1. Copyright © by Houghton Mifflin Company. All rights reserved.1 Financial & Managerial Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson - - - - - - - - - - - Multimedia Slides by: Harry Hooper Santa Fe Community College

2. Chapter 9 Current Liabilities

3. Copyright © by Houghton Mifflin Company. All rights reserved.3 LEARNING OBJECTIVES 1.Identify the management issues related to recognition, valuation, classification, and disclosure of current liabilities. 2.Identify, compute, and record definitely determinable and estimated current liabilities. 3.Define contingent liability.

4. Copyright © by Houghton Mifflin Company. All rights reserved.4 4.Compute and record the liabilities associated with payroll accounting. SUPPLEMENTAL OBJECTIVE

5. OBJECTIVE 1 Identify the management issues related to recognition, valuation, classification, and disclosure of current liabilities. Management Issues Related to Accounting for Current Liabilities

6. Copyright © by Houghton Mifflin Company. All rights reserved.6 Management Issues Related to Accounting for Current Liabilities u Current liabilities are incurred to meet cash needs during the operating cycle.

7. Copyright © by Houghton Mifflin Company. All rights reserved.7 Managing Liquidity and Cash Flows u The primary purpose of current liabilities is to meet needs for cash during the operating cycle. 4 The operating cycle converts cash to purchases, to sales, to accounts receivable, and back to cash. 4 Most current liabilities support this cycle. u Failure to manage related cash flows can have serious consequences. 4 If suppliers are not paid, they may not ship. 4 A continued inability to meet payments when due can lead to bankruptcy.

8. Copyright © by Houghton Mifflin Company. All rights reserved.8 Payables turnover and average days’ payable are the common measures of time that creditors are willing to give a company to pay its accounts payable. Payables Turnover and Average Days’ Payable

9. Copyright © by Houghton Mifflin Company. All rights reserved.9 Payables Turnover Payables Turnover= COGS+/-Change in Merchandise Inventory Average Accounts Payable = $2,042.7 - $50.7 ($234.8 + $206.4) ÷ 2 = $1,992.0 $220.6 = 9.0 times The number of times on average that accounts payable are paid in an accounting period.

10. Copyright © by Houghton Mifflin Company. All rights reserved.10 Average Day Payable = 365 days = 365 days = 40.6 days Payables Turnover 9.4 u How long on average a company takes to pay its accounts payables. Average Day Payable

11. Copyright © by Houghton Mifflin Company. All rights reserved.11 Payable Turnover for Selected Industries

12. Copyright © by Houghton Mifflin Company. All rights reserved.12 Recognition of Liabilities u Timing is important in the recognition of liabilities. u Failure to record a liability may go along with failure to record an expense. u These errors lead to an understatement of expenses and an overstatement of income. u A liability is recorded when an obligation occurs. 4 This rule is difficult to apply. 4 Adjusting entries recognize unrecorded liabilities. u Liabilities only relate to past, not future transactions or commitments.

13. Copyright © by Houghton Mifflin Company. All rights reserved.13 Valuation of Liabilities u Liabilities are generally valued on the balance sheet at either: 4 The amount of money needed to pay the debt, or 4 The Fair Market Value of goods or services to be delivered. u The amount of the liability is usually known, but sometimes the amount must be estimated. 4 Service warranties on cars. 4 Estimates are based on past experience and anticipated changes in the business environment. u Additional financial statement disclosure may be required.

14. Copyright © by Houghton Mifflin Company. All rights reserved.14 Classification of Liabilities u Current liabilities are: 4 Expected to be satisfied within one year or within the normal operating cycle, whichever is longer. 4 Paid out of current assets or with cash generated from operations. u Long-term liabilities are: 4 Due beyond one year or beyond the normal operating cycle. 4 Used to finance long-term assets. u It is important to distinguish between current and long-term liabilities because of the effect on liquidity.

15. Copyright © by Houghton Mifflin Company. All rights reserved.15 Disclosure of Liabilities 4 Large amount of notes payable. 4 Special credit arrangements. 4 Commercial paper. 4 Lines of credit. u Supplemental disclosure may be required in the notes to the financial statements.

16. Copyright © by Houghton Mifflin Company. All rights reserved.16Discussion Q. Q. What is the rule for classifying a liability as current? A. A. A liability is current if the obligation will be satisfied within one year or within the normal operating cycle, whichever is longer.

17. OBJECTIVE 2 Identify, compute, and record definitely determinable and estimated current liabilities. Common Categories of Current Liabilities

18. Copyright © by Houghton Mifflin Company. All rights reserved.18 Definitely Determinable Liabilities u Definitely determinable liabilities are set by contract or by statute and can be measured exactly.

19. Copyright © by Houghton Mifflin Company. All rights reserved.19 Types of Definitely Determinable Liabilities u Accounts payable. u Bank loans and commercial paper. u Notes payable. u Accrued liabilities. u Dividends payable. u Sales and excise taxes payable. u Current portions of long-term debt. u Payroll liabilities. u Unearned or deferred revenues.

20. Copyright © by Houghton Mifflin Company. All rights reserved.20 (Trade) Accounts Payable u Short-term obligations to suppliers for goods and services. u Amount in Accounts Payable account in the general ledger is generally supported by an Accounts Payable subsidiary ledger. u Accounts Payable subsidiary ledger contains an individual account for each person or company to which money is owed.

21. Copyright © by Houghton Mifflin Company. All rights reserved.21 Bank Loans and Commercial Paper u A line of credit allows a company to borrow funds when needed to finance current operations. u The bank may require the company to meet certain financial goals. 4 Maintain specific profit margins. 4 Maintain current ratios. 4 Maintain debt to equity ratios.

22. Copyright © by Houghton Mifflin Company. All rights reserved.22 Commercial Paper u Unsecured loans that are sold to the public. u The portion of the line of credit borrowed and the amount of commercial paper issued are usually combined with notes payable in the current liabilities section of the balance sheet. u Details are disclosed in a note to the financial statements.

23. Copyright © by Houghton Mifflin Company. All rights reserved.23 Notes Payable u Obligations represented by promissory notes. u Notes payable can be used to secure bank loans, pay suppliers, or obtain other credit. u The interest may be: 4 Stated separately on the face of the note. 4 Deducted in advance by discounting it from the face value of the note.

24. Copyright © by Houghton Mifflin Company. All rights reserved.24 Two Promissory Notes: One with Interest Stated Separately; One with Interest in Face Amount

25. Copyright © by Houghton Mifflin Company. All rights reserved.25 Aug. 31 Cash 5,000 Notes Payable 5,000 To record 60-day, 12% promissory note with interest stated separately Issued Note: Interest Stated Separately

26. Copyright © by Houghton Mifflin Company. All rights reserved.26 Oct. 30 Notes Payable 5,000 Interest Expense 100 Cash 5,100 Payment of note with interest stated separately $5,000 x (60) x.12 = $100 360 Payment of Note: Interest Stated Separately

27. Copyright © by Houghton Mifflin Company. All rights reserved.27 Aug. 31 Cash 4,900 Discount on Notes Payable 100 Notes Payable 5,000 To record 60-day promissory note with $100 interest included in face amount Issued Note: Interest in Face Amount

28. Copyright © by Houghton Mifflin Company. All rights reserved.28 Oct. 30 Notes Payable 5,000 Cash 5,000 Payment of note with interest included in face amount Interest Expense 100 Discount on Notes Payable 100 Interest expense on note payable Payment of Note: Interest in Face Amount

29. Copyright © by Houghton Mifflin Company. All rights reserved.29 Accrued Liabilities u Adjusting entries are required to recognize and record liabilities that are not already in the accounting records.

30. Copyright © by Houghton Mifflin Company. All rights reserved.30 Accrued Liabilities: Interest Stated Separately Sept. 30 Interest Expense 50 Interest Payable 50 To record interest expense for 30 days on note with interest stated separately $5,000 x (30) x.12 = $50 360

31. Copyright © by Houghton Mifflin Company. All rights reserved.31 Sept. 30 Interest Expense 50 Discount on Notes Payable 50 To record interest expense on note with interest included in face amount $100 x (30) = $50 60 Accrued Liabilities: Interest in Face Amount

32. Copyright © by Houghton Mifflin Company. All rights reserved.32 Dividends Payable u Cash dividends are a distribution of earnings by a corporation. u The decision to pay dividends is solely up to the board of directors. u There is no liability until the board declares a dividend. u During the short time between the date of declaration and the date of payment, dividends are a current liability.

33. Copyright © by Houghton Mifflin Company. All rights reserved.33 Sales and Excise Taxes Payable u Most states and many cities levy a sales tax on retail transactions. u Sales taxes are collected by the merchant and forwarded to the appropriate government agency. u The amount of tax collected is a current liability until remitted to the government.

34. Copyright © by Houghton Mifflin Company. All rights reserved.34 Example of Sales and Excise Taxes Payable June 1 Cash115 Sales100 Sales Tax Payable 5 Excise Tax Payable 10 Sale of merchandise and collection of sales and collection of sales and excise taxes excise taxes

35. Copyright © by Houghton Mifflin Company. All rights reserved.35 Current Portions of Long-Term Debt u That portion of long-term debt that is due within the next year and is to be paid from current assets is classified as a current liability. u No journal entry is required. u Debt is reclassified when financial statements are prepared.

36. Copyright © by Houghton Mifflin Company. All rights reserved.36 Payroll Liabilities u Payroll accounting is important because complex laws and significant liabilities are involved. u The employer is liable to employees for wages and salaries. u The employer is responsible to various government and other agencies for amounts withheld and related taxes. u It is important to distinguish between employees and independent contractors. u The journal entry to record payroll is lengthy.

37. Copyright © by Houghton Mifflin Company. All rights reserved.37 Illustration of Payroll Liabilities

38. Copyright © by Houghton Mifflin Company. All rights reserved.38 Unearned Revenues u Unearned revenues are obligations for goods or services that the company must provide or deliver in a future accounting period in return for an advance payment from a customer.

39. Copyright © by Houghton Mifflin Company. All rights reserved.39 Example of Unearned Revenues Cash240 Unearned Subscriptions240 Receipt of annual subscriptions in advance Unearned Subscriptions 20 Subscription Revenues 20 Delivery of monthly magazine issues

40. Copyright © by Houghton Mifflin Company. All rights reserved.40 Estimated Liabilities u Definite debts or obligations of which the exact dollar amount cannot be known until a later date. u There is no doubt about the existence of the legal obligation. u The primary accounting problem is to estimate and record the amount of the liability.

41. Copyright © by Houghton Mifflin Company. All rights reserved.41 Examples of Estimated Liabilities u Income taxes. u Property taxes. u Product warranties. u Vacation pay.

42. Copyright © by Houghton Mifflin Company. All rights reserved.42 u The amount of income taxes liability depends on the results of operations. u The amount may not be known until after the end of the year. u The company must make an adjusting entry to record the estimated tax liability. Dec. 31 Income Taxes Expense 53,000 Estimated Income Taxes Payable 53,000 To record estimated federal To record estimated federal income taxes income taxes u Sole proprietorships and partnerships do not pay income taxes. Their owners pay on their individual returns. Income Taxes

43. Copyright © by Houghton Mifflin Company. All rights reserved.43 Property Tax Payable u Property taxes are levied on real and personal property. u They are assessed annually, but the government unit’s fiscal year and the company’s may not correspond. u The company must estimate the amount of property tax that applies to each month of the year.

44. Copyright © by Houghton Mifflin Company. All rights reserved.44 Example of Property Tax Payable July 31 Property Tax Expense 2,000 Estimated Property Tax Payable 2,000 To record estimated property tax expense for the month $24,000 ÷ 12 months = $2,000 Nov. 30 Property Tax Expense 2,300 Estimated Property Tax Payable 2,300 To record estimated property tax Dec. 15 Estimated Property Tax Payable 10,300 Prepaid Property Tax 14,420 Cash 24,720 Payment of property tax

45. Copyright © by Houghton Mifflin Company. All rights reserved.45 Product Warranty Liability u The liability exists for the length of the warranty. u The cost of the warranty is debited to an expense account in the period of sale. u A company can estimate the future cost of the liability based on past experience with claims for the product or services. u A company usually uses an average cost.

46. Copyright © by Houghton Mifflin Company. All rights reserved.46 July 31 Product Warranty Expense 525 Estimated Product Warranty Liability 525 Based on: Based on: Number of units sold 350 Number of units sold 350 Rate of replacement x.06 Rate of replacement x.06 Est. units to be replaced 21 Est. units to be replaced 21 Est. cost per unit x $25 Est. cost per unit x $25 Est. product warranty liability $525 Est. product warranty liability $525 Computation of Product Warranty Liability Expense

47. Copyright © by Houghton Mifflin Company. All rights reserved.47 Example of Product Warranty Liability Dec. 5 Cash 10 Estimated Product Warranty Liability 20 Service Revenue10 Merchandise Inventory20 Replacement of muffler Replacement of muffler under warranty under warranty

48. Copyright © by Houghton Mifflin Company. All rights reserved.48 Vacation Pay Liability u Vacation pay (and other payroll costs, such as bonuses and pensions) is a cost to the company. u The cost should be allocated over the entire year so that periods are not distorted. Apr. 20 Vacation Pay Expense 600 Estimated Liability for Vacation Pay 600 Estimated vacation pay expense Aug. 31 Estimated Liability for Vacation Pay 1,000 Cash (or Wages Payable) 1,000 Wages of employees on vacation

49. Copyright © by Houghton Mifflin Company. All rights reserved.49Discussion Q. Q. Indicate whether each of the following is (a) a definitely determinable liability or (b) an estimated liability. 1. Dividends payable 2. Income taxes payable 3. Current portion of long-term debt 4. Vacation pay liability

50. Copyright © by Houghton Mifflin Company. All rights reserved.50 A. A. 1. a 2. b 3. a 4. b KEY (a) a definitely determinable liability (b) an estimated liabilityKEY (a) a definitely determinable liability (b) an estimated liability

51. OBJECTIVE 3. Define contingent liability. Contingent Liabilities

52. Copyright © by Houghton Mifflin Company. All rights reserved.52 Contingent Liabilities u A contingent liability is potential liability that depends on a future event arising out of a past transaction, such as a lawsuit. u Two conditions have been established by the FASB for determining when a contingency should be entered in the accounting records. 1. Liability must be probable. 2. Liability must be reasonably estimated. Examples: vacation pay, income taxes, and warranty liability

53. Copyright © by Houghton Mifflin Company. All rights reserved.53 Accounting for Contingent Liabilities u Contingent liabilities are accrued in the accounting records. u Potential liabilities that do not meet the two conditions are reported in the notes to the financial statements. u Losses from potential liabilities are recorded when the conditions set by the FASB are met.

54. Copyright © by Houghton Mifflin Company. All rights reserved.54Discussion Q. Q. What is a contingent liability, and how does it differ from an estimated liability? A. A. A contingent liability is a potential liability that depends on a future event arising out of a past transaction. It differs from an estimated liability in that an estimated liability is not a potential liability but a current liability for which the amount is uncertain and must be estimated.

55. SUPPLEMENTAL OBJECTIVE 4 Compute and record the liabilities associated with payroll accounting. Payroll Accounting Illustrated

56. Copyright © by Houghton Mifflin Company. All rights reserved.56 Computation of an Employee’s Take-Home Pay u Fair Labor Standards Act sets minimum wage and regulates overtime pay. Method: 1.Calculate total earnings, including overtime. 2.Subtract all deductions (including federal income tax, based on number of exemptions) and voluntary contributions. 3.Result equals Net (take-home) pay.

57. Copyright © by Houghton Mifflin Company. All rights reserved.57 u Payroll Register is a detailed listing of a firm’s total payroll, prepared each pay period. u Recording the Payroll - the column totals from the payroll register are used to make the payroll journal entry. u Employee Earnings Record shows the year-to-date earnings for each employee and is used for legal reporting requirements at year end.

58. Copyright © by Houghton Mifflin Company. All rights reserved.58 u Recording Payroll Taxes – the total payroll taxes expense and liabilities for each type of payroll tax are taken from the payroll register and entered in the journal. u Payment of Payroll and Payroll Taxes - Any Wages Payable liability at the end of the pay period is paid based on the system used by the company. Payroll tax liabilities and liabilities for any other payroll deductions are paid as required by the law of the relevant contract or agreement.

59. Copyright © by Houghton Mifflin Company. All rights reserved.59 Sample Withholding Table

60. Copyright © by Houghton Mifflin Company. All rights reserved.60 OK, LET’S REVIEW... 1.Identify the management issues related to recognition, valuation, classification, and disclosure of current liabilities. 2.Identify, compute, and record definitely determinable and estimated current liabilities. contingent liability. 3.Define contingent liability.

61. Copyright © by Houghton Mifflin Company. All rights reserved.61 4.Compute and record the liabilities associates with payroll accounting. AND FINALLY... SUPPLEMENTAL OBJECTIVE