ACC 319 Chapter 12

Maloy, Creighton University

liability

possible future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events

current liability (in fact/theory)

a liability that will be paid with current assets or replaced with another current liability

current liability (in most cases)

liabilities that are due within one year or operating cycle, whichever is longer

measurement of a current liability with an original maturity of 1 year or less

recorded at face value, interest is included in the amount

measurement of a current liability with an original maturity of more than 1 year

recorded at present value with the use of a market interest rate that is either computed or imputed

where do current liabilities appear on the balance sheet?

• listed before long-term liabilities

• shown as a group

• no strict rule on order of accounts

what are some ways that current liability accounts could be ordered on the balance sheet?

companies may order by:

• maturity (soonest first)

• size (largest first)

• liquidation priority

what items are classified as a current liability?

• accounts payable

• notes payable

• current maturity of long-term debt

• mortgage notes payable

• dividends payable

• advances from customers

• accrued liabilities

• sales tax

• wage and payroll-related taxes

• advance sales of tickets, tokens, or gift certificates

• guarantees and warranties

• premiums, consideration payable, and rebates

• contingencies

trade payable

another name for accounts payable; an account used specifically to record the purchase of merchandise inventory on account

accounts payable

an account used to record operating expenses purchased on account from external suppliers or creditors (non-trade)

how is accounts payable recorded?

• A/P is always shown at gross amount

  • this applies even if the net method is used for accounting for purchases

if companies show accounts payable at its net amount, how is this justified?

materiality

trade notes payable

note payable that is created when purchasing merchandise inventory and a formal legal instrument document is used

how is notes payable recorded (in theory)?

all are recorded at present value using the market interest rate, regardless of their original maturities

*market interest rate used is the one at the time of issuance

when are liabilities required to be recorded at present value?

their original maturity > 1 year

does GAAP have a mandate on how current liabilities should be ordered?

no

when are notes payable recorded at present value?

only when:

• original maturity > 1 year

• issued in a non-cash transaction

• stated interest rate is “clearly unreasonable”

what is the required amortization method for discounts/premiums on notes payable?

effective-interest rate method

how is the effective-interest-rate amortization schedule prepared if a note payable is non-interest-bearing?

in the normal manner, but the “cash interest payment” column is always $0

if companies use the straight-line method of amortizing discounts/premiums on notes payable, how do they justify it?

materiality

in what scenarios do companies justify modifications of GAAP with “materiality”?

• showing accounts payable at net amount

• recording notes that are short-term at face value

• using straight-line method of amortizing a discount/premium on notes payable

• use of cash method of accounting for warranties

• netting debit balance liabilities with other liabilities

entry to record issuance of a note

Db. Cash [Land, Machinery, etc,]

Cr. Notes Payable

*balance with “Discount on N/P” or “Premium on N/P” if needed

entry to record payment of interest on a note (interest has not been accrued previously)

Db. Interest Expense

Cr. Cash

entry to record payment of interest on a note (interest has been accrued previously)

Db. Interest Expense

Db. Interest Payable

Cr. Cash

entry to record accrual of interest on a note

Db. Interest Expense [principal x interest rate x time]

Cr. Interest Payable

entry to record amortization of discount on notes payable

Db. Interest Expense

Cr. Discount on Notes Payable

entry to record amortization of premium on notes payable

Db. Premium on Notes Payable

Cr. Interest Expense

entry to record payment of interest and principal on a note

Db. Interest Expense

Db. Interest Payable [if previously accrued]

Db. Notes Payable

Cr. Cash

the effective-interest-rate method for N/P combines _________ and _______ into one entry

payment/accrual of interest; amortization of discount/premium

what are examples of current maturities of long-term debt?

• bonds payable

• capital leases

• mortgage notes payable

how is the portion of a mortgage N/P that is classified as current determinded?

by looking at the mortgage note effective-interest-rate amortization schedule

what portions of long-term debt can be classified as a current liability?

portions due within:

• 1 year, or

• 1 operating cycle

(whichever is longer)

how are current maturities of long-term debt presented on the balance sheet?

the liability and any related discount/premium are transferred to the current liability section

how is mortgage notes payable calculated and recorded?

1. make a present value computation and make an entry from it

2. make an effective-interest-rate amortization schedule

3. make entries using the schedule

entry to record issuance of mortgage note

Db. Assets(s) Acquired [Land, Building, etc.]

Cr. Mortgage Note Payable [for face value of note]

Cr. Cash [for amount of down payment]

table headings for mortgage note effective-interest-rate amortization schedule (left → right)

• date

• mortgage payment

• interest expense

• reduction in principal → shows amount to be reported on B/S as a current liability

• book value of mortgage note

what is included as part of dividends payable?

• cash dividends

• scrip dividends

scrip dividends

a type of dividend that gives the shareholder a choice between a cash dividend or the equivalent in additional shares

what type of dividends payable could be a long-term liability, in rare cases?

scrip dividends

what is excluded from dividends payable?

stock dividends → reported as part of legal capital

advances from customers (deferred revenue)

an account for goods or services that will be provided to customers at a later date

what are some common account titles for advances from customers?

• unearned rent revenue

• unearned commissions revenue

• liability for prepaid advertising services

when do advances to customers become earned revenue?

when the goods or services have been provided to the customers (performance obligation satisfied)

accrued liabilities

an account for operating expenses that have been incurred but will be paid at a later date

common examples of accrued liabilities

• rent payable

• salaries payable

• property taxes payable

income taxes payable

a type of accrued liability, an account that applies only to “C” corporations for income earned

why is the income taxes payable account only used by “C” corporations?

other entities’ income is reported by owners on their personal tax returns

entry to record sale of goods (sales tax is segregated (recorded) @ sale)

Db. Cash / Accounts Receivable [full amount of transaction]

Cr. Sales Revenue [amount of sale itself]

Cr. Sales Tax Payable [amount of sales tax collected]

adjusting entry related to sales tax payable (recorded “sales tax payable” is greater than it should be and sales tax is segregated (recorded) @ sale)

Db. Sales Tax Payable

Cr. Gain from Sales Tax Adjustment

adjusting entry related to sales tax payable (recorded “sales tax payable” is less than it should be and sales tax is segregated (recorded) @ sale)

Db. Loss from Sales Tax Adjustment

Cr. Sales Tax Payable

entry to record sale of goods (sales tax is not segregated (recorded) @ sale)

Db. Cash / Accounts Receivable [full amount of transaction]

Cr. Sales Revenue [full amount of transaction]

adjusting entry related to sales tax payable (sales tax is not segregated (recorded) @ sale)

Db. Sales Revenue

Cr. Sales Tax Payable

[(recorded sales = x + (sales tax rate)x)]

→ solve for x and subtract from recorded sales to find sales tax

what are the types of employee tax withholdings?

• federal income tax

• state income tax

• Federal Insurance Contributions Act (FICA ) → consists of:

  • Social Security

  • Medicare

• non-tax payroll deductions

how is federal income tax withholding computed?

from a tax table, which uses a progressive rate

what is an individual’s federal tax rate based on?

• the number of dependents claimed on their W-4

• the amount of gross earnings for the current pay period

• the pay period (ex. weekly, monthly, etc.)

• their filing status

how is state income tax withholding computed?

in the same manner that federal withholding is computed

how are Social Security taxes computed?

a fixed rate (6.2%) x employee’s gross earnings for the current pay period (max. upper limit)

taxes that have an upper limit result in a _______ tax rate

regressive

how are Medicare taxes computed?

a fixed rate (1.45%) x employee’s gross earnings for the current period

(additional 0.9% Medicare tax for employees whose gross earnings exceed a certain earnings level)

which portion of FICA taxes has a yearly upper limit?

Social Security

entry to record employee payroll expenses (made by employer)

Db. Salaries Expense

Cr. Withholding Payables

Cr. Salaries Payable / Cash

what are some examples of non-tax payroll deductions?

• insurance or benefit premiums

• pension or retirement plan contributions

• union dues

• charitable contributions

what are the types of employer tax withholdings?

• FICA

• Federal Unemployment Tax Act (FUTA)

• State Unemployment Tax Act (SUTA)

• employer contributions for the benefit of employees

how is the amount of FICA tax paid by an employer determined?

the amount paid matches each employee’s required payment for both Social Security and Medicare

how is FUTA tax computed?

[a fixed unemployment rate (6%) - a credit given by the gov. (usually 5.4%)] x employee’s gross earnings for the current period (max. upper limit for each employee)

how is SUTA tax computed?

an assigned fixed state rate x employee’s gross earnings for the current period (max. upper limit that varies by state)

how is the state rate for SUTA tax determined and assigned to entities?

rate is based on the category and entity falls into:

• newer companies → lower rate

• assigned based on historical benefit claims by companies within the same industry

what are some examples of employer contributions for the benefit of employees?

contributions for employee’s…

• union

• retirement or pension plan

• insurance plans

entry to record employer payroll expenses

Db. Payroll Tax Expense

Db. Benefits Expense

Cr. Payroll Tax Payables

entry to record the sale of tickets, tokens, or gift certificates

Db. Cash

Cr. Deferred Revenue

entry to record the redemption of tickets, tokens, or gift certificates by customers

Db. Deferred Revenue

Cr. Revenue

adjusting entry for tickets, tokens, and gift cards to estimate the amount that will never be redeemed

Db. Deferred Revenue

Cr. Gain from Non-Redemption of Tickets/Tokens/Gift Certificates

entries to record the sale of a warranted item

Db. Cash/Accounts Receivable

Cr. Sales Revenue

Db. Warranty Expense [for estimated cost of fulfilling the warranty on items sold @ the current time]

Cr. Estimated Liability for Warranties

entry to record the incurrence of warranty costs (customers presenting warranties for fulfillment)

Db. Estimated Liability for Warranties

Cr. Misc. Accounts [ex. Cash, Inventory of Parts, Service Fees Payable]

how do companies who use the cash method of accounting for warranties justify it?

materiality

cash method of accounting for warranties

warranty expenses are only recorded when warranty costs are incurred

entry to record acquisition of premium gift items

Db. Premium Inventory

Cr. Cash/Payable

entry to record sale of items with a premium offer

Db. Cash/Accounts Receivable

Cr. Sales Revenue

entry to record customers’ redemption of premiums

Db. Cash [amount received from customer]

Db. Premium Expense [for net cost of providing premium gift to customer]

Cr. Premium Inventory [for the cost of premium gifts distributed to customers]

Cr. Postage Payable/Cash [for the cost of mailing premium gift to customers]

*entry could have less or more accounts depending on circumstances

adjusting entry related to premiums

Db. Premium Expense [for estimated number of premium claims that will be made in the future]

Cr. Estimated Liability for Premium Offer

when can companies classify current liabilities as long-term?

• must intend to refinance with a long-term liability

• must demonstrate its ability to refinance the liability by…

  • having already done it by the financial statement date

  • having signed a firm financing agreement by the financial statement date

what are the criteria related to a firm financing agreement for refinancing long-term liabilities?

• agreement must be noncancelable to all parties

• company cannot be in violation of any conditions of the agreement at the balance sheet date

• lender/investor must be considered financially capable of honoring the agreement

criteria for determining the reported amount of a liability that is refinanced as long-term

the amount is…

• not in excess of the amount in the financing agreement

• adjusted for any limitations or restrictions in the agreement

• not in excess of a reasonable estimate of the minimum amount that will be available through financing to retire it

does refinancing a current liability with the issuance of equity securities affect its classification?

no

what are the required disclosures related to financing agreements?

disclosures should include:

• a general description of the financing agreement

• the terms of the new obligation incurred

• the terms of any equity security issued if applicable

contingent receivables

if certain criteria are met, company receives money and will realize a gain

contingent liabilities

if certain criteria are met, company has to pay money and will realize a loss

when are gain contingencies recorded?

never

when are loss contingencies recorded?

only if:

• loss is probable

• loss can be easily estimated

how is the recording of loss contingencies handled if the reasonable estimate is a range?

• if there is a “best estimate” → “best estimate” is recorded as a loss/liability

• no “best estimate” → minimum number in the range is recorded as a loss/liability

*in both cases, the range is disclosed

how are losses from a lawsuit recorded?

loss does not have to be recorded even if probable and reasonable estimateable, if doing so would damage the company’s legal position

how are gains/losses from lawsuits filed in a prior year and settled in the current reported?

as a gain/loss on the current period income statement (cannot be reported as a prior period adjustment)

required disclosures relating to contingencies

• the nature of the contingency

• an estimate of the range of possible gains and losses

• no estimate of the probability of occurrence

if a contingent loss is probable but cannot be reasonably estimated, is it disclosed?

yes

if a contingent loss is not probable, is it disclosed?

disclosure is determined based on the magnitude of the loss

how are liabilities with a debit balance recorded? (in theory)

as receivables

how are liabilities with a debit balance recorded? (in practice)

they are netted with other liabilities

how do companies justify netting debit balance liabilities with other liabilities?

materiality

current ratio

current assets / current liabilities

• type: liquidity ratio

• measured in: a single number

working capital ratio

current assets - current liabilities

• type: liquidity ratio

• measured in: currency