Principles of financial accounting 12e by needles crosson chapter 11

Concepts Underlying Current Liabilities Current liabilities are debts and obligations that a company expects to satisfy within one year or within its normal operating cycle..  On the

Concepts Underlying Current Liabilities

 Current liabilities are debts and obligations that a company expects to satisfy within one year or within its normal operating cycle.

 Timing is important in the recognition of

 On the balance sheet, a liability is

generally valued at the amount of

money needed to pay the debt or

reported at the fair market value of the goods or services to be delivered.

– Some liabilities must be estimated For

example, if an automobile dealer sells a car with a one-year warranty on parts and

service, the obligation is definite because the sale has occurred; but the amount of the obligation can only be estimated.

 Current liabilities are due in the next year

or within the normal operating cycle,

whichever is longer, and are normally

paid out of current assets or with cash

generated by operations.

 They contrast with long-term liabilities , which are liabilities due beyond one year

or beyond the normal operating cycle.

 The distinction between current and term liabilities affects the evaluation of a company’s liquidity.

 In addition to reporting liabilities on the balance sheet, a company may need to include additional explanation in the

notes to its financial statements.

– If a company’s Notes Payable account is

large, it should disclose the features of the

debts in an explanatory note.

– Any special credit arrangements, such as a line of credit, should also be disclosed.

 A line of credit with a bank allows a company to borrow funds on short notice up to the credit

Definitely Determinable Liabilities

 Current liabilities that are set by contract and that can be measured exactly are

called definitely determinable

liabilities These include:

– Accounts payable , which are short-term

obligations to suppliers for goods and services – Short-term notes payable , which are

represented by promissory notes

 A promissory note is a written agreement to pay according to certain terms.

Bank Loans and Commercial Paper

 Although a company signs a promissory note for the full amount of a line of credit, it can increase its borrowing up to the limit when it needs cash and reduce the amount borrowed when it generates enough cash on its own.

 Companies with excellent credit ratings can borrow short-terms funds by issuing

commercial paper —unsecured loans that are sold to the public, usually investment

firms.

Accrued Liabilities

 A key reason for making adjusting

entries is to recognize accrued

liabilities that are not already in the

accounting records.

– These may include estimated liabilities.

– Interest payable, a definitely determinable liability, is an accrued liability

period to record the interest obligation up to that point.

Dividends Payable

 Cash dividends are a distribution of

earnings to a corporation’s stockholders.

– A corporation’s board of directors has the

sole authority to declare them.

– A corporation has no liability for dividends

until the date of declaration

– During the brief period between that date

and the date of payment, the dividends declared are considered current liabilities of the corporation.

Sales and Excise Taxes Payable

 Most states and many cities levy a sales tax

Current Portion of Long-Term Debt

due within the next year and is to be

paid from current assets is classified as

a current liability.

– No journal entry is necessary when this is the case.

– The total debt is simply reclassified as

short-term and long-term when the company prepares its balance sheet and other financial statements.

Payroll Liabilities

 Employers are liable to employees for wages and salaries and to various agencies for withholdings from wages and salaries and related taxes.

– Wages are compensation at an hourly rate.

– Salaries are compensation at a monthly or yearly rate. – An employee is paid a wage or salary by an

organization and is under its direct supervision and control Payroll accounting applies only to employees.

– An independent contractor offers services for a fee but is not under the organization’s direct control or supervision.

Illustration of Payroll Costs

than the amount of their earnings because employers are required by law or are

requested by employees to withhold certain amounts from wages.

 An employer’s total liabilities exceed

employee’s earnings because the employer must pay additional taxes and make other contributions (such as for pensions and

medical care) that increase payroll costs.

Withholdings, Taxes, and Other Payroll Costs

(slide 1 of 2)

other payroll costs are:

– Federal income taxes—Employers are required to

withhold these and pay them to the U.S Treasury.

– State and local income taxes—Most states and some local governments require that these taxes be

withheld.

– Social security (FICA) tax: Paid by both the employee and the employer; both the rate and base may change – Medicare tax: 1.45 percent of gross income, with no limit, paid by both the employee and the employer

Withholdings, Taxes, and Other Payroll Costs

(slide 2 of 2)

– Medical insurance—The employee often contributes a portion of the cost through withholdings, and the

employer pays the rest to the insurance company.

– Pension contributions—A portion of the contribution is withheld from the employee’s income, and the

employer pays the rest of the amount into the pension fund.

– Federal unemployment insurance (FUTA) tax and state unemployment insurance tax: These taxes are paid

only by employers; the FUTA tax may be reduced by

the amount of unemployment tax paid to the state.

– Vacation pay: The cost of accrued vacation should be allocated as an expense over the year.

Unearned Revenues and Estimated Liabilities

 Unearned revenues are advance payments for goods or services that a company must provide in the future.

 Estimated liabilities are definite debts or

obligations whose exact dollar amount cannot be known until a later date Examples include:

– Income taxes payable—taxes on a corporation’s income (not owed by sole proprietorships or partnerships)

– Property taxes payable—taxes on real property and

personal property, such as inventory and equipment – Promotional costs—coupons, rebates, and other marketing programs, such as frequent flyer programs

– Product warranty liability

Contingent Liabilities and Commitments

(slide 1 of 2)

 A contingent liability is a potential

liability because it depends on a future

event arising out of a past transaction

– Contingent liabilities often involve:

 Lawsuits

 Income tax disputes

 Discounted notes receivable

 Guarantees of debt

 Failure to follow government regulations

– The FASB requires that contingent liabilities be disclosed in a note to the financial statements.

Contingent Liabilities and Commitments

(slide 2 of 2)

– A contingent liability should be entered in the accounting records if it meets two conditions:

 The liability must be probable.

 The liability can be reasonably estimated.

 A commitment is a legal obligation that does not meet the technical requirements for recognition as

a liability and so is not recorded.

– Examples include purchase agreements, leases, and commitments for construction or acquisition

of assets.

– Commitments must also be disclosed in notes to the financial statements.

Valuation Approaches to Fair Value

Accounting

 Fair value is the price for which an asset or

liability could be sold or exit the company.

– Three approaches to measurement of fair value are:

 Market approach—ideal for valuing investments and liabilities for which there is an active market and quoted prices are available for the specific asset or liability

 Income (or cash flow) approach—converts future cash flows to a single present value; used when there are no identical or comparable quoted prices available

 Cost approach—based on the amount that currently would

be required to replace an asset with a comparable asset; must be adjusted to take into account the asset’s age, condition, etc.

Interest, the Time Value of Money, and Future Value

 The time value of money refers to the costs

or benefits of holding or not holding money

over time.

– Interest is the cost of using money for a specific period.

periods when the principal stays the same from period to period.

periods when the principal sum is increased at the end of each period by the interest earned in that period.

– The amount of principal plus interest after one or more periods is known as future value

Present Value

 Present value is the amount that must be invested today at a given rate of interest to produce a given future value.

– The concept of present value is widely used in business decision making and financial reporting.

 The value of a long-term note receivable or payable can

be determined by calculating the present value of the future interest payments.

 The FASB has made present value an important component of its approach in determining the fair value

of assets and liabilities when a market price is not available.

Business Issues Related to Current Liabilities

 The primary reason a company incurs current liabilities is to meet its needs for cash during the operating cycle.

– To evaluate a company’s ability to pay its current liabilities, analysts use two measures of liquidity:

Working Capital = Current Assets − Current

Liabilities Current Ratio = Current Assets ÷ Current

Liabilities

- Measurements commonly used to assess a

company’s ability to pay within a certain time

frame are payables turnover and days’ payable.

Payables Turnover

times, on average, that a company

pays its accounts payable in an

accounting period.

Days’ Payable

average, a company takes to pay its

accounts payable