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CHAPTER 13

Current Liabilities and Contingencies

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 ofcontingent liabilities.

I. Current Liabilities.

1. Definition of current liabilities: Obligations whose

liquidation is reasonably expected to require the use

of existing resources classified as current assets, or

the creation of other current liabilities.

2. Current liabilities can be classified as either

determinableorcontingent.

II. Determinable Current Liabilities: Such liabilities can

be measured with a fair degree of precision and the

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amount and timing of the cash outflows are reasonably

certain.

1. Accounts Payable.

2. Notes Payable.

a. Trade notes.

Example No.1

On Feb. 1, the company purchased $10,000 of

merchandise by signing a 3-month, 10% note.

Dr. Purchases 10,000

Cr. N/P 10,000

On May 1, 2004, the company paid the note and

interest.

Dr. N/P 10,000

Dr. Interest Expense 250

Cr. Cash 10,250

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b. Short-term loan notes: Such notes represent a

current liability and generally are the result of cash

loans. The notes may be interest bearing or

zero-interest bearing.

(1) Interest bearing notes: the borrower receives

the face value of the note and records the note

at face value.

Example No.2

On Jan. 7, 2004, the company borrowed from First Bank

by signing a $20,000, 10%, 6-month note which

matures on July 6.

Dr. Cash 20,000

Cr. N/P 20,000

At maturity

Dr. N/P 20,000Dr. Interest Expense 1,000

Cr. Cash 21,000

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(2) Zero-interest bearing notes: the borrower

receives an amount equal to the face value of

the note less the interest. The note is recorded

at its face value and the "prepaid" interest isrecorded in a Discount on Notes Payable

account.

Example No.3

The company took an one-year loan from State Bank on

1/1/04 by signing a $100,000 non-interest bearing

note which matures on 12/31/04

Dr. Cash 90,909

Dr. Discount on N/P 9,091

Cr. N/P 100,000

At maturity

Dr. N/P 100,000

Cr. Cash 100,000

Dr. Interest Expense 9,091

Cr. Disc on N/P 9,091

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c. Current maturities of long-term debt: That portion

of long-term debt that matures within the next

fiscal year is reported as a current liability, unless

it is to be refinanced by a new debt issue or byconversion into stock.

3. Short-term obligations expected to be refinanced.

a. Can be excluded from current liabilities only if the

firm:

(1) Intends to refinance, and

(2)Demonstrates an ability to refinance.

b. Ability can be evidenced by:

(1)Actual refinancing, or

(2)Signing a refinancing agreement (with a

capable lender) which is noncancellable and

not violated.

4. Dividends Payable: At the date of declaration of acash dividend, the corporation assumes a liability.

Preferred dividends in arrears are not a legal

obligation until a distribution is formally authorized.

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Stock dividends are part of stockholders' equity (not

a liability).

5. Returnable deposits.

6. Unearned Revenues.

7. Sales taxes payable.

8. Property taxes payable

9. Income taxes payable

10. Employee-related liabilities

Example No.4

You accepted an offer from Johnson for an annual salary

of $60,000. In addition to salary, Johnson will

contribute equivalent of 15% of your salary to the

pension fund of your choice and pay your health

insurance and life insurance premium of

$1,500/month. Finally, Johnson is required to

match employees FICA tax (7.65% on wages to

$90,000 and 1.45% in excess of $90,000), .8%

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and 5.4% of Federal and State Unemployment

tax, respectively (Unemployment tax is based on

the first $7,000 of each employees

compensation).In addition to the FICA tax withholding, your federal

income tax withholding rate is 28% and state

income tax rate is 6.5%. You also authorized

Johnson to make the following voluntary monthly

deductions: (1) union dues of $100, (2) United

Way contributions of $150, (3) dental insurancepremium of $50.

Prepared necessary entries for Johnson related to

your payroll.

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Two entries to record payroll:

a. To record the payroll

Dr. Salaries Expense 5,000

Cr. Fed. Inc. Tax Withheld Payable 1400

Cr. State Inc. Tax Withheld Payable 325

Cr. FICA Tax withheld Payable 382.5

Cr. Union Dues Payable 100Cr. United Way Contrib. Payable 150

Cr. Dental Ins. Premium Payable 50

Cr. Payroll Payable 2,592.9

b.To record the payroll taxes and fringe benefits

Dr. Payroll tax expenses 692.5

Dr. Fringe benefit expenses 2,250

Cr. Pension Payable 750

Cr. Health Ins. Premium Payable 1,500

Cr. FICA Tax Payable 382.5

Cr. Fed. Unempl. Tax Payable 40

Cr. State Unempl. Tax Payable 270

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III. Contingent Liabilities

A.Contingencies: an existing condition, situation, or set

of circumstances involving uncertainty as to possiblegain (gain contingency) or loss (loss contingency) to

an enterprise that will ultimately by resolved when one

or more future events occur or fail to occur.

1. Gain contingencies: are not recorded and are only

disclosed when the probability is high that it willbecome a reality.

2. Loss contingencies: result in recognition of a

contingent liability.

B.Contingent Liabilities: Liabilities which are dependent

upon the occurrence or nonoccurrence of one or more

future events to confirm either the amount payable, or

the payee, or the date payable, or its existence. The

condition had to exist at the balance sheet date.

Information has to be available prior to issuing financial

statements.

1. The likelihood that the future event or events will

confirm the incurrence of a liability can be classified

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a. Probable. The future event or events are likely to

occur. A liability is recorded if the informationindicates that it is probable that a liability had

been incurred at the balance sheet date and the

amount of the loss can be reasonably estimated.

b. Reasonably possible. The chance of the future

event or events occurring is more than remote butless than likely.

c. Remote. The chance of the future event or

events occurring is slight.

2. Accrual of a loss contingency should be made if both

of the following conditions are met:

a. It is probable that a liability has been incurred

at the date of the financial statements.

b. The amount of the loss can be reasonably

estimated.

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**** An entry must be made to accrue the loss contingency

if both conditions are met:

Dr. Loss from lawsuits/warranty exp. $$$$Cr. Estimated Liability from lawsuits $$$$

3. Common loss contingencies

a. Litigation, claims, and assessments.

b. Guarantee and warranty costs: The amount of

the liability is an estimate of all the costs that will

be incurred after sale and delivery.

(1)Cash basis method.

(2)Accrual methods (Follows the Matching

Principles, i.e., the revenue and the associated warranty

costs are recognized in the same period)

(a)Expense warranty treatment. This method

should be used whenever the warranty is an

integral and inseparable part of the product

sale and requires warranty costs to be

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(b)Sales warranty treatment. This method is

used when the warranty is sold separately

from the product and requires that revenuesfrom the sale of the warranty be deferred

and subsequently recognized as income

over the life of the warranty contract.

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Example No.5

Case sold 1,000 tractors at $20,000 each in Dec. 2006.

Each tractor sold carries a 3-year warranty.

Based on past experience, it is estimated that theaverage cost of warranty repair for each tractor is

$1,200. The actual repair cost in 2007 was

$300,000.

Required:

1. which method (expense warranty or sale warranty

treatment) should be used?2. prepare all necessary entries.

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Expense Warranty

Treatment

(Accrual basis)

Cash Basis

(Not acceptable if the

warranty expense is

material)

To record

the sale

(Dec. 2006)

Dr. Cash/A/R 20,000,000

Cr. Sales 20,000,000

Dr. Cash/A/R 20,000,000

Cr. Sales 20,000,000

To record

the

estimatedwarranty

cost

(12/31/06)

Dr. Warranty Exp. 1,200,000*

Cr. Estimated L. from

Warranty 1,200,000(1,000*$1,200)

No enty

F/S of 06 On B/S:

Current L Est. L from

warranty 400,000

L-T L Est.L from warranty

$800,000

On I/S:

Warranty expense 1,200,000

On B/S:

No liability is reported

On I/S:

No warranty expense is

reported

To record

the actual

warrantyrepair in 07

for tractors

sold in 06

Dr. Estimated L. from

Warranty 300,000

Cr. Cash/Parts/other 300,000

Dr. Warranty expense

300,000

Cr. Cash/Parts/other300,000

Comments No expense is reported in

2007 for repairing tractors sold

$300,000 warranty expense is

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in 2006 the sales revenue of those

tractors was recorded in 2006

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Example No.6

In Dec. 2006, Best Buy sold a large screen TV for $2,400.

The TV carries a one-year manufacturers warranty. Best

Buy sold a 3-year extended warranty for $450.

Required:

1. Which treatment (expense warranty or sale warranty

treatment) should be used for the extended warranty?

2. Prepare all necessary entries.

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To record the sale

of the TV and the

extendedwarranty

Dr. Cash 2,850

Cr. Sales 2,400

Cr. Unearned Warranty Rev 450

12/31/06 The unearned warranty revenue will

be reported as a liability

(Q: should it be a current L or L-T L?)

In 2007 No entry for this warranty

In 2008 Dr. Unearned Warranty Rev. 150

Cr. Warranty Revenue 150

Actual repair:

Dr. Warranty Expense $$

Cr. Cash/Parts $$

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Presentation and Analysis

A.Presentation of current liabilities

1. Owing to their short-term nature current liabilities are

reported at their full maturity value, not their

present value.

2. The current liability accounts are generally the first

classification in the liability section of the balance

sheet.

3. Current liabilities are frequently listed in order of

maturity, according to amount, or in order of

liquidation preference.

4. Disclosures for short-term obligations expected to be

refinanced should include:

a. A general description of the financing agreement.

b. The terms of any new obligations incurred or to be

incurred.

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c. The terms of any equity security issued or to be

issued.

5. Currently maturing debt to be paid with noncurrent

assets should be classified as long-term liabilities.

6. Secured liabilities should be identified and the related

assets clearly indicated.

B.Presentation of contingencies.

1. If a loss contingency is either probable or

estimatable but not both and if there is at least a

reasonable possibility that a liability may have been

incurred, the following disclosure is required:

a. The nature of the contingency.

b. An estimate of the possible loss or range of loss

or a statement that an estimate cannot be made.

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2. Other contingent liabilities that should be disclosed

even if the possibility of a loss is remote are:

a. Guarantees of indebtedness to others.

b. Obligations to banks under "stand-by letters of

credit".

c. Guarantees to repurchase receivables (or any

related property) that have been sold or assigned.

3. Disclosure should include the nature and amount of

the guarantee and, if estimable, the amount to be

recovered from outside parties.

C.Analysis of current liabilities.

1. Current ratio =

2. Acid-test ratio =