Current Liabilities and Contingencies| Intermediate Accounting | CPA Exam FAR | Chapter 13

This chapter covers current liabilities including payroll liabilities, notes payable, accounts payable, unearned revenues, loss contingencies, warranties and liabilities analysis.

CPA Exam Questions Financial Accounting and Reporting FAR

Current Liabilities

Short-Term Obligations Expected to Be Refinanced

Employee-Related Liabilities

Loss Contingencies, and Estimated Liabilities

Example: Payroll Tax Liabilities and Expenses

Example: Premium Liability/Expense

Asset Retirement Obligation (ARO)

Example: Warranty Expense/Liability|Accrual/Cash Basis

Example: Payroll Liabilities (Tax Entries)

Loss Contingencies Example: Amazon EU Tax Issue

Warranty Expense/Reserve Example: Tesla Company

Chapter 13 presents a discussion of the nature and measurement of items classified on the balance sheet as current liabilities. Attention is focused on the mechanics involved in recording current liabilities and financial statement disclosure requirements. Also included is a discussion concerning the identification and reporting of contingent liabilities.

Current Liabilities

In general, liabilities involve future disbursements of assets or services. According to the FASB, a liability has three essential characteristics: (a) it is a present obligation that entails settlement by probable future transfer or use of cash, goods, or services; (b) it is an unavoidable obligation; and (c) the transaction or other event creating the obligation has already occurred.

Liabilities are classified on the balance sheet as current obligations or long-term obligations. Current liabilities are those obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets or the creation of other current liabilities.

The relationship between current assets and current liabilities is an important factor in the analysis of a company’s financial condition. Thus, the definition of current liabilities for
a particular industry will depend upon the time period (operating cycle or one year, whichever is longer) used in defining current assets in that industry.

Accounts Payable

Accounts payable represents obligations owed to others for goods, supplies, and services purchased on open account. These obligations, commonly known as trade accounts payable, should be recorded to coincide with the receipt of the goods or at the time title passes to the purchaser. Attention must be paid to transactions occurring near the end of one accounting period and at the beginning of the next to ascertain that the record of goods received (inventory) is in agreement with the liability (accounts payable) and that both are recorded in the proper period.

Notes Payable

Notes payable are written promises to pay a certain sum of money on a specified future date and may arise from sales, financing, or other transactions. Notes may be classified as short-term or long-term, depending on the maturity date.

Short-term notes payable resulting from borrowing funds from a lending institution may be interest-bearing or zero-interest-bearing. Interest-bearing notes payable are reported as
a liability at the face amount of the note along with any accrued interest payable. A zero-interest-bearing note does not explicitly state an interest rate on the face of the note. Interest is the difference between the present value of the note and the face value of the note at maturity. For example, Burke Co. borrowed $138,000 from a bank by giving the bank  a one-year, zero-interest-bearing note that has a face amount of $150,000. The entry to record this transaction on Burke’s books is as follows:

Cash………………………………………………………….           138,000

Discount on Notes Payable……………………….             12,000

Notes Payable………………………………………                                   150,000

The balance in the Discount on Notes Payable account is a contra account deducted from the Notes Payable account on the balance sheet.

The currently maturing portion of long-term debt is classified as a current liability. When a portion of long-term debt is so classified, it is expected that the amount will be paid within the next 12 months out of funds classified as current assets.

Dividends Payable

Cash dividends payable are classified as current liabilities when declared. Once declared, a cash dividend is a binding obligation of a corporation payable to its stockholders. Stock dividends distributable are reported in the stockholders’ equity section when declared as they do not require future outlays of assets or services, therefore do not meet the definition of a liability.

Customer Advances and Deposits

When returnable deposits are received from customers or employees, a liability corresponding to the asset received is recorded. The classification of these items as current or noncurrent liabilities is dependent on the time involved between the date of the deposit and the termination of the relationship that required the deposit.

Unearned Revenues

A company sometimes receives cash in advance of the performance of services or issuance of merchandise. Such transactions result in a credit to a deferred or unearned revenue account classified as a current liability on the balance sheet. As claims of this nature are redeemed, the liability is reduced and a revenue account is credited.

Sales Taxes Payable

Current tax laws require most retailers to collect sales tax from customers and periodically remit these collections to the appropriate governmental unit. In such instances, the retailer is acting as a collection agency for a third party. If tax amounts due to governmental units are on hand at the financial statement date, they are reported as current liabilities.

To illustrate the collection and remittance of sales tax by a company, assume that Bentham Company rang up $230,000 on its cash registers during the period. Bentham is subject to a 7% sales tax collection that must be remitted to the State. Bentham’s policy is to record the total amount of sales with sales taxes in the Sales Revenue account. To determine the sales taxes to be remitted to the State, divide the $230,000 by 1.07 to yield the amount of sales for the period, $214,953.27. Of the $230,000 total, $214,953.27 is sales revenue and the difference of $15,046.73 is the amount of sales taxes collected due to the taxing unit. The entry to record the sales tax liability is:

Sales Revenue…………………………………………         15,046.73

Sales Taxes Payable…………………………..                                       15,046.73

When payment is made, the Sales Taxes Payable account is debited and Cash is credited.

A corporation should estimate and record the amount of income tax liability as computed on its income tax return. Chapter 19 discusses in detail the complexities involved in accounting for the difference between taxable income under the tax laws and accounting income under generally accepted accounting principles.

Employee-Related Liabilities

Amounts owed to employees for salaries or wages of an accounting period are reported as a current liability. The following additional items are related to employee compensation and are reported as current liabilities until paid:

  1. Payroll deductions.
  2. Compensated absences.
  3. Bonuses.

Payroll deductions include Social Security taxes, income tax withholding amounts, and certain other amounts authorized by employees, such as health insurance and union dues. Social Security taxes consist of both FICA and Hospital Insurance (Medicare) tax. Employers must pay an additional share of Social Security taxes, along with both state and federal unemployment taxes.

The following illustrates the concept of accrued liabilities related to payroll deductions. Assume Mill Company has a weekly payroll of $25,000 that is entirely subject to FICA and Medicare (7.65%), federal unemployment tax (.8%), and state unemployment tax (3%). Income tax withholding amounts to $3,300, and employee credit union deductions for the week total $975. No employee’s wages exceed the $7,000 compensation ceiling got unemployment taxes. Two entries are necessary to record the payroll: (1) salaries and wages paid to employees, and (2) employer’s payroll taxes. The two entries are as follows:

 

Salaries and Wages Expense………………………          25,000

Withholding Taxes Payable…………………….                                       3,300

FICA Taxes Payable……………………………….                                       1,913

Credit Union Payments Payable…………….                                          975

Cash……………………………………………………….                                     18,812

 

Payroll Tax Expense…………………………………….             2,863

FICA Taxes Payable……………………………….                                       1,913

FUTA Taxes Payable………………………………                                          200

SUTA Taxes Payable………………………………                                          750

Compensated absences are absences from employment—such as vacation, illness, and holidays—for which it is expected that employees will be paid. In connection with compensated absences, vested rights exist when an employer has an obligation to make payment to an employee even if that employee terminates. Accumulated rights are those rights that can be carried forward to future periods if not used in the period in which earned.

A liability must be accrued for the cost of compensation for future absences if all of the following conditions are met: (a) the employer’s obligation relating to employees’ rights to receive compensation for future absences is attributable to employees’ services already rendered, (b) the obligation relates to the rights that vest or accumulate, (c) payment of the compensation is probable, and (d) the amount can be reasonably estimated. If an employer fails to accrue a liability because of a failure to meet only condition (d), that fact should be disclosed. The expense and related liability for compensated absences should be recognized in the year earned by employees. Thus, if employees are entitled to a two week vacation after working one year, the vacation pay is considered to be earned during the first year. The entry to accrue the accumulated vacation pay at the end of year one will include a debit to Salaries and Wages Expense and a credit to Salaries and Wages Payable.

 

  1. Bonus agreements are common incentives established by companies for certain key executives or employees. In many cases, the bonus is dependent upon the amount of income earned by the company. However, because the bonus is an expense used in determining net income, it must be deducted before net income can be computed. As a result, there is the need to solve an algebraic formula to compute the bonus. In addition, when the concept of income taxes is added to the formula, calculation of the bonus requires solving simultaneous equations.

Refinancing

Certain short-term obligations expected to be refinanced on a long-term basis should be excluded from current liabilities. A short-term obligation is excluded from current liabilities if (a) it is intended to be refinanced on a long-term basis and (b) the ability to accomplish the refinancing is reasonably demonstrated. Both conditions must exist before the item can be excluded from current liabilities. Evidence as to the intent and ability to refinance usually comes from actually refinancing or entering into a refinancing agreement.

Contingencies

A contingency is an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. Gain contingencies are not recorded and are disclosed in the notes only when the probabilities are high that a gain contingency will be realized.

Loss Contingencies

Loss contingencies involve possible losses. Contingent liabilities depend upon the occurrence or non-occurrence of one or more future events to resolve its status. When a loss contingency exists, the likelihood that the future event or events will confirm the incurrence of a liability and are categorized as probable, reasonably possible, or remote.

If the realization of a loss contingency that could result in a liability (1) is probable (likely to occur) and (2) the amount of the loss can be reasonably estimated, a liability is recognized. This liability should be recorded along with a charge to income in the period in which the determination is made. It is important to note that both conditions listed above must be met before a liability can be recorded. In addition, note disclosure should describe the nature of the contingency.

If a loss is either probable or estimable, but not both, and if there is at least a reasonable possibility that a liability may have been incurred, then the financial statements should include the following footnote disclosures: (a) the nature of the contingency, and (b) an estimate of the possible loss, range of loss, or indication that an estimate cannot be made.

In instances where a possible loss is remote, no liability is accrued or disclosed in the notes.

Litigation, Claims, and Assessments

When a company is threatened by legal action such as litigation, claims, and assessments, the recording of a liability will depend upon certain factors. Among the more prevalent are: (a) the time period in which the underlying cause for action occurred,
(b) the probability of an unfavorable outcome, and (c) the ability to make a reasonable estimate of the amount of loss.

Warranties

warranty (product guarantee) represents a promise by a seller to a buyer to make good on any deficiency of quantity, quality or performance specifications in a product. Warranty costs are usually significant and the related liability must be recognized in the accounts if they can be reasonably estimated. The estimated amount includes all costs that the company will incur to correct the deficiencies required under the warranty provisions. There are two types of warranties.

An assurance-type warranty guarantees the product (service) meets agreed upon specifications in the contract at the time of the sale and is included in the sales price. Companies do not record a separate performance obligation for this type of warranty. The estimated costs and liability are recorded at the point of sale with a debit to Warranty Expense and a credit to Warranty Liability. As warranty costs are incurred, the Warranty Liability account is debited and various other accounts are credited.

A service-type warranty is sold separately from the product, usually as an extended warranty. This type of warranty is recorded as a separate performance obligation. The sale of a service-type warranty is recorded as Unearned Warranty Revenue. The company then recognizes revenue over the period of the warranty on a straight-line basis.

Premiums and Coupons

If a company offers premiums to customers in return for proof of purchase items such as product barcodes, box tops, and labels. Printed coupons and rebates often used as marketing tools as well. The costs of premiums and coupons should be recognized as an expense in the period of the sale that benefits from the plan. A liability should be recognized for outstanding premium offers expected to be redeemed.

Environmental Liabilities

A company must recognize an asset retirement obligation (ARO) when it has an existing legal obligation associated with the retirement of a long-lived asset and when it can reasonably estimate the amount of the liability. A company initially measures an ARO at fair value, which is the amount that the company would pay in an active market to settle the ARO. A company includes the cost associated with the ARO in the carrying amount of the related long-lived asset, and records a liability for the same amount. In subsequent periods, companies allocate the cost of the ARO to expense over the asset’s useful life.

Self-Insurance

Self-insurance is not insurance, but risk assumption. The conditions for accrual according to GAAP are not satisfied prior to the occurrence of the event.

Pesentation and Analysis of Current Liabilities

Current liabilities are reported in the financial statements at their maturity value. Present value techniques are not normally used in measuring current liabilities because of the short time periods involved. Current liabilities are normally listed at the beginning of the liabilities section of the balance sheet. Within the current liability section, the accounts may be listed in order of maturity, in descending order of amount, or in order of liquidation preference.

If a short-term obligation is excluded from current liabilities because of refinancing, a footnote to the financial statements should include: (a) a general description of the financing agreement, (b) the terms of any new obligation incurred or to be incurred, and (c) the terms of any equity security issued or to be issued.

Analysis of Current Liabilities

Two ratios often used to analyze liquidity are the current ratio and the acid-test ratio. Liquidity regarding a liability is the expected time to elapse before its payment.