Chapter 9

Liability

a proable future payment of assets or services that a company is presently obligated to make as a result of past transactions or events.

Characterstics/elements of a liability

• due to a past transactions or event…

• company has a present obligation

• …for future payment of assets or services.

NO liability is reported when one or more of those elements are missing.

Liabilities are classified as either

current liabilities or long-term liabilities

Curent liabilities, or Short-Term Liabilities

liabilities due within one year (or the company’s operating cycle if longer). most are paid using current assets or creating other current liabilities. (common examples: accounts payable, short-term notes payable, wages payable, warranty liabilities, and taxes payable.)

Long-term Liabilities

obligations due after one year (or the company’s operating cycle if longer). (common examples: long-term notes payable, warranty liabilities, lease liabilities, and bonds payable.)

What questions do you have to answer to account for liabilities?

Whom to pay? When to pay? How much to pay?

Uncertainty to Whom to Pay?

liabilities can involve uncertainty in whom to pay. for example, a company can create a liability with a known amount when issuing a note that is payable to its holder. in this case a specified amount is payable to the note’s holder at a specified date, but the company does not know who the holder is until that date. despite this uncertainty, the company reports this liability on its balance sheet.

Uncertainty in When to Pay?

a company can have an obligation of a specific amount to a known creditor but not know when it must be paid. for example, a law firm can accept fees in advance from a cilent who plans to use the firm’s services in the future. the law firm has a liability (unearned revenue) that it settles by providing services at an unknown future date. although uncertainty exists, the law firm’s balance sheet must report this liability. these type of obligations are reported as current liabilities because they are likely to be settled in the short term.

Uncertainty in How Much in Pay?

a company can be aware of an obligation but not know how much it will be required to pay. for example, a company using electrical power is billed only after the meter has been read. this cost is incurred and the liability created before a bill is received. a liability to the power company is reported as an estimated amount if the balance sheet is prepared before a bill arrives.

Known Liabilities

measurable obligations arising from agreements, contracts, or laws. known liabilities include accounts payable, notes payable, payroll obligations, sales taxes, and unearned revenues.

Accounts Payable

amounts owed to suppliers for products or services purchased on credit. they are a focus of merchandising chapter.

Sales Taxes Payable

nearly all states and many cities levy taxes on retail sales. sales taxes are shown as a percent of selling prices. the seller collects sales taxes from customers when sales occur and send these collections to the government. because sellers currently owe these collections to the government, this amount is a current liability.

How to record Sales Taxes Payable:

if Home Depot sells materials on august 31 for $6,000 cash that are subject to a 5% sales tax, the revenue portion of this transaction is recorded as follows.

Aug. 31 Cash 6,300

. Sales 6,000

. Sales Taxes Payable ($6,000 × 0.05) 300

record cash sales and 5% sales tax

*we also Dr. Cost of Sales and Cr. Inventory for cost of sale.

later, when Home Depot sends the $300 collected to the government, it debits sales taxes payable and credits cash.

Unearned revenues, or deferred revenues

amounts received in advance from customer for future products or services. unearned revenues arise with airline ticket sales, magazine subscription, construction projects, hotel reservations, gift card sales, and custom-orders.

advance ticket sales for sporting events or concerts are other examples.

How to record unearned revenues:

if Kumi Koda sells $900,000 in tickets for three concerts, this transaction is recorded as follows,

June 30. Cash 900,000

. Unearned Ticket Revenue 900,000

record sale of tickets for three concerts.

If Kumi Koda completes one concert, 1/3 of the liability is satisfied and 1/3 of the revenue is recorded.

Oct. 31. Unearned Ticket Revenue 300,000

. Ticket Revenue 300,000

record concert revenues ($900,000 × 1/3).

Short-term note payable

written promise to pay a specific amount of a stated future date within one year. notes can be sold or transferred. most notes payable bear interest. the written documentation with notes is helpful in resolving legal disputes.

How to record notes given to extend credit period:

a company can replace an account payable with a notes payable. a common example is a creditor that requires an interest-bearing note for an overdue account payable.

assume that on august 23, Brady asks to extend its past-due $600 account payable to McGraw. after negotiations, McGraw agrees to accept $100 cash and a 60-day, 12%, $500 note payable to replace the account payable.

Aug. 23 Accounts Payable-McGraw 600

. Cash 100

. Notes Payable-McGraw 500

sent cash and a note for payment on account.

signing the note changes Brady’s debt from an account payable to a note payable. McGraw prefers the note payable over the account payable. because it earns interest and it is written documentation of the debt’s existence, term, and amount. when the note comes due on its maturity date, Brady pays the notes plus interest (called maturity value) to McGraw and records this entry:

Oct. 22 Notes Payable-McGraw 500

. Interest Expense 10

. Cash 510

paid notes with interest ($500 × 12% × 60/360).

Interest Expense

Principal of note × annual interest rate % × fraction of the year is outstanding

How to record notes given to borrow from bank:

a bank requires a borrower to sign a note when making a loan. when the note comes due, the borrower repays the note with an amount larger than the borrowed. the difference between the amount borrowed and the amount repaid is interest. the amount borrowed is called principal or face value of the note.

assume that a company borrows $2,000 from a bank at 12% interest. The loan is made on September 30, 2021, and is due in 60 days. The note says: “I promise to pay $2,000 plus interest at 12% within 60 days after september 30.”

the borrower records its receipt of cash and the new liability with this entry:

Sep. 30 Cash 2,000

. Notes Payable 2,000

borrow $2,000 cash with 60-day, 12%, $2,000 note.

when principal interest are paid, the borrower records payment with this entry:

Nov. 29 Notes Payable 2,000

. Interest Expense 40

. Cash 2,040

paid note with interest ($2,000 × 12% × 60/360).

How to record when a note extends over two periods:

when a note is issued in one period but paid in the next, interest expense is recorded in each period based on the number of days the note extends over each period.

assume a company borrows $2,000 cash on December 16, 2021, at 12% annual interest. this 60-day note matures on February 14, 2022, and the company’s fiscal year end on december 31. this means 15 of the 60 days are in 2021 and 45 of the 60 days are in 2022.

interest for these two periods is:

• 12/16/2021 to 12/31/2021 = 15 days. interest expense = $2,000 × 12% × 15/360 = $10.

• 01/01/2022 to 02/14/2022 = 45 days. interest expense = $2,000 × 12% × 45/360 = $30

the borrower records the 2021 expense with the following adjusting entry:

Dec. 31, 2021 Interest Expense 10

. Interest Payable 10

record accrued interest ($2,000 × 12% × 15/360).

when this note is paid on February 14, the borrower records 45 days of interest expense in 2022 and removes the balance of the two liability accounts.

Feb. 14, 2022 Interest Expense 30

. Interest Payable 10

. Notes Payable 2,000

. Cash 2,040

paid note with interest. *$2,000 × 12% × 45/360.

Payroll Liabilities

from salaries and wages, employee benefits, and payroll taxes levied on the employer.

for example, Boston beer reports current payroll liabilities of more than $14 million from accrued “employee wages, benefits and reimbursements.”

Gross Pay

the total compensation an employee earns including wages, salaries, commissions, bonuses, and any compensation earned before taxes.

Wages

payment to employees at an hourly rate.

Salaries

payments to employees at a monthly or yearly rate.

Net Pay, or take-home pay

gross pay minus all deductions

Payroll deductions, or withholdings

amounts withheld from an employee’s gross pay, either required or voluntary.

What do required deductions result from?

Laws and include income taxes and social security taxes.

What do voluntary deductions, at an employee’s option, include?

Pension and health contributions, health and life insurance premiums, union dues, and donations.

Are deductions at (some companies) required?

Deductions such as those for insurance coverage are under labor contract.

Payroll deductions substracted from Gross Pay?

minus federal Income tax, state and tax local income tax, voluntary deductions, fica taxes (medicare), fica taxes (social security). = Net pay

Employee FICA taxes

employers withhold federal insurance contributions act (FICA) taxes from employees’ pay. employer’s separate FICA taxes into two groups.

Two groups of FICA taxes

Social Security taxes and Medicare.

Social Security

withholdings to cover retirement, disability, and survivorship.

Medicare

withholdings to cover medical benefits.

Are taxes for social security and medicare are computed separately?

Yes.

Employee Income Tax

most employers withhold federal income tax from each employee’s paycheck. the amount withheld is computed using IRS tables. the amount depends on the employee’s income and the number of withholding allowances the employee claims. allowances reduce taxes owed to the government. employees can claim allowances for themselves and their dependents. until the government is paid, withholdings are reported as a current liability on the employer’s balance sheet.

Employee voluntary deductions

voluntary deductions witholdings come from employee requests, contracts, unions, or other agreements. they include charitable giving, medical and life insurance premiums, pension contributions, and union dues. until they are paid, voluntary withholdings are reported as part of employer’s current liabilties.

How to record employee payroll

employers accrue payroll expense and liabilities at the end of each pay period.

assume that an employee earns a salary of $2,000 per month. at the end of january, the employer’s entry to accrue payroll expenses and liabilities for this employee is:

Jan. 31

Salaries Expense 2000

. FICA-Social Security Taxes Payable(6.2%) 124

. FICA-Medicare Taxes Payable(1.5%) 29

. Employee Federal Income Taxes Payable 213

. Employee Medical Insurance Payable 85

. Employee Union Dues Payable 25

. Salaries Payable 1,524

record accrued payroll for january.

amounts taken from employer’s accounting records.

salaries expense shows that the employee earns a gross salary of $2,000. the first five payables show the liabilities the employer owes on behalf of this employee to cover FICA taxes, income taxes, medical insurance, and union dues. the salaries payable account records the $1,524 net pay the employee receives from the $2,000 gross pay earned.

the february 1 entry to record cash payment to this employee is:

Feb. 1. Salaries Payable 1,524

. Cash 1,524

record payment of payroll.

Employer payroll taxes

employees must pay payroll taxes in addition to those required of employees. employer taxes include FICA and unemployment taxes.

Employer FICA tax

employers must pay FICA taxes on their payroll. for 2020, the employer must pay social security tax of 6.2% on the first $137,700 earned by each employee and 1.45% medicare tax on all earnings of each employee. An employer’s tax is credited to the same FICA Taxes payable accounts used to record the social security and medicare taxes withheld from employees.

What taxes must a self-employed person pay?

Employee FICA taxes and Employer FICA taxes.

Employer unemployment taxes

the federal government works with states in a joint federal and state unemployment insurance program. each state has its own program. these programs provide unemployment benefits to qualified workers.

Federal unemployment tax act (FUTA)

employer must pay a federal unemployment tax on wages and salaries earned by their employee. for the recent year, employers were required to pay FUTA taxes of as much 6.0% of the first $7,000 earned by each employee. this federal tax can be reduced by a credit of up to 5.4% for taxes paid to a state program. as a result, the net federal unemployment tax is often 0.6%.

State unemployment tax act (SUTA)

all states fund their unemployment insurance programs by placing a payroll tax on employers. (a few states require the employee to make a contribution. in the book’s assignments, we assume this tax is only levied on the employer.) in most states, the base rate for SUTA taxes in 5.4% of the first $7,000 earned by each employee (the dollar level varies by state).

this base rate is adjusted according to an employer’s merit rating. the state assigns a merit rating based on a company’s stability in employing workers. a good rating reflects stability in employment and means an employer can pay less than the 5.4% base rate. a low rating means high turnovers or seasonal wirings and layouts.

How to record employer payroll taxes

employer payroll taxes are an added expense beyond the wages and salaries earned by employees. these taxes are often recorded in an entry separate from the one recording payroll expenses and deductions.

assume that the $2,000 recorded salaries expense from the previous example is earned by an employee whose earnings have not yet reached $5,000 for the year. this means the entire salaries expense for this period is subject to tax because year-to-date pay is under $7,000. conquestly, the FICA portion of the employer’s tax is $153, computed by multiplying both the 6.2% and 1.45% by the $2,000 gross pay.

assume that the federal unemployment tax rate is 0.6% and the state unemployment tax rate is 5.4%. this means state unemployment (SUTA) taxes are $108 (5.4% of the $2,000 gross pay) and federal unemployment (FUTA) taxes are $12 (0.6% of $2,000).

The entry to record the employer’s payroll tax expense and related liabilities:

Jan 31.

Payroll Taxes Expense. 273

. FICA-Social Security Taxes Payable (6.2%). 124

. FICA-Medicare Taxes Payable (1.45%). 29

. State Unemployment Taxes Payable. 108

. Federal Unemployment Taxes Payable. 12

record employer payroll taxes.

What are the four key areas of payroll activities that we aim to separate and monitor?

Employee Hiring, Payroll Preparation, Timekeeping, and Payroll Payment.

Multi-Period Known Liabilities

many known liabilities extend over multiple periods. these often include unearned revenues and note payable. for example, if sports illustrated sells a three-year digital magazine subscription. it records amount received for this subscription in an unearned subscription revenues account.

amounts in this account are liabilities, but are they current or long term? they are both. the portion of the unearned subscription revenues account that will be fulfilled in the next year is reported as a current liability. The remaining portion is reported as a long-term liability.

the same analysis applies to note payable. for example, a borrower reports a three-year note payable as a long-term liability in first two years it is outstanding. in the third year, the borrower reclassifies this note as a current liability because it is due within one year. the current portion of long-term debt is that part of long-term debt due within one year. long term debt is reported under current liabilities.

assume that a $7,500 debt is paid in installment of $1,500 per year for five years. the $1,500 due within the year is reported as a current liability. we classify the amounts for debt as either current or long-term when the balance sheet is prepared.

Estimated Liability

a known obligation of an uncertain amount that can be reasonably estimated.

(common examples are employee benefits such as pensions, healthcare, and vacation pay, and warranties offered by a seller.)

Health and Pension Benefits

many companies provide employee benefits. An employer often pays all or part of medical, dental, life, and disability insurance. many employers also contribute to pension plans, which are agreements by employers to provide payments to employees after retirement. many companies also provide medical care and insurance benefits to their retirees.

How to recover health and pension benefits.

assume an employer agrees to (1) pay $8,000 for medical insurance and (2) contribute an additional 10% of the employees' $120,000 gross salaries to a retirement program.

the entry to record these accrued benefits is:

Dec. 31

Employee Benefits Expense. 20,000

. Employee Medical Insurance Payable. 8,000

. Employee Retirement Program Payable 12,000

record costs of employee benefits

Vacation benefits

many employers offer paid vacation beenfits, or paid absences. vacation benefits are estimated and expensed in the period when employees earn them.

How to record vacation benefits

assume that salaried employees earn 2 weeks’ paid vacation per year.

the year-end adjusting entry to record $3,200 of accrued vacation benefits follows:

Dec. 31 Vacation Benefits Expense 3,200

. Vacation Benefits Payable 3,200

record vacation benefits accrued.

vacation benefits expense is an operating expense and vacation benefits payable is a current liability. when an employee takes a vacation, the employer reduces (debits) vacation benefits payable and credits cash.

Jan. 20 Vacation Benefits Payable 400

. Cash 400

record vacation benefits taken.

Bonus Plans

many companies offer bonuses to employees, and many of the bonuses depend on net income.

How to record bonus plans:

assume that an employer gives a bonus to its employees based on the company’s annual net income (to be equally shared by all).

the year-end adjusting entry to record a $10,000 bonus is:

Dec. 31 Employee Bonus Expense. 10,000

. Bonus Payable 10,000

record expected bonus costs.

Warranty

a seller’s obligation to replace or fix a product or service that fails to perform as expected withn a specified period.

for example, a new jeep is sold with a warranty covering parts for a specified period of time. the seller reports the expected warranty expense in the period when the revenue from the sale of the product or service is reported.

the seller reports this warranty liability, even though the existence, amount, payee, and date of future payments are uncertain. this is because warranty costs are probable and the amount can be estimated using past experience.

How to report Warranty Liabilities

assume a dealer sells a car for $16,000 on December 1, 2021, with a one-year or 12,000-mile warranty covering parts. experience shows that warranty expense is 4% of a car's selling price, or $640 in this case ($16,000 × 4%).

the dealer records the estimated expense and liability related to this sale with this end-of-period adjustment:

Dec. 31 Warranty Expense 640

. Estimated Warranty Liability 640

record estimated warranty expense

this entry alternatively could be made at the time of sale. either way, the estimated warranty expense is reported on the 2021 income statement and the warranty liability on the 2021 balance sheet. continuing this example, assume the customer brings the car in for warranty repairs on January 9, 2022. the dealer fixes the car by replacing parts costing $200.

The entry to record the repair is

Dec. 31

Estimated Warranty Liability 200

. Parts Inventory 200

record costs of warranty repairs.

this entry reduces the balance of the Estimated Warranty Liability account, but no expense is recorded in 2022 for the repair. warranty expense was previously recorded in 2021, the year the car was sold with the warranty.

finally, what happens if total warranty expenses are more or less than the estimated 4%, or $640? the answer is that management should monitor actual warranty expenses to see if a 4% rate is accurate. if not, the rate is changed for future periods.

Multi-Period Estimated Liabilities

estimated liabilities can be both current and long term. for example, pension liabilities to employees are long term to workers who will not retire within the next year. for employees who are retired or will retire within the next year, a portion of pension liabilities is current. other examples include employee health benefits and warranties.

Contingent Liability

a potential obligation that depends on a future event arising from a past transaction or event. an example is a pending lawsuit. here, a past transaction or event leads to a lawsuit whose financial outcome depends on the result of the lawsuit.

What does accounting for contingent liabilities depend on?

The likelihold that a future event will occur and the ability to estimate the future amount owed if this event occurs.

What are the three possibilities of a contingent liability?

Record liability with a journal entry, disclose in notes to financial statements, or no disclosure.

What conditons determine if a contingent liability is recorded?

If the future event is probable (likely) and the amount owed can be reasonably estimated. examples are warranties, vacation pay, and income taxes.

What conditons determine if a contingent liability is disclosed in notes?

if the future event is reasonably possible (could occur)

What conditons determine if a contingent liability isn’t disclosed?

if the future event is remote (unlikely).

What are common contingent liabilities?

Potential legal claims, debt guarantees, other contingencies.

Potential legal claims

many companies are sued or at risk of being sued. the accounting issue is whether the defendant records a liability or discloses a contingent liability in its notes while a lawsuit is outstanding and not yet settled. the answer is that a potential claim is recorded only if payment for damages is probable and the amount can be reasonably estimated. if the potential claim cannot be reasonably estimated but is reasonably possible, it is disclosed.

for example, Ford includes the following note in its annual report: "Various legal actions, proceedings,

and claims are pending ... arising out of alleged defects in our products."

Debt Guarantees

sometimes a company guarantees the payment of debt owed by a supplier, customer, or another company. the guarantor usually discloses the guarantee in its financial statement notes as a contingent liability. if it is probable that the debtor will default, the guarantor reports the guarantee as a liability.

the Boston Celtics report a unique guarantee: "Contracts provide for guaranteed payments which must be paid even if the employee [player] is injured or terminated."

Other Contingencies

other examples of contingencies include environmental damages, possible tax assessments, insurance losses, and government investigations.

Chevron, for example, reports that it "is subject to loss contingencies ... related to environmental matters.... The amount of additional future costs are not fully determinable." many of Chevron's contingencies are revealed only in notes.

Uncertainties that are not Contingencies

all organizations face uncertainties from future events such as natural disasters and new technologies. these uncertainties are not contingent liabilities because they are future events not arising from past transactions. accordingly, they are not disclosed

Times interest earned

Income before interest expense and income taxes/ Interest Expense