Chapter 10: Current Liabilities and Contingent Liabilities
- 1 Learning Objectives
- 2 Current Liabilities
- 3 Accounting for Accounts Payable
- 4 Accounting for Notes Payable
- 5 Customer Advances and Deposits
- 6 Dividends Payable
- 7 Unearned Revenue
- 8 Taxes Payable
- 9 Employee Liabilities
- 10 Current Portion of Long-Term Liabilities
- 11 Financial Statement Presentation of Current Liabilities
- 12 Contingent Liabilities
- 13 Gain Contingencies
- 14 Loss Contingencies
- 15 Warranties
- 16 Financial Statement Presentation of Contingencies
As you may recall from previous chapters, a liability is a probable future economic sacrifice resulting from current obligations to provide assets or services that have resulted from past transactions. In other words, a liability is when you owe another company money. It may also be referred to as a debt. A current liability is when the debt must be repaid within the next 12 months. A current liability is classified as current because the current liability will require current assets (cash or equivalent assets) to repay. Any liability that is going to be repaid beyond the next 12 months is classified as a long-term liability.
A lender is when a firm extends credit to another firm. The firm borrowing the money is called the debtor. An account payable is a short-term informal credit that is extended to help facilitate business transactions. A firm will use their account payable account and then repay the account periodically. A more formal form of credit is a short-term note. A short-term note is recorded on formal business documents and is often associated with higher amounts of borrowings. If the borrower defaults on the short-term note the creditor can use the note to force the borrower to repay through the use of the court system. Another primary difference between an account payable and a note payable is that the account payable will generally not charge any interest while a note payable will charge interest.
Accounting for Accounts Payable
Accounts payable are accounts open with various businesses that are designed to help facilitate trade with businesses. Usually an account payable is established for a repeat customer or vendor. Instead of going through the normal billing process, a customer on account can charge their purchases to their account payable and then repay the account at fixed intervals or when the balance reaches a certain level. Accounts payable usually use the standard credit terms of 2/10, n/30 or EOM (end of month).
Luckily the accounting for accounts payable is relatively straight forward. The creation of an account payable begins with purchasing something on credit. In a cash sale we would credit cash. Instead of crediting cash for a credit sale we will credit accounts payable, as shown below:
When the company is ready to repay the account payable, the following journal entry would be recorded for each payment:
Take note that no interest is calculated even though the repayment occurred after 15 days. The reason for this is because it is not customary to charge interest for accounts payable.
Accounting for Notes Payable
A note payable is a formal form of credit that is generally recorded with mutually-agreed credit terms. A note payable may also be referred to as a promissory note. Generally a note payable is for large amounts of credit, has an interest rate, and is signed by both the borrower and creditor. All terms of the note are negotiable until the note is signed. This includes the interest factor. A note payable can be interesting bear or non-interest bearing. The following is the general format for a promissory note agreement:
As you can see from the above, the promissory note is used to create a note payable. In this case, $50,000 cash is being borrowed at a rate of 7% interest over 6 months. Once a note payable has been agreed and signed, the borrower is legally liable for repayment of the liability. Accounts payable, in contrast, will generally be written off if a borrower defaults on the liability. The reason for this difference is that an account payable is generally for a smaller amount of credit. The accounting for accounts payable is relatively straight forward due to the lack of interest. For notes payable, we need to factor in the impact of interest that is being earned or paid over the life of the note payable. We will work through basic note payable journal entries to fully understand the accounting for interest-bearing note payables.
Using our example note payable above with a principal of $50,000 with a 7% interest rate and payable over 6 months, we can perform the following journal entries. We will review the entries for the borrower and creditor to see how both sides of the transactions would be accounted for. For the borrower, they will be recording interest expense while the creditor will record interest revenue.
When the note is issued on January 1st, 2016, the borrower would record the following journal entry:
The creditor would record the following entry when they issue the note:
As you can see, a note payable by a borrower becomes a note receivable by the lender.
When we need to prepare our financial statements we must perform adjusting entries to recognize the amount of interest that has been accrued and how much interest expense to recognize. We perform a similar adjusting entry to recognize interest revenue for the lender. The adjusting entry could be performed monthly or when the financial statements are prepared (monthly, quarterly, annually). In this case, we will record our adjusting entry after three months has passed on March 31st, 2016.
Before recording our interest factor, we need to calculate it. To do this we take the principal of the loan ($50,000) and then multiply it by our interest rate of 7%. We then multiply that amount by 3/6 which is three months over the life of the loan which is 50%. Our answer is $1,750. We record this adjusting entry using the following journal entry:
Take note that an interest payable account was used instead of cash. This is because no cash has changed hands during this journal entry. The cash for the interest will be paid at the maturity (end date) of the note.
At maturity, the borrower will record the following journal entry:
At the end of the term of the note. The note must be repaid in full with the all the interest paid in cash or other agreed-upon property. In this case, $53,500 cash was paid to repay the $50,000 principal and 6 months worth of interest at 7% interest which is $3,500 ($50,000 X 7% X 6/12). We recognize half $1,750 of interest expense because the other half of the interest expense was accrued in our previous journal entry. The interest payable is debited (which eliminates the outstanding balance in it) for $1,750 to recognize that the interest payable is being paid off in full. The note payable account is also debited for $50,000 to recognize that the note payable has been paid in full.
Customer Advances and Deposits
Companies often require their customers to provide a deposit or cash advance as a form of security for the company. For example, if you are renting an apartment, the landlord might require you to provide half of the first month rent as a security deposit. The terms of the deposit might say that the deposit is refundable in full if no damage is observed in the first six months of the lease. After six months has elapsed, the landlord will give you the deposit back. Since the deposit is potentially fully refundable the land lord must record the deposit as a liability. The classification of the deposit as current or long-term depends on how long the contract is for. If the deposit will be returnable in a maximum of six months then it is classified as current. If the contract states that the deposit will be returned over 12 months then it is classified as a long-term liability.
When the board of directors or management of the business authorizes a dividend to be paid, the company creates a liability to pay the dividend to the owner's of the company. The vast majority of dividends are paid within 12 months and therefore are classified as current liabilities.
If the company decides to make the dividend in the form of stock then this type of dividend is not classified as a liability. The reason is because a stock dividend does not require an outflow of cash or assets. The stock dividends are reported as retained earnings and then converted to additional paid-in capital when the shares are distributed.
The following journal entry records the declaration of a dividend:
Take note that the dividends are being debited to retained earnings. This is to represent that retained earnings is being decreased by the delcaration of dividends.
After three months, the company paid the cash dividend and recorded it with the following journal entry:
Additional information on dividends will be discussed in Chapter 15: Stockholder's Equity.
A company can only recognize revenue when it has earned the revenue. In other words, if the company has not substantially performed the contract then no revenue can be recorded until the earnings process is substantially complete. For example, if the company is a retailer then the retailer cannot recognize any revenue until the merchandise has been shipped to the customer.
If a customer prepays for the service or merchandise then an unearned revenue must be recorded. Unearned revenues are a current liability until the company has earned the revenue. Unearned revenue is common with prepaid services, such as, insurance.
Luckily, the accounting for unearned revenues is fairly straight forward. When a company receives cash for services or merchandise to be delivered in the future they will simply debit cash and credit and unearned revenue account (current liability). Once the service has been performed the company can recognize the revenue by debiting an unearned revenue account and crediting a revenue account.
The following journal entry shows the original receipt of cash:
The following journal entry shows the company earning the revenue after performing the service.
Unearned revenue is reported on the balance sheet as a current liability while sales revenue is reported on the income statement.
Most governments levy taxes in order to fund government operations and programs. When the business performs a taxable event in which it must collect a tax from the customer the company has a custodial duty for the tax money that is collected from the customer. The most common forms of transaction taxes is a sales tax which is levied on the sale of tangible personal property and select other transactions. To account for our tax collections that are to be remitted to the government we will use a sales tax payable account or simply a tax payable account. As taxable sales are made, the tax collections will be credited to the tax payable account. When the company remits the money to the government the transaction will be accounted for by debiting the tax payable account.
The following transaction shows how to record a sale to a customer where a 5% sales tax is to be levied on the transaction:
At the end of the month, the company would remit the tax money to the government and record the entry using the following:
Some companies decide to note use a tax payable for their sales tax collections. Instead they credit all of the cash collections, including taxes, directly to sales revenue. For example, in the above journal entries imagine if $105 was credited to sales revenue instead of $100. When it comes time to pay the government they would calculate the amount of tax that needs to be remitted, for example: $100 x .05 = $5 tax. Then a journal entry would be recorded of debit $5 sales revenue and credit $5 sales tax payable.
Taxes related to income tax are slightly more complex and are covered in chapter 17.
Employees create various current liabilities due to government regulation as well as due to other contractual agreements with the employee. The employee of course needs to be paid a wage which is referred to as payroll. That wage is accumulated in a wages payable account before being paid to the employee. Employees might also have fringe benefits for vacation time, sick time or health insurance. In terms of government regulations, the government might require that a certain amount of taxes be withheld from the employee's paycheck.
The accounting for payroll related liabilities can be somewhat complex due to various government regulations. The complexity is made even more difficult with governments requiring different rules. In this section we will cover the high-level overview of employee related liabilities and our review will cover the following topics:
- Payroll Deductions
- Compensated Fringe Benefits
- Bonus Contracts
Note that we will not be covering the country specific benefit programs like the United States Social Security System or similar. We will only cover how to record liabilities related to a generic benefits system.
The most common forms of payroll deductions are deductions for income taxes, insurance, employee retirement funds, unemployment funds, and union related dues. Various other deductions could exist if a court orders it. For example, money could be deducted to support a child or similar person. Any deductions that are being temporarily withheld are classified as current liabilities until they are remitted to the appropriate government agency.
The first step is to determine how much deductions are to be withheld and where to remit the withheld funds. The employer will also need to determine if any obligations exist that the employer is responsible for paying. As mentioned earlier, payroll related deductions vary from country to country so it is advised that companies consult with a competent professional in terms of their payroll related obligations. The following is a basic example of how to record payroll related obligations, all information is for example only:
Example: Your company has hired a new employee and you have consulted with a payroll professional regarding your tax obligations. The payroll professional has provided the following guidance:
"All employers in your location must collect 5% income tax from all wages paid to the employee. The state also requires 2.5% of wages to be collected up to $2,500 of wages paid per month for the state's unemployment fund. The employer is responsible for matching this 2.5% rate as well so a total of 5% in tax must be remitted. The employee is a member of a union and the union requires $50 in dues per month."
Task: Record the journal entries related to this new employee being paid $5,000 per month.
Answer: The first step is to record the amount paid to the employee as well as the employee's share of the deductions. The amounts withheld will be recorded to payable accounts, as seen below:
As you can see from the above our income tax payable account is calculated as $5,000 of wages x 5% = $250. Our unemployment tax is calculated at $2,500 x 2.5% = $62.50. Our union dues are $50 per month given in the fact pattern. Cash of $4,636.50 is the amount of cash that the employee will receive. When the payable accounts are remitted to the government we will credit cash when we pay those accounts.
The second part of our journal entry relates to the taxes that the employer is responsible for paying. This would be the 2.5% unemployment tax on the first $2,500 of wages paid.
Compensated Fringe Benefits
Fringe benefits are benefits given to the employee for vacation, sick, and holidays. The employee will be compensated for these days even if they do not work and thus the company has a future obligation to pay the employee even though the employee will not be working on these days. Other examples of fringe benefits are employer paid for health insurance, subsidized meals, tuition reimbursement or a company car. To account for these obligations the company will need to accrue a liability when all of the following conditions exist:
- The payment of compensation is probable
- The Payment of the compensation can be estimated
- The employee has a right to the compensation (vested right)
- The employee has performed their services that results in the employer being obligated to pay for the fringe benefit
If the amount of accrual cannot be estimated then a footnote disclosure is required assuming all the other conditions have been met.
The accounting for fringe benefits is slightly complicated due to certain legal definitions that need to be understood. Let's cover these terms briefly:
- Accumulated rights: Accumulated rights are when your compensated benefits can be carried forward to future periods. If the employee does not use the compensated benefit then they can receive cash compensation for the benefit. For example, a company might have a benefits plan that gives employees two paid sick days per year. At the end of the year if the employee does not use the sick days then they will receive $50 cash for each unused sick day. For an accumulated rights benefit the company must accrue the expense associated with the benefit.
- Vested rights: A vested right is when the employee has a legally binding obligation to the compensation. The compensation must be paid even if the employee no longer works for the company. A vested right is not contingent on the employee's future service to the company.
If the rights do not have a compensation element then the accrual gets adjusted based on any forfeitures due to employees quitting or terminations.
The most important element of compensated benefits is that the company must accrue the expense as the employee earns the benefit. For example if an employee years 2 sick days per month then the company must accrue the expense when the benefit has been earned by the employee. That would mean the company would accrue the sick day expense at the end of each month.
Example: Your company has three employees and each employee earns one vacation day per month that vests at the end of the month. Unused vacation days are automatically cashed out at $50 per day for each unused vacation day. Each employee earns $180 per day. On January 31st, 2016, the following journal entry would be posted to show the accrual of the vacation day expense:
As employees use their vacation days the finge benefit payable account would be debited for $180 and cash would be credited for $180.
A bonus is when the employer provides additional compensation in the form of cash, prizes or other benefits to reward employees. For example, a company might give $500 to the employee who has the highest sales or exceeds their sales goals. A company could also have a profit sharing plan that rewards employees for helping to improve the profitability of the company.
A bonus contract is to be recorded when the company is legally obligated to pay the bonus. It should be recorded as a current liability until the cash is paid to the employee.
Example: Your company has a company policy where the highest performing sales employee will receive a $24,000 cash bonus.
Each month the company should accrue $2,000 to account for the bonus. The following journal entries would be recorded:
First, record the $2,000 per month expense accrual. This journal entry would be recorded at the end of each month:
Second, record the cash payment that is made to the employee at the end of the year:
We record $2,000 of bonus expense to account for the expense for December. Prior to this entry, only $22,000 of bonus expense was recorded in the previous 12 months.
The bonus payable account would be reported as a current liability on the balance sheet.
Current Portion of Long-Term Liabilities
As mentioned previously, a current liability is any debt that is owed in the next 12 months. What about if we have a long-term liability that is being repaid on a monthly basis? In this case we will classify the payments that are required to be made in the next 12 months as a current liability and any amount that remains (due after 12 months) will be classified as a long-term liability.
For example, lets assume that you have a $5,000 note payable that is to be repaid over the next 2 years on a monthly basis. All payments that are due within the next 12 months would be classified as a current liability while any remaining payments will be classified as a long-term liability. Using the amortization table below, we can see how the payments are classified:
For our December 31st, 2016 balance sheet we would classify $2,527 as current liabilities and $2,526 as long-term liabilities.
Financial Statement Presentation of Current Liabilities
Current liabilities are fairly straight forward to report on the financial statements. They are reported at their full maturity value without taking into account the impact of present value calculations (time value of money). The impact of present value on the balances of current liabilities are regarded as being immaterial (insignificant) to calculate and report. Generally the current liabilities are reported in a sub section on the balance sheet under liabilities. Another sub section is created for long-term liabilities which follows the current liabilities sub section. The ordering of the accounts is to be left to the financial statement prepared to determine. However, the ordering should follow a logical pattern like highest balance to lowest or by maturity date. The following balance sheet shows a typical presentation of current liabilities:
Uncertainty is a common aspect in business and is common to liabilities. A contingency is a future event that might impact the company in the future but it is not possible to predict the outcome of the event. For example, a lawsuit is a contingency because the courts will have to perform the trial to determine the outcome. When the company is served with the lawsuit the company only knows that a possible negative result could occur. The result could be positive or negative. The following are typical situations where contingencies are involved:
- Lawsuits: What will be the result of the lawsuit?
- Warranties: Will the customer use the warranty?
- Government Seizure or Fines: Will the government seize my assets or issue a fine?
- Product Liability: Will customers get hurt by my products?
Contingencies that result in positive gains are called gain contingencies. Contingencies that result in a loss are called loss contingencies.
A specific set of guidelines are used to determine how to record contingencies
Gain contingencies are when the firm expects to receive an inflow of resources to the firm as a result of a past event. The outcome of the contingency and the amount of gain is not reasonable predictable. Example of gain contingencies are the following:
- Tax Refund Dispute: If the company requested a refund for prior taxes paid, the amount of refund that will be approved is uncertain.
- Donations: A company could receive a donation or be pledged a gift and the amount of the value of the donation is uncertain.
- Lawsuits: If a lawsuit results in a favorable outcome, the company could be the recipient of a flow of a resources.
The accounting for gain contingencies is very simple: do not record gain contingencies until they have been fully resolved and the resources have been collected. We follow this rule based on the rule of conservatism. If the gain contingency is highly probable of being received then the gain contingency can be disclosed in the notes to the financial statements. As a general rule, gain contingencies should not be disclosed to prevent financial statement users from getting a misleading view of the company.
Example: On June 1st, 2015, Mayfield Corp requested a tax refund for $1,000,000 from the local government. The tax refund is subject to a review and will only be paid on approved amounts. On August 1st, 2015, the local government approved $750,000 of the refund and a check was recieved on that same day in the amount of $750,000.
On June 1st, 2015, Mayfield corp would not record anything in the books and would not disclose anything in the financial statments related to the gain contingencies. On August 1st, 2015, the company would record the receipt of $750,000 for a tax refund.
A loss contingency is when a future outflow of resources is dependent on a future event occurring. If a loss is going to occur then it is a liability to the company. Due to the rule of conservatism we should report all losses as soon as possible. However, loss contingencies are made complicated due to the element of uncertainty. To prevent reporting loss contingencies that are unlikely to occur we will report loss contingencies only when a certain probability of occurrence has been established. We use a range from probable to remote to determine what actions we will perform in regard to the loss contingency.
- Remote: The likelihood of the event occurring has a low probability.
- Reasonably Probable: The likelihood of the event occurring is higher than a remote possibility but less than a probable possibility.
- Probable: The likelihood of the event occurring has a high probability.
The above classifications are based on management's judgement. Managers should be prepared to justify all contingent liabilities in terms of the above classifications. Managers should never intentionally report a contingent liability at a false probability or fail to report a contingent liability that must be reported. Intentional disregard of these rules is considered accounting fraud as it would create a misleading set of financial statements.
Independent counsel from competent professionals (lawyers, business professionals, experts in the area of the contingent liability etc.) should be used as much as possible in terms of determining the probability of contingent liabilities.
Once we have established the probabilities for our contingent liabilities we should perform the following actions:
- Probable: If the contingency is probable and can be reasonably estimated then the company should accrue an estimated amount by setting up an expense and recording the associated estimated liability payable. Disclosure of the loss should be reported in the footnotes of the financial statements. If the liability is probable but can not be estimated then footnote disclosure is required (no journal entry is recorded).
- Reasonably Probable: If the contingency is reasonably probable of occurring then footnote disclosure is the only requirement. A journal entry is not required for reasonably probable contingencies.
- Remote: If a contingency is remote then no action should be taken. A footnote disclosure is not required. A journal entry should not be recorded.
Example: On June 1st, 2016 your company was impacted by a environmental lawsuit. You have retained legal counsel to fight the lawsuit. Your lawyer has reviewed all facts of the case and has determined the lawsuit to have a probable likelihood of creating a liability of $5,000,000 for the company. In other words, your lawyer believes the company will lose the lawsuit and be ordered to pay $5,000,000 as a result of losing the lawsuit.
The above event has shown us that we have a probable contingent loss liability and the loss can be estimated. The following journal entry should be recorded:
The following decision tree can help to determine how a contingent loss should be handled:
A warranty is a promise by a manufacturer or seller of the product to replace or repair the product if it is damaged. Warranties are generally for a fixed amount of time such as 12 months or for the life of the product which is called a lifetime warranty. When a product is sold with a warranty is creates a contingent liability for the seller issuing the warranty. If the customer decides to request a repair or replacement of the product based on a valid warranty then the seller will have to use resources to replace or repair the broken product. By issuing a warranty with each product sold the seller or manufacturer is creating a contingent liability.
With warranties there are a lot of uncertainties that must be estimated based on the best available information:
- The cost of each warranty if it were to be redeemed
- The likelihood of each warranty being redeemed and how many will be redeemed
- The total cost of all warranty redemptions
To calculate these estimates, the accounting staff must use reports and various other data to determine the amounts for each estimate. Historical patterns are a common method of calculating estimates. The accounting staff should also factor in other conditions such as legal terms, the overall economic condition of the economy and any other similar factors.
Once we have calculated our expected rate and amount of warranties that will be redeemed we can proceed to recording our journal entries. The easiest way to learn how to record warranties is through an example.
Example: On January 1st, 2016, your company sells $100,000 worth of televisions. Each television sells for $1,000 and the accounting department has calculated based on historical data that 10% of the televisions are returned for repairs. Each repair costs $100. The total warranty liability related to the $100,000 sales is $1,000 (100 units x 10% = 10 repairs @ $100 each). The warranty issued is a standard 1 year warranty that is included at no additional cost to the customer.
Based on the example data above, the following journal entries will be recorded:
On January 1st, 2016, we need to record the sales revenue related to the sale of the television:
Based on the matching principle, we must match our expenses with the associated revenue which created the expenses. The expected loss related to the warranty is also probable and estimable which requires a journal entry. The warranties that are associated with the revenue would be recorded as follows:
After 6 months has elapsed we verify our records to find that four warranty repairs were made for a total amount of $357. Since we used estimations for our warranty expense the amount of actual cash outflows may differ. The warranty journal entry could also be recorded after each repair. We record the expenditures for the warranty repairs as follows:
After the above journal entry has been posted our warranty payable account will report $643 ($1,000 - $357). We need to evaluate if this is still the correct amount of warranty payable we should have recorded. We do not want our warranty payable to be overstated or understated. If the warranty payable is correct then no adjustment is necessary. If the warranty payable is overstated or understated then an adjusting entry will need to be recorded to correct the overstatement or understatement. If we determined that our warranty liability should actually be $750 then we will record the following entry to adjust the account:
The warranty payable will now reporting the correct amount. A retroactive adjustment of our January 1st, 2016 journal entry is not required since we used an estimate. Retroactive adjustment is only required when the entry was made in bad faith (fraud, deception etc.).
Now lets assume that at the end of the year all of the warranties have expired and no additional warranty repairs have been performed. At this point, the business is under no obligation to honor the warranties anymore and therefore there is no contingent liability that exists. We need to perform our final adjusting entry which is to eliminate the contingent liability from our books. We currently have a contingent liability of $750 reported. This entry will correct the overstated liability and overstated expense. To eliminate this amount we will post the following journal entry:
Unlike a standard warranty that is automatically created upon sale of the merchandise, an extended warranty is sold with additional consideration (money) received for the extended warranty. Extended warranties are accounted for slightly different compared to standard warranties. First, the extended warranty does not recognize revenue until the earnings process is substantially completed. Thus, when an extended warranty is sold we will credit unearned revenue rather than revenue. The company still might owe services to be performed to the warranty holder and thus it does not qualify for revenue recognition immediately.
When the extended warranty is sold, we will use the following journal entry:
The associated warranty expense liability is not recorded because the earnings process has not been completed. The warranty revenue can be recognized on a straight-line basis as the warranty expires. For example if the warranty was for a term of 1 year then 1/12th of the warranty would be recognized each month. The following journal entry would be recorded to record one month of warranty that has been earned:
When warranty repairs are made we will record the warranty expense associated in the period in which the repair occurred. We record the expense in terms of the amount of cost to perform the repair. We will use the following entry to record our warranty repairs:
Financial Statement Presentation of Contingencies
The financial statement impact of contingencies is relatively straight forward. Gain contingencies have no impact on the financial statements until they are realized. For loss contingencies the impact on the financial statements depends on if you can estimate the amount of the loss and the probability of the loss occurring. For remote events, there is no impact on the financial statements since nothing is recorded or requires a footnote disclosure. For reasonably probable events the only requirement is a footnote disclosure. For events that can be estimated and are probable of occurring we will accrue the loss which impacts the income statement similar to how any other loss would impact the financial statements.
The following is an example of a footnote disclosure for a loss contingency that cannot be estimated but is reasonably probable of occurring:
"On June 30th, 2016, the company received notice that the company's foreign operations in Chile could be subject to seizure by the Chilean government. The value of these assets have a book value of $23 million. Our legal counsel has estimated the probability of this event occurring is reasonably probable and the estimated loss would be $23 million."