1
21
Other Liabilities
Other liabilities
both
current and
long term
1.
Learning Objectives
Account for estimated liabilities
involving warranties and rebates
2. Account for estimated liabilities arising
from compensated absences and bonus
plans
3. Explain accounting issues involving
estimated and deferred income tax
BALANCE SHEET
Assets
Liabilities
INCOME STATEMENT
Revenue
4. Explain accounting issues involving
contingent liabilities
5. Analysis: Compute and explain working
capital as a percentage of sales
Expenses
Equity
Profit
Debit
Credit
or
Loss
©CourseCollege.com
2
Liabilities -definition
The FASB definition of a liability includes these 3 essential
elements:
1. It is an obligation in effect that must be settled by giving up
cash, goods or services in the future.
2. It is an obligation that cannot be avoided.
3. The event that created the obligation has already occurred.
In this chapter we will study several liabilities that could meet
this definition but may:
Require an estimate as to
 the size of the liability,
 the date it must be paid and
 the party to whom it will be paid
Exhibit uncertainty as to whether the liability will occur
©CourseCollege.com
3
Objective 21.1: Account for estimated
liabilities involving warranties and rebates
Estimated liabilities are known
obligations of an uncertain amount.
They often also exhibit uncertainty as
to the date they must be paid and the
party to whom they will be paid.
O21.1
©CourseCollege.com
4
Account for estimated liabilities
involving warranties and rebates
Firms often guarantee their products and
services under a warranty agreement. Based
on the expected occurrence of claims, they
must follow the Matching Concept and
expense the warranty repair or replacement in
the same fiscal period as the sales that
involved the warranty.
WARRANTY
We guarantee.
O21.1
..
Matching Concept
©CourseCollege.com
5
Account for estimated liabilities
involving warranties and rebates
Firms also offer inducements to generate
sales and develop customer loyalty through
the use of marketing innovations such as cash
rebates. This additional expense, must follow
the Matching Concept and be included in the
same fiscal period as the sales that these
inducements helped generate.
$25 Rebate
With the purchase of. . .
O21.1
Matching Concept
©CourseCollege.com
6
Account for estimated liabilities
involving warranties and rebates
Problem -When the warranty or rebate is
expensed, the firm doesn’t know precisely:
•Who will be paid
•How much or how many will be paid
•When they will be paid
Solution -Estimate the warranty and rebate
expense expected
O21.1
©CourseCollege.com
7
Account for estimated liabilities
involving warranties and rebates
Warranty liabilities
After sale obligations arising from guaranty
agreements for products and services
Estimates must be used to predict expected warranty
claims
Warranty liability and expense must be recorded in
the same period as sales subject to the warranty

WARRANTY
We guarantee. . .
O21.1
©CourseCollege.com
8
Account for estimated liabilities
involving warranties and rebates
Rebate liabilities
Subject to a sale, cash, product or service obligation
to a customer
Estimates must be used to predict amounts that
must be paid based on expected redemption rates
Rebate liability and expense must be recorded in
the same period as the sales subject to the incentive

$25
Rebate
With the purchase of. . .
O21.1
©CourseCollege.com
9
Example WARRANTY–On January 1, Greenline Engine Rebuilders
began to offer a 2 year 20,000 mile parts and labor warranty on
their rebuilt auto and truck engines. Management estimates that
warranty expenses will average 3% of net sales.
As of December 31, net sales = $2,350,000. Estimated warranty
claims are: $2,350,000 x 3% = $70,500
GENERAL JOURNAL
Date
Description
Page 19
PR
Debit
Credit
Adjusting Entries
12/31/10
¢Warranty Expense
565
¢Estimated Warranty Liability
BALANCE SHEET
Assets
Liabilities
INCOME STATEMENT
Revenue
Expenses
238
70,500
70,500
Greenline will report
$70,500 less net income
as a result of this
adjustment.
Equity
O21.1
Profit
Debit
Credit
or
Loss
©CourseCollege.com
10
Example WARRANTY–In January following the first year of the
warranty agreement, a customer submitted a claim for $500 for
warranty repairs made on a Greenline engine.
GENERAL JOURNAL
Date
Description
1/1/11
¢Estimated Warranty Liability
Assets
Liabilities
238
Debit
Credit
500
100
¢Cash
BALANCE SHEET
PR
Page 20
500
INCOME STATEMENT
No change in net income
as a result of this
transaction
Revenue
Expenses
Equity
Profit
Debit
Credit
or
Loss
Note that the debit does not go to an expense account, it reduces
the Warranty Liability. This obligation has already been
expensed in the prior fiscal period.
O21.1
©CourseCollege.com
11
Example REBATE –On January 1, YardMax Tools began to offer a
$25 mail-in rebate on the purchase of their new garden tiller.
Management estimates that 40% of customers will submit the mailin rebate. The sales price for the new tiller is $425.
Sales totaled $850,000. Estimated rebate expense:
$850,000/$425 = 2000 tillers x 40% x $25 = $20,000
GENERAL JOURNAL
Date
Description
Page 56
PR
Debit
Credit
Adjusting Entries
1/31/11
¢Rebate Expense
590
¢Estimated Rebate Liability
BALANCE SHEET
Assets
Liabilities
241
20,000
20,000
INCOME STATEMENT
Revenue
YardMax will report
$20,000 less net income
Expenses
Equity
O21.1
Profit
Debit
Credit
or
Loss
©CourseCollege.com
12
Objective 21.2:
Account for estimated
liabilities arising from compensated
absences and bonus plans
Compensated absence plans include:
Vacations
Sick pay
Holidays
Family leave
earned by employees
O21.2
©CourseCollege.com
13
Account for estimated liabilities arising from
compensated absences and bonus plans
FASB rules indicate these expenses should be
accrued if the following conditions are met:
•The obligation to compensate for absences
arises from services already rendered by the
employee.
•The obligation is related to rights for time
off that vest or accumulate
•Payment is probable
•Amounts can be reasonably estimated
O21.2
©CourseCollege.com
14
Account for estimated liabilities arising from
compensated absences and bonus plans
Vested rights exist when the employee has
a right to the benefit even if terminated
Accumulated rights exists when benefits
can be carried forward into future periods
if not used in the current period
O21.2
©CourseCollege.com
15
Compensated absences -example
Consider start up firm Barrier Systems who began
operation on July 1 (FYE 6/30). Barrier has 10 employees
who earn, on average, $625 per week.
During the year employees earned 20 weeks of paid
vacation and none was used.
$625 x 10 employees x 20 weeks = $125,000
GENERAL JOURNAL
Date
Description
PR
Page 62
Debit
Credit
Adjusting Entries
6/30/11 ¢Vacation Wages Expense
¢Vacation Wages Payable
O21.2
560
240
125,000
125,000
©CourseCollege.com
16
Compensated absences -example
In the first month of the subsequent fiscal year,
employee Ralph Tonga takes his 2 week vacation. His
weekly wage, net of all payroll costs and deductions, is
$725.
GENERAL JOURNAL
Date
Description
PR
7/31/11 ¢Vacation Wages Payable
240
¢Cash
100
Page 64
Debit
Credit
1,450
1,450
Additional entries (i.e. debits to the Vacation Wages Payable & credits
to various payroll payable accounts) for employee deductions and the
employer payroll costs would be necessary to complete the payroll
recording. (See Chapter 8)
O21.2
©CourseCollege.com
17
Bonus agreements -example
Ridlow Corporation’s bonus plan pools 20% of net profits (after the
expense of the profit sharing is deducted) for distribution to all
employees weighted by their total annual compensation. Ridlow’s net
income before any bonus plan deductions is $1,500,000.
Let B equal the amount of the bonus, then:
B = 20% x ($1,500,000—B)
B = $300,000 - .20B
1.20B = $300,000
B = $250,000
GENERAL JOURNAL
Date
Description
PR
Page 26
Debit
Credit
Adjusting Entries
12/31/10 ¢Employee's Bonus Expense
¢Profit Sharing Bonus Payable
O21.2
595
265
250,000
250,000
©CourseCollege.com
18
Objective 21.3:
Explain accounting
issues involving estimated and deferred
income tax
The regular C-corporation is subject to federal
income taxes which must be accounted for on the
corporate financial statements
Estimates are recorded during the tax year based
on anticipated taxable income levels
Corporations are required to make estimated
quarterly income tax payments to the IRS to avoid
penalties
O21.3
©CourseCollege.com
19
Explain accounting issues involving
estimated and deferred income tax
At month end, Nappy Corp estimates the first
quarterly tax payments due April 15 to be $22,000.
GENERAL JOURNAL
Date
Description
PR
Page 33
Debit
Credit
Adjusting Entries
3/31/10 ¢Income Tax Expense
¢Income Taxes Payable
BALANCE SHEET
Assets
Liabilities
598
22,000
235
22,000
INCOME STATEMENT
Note that the
estimate is
expensed
Revenue
Expenses
Equity
Profit
O21.3
Debit
Credit
or
Loss
©CourseCollege.com
20
Explain accounting issues involving
estimated and deferred income tax
On April 15, the tax payment is made
GENERAL JOURNAL
Date
Description
4/12/10 ¢Income Taxes Payable
Page 33
Debit
PR
235
22,000
100
¢Cash
Credit
22,000
Quarterly estimated IRS payment
BALANCE SHEET
Assets
Liabilities
INCOME STATEMENT
Revenue
Expenses
Equity
The payable is
satisfied with
the cash
payment
Profit
O21.3
Debit
Credit
or
Loss
©CourseCollege.com
21
Explain accounting issues involving
estimated and deferred income tax
Deferred Income Tax Liabilities
income under GAAP and income under IRS
rules is usually different
most differences are temporary* due to
timing issues
over longer periods of time (years) different
income amounts between IRS and GAAP due to
timing are eliminated
*except for some permanent differences
O21.3
©CourseCollege.com
22
Explain accounting issues involving
estimated and deferred income tax
Consider the different income for the same
year under GAAP and IRS for Vision
Corporation:
O21.3
Vision Corporation
12/31/10
Vision Corporation
12/31/10
GAAP
IRS
Pre-tax net
Income $30,000
Pre-tax net
Income $10,000
©CourseCollege.com
23
Explain accounting issues involving
estimated and deferred income tax
Why is the income
(GAAP vs IRS)
different?
For temporary and permanent reasons.
Some examples of permanent reasons are:
Permanent
GAAP
IRS

Is municipal bond interest revenue?
Yes
No

Are fines for legal violations expenses?
Yes
No
O21.3
©CourseCollege.com
24
Explain accounting issues involving
estimated and deferred income tax
Why is the income
(GAAP vs IRS)
different?
Due to temporary timing differences in the
recognition of revenues and expenses
Some examples of temporary reasons are: (eventually
results will be same for GAAP & IRS)
•Straight line depreciation could be used for GAAP but an
accelerated depreciation for IRS
•Uncollectible account expense and warranty expense is
accrued under GAAP but IRS only allows these to be
expensed when cash is actually paid
O21.3
©CourseCollege.com
25
Explain accounting issues involving
estimated and deferred income tax
These differences often result in a deferred income
tax liability (or asset)
Keep in mind that we are preparing GAAP statements here
Vision Corporation
12/31/10
GAAP
Vision Corporation
12/31/10
IRS
Net Income $30,000
Net Income $10,000
We are obliged to record the federal income tax
expense based on the $30,000 GAAP income –NOT
the $10,000 IRS taxable income.
O21.3
©CourseCollege.com
26
Explain accounting issues involving
estimated and deferred income tax
If the tax rate is 15% for Vision Corporation, this would require:
15% x $30,000 = $4,500 debit to income tax expense
GENERAL JOURNAL
Date
Description
12/31/10 ¢Income Tax Expense
Page 36
PR
598
Debit
Credit
4,500
¢Income Taxes Payable
235
1,500
¢Deferred Income Tax Liability
298
3,000
The amount currently due (must be paid this period) to the IRS:
15% x $10,000 = $1,500
The balancing entry of $3,000 is the deferred amount (will be
paid in future years)
O21.3
©CourseCollege.com
27
Explain accounting issues involving estimated and deferred
income tax
These differences can also result in a deferred income
tax asset
Consider Cascade Corporation net income of
$20,000 under GAAP and $50,000 under IRS.
GENERAL JOURNAL
Date
Description
PR
6/30/10 ¢Income Tax Expense
¢Deferred Income Tax Asset
¢Income Taxes Payable
BALANCE SHEET
Assets
Liabilities
Debit
598
3,000
198
4,500
235
Credit
7,500
INCOME STATEMENT
The deferred tax
asset will be
used up in
future periods.
Revenue
Expenses
Equity
O21.3
Page 97
Profit
Debit
Credit
or
Loss
©CourseCollege.com
28
Objective 21.4:
Explain accounting
issues involving contingent liabilities
Contingent liabilities are potential liabilities
arising from an existing set of circumstances
Example:
Consider a product defect lawsuit
pending against PNC Corporation. If the
firm loses the suit they may be required
to pay substantial amounts.
O21.4
©CourseCollege.com
29
Explain accounting issues involving
contingent liabilities
Depending on how future events
unfold, PNC Corporation could suffer a
loss based on the outcome of the
lawsuit.
BALANCE SHEET
Assets
Liabilities
INCOME STATEMENT
The loss is
uncertain until
the lawsuit is
over
Revenue
Expenses
Equity
O21.4
Profit
Debit
Credit
or
Loss
©CourseCollege.com
30
Explain accounting issues involving
contingent liabilities
FASB rules regarding the recording of
contingent liabilities are based on two
questions:
What are the chances the event will occur?
Can the size of the potential loss be
reasonably estimated?
O21.4
©CourseCollege.com
31
Explain accounting issues involving
contingent liabilities
FASB assigns three ranges of possibility to
the first question.
Probable –The future event is likely to
occur
Reasonably possible –The chance of the
event occurring is less than likely but more
than remote
Remote –The chance of the future event
occurring is slight
O21.4
©CourseCollege.com
32
Explain accounting issues involving
contingent liabilities
Likelihood of the Loss occurring
Probable
Reasonably Possible
Remote
Can be
reasonably
estimated
Record the contingent
liability
Disclose the contingent
liability in financial
statement notes
Take no
Action
Cannot be
reasonably
estimated
Disclose the contingent
liability in financial
statement notes
Disclose the contingent
liability in financial
statement notes
Take no
Action
Only one of these
situations require the
liability to be recorded
O21.4
©CourseCollege.com
33
Explain accounting issues involving contingent liabilities
Assuming that the PNC corporation product
defect lawsuit has been determined to be
both probable and can be reasonably
estimated as a 500,000 potential loss. . .
GENERAL JOURNAL
Date
Description
6/30/10 ¢Estimated loss from pending lawsuit
Page 124
PR
Debit
Credit
599
500,000
¢Estimated liability
from pending lawsuit
The loss is still
probable, not
100% certain
299
500,000
BALANCE SHEET
Assets
Liabilities
INCOME STATEMENT
Revenue
Expenses
Equity
Profit
Debit
O21.4
Credit
or
Loss
©CourseCollege.com
34
Explain accounting issues involving
contingent liabilities
Also:
A set of circumstances could possibly
result in a gain (i.e. the firm began a lawsuit against
another party for damages)
•If the firm wins, a gain could result
• However, GAAP rules lean toward the
Conservatism Concept in the case of
gains and they are not recorded until
they actually occur
O21.4
©CourseCollege.com
35
Objective 21.5:
Analysis: Compute and
explain average working capital as a
percentage of sales
Working capital answers the following
question: How many dollars of current
assets would remain if all current liabilities
were paid using current assets? The higher
the number, the more liquidity is displayed
by the balance sheet.
Current Assets
O21.5
Current Liabilities
Working
Capital
©CourseCollege.com
36
Analysis: Compute and explain average
working capital as a percentage of sales
Average working capital =
Working capital (beg.) + Working capital (ending)
2
Average working capital as a percentage of sales
Average
Working
Capital
Sales
O21.5
©CourseCollege.com
37
Analysis: Compute and explain average
working capital as a percentage of sales
Average working capital as a percentage of sales
answers the question:
“What level of working capital was necessary to
achieve the reported sales for the year?”
Average
working
capital as a
percentage
of sales
O21.5
Average
Working
Capital
Sales
©CourseCollege.com
38
Example
Balance Sheet -Kauri Steel
As of 12/31 2009 & 2010
Assets
Cash
Accounts receivable
Inventory
Current assets
Prop, plant, equip
Other assets
Total assets
2009
8,500
41,200
76,500
126,200
28,400
2010
7,000
85,700
82,300
175,000
31,500
Liabilities
Accounts Payable
Current liabilities
Long term debt
2009
121,400
121,400
5,000
2010
123,600
123,600
4,200
Total liabilities
126,400
127,800
0
154,600
1,000
207,500
Equity
Ow ner, Capital
28,200
79,700
Income Statement
For the year ended 12/31/10
Sales
Cost of Goods Sold
Wages expense
Selling expenses
Interest expense
Miscellaneous expense
Net Profit
O21.5
598,700
449,025
31,500
1,250
450
64,975
Average w orking capital (WC)
(WC for years 2009 +2010) / 2
WC as a % o f Sales
(Net Income / Avg. WC)
Current ratio 2010
28,100
4.7%
1.4
51,500
©CourseCollege.com
39
End Unit 21
©CourseCollege.com