1. Known Liabilities

What is a liability?

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

What three characteristics does a liability need to be characterized as a liability? If it is missing one of these three, it is not a liability.

Past, Present, and Future.

Due to a past transaction or event a company has a present obligation for future payments of assets or services.

What would be an example of something that might seem like a liability but is not.

Companies expect to pay wages in future years, but these future payments are not liabilities because no past event such as employee work resulted in a present obligation. Instead, liabilities are recorded when employees perform work and earn wages.

What words do most liability accounts use in their titles?

They use payable or unearned in their titles.

What are the two ways liabilities can be classified?

Current or long term.

What are current (or short-term) liabilities?

liabilities due within one year (or the company's operating cycle if longer).

How are current liabilities usually paid?

Most are paid using current assets or by creating other account liabilities.

What are common examples of current liabilities?

Accounts payable, short-term notes payable, wages payable, warranty liabilities, and taxes payable.

If a liability does not have a fixed due date but instead are payable on the creditor's demand what is this reported as?

These are reported as current liabilities because of the possibility of payment in their near term.

Current liabilities differ across companies because they depend on the type of company operations.

For example, MGM Resorts reports casino outstanding chip liability. Harley-Davidson reports different current liabilities such as warranty, recall, and dealer incentive liabilities.

What are long-term liabilities?

Obligations due after one year (or the company's operating cycle if longer).

What are examples of long-term liabilities?

Long-term notes payable, warranty liabilities, lease liabilities, and bonds payable.

How can a single liability be divided if needed?

A single liability can be divided between the current and noncurrent sections if a company expects to make payments toward it in both the short and long term.

What are the three important questions to answer when accounting for liabilities?

- Whom to pay?

- When to pay?

- How much to pay?

- Answers are usually decided when a liability is incurred.

Give an example of a liability which involves 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 specific amount is payable to the note's holder at a specific date, but the company does not know who the holder is until that date.

Even if the company is uncertain about who the note is payable to, should they still record the liability on the balance sheet?

Yes

Review example of uncertainty in when to pay on back of flashcard.

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 client 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 types of obligations are reported as current liabilities because they are likely to be settled in the short term.

Describe uncertainty in how much to pay

A company can be aware of an obligation but not know much it will be required to pay.

Give an example of uncertainty in how much to pay 

A company hiring outside lawyers and consultants is often billed only after each period is complete. These service costs that are incurred this period, and before any bill is received, is a liability.

If there is uncertainty in how much to pay, how is the liability reportedon the balance sheet?

This liability is reported as an estimated amount if the balance sheet is prepared before a bill arrives.

What are known liabilities?

Measurable obligations arising from agreements, contracts, or laws.

Give examples of known liabilities

Accounts payable, notes payable, payroll obligations, sales taxes, and unearned revenues.

What is accounts payable (or trade accounts payable)?

amounts owed to suppliers for products or services purchased on credit.

How are sales taxes calculated?

As a percent of selling prices.

When does the seller collect sales taxes from customers?

When sales occur.

Who does the business send the collected taxes to?

The government.

Why are the sales taxes seen as a liability?

Because sellers currently owe these collected taxes to the government it is seen as a current liability.

What is the entry for the company to record sales tax on merchandise sold?

debit Cash for full amount, credit Sales for amount of merchandise, credit Sales Taxes Payable for tax amount.

What is the entry for the merchandiser when they later send the taxed amount to the government?

debit Sales Taxes payable, credit Cash

Review example under Sales Tax payable

What are unearned (or deferred) revenues?

Amounts received in advance from customers for future products or services.

Give examples of when unearned revenues would arise.

Unearned revenue arise with airline ticket sales, magazine subscriptions, construction projects, hotel reservations, gift card sales, and custom orders. Advanced ticket sales for sporting events or concerts are other examples.

What is the entry to record ticket sales?

debit Cash, credit Unearned Ticket Revenue

What type of account is unearned ticket revenue?

Current liability.

What is the entry to record one concert being played if total ticket sales were $900,000 and there are three total concerts in the tour?

We can assume $300,000 is the revenue for one concert since $900,000 / 3 = $300,000.

We debit Unearned Ticket Revenue $300,000, credit Ticket Revenue $300,000.

What is a short-term note payable?

A written promise to pay a specified amount on a stated future date within one year.

Can notes be sold or transferred?

Yes

Do most notes payable have interest?

Yes.

Why are the written documentation with notes helpful?

In resolving legal disputes.

When might a company replace an account payable (liability they have) with a note payable?

For example, if the creditor requires an interest-bearing note for an overdue account payable.

What is the entry for the company asking to extend its account payable with a note payable?

debit Accounts Payable - Company name of company you are paying, credit Cash (if the other company agrees to a cash amount to extend the note), credit Notes Payable - Company name of company you are paying.

Why does the company receiving the note payable prefer it over the account payable?

Because it earns interest and it is written documentation of the debt's existence, term, and amount.

When the company that has to pay off the note payable pays it off, what is the entry to record this?

debit Notes Payable - Company you are paying’s name, debit Interest Expense for amount of interest calculated, credit Cash for principle + interest.

Review example under Note Given to Extend Credit Period.

How is the note payable interest calculated?

principle of note x annual interest rate x fraction of year the note is outstanding (for example 60/360)

What does the bank require the borrower to sign when making a loan?

A bank requires a borrower to sign a note when making a loan.

What is the difference between the amount borrowed and amount repaid known as?

Interest

How would the borrower of a note from a bank record the note payable?

debit Cash, credit Notes Payable for amount borrowed

How would the borrower of a note from a bank record when paying off the note?

debit notes payable for principle, debit Interest expense for interest amount, credit cash for principle + interest

When a note extends over two periods (issued in one period but paid in the next), how is interest expense recorded?

Interest expense is recorded in each period based on the number of days the note extends over each period.

If the company has the note payable for 15 days before the period ends, how would you calculate interest expense for these 15 days?

principle x interest percent x (15/360)

What is the entry to record the interest expense incurred in the current period at period end before the note is paid in the next period?

debit Interest Expense, credit Interest payable for amount of interest expense incurred.

What is the entry to record interest expense in the next period when the full principle + interest amount of the note is paid?

debit Interest expense for the interest incurred in the period when the note is paid, debit Interest Payable for the interest amount from the last period, debit Notes Payable for Principle amount, credit Cash for principle + full interest.

Review Need-To-Know 11-1