Financial Accounting Current Liabilities Chapter 8 Spiceland Thomas

Financial Accounting Current Liabilities Chapter 8 Spiceland | Thomas | Herrmann Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -2 Learning Objectives • Distinguish between current and long-term liabilities • Account for notes payable and interest expense • Account for employee and employer payroll liabilities • Explain the accounting for other current liabilities • Apply the appropriate accounting treatment for contingencies • Assess liquidity using current liability ratios Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -3 Part A Current Liabilities Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -4 Current Liabilities • Liability: a present responsibility to sacrifice assets in the future due to a transaction or other event that happened in the past Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -5 Learning Objective 1 Distinguish between current and long-term liabilities Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -6 Current vs. Long-Term Liabilities Current • Payable within one year or an operating cycle Long-Term • Payable more than one year or an operating cycle Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -7 Learning Objective 2 Account for notes payable and interest expense Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -8 Notes Payable • Note signed by a firm promising to repay the amount borrowed plus interest • Interest on notes is calculated as: Interest = Face value Annual × interest rate × Fraction of the year Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -9 Recording Notes Payable Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

Recording Interest Payable and Repayment of Notes Payable • Interest payable • Repayment of note Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 8 -10

Notes Payable Recorded as Notes Receivable for Lender Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 8 -11

8 -12 Line of Credit & Commercial Paper • Line of credit: • Informal agreement • Permits a company to borrow up to a prearranged limit • No formal loan procedures and paperwork • Commercial paper: • Company borrows from another company rather than from a bank • Sold with maturities normally ranging from 30 to 270 days • Interest rate is usually lower than on a bank loan Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -13 Accounts Payable • Amounts owed to suppliers of merchandise or services • Sometimes called trade accounts payable Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -14 Learning Objective 3 Account for employee and employer payroll liabilities Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

Illustration 8. 3—Payroll Costs for Employees and Employers Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 8 -15

8 -16 Employee Costs • Federal and state income taxes • FICA taxes • 7. 65% (6. 2% + 1. 45%) • Collectively, Social Security and Medicare taxes • Employees may opt to have additional amounts withheld from their paychecks • Employer records the amounts deducted and pays them to the appropriate organizations Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -17 Employer Costs • Additional (matching) FICA tax on behalf of the employee • Employers also pay federal and state unemployment taxes on behalf of its employees • FUTA and SUTA • Fringe benefits: Additional employee benefits paid for by the employer Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -18 Illustration 8. 4—Payroll Example Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

Recording Fringe Benefits and Employer Payroll Taxes • Recording employer-provided fringe benefits • Recording employer payroll taxes Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 8 -19

8 -20 Learning Objective 4 Explain the accounting for other current liabilities Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -21 Other Current Liabilities • Unearned revenues: liability account used to record cash received in advance of the sale or service • Sales tax payable: collected from customers by the seller • Current portion of long-term debt: debt that will be paid within the next year Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -22 Example—Unearned Revenues Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -23 Example—Sales Tax Payable Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -24 Current Portion of Long-Term Debt • Debt that will be paid within the next year • Provides information about a company’s bankruptcy risk Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

Illustration 8. 6—Current Portion of Long-Term Debt Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 8 -25

8 -26 Part B Contingencies Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -27 Learning Objective 5 Apply the appropriate accounting treatment for contingencies Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -28 Contingent Liabilities • An existing uncertain situation that might result in a loss Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

Illustration 8. 8—Accounting Treatment of Contingent Liabilities Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 8 -29

8 -30 Warranties • Most common example of contingent liabilities • Help increase sales • Warranty expense is recorded in the same accounting period as the sale • It should be probable and the amount can be reasonably estimated Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -31 Accounting Warranties Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -32 Contingent Gains • An existing uncertain situation that might result in a gain • Not recorded until the gain is certain • Conservative reasoning • Not recorded in the accounts • Firms sometimes disclose them in notes to the financial statements Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -33 Learning Objective 6 Assess liquidity using current liability ratios Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -34 Liquidity Analysis • Liquidity: refers to having sufficient cash or other current assets to pay currently maturing debts • Lack of liquidity can result in financial difficulties or even bankruptcy • Three liquidity measures: • Working capital • Current ratio • Acid-test ratio Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -35 Working Capital • A large positive working capital is an indicator of liquidity • Not the best measure of liquidity for comparison Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -36 Current Ratio • Ratio of 1 or higher often reflects an acceptable level of liquidity • Higher the current ratio, the greater the company’s liquidity Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -37 Acid-Test Ratio or Quick Ratio • Based on a more conservative measure • Quick assets are readily convertible into cash Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

Effect of Transactions on Current Ratio and Acid-Test Ratio • Same denominator: current liabilities • Decrease in current liabilities will increase the ratios • Increase in current liabilities will decrease the ratios • Different numerator: current assets; quick assets • Increase in cash, current investments, and accounts receivable will increase both ratios • Increase to inventory or other current assets will increase the current ratio, but not the acid-test ratio Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 8 -38

8 -39 Liquidity Management • Management can influence the ratios that measure liquidity • Debt covenant: agreement between a borrower and a lender that requires certain minimum financial measures be met or the lender can recall the debt Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

8 -40 End of Chapter 8 Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.