1

Chapter 12
Current
Current
Liabilities
Liabilities and
and
Contingencies
Contingencies
An
Anelectronic
electronicpresentation
presentation
by
byDouglas
DouglasCloud
Cloud
Pepperdine
PepperdineUniversity
University
 2

Objectives
Objectives
1. Explain the characteristics of a liability.
2. Define current liabilities.
3. Account for compensated absences.
4. Understand and record payroll taxes and
deductions.
5. Record property taxes.
6. Account for warranty costs.
Continued
Continued
 3

Objectives
Objectives
7. Explain the terms “probable,” “reasonably
possible,” and “remote” related to
contingencies.
8. Record and report a loss contingency.
9. Disclose a gain contingency.
 4

Conceptual
Conceptual Overview
Overview
of
of Liabilities
Liabilities
Liabilities are probable
future sacrifices of
economic benefits arising
from present obligations
of a company to transfer
assets or provide services
to other entities in the
future as a result of past
transactions or events.
 5

Three
Three Essential
Essential Characteristics
Characteristics
of
of aa Liability
Liability
1. It involves a present duty or responsibility of the
company to one or more entities that will be settled by
the probable future transfer or use of assets at a
specified or determinable date, on occurrence of a
specific event, or on demand.
2. The duty or responsibility obligates the company, leaving
it little or no discretion to avoid the future sacrifice.
3. The transaction or other event obligating the company
has already happened.
 6

Primary
Primary Liabilities
Liabilities Issues
Issues
1. Identification of liabilities—the detection of a
company’s obligations.
2. Measurement or valuation of the liabilities and
the related expense—the determination of an
amount to attach to each obligation and to match as
an expense against revenues.
3. Reporting on the financial statements—the
specific disclosures in both the company’s financial
statements and the related notes.
 7

Current
Current Liabilities
Liabilities

Current
Current liabilities
liabilities are
are
…or the
…orobligationscreation
the creationwhose of other
of other
current obligations
liabilities whoseone
within
current liabilities
liquidation is within one
expected to
yearliquidation
or an is
operatingexpected
cycle,to
year or an
require the operating
used of cycle,
existing
require
whicheverthe usedis of existing
longer.
whichever
current is longer.
assets...
current assets...
 8

Operating
Operating Cycle
Cycle
Inventory

Cash Receivables
 9

Liquidity
Liquidity
Liquidity
Liquidity refers
refers to
to how
how quickly
quickly
aa liability
liability can
can be
be paid,
paid, or
or its
its
nearness
nearness to to cash.
cash.
 10

Ways
Ways of
of Reporting
Reporting Liquidity
Liquidity
1. Classify current liabilities and assets (mixture of
operating-cycle and maturity-date approach).
2. Classify current liabilities and assets using the “pure”
operating-cycle approach.
3. Classify current liabilities and assets under the maturity-
date approach only.
4. Adopt a different classification scheme, possibly using
more classes.
5. Leave the balance sheet unclassified but arranging items
in order of liquidity.
 11

Liquidity
Liquidity Ratios
Ratios
1. Cash flows to total debt.
2. Net income to total assets (return on total
assets ratio).
3. Total debt to total assets.
4. Current assets to current liabilities (current
ratio).
5. Cash to current liabilities.
 12

Types
Types of
of Current
Current Liabilities
Liabilities
Having
Having Contractual
Contractual
Amount
Amount

Accounts payable
Notes payable
Currently maturing portion of long-
term debt
Dividends payable
Advances and refundable deposits
Accrued items
Unearned items
 13

Types
Types of
of Current
Current Liabilities
Liabilities
Amount
Amount Depends
Depends
on
on Operations
Operations

Sales (use) taxes

Payroll taxes
Income taxes
Bonuses
 14

Types
Types of
of Current
Current Liabilities
Liabilities
Amount
Amount Must
Must Be
Be
Estimated
Estimated

Property taxes
Warranties
Premiums and
coupons
Other contingencies
 15

Current
Current Liabilities
Liabilities Having
Having
A
A Contractual
Contractual Amount
Amount

Trade accounts payable arise from the

purchase of inventory, supplies, or
services on an open charge-account
basis.
 16

Current
Current Liabilities
Liabilities Having
Having
A
A Contractual
Contractual Amount
Amount

A note payable is an
unconditional written
agreement to pay a sum
of money to the bearer on
a specific date.
 17

Current
Current Liabilities
Liabilities Having
Having
A
A Contractual
Contractual Amount
Amount
Trishan
TrishanCorporation
Corporationuses
usesaaperpetual
perpetualinventory
inventorysystem
systemand
and
purchases
purchasesmerchandise
merchandisefor
for$7,000
$7,000on
onSeptember
September1, 1,2004
2004byby
issuing
issuingaa$7,000,
$7,000,12%,
12%,30-day
30-daynote
noteto
tothe
thesupplier.
supplier.
September 1, 2004
Inventory 7,000
Notes Payable 7,000
October 1, 2004
Interest Expense ($7,000 x 0.12 x30/360) 70
Notes Payable 7,000
Cash 7,070
 18

Current
Current Liabilities
Liabilities Having
Having
A
A Contractual
Contractual Amount
Amount
On
On December
December 1,1, 2004,
2004, the
the Trollingwood
Trollingwood Corporation
Corporation
borrows
borrows money
money at at First
First National
National Bank
Bank byby issuing
issuing aa
$10,000,
$10,000, 90
90 -day,
-day, non-interest-bearing
non-interest-bearing note
note that
that isis
discounted
discounted on on aa 12%
12% basis.
basis.

December 1, 2004
Cash 9,700
Discount on Notes Payable 300
Notes Payable 10,000
Continued
Continued
 19

Current
Current Liabilities
Liabilities Having
Having
A
A Contractual
Contractual Amount
Amount
December 31, 2004
Interest Expense 100
Discount on Notes Payable 100
March 1, 2005
Interest Expense 200
Discount on Notes Payable 200
Notes Payable 10,000
Cash 10,000
 20

Current
Current Liabilities
Liabilities Having
Having
A
A Contractual
Contractual Amount
Amount
On
On July
July 1,
1, 2003,
2003, Rexlow
Rexlow Corporation
Corporation issues
issues 13%
13%
serial
serial bonds
bonds with
with aa face
face value
valueof of $1
$1 million.
million.
These
These bonds
bonds are
are to
to be
be retired
retired in
in installments
installments of
of
$100,000,
$100,000, beginning
beginning on on July
July 1,1, 2005.
2005.
December 31, 2004 Balance Sheet
Current liability:
Bonds Payable, due July, 2005 $100,000
Long-term liability:
Bonds payable $900,000
 21

Compensated
Compensated Absences
Absences
A company recognizes an expense and accrues a liability
for employees’ compensation for future absences if all the
following conditions are met:
1.
1.The
The company’s
company’s obligation
obligation relating
relating toto the
the employee’s
employee’s
rights
rights to
to receive
receive compensation
compensation for for future
future absences
absences isis
attributed
attributed to to the
the employee’s
employee’s services
services already
already rendered.
rendered.
2.
2.The
The obligation
obligation relates
relates to
to rights
rights that
that vest
vest or
or accumulate.
accumulate.
3.
3.Payment
Payment of of the
thecompensation
compensation isis probable.
probable.
4.
4.The
The amount
amount can can be
be reasonably
reasonably estimated.
estimated.
 22

Compensated
Compensated Absences
Absences
A
A vested
vested right
right exists
exists when
when anan employer
employer
has
has an
an obligation
obligation toto make
make payments
payments toto
an
an employee
employee that
that isis not
not contingent
contingent onon
the
the employee’s
employee’s futurefuture services.
services.
 23

Compensated
Compensated Absences
Absences
Accumulated
Accumulated rightsrights are
are those
those that
that can
can be
be
carried
carried forward
forward by by the
the employee
employee toto future
future
periods
periods ifif not
not taken
taken inin the
the period
period in
in which
which
they
they are
are earned.
earned.
 24

Compensated
Compensated Absences
Absences
Milton
Milton Company
Company has has 100
100 employees
employees who
who are
are paid
paid
an
an average
average of
of $100
$100 per
per day.
day. Company
Company policy
policy
allows
allows each
each employee
employee 12 12 days
days of
of paid
paid vacation
vacation
per
per year.
year. Assume
Assume no no vacation
vacation days
days were
were taken.
taken.

March 31, 2005

Sales Salaries Exp. Compensated Absences 15,000
Office Salaries Exp. Compensated Absences 15,000
Liability for Employees’ Compensation
for Future Absences (3/12 x $120,000) 30,000
 25

Compensated
Compensated Absences
Absences
The
The $200,000
$200,000 April
April 30,
30, 2005
2005 payroll,
payroll,
including
including paid
paid vacation
vacation time
time taken
taken by
by the
the
sales
sales and
and office
office staff,
staff, isis as
as follows:
follows:
Payroll for
Time Worked Vacation Taken
Sales staff $97,000 $3,000
Office staff 96,500 3,500

Continued
Continued
 26

Compensated
Compensated Absences
Absences
April 30, 2005
Sales Salaries Expense 97,000
Office Salaries Expense 96,500
Liability for Employees’ Compen-
sation for Future Absences 6,500
Cash 200,000
 27

Disclosure
Disclosure of
of Off-Balance
Off-Balance
Sheet
Sheet Obligations
Obligations
FASB
FASB Statement
Statement No. No. 4747 requires
requires that
that ifif aa
company
company enters
enters into
into anan unconditional
unconditional purchase
purchase
obligation
obligation thatthat (1)
(1) isis noncancellable,
noncancellable, (2)(2) isis
negotiated
negotiated as as part
part of of arranging
arranging financing
financing for for
facilities
facilities to
to provide
provide the the contracted
contracted items,
items, and
and (3) (3)
contains
contains aa term
term in in excess
excess ofof one
one year,
year, the
the
company
company must must make
make certain
certain disclosures
disclosures inin the
the
notes
notes to to its
its financial
financial statements.
statements.
 28

Disclosure
Disclosure of
of Off-Balance
Off-Balance
Sheet
Sheet Obligations
Obligations
FASB
FASB Statement
Statement No.No. 107
107 requires
requires aa company
company to to
disclose
disclose the
the fair
fair value
value ofof all
all its
its financial
financial
instruments
instruments (both
(both assets
assets and
and liabilities),
liabilities), whether
whether
recognized
FASB
recognized
FASB or
or not
Statement
Statement No.
not on
No. the
the balance
on131
131 requiressheet.
requires
balance aa company
sheet.
company
to
to recognize
recognize as as liabilities
liabilities any
any “derivative”
“derivative”
financial
financial instruments
instruments thatthat are
are obligations
obligations of of
the
the company,
company, basedbased onon their
their fair
fair value.
value.
 29

Current
Current Liabilities
Liabilities Whose
Whose
Amounts
Amounts Depend
Depend onon
Operations
Operations
 30

Sales
Sales and
and Use
Use Taxes
Taxes
Typical
Typical Situation
Situation

Selleroy
Selleroy Company
Company sells
sells merchandise
merchandise for
for cash
cash with
with
aa retail
retail sales
sales price
price of
of $50,000
$50,000 on
on which
which aa sales
sales tax
tax
of
of 6%
6% isis levied.
levied. The
The company
company collects
collects $53,000.
$53,000.

Cash 53,000
Sales 50,000
Sales Taxes Payable 3,000
 31

Sales
Sales and
and Use
Use Taxes
Taxes
The
The Sales
Sales Tax
Tax isis Included
Included in
in the
the Price
Price
Charged
Charged to to the
the Customer
Customer
Cash 53,000
Sales 53,000
At
At the
the end
end of
of January
January the
the Sales
Sales account
account isis adjusted
adjusted
to
to record
record the
the tax
tax on
on all
all goods
goods sold
sold [$53,000
[$53,000 ––
($53,000
($53,000 ÷÷ 1.06)]
1.06)] == $3,000.
$3,000.
Sales 3,000
Sales Taxes Payable 3,000
 32

Liabilities
Liabilities Related
Related to
to Payrolls
Payrolls
Involuntary
Involuntary Taxes
Taxes Involuntary
Involuntary Taxes
Taxes
Withheld
Withheld from
from Withheld
Withheld from
from
Employees
Employees Employers
Employers
Federal
Federal income
income tax
tax F.I.C.A.
F.I.C.A. taxes:
taxes:
State
State income
income tax
tax O.A.S.D.I.
O.A.S.D.I.
F.I.C.A.
F.I.C.A. taxes:
taxes: Medicare
Medicare
O.A.S.D.I.
O.A.S.D.I. Federal
Federal unemploy-
unemploy-
Medicare
Medicare ment
ment tax
tax
State
State unemployment
unemployment
tax
tax
 33

Liabilities
Liabilities Related
Related to
to Payrolls
Payrolls
Voluntary
Voluntary Payroll
Payroll
Deductions
Deductions Withheld
Withheld
from
from Employees
Employees
Union
Union dues
dues
Government
Government bonds
bonds
Group
Group hospital
hospital
insurance
insurance
Accident
Accident insurance
insurance
Life
Life insurance
insurance
Others
Others
 34

Accounting
Accounting for
for Payroll
Payroll
Taxes
Taxes and
and Deductions
Deductions
To record salaries and employee withholding items:
Sales Salaries Expense 10,000
Office Salaries Expense 4,000
F.I.C.A. Taxes Payable (8% x $14,000) 1,120
Employee Federal Income Taxes
Withholding Payable 990
Employee State Income Taxes
Withholding Payable 500
Employee Union Dues Withholding
Payable 180
Cash 11,210
 35

Accounting
Accounting for
for Payroll
Payroll
Taxes
Taxes and
and Deductions
Deductions
To record employer payroll taxes:
Payroll Taxes Expense 1,988
F.I.C.A. Taxes Payable
(8% x $14,000) 1,120
Federal Unemployment Taxes
Payable ((0.8% x $14,000) 112
State Unemployment Taxes
Payable (5.4% x $14,000) 756
 36

Bonus
Bonus Obligations
Obligations

1)
1) The
The bonus
bonus isis based
based on on the
the
corporation’s
corporation’s income
income after
after
deducting
deducting income
income taxes,
taxes, but
but
before
before deducting
deducting the the bonus.
bonus.
2)
2) The
The bonus
bonus isis based
based on on the
the
corporation’s
corporation’s net net income
income
after
after deducting
deducting both
both the
the
bonus
bonus and
and the
the income
income tax.tax.
 37

Bonus
Bonus Obligations
Obligations

Bonex
Bonex Corporation’s
Corporation’s
reported
reported income
income for for the
the
current
current year
year isis $260,000
$260,000
before
before deducting
deducting income
income
taxes
taxes and
and bonus.
bonus. The The
effective
effective tax
tax rate
rate isis 30%
30%
and
and the
the bonus
bonus isis 10%.
10%.
 38

Bonus
Bonus Obligations
Obligations
Method 1: Bonus computed on income after
deducting taxes but before deducting the bonus:
B = 0.10($260,000 – T)
T = 0.30($260,000 – B)
B = 0.10[($260,000 – .30($260,000 – B)]
B = 0.10($260,000 – $78,000 + 0.30B)
B = $26,000 – $7,800 + 0.03B)
B – 0.03B = $18,200
0.97 B = $18,200
B = $18,200 ÷ 0.97
B = $18,763 (rounded)
 39

Bonus
Bonus Obligations
Obligations
Method 2: Bonus computed on income after
deducting both taxes and the bonus:
B = 0.10($260,000 – B – T)
T = 0.30($260,000 – B)
B = 0.10[$260,000 – B – .30($260,000 -B)]
B = 0.10[$260,000 – B – $78,000 + 0.30B]
B = $26,000 – 0.10B – $7,800 + 0.03B
+ 0.10B – 0.03B = $18,200
1.07B = $18,200
B = $18,200 ÷ 1.07
B = $17,009 (rounded)
 40

Bonus
Bonus Obligations
Obligations
To record the bonus:
Salaries Expense (Officer’s Bonus) 17,009
Officer’s Bonus Payable 17,009
To record the income tax expense:
Income Tax Expense 72,897
Income Taxes Payable Current
72,897
Liability

Current
Liability
 41

Current
Current Liabilities
Liabilities
Requiring
Requiring Amounts
Amounts to to be
be
Estimated
Estimated
 42

Property
Property Taxes
Taxes
Ezzell
Ezzell Company
Company closes
closes its
its books
books annually
annually eacheach
December
December 31. 31. The
The fiscal
fiscal year
year forfor the
the town
town and
and
county
county in in which
which the
the firm
firm isis located
located ends
ends on
on June
June
30.
30. The The estimated
estimated property
property taxestaxes for
for the
the period
period
July
July 1,1, 2004
2004 to
to June
June 30,
30, 2005
2005 are are $7,200.
$7,200. The The tax
tax
bill
bill isis mailed
mailed inin October
October with
with aa requirement
requirement that that
the
the tax
tax be bepaid
paid before
before December
December 31, 31, 2004.
2004. The
The taxtax
bill
bill reported
reported anan actual
actual tax
tax of of $7,290,
$7,290, and and the
the
corporation
corporation pays pays this
this amount
amount on on October
October31, 31, 2004.
2004.
 43

Property
Property Taxes
Taxes
Three Monthly Entries July 31–September 30, 2004
Property Tax Expense ($7,200 ÷ 12) 600
Property Taxes Payable 600
October 31, 2004: Payment of Property Taxes
Property Tax Payable 1,800
Prepaid Property Taxes 5,490
Cash 7,290
Three Monthly Entries: October 31–December 31, 2004
Property Tax Expense 610
Prepaid Property Taxes 610
 44

Expense
Expense Warranty
Warranty
Accrual
Accrual Method
Method
 45

Warranty
Warranty Obligations
Obligations
Anglee
Anglee Machinery
Machinery Corporation
Corporation begins
begins production
production on on
aa new
new machine
machine inin April
April 2004
2004 and
and sells
sells 200
200 of
of these
these
machines
machines at
at $6,000
$6,000 each
each by
by December
December 31, 31, 2004.
2004.

Cash or Accounts Receivable 1,200,000

Sales 1,200,000
Warranty
Warranty cost
cost per
per machine
machineisis estimated
estimated at
at $150.
$150.
Warranty Expense 30,000
Estimated LiabilityContinued
under
Continued
Warranties 30,000
 46

Warranty
Warranty Obligations
Obligations
The
The corporation
corporation spent
spent $5,000
$5,000 in in 2004
2004 to
to fulfill
fulfill
warranty
warranty agreements
agreements for
for the
the 200
200 machines.
machines.
Estimated Liability under Warranties 5,000
Cash (or other assets) 5,000
The
The corporation
corporation spent
spent $25,150
$25,150 in in 2005
2005 to
to fulfill
fulfill
warranty
warranty agreements
agreements for
for the
the two
two machines.
machines.
Estimated Liability under Warranties 25,000
Warranty Expense 150
Cash (or other assets) 25,150
 47

Warranty
Warranty Obligations
Obligations
Anglee
Anglee Machinery
Machinery Corporation
Corporation sells
sells 200
200 machines
machines
for
for $6,000.
$6,000. This
This amount
amount includes
includes aa service
service contract
contract
sale
sale of Sales
of $150 and
Sales
$150 Warranty
and aaWarranty
machine
machine sale
sale ofof $5,850.
$5,850.
Accrual
Accrual
Cash or Accounts Method
Method
Receivable 1,200,000
Sales ($5,850 x 200) 1,170,000
Unearned Warranty Revenue 30,000

Continued
Continued
 48

Warranty
Warranty Obligations
Obligations
Recognition
Recognition of
of warranty
warranty expense
expense for
for period,
period, April–
April–
December,
December, 2004.
2004.
Warranty Expense 5,000
Cash (or other assets) 5,000
Recognition
Recognition of
of warranty
warranty revenue
revenue for
for period,
period, April–
April–
December,
December, 2004.
2004.
Unearned Warranty Revenue 5,000
Warranty Revenue 5,000
Continued
Continued
 49

Warranty
Warranty Obligations
Obligations
Recognition
Recognition of
of warranty
warranty expense
expense during
during 2005.
2005.
Warranty Expense 25,150
Cash (or other assets) 25,150

Recognition
Recognition of
of warranty
warranty revenue
revenue during
during 2005.
2005.
Unearned Warranty Revenue 25,000
Warranty Revenue 25,000
 50

Premium
Premium and
and Coupon
Coupon
Obligations
Obligations
On October 1, 2004, the American Meatball
Corporation began offering to customers a serving
disk in return for 30 meatball can labels. The offer
expires on April 1, 2005. The cost of each premium
serving disk is $2. It is estimated that 60% of the
labels will be redeemed.
 51

Premium
Premium and
and Coupon
Coupon
Obligations
Obligations
Purchased 12,000 serving dishes at $2 each.
Inventory of Premium Serving Dishes 24,000
Cash (or Accounts Payable) 24,000

Sold 300,000 cans of meatball at $1.80 each...

Cash (or Accounts Receivable) 540,000
Sales 540,000

Continued
Continued
 52

Premium
Premium and
and Coupon
Coupon
Obligations
Obligations
Received 105,000 labels from customers:.
Premium Expense 7,000
Inventory of Premium Serving Dishes 7,000

Estimated that 75,000 labels will be submitted next year:

(105,000 ÷ 30)
Premium Expense 5,000
x $2)
Estimated Premium Claims Outstanding 5,000
Premium expense
Estimated labels that
for will
estimated
be redeemed
future redemptions:
(300,000 x .60) 180,000
Deduct labels
[(75,000 redeemed
÷ 30) x $2) during 2004 (105,000
$5,000 )
Estimated number of future label redemptions 75,000
 53

Contingencies
Contingencies
AA contingency
contingency isis an
an existing
existing
condition
condition involving
involving uncertainty
uncertainty as as
to
to possible
possiblegain
gain or
or loss
loss that
that will
will
ultimately
ultimately be
be resolved.
resolved.
 54

Contingencies
Contingencies

• Probable. The future event or events is

likely to occur.
• Reasonably possible. The chance of the
future event occurring is more than remote
but less than likely.
• Remote. The chance of the future event
occurring is slight.
 55

Contingencies
Contingencies
Criteria Disclosure

No Future event probable? Yes Report amount

in financial
or and
statements
Amount reasonably
No estimated? Yes
and
Reasonable possibility Not required
Yes of loss No
to disclose
Disclose in notes to
financial statements
 56

Disclosure
Disclosure of
of Gain
Gain
Contingencies
Contingencies
FASB Statement No. 5 requires that these gains be disclosed in
the notes to the company’s financial statements.
(a) Contingencies that might result in gains usually are
not reflected in [a company’s] accounts since to do so
might be to recognize revenue prior to its realization.
(b) Adequate disclosure shall be made of contingencies
that might result in gains, but care shall be exercised
to avoid misleading implications as to the likelihood
of realization.
 57

Short-Term
Short-Term Debt
Debt Expected
Expected
to
to be
be Refinanced
Refinanced
When
When aa company
company relies relies on on aa
financing
financing agreement
agreement to to demonstrate
demonstrate
the
the ability
ability to
to refinance,
refinance, the the amount
amount of of
the
the short-term
short-term debtdebt that
that itit excludes
excludes
from
fromcurrent
current liabilities
liabilities isis reduced
reduced to to
an
an amount
amount thatthat isis the
the lesser
lesser of...
of...

Continued
Continued
 58

Short-Term
Short-Term Debt
Debt Expected
Expected
to
to be
be Refinanced
Refinanced
1. The amount available for refinancing under the
agreement, or
2. The amount obtainable under the agreement after
considering the restrictions included in other
agreements, or
3. A reasonable estimate of the minimum amount
expected to be available for future refinancing if
the amount that could be obtained fluctuates.
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Chapter 12

The
The End
End
60