Accounting Chapter 9 Characteristics Of Liabilities Notes

CHARACTERISTICS OF LIABILITIES DEFINING LIABILITIES A LIABILITIES is a probable future payment of assets or services that a company is presently obligated to make as a result of past transactions or events. No liability is reported when one or more of these elements are missing. For example, companies expect to pay wages in future years, but these future payments are NOT liabilities because no past event such as employee work resulted in a present obligation. Instead, liabilities are recorded when employees perform work and earn wages. CLASSIFYING LIABILITIES Liabilities are classified as either current or long term CURRENT LIABILITIES CURRENT LIABILITIES, or short-term liabilities, are liabilities due within ONE YEAR (or the company's operating cycle if longer). Most are paid using current assets or by creating other current liabilities. Common examples are accounts payable, short-term notes payable, wages payable, warranty liabilities, and taxes payable. Some liabilities do not have a fixed due date but instead are payable on the creditor's demand. These are reported as current liabilities because of the possibility of payment in the near term. Current liabilities differ across companies because they depend on the type of company operations. For example, MGM Resorts reports casino outstanding chip liability. Harley-Davidson reports different current liabilities such as warranty, recall, and dealer incentive liabilities. LONG-TERM LIABILITIES LONG-TERM LIABILITIES are obligations due AFTER ONE YEAR (or the company's operating cycle if longer). They include long-term notes payable, warranty liabilities, lease liabilities, and bonds payable. For example, Domino's pizza reports long-term liabilities of $2,196 million. A single liability can be divided between the current and noncurrent sections if a company expects to make payments toward it in both the short and long term. Domino's reports long-term debt of $2,149 million and current portion of long-term debt of $39 million. The current portion is reported in current liabilities. UNCERTAINTY IN WHOM TO PAY Liabilities can involve uncertainty in whom to pay. For example, a company can create a liability with a known amount when issuing a note that is payable to its holder. In this case, a specific amount is payable to the note's holder at a specified date, but the company does not know who the holder Is until that date. Despite this uncertainty, the company reports this liability on its balance. UNCERTAINTY IN WHEN TO PAY A company can have an obligation of a specific amount to a known creditor but not know when it must be paid. For example, a law firm can accept fees in advance from a client who plans to use the firm's services in the future. The law firm has a liability (unearned revenue) that it settles by providing services at an unknown future date. Although uncertainty exists, the law firm's balance sheet must report this liability. These types of obligations are reported as current liabilities because they are likely to be settled in the short term. UNCERTAINTY IN HOW MUCH TO PAY A company can be aware of an obligation but not know how much it will be required to pay. For example, a company using electrical power is only billed after the meter has been read. This cost is incurred and the liability created before a bill is received. A liability to the power company is reported as an estimated amount if the balance sheet is prepared before a bill arrives. EXAMPLES OF KNOWN LIABILITIES Known liabilities are measurable obligations arising from agreements, contacts, or laws. Known liabilities include accounts payable, notes payable, payroll obligations, sales taxes, and unearned revenues. ACCOUNTS PAYABLE Accounts payable, or trade accounts payable, are amounts owed to suppliers for products or services purchased on credit. Accounts payable are a focus of the merchandising chapter. SALES TAXES PAYABLE Nearly all states and many cities levy taxes on retail sales. Sales taxes are shown as a percent of selling prices. The seller collects sales taxes from customers when sales occur and sends these collections to the government. Because sellers currently owe these collections to the government, this amount is a current liability. If Home Depot sells materials on August 31 for $6,000 cash that are subject to a 5% sales tax, the revenue portion of this transaction is recorded as follows. Later, when HD sends the $300 collected to the government, it debits SALES TAXES PAYABLE and credits CASH. UNEARNED REVENUES UNEARNED REVENUES, or DEFERRED REVENUES, are amounts received in advance from customers for future products or services. Unearned revenues arise with airline ticket sales, magazine subscriptions, construction projects, hotel reservation, gift card sales, and custom orders. Advance ticket sales for sporting events or concerts are other examples. Unearned ticket revenue is reported as a current liability. SHORT-TERM NOTES PAYABLE A SHORT-TERM NOTE PAYABLE is a written promise to pay a specified amount on a stated future date within one year. Notes can be sold or transferred. Most notes payable bear interest. The written documentation with notes is helpful in resolving legal disputes. We describe two transactions that create notes payable. NOTE GIVEN TO EXTEND CREDIT PERIOD A company can replace an account payable with a note payable. A common example is a creditor that requires an interest-bearing note for an overdue account payable. INTEREST EXPENSE IS COMPUTED BY MULTIPLYING THE PRINCIPLE OF THE NOTE BY THE ANNUAL INTEREST RATE FOR THE FRACTION OF THE YEAR THE NOTE IS OUTSTANDING NOTE GIVEN TO BORROW FROM BANK A bank requires a borrower to sign a note when making a loan. When the note comes due, the borrower repays the note with an amount larger than the amount borrowed. The difference between the amount borrowed and the amount repaid is INTEREST. The amount borrowed is called PRINCIPLE OR FACE VALUE of the note. Assume that a company borrows $2,000 from a bank at 12% annual interest. WHEN NOTE EXTENDS OVER TWO PERIODS When a note is issued in one period but paid in the next, interest expense is recorded in each period based on the number of days the note extends over each period. Assume a company borrows $2,000 cash on December 16, 2020, at 12% annual interest. This 60-day note matures on February 14, 2021 and the company's fiscal year ends on Dec 31. this means 15 of the 60 days are in 2020 and 45 of the 60 days are in 2021. interest for these two periods is:  12/16/2020 to 12/21/2020 = 15 days interest expense = $2,000 X 12% X 45/60 = $30 PAYROLL LIABILITIES Payroll liabilities are from salaries and wages, employee benefits, and payroll taxes levied on the employer. For example, Boston Beer reports current payroll liabilities of more than $14 million from accrued "employee wages, benefits and reimbursements." EMPLOYEE PAYROLL AND DEDUCTIONS GROSS PAY is the total compensation an employee earns including wages, salaries, commissions, bonuses, and any compensation earned before deductions such as taxes. WAGES usually refer to payments to employees at an hourly rate. SALARIES usually refer to payments to employees at a monthly or yearly rate. NET PAY, or TAKE-HOME PAY, is gross pay minus all deductions. PAYROLL DEDUCTIONS, or WITHHOLDINGS, are amounts withheld from an employees gross pay, either required or voluntary. Required deductions result from laws and include income taxes and social security taxes. Voluntary deductions, at an employee's option, include pension and health contributions, health and life insurance premiums, union dues, and donations. The employer withholds payroll deductions from employees pay and sends this money to the designated group or government. The employer records payroll deductions as current liabilities until these amounts are sent. EMPLOYEE FICA TAXES Employers withhold FEDERAL INSURANCE CONTRIBUTIONS ACT (FICA TAXES) from employees pay. Employers separate FICA taxes into two groups:  SOCIAL SECURITY TAXES: withholdings to cover retirement, disability, and survivorship  MEDCIARE TAXES: withholdings to cover medical benefits Taxes for social security and medicare are computed separately. For 2019, the amount withheld from each employee's pay for social security tax is 6.2% of the first $132,900 the employee earns in the calendar year. The medicare tax is 1.45% of ALL amounts the employee earns; there is no maximum limit to medicare tax. A 0.9% ADDITIONAL MEDICARE TAX is imposed on the high-income employee for pay usually in excess of $200,000 (this additional tax is NOT imposed on the employer, whereas others are). Until the taxes are sent to the IRS, they are included in the employers' current liabilities. For any changes in rates or earning levels, check IRS.gov or SSA.gov EMPLOYEE INCOME TAX Most employers withhold federal income tax from each employee's paycheck. The amount withheld is computed using IRS tables. The amount depends on the employee's income and the number of WITHHOLDING ALLOWANCES the employee claims. Allowances reduce taxes owed to the government. Employees can claim allowances for themselves and their dependents. Until the government is paid, withholdings are reported as a current liability on the employers balance sheet. EMPLOYEE VOLUNTARY DEDUCTIONS Voluntary deduction withholdings come from employee requests, contracts, unions, or other agreements. They include charitable giving, medical life insurance premiums, pension contributions, and union dues. Until they are paid, voluntary withholdings are reported as part of employers' current liabilities. EMPLOYEE PAYROLL RECORDING Employers accrue payroll expenses and liabilities at the end of each pay period. EMPLOYER PAYROLL TAXES Employers must pay payroll taxes in addition to those required of employees. Employers taxes include FICA and unemployment taxes. EMPLOYER FICA TAXES Employers must pay FICA taxes on their payroll. For 2019, the employer must pay Social Security tax of 6.2% on the first $132,900 earned by each employee and 1.45% medicare tax on all earnings of each employee. An employers tax is credited to the same FICA taxes and Payable accounts used to record the Social Security and Medicare taxes withheld from employees. EMPLOYER UNEMPLOYMENT TAXES The federal government works with states in a joint federal and state unemployment insurance program. Each state has its own program. These programs provide unemployment benefits to qualified workers. FEDERAL UNEMPLOYMENT TAX ACT (FUTA) Employers must pay a federal unemployment tax on wages and salaries earned by their employees. For the recent year, employers were required to pay FUTA taxes of as much as 6.0% of the first $7,000 earned by each employee. This federal tax can be reduced by a credit of up to 5.4% for taxes paid to a state program. As a result, the net federal unemployment tax is often 0.6% STATE UNEMPLOYMENT TAX (SUTA) All states fund their unemployment insurance programs by placing a payroll tax on employers. (a few states require employees to make a contribution. In the books assignments, we assume this tax is only levied on the employer). In most states, the base rate for SUTA taxes is 5.4% of the first $7,000 earned by each employee (the dollar level varies by state.) this base rate is adjusted according to an employers merit rating. The state assigns a MERIT RATING based on a company's stability in employing workers. A good rating reflects stability in employment and means an employer can pay less than the 5.4% base rate. A low rating means high turnover or seasonal hirings and layoffs. INTERNAL CONTROL OF PAYROLL Internal controls are crucial for payroll because of a high risk of fraud and error. Below identifies and explain four key areas of payroll activities that we aim to SEPARATE AND MONITOR     EMPLOYEE HIRING  Duty: authorize, hire, and fire  Aim: keep fake workers off payroll PAYROLL PREPERATION  Duty: verify tax rates and payroll amounts  Aim: rates updated and amounts accurate TIMEKEEPING  Duty: track and verify time worked  Aim: paid for time worked only PAYROLL PAYMENT  Duty: sing and issue prenumbered checks  Aim: checks valid, secured, and correct MULTI-PERIOD KNOWN LIABILITIES Many known liabilities extend over multiple periods. These often include unearned revenues and notes payable. For example, if SPORTS ILLUSTRATED sells a three-year digital magazine subscription, it records amounts received for this subscription in an Unearned Subscription Revenues account. Amounts in this account are liabilities, but are they current or long term? They are BOTH. The portion of the Unearned Subscription Revenue account that will be fulfilled in the next year is reported as a current liability. The remaining portion is reported as a long-term liability. The same analysis applies to notes payable. For example, a borrower reports a three year note payable as a long-term liability in the first two years it is outstanding. In the third year, the borrower reclassifies this note as a current liability because it is due within one year. The current portion of long term debt is that part of long-term debt due in one year. Long-term debt is reported under long-term liabilities, but the CURRENT PORTION DUE is reported under long-term liabilities. Assume that a $7,500 debt is paid in installments of $1,500 per year for 5 years. The $1,500 due within the year is reported as a current liability. We classify the amounts for debit as either current or long term when the balance sheet is prepared. ESTIMATED LIABILITIES An ESTIMATED LIABILITY is a known obligation of an uncertain amount that can be reasonably estimated. Common examples are employee benefits such as pensions, health care, and vacation pay, and warranties offered by a seller. HEALTH AND PENSION BENEFITS Many companies provide employee benefits. An employer often pays all or part of medical, dental, life, and disability insurance. Many employers also contribute to PENSION PLANS, which are agreements by employers to provide medical care and insurance benefits to their retirees. Assume an employer agrees to (1) pay $8,000 for medical insurance and (2) contribute an additional 10% of the employees' $120,000 gross salaries to a retirement program. VACATION BENEFITS Many employers offer paid vacation benefits, or PAID ABSENCES. Vacation benefits are estimated and expensed in the period when employees earn them. Assume that salaried employees earn 2 weeks' paid vacation per year. Vacation Benefits Expense is an operating expense, a Vacation Benefits Payable is a current liability. When an employee takes a one-week vacation, the employer reduces (debits) Vacation Benefits Payable and credits Cash BONUS PLANS Many companies offer bonuses to employees, and many of the bonuses depend on net income. Assume that an employer gives a bonus to its employees based on the company's annual net income (to be equally shared by all.) WARRANTY LIABILITIES A WARRANTY is a sellers obligation to replace or fix a product or service that fails to perform as expected within a specified period. For example, new FORD cars are sold with a warranty covering parts for a specified period of time. The seller reports the expected warranty expense in the period when revenue from the sale of the product or service is reported. The seller reports this warranty liability, even though the existence, amount, payee, and date of future payments are uncertain. This is because warranty costs are probable and the amount can be estimated using past experience. Assume a dealer sells a car for $16,000 on DEC 1, 2020 with a one year or 12,000 mile warranty covering parts. Experience shows that warranty expense is 4% of a car's selling price, or $640 in this case. Assume the customer brings the car in for warranty repairs on Jan 9, 2021. the dealer fixes the car by replacing parts costing $200. the entry reduces the balance of the Estimated Warranty liability account, but no expense is recorded in 2021 for the repair. Warranty expense was previously recorded in 2020, the year the car was sold with the warranty. Finally, what happens if total warranty expenses are more or less than the 4% or $640? The answer is that management should monitor actual warranty expenses to see if a 4% rate is accurate. If not, the rate is changed for future periods. MULTI-PERIOD ESTIMATED LIABILITIES Estimated liabilities can be both current and long term. For example, pension liabilities to employees are long term to workers who will not retire within the next year. For employees who are retired or will retire within the next year, a portion of pension liabilities is current. Other examples include employee health benefits and warranties. CONTINGENT LIABILITIES A CONTINGENT LIABILITY is a potential obligation that depends on a future event arising from a past transaction or event. An example is a pending lawsuit. Here, a past transaction or event leads to a lawsuit whose financial outcome depends on the result of the suit. ACCOUNTING FOR CONTINGENT LIABILITIES Accounting for contingent liabilities depends on the likelihood that a future event will occur and the ability to estimate the future amount owed if this event occurs. The conditions that determine each of these possibilities follow:  Record liability: the future event is PROBABLE and the amount owed can be REASONABLY ESTIMATED. Examples are warranties, vacation pay, and income taxes.  No disclosure: the future event is REMOTE (unlikely) APPLYING RULES OF CONTINGENT LIABILITIES POTENTIAL LEGAL CLAIMS Many companies are sued or at risk of being sued. The accounting issue is whether the defendant records a liability or discloses a contingent liability in its notes while a lawsuit is outstanding and not yet settled. The answer is that a potential claim is recorded ONLY IF payment for damages is probable. And the amount can be reasonably estimated. If the potential claim cannot be reasonably estimated. If the potential claim cannot be reasonably estimated but is reasonably possible, it is disclosed. For example, FORD includes the following note in its annual report: "Various legal actions, proceedings, and claims are pending… arising out of alleged defects in our products." DEBT GUARANTEES Sometimes a company guarantees the payment of debt owed by a supplier, customer, or another company. The guarantor usually discloses the guarantee in its financial statement notes as a contingent liability. If it is probable that the debtor will default, the guarantor reports the guarantee as a liability. The BOSTON CELTICS report a unique guarantee: "contracts provide for guaranteed payments which must be paid even if the employee (player) is injured or terminated." OTHER CONTINGENCIES Other examples of contingencies include environmental damages, possible tax assignments, insurance losses, and government investigations. CHEVRON, for example, reports that it "is subject to loss contingencies.. Related to environmental matters.. The amount of additional future costs are not fully determinable." Many of Chevron's contingencies are revealed only in notes. UNCERTAINTIES THAT ARE NOT CONTINGENCIES All organizations face uncertainties from future events such as natural disasters and new technologies. These uncertainties are not contingent liabilities because they are future events NOT arising from past transactions. Accordingly, they are NOT disclosed.