Needles Finman Irm Ch08

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CHAPTER 8
Current Liabilities and Fair Value Accounting
PLANNING MATRIX
Enhancing Your
Building Your Basic Knowledge and Knowledge, Skills,
Learning Objective Skills and Critical Thinking
1. Identify the management issues SE 1, 2 E 1, 3, 4 P 1, 4, 9 C4
related to current liabilities. C7
C8
2. Identify, compute, and record SE 3 E 1, 5, 6, 7, P 1, 2, 3, C1

definitely determinable and 8, 9 6, 7 C5
estimated current liabilities. C9
C 10
C 11
3. Distinguish contingent SE 3 E1 P1 C7
liabilities from commitments. C 10
4. Identify the valuation SE 7, 8, E 2, 10, 11, P 5, 8 C3
approaches to fair value 12, 13, 14, C6
accounting, and define time 15, 16
value of money and interest
and apply them to present
values
5. Apply present value to simple SE 9 E 10, 12, 14, P 5, 8 C3
valuation situations 15, 16 C6
C 11
C 12
MEMORANDA:
SE: Short Exercises
E: Exercises
P: Problems (Each problem has a User Insight question.)
All questions are in the text with related Learning Objectives (Stop, Think, and Apply).
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 8: Current Liabilities and Fair Value Accounting 103
SUGGESTED INSTRUCTIONAL STRATEGY

Output Skills Developed:
Communication, Personal/Self
Related Learning Objective:

2
Instructional Strategy
Learning activity: Group work, discussion
Learning environment: Active classroom
Learning tool: Textbook assignment Case 4
Steps to Implement
1. Assign the case to small groups in class. Use previously established groups or assign groups
randomly. Each group should select a representative to speak for the group.
2. Be clear on the expected output of the learning activity. Identify questions to address and
determine whether written answers are necessary. For example, ask one person from each group
to present one alternative and explain why that alternative would be best.
3. Elicit as many alternatives as possible for the class to consider. After each group has presented
one alternative, if time permits, ask if any other alternatives might be available.
4. Allow groups one or two minutes to consider which alternative they prefer and why. Poll the class
as to their preferred response.
Assessment
Communication skills: Present a related case on the next examination and evaluate reasoning and clarity
of response. If responses are written, these could be graded for reasoning ability and clarity.
Personal/self skills: Using a short questionnaire, ask each student if the discussion provided additional
options or insights about the choices presented that the groups had not considered. Did class discussion
result in a change of preferred alternative? If so, how?
RESOURCE MATERIALS AND OUTLINES

OBJECTIVE 1: Identify the management issues related to current liabilities.
Summary Statement
Liabilities are legal obligations requiring either future payment of assets or future performance of
services that result from past transactions. The primary reason for incurring current liabilities is to meet
needs for cash during the operating cycle. Management must carefully manage the cash flows related to
current liabilities; the appropriate level of liabilities is critical to business success.
Two common measures of the length of time creditors allow for payment are the payables turnover and
the days’ payable. The payables turnover is the number of times, on average, that accounts payable are
paid in an accounting period and shows the relative size of a company’s accounts payable. The days’
payable, on the other hand, shows the average length of time a company takes to pay its accounts
payable.
104 Chapter 8: Current Liabilities and Fair Value Accounting
A liability generally should be recorded when an obligation arises, but it is also necessary to make end-
of-period adjustments for accrued and estimated liabilities. Failure to record a liability often results in
an understatement of expense and, therefore, an overstatement of income. Contracts representing future
obligations are not recorded as liabilities until they become current obligations. Liabilities are valued at
the actual or estimated amount due or at the fair market value of goods or services to be delivered.
Current liabilities are present obligations that are expected to be satisfied within one year or within the
normal operating cycle, whichever is longer. Payment is expected to be out of current assets or through
the incurrence of another current liability. Long-term liabilities are obligations that are not expected to
be satisfied within the longer of one year or the normal operating cycle.
Required disclosures for liabilities include balances, maturity dates, and interest rates of notes payable,
as well as lines of credit and other special credit arrangements.
New Concepts and Terminology

current liabilities; long-term liabilities
Key Ratios
payables turnover; days’ payable
Related Text Illustrations

Focus on Business Practice: Debt Problems Can Plague Even Well-Known Companies.
Figure 1: Payables Turnover for Selected Industries
Figure 2: Days’ Payable for Selected Industries
Lecture Outline
I. Liabilities are legal obligations that must be satisfied through the future payment of assets or
performance of services.
A. A liability should be recognized when it is incurred; end-of-period adjustments may be
necessary.
1. Failure to record a liability often results in an understatement of expenses.
B. Liabilities are valued at the amount due or at the fair market value of goods or services to be
delivered.
C. Liabilities are classified as current or long-term.
1. A current liability is a liability due within one year or within the normal operating
cycle, whichever is longer.
2. A long-term liability is a liability due beyond the normal operating cycle.
II. Two common measures of the length of time creditors allow for payment are the payables turnover and
the days’ payable.
A. The payables turnover is the average number of times that accounts payable are paid in an
accounting period and shows the relative size of a company’s accounts payable.
B. The days’ payable shows the average length of time a company takes to pay its accounts payable.
III. Required disclosures for liabilities include the following:
A. Balances
B. Maturity dates
C. Interest rates
D. Lines of credit
E. Other special credit arrangements
Teaching Strategy
Students should be reminded of the definition of a liability—that is, a present obligation for future
payment (of cash or services), based on a past transaction. A reminder of the definition of current
period (the longer of one year or the normal operating cycle) is helpful in defining current versus long-
term liabilities (that is, classification of liabilities).
In the discussion of the recognition of liabilities, point out the difficulty in certain cases of determining
when an obligation occurs (as with a product warranty). In addition, explain why future commitments
may not be liabilities currently.
In the discussion of valuation of liabilities, be sure to mention the difference between definitely
determinable amounts and estimated amounts.
Review required disclosures for liabilities.
Short Exercises 1 and 2, Exercises 3 and 4, and Problem 4 apply to this objective.
OBJECTIVE 2: Identify, compute, and record definitely determinable and estimated current
liabilities.
Summary Statement
Current liabilities consist of definitely determinable liabilities and estimated liabilities. Definitely
determinable liabilities are obligations that can be measured exactly. They include accounts payable,
bank loans and commercial paper, notes payable, accrued liabilities, dividends payable, sales and excise
taxes payable, current portions of long-term debt, payroll liabilities, and unearned revenues.
1. Accounts payable are short-term obligations to suppliers for goods and services.
2. Companies often obtain a line of credit with a bank to finance operations. In addition, a company
may borrow short-term funds by issuing commercial paper (unsecured loans sold to the public).
3. Short-term notes payable are current obligations evidenced by promissory notes. Usually, interest
is stated separately on the face of the note.
4. An accrued liability is an actual or estimated liability that exists at the balance sheet date but is
unrecorded. An end-of-period adjustment is needed to record both expenses and accrued
liabilities.
5. Dividends payable represent an obligation to distribute a corporation’s earnings to its
stockholders. This arises only when the board of directors declares a dividend.
6. Most states and many cities levy a sales tax on retail transactions, and the federal government also
charges an excise tax on some products. The merchant must collect the taxes at the time of the
sale and record the receipt of cash and the proper tax liabilities.
7. If a portion of long-term debt is due within the next year and is to be paid from current assets, then
that current portion of long-term debt is classified as a current liability. The remaining debt is
classified as a long-term liability.
8. Payroll liabilities consist of the labor-related obligations incurred by a business. Not only is the
business responsible for wages, paid at an hourly rate, and salaries, paid at a monthly or yearly
rate, earned by its employees, but also it is obligated for items such as social security (FICA)
taxes, Medicare tax, and unemployment taxes. The business is likewise liable for amounts
withheld from its employees’ gross earnings that must be remitted to governmental and other
agencies.
9. Unearned revenues represent obligations to deliver goods or services in return for advance
payment. When delivery takes place, Unearned Revenue is debited and a revenue account is
credited.
Estimated liabilities are definite obligations. Nevertheless, the amount of the obligation must be
estimated at the balance sheet date because the exact figure will not be known until a future date.
Examples of estimated liabilities are income taxes, property taxes, product warranties, and vacation
pay.
1. A corporation’s income tax is dependent on its taxable net income, a figure that often is not
determined until well after the balance sheet date.
2. Property taxes are taxes levied on real and personal property. Often a company’s accounting
period ends before property taxes are assessed, making it necessary to estimate the property tax
applicable to each month of the year.
3. Promotional costs such as coupons, rebates, and frequent flyer programs are recorded as a
reduction of sales.
4. Warranties for many of the products or services a company sells will still be in effect during the
next accounting period. Nevertheless, the warranty expense and liability must be recorded in the
period of the sale regardless of when the company makes good on its warranties. Therefore, at the
end of each accounting period, the company should estimate the future warranty expense that
applies to the present period’s sales.
5. In most companies, employees accrue vacation pay for working a certain length of time.
Therefore, the company must estimate the vacation pay applicable to each payroll period, debit
Vacation Pay Expense, and credit Estimated Liability for Vacation Pay.
The following journal entries are introduced in this learning objective:
Cash XX (amount received)
Notes Payable XX (face amount)
Issued promissory note with interest stated separately
Notes Payable XX (face amount)

Interest Expense XX (amount incurred)
Cash XX (maturity amount)
Payment of note with interest stated separately
Interest Expense XX (amount accrued)

Interest Payable XX (amount accrued)
To record interest expense on note with interest stated
separately
Cash XX (amount collected)

Sales XX (price charged)
Sales Tax Payable XX (amount to remit)
Excise Tax Payable XX (amount to remit)
Sale of merchandise and collection of sales and excise taxes
Wages Expense XX (gross amount)

Employees’ Federal Income Taxes Payable XX (amount withheld)
Employees’ State Income Taxes Payable XX (amount withheld)
Social Security Tax Payable XX (employees’ share)
Medicare Tax Payable XX (employees’ share)

Medical Insurance Premiums Payable XX (employees’ share)
Pension Contributions Payable XX (employees’ share)
Wages Payable XX (take-home pay)
To record payroll
Payroll Taxes and Benefits Expense XX (total employer payroll taxes)

Social Security Tax Payable XX (employer’s share)
Medicare Tax Payable XX (employer’s share)
Medical Insurance Premiums Payable XX (employer’s share)
Pension Contributions Payable XX (employer’s share)
Federal Unemployment Tax Payable XX (amount incurred)
State Unemployment Tax Payable XX (amount incurred)
To record payroll taxes and other costs
Cash XX (amount prepaid)

Unearned Revenue XX (amount to earn)
Receipt of membership dues in advance
Unearned Revenue XX (amount earned)

Revenue XX (amount earned)
Recognition of revenue for services provided
Product Warranty Expense XX (estimated amount)

Estimated Product Warranty Liability XX (estimated amount)
To record estimated product warranty expense
Cash XX (fee charged)

Estimated Product Warranty Liability XX (cost of part)
Service Revenue XX (fee charged)
Merchandise Inventory XX (cost of part)
Replacement of part under warranty
Vacation Pay Expense XX (amount incurred)

Estimated Liability for Vacation Pay XX (amount owed or accrued)
Estimated vacation pay expense
Estimated Liability for Vacation Pay XX (amount taken)

Cash (or Wages Payable) XX (amount paid or payable)
Wages of employees on vacation

definitely determinable liabilities; line of credit; commercial paper; wages; salaries; unearned
revenues; estimated liabilities

Figure 3: Promissory Note
Focus on Business Practice: Small Businesses Offer Benefits, Too.
Figure 4: Illustration of Payroll Costs

Focus on Business Practice: Those Little Coupons Can Add Up.
Focus on Business Practice: What Is the Cost of Frequent Flyer Miles?
Lecture Outline
I. Current liabilities consist of definitely determinable liabilities and estimated liabilities.
II. A definitely determinable liability can be measured precisely.
A. Accounts payable
B. Bank loans and commercial paper
C. Notes Payable
1. Journalize entries for notes payable with interest stated separately.
a. Issue note.
b. Accrue interest.
c. Pay note.
2. Journalize entries for notes payable with interest included in the face amount.
a. Issue note.
b. Accrue interest.
c. Pay note.
D. Accrued liabilities (such as interest payable)
E. Dividends payable
F. Journalize collection of sales and excise taxes.
G. Current portion of long-term debt
H. Payroll liabilities
1. Record the payroll.
2. Record employer payroll taxes.
I. Unearned revenues
1. Journalize receipt of revenues in advance.
2. Journalize performance of services for revenues received in advance.
III. Estimated liabilities are definite obligations whose exact amounts cannot be known until a later
date.
A. Record estimated income taxes.
B. Property taxes
1. Journalize estimated expense.
2. Journalize payment of property taxes.
C. Promotion costs
1. Examples: coupons, rebate, frequent flyer programs
2. Usually recorded as a reduction in revenue (contra-sales account)
D. Product warranties
1. Journalize estimated expense.
2. Journalize replacement of product under warranty.
E. Vacation pay
1. Journalize estimated vacation pay expense.
2. Journalize payment of vacation pay.
Teaching Strategy
After you define definitely determinable and estimated liabilities, ask students to identify several
examples of each.
Students may have difficulty understanding the concept of notes with interest included in the face
amount. Perhaps a diagram dividing the note into part principal (mostly) and part interest will help
convey the concept.
Short Exercise 4 and Exercise 5 pertain to interest expense. Short Exercise 5 and Exercise 7 pertain to
payroll concepts and entries.
Discuss the concept of uncertainty and the desire to follow the matching principle at the expense of
perfect accuracy.
Students may also have difficulty understanding the topic of property tax payable. A time-line diagram
by month helps explain prepaid property tax versus estimated property tax payable.
Case 1 and Case 5 are good cases for conceptual analysis of this learning objective. Also, use Case 11
for a group assignment.
OBJECTIVE 3: Distinguish contingent liabilities from commitments.

Summary Statement
A contingent liability is a potential liability that may or may not become an actual liability. The
uncertainty regarding its outcome is resolved by the occurrence or nonoccurrence of a future event.
Contingent liabilities arise from pending lawsuits, tax disputes, and failure to follow government
regulations. Contingent liabilities are recorded if the occurrence is probable and the amount can be
reasonably estimated. A commitment is a legal obligation that does not meet the technical requirements
for recognition as a liability. The most common examples are purchase agreements and leases.

contingent liability; commitment
Lecture Outline
I. A contingent liability is a potential liability that may or may not become an actual liability.
Examples are as follows:
A. Pending lawsuits
B. Tax disputes
C. Failure to comply with government regulations
II. There are two criteria for recording a contingent liability:
A. Occurrence is probable.
B. The amount can be reasonably estimated.
III. A commitment is a legal obligation that does not meet the technical requirements for recognition
as a liability. Examples are as follows:
A. Purchase agreements
B. Leases
Teaching Strategy
Students should know that a contingent liability is a possible liability that may or may not become an
actual liability (when a future event occurs or does not occur). Point out that contingent liabilities such
as product warranty liability and vacation pay liability are accrued because they are probable, and their
amounts can usually be reasonably estimated (otherwise, just a footnote is required). Have students list
some contingent liabilities, and explain why they are described as such. Students should also know that
a commitment is a legal obligation that does not meet the technical requirements for recognition as a
liability. Have students explain why purchase agreements and leases are examples of a commitment.
Case 7 is a good real-world case for this topic.
OBJECTIVE 4: Identify the valuation approaches to fair value accounting, and define time
value of money and interest and apply them to present values.
Summary Statement
Fair value is the price for which an asset or liability can be sold. The three approaches to measurement
of fair value are the market approach, income (or cash flow) approach, and the cost approach.
Time value of money is the effects of the passage of time on holding or not holding money. The timing
of the receipt and payment of cash (measured in interest) should be considered in making business
decisions. Interest is the specific cost measure of these effects for a period of time. It may be calculated
on a simple or compound basis.
1. Simple interest is the interest cost for one or more periods under the assumption that the amount
on which interest is computed does not increase each period (that is, interest is not computed on
accrued interest).
2. However, compound interest is the interest cost for two or more periods under the assumption that
the amount on which interest is computed does increase each period (that is, interest is computed
on accrued interest).
Present value is the amount that must be invested now at a given rate of interest to produce a given
future value or values. Present value may be computed on a single sum due in the future; Table 1
facilitates this computation.
Present value may also be computed on an ordinary annuity. Conceptually, the present value of an
ordinary annuity is that amount that may be invested today at a given percentage to enable periodic
withdrawals of the given amount; Table 2 facilitates this computation.

time value of money; interest; simple interest; compound interest; future value; present value; ordinary
annuity

Table 1: Present Value of $1 to Be Received at the End of a Given Number of Periods
Table 2: Present Value of an Ordinary $1 Annuity Received in Each Period for a Given Number of
Periods
Lecture Outline
I. Fair value is the price for which an asset or liability could be sold.
A. Market approach
1. Involves identical or comparable assets or liabilities.
2. Ready market not as available, as in case of special-purpose equipment.
B. Income (or cash flow) approach
1. Converts future cash flows into a single present value.
2. Based on reasonable internally generated information.
C. Cost approach
1. The amount that currently would be required to replace an asset.
2. Inventory usually valued at lower of cost or market.
3. Plant value would take into account asset’s age, condition, depreciation, and
obsolescence.
II. Interest and the time value of money

A. Time value of money is the effects of the passage of time on holding or not holding money.
B. Interest is the cost of using money.
1. With simple interest, interest is not computed on accrued interest.
2. With compound interest, interest is computed on accrued interest.
III. Calculating present value
A. Illustrate the computation of the present value of an amount, using Table 1 in the text.
B. Illustrate the computation of the present value of an annuity, using Table 2 in the text.
C. Discuss time periods of less than one year for which interest is compounded.
1. Some savings accounts can record interest quarterly.
2. Some bonds pay interest semiannually.
Teaching Strategy
This chapter begins with a review of fair value. Although the market and cost approaches are
conceptually straightforward, the income, or cash flow, approach requires a knowledge of interest and
the time value of money.
A good way to begin the topic of the time value of money is by explaining the basic concept—that it is
best to pay out a dollar as far into the future as possible and to receive a dollar as close to today as
possible. Interest is assumed to be earned on any money currently held (invested).
Make sure your students remember the basic calculation of interest. Then contrast simple and
compound interest using a straightforward example, stressing that compound interest is built into the
time value of money tables.
Short Exercise 7 can be used to illustrate the difference between simple and compound interest.
Present value is a difficult concept for a student to understand. Define it as the amount that we would
require now to have the equivalent of some other amount payable or receivable in the future. When
working out an example, prove that the present value amount determined will grow to the given future
value amount, at the chosen interest rate. For an annuity, demonstrate that the present value invested in
the bank will enable one to withdraw the given annual amounts, with zero remaining.
Short Exercise 8 and Exercises 10 through 13 apply to present values.
OBJECTIVE 5: Apply the present value to simple accounting situations.

Summary Statement
Present value may be used in accounting to (a) determine the value of an asset being considered for
purchase, (b) calculate deferred payments for the purchase of an asset, (c) account for the investment of
idle cash, (d) accumulate funds needed to pay off a loan, and (e) determine numerous other accounting
values, such as the value of a bond, pension and lease obligations, and depreciation.
Lecture Outline
I. Present value has several applications in accounting:
A. Determine the value of an asset considered for purchase.
B. Calculate deferred payments.
C. Account for idle cash invested.
D. Accumulate funds to pay off a loan.
E. Other applications, such as imputing interest on non-interest-bearing notes, accounting for
installment notes, determining the value of a bond, pension and lease obligations, and
depreciation of property, plant, and equipment.
Teaching Strategy
By this time, students should understand that comparing current amounts with future amounts is like
comparing apples and oranges. Make sure to present situations that rely on present value calculations
for their logical valuation on the books, such as valuing an asset or calculating deferred payments.
Short Exercise 9 and Exercises 14 through 16 provide several applications of present values. Case 11 is
a good group activity that combines the time value of money with estimated liabilities.
REVIEW QUIZ
True-False
1. T F Taxes for social security and Medicare are borne by both the employer and the
employee.
2. T F The lower the interest rate, the lower the present value factor.
3. T F An annuity is a series of equal payments made at equal time intervals.
4. T F Under no circumstances should a contingent liability be accrued in the accounting
records.
5. T F If a computer is sold in year 1 and a repair is made in year 2, the manufacturer’s entry
upon making the repair would include a debit to Product Warranty Expense.
6. T F When payables turnover decreases, days’ payable increases.
7. T F When a business sells an item and collects a state sales tax on it, a current liability to
the state arises.
Multiple Choice
8. Jack Harkness has sold a piece of property and is to receive $21,000 in three equal annual
payments of $7,000 beginning one year from today. What is the present value of this sale if the
current interest rate is 4 percent?
a. 19,342
b. 19,482
c. 39,361
d. 6,734
e. 19,425
9. Which of the following is not an estimated liability?

a. Sales taxes payable
b. Property taxes payable
c. Vacation pay liability
d. Income taxes payable
e. Product warranty liability
10. Each of the following will affect payables turnover except

a. Change in inventory.
b. This year’s level of accounts payable.
c. Cost of goods sold.
d. Net Sales.
e. Last year’s level of accounts payable.
11. Of a company’s employees, 60 percent typically qualify to receive two weeks’ paid vacation a
year. What is the amount of estimated vacation pay liability for a week in which the total payroll
is $7,000?
a. $84
b. $112
c. $140
d. $168
e. $28,012
12. Each year there is a ceiling for the amount that is subject to all of the following, except
a. social security tax payable.
b. federal unemployment tax payable.
c. Medicare tax payable.
d. state unemployment tax payable.
e. none of these; all of the above have ceilings.
13. A liability is recognized when

a. an obligation exists.
b. a contract is signed.
c. cash is received.
d. payment is now due.
e. an invoice is received.
14. A new piece of equipment will save a company $25,000 per year over the present equipment. The
value of the new machine is calculated by multiplying the $25,000 savings by the
a. number of years the equipment will be used.
b. present value of an ordinary annuity factor.
c. current market price.
d. present value of a single amount factor.
e. number of time periods it will be used.
15. When accounting for property taxes, which of the following accounts normally would not be
credited?
a. Prepaid Property Taxes
b. Cash
c. Estimated Property Taxes Payable
d. Property Taxes Expense
e. All of these accounts could be credited in this transaction.
16. Which of the following involves a contingent liability?

a. Dividends declared
b. Current portion of long-term debt
c. Deferred revenues
d. Payroll liabilities
e. A pending lawsuit
17. Compound interest is computed semiannually on $500 in the bank for six years at 4 percent
annual interest. To calculate the accumulated amount after six years, one would multiply the $500
by which future value factor?
a. 6 periods at 2 percent
b. 12 periods at 4 percent
c. 3 periods at 8 percent
d. 6 periods at 4 percent
e. 12 periods at 2 percent
ANSWERS TO REVIEW QUIZ

True-False Multiple Choice
1. T 8. b
2. F 9. a
3. T 10. d
4. F 11. d
5. F 12. c
6. T 13. a
7. T 14. b
15. d
16. e
17. e

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ً ‫ صفحة الباحث العلوي هجانا‬Alaa.aliasrei@gmail.

com ‫@ عالء هحسن شحن‬Aliasrei ‫تلكرام‬

2. Identify, compute, and record SE 3 E 1, 5, 6, 7, P 1, 2, 3, C1

SUGGESTED INSTRUCTIONAL STRATEGY

Related Learning Objective:

RESOURCE MATERIALS AND OUTLINES

New Concepts and Terminology

Related Text Illustrations

Notes Payable XX (face amount)

Interest Expense XX (amount accrued)

Cash XX (amount collected)

Wages Expense XX (gross amount)

Medicare Tax Payable XX (employees’ share)

Payroll Taxes and Benefits Expense XX (total employer payroll taxes)

Cash XX (amount prepaid)

Unearned Revenue XX (amount earned)

Product Warranty Expense XX (estimated amount)

Cash XX (fee charged)

Vacation Pay Expense XX (amount incurred)

Estimated Liability for Vacation Pay XX (amount taken)

New Concepts and Terminology

Related Text Illustrations

Figure 4: Illustration of Payroll Costs

OBJECTIVE 3: Distinguish contingent liabilities from commitments.

New Concepts and Terminology

Case 7 is a good real-world case for this topic.

New Concepts and Terminology

Related Text Illustrations

II. Interest and the time value of money

OBJECTIVE 5: Apply the present value to simple accounting situations.

9. Which of the following is not an estimated liability?

10. Each of the following will affect payables turnover except

13. A liability is recognized when

16. Which of the following involves a contingent liability?

ANSWERS TO REVIEW QUIZ

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