Chapter 13

Current Liabilities and

Contingencies
Intermediate Accounting 11th edition

Nikolai Bazley Jones

An electronic presentation
By Norman Sunderman
and Kenneth Buchanan
Angelo State University
COPYRIGHT © 2010 South-Western/Cengage Learning
 2

Conceptual Overview of Liabilities

Liabilities are the

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.
 3

Three Essential Characteristics of a Liability

1. A liability involves a responsibility 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 responsibility obligates the company so
that it has little or no discretion to avoid the
future sacrifice.
3. The transaction or other event obligating the
company has already happened.
 4

Primary Liability Issues

1. Identification of liabilities—the detection of
a company’s obligations.
2. Valuation of the liabilities and
measurement of the related expense—the
determination of an amount to record for 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.
 5

Current Liabilities

Current
Currentliabilities
liabilitiesare
are
obligations
obligationswhose
whoseliquidation
liquidation
isisexpected
expectedtotorequire
requirethe
theuse
use
of
ofexisting
existingcurrent
currentassets…
assets…
 6

Current Liabilities

…or
…orthethecreation
creationof
ofother
other
current
currentliabilities
liabilitieswithin
withinone
one
year
yearororaanormal
normaloperating
operating
cycle,
cycle,whichever
whicheverisislonger.
longer.
 7

Operating Cycle
Inventory

Cash Receivables
 8

Liquidity
Liquidity
Liquidityrefers
referstotohow
howquickly
quicklyaa
company
companycan
canconvert
convertits
itsassets
assetsto
tocash
cashto
to
pay
payits
itsliabilities.
liabilities.
 9

Liquidity Ratios
1. Cash flows to total debt
2. Net income to total assets (return on total
assets ratio)
3. Total debt to total assets (debt ratio)
4. Current assets to current liabilities (current
ratio)
5. Cash to current liabilities
 10

Types of Current Liabilities

Having
Having Contractual
Contractual
Amount
Amount


 Accounts
Accounts payable
payable

 Notes
Notes payable
payable

 Currently
Currently maturing
maturing portion
portion of
of long-term
long-term debt
debt

 Dividends
Dividends payable
payable

 Advances
Advances and
and refundable
refundable deposits
deposits

 Accrued
Accrued items
items

 Unearned
Unearned items
items
 11

Types of Current Liabilities

Amount
Amount
Depends
Depends on
on
Operations
Operations


 Sales
Sales (use)
(use) taxes
taxes

 Payroll
Payroll taxes
taxes

 Income
Income taxes
taxes

 Bonuses
Bonuses
 12

Types of Current Liabilities

Amount
Amount Must
Must Be
Be
Estimated
Estimated


 Property
Propertytaxes
taxes

 Warranties
Warranties

 Premiums
Premiumsand
and
coupons
coupons

 Other
Othercontingencies
contingencies
 13

Current Liabilities Having a Contractual Amount

Trade accounts payable arise from the

purchase of inventory, supplies, or services on
credit.
 14

Current Liabilities Having a Contractual Amount

A note payable is an
unconditional written
agreement to pay a sum
of money to the bearer
on a specific date.
 15

Short-Term Line of Credit

AAline
lineof
ofcredit
creditwith
withaabank
bankisisan
an
agreement
agreementallowing
allowingaacorporation
corporationtoto
borrow
borrowupuptotoaaprearranged
prearrangedlimit.
limit.

Its
Itsadvantage
advantageoveroveraaregular
regularnote
note
payable
payableisisthat
thataacorporation
corporationcan
canonly
only
borrow
borrowthetheamount
amountcurrently
currentlyneeded,
needed,
and
andinterest
interestisisnot
notcharged
chargedononthe
the
unused
unusedportion
portionof ofthe
theloan.
loan.
 16

Commercial Paper
Commercial
Commercialpaperpaperisisan
anunsecured
unsecurednote
note
payable,
payable,normally
normallymaturing
maturinginin30–270
30–270
days,
days,that
thatisisused
usedtotofinance
financeshort-term
short-term
obligations.
obligations.

AAmajor
majorbenefit
benefitof
ofcommercial
commercialpaper
paperisis
that
thatititdoes
doesnot
nothave
havetotobe
beregistered
registered
with
withthetheSecurities
Securitiesand
andExchange
Exchange
Commission
Commissionas aslong
longas
asititmatures
matures
before
before270270days,
days,making
makingititvery
verycost
cost
effective.
effective.
 17

Dividends Payable

 Cash
Cash (Dividends
(Dividends Payable)
Payable)

 Property
Property (Property
(Property Dividends
Dividends
Payable)
Payable)

 Scrip
Scrip (Dividends
(DividendsPayable
Payablein
inScrip)
Scrip)

The declaration of a dividend reduces

retained earnings and recognizes a
current liability.
 18

Advances and Refundable Deposits

Many utility and other companies require

customers and employees to make
deposits. These deposits may be required
as guarantees to cover equipment used by
the customer, to cover payments that may
arise in the future, or to guarantee
performance of a contract or service.
 19

Advances and Refundable Deposits

The law frequently requires that interest

be paid on these deposits. Therefore, most
utility companies refund the deposit as
soon as a customer has established a good
credit standing.
 20

Compensated Absences
A company recognizes an expense and accrues a
liability for employees’ compensation for future
absences if all the following conditions are met:
1. The company’s obligation relating to the
employee’s rights to receive compensation for
future absences is attributed to the employee’s
services already rendered
2. The obligation relates to rights that vest or
accumulate
3. Payment of the compensation is probable
4. The amount can be reasonably estimated
 21

Compensated Absences

AAvested
vestedright
rightexists
existswhen
whenananemployer
employer
has
hasan
anobligation
obligationtotomake
makepayment
paymenttotoan
an
employee
employeethat
thatisisnot
notcontingent
contingenton
onthe
the
employee’s
employee’sfuture
futureservices.
services.
 22

Compensated Absences
Accumulated
Accumulatedrights
rightsare
arethose
thosethat
thatcan
canbe
be
carried
carriedforward
forwardby
bythe
theemployee
employeeto tofuture
future
periods
periodsififnot
nottaken
takenin
inthe
theperiod
periodin
inwhich
whichthey
they
are
areearned.
earned.
 23

Liabilities from Noncancellable Obligations

GAAP
GAAP requires
requiresthat
that ifif aa company
company enters
enters into
into an an
unconditional
unconditional purchase
purchase obligation
obligation that that (1)
(1) isis
noncancellable,
noncancellable, (2) (2) has
has aa specified
specified price
price forfor aa
fixed
fixed amount
amount of of goods
goods andand services,
services, and
and (3)
(3) ifif any
any
of
of the
the payment
payment falls
falls within
within the the operating
operating cycle,
cycle, itit
isis recorded
recorded asas aa current
current liability.
liability. If
If the
the market
market
price
price goes
goes below
below thethe set
set price,
price, the
the company
company must must
accrue
accrueaa loss
loss and
and record
record aa liability.
liability.
 24

Unearned Items
A company’s unearned items (sometimes called
deferred revenues) include amounts that it has
collected in advance for future sales but has not yet
earned and has not recorded as revenues.


 Rent
Rent

 Magazine
Magazine subscriptions
subscriptions

 Royalties
Royalties

 Tickets
Tickets

 Gift
Gift certificates
certificates

 Service
Service contracts
contracts
 25

Current
Current Liabilities
Liabilities Whose
Whose
Amounts
Amounts Depend
Depend on on
Operations
Operations
 26

Sales and Use Taxes

Selleroy
Selleroy Company
Company sellssells 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
 27

Sales and Use Taxes

If
If the
the sales
sales tax
tax isis included
included in
in the
the price
price charged
charged to
to
the
the customer:
customer:
Cash 169,000
Sales 169,000

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 6%
6% sales
sales tax
tax on
on all
all goods
goods
sold
sold [$169,000
[$169,000 –– ($169,000
($169,000 ÷÷ 1.06)]
1.06)] == $9,600.
$9,600.
Sales 9,600
Sales Taxes Payable 9,600
 28

Liabilities Related to Payrolls

Involuntary
Involuntary Taxes
Taxes Involuntary
Involuntary Taxes
Taxes
Withheld
Withheld from
from Withheld
Withheld from
from
Employees
Employees Employers
Employers

Federal
Federalincome
incometaxtax 
F.I.C.A.
F.I.C.A.taxes:
taxes:

State
Stateincome
incometaxtax –– O.A.S.D.I.
O.A.S.D.I.(6.20%)
(6.20%)

F.I.C.A.
F.I.C.A.taxes:
taxes: –– Medicare
Medicare(1.45%)
(1.45%)
–– O.A.S.D.I.
O.A.S.D.I.(6.20%)
(6.20%) 
Federal
Federalunemployment
unemployment
–– Medicare
Medicare(1.45%)
(1.45%) tax
tax(0.8%
(0.8%ononfirst
first$7,000)
$7,000)

State
Stateunemployment
unemploymenttax tax
(5.4%
(5.4%ononfirst
first$7,000)
$7,000)
 29

Liabilities Related to Payrolls

Voluntary
Voluntary Payroll
Payroll
Deductions
Deductions Withheld
Withheld
from
from Employees
Employees

Union
Uniondues
dues

Government
Governmentbonds
bonds

Group
Grouphospital
hospital
insurance
insurance

Accident
Accidentinsurance
insurance

Life
Lifeinsurance
insurance

Others
Others
 30

Accounting for Payroll Taxes and Deductions

To record salaries and employee withholding items:

Sales Salaries Expense 20,000
Office Salaries Expense 8,000
F.I.C.A. Taxes Payable (8% × $14,000) 2,240
Employee Federal Income Taxes Withholding
Payable 1,980
Employee State Income Taxes Withholding
Payable 1,000
Employee Union Dues Withholding Payable 360
Cash 22,420

The actual O.A.S.D.I. rate is 6.20% and Medicare is 1.45% for a total of
7.65%. Together these taxes are referred to as social security taxes. For
simplicity, an assumed rate of 8% is used for both these taxes.
 31

Accounting for Payroll Taxes and Deductions

To record employer payroll taxes:

Payroll Taxes Expense 3,976
F.I.C.A. Taxes Payable
(8% × $28,000) 2,240
Federal Unemployment Taxes
Payable (0.8% × $28,000) 224
State Unemployment Taxes
Payable (5.4% × $28,000) 1,512
 32

Bonus Obligations
Alternative Methods
1.
1. The
The bonus
bonus isis based
based onon the
the
corporation’s
corporation’s income
income after
after
deducting
deducting income
income taxes,
taxes, but
but
before
beforededucting
deducting thethe bonus.
bonus.
2.
2. The
The bonus
bonus isis based
based onon the
the
corporation’s
corporation’s netnet income
income
after
after deducting
deducting both
both the
the
bonus
bonus and
and the
the income
income
taxes.
taxes.
 33

Current
Current Liabilities
Liabilities
Requiring
Requiring Amounts
Amounts to to
be
be Estimated
Estimated
 34

Property Taxes
Ezzell
Ezzell Company
Company closes closes its
its books
books annually
annually each
each
December
December 31. 31. The
The fiscal
fiscal year
year for
for the
the town
town and
and
county
county in in which
which thethe firm
firm isis located
located ends
ends onon June
June
30.
30. The
The estimated
estimated property
property taxestaxes for
forthe
the period
period
July
July 1,
1, 2010
2010 to to June
June 30,
30, 2011,
2011, are
are $7,200.
$7,200. The
The
tax
tax bill
bill isis mailed
mailed in in October
October with with aa requirement
requirement
that
that the
the tax
tax be
be paid
paid before
before December
December 31, 31, 2010.
2010.
The
The tax
tax bill
bill reported
reported an an actual
actual tax
tax ofof $7,290,
$7,290,
and
and the
the company
company pays pays this
this amount
amount on on October
October
31,
31, 2010.
2010.
 35

Property Taxes
Three Monthly Entries: July 31–September 30, 2010
Property Tax Expense ($7,200 ÷ 12) 600
Property Taxes Payable 600

October 31, 2010: Payment of Property Taxes

Property Taxes Payable 1,800
Prepaid Property Taxes 5,490
Cash 7,290
Three Monthly Entries: October 31–December 31, 2010
Property Tax Expense 610
Prepaid Property Taxes 610
 36

Warranty Obligations
Expense
Expense Warranty
Warranty Accrual
Accrual Method
Method
Anglee
AngleeMachinery
MachineryCorporation
Corporationbegins
beginsproduction
productionononaa
new
newmachine
machinein inApril
April2010
2010and
andsells
sells200
200of
ofthese
thesemachines
machines
at
at$6,000
$6,000each
eachby
byDecember
December31,31,2010.
2010.
Cash or Accounts Receivable ($6,000 × 200) 1,200,000
Sales 1,200,000

Warranty
Warrantycost
costper
permachine
machineisisestimated
estimatedat
at$150.
$150.
Warranty Expense ($150 × 200) 30,000
Estimated Liability under Warranties 30,000
 37

Warranty Obligations
The
Thecorporation
corporationspent
spent$5,000
$5,000in
in2010
2010to
tofulfill
fulfillwarranty
warranty
agreements
agreementsfor
forthe
the200
200machines.
machines.
Estimated Liability under Warranties 5,000
Cash (or other assets) 5,000

The
Thecorporation
corporationspent
spent$25,150
$25,150in
in2011
2011to
tofulfill
fulfillthe
the
warranty
warrantyagreements
agreementsfor
forthe
the200
200machines
machinessold
soldinin2010.
2010.
Estimated Liability under Warranties 25,000
Warranty Expense 150
Cash (or other assets) 25,150
 38

Warranty Obligations
Sales
Sales Warranty
Warranty Accrual
Accrual Method
Method
Anglee
AngleeMachinery
MachineryCorporation
Corporationsells
sells200
200machines
machinesforfor
$6,000.
$6,000.This
Thisamount
amountincludes
includesboth
bothananimplied
impliedservice
service
contract
contractof
of$150
$150and
andaasale
saleof
ofaamachine
machinewith
withaaselling
selling
price
priceof
of$5,850.
$5,850.
Cash or Accounts Receivable ($6,000 × 200) 1,200,000
Sales ($5,850 × 200) 1,170,000
Unearned Warranty Revenue ($150 × 200) 30,000

Continued
Continued
 39

Warranty Obligations
Recognition of Warranty Expense for Period, April–
December 2010
Warranty Expense 5,000
Cash (or other assets) 5,000

Recognition of Warranty Revenue for Period, April–

December 2010
Unearned Warranty Revenue 5,000
Warranty Revenue 5,000

Continued
Continued
 40

Warranty Obligations
Recognition of Warranty Expense during 2011
Warranty Expense 25,150
Cash (or other assets) 25,150
Recognition of Warranty Revenue during 2011
Unearned Warranty Revenue 25,000
Warranty Revenue 25,000
 41

Premium and Coupon Obligations

On October 1, 2010, the American Spaghetti

Corporation began offering to customers a CD in
return for 30 spaghetti can labels. The offer
expires on April 1, 2011. The cost of each
premium CD is $2. It is estimated that 60% of
the labels will be redeemed.
 42

Premium and Coupon Obligations

Purchase of 6,000 CDs

Inventory of Premium CDs 12,000
Cash (or Accounts Payable) 12,000

Sale of 300,000 Cans of Spaghetti

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

Continued
Continued
 43

Premium and Coupon Obligations

(105,000 ÷ 30)
× $2
Redemption of 105,000 Labels
Premium Expense 7,000
Inventory of Premium Serving Dishes 7,000

End-of-Year Recording of Estimated Liability for

Outstanding Premium Offers
Premium Expense 5,000
Estimated Premium Claims Outstanding 5,000
Estimated labels that will be redeemed (300,000 × 0.60) 180,000
Deduct labels redeemed during 2010 (105,000
)
Estimated number of future label redemptions 75,000
Premium expense for estimated future redemptions:
(75,000 ÷ 30) × $2
 44

Advertising Costs

Companies
Companiesare arerequired
requiredto toexpense
expensetheir
their
advertising
advertisingcosts
costsas
asincurred
incurredor orat
atthe
the
first
firsttime
timethe
theadvertising
advertisingtakes
takesplace
place
because
becauseititisisdifficult
difficultto
tomeasure
measurethethe
future
futureeconomic
economicbenefits.
benefits.
 45

Contingencies

AAcontingency
contingencyisisananexisting
existingcondition,
condition,
situation,
situation,or
orset
setof
ofcircumstances
circumstances
involving
involvinguncertainty
uncertaintyasastotopossible
possiblegain
gain
or
orloss
lossthat
thatwill
willultimately
ultimatelybe beresolved.
resolved.
 46

Contingencies
 Probable. The future event 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.
 47

Contingencies

Criteria Disclosure

No Future event probable? Yes Report

Report amount
amount in
in
financial
financial
or and statements
statements
Amount reasonably
No Yes
estimated?
and
Reasonable possibility Not required to
Yes No
of loss disclose

Disclose
Disclose in
in notes
notes to
to financial
financial
statements
statements
 48

Disclosure of Loss Contingencies

 If a company does not accrue a loss for a loss
contingency, it must disclose the contingency when
there is at least a reasonable possibility that it has
incurred a loss.
 Certain loss contingencies, where the possibility of loss
is only remote, are also disclosed in the notes to a
company’s financial statements.
 Direct and indirect guarantees of indebtedness of
others
 Obligations of commercial banks under “standby
letters of credit”
 Guarantees to repurchase receivables that have
been sold or otherwise assigned
 49

Disclosure of Gain Contingencies

GAAP 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.
 50

Executory Contracts
An executory contract is a contract in which two
parties agree to a future exchange of resources or
services, but neither party has performed any of
its responsibilities.
 Unused line of credit
 Purchase commitment
 Agreement to pay future compensation
 Contract for having a factory built
 51

Financial Statement Presentation of Current Liabilities

 The guidelines suggest that a company should

arrange its current liabilities in a way that will
highlight their liquidity characteristics and
their effect on its financial flexibility.
 Most companies report current liabilities at the
top of the Liabilities classification. Items within
the current liability section typically may be
listed (1) in the order of their average length of
maturity, (2) according to amount, or (3) in the
order of liquidation preference.
 52

Financial Statement Presentation of Current Liabilities

A popular way of presenting these items is as

follows:
 Accounts payable
 Notes payable
 Accrued liability items
 Unearned revenue items
 Other current liabilities
 53

IFRS vs. U.S. GAAP

 IFRS deal with loss contingencies but refer to
them as provisions.
 A company is required to recognize a provision
when it has a present obligation as a result of a
past event, when it is probable that the
company will have a future outflow of
resources to settle the obligation, and when it
can make a reliable estimate of the amount.
 54

IFRS vs. U.S. GAAP

 IFRS require a company to measure the
provision at the settlement price on the balance
sheet date using present value techniques
whenever the effect of the measurement of the
liability is material.
 If a range of estimates exist and no amount in
the range is more likely than any other amount
in the range, IFRS require the mid-point of the
range be used to measure the liability. Under
U.S. GAAP, the minimum amount of the range
is used in such a situation.
 55

Short-Term Debt Expected to Be Refinanced

AAcompany
companymay mayreclassify
reclassifyits
itscurrent
current
liabilities
liabilitiesto
tolong-term
long-termtotoimprove
improveits its
working
workingcapital
capitaland
andcurrent
currentratio.
ratio.
 56

Conditions for Reclassifying Short-Term as Long-Term Liabilities

Short-term obligations are excluded from a

company’s current liabilities if two conditions are
met:
1. The company intends to refinance the
obligation on a long-term basis.
2. The company can demonstrate the ability to
consummate the refinancing.
 57

Conditions for Reclassifying Short-Term as Long-Term Liabilities

The ability to refinance must be demonstrated

by the fact that the company:
1. Has issued long-term obligations or equity
securities after the date of its balance sheet but
before it issues its balance sheet
2. Has entered into a bona fide long-term
financing agreement before it issues its balance
sheet that clearly permits the company to
refinance the short-term obligations on a long-
term basis.
 58

Chapter 13

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