Chapter 12: Current Liabilities

Why is info about current liabilities important?

Investors and creditors are interested in a company's liquidity, which is the ability of a company to pay its current liabilities on time.

liability

when you owe money to another party

requirements for a liability to be recorded:

Probable future sacrifices of economic benefits (cash, goods, services).

Arises from present obligation (it is unavoidable).

The present obligation arises from a past transaction or event (occurred in the past)

current liabilities

the obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities.

Current liabilities include:

Payables resulting from the acquisition of goods and services, such as accounts payable, wages payable, taxes payable, and so on.

Collections received in advance for the delivery of goods or performance of services, such as unearned rent revenue or unearned subscriptions revenue.

Other liabilities whose liquidation will take place within the operating cycle, such as the portion of long-term bonds to be paid in the current period or short-term obligations arising from the purchase of equipment or other assets.

Accounts Payable

balances owed to others for goods, supplies, or services purchased on open account

- arise because of the time lag between the receipt of services or acquisition of assets and the payment for them

Notes Payable

written promises to pay a certain sum of money on a specified future date. They may arise from purchases, financing, or other transactions

- short term or long term depending on due date

zero-interest-bearing note

does not explicitly state an interest rate on the face of the note

- INTEREST IS STILL CHARGED

- The present value equals the face value of the note at maturity minus the interest or discount charged by the lender for the term of the note. In essence, the bank takes its fee "upfront" rather than on the date the note matures.

Discount on Notes Payable

A contra liability that represents interest deducted from a loan in advance

Is sales tax an expense for the customer or a retailer from a purchased item?

CUSTOMER

- retailer has to credit payable until amount is received from customer so the retailer can pay the government

Marshal Co.'s Sales Revenue account balance of $150,000 includes sales taxes of 4%.

QUESTION: What is the entry to record sales taxes payable?

DR Sales Revenue 5,769.23

CR Sales Taxes Payable 5,769.23

150000/1.04

what are taxable entities?

corporations

- NOT proprietorships and partnerships

Why are partnerships and proprietorships not taxable entities

the individual proprietor and the members of a partnership are subject to personal income taxes on their share of the business's taxable income, income tax liabilities do not appear on the financial statements of proprietorships and partnerships.

what are some current liabilities that a company may report?

Payroll deductions.

Compensated absences.

Bonuses.

contingency

an existing condition, situation, or set of circumstances involving uncertainty as to possible loss or gain to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur

loss contingencies

involve possible losses

contingent liability

a liability incurred as a result of a loss contingency

terms associated with the likelihood of future events or events will confirm the incurrence of a liability

The FASB uses the terms probable, reasonably possible, and remote.

probable

The future event or events are likely to occur.

reasonably possible

The chance of the future event or events occurring is more than remote but less than likely.

remote

The chance of the future event or events occurring is slight.

companies should accrue an estimated loss from a loss contingency ONLY IF

Information available prior to the issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements.

The amount of the loss can be reasonably estimated.

loss contingencies that are usually accrued

Obligations related to product warranties and product defects.

Premiums offered to customers.

loss contingencies that are not accrued

Risk of loss or damage of enterprise property by fire, explosion, or other hazards.

General or unspecified business risks.

loss contingencies that may be accrued

Threat of expropriation of assets.

Pending or threatened litigation.

Actual or possible claims and assessments.**

Guarantees of indebtedness of others.

Agreements to repurchase receivables (or the related property) that have been sold.

when recording a liability on a contingency loss a company must know...

whether it is probable that it incurred a liability

expropriation

occurs when a government claims privately owned property against the wishes of its owners

common loss contingencies:

Litigation, claims, and assessments.

Guarantee and warranty costs.

Consideration payable (e.g., premiums and coupons).

when do you determine whether to record a liability with respect to pending or threatened litigation and actual or possible claims and assessments?

The time period in which the underlying cause of action occurred.

The probability of an unfavorable outcome.

The ability to make a reasonable estimate of the amount of loss.

Requirements to report a loss and a liability in the financial statements are:

the cause for litigation must have occurred on or before the date of the financial statements

With respect to unfiled suits and unasserted claims and assessments, a company must determine:

The degree of probability that a suit may be filed or a claim or assessment may be asserted.

The probability of an unfavorable outcome.

warranty

a promise made by a seller to a buyer to make good on a deficiency of quantity, quality, or performance in a product

assurance-type warranty

Warranty that the product meets agreed-upon specifications in the contract at the time the product is sold. This type of warranty is included in the sales price of a company's product.

service-type warranty

Warranty that provides an additional service beyond the assurance-type warranty. This warranty is not included in the sales price of the product

When are assurance-type warranties expensed?

in the period the goods are provided or services performed. In addition, the company should record a warranty liability. The estimated amount of the liability includes all the costs that the company will incur in the future due to the correction of defects or deficiencies required under the warranty provisions

how is a service-type warranty usually recorded?

Unearned Warranty Revenue account.

Companies then recognize revenue on a straight-line basis over the period the service-type warranty is in effect.

consideration payable

may reflect discounts, volume rebates, free products, or services

- printed coupons are also popular

- cash rebates

How do companies reflect existing current liability in premium offers outstanding?

the company estimates the number of outstanding premium offers that customers will present for redemption

the company then charges the cost of premium offers to Premium Expense. It credits the outstanding obligations to Premium Liability

gain contingencies

claim or rights to receive assets (or have a liability reduced) whose existence is uncertain but which may become valid eventually

typical gain contingencies

Possible receipts of monies from gifts, donations, and asset sales.

Possible refunds from the government in tax disputes.

Pending court cases with a probable favorable outcome.

do companies report gain contingencies?

they do not

disclosure of gain contingency

A company discloses gain contingencies in the notes only when a high probability exists for realizing them.

It is unusual to find information about contingent gains in the financial statements and the accompanying notes.

in the financial statements, current liabilities...

Are usually reported in financial statements at their full maturity value.

May be listed in the financial statements in order of maturity, in order of amount, or in order of liquidation preference.

Are usually presented as the first classification in the liabilities and stockholders' equity section of the balance sheet.

current maturities of long term debt

should be classified as current liabilities

when do you exclude long-term debts maturing currently from current liabilities?

Retired by assets accumulated for this purpose that properly have not been shown as current assets.

Refinanced, or retired from the proceeds of a new debt issue.

Converted into capital stock.

callable loan

a loan that the lender will or may demand to be repaid prior to the maturity date

why are some loans callable?

if there is a violation of the debt agreement

- violating a certain defined level of equity to debt ratio

short term obligations

debts scheduled to mature within one year after the date of a company's balance sheet or within its operating cycle, whichever is longer

criteria for which short term obligations may be properly excluded from current liabilities

The company must intend to refinance the obligation on a long-term basis.

The company must demonstrate an ability to consummate the refinancing.

refinancing

The process of paying off one loan with the proceeds from a new loan secured by the same property.

how do you demonstrate the ability to consummate the financing?

Actually refinancing the short-term obligation by issuing a long-term obligation or equity securities after the date of the balance sheet but before it is issued.

Entering into a financing agreement that clearly permits the company to refinance the debt on a long-term basis on terms that are readily determinable.

current ratio

current assets divided by current liabilities

- shows how many times the current assets can cover, or be used to extinguish current liabilities

most common types of current assets?

cash, short-term investments, A/R, inventory, prepaid expenses

what are potential issues with the current ratio formula?

it does not reflect how difficult it may be to convert some current assets into cash to pay current liabilities

Acid-Test Ratio

(cash + S-T Inv. + A/R) / (Current Liabilities)

Why use the Acid-Test Ratio?

it excludes all inventories and prepaid expenses, which cannot be easily converted into cash

this then provides us with a more accurate ratio in comparison to the current ratio formula

asset retirement obligations

obligations associated with the disposition of an operational asset.

- a liability account

accretion expense

a periodic expense recognized when updating the present value of a balance sheet liability

examples of existing legal obligations that require recognition of an ARO

Decommissioning of nuclear facilities.

Dismantling, restoring, and reclaiming of oil and gas properties.

Certain closure, reclamation, and removal costs of mining facilities.

Closure and post-closure costs of landfills.