntary Deductions
Net Pay

32. Employees’ Withholding Taxes
State and Local Income Taxes
Federal Income Tax
Amounts withheld depend on the employee’s earnings, tax rates, and number of withholding allowances.
Employers are required by law to withhold federal (and sometimes state) income taxes and Social Security taxes from employees’ paychecks and remit these to the Internal Revenue Service.
The amount of income taxes withheld from your gross pay usually depends on how much you earn during the pay period and the number of withholding allowances you claimed on the W4 form you completed when you first went to work. Your employer must pay the taxes withheld from employees’ gross pay to the appropriate government agency.
Employers must pay the taxes withheld from employees’ gross pay to the appropriate government agency.

33. Employees’ Withholding Taxes
Federal Insurance Contributions Act (FICA)
FICA Taxes
Medicare Taxes
6.2% of the first $108,000 earned in the year.
The rate of withholding for FICA taxes and Medicare taxes increase periodically. Currently, the FICA rate is 6.2 percent on the first $108,000 of gross pay. In addition, the Medicare rate of 1.4 percent is applied to total gross pay.
Your employer is required to match the amounts withheld for FICA and Medicare on a dollar for dollar basis. For example, for every ten dollars withheld from your paycheck, your employer must pay ten dollars on your behalf to the Internal Revenue Service.
1.45% of all wages earned in the year.
Employers must pay withheld taxes to the Internal Revenue Service (IRS).

34. Voluntary Deductions Voluntary Deductions
Amounts withheld depend on the employee’s request.
Examples include union dues, savings accounts, pension contributions, insurance premiums, charities.
The amount withheld from gross pay for voluntary deductions depends upon which plans you participate in at your place of employment. Your employer makes payments to the proper designated agencies for amounts withheld as voluntary deductions.
Employers owe voluntary amounts withheld from employees’ gross pay to the designated agency.

35. Employers’ Payroll Taxes
Medicare Taxes
Federal and State Unemployment Taxes
FICA Taxes
Employers pay amounts equal to that withheld from the employee’s gross pay.
Your employer must match your contributions for FICA and Medicare taxes. In addition to matching your contributions for FICA and Medicare, your employer must pay all federal and state unemployment taxes. Let’s look a little closer at the unemployment taxes on the next slide.

36. Federal and State Unemployment Taxes
6.2% on the first $7,000 of wages paid to each employee (A credit up to 5.4% is given for SUTA paid.)
Federal Unemployment Tax Act (FUTA)
Basic rate of 5.4% on the first $7,000 of wages paid to each employee (Merit ratings may lower SUTA rates.)
State Unemployment Tax Act (SUTA)
The federal and state unemployment tax rates are subject to change. Currently, the federal rate is a maximum of 6.2 percent on the first $7,000 of earnings for each employee. The federal tax can be reduced by as much as 5.4 percent for contributions to state unemployment programs. Most states reduce this rate for employers with excellent employment records.

37. Fringe Benefits
In addition to salaries and wages, withholding taxes, and payroll taxes, most companies provide a variety of fringe benefits.
Health insurance premiums
Life insurance premiums
Retirement plan contributions
In addition to salaries and wages, withholding taxes, and payroll taxes, most companies provide a variety of fringe benefits such as health insurance, life insurance, and retirement programs. Employers must pay the amounts promised to fund employee fringe benefits to the designated agency.
Employers must pay the amounts promised to fund employee fringe benefits to the designated agency.

38. End of Chapter 13
End of Chapter 13