Chapter 8: Current Liabilities

Chapter 8: Current Liabilities

Part A: Liabilities

Definition of Liabilities

• A liability is a company's obligation to transfer economic benefits in the future.
• Most liabilities involve future cash payments, such as:
  • Accounts payable
  • Notes payable
  • Salaries payable
• Some liabilities, like deferred revenue, arise from receiving cash in advance, obligating the company to provide goods or services later.

Current vs. Long-Term Liabilities

• Current Liabilities:
  • Typically due within one year from the balance sheet date.
• Long-Term Liabilities:
  • Payable in more than one year from the balance sheet date.
• Operating Cycle:
  • The time from spending cash on goods/services to collecting cash from customers.
  • If the operating cycle exceeds one year, current liabilities are defined by the operating cycle duration (e.g., a 15-month operating cycle means current liabilities are due within 15 months).

Southwest Airlines Example of Current Liabilities

• A breakdown of Southwest Airlines' current liabilities includes:
  • Accounts payable: 1,574 million
  • Accrued liabilities: 1,749 million
  • Current operating lease liabilities: 353 million
  • Air traffic liability: 4,457 million
  • Current maturities of long-term debt: 819 million
  • Total current liabilities: 8,952 million

Notes Payable

• A note is signed by a firm promising to repay the borrowed amount plus interest.
• Interest Calculation:
  • The formula to calculate interest on notes is: Interest = Face \ value
    \times Annual \ interest \ rate
    \times Fraction \ of \ the \ year

Recording Notes Payable: Southwest Airlines Example

• Southwest Airlines borrows 100,000 from Bank of America on September 1, 2024, with a 6% interest rate, six-month note due on March 1, 2025.
• September 1, 2024 (Issuance):
  • Debit Cash 100,000
  • Credit Notes Payable 100,000

Recording Interest Payable

• Interest for the six-month period is calculated as: $100,000 \times 6\% \times (6/12) = $3,000.
• For the year ending December 31, Southwest reports four months of accrued interest.
• Interest for four months is: $100,000 \times 6\% \times (4/12) = $2,000.
• December 31, 2024 (Adjusting Entry):
  • Debit Interest Expense 2,000
  • Credit Interest Payable 2,000

Recording Repayment of Notes Payable

• On March 1, 2025, Southwest repays the face value plus interest.
• Interest from January to February 2025 is: $100,000 \times 6\% \times (2/12) = $1,000.
• March 1, 2025 (Repayment):
  • Debit Notes Payable 100,000
  • Debit Interest Expense 1,000
  • Debit Interest Payable 2,000
  • Credit Cash 103,000

Key Point: Interest Expense Recognition

• Interest expense is recorded in the period it is incurred, not when it is paid.

Line of Credit & Commercial Paper

• Line of Credit:
  • Informal agreement allowing borrowing up to a limit.
  • Accounting is similar to notes payable.
• Commercial Paper:
  • Borrowing from another company, not a bank.
  • Maturities range from 30 to 270 days.
  • Interest rates are typically lower than bank loans.

Accounts Payable

• Amounts owed to suppliers for goods or services.
• Often called trade accounts payable.
• Usually current liabilities, but can be long-term based on the due date.

Payroll Costs for Employees and Employers

• Employee Costs:
  • Federal and state income taxes.
  • Employee portion of Social Security and Medicare (FICA taxes).
  • Employee contributions for health, dental, disability, and life insurance.
  • Employee investments in retirement or savings plans.
• Employer Costs:
  • Federal and state unemployment taxes.
  • Employer matching portion of Social Security and Medicare.
  • Employer contributions for health, dental, disability, and life insurance.
  • Employer contributions to retirement or savings plans.

Employee Costs: Taxes and Withholdings

• FICA taxes:
  • 7.65% (6.2% Social Security tax up to a maximum base amount + 1.45% Medicare tax with no maximum).
  • Social Security and Medicare taxes combined.
• Employees may have additional withholdings for:
  • Health, dental, disability, and life insurance.
  • Retirement or employee savings plans.

Employer Costs: Taxes and Benefits

• Employers match the employee FICA tax.
• Employers pay federal and state unemployment taxes (FUTA and SUTA).
• Fringe Benefits:
  • Additional employee benefits paid by the employer.
  • Includes health, dental, disability, and life insurance.
  • Contributions to retirement or savings plans.

Common Mistake: FICA Taxes

• Both employees and employers pay FICA taxes, with the employer matching the employee's contribution.

Payroll Example: Hawaiian Travel Agency

• Hawaiian Travel Agency has a 100,000 payroll for January for 20 employees.
• Withholdings and employer-provided benefits:
  • Federal and state income tax withheld: 24,000
  • FICA tax rate: 7.65%
  • Health insurance premiums paid by employer: 5,000
  • Retirement plan contribution paid by employer: 10,000
  • Federal and state unemployment tax rate: 6.2%
• January 31 (Employee Salary Expense):
  • Debit Salaries Expense 100,000
  • Credit Employee Income Tax Payable 24,000
  • Credit FICA Tax Payable (0.0765 \times $100,000) 7,650
  • Credit Salaries Payable 68,350

Recording Employer-Provided Fringe Benefits

• January 31 (Fringe Benefits):
  • Debit Salaries Expense (fringe benefits) 15,000
  • Credit Fringe Benefits Payable (to Blue Cross) 5,000
  • Credit Fringe Benefits Payable (to Fidelity) 10,000

Recording Employer Payroll Taxes

• Hawaiian Travel Agency pays employer's FICA taxes (7.65%) and unemployment taxes (6.2%).
• December 31 (Employer Payroll Taxes):
  • Debit Payroll Tax Expense 13,850
  • Credit FICA Tax Payable (0.0765 \times $100,000) 7,650
  • Credit Unemployment Tax Payable (0.062 \times $100,000) 6,200

Key Point: Employee and Employer Payroll Expenses

• Employee salaries are reduced by withholdings.
• Employers incur additional payroll expenses for unemployment taxes, FICA taxes, and contributions to benefits.

Other Current Liabilities

• Deferred Revenue:
  • Cash received in advance for future products or services.
• Sales Tax Payable:
  • Sales tax collected from customers, payable to the government.
• Current Portion of Long-Term Debt:
  • Debt that will be paid within one year from the balance sheet date.

Deferred Revenues: Apple Inc. Example

• Apple sells an iTunes gift card for 100.
• Initial Sale:
  • Debit Cash 100
  • Credit Deferred Revenue 100
• When 15 of music is downloaded:
  • Debit Deferred Revenue 15
  • Credit Sales Revenue 15

Common Mistake: Deferred Revenue

• Deferred Revenue is a liability account, not a revenue account.

Sales Tax Payable

• Lunch purchase for 15 with 10% sales tax.
• Transaction:
  • Debit Cash 16.50
  • Credit Sales Revenue 15.00
  • Credit Sales Tax Payable (15 \times 10\%) 1.50

Key Point: Sales Taxes

• Sales taxes collected are not an expense but a liability payable to the government.

Current Portion of Long-Term Debt

• The amount of long-term debt due within one year.
• Management needs this to budget cash flow.
• If a company has $1,000,000 long-term debt and $200,000 is due next year:
  • Reclassification:
    • Debit Notes Payable (long-term) 200,000
    • Credit Notes Payable (short-term) 200,000

Southwest Airlines: Current Maturities of Long-Term Debt

• Balance Sheet:
  • Current liabilities: Current maturities of long-term debt 566 million
  • Long-term liabilities: Long-term debt less current maturities 2,821 million
  • Total borrowings 3,387 million

Key Point: Reporting Maturing Debt

• The currently maturing portion of long-term debt is reported as a current liability.

Part B: Contingencies

Contingent Liabilities

• Contingencies:
  • Uncertain situations with potential gains or losses.
• Contingent Liability:
  • An existing uncertain situation that might result in a loss.

Criteria for Reporting a Contingent Liability

• A contingent liability is recorded if a loss is probable and the amount is reasonably estimable.
• Likelihood of Payment:
  • Probable: Likely to occur.
  • Reasonably Possible: More than remote but less than probable.
  • Remote: Slight chance.
• Amount of Payment:
  • Reasonably Estimable.
  • Not Reasonably Estimable.

Accounting Treatment of Contingent Liabilities

• Example: Jeeps, Inc.
  • Probable $100 million lawsuit loss:
    • Debit Loss 100,000
    • Credit Contingent Liability 100,000

Disclosure of Contingencies: United Airlines Example

• United Airlines discloses legal and environmental contingencies when a loss is probable and reasonably estimable, based on management's assessment and legal counsel's views.

Warranties

• A common example of contingent liabilities.
• Criteria for Recording:
  1. Probable.
  2. Reasonably Estimable.
• Reasonable predictions are formulated based on:
  • Past experiences.
  • Industry statistics.
  • Current business conditions.

Accounting for Warranties

• Warranty costs are estimated at 3% of sales.
• December 2024 sales are $1.5 million.
• December 31, 2024 (Adjusting Entry):
  • Debit Warranty Expense 45,000
  • Credit Warranty Liability 45,000
  • ($45,000 = $1.5 \ million \times 3\%)
• January 2025 warranty claims total $12,000.
• January 31, 2025 (Warranty Expenditures):
  • Debit Warranty Liability 12,000
  • Credit Cash 12,000

Common Mistake: Warranty Liability

• The Warranty Liability account is not always equal to Warranty Expense.
• Warranty Liability is increased when the liability is recorded and decreased by actual expenditures.

Contingent Gains

• An existing uncertain situation that might result in a gain.
• The plaintiff in a lawsuit has a contingent gain, while the defendant faces a contingent liability.
• Contingent gains are not recorded until the gain is known with certainty.

Liquidity Analysis

Liquidity Analysis

• Liquidity:
  • Having sufficient cash or current assets to pay maturing debts.
  • Lack of liquidity can lead to financial difficulties or bankruptcy.
• Three Liquidity Measures:
  • Working capital
  • Current ratio
  • Acid-test ratio

Working Capital

• The measure of current assets remaining after paying current liabilities.
• A large positive working capital indicates good liquidity.
• It is not the best measure for comparing companies.
• Formula:
  • Working \ capital = Current \ assets - Current \ liabilities

Current Ratio

• The amount of current assets available for every $1 of current liabilities.
• A higher current ratio indicates greater liquidity.
• A current ratio of 1.5 means $1.50 of current assets for every dollar of current liabilities.
• Formula:
  • Current \ Ratio = \frac{Current \ assets}{Current \ liabilities}

Acid-Test Ratio (Quick Ratio)

• The amount of