Intermediate Financial Accounting I: Current Liabilities and Contingencies

Intermediate
Financial Accounting I
Current Liabilities and

Contingencies
Objectives of the Chapter

1. Accounting for current liabilities with definite
amount (i.e., trade related liabilities,
employee payroll related liabilities and
accrued liabilities.)
2. Accounting for estimated liabilities (i.e.,
warranty obligations, coupons and
premiums obligations).
3. Accounting for contingent liabilities.
Current Liabilities and Contigencies
Liabilities
Legal obligations require future

payments of cash or services or the
creation of other liabilities as a result of
past transactions.
Current liabilities: Obligations must be
fulfilled in one year or one operating
cycle, whichever is longer.
Current Liabilities
Examples of current liabilities with definite

amount as a result of a business transaction:
A/P (accounts payable)
N/P (notes payable including commercial
paper issued)
Current maturity portion of a long-term debt
Sales taxes payable
Accrued liabilities
Payroll taxes withholdings
Sales Taxes Payable
Sales taxes are taxes levied by states on retail

sales, not on manufacturers (i.e., GE, GM, etc).
Every state, except Alaska, Delaware, Montana,
New Hampshire, and Oregon, levies state sales
taxes on retail sales.
The rate varies state by state (for example, Starting
4/1/2009, California has a statewide sales tax at 8.25%
with a local supplementary tax for up to 10.75%).
Current and Long-Term Liabilities
Sales Taxes Payable (contd.)
Retailers charge their customers the

sales taxes in addition to the price of
the merchandise.
The retailers have to forward the
collected sales taxes to the state at
regular intervals.
Example
Assume that the 12/22/x9 sales of

Macys in California totaled $2,000,000.
The state tax rate is 8.25%. The
business would record the days sales as
follows:
Cash
2,165,000
Sales Revenue
2,000,000
Sales Taxes Payable
165,000
Accrued Liabilities
Obligations accumulated on a daily

basis but not recorded until the end of
period through adjusting entries (i.e.,
Interest payable, salaries payable, rent
payable)
Employee Related Liabilities: FICA, Federal

I/T, state I/T, Medical Insurance Premiums
Salaries Expense
50,000
Employee F.I.C.A. Taxes Payable* 3,825
Federal I/T Payable
10,000
State I/T Payable
2,500
Cash
32,675
*(6.2% +1.45%) *$50,000 or 7.65% x $50,000
F.I.C.A. taxes include Social Security tax of 6.2% (max earnings
taxable is $106,800 for 2009) and 1.45% of Medicare tax (no limit on
maximum earnings taxable).
Employee Related Liabilities (contd.)
Employer payroll taxes:

Payroll Taxes Expense
6,925
Employer F.I.C.A. Taxes Payable
3,825
F.U.T.A. Taxes Payablea
400
State Unemployment Tax Payableb 2,700
a. 6.2% of the first $7,000 of salaries paid to
employees.
b. assuming a state unemployment tax = 5.4%.
10
Other Current Liabilities
Refundable Deposits
Cash
Refund Deposit Liabilities
xxx
xxx
Dividends Payable
Unearned Revenue
11
Estimated Liabilities
Liabilities exist but the amount is

unknown:
A. Property taxes
B. Warranty obligations
C. Coupon and premium obligations
D. Compensated absences
E. Environmental liabilities
12
A. Property Taxes
Property taxes are assessed by local

governments (city, state ) on the value of
properties. The assessed property taxes
become a lien on the properties on a day
specified by law (i.e., July 1)
In general, the bills of the property taxes are
not received until a few months after the lien
day. The property taxes must be estimated and
recognized on a monthly basis (recommended
by the AICPA) starting the lien day.
13
A. Property Taxes (contd.)
Also, the property taxes expenses should be

allocated over the fiscal year of the local
government (i.e., 7/1/x1 ~ 6/30/x2).
If there are differences between the
estimates and the actual taxes, the
adjustments are considered as an estimate
change and are spread to the remaining tax
period (no retroactive effect).
14
Example
The fiscal year of the local government
=> 7/1/x8 - 6/31/x9
The property tax becomes a lien on the property on
=> 7/1/x8
Estimated property tax expenses (for 7/1/x8 - 6/30/x9)
=>$12,000
Tax bill received on
=> 10/29/x8
Actual tax expense
=> $13,800
Tax paid on
=>11/30/x8
15
Example (contd.)
Prepare journal entries regarding the property

tax for the period of 7/1/x8 - 6/30/x9:
7/1/x8 No journal entry (accrued the liability, on a monthly basis)
7/31/x8 Property Tax Expenses
1,000
Property Tax Payable
1,000
($12,000/12=$1,000)
8/31/x8 P/T Exp
1,000
P/T Payable
1,000
9/30/x8 P/T Exp
1,000
P/T Payable
1,000
10/31/x8 P/T Exp
1,200
P/T Payable
1,200
(($13,800 -$3,000)/(12-3) = $1,200 the difference is treated as changes
in estimates; no retroactive effect. (APB 20))
16
Prepare journal entries regarding the property

tax for the period of 7/1/x8 - 6/30/x9: (contd.)
11/30/x8 P/T Payable
Prepaid P/T
Cash
13,800
P/T Expense
Prepaid P/T
12/31/x8 P/T Exp 1,200
Prepaid P/T
4,200
9,600
1,200
1,200
1,200
:
:
6/30/x9
P/T Exp 1,200

Prepaid P/T
1,200
17
B. Warranty Obligations (Product Warranty)

1. Cash basis (for Income Tax Filing
Purposes, not GAAP)
2. Expense warranty using accrued
method (GAAP)
18
1. Cash Basis (for tax filing)

(Not Acceptable for Financial Reporting Purpose)
Warranty expenses are recognized when

these expenses are paid for (violating the
matching principle)
Journal Entry:
Warranty Exp
Cash
(only for I/T filling)
xxx
xxx
19
2. Expense Warranty Using Accrued

Method
(for financial Reporting Purposes)
Estimate the warranty exp. associated

with the sales (of the period) at the
end of the period and recognize it.
20
2. Expense Warranty Using Accrued

Method (contd.)
Journal Entry:
Warranty Expenses
xxx
Estimated Warranty Liabilities
xxx
When warranty services provided:
Estimated warranty liabilities
Cash (or Inventory)
xxx
xxx
If the estimated warranty liabilities are not enough

to cover the current years warranty services, treat it
as a change in accounting estimates (i.e., no
retroactive effect).
21
Example
The estimated warranty liabilities account has an
ending balance of $2,000 before the following year
end adjustment:
12/31/x2 Warranty Expenses
3,000
Estimated Warranty Liability
3,000
During 20x3, the actual warranty expenses
amounted to $5,800.
20x3:
Estimated warranty liability
5,000
* Warranty Expenses
800
Cash (or Inventory)
5,800
22
C. Premiums and Coupons

Obligations
Liabilities of premiums and coupons

should be estimated and recognized in
the year when sales are made.
Journal Entry
Premium (or Coupon) Expensexxx
Estimated Premium Claims
(or coupon) outstanding
xxx
23
C. Premiums and Coupons

Obligations (contd.)
When premiums (or coupons) are claimed:

Journal Entry
Estimated Premium Claims
(coupon) outstanding
xxx
Inventory
xxx
* If the actual redemption of coupons (or
premiums) is greater than the estimated

liabilities, the underestimated amount would be
recognized as the expense of the current year.
24
D. Compensated Absences
Compensation for vacation, illness and
holidays.
Companies should estimate the amount of
liabilities and recognize them at the end of
the reporting period if:
a. Employees services needed to receive these
rights have been rendered.
b. The obligation relates to these rights are vested.
c. Payment of the compensation is probable.
d. The amount of liabilities can be reasonably
estimated.
25
E. Environmental Liabilities (SFAS

143)
A company must recognize an asset

retirement obligation (ARO) when
1) it has an existing legal obligation
associated with the retirement of a longlived asset , and
2) the liability can be reasonably
estimated.
Examples of obligating events: decommissioning
nuclear facilities, dismantling, restoring and
reclamation of oil and gas properties, etc.
26
Recognition and Allocation of ARO

The estimated fair value of ARO is
capitalized on 1/1/2002 :
Nuclear Plant
50,000
Asset Retirement Obligation 50,000
The cost of ARO will be subsequently
allocated as depre. expense over the life of
the asset (i.e., 5 years):
Depre. Expense 10,000
Acc. Depre. Nuclear Plant 10,000
27
Recognition and Allocation of ARO

(contd.)
The accrued interest of ARO should be
recognized periodically (assuming 10% interest):
12/31/2002Interest expense (10% x50,000) 5,000
ARO
5,000
On 1/1/2008, the decommissioning cost
amounted to $78,000, the following will be
recorded:
ARO 80,525
Cash
Gain on Settlement of ARO
78,000
2,525
28
Contingencies
Contingent Liabilities
Contingent Losses
Contingent Gains
29
Obligations may arise because of the

occurrence or not occurrence of future
event(s). (i.e., warranty obligations)
30
Liabilities may arise because of the

event(s).
(i.e., guarantee and warranty costs,
litigation and claims, premiums and
coupons, environment al liabilities, etc.)
31
Contingent Gains
Gains may arise because of the

events). (i.e., pending lawsuit gains)
32
Accounting Treatments of
Contingencies
The accounting treatments of the contingencies

depend on the occurrence probability of the related
future event(s).(FASB 5)
1. Probable: The future event(s) is(are) likely to occur.
2. Reasonably possible: The chance for the future
event(s) to occur is less than probable but greater
than remote
3. Remote: The chance of the future event to occur is
unlikely (slight).
33
Contingencies (contd.)
If the future event(s) is(are)

a. Probable, and
b. amount of liability can be estimated

The loss (liability) should be estimated,
and recognized (accrued).
34
Examples:
Warranty Expense
xxx
Estimated Warranty Liabilities
xxx
Lawsuit Expenses
xxx
Estimate Liability under litigation
xxx
35
If the future event is probable, but the amount

of loss (or liability) cannot be estimated, the
contingent loss (or liability) should only be
footnoted (not accrued).
Contingent gains:
If the event is probable and the amount of
contingent gains is determinable, only
footnote the information. No unrealized
gain can be recognized under the current
accounting standards (conservatism!!!)
36
Additional Notes For Current

Liabilities
1. Obligations that are callable by the creditors

within the longer period of one year or one
operating cycle: reported as current liabilities.
2. Obligation that matures in one year or one
operating cycle, whichever is longer:
reported as current liabilities.
3. Short-term obligations that are expected to
be refinanced by a long-term debt: reported
as a long-term debt if conditions (i.e.,
intention and ability to do so) are met.
37

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Intermediate Financial Accounting I: Current Liabilities and Contingencies

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Intermediate

Current Liabilities and

Objectives of the Chapter

Current Liabilities and Contigencies

Legal obligations require future

Examples of current liabilities with definite

Sales Taxes Payable

Sales taxes are taxes levied by states on retail

Current and Long-Term Liabilities

Sales Taxes Payable (contd.)

Retailers charge their customers the

Current and Long-Term Liabilities

Assume that the 12/22/x9 sales of

Current and Long-Term Liabilities

Obligations accumulated on a daily

Current Liabilities and Contigencies

Employee Related Liabilities: FICA, Federal

Employee Related Liabilities (contd.)

Employer payroll taxes:

Other Current Liabilities

Current Liabilities and Contigencies

Liabilities exist but the amount is

Property taxes are assessed by local

A. Property Taxes (contd.)

Also, the property taxes expenses should be

Prepare journal entries regarding the property

Prepare journal entries regarding the property

P/T Exp 1,200

Current Liabilities and Contigencies

B. Warranty Obligations (Product Warranty)

Current Liabilities and Contigencies

1. Cash Basis (for tax filing)

Warranty expenses are recognized when

Current Liabilities and Contigencies

2. Expense Warranty Using Accrued

Estimate the warranty exp. associated

Current Liabilities and Contigencies

2. Expense Warranty Using Accrued

If the estimated warranty liabilities are not enough

C. Premiums and Coupons

Liabilities of premiums and coupons

C. Premiums and Coupons

When premiums (or coupons) are claimed:

premiums) is greater than the estimated

E. Environmental Liabilities (SFAS

A company must recognize an asset

Recognition and Allocation of ARO

Recognition and Allocation of ARO

Current Liabilities and Contigencies

Obligations may arise because of the

Current Liabilities and Contigencies

Liabilities may arise because of the

Current Liabilities and Contigencies

Gains may arise because of the

Current Liabilities and Contigencies

The accounting treatments of the contingencies

Current Liabilities and Contigencies

If the future event(s) is(are)

b. amount of liability can be estimated