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 2

Liabilities n n 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 and Contigencies 3

Current Liabilities n Examples of current liabilities with definite amount as a result of a business transaction: u A/P (accounts payable) u N/P (notes payable including commercial paper issued) u Current maturity portion of a long-term debt u Sales taxes payable u Accrued liabilities u Payroll taxes withholdings Current Liabilities and Contigencies 4

Sales Taxes Payable Sales taxes are taxes levied by states on retail sales, not on manufacturers (i. e. , GE, GM, etc). n Every state, except Alaska, Delaware, Montana, New Hampshire, and Oregon, levies state sales taxes on retail sales. n n 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 5

Sales Taxes Payable (contd. ) n n 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. Current and Long-Term Liabilities 6

Example n Assume that the 12/22/x 9 sales of Macy’s in California totaled $2, 000. The state tax rate is 8. 25%. The business would record the day’s sales as follows: Cash 2, 165, 000 Sales Revenue 2, 000 Sales Taxes Payable 165, 000 Current and Long-Term Liabilities 7

Accrued Liabilities n 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…) Current Liabilities and Contigencies 8

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 Current taxable). Liabilities and Contigencies 9

Employee Related Liabilities (contd. ) n 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%. Current Liabilities and Contigencies 10

Other Current Liabilities n n n Refundable Deposits Cash Refund Deposit Liabilities xxx Dividends Payable Unearned Revenue Current Liabilities and Contigencies 11

Estimated Liabilities n Liabilities exist but the amount is unknown: A. Property taxes B. Warranty obligations C. Coupon and premium obligations D. Compensated absences E. Environmental liabilities Current Liabilities and Contigencies 12

A. Property Taxes n n 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. Current Liabilities and Contigencies 13

A. Property Taxes (contd. ) n n Also, the property taxes expenses should be allocated over the fiscal year of the local government (i. e. , 7/1/x 1 ~ 6/30/x 2). 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). Current Liabilities and Contigencies 14

Example The fiscal year of the local government => 7/1/x 8 - 6/31/x 9 The property tax becomes a lien on the property on => 7/1/x 8 Estimated property tax expenses (for 7/1/x 8 6/30/x 9) =>$12, 000 Tax bill received on => 10/29/x 8 Actual tax expense => $13, 800 Tax paid on =>11/30/x 8 Current Liabilities and Contigencies 15

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

Prepare journal entries regarding the property tax for the period of 7/1/x 8 - 6/30/x 9: (contd. ) 11/30/x 8 P/T Payable Prepaid P/T Cash P/T Expense Prepaid P/T 12/31/x 8 P/T Exp Prepaid P/T 4, 200 9, 600 13, 800 1, 200 : : 6/30/x 9 P/T Exp 1, 200 Prepaid P/T Current Liabilities and Contigencies 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) Current Liabilities and Contigencies 18

1. Cash Basis (for tax filing) (Not Acceptable for Financial Reporting Purpose) n Warranty expenses are recognized when these expenses are paid for (violating the matching principle) Journal Entry: Warranty Exp Cash (only for I/T filling) n xxx Current Liabilities and Contigencies 19

2. Expense Warranty Using Accrued Method (for financial Reporting Purposes) n Estimate the warranty exp. associated with the sales (of the period) at the end of the period and recognize it. Current Liabilities and Contigencies 20

2. Expense Warranty Using Accrued Method (contd. ) n Journal Entry: Warranty Expenses xxx Estimated Warranty Liabilities When warranty services provided: Estimated warranty liabilities xxx Cash (or Inventory) xxx If the estimated warranty liabilities are not enough to cover the current year’s warranty services, treat it as a change in accounting estimates (i. e. , no retroactive effect). Current Liabilities and Contigencies 21

Example The estimated warranty liabilities account has an ending balance of $2, 000 before the following year end adjustment: 12/31/x 2 Warranty Expenses 3, 000 Estimated Warranty Liability 3, 000 During 20 x 3, the actual warranty expenses amounted to $5, 800. 20 x 3: Estimated warranty liability 5, 000 * Warranty Expenses 800 Cash (or Inventory) 5, 800 Current Liabilities and Contigencies 22

C. Premiums and Coupons Obligations n n 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 Current Liabilities and Contigencies xxx 23

C. Premiums and Coupons Obligations (contd. ) n 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. Current Liabilities and Contigencies 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. Employee’s 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. Current Liabilities and Contigencies 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. Current Liabilities and Contigencies 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 Current Liabilities and Contigencies 27

Recognition and Allocation of ARO (contd. ) The accrued interest of ARO should be recognized periodically (assuming 10% interest): 12/31/2002 Interest expense (10% x 50, 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 Current Liabilities and Contigencies 78, 000 2, 525 28

Contingencies u Contingent Liabilities u Contingent Losses u Contingent Gains Current Liabilities and Contigencies 29

Contingent Liabilities n Obligations may arise because of the occurrence or not occurrence of future event(s). (i. e. , warranty obligations) Current Liabilities and Contigencies 30

Contingent Liabilities n Liabilities may arise because of the occurrence or not occurrence of future event(s). (i. e. , guarantee and warranty costs, litigation and claims, premiums and coupons, environment al liabilities, etc. ) Current Liabilities and Contigencies 31

Contingent Gains n Gains may arise because of the occurrence or not occurrence of future events). (i. e. , pending lawsuit gains) Current Liabilities and Contigencies 32

Accounting Treatments of Contingencies n 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 Current Liabilities and Contigencies 33

Accounting Treatments of Contingencies (contd. ) n 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). Current Liabilities and Contigencies 34

Accounting Treatments of Contingencies (contd. ) n Examples: Warranty Expense xxx Estimated Warranty Liabilities xxx Lawsuit Expenses xxx Estimate Liability under litigation Current Liabilities and Contigencies xxx 35

Accounting Treatments of Contingencies (contd. ) n n 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: u 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!!!) Current Liabilities and Contigencies 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. Current Liabilities and Contigencies 37