978-1133939283 Chapter 11 Lecture Note Part 2

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Summary

Current liabilities consist of denitely determinable liabilities and estimated liabilities.

Denitely determinable liabilities are obligations that can be measured exactly. They

include accounts payable, bank loans and commercial paper, notes payable, accrued

liabilities, dividends payable, sales and excise taxes payable, current portions of long-term

debt, payroll liabilities, and unearned revenues. Denitely determinable liabilities include:

00. Accounts payable are short-term obligations to suppliers for goods and services.

20. Short-term notes payable are current obligations evidenced by promissory notes.

Usually, interest is stated separately on the face of the note.

30. Companies often obtain a line of credit with a bank to nance operations. In addition, a

company may borrow short-term funds by issuing commercial paper (unsecured loans

sold to the public).

00. Accrued liabilities are actual or estimated liabilities that exist at the balance sheet

date but are unrecorded. An end-of-period adjustment is needed to record both

expenses and accrued liabilities.

00. Cash dividends are a distribution of earnings to a corporation’s stockholders.

Dividends payable represent an obligation to distribute a corporation’s earnings to its

stockholders. This arises only when the board of directors declares a dividend.

00. Most states and many cities levy a sales tax on retail transactions, and the federal

government also charges an excise tax on some products. The merchant must collect

the taxes at the time of the sale and record the receipt of cash and the proper tax

liabilities.

00. If a portion of long-term debt is due within the next year and is to be paid from current

assets, then that current portion of long-term debt is classied as a current liability. The

remaining debt is classied as a long-term liability.

00. Payroll liabilities consist of the labor-related obligations incurred by a business. Not only

is the business responsible for wages, paid at an hourly rate, and salaries, paid at a

monthly or yearly rate, earned by its employees, but also it is obligated for items such

as social security (FICA) taxes, Medicare tax, and unemployment taxes. The business is

likewise liable for amounts withheld from its employees’ gross earnings that must be

remitted to governmental and other agencies.

00. Unearned revenues represent obligations to deliver goods or services in return for

advance payment. When delivery takes place, Unearned Revenue is debited and a

revenue account is credited.

Estimated liabilities are denite obligations. Nevertheless, the amount of the obligation

must be estimated at the balance sheet date because the exact gure will not be known

until a future date. Examples of estimated liabilities are income taxes, property taxes,

product warranties, and vacation pay.0

00. A corporation’s income tax is dependent on its taxable net income, a gure that often is

not determined until well after the balance sheet date.

00. Property taxes are levied on real and personal property. Often a company’s accounting

period ends before property taxes are assessed, making it necessary to estimate the

property tax applicable to each month of the year.

00. Promotional costs such as coupons, rebates, and frequent 4yer programs are recorded

as a reduction of sales.

00. Warranties for many of the products or services a company sells will still be in e5ect

during the next accounting period. Nevertheless, the warranty expense and liability

or posted to a publicly accessible website, in whole or in part.

Chapter 11: Current Liabilities and Fair Value Accounting Instructor’s Manual, p. 2

must be recorded in the period of the sale regardless of when the company makes good

on its warranties. Therefore, at the end of each accounting period, the company should

estimate the future warranty expense that applies to the present period’s sales.

00. In most companies, employees accrue vacation pay for working a certain length of

time. Therefore, the company must estimate the vacation pay applicable to each

payroll period, debit Vacation Pay Expense, and credit Estimated Liability for Vacation

Pay.

The following journal entries are introduced in this section:

Cash XX (amount received)

Notes Payable XX (face amount)

Issued promissory note with interest stated

separately

Notes Payable XX (face amount)

Interest Expense XX (amount incurred)

Cash XX (maturity amount)

Payment of note with interest stated separately

Interest Expense XX (amount accrued)

Interest Payable XX (amount accrued)

To record interest expense on note with interest

stated separately

Cash XX (amount collected)

Sales XX (price charged)

Sales Tax Payable XX (amount to remit)

Excise Tax Payable XX (amount to remit)

Sale of merchandise and collection of sales and

excise taxes

Wages Expense XX (gross amount)

Employees’ Federal Income Taxes Payable XX (amount withheld)

Employees’ State Income Taxes Payable XX (amount withheld)

Social Security Tax Payable XX (employees’ share)

Medicare Tax Payable XX (employees’ share)

Medical Insurance Premiums Payable XX (employees’ share)

Pension Contributions Payable XX (employees’ share)

Wages Payable XX (take-home pay)

To record payroll

Payroll Taxes and Benets Expense XX (total employer payroll taxes)

Social Security Tax Payable XX (employer’s share)

Medicare Tax Payable XX (employer’s share)

Medical Insurance Premiums Payable XX (employer’s share)

Pension Contributions Payable XX (employer’s share)

Federal Unemployment Tax Payable XX (amount incurred)

State Unemployment Tax Payable XX (amount incurred)

To record payroll taxes and other costs

Cash XX (amount prepaid)

Unearned Revenue XX (amount to earn)

Receipt of membership dues in advance

or posted to a publicly accessible website, in whole or in part.

Chapter 11: Current Liabilities and Fair Value Accounting Instructor’s Manual, p. 3

Unearned Revenue XX (amount earned)

Revenue XX (amount earned)

Recognition of revenue for services provided

Product Warranty Expense XX (estimated amount)

Estimated Product Warranty Liability XX (estimated amount)

To record estimated product warranty expense

Cash XX (fee charged)

Estimated Product Warranty Liability XX (cost of part)

Service Revenue XX (fee charged)

Merchandise Inventory XX (cost of part)

Replacement of part under warranty

Vacation Pay Expense XX (amount incurred)

Estimated Liability for Vacation Pay XX (amount owed or accrued)

Estimated vacation pay expense

Estimated Liability for Vacation Pay XX (amount taken)

Cash (or Wages Payable) XX (amount paid or payable)

Wages of employees on vacation

A contingent liability is a potential liability that may or may not become an actual liability.

The uncertainty regarding its outcome is resolved by the occurrence or nonoccurrence of a

future event. Contingent liabilities arise from pending lawsuits, tax disputes, and failure to

follow government regulations. Contingent liabilities are recorded if the occurrence is

probable and the amount can be reasonably estimated. A commitment is a legal obligation

that does not meet the technical requirements for recognition as a liability. The most

common examples are purchase agreements and leases.

Fair value is the price for which an asset or liability can be sold. The three approaches to

measurement of fair value are the market approach, income (or cash 4ow) approach, and

the cost approach.

Time value of money is the e5ects of the passage of time on holding or not holding

money. The timing of the receipt and payment of cash (measured in interest) should be

considered in making business decisions. Interest is the specic cost measure of these

e5ects for a period of time. The amount of principal plus interest after one or more periods is

known as future value. It may be calculated using either simple interest or compound

interest.

10. Simple interest is the interest cost for one or more periods under the assumption that

the amount on which interest is computed does not increase each period (that is,

interest is not computed on previously earned interest).

20. Compound interest is the interest cost for two or more periods under the assumption

that the amount on which interest is computed does increase each period (that is,

interest is computed on previously earned interest).

Present value is the amount that must be invested now at a given rate of interest to

produce a given future value or values. Present value may be computed on a single sum due

in the future; Exhibit 3 facilitates this computation.

Present value may also be computed on an ordinary annuity. Conceptually, the present

value of an ordinary annuity is that amount that may be invested today at a given

percentage to enable periodic withdrawals of the given amount; Exhibit 4 facilitates this

computation.

or posted to a publicly accessible website, in whole or in part.

Chapter 11: Current Liabilities and Fair Value Accounting Instructor’s Manual, p. 4

Present value may be used in accounting to (a) determine the value of an asset being

considered for purchase, (b) calculate deferred payments for the purchase of an asset, (c)

account for the investment of idle cash, (d) accumulate funds needed to pay o5 a loan, and

(e) determine numerous other accounting values, such as the value of a bond, pension and

lease obligations, and depreciation.

Relevant Examples and Exhibits

Exhibit 1 Promissory Note

Example: Issuance of Note Payable

Example: Payment of Note with Interest

Example: Recognizing Accrual Interest Expense

Example: Recording Sales and Excise Taxes

Exhibit 2 Illustration of Payroll Costs

Example: Recording Payroll and Related Withholdings

Example: Recording Employer Payroll Taxes and Health Insurance Cost and Pension

Benets

Example: Recording Unearned Revenues

Example: Recognizing Unearned Revenues That Are Now Earned

Example: Recording Product Liability

Example: Recording Product Liability and Service

Example: Recording Vacation Pay Expense

Example: Recording Payment When Vacation is Taken

Example: Future Value Using Simple Interest

Example: Future Value Using Compound Interest

Example: Present Value

Exhibit 3 Present Value of $1 to Be Received at the End of a Given Number of Periods

Example: Present Value of an Ordinary Annuity

Exhibit 4 Present Value of an Ordinary $1 Annuity Received in Each Period for a Given

Number of Periods

Example: Present Value When Compounding Period Is Less than One Year

Example: The Present Value of an Asset

Example: Present Value of a Deferred Payment

Exhibit 5 Accrued Expenses and Related Accrued Liabilities

Teaching Strategy

After you dene denitely determinable and estimated liabilities, ask students to identify

several examples of each.

Short Exercise 2 and Exercise 2A pertain to interest expense. Short Exercise 3 and Exercise

4A pertain to payroll concepts and entries.

Discuss the concept of uncertainty and the desire to follow the matching principle at the

expense of perfect accuracy.

Students may also have diEculty understanding the topic of property tax payable. A

time-line diagram by month helps explain prepaid property tax versus estimated property

tax payable.

Students should know that a contingent liability is a possible liability that may or may not

become an actual liability (when a future event occurs or does not occur). Point out that

contingent liabilities such as product warranty liability and vacation pay liability are accrued

or posted to a publicly accessible website, in whole or in part.

Chapter 11: Current Liabilities and Fair Value Accounting Instructor’s Manual, p. 5

because they are probable, and their amounts can usually be reasonably estimated

(otherwise, just a footnote is required). Have students list some contingent liabilities and

explain why they are described as such. Students should also know that a commitment is a

legal obligation that does not meet the technical requirements for recognition as a liability.

Have students explain why purchase agreements and leases are examples of a commitment.

Cases 2 and 5 are good activities for this topic.

Regarding fair value, although the market and cost approaches are conceptually

straightforward, the income, or cash 4ow, approach requires knowledge of interest and the

time value of money. A good way to begin the topic of the time value of money is by

explaining the basic concept—that it is best to pay out a dollar as far into the future as

possible and to receive a dollar as close to today as possible. Interest is assumed to be

earned on any money currently held (invested).

Make sure your students remember the basic calculation of interest. Then contrast simple

and compound interest using a straightforward example, stressing that compound interest is

built into the time value of money tables. Short Exercise 6 can be used to illustrate the

di5erence between simple and compound interest.

Present value is a diEcult concept for a student to understand. Dene it as the amount that

we would require now to have the equivalent of some other amount payable or receivable in

the future. When working out an example, prove that the present value amount determined

will grow to the given future value amount at the chosen interest rate. For an annuity,

demonstrate that the present value invested in the bank will enable one to withdraw the

given annual amounts with zero remaining. Short Exercise 7 and Exercises 9A through 11A

pertain to present values.

By this time, students should understand that comparing current amounts with future

amounts is like comparing apples and oranges. Make sure to present situations that rely on

present value calculations for their logical valuation on the books, such as valuing an asset

or calculating deferred payments. Short Exercise 8 and Exercises 12A through 14A provide

several applications of present values. Case 3 provides a good group activity that combines

the time value of money with estimated liabilities.

Section 3: Business Applications

Business Applications

Liquidity

Cash 4ows

Lecture Outline

I. Failure to manage the cash 4ows related to current liabilities can have serious

consequences for a business.

A. The operating cycle is the length of time it takes to purchase inventory, sell

inventory, and collect the resulting receivable.

B. Analysts often use working capital and current ratio as measures of liquidity.

1. Working Capital = Current Assets – Current Liabilities

2. Current Ratio = Current Assets ÷ Current Liabilities

C. Measurements commonly used to assess a company’s ability to pay within a

certain time frame are payables turnover and days’ payable.

or posted to a publicly accessible website, in whole or in part.

Chapter 11: Current Liabilities and Fair Value Accounting Instructor’s Manual, p. 6

1. Payables turnover is the number of times, on average, that a company pays

its accounts payable in an accounting period.

2. Payables Turnover = Cost of Goods Sold + Change in Merchandise Inventory

÷ Average Accounts Payable

3. Days’ payable shows how long, on average, a company takes to pay its

accounts payable.

4. Days’ Payable = 365 days ÷ Payables Turnover

Summary

To evaluate a company’s ability to pay its current liabilities, analysts often use two measures

of liquidity, both of which were dened in an earlier chapter:

Working Capital = Current Assets – Current Liabilities

Current Ratio = Current Assets ÷ Current Liabilities

Two common measures of a company’s ability to pay within a certain time frame are the

payables turnover and the days’ payable. The payables turnover is the number of times,

on average, that accounts payable are paid in an accounting period and shows the relative

size of a company’s accounts payable. The days’ payable, on the other hand, shows the

average length of time a company takes to pay its accounts payable.

Management must carefully manage the cash 4ows related to current liabilities; the

appropriate level of liabilities is critical to business success.

Relevant Examples and Exhibits

Example: Working capital and current ratio for Nike

Example: Payables Turnover for Nike

Example: Days’ Payable for Nike

Teaching Strategy

Emphasize the importance of carefully managing cash 4ows related to current liabilities.

Many new businesses fail due to cash 4ow problems and the inability to pay creditors on

time. Explain that creditors use several measures to assess a company’s creditworthiness.

Discuss working capital, the current ratio, payables turnover, and days’ payable in terms of

both what they measure and how they are calculated.

Short Exercise 9 and Exercise 15A apply this section. Case 4 provides for application of the

discussed measures in the evaluation of real companies.

Student Engagement Tactics

10. Assign Case 8 to small groups in class. Use previously established groups or assign

groups randomly. Each group should select a representative to speak for the group.

20. Be clear on the expected output of the learning activity. Identify questions to address

and determine whether written answers are necessary. For example, ask one person

from each group to present one alternative and explain why that alternative would be

best.

or posted to a publicly accessible website, in whole or in part.

Chapter 11: Current Liabilities and Fair Value Accounting Instructor’s Manual, p. 7

30. Elicit as many alternatives as possible for the class to consider. After each group has

presented one alternative, if time permits, ask if any other alternatives might be

available.

40. Allow groups one or two minutes to consider which alternative they prefer and why. Poll

the class as to their preferred response.

or posted to a publicly accessible website, in whole or in part.