©2009 The McGraw-Hill Companies, Inc.
Chapter 8
Current Liabilities
8-2
Current Liabilities
o
o
Usually, but not always, due within one year.
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.
Liability:
A present responsibility to sacrifice assets in the
future due to a transaction or other event that
happened in the past.
©2009 The McGraw-Hill Companies, Inc.
Part A
Current Liabilities
8-4
LO1 Distinguish between current and
long-term liabilities
Reporting Liabilities
o
Three characteristics of liabilities:
o
o
o
Probable future sacrifices of economic
benefits.
Arising from present obligations to other
entities.
Resulting from past transactions or
events.
8-5
Current vs. Long-Term Liabilities
LIABILITIES
CURRENT
Payable within one
year
LONG-TERM
With in the
Payable
more
company
one year
than
8-6
Reporting Current Liabilities
o
o
o
Distinguishing between current and long-term
liabilities helps investors and creditors assess
risk.
Companies often prefer to report a liability as
long-term because it may cause the firm to
appear less risky.
Many companies list notes payable first, followed
by accounts payable, and then other current
liabilities from largest to smallest.
8-7
LO2 Account for Notes Payable and
Interest Expense
o
Notes Payable
o
o
o
o
A company borrowing cash (borrower) from a bank
is required to sign a note promising to repay the
amount borrowed plus interest.
The borrower reports its liability as notes payable.
Small firms rely heavily on short-term financing.
Large companies also use short-term debt as a
significant part of their capital structure.
8-8
Example of Southwest Airlines



Southwest Airlines borrows $100,000 from Bank of America
on September 1, 2010.
Signing a 6%, six-month note with the amount borrowed
plus accrued interest due six months later on March 1,
2011.
On September 1, 2010, Southwest will receive $100,000 in
cash and record the following entry:
8-9
Measuring Interest
o
o
o
Interest is stated in terms of a percentage rate to be
applied to the face value of the loan.
Interest rate is stated as an annual rate.
When 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 rate x Fraction of the Year
How much interest cost does Southwest incur for the six-month
period of the note from September 1, 2010 to March 1, 2011?
$3,000 = $100,000 x 6% x 6/12
8-10
Interest Accrued and Repayment of Note
If Southwest’s reporting period ends on December 31, 2010, it records
the four months’ interest incurred during 2010 in an adjusting entry
prior to preparing the 2010 financial statements:
On maturity, Southwest Airlines will pay the face value of the loan plus
the entire interest incurred. It makes the following journal entry
8-11
Flip Side Bank of America
o
How would the lender, Bank of America, record this note?
o
o
o
For the bank it’s a note receivable rather than a note payable.
It generates interest revenue rather than interest expense.
The entries are as follows:
8-12
Line of Credit
o
An informal agreement that permits a company to
borrow up to a prearranged limit without having to
follow formal loan procedures and prepare
paperwork.
o
o
Similar to notes payable.
Company is able to borrow without having to go
through a formal loan approval process each time it
borrows money.
8-13
LO3 Account for Employee and
Employer Payroll Liabilities
o
Prior to depositing a monthly payroll check, an employer
withholds
o
o
o
o
o
o
Federal and state income taxes,
Social Security and Medicare,
Health, dental, disability, and life insurance premiums, and
Employee investments to retirement or savings plans.
As an employer, the costs of hiring an employee are higher
than the salary.
Significant costs include
o
o
o
o
Federal and state unemployment taxes,
The employer portion of Social Security and Medicare,
Employer contributions for health, dental, disability, and life
insurance,
Employer contributions to retirement or savings plans.
8-14
Summary of Payroll Costs
8-15
Employee Costs
o
o
o
Companies are required by law to withhold federal and state
income taxes from employees’ paychecks and remit these taxes
to the government.
FICA taxes - Collectively, Social Security and Medicare taxes.
FICA Act requires employers to withhold:
o
o
o
o
6.2% Social Security tax up to a maximum base amount.
1.45% Medicare tax with no maximum.
Total FICA tax is 7.65% (6.2% + 1.45%) on income up to a base
amount ($102,000 in 2008) and 1.45% on all income above the
base amount.
Employees may opt to have additional amounts withheld from
their paychecks.
8-16
Employer Costs
o
Employer pays an additional (matching) FICA tax on
behalf of the employee.
o
o
o
Employer’s limits on FICA tax are the same as
employee’s.
Employer must also pay federal and state
unemployment taxes on behalf of the employees.
FUTA 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%.
8-17
Employer Costs (cont.)
o
o
SUTA, in many states the maximum state
unemployment tax rate is 5.4%, but many companies
pay a lower rate based on past employment history.
Fringe benefits: Additional employee benefits paid by
the employer include
o
o
o
All or part of employees’ insurance premiums.
Contributions to retirement or savings plans.
Many 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.
8-18
Payroll Costs
8-19
Payroll Costs (cont.)
8-20
LO4 Demonstrate the Accounting for
other Current Liabilities
o
Three additional current liabilities
companies report:
o
o
o
o
Unearned revenues
Sales taxes payable
The current portion of long-term debt
We explore each of these in more
detail in the following slides.
8-21
Unearned Revenues
o
Companies account for cash received in
advance by:
o
o
Increasing (debit) cash and increasing (credit)
a current liability account called unearned
revenue.
Decreasing (debit) unearned revenue and
increasing (credit) revenue once revenue is
earned.
8-22
Sales Taxes Payable
o
o
Company selling products subject to sales taxes are
responsible for collecting, and remitting sales taxes to
state and local governments.
Suppose you buy lunch in the airport for $15 plus 9% sales
tax. The airport restaurant should record the transaction
this way:
8-23
Current Portion of Long-Term Debt
o
o
o
Distinguishing between current portion of long-term debt and
long-term debt is important to management, investors, and
lenders.
Long-term obligations are reclassified and reported as current
liabilities when they become payable within the upcoming year.
Assume Southwest Airlines has a $100 million liability at
December 31, 2010, of which $5 million is payable in 2011. In its
2010 balance sheet, the company records the $100 million debt
as shown below
©2009 The McGraw-Hill Companies, Inc.
Part B
Loss Contingencies
8-25
LO5 Apply the appropriate accounting
treatment for loss contingencies
o
o
Loss contingency:
An existing, uncertain situation that might
result in a loss.
Examples:
o
Lawsuits, product warranties, environmental
problems, and premium offers
8-26
Loss Contingency for Jeeps, Inc.
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 the 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. The auditor discussed the situation carefully with the
outside legal counsel representing Jeeps, Inc. Legal counsel indicated that the
possibility of loss was remote and that if the case went to trial, Jeeps would almost
assuredly win.
If you were the auditor, how would you report this situation? Consider four
options. You could (1) report a liability for the full $100 million, (2) report a liability
for less than $100 million based on estimated outcomes, (3) provide full disclosure
in one of the financial statements’ footnotes and not report any liability in the
balance sheet, or (4) provide no disclosure at all since the possibility of loss is
remote.
Which approach did Deloitte take?
8-27
Loss Contingencies
o
Whether we report a loss contingency as a liability depends
on two criteria:
1. The likelihood of the loss occurring can be
a.
b.
c.
2.
The ability to estimate the loss amount is either:
a.
b.
o
o
Probable—likely to occur
Reasonably possible—more than remote but less than likely, or
Remote—the chance is slight
Known or reasonably estimable or
Not reasonably estimable.
We record a liability if the loss is probable and the amount is
at least reasonably estimable.
The journal entry to record a loss contingency requires a debit
to a loss (or expense) account and a credit to a liability.
8-28
ESTIMABLE WITHIN A RANGE
o
If one amount within a range of potential losses appears more
likely than other amounts within the range, we record that
amount.
o
When no amount within the range appears more likely than
others, we record the minimum amount and disclose the
potential additional loss.
o
If 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.
o
If the likelihood of loss is remote, disclosure usually is not
required.
8-29
Accounting Treatment of Loss
Contingencies
8-30
Back to Jeeps, Inc.
Now how do you think Deloitte, the auditor of Jeeps,
Inc., treated the litigation described earlier?
o
Based on the response of legal counsel, the likelihood
of the loss occurring was considered to be remote, so
disclosure was not required.
o
However, 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
WARRANTY LIABILITY
o
o
o
o
o
When you buy a new Dell notebook, it comes with a warranty.
Why does Dell offer a warranty? To increase sales, of course.
Based on the matching principle, the company needs to record
warranty expense in the same accounting period as the sale.
A warranty represents an expense and a liability at the time of
the sale, because it meets the criteria for recording a loss
contingency.
Even though Dell doesn’t know exactly at the time of the sale
what that warranty expense will be, based on experience, the
company can reasonably estimate the amount.
8-32
GAIN CONTINGENCIES
o
o
o
o
o
Is an existing uncertain situation that might result in a gain, which
often is the flip side of loss contingencies.
In a lawsuit, one side—the defendant—faces a loss contingency,
while the other side—the plaintiff—has a gain contingency.
We record loss contingencies when the loss is probable and the
amount is reasonably estimable.
We do not record gain contingencies of this type until the gain is
certain.
Though firms do not record gain contingencies in the accounts, they
sometimes disclose them in notes to the financial statements
8-33
LO6 Assess liquidity using current
liability ratios
Liquidity Analysis
o
o
A company is said to be liquid if it has sufficient cash to pay
currently maturing debts.
Lack of liquidity can result in financial difficulties or even
bankruptcy.
Liquidity Ratios
o
Current ratio:
o
o
We calculate it by dividing current assets by current liabilities.
Acid-test ratio:
o
o
o
Similar to the current ratio but is based on a more conservative
measure of current assets available to pay current liabilities.
We calculate it by dividing “quick assets” by current liabilities.
Quick assets include cash, short-term investments, and accounts
receivable.
8-34
STOP AND REVIEW
Selected financial data regarding current assets and current
liabilities for United and Southwest Airlines are as follows.
1. Calculate the current ratio for United Airlines and Southwest Airlines. Which has
the better current ratio?
2. Calculate the acid-test (quick) ratio for United Airlines and Southwest Airlines.
Which has the better acid-test ratio?
8-35
STOP AND REVIEW
Solution:
1.
2.
8-36
LIQUIDITY MANAGEMENT
o
o
o
o
Can management influence the ratios that measure
liquidity?
Yes, at least to some extent.
A large auto manufacturer like General Motors or Ford
might use its economic muscle or persuasive powers to
influence the timing of accounts payable recognition by
asking suppliers to change their delivery schedules.
The 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.
8-37
EFFECT OF TRANSACTIONS ON
LIQUIDITY RATIOS
o
o
o
o
It is important to understand the effect of specific
transactions on the current ratio and acid-test ratio.
Both 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.
Both ratios include cash, short-term investments, and
accounts receivable, so an increase in any of those
accounts will increase both ratios.
Only 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.
©2009 The McGraw-Hill Companies, Inc.
End of chapter 8