Financial Accounting: The Cornerstone of Business Decision Making © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 8 Current and Contingent Liabilities © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objectives By the end of this chapter you should be able to: 1. Explain liability recognition and measurement criteria. 2. Identify the kinds of activities that produce current liabilities and prepare journal entries for these activities. 3. Describe contingent liabilities and the alternatives for their recognition and measurement. 4. Calculate warranty liabilities and warranty expense and prepare the necessary journal entries. 5. Analyze short-term liquidity using information contained in the current liabilities section. [Author Name], [Book Title], [#] Edition. © [Insert Year] Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Recognition and Measurement of Liabilities (Learning Objective 1) • Liabilities are probable future sacrifices of economic benefits. • Recognition of Liabilities: • Occurs when goods or services are received or money is borrowed • Occurs when a liability depends on a future event • Measurement of Liabilities: • Theoretically interest exists, but is ignored in most current liabilities • Most current liabilities are recorded and reported at the total amount owed © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 8.1: Characteristics of Liabilities (Learning Objective 1) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Current Liabilities (Learning Objective 2) • Current liabilities are obligations due within one year or within the operating cycle, which is typically one year or less. • Current liabilities are reported on the balance sheet • Accounts payable are goods and services purchased on credit • Usually due within 30 to 60 days • Seldom require the payment of interest • No formal agreement or contract required • Accrued liabilities are recognized by adjusting entries at the end of a period • Examples include wages payable or income taxes payable © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Notes Payable (Learning Objective 2) • A note payable occurs when a business borrows money or purchases goods or services from a company, which requires a formal contract or agreement. • A note payable: • Shows the timing of repayment and the amount to be repaid • Typically matures between three and twelve months, but can be longer • Can be created as an extension of time to pay an accounts payable amount • A note payable from a bank: • Is called an interest-bearing note as it explicitly states an interest rate • Specifies the amount to be repaid indirectly, stating the principal and interest rate • Is recorded in a transaction at the amount borrowed © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Recording Notes Payable and Accrued Interest (Learning Objective 2) (1 of 3) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Recording Notes Payable and Accrued Interest (Learning Objective 2) (2 of 3) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Recording Notes Payable and Accrued Interest (Learning Objective 2) (3 of 3) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Current Portion of Long-Term Debt (Learning Objective 2) The current portion of long-term debt is the amount of long-term debt due within the next year. • At the end of each accounting period, the amount of the long-term debt that is due within the next year is reclassified as a current liability • Journal entries are not needed as it is a reclassification on the balance sheet • Current liabilities must be retired with current assets, as a new long-term debt is the creation of a new long-term liability © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Other Payables (Learning Objective 2) Sales, usage, and excise taxes are collected by a company on behalf of a local, state, or federal taxing authority. • These are not additions to revenue, although collected as part of the selling price • Tax collections are liabilities until paid to the taxing authority, usually quarterly © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Recording Liabilities at the Point of Sale (Learning Objective 2) (1 of 2) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Recording Liabilities at the Point of Sale (Learning Objective 2) (2 of 2) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Withholding and Payroll Taxes (Learning Objective 2) Withholding and payroll taxes from employees’ earnings are liabilities until they are paid to the taxing authority. Both employees and employers incur payroll taxes. • Employee withholdings can include: • Federal, state, and possibly local income taxes • Social Security and Medicare taxes (FICA) • 401(k) retirement, parking, union dues, health insurance, etc. • Employers pay: • Match to employees’ Social Security and Medicare taxes (FICA) • Federal and state unemployment taxes • Fringe benefits including 401(k) contributions, health insurance or other © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Recording Payroll Taxes (Learning Objective 2) (1 of 4) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Example 8.3: Recording Payroll Taxes (Learning Objective 2) (2 of 4) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Recording Payroll Taxes (Learning Objective 2) (3 of 4) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Recording Payroll Taxes (Learning Objective 2) (4 of 4) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Knowledge Check 1: Application (Learning Objective 2) Which of the following payroll taxes is paid by both the employee and the employer? A. Federal income tax B. Federal unemployment tax C. Social Security and Medicare tax (FICA) D. State unemployment tax © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Knowledge Check 1: Answer (Learning Objective 2) Which of the following payroll taxes is paid by both the employee and the employer? A. Federal income tax B. Federal unemployment tax C. Social Security and Medicare tax (FICA) (FICA tax is paid in equal amounts by both the employee and employer. Federal income tax is paid only by the employee. Federal and state unemployment tax is paid only by the employer.) D. State unemployment tax © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Unearned Revenue (Learning Objective 2) Unearned revenue is a liability created when a customer pays in advance. • Unearned revenue: • Creates a liability for the seller • Recognized when the goods or services purchased are provided © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Recording Unearned Revenues (Learning Objective 2) (1 of 2) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Recording Unearned Revenues (Learning Objective 2) (2 of 2) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Contingent Liabilities (Learning Objective 3) Contingent liabilities involve the possibility of an existing condition, situation, or set of circumstances that have uncertainties of a gain or loss. • A contingent liability is not recognized until both of the following are true: • The event on which it is contingent is probable • A reasonable estimate of the loss can be made • Otherwise: • If the contingent event is considered only reasonably possible, or reliable measurement of the liability is impossible, no liability is recorded, but the event must be disclosed in the financial statements • If the contingent event is considered remote, neither a journal entry nor a disclosure in the financial statements are necessary • Examples of contingent liabilities include lawsuits, warranties and pensions. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 8.5: Recognition of Contingent Liabilities (Learning Objective 3) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Knowledge Check 2: Application (Learning Objective 3) Lakeside Marina, Inc. is currently engaged in a lawsuit from a customer who was badly hurt in one of their rental boats. Lakeside’s attorneys believe it is probable the marina will lose the lawsuit and will be required to pay $2,000,000 in damages. How should Lakeside Marina recognize this contingent liability? A. No journal entry is required, but a disclosure should be made in a footnote. B. A journal entry is required in the amount of the probable damages. C. No journal entry nor disclosure is needed until the lawsuit is concluded. D. A journal entry is required for an amount less than the probable damages. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Knowledge Check 2: Answer (Learning Objective 3) Lakeside Marina, Inc. is currently engaged in a lawsuit from a customer who was badly hurt in one of their rental boats. Lakeside’s attorneys believe it is probable the marina will lose the lawsuit and will be required to pay $2,000,000 in damages. How should Lakeside Marina recognize this contingent liability? A. No journal entry is required, but a disclosure should be made in a footnote. B. A journal entry is required in the amount of the probable damages. (Because it is deemed probable they will lose the lawsuit and the damages can be reasonably estimated, a journal entry is required to record a $2,000,000 contingent liability.) C. No journal entry nor disclosure is needed until the lawsuit is concluded. D. A journal entry is required for an amount less than the probable damages. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Exhibit 8.6: Disclosure of Contingencies (Learning Objective 3) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Warranties (Learning Objective 4) Warranties guarantee the repair or replacement of defective goods during a specific period following a sale. • Warranty expenses can occur in the accounting period of the sale or in subsequent accounting periods • Future warranty costs on the sales that occurred in the current accounting period must be estimated • Recognition of future estimated warranty expense and liability is recorded as an adjusting journal entry at the end of the current accounting period • When warranty expenses on customer claims are incurred, the liability is reduced © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Recording Warranty Liabilities (Learning Objective 4) (1 of 2) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Recording Warranty Liabilities (Learning Objective 4) (2 of 2) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Discussion Activity (Learning Objective 4) Go to a website of your choice that contains financial statements of publicly traded companies. Find a company that has warranties payable on their balance sheet and warranties expense on their income statement. Describe what you found with your class in terms of what product(s) may be under warranty and your thoughts on any difference in the amounts between the warranties expense and the warranties payable. HINT: Financial statements may be found on www.sec.gov or financial sites such as yahoo finance, etc. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Analyzing Current Liabilities (Learning Objective 5) (1 of 2) Analyzing current liabilities can help determine if a company is able to meet its short-term obligations. • Current Ratio: • Compares all or parts of current assets to current liabilities • Calculation greater than 1.0 implies a company can meet its obligations • Quick Ratio: • Compares current assets (less inventory) to current liabilities • Operating Cash Flow: • Looks at the ability of cash generated from operating activities to meet current obligations © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Analyzing Current Liabilities (Learning Objective 5) (2 of 2) Common ratios used to analyze a company’s ability to pay its current obligations: © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Calculating Liquidity Ratios (Learning Objective 5) (1 of 2) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Calculating Liquidity Ratios (Learning Objective 5) (2 of 2) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Knowledge Check 3: Application (Learning Objective 5) Company A has a current ratio of 1.8 and a quick ratio of 0.75. Company B has a current ratio of 1.3 and a quick ratio of 1.1. Which of the two companies is more likely to be able to meet its current obligations? A. Company A B. Neither Company A nor Company B can meet its current obligations C. Cannot determine based on the given information D. Company B © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Knowledge Check 3: Answer (Learning Objective 5) Company A has a current ratio of 1.8 and a quick ratio of 0.75. Company B has a current ratio of 1.3 and a quick ratio of 1.1. Which of the two companies is more likely to be able to meet its current obligations? A. Company A B. Neither Company A nor Company B can meet its current obligations C. Cannot determine based on the given information D. Company B (While it is not entirely possible to determine which company will be able to meet its current obligations in the long run, at this point Company B’s current and quick ratios are both above 1.0, which indicates they have more than $1 of current assets to meet a current liability of $1.) © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Summary (1 of 2) • Liabilities are probable future sacrifice of economic benefits. • Current liabilities are obligations due within one year or within the operating cycle, which is typically one year or less. • The current portion of long-term debt is the amount of long-term debt due within the next year. • Sales, usage, and excise taxes are collected by a company on behalf of a local, state, or federal taxing authority. • Withholding and payroll taxes from employees’ earnings are liabilities until they are paid to a taxing authority. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Summary (2 of 2) • Unearned revenue is a liability created when a customer pays in advance. • Contingent liabilities involve the possibility of an existing condition, situation, or set of circumstances that have uncertainties of a gain or loss. • Warranties guarantee the repair or replacement of defective goods during a specific period following a sale. • Various ratios used to measure the likelihood of meeting current obligations including the current ratio, quick ratio, cash ratio, and operating cash flow ratio. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
