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Chapter 08
Current Liabilities
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Part A
Current Liabilities
8-2
Current Liabilities
Liability - A present responsibility to sacrifice assets
in the future due to a transaction or other event
that happened in the past.
o
o
Current liabilities are usually, but not always, due
within one year. Notes payable, accounts payable,
and payroll liabilities are the three main categories.
_ 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.
Current liabilities are also sometimes called shortterm liabilities.
8-3
LO1 Distinguish between current and
long-term liabilities
Reporting Liabilities
Three characteristics of liabilities:
o probable future sacrifices of economic
benefits.
o arising from present obligations to other
entities.
o resulting from past transactions or events.
8-4
Current vs. Long-Term Liabilities
LIABILITIES
CURRENT
Payable within one
year
LONG-TERM
With in the
Payable
more
company
than
one year
8-5
Reporting Current Liabilities
o Distinguishing between current and long-term
liabilities helps investors and creditors assess
risk.
o Companies often prefer to report a liability as
long-term because it may cause the firm to
appear less risky.
o Many companies list notes payable first, followed
by accounts payable, and then other current
liabilities from largest to smallest.
8-6
LO2 Account for Notes Payable and
Interest Expense
o Notes Payable
o A company borrowing cash (borrower) from a bank is
required to sign a note promising to repay the amount
borrowed plus interest.
o The borrower reports its liability as notes payable.
o Notes payable is a liability that creates interest expense
o Small firms rely heavily on short-term financing.
o Large companies also use short-term debt as a
significant part of their capital structure.
8-7
Example of Southwest Airlines
o Southwest Airlines borrows $100,000 from Bank
of America on September 1, 2012.
o Signing a 6%, six-month note for the amount
borrowed plus accrued interest due six months
later on March 1, 2013.
o On September 1, 2012, Southwest will receive
$100,000 in cash and record the following entry:
September 1, 2012
Cash
Notes Payable
Debit
Credit
100,000
100,000
(Issue notes payable)
8-8
Measuring Interest
o
o
o
Interest is stated in terms of an annual 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 interest rate x Fraction of the Year
o
How much interest cost does Southwest incur for the
six-month period of the note from September 1, 2012
to March 1, 2013?
$3,000 = $100,000 x 6% x 6/12
8-9
Interest Accrued and Repayment of Note
If Southwest’s reporting period ends on December 31, 2012, company
records the four months’ interest incurred during 2012 in an adjusting
entry prior to preparing the 2012 financial statements:
December 31, 2012
Debit
Interest Expense ($100,000 x 6% x 4/12)
2,000
Interest Payable
Credit
2,000
(Record interest incurred, but not paid )
On maturity, Southwest Airlines will pay the face value of the loan plus
the entire interest incurred. It makes the following journal entry
March 1, 2013
Notes Payable (face value)
Debit
100,000
Interest Expense ($100,000 x 6% x 2/12)
1,000
Interest Payable ($100,000 x 6% x 4/12)
2,000
Cash
Credit
103,000
(Pay notes payable and interest )
8-10
Flip Side: Bank of America
How would the lender, Bank of America, record this note?
o For the bank it’s a note receivable rather than a note payable.
o It generates interest revenue rather than interest expense.
o The entries are as follows:
September 1, 2012
Debit
Notes Receivable
100,000
Cash
(Issue notes receivable )
December 31, 2012
Debit
Interest Receivable
2,000
Interest Revenue ($100,000 × 6% × 4/12)
(Record interest earned, but not received )
March 1, 2013
Debit
Cash
103,000
Interest Revenue ($100,000 × 6% × 2/12)
Interest Receivable ($100,000 × 6% × 4/12)
Notes Receivable (face value)
(Collect notes receivable and interest )
Credit
100,000
Credit
2,000
Credit
1,000
2,000
100,000
8-11
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 Similar to notes payable except the company is
able to borrow without having to go through a
formal loan approval process each time it borrows
money.
o Many short-term loans are arranged under an
existing line of credit with a bank, or for larger
corporations in the form of commercial paper, a
loan from one company to another.
8-12
LO3 Account for Employee and
Employer Payroll Liabilities
o Prior to depositing a monthly payroll check, an employer
withholds
o Federal and state income taxes,
o Social Security and Medicare,
o Health, dental, disability, and life insurance premiums, and
o Employee investments to retirement or savings plans.
o As an employer, the costs of hiring an employee are higher
than the salary.
o Significant costs include
o Federal and state unemployment taxes,
o The employer portion of Social Security and Medicare,
o Employer contributions for health, dental, disability, and life
insurance,
o Employer contributions to retirement or savings plans.
8-13
Summary of Payroll Costs
Employee Payroll Costs
Federal and state income taxes
Social Security and Medicare
Health, dental, disability, and life insurance
premiums
Employee investments in retirement or
savings plans
Employer Payroll Costs
Federal and state unemployment taxes
Employer matching portion of Social
Security and Medicare
Employer contributions for health, dental,
disability, and life insurance
Employer contributions to retirement or
savings plans
8-14
Employee Costs
o Employers are required by law to withhold federal and state
income taxes from employees’ paychecks and remit these
taxes to the government.
o FICA taxes - Collectively, Social Security and Medicare
taxes.
o FICA Act requires employers to withhold:
o 6.2% Social Security tax up to a maximum base amount.
o 1.45% Medicare tax with no maximum.
o Total FICA tax is 7.65% (6.2% + 1.45%) on income up to a base
amount ($106,800 in 2010) and 1.45% on all income above the
base amount.
o Employees may opt to have additional amounts withheld from
their paychecks.
8-15
Employer Costs
o Employer pays an additional (matching) FICA tax on
behalf of the employee.
o Employer’s limits on FICA tax are the same as
employee’s.
o Employer must also pay federal and state
unemployment taxes on behalf of the employees.
o 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%.
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.
8-16
Employer Costs (contd.)
o Fringe benefits: Additional employee benefits paid by
the employer include
o All or part of employees’ insurance premiums.
o Contributions to retirement or savings plans.
o 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.
8-17
Payroll Costs
Hawaiian Travel Agency
o Payroll information is provided in the speaker notes.
o Records the employee salary expense, withholdings,
and salaries payable on January 31 as follows:
January 31
Salaries Expense
Federal Income Taxes Payable
State Income Taxes Payable
FICA Taxes Payable (.0765 × $100,000)
Salaries Payable (to balance)
(Record employee salary expense and withholdings)
Debit
100,000
Credit
20,000
4,000
7,650
68,350
8-18
Payroll Costs (contd.)
Hawaiian Travel Agency records its employer-provided fringe benefits as
follows:
January 31
Debit
Salaries Expense (fringe benefits)
15,000
Accounts Payable (to Blue Cross)
Accounts Payable (to Fidelity)
(Record employer-provided fringe benefits )
Credit
5,000
10,000
Hawaiian Travel Agency pays employer’s FICA taxes at the same rate
that the employees pay (7.65%) and also pays unemployment taxes at
the rate of 6.2%. The agency records its employer’s payroll taxes as
follows:
January 31
Debit
Credit
Payroll Tax Expense (total)
13,850
FICA Taxes Payable (.0765 × $100,000)
7,650
Unemployment Taxes Payable (.062 × $100,000)
6,200
(Record employer payroll taxes)
8-19
LO4 Demonstrate the Accounting for
other Current Liabilities
o Additional current liabilities companies report:
o
o
o
o
Unearned revenues
Sales taxes payable
The current portion of long-term debt
Deferred taxes
o We explore each of these in more detail in the
following slides.
8-20
Unearned Revenues
Companies account for cash received in advance
by:
o Increasing (debit) cash and increasing (credit) a
current liability account called unearned revenue.
o Decreasing (debit) unearned revenue and
increasing (credit) revenue once revenue is
earned.
8-21
Sales Taxes Payable
o Company selling products subject to sales taxes is
responsible for collecting the sales tax directly from
customers and periodically sending the sales taxes
collected to the state and local governments.
o When the company collects the sales taxes, it increases
cash (a debit) and increases sales taxes payable (a
credit).
Suppose you buy lunch in the airport for $15 plus 9% sales
tax. The airport restaurant records the transaction this way:
Cash
Sales Revenue
Sales Taxes Payable ($15 × .09)
(Record sales and sales taxes )
Debit
16.35
Credit
15.00
1.35
8-22
Current Portion of Long-Term Debt
o Currently maturing portion of a long-term debt is reported as a
current liability on the balance sheet.
o Assume Southwest Airlines had total borrowings of $3,515 million
at December 31, 2009, of which $190 million was payable in 2010
and the remaining $3,325 million is due after 2010. In its 2009
balance sheet, the company records the $3,515 million in current
and long-term debt, as shown below
SOUTHWEST AIRLINES
Balance Sheet (partial)
December 31, 2009
($ in millions)
Current liabilities:
Current portion of long-term debt
Long-term debt
Long-term liabilities:
Total borrowings
$190
3,325
$3,515
8-23
Deferred taxes
o Net income and taxable income often differ
because of differences in financial accounting and
tax accounting rules.
o These differences can result in deferred tax
liabilities, in which income is reported now but the
tax on the income will not be paid until future
years.
8-24
Part B
Contingencies
8-25
LO5 Apply the appropriate accounting
treatment for contingencies
o Contingent liability:
o An existing, uncertain situation that might result in
a loss.
o Examples: Lawsuits, product warranties,
environmental problems, and premium offers
o A contingent liability may not be a liability at all.
Whether it is, depends on whether an uncertain
event that might result in a loss occurs or not.
8-26
Litigations and Other Causes
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 Deloitte’s 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. Legal counsel representing Jeeps, Inc.
indicated that the possibility of payment was remote and that if the case
went to trial, Jeeps would almost surely win.
As the auditor, you could choose one of three options to report the
situation: (1) report a liability for the full $100 million or for some lesser
amount, (2) provide full disclosure in a financial statement footnote but
not report a liability in the balance sheet, or (3) provide no disclosure at
all.
8-27
Contingent Liabilities
o Whether we report a loss contingent liability depends on two
criteria:
o The likelihood of payment can be:
o Probable—likely to occur
o Reasonably possible—more than remote but less
than probable; or
o Remote—the chance is slight
o The ability to estimate the payment amount is either:
o Known or reasonably estimable; or
o Not reasonably estimable.
o We record a liability if the loss is probable and the amount is
at least reasonably estimable.
o The journal entry to record a contingent liability requires a
debit to a loss (or expense) account and a credit to a liability.
8-28
Contingent Liabilities
o If the likelihood of payment is probable and if one
amount within a range appears more likely, 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 payment is remote, disclosure
usually is not required.
8-29
Accounting Treatment of Contingent
Liabilities
If payment is:
Known or Reasonably
Estimable
Probable
Liability recorded and
disclosure required
Not Reasonably
Estimable
Disclosure required
Reasonably possible Disclosure required
Disclosure required
Remote
Disclosure not required
Disclosure not required
8-30
Contingent Liabilities
Back to Jeeps, Inc.
How do you think Deloitte, as the auditor of Jeeps,
Inc., treated the litigation described earlier?
o Based on the response of legal counsel, the
likelihood of the payment 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
Warranties
o When you buy a new Dell notebook, it comes with a warranty
covering the hardware from defect for either a 90-day, oneyear, or two-year period depending on the product.
o Why does Dell offer a warranty?
o To increase sales, of course.
o Based on the matching principle, the company needs to
record warranty expense in the same accounting period as
the sale.
o A warranty represents an expense and a liability at the time of
the sale, because it meets the criteria for recording a
contingent liability.
o Even though Dell doesn’t know exactly at the time of the sale
what that warranty expense will be, it can, based on
experience, reasonably estimate the amount.
8-32
Contingent Gains
o Is an existing uncertain situation that might result in
a gain, which often is the flip side of contingent
liabilities.
o In a pending lawsuit, one side—the defendant—
faces a contingent liability, while the other side—the
plaintiff—has a contingent gain.
o We record contingent liabilities when the loss is
probable and the amount is reasonably estimable.
o We do not record contingent gains until the gain is
certain.
o Though firms do not record contingent gains in the
accounts, they sometimes disclose them in notes to
the financial statements
8-33
LO6 Assess liquidity using current
liability ratios
o Liquidity Analysis
o Liquidity refers to having sufficient cash to pay currently
maturing debts.
o Working Capital:
o It is the difference between current assets and current
liabilities.
o Current ratio:
o We calculate it by dividing current assets by current
liabilities.
o Acid-test ratio/Quick ratio:
o We calculate it by dividing “quick assets” by current
liabilities.
o Quick assets include cash, short-term investments, and
accounts receivable.
8-34
Let’s Review
Selected financial data regarding current assets and current
liabilities for United and Southwest Airlines are as follows
($ in millions)
Current assets
Cash and cash equivalents
Current investments
Net receivables
Inventory
Other current assets
Total current assets
Current liabilities
Accounts payable
Short/current long-term debt
Other current liabilities
Total current liabilities
United
$3,046
977
237
601
$4,861
$3,231
1,808
2,242
$7,281
Southwest
$1,368
435
574
203
313
$2,893
$2,643
163
$2,806
1. Calculate working capital for United Airlines and Southwest Airlines.
2. Calculate the current ratio for United Airlines and Southwest Airlines.
3. Calculate the acid-test (quick) ratio for United Airlines and Southwest Airlines.
8-35
Let’s Review
Solution:
1.
($ in millions)
Total Current
Assets
-
Total Current
Liabilities
=
Working
Capital
United
$4,861
-
$7,281
=
$(2,420)
Southwest
$2,893
-
$2,806
=
$ 87
Total Current
Assets
÷
Total Current
Liabilities
=
United
$4,861
÷
$7,281
=
0.67
Southwest
$2,893
÷
$2,806
=
1.03
Quick Assets
÷
Total Current
Liabilities
=
Acid-Test
Ratio
United
$4,023
÷
$7,281
=
0.55
Southwest
$2,377
÷
$2,806
=
0.85
2.
($ in millions)
3.
($ in millions)
Current Ratio
8-36
Effect of Transactions on Liquidity
Ratios
o It is important to understand the effect of specific
transactions on the current ratio and acid-test ratio.
o 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.
o Both ratios include cash, current investments, and
accounts receivable, so an increase in any of those
will increase both ratios.
o 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.
8-37
Liquidity Management
o Can management influence the ratios that measure
liquidity?
o Yes, at least to some extent.
o A company can influence the timing of accounts
payable recognition by asking suppliers to change their
delivery schedules.
o 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.
o A debt covenant is an agreement between a borrower
and a lender that requires certain minimum financial
measures be met or the lender can recall the debt.
8-38
End of chapter 08
8-39