Chapter 9

Wild Chapter 9McGraw-Hill/Irwin
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In chapter eleven, we will discuss current liabilities in detail and look at the basics of payroll accounting. We will spend much of our time discussing new coverage of current liabilities. We think you will find much of the information in this presentation interesting and useful in your career.
© The McGraw-Hill Companies, Inc., 2008
McGraw-Hill/Irwin
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C2: Identify and describe known current liabilities
C3: Explain how to account for contingent liabilities
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A1: Compute the times interest earned ratio and use it to analyze liabilities
Analytical Learning Objectives
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P1: Prepare entries to account for short-term notes payable
P2: Compute and record employee payroll deductions and liabilities
P3: Compute and record employer payroll expenses and liabilities
P4: Account for estimated liabilities, including warranties and bonuses
P5: Appendix 11A: Identify and describe the details of payroll reports, records, and procedures
Procedural Learning Objectives
McGraw-Hill/Irwin
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Past
Present
Future
2
2
A liability is a present obligation that grew out of a past event and will require a future sacrifice to extinguish the obligation.
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Classifying Liabilities
Current Liabilities
C 1
Expected to be paid within one year or the company’s operating cycle, whichever is longer.
Expected not to be paid within one year or the company’s operating cycle, whichever is longer.
Long-Term Liabilities
Part One
Current liabilities are expected to be paid within one year or the normal operating cycle of the company, whichever is longer. Current liabilities are usually extinguished by payment of current assets.
Part Two
Long-term liabilities are not expected to be paid or extinguished within one year. In this chapter, we will concentrate on current liabilities.
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2
2
The relationship between total liabilities and current liabilities depends upon the nature of business operations. Cannondale, a manufacturer and distributor of linen products, has a relatively low level of current liabilities when compared to Apple Computer or Rawlings Sporting Goods.
Chart1
Cannondale
0.48
0.54
0.73
0.94
Sheet1
Cannondale
48%
Sheet2
Sheet3
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Uncertainty in How Much to Pay
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2
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Before we can determine the nature of a liability and properly classify it, we must examine three major uncertainties.
First, we must determine whether we know who will be paid to extinguish the liability. Second, we must know when the amount must be paid, and third, we must know exactly how much must be paid to extinguish the liability.
If we don’t know all three, we do not have a determinable liability.
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2
2
For the accounts shown, we have been able to determine all three variables discussed on the previous screen, so these are known, or determinable, liabilities.
Let’s begin our discussion of current liabilities by looking at sales tax accounting.
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On May 15, 2007, Max Hardware sold building materials for $7,500 that are subject to a 6% sales tax.
Sales Taxes Payable
Part One
On May fifteenth, 2007, Max Hardware sold building materials to a customer for seventy-five hundred dollars. The amount of the sale is subject to a six percent sales tax and Max Hardware is responsible for collecting and paying the tax to the state government. Let’s make the journal entry to record this sale.
Part Two
We begin with a debit to the cash account for seven thousand, nine hundred fifty dollars, the amount of the sale and the tax collected. We credit the sales account for seventy-five hundred dollars and credit the current liability account, sales taxes payable, for four hundred fifty dollars. The sales tax is six percent of the total sale of seventy-five hundred dollars.
Max Hardware will extinguish the sales taxes payable account when payment is made to the taxing authority.
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Anheuser-Busch
0.97
0.95
0.97
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$ 275,000
Inventory
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On May 1, 2007, A-1 Catering received $3,000 in advance for catering a wedding party to take place on July 12, 2007.
Unearned Revenues
C 2
Part One
We previously studied unearned revenues in the chapter on adjusting entries. Unearned revenues are usually current liabilities. In our example, A One Catering received three thousand dollars as an advance payment for catering a wedding party scheduled for July twelfth.
Part Two
On May first, when the cash is received, the company would debit, or increase, its cash account, and credit unearned revenue, a current liability, for three thousand dollars. The three thousand dollars will not be recognized as revenue until the company completes its obligation to provide catering for a wedding party.
Part Three
On July twelfth, the party was catered and the company debited, or reduced, its current liability, unearned revenue, and credited, or increased, revenue for three thousand dollars.
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A written promise to pay a specified amount on a definite future date within one year or the company’s operating cycle, whichever is longer.
Short-Term Notes Payable
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Let’s spend some time looking at short-term, or current, notes payable. A note payable is a written promise to pay a specific amount at a definite future date. Short-term notes normally bear interest.
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On August 1, 2007, Matrix, Inc. asked Carter, Co. to accept a 90-day, 12% note to replace its existing $5,000 account payable to Carter. Matrix would make the following entry:
Note Given to Extend Credit Period
P1
Part One
In our first example, Matrix asked Carter Company to accept a ninety day, twelve percent note to replace its current account payable of five thousand dollars. If Carter accepts this offer, we will need to make an entry on the books of Matrix.
Part Two
On August first, Matrix would debit, or reduce, its account payable to Carter and credit, or increase, its note payable to Carter. Matrix is exchanging one current liability for another.
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On October 30, 2007, Matrix, Inc. pays the note plus interest to Carter.
Note Given to Extend Credit Period
P1
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Part One
On October thirtieth, Matrix pays the note and all interest to Carter. Let’s prepare the journal entry on the books of Matrix.
Part Two
We debit, or decrease, the notes payable to Carter for five thousand dollars and debit interest expense for one hundred fifty dollars. The one hundred fifty dollars is interest at twelve percent annual rate for ninety days. Finally, we will credit, or decrease, the cash account for the total of five thousand, one hundred fifty dollars.
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Anheuser-Busch
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Inventory
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P1
American Bank
Nashville, TN
$20,000
2
2
Instead of replacing an account payable with a note payable, let’s look at a promissory note issued to borrow money from the bank.
This is a typical promissory note. Notice that we have a definite payee, American Bank in Nashville, Tennessee, a determinable amount of the payment, twenty thousand dollars plus interest at six percent for ninety days. The entire amount is to be paid on November 30, 2008, the date the note matures.
Let’s look at the accounting involved over the life of this note payable.
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Face Value Equals Amount Borrowed
On September 1, 2008, Jackson Smith borrows $20,000 from American Bank. The note bears interest at 6% per year. Principal and interest are due in 90 days (November 30, 2008).
P1
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On September first, the date the note was signed, Jackson Smith will debit the cash account for twenty thousand dollars and credit the current liability, notes payable, for the same amount.
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Inventory
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make the following entry:
P1
*
Part One
Let’s prepare the journal entry at November thirtieth, 2008, when the note matures and is paid by Jackson Smith.
Part Two
We will debit notes payable for twenty thousand dollars and debit interest expense for three hundred dollars. The three hundred dollars of interest expense is calculated by multiplying twenty thousand dollars times six percent and modifying this amount for the length of time the note was outstanding during the year (ninety days divided by three hundred sixty days). To complete the entry, we need to credit cash for the total amount paid of twenty thousand, three hundred dollars.
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Anheuser-Busch
0.97
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3,000
$ 275,000
Inventory
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McGraw-Hill/Irwin
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P1
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2
2
If a short-term note payable is issued in one accounting period but is not payable until the following accounting period, it is necessary to make an adjusting entry at year-end to record the interest expense. Let’s look at a specific example.
McGraw-Hill/Irwin
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Dec. 16, 2008
Dec. 31, 2008
Feb. 14, 2009
James Burrows borrowed $8,000 on Dec. 16, 2008, by signing a 12%, 60-day note payable.
End-of-Period Adjustment to Notes
2
2
On December sixteenth, 2008, James Burrows borrows eight thousand dollars and agrees to repay that amount plus interest at twelve percent annual rate in sixty days. First, let’s prepare the journal entry to record the issuance of the note.
McGraw-Hill/Irwin
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On December 16, 2008, James Burrows would make the following entry:
$8,000 × 12% × (15 ÷ 360) = $40
P1
Part One
On December sixteenth, we will debit the cash account for eight thousand dollars and credit the current liability account, notes payable, for the same amount.
Part Two
See if you can prepare the adjusting journal entry on December thirty first, 2008, before going to the next screen.
Part Three
How did you do? We need to accrue forty dollars in interest expense for 2008. The entry is to debit the interest expense account and credit a liability account, interest payable, for forty dollars.
We calculate the forty dollars by multiplying eight thousand dollars times twelve percent annual interest and multiply that amount by fifteen days divided by three hundred sixty days. It is necessary to adjust the annual interest or the number of days from the date the note was issued until the end of the year, fifteen days.
Now let’s complete our example by making the entry to record the payment of the note and interest. Be careful, many students miss this entry.
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Inventory
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On February 14, 2009, James Burrows would make the following entry.
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2
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The note falls due, and is paid in full on February fourteenth, 2009. James owes eight thousand, one hundred sixty dollars for the principal and interest. The total interest is calculated by multiplying eight thousand dollars by twelve percent and adjusting this amount for the sixty-day life of the note. The total interest of one hundred sixty dollars is divided between the amount incurred in 2008, and the amount to be recorded in 2009.
The journal entry is to debit notes payable for eight thousand dollars, eliminate the interest payable amount of forty dollars, debit the interest expense account for one hundred twenty dollars, and credit cash for the total amount due of eight thousand, one hundred sixty dollars.
We think it will be a good idea to go over this example when you study for the next exam.
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Payroll Liabilities
2
2
Most of you have probably worked at some time in your life. You know that amounts are withheld from your paycheck, and you may have wondered how this money is handled by your employer. You may not know that your employer pays payroll tax expenses in connection with having you on the payroll. These are not amounts withheld from your paycheck but are costs to your employer.
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Voluntary Deductions
Gross Pay
2
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Gross pay is the amount you actually earn during a pay period. Out of your gross pay, amounts are withheld for social security (FICA) taxes, Medicare taxes, and federal income taxes. If you live in a state or locality that has an income tax, additional amounts will be withheld. In addition to this mandatory withholding, you may elect to have amounts withheld from your gross pay. For example, you may be eligible to participate in a contributory retirement plan or a medical reimbursement plan.
Your gross pay less all withholdings, mandatory and voluntary, is your net pay. This is the amount of cash you can put in the bank.
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FICA Taxes — Medicare
2006: 6.2% of the first $94,200 earned in the year ( Max = $5,840).
2006: 1.45% of all wages earned in the year.
Employers must pay withheld taxes to the Internal Revenue Service (IRS).
Employee FICA Taxes
P2
2
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The rate of withholding for FICA taxes and Medicare taxes varies from year to year, but in 2005, the FICA rate was six point two percent on the first ninety thousand dollars of gross pay. The Medicare rate of one point forty-five percent was applied on all of your gross pay in 2005, as well.
Your employer is required to match the amounts withheld for FICA and Medicare on a dollar for dollar basis. For every ten dollars withheld from your paycheck, your employer must pay ten dollars on your behalf to the Internal Revenue Service.
McGraw-Hill/Irwin
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Amounts withheld depend on the employee’s earnings, tax rates, and number of withholding allowances.
Employers must pay the taxes withheld from employees’ gross pay to the appropriate government agency.
Federal Income Tax
Employee Income Tax
2
2
The amount of income taxes withheld from your gross pay usually depends on how much you earn during the pay period and the number of withholding allowances you claimed on the W4 form you completed when you first went to work.
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Amounts withheld depend on the employee’s request.
Employers owe voluntary amounts withheld from employees’ gross pay to the designated agency.
Voluntary Deductions
Employee Voluntary Deductions
2
2
The amount withheld from gross pay for voluntary deductions depends upon which plans you participate in at your place of employment. Your employer makes payments to the proper designated agencies for amounts you have withheld as voluntary deductions.
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The entry to record payroll expenses and deductions for an employee might look like this.
Recording Employee Payroll Deductions
2
2
Here is an example of a typical payroll entry to record the employees’ withholdings and net pay. The amount of net pay is credited to accrued salaries payable when the payroll is prepared. When the paychecks are written, the journal entry is to debit, or eliminate, accrued salaries payable for three thousand, one hundred twenty-six dollars and credit cash for the same amount.
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PR
Debit
Credit
Balance
Total
420
216
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3,000
$ 275,000
Matrix, Inc.
$ 174,000
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Employee's Medical Insurance Payable48
Employee's Pension Contribution Payable100
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Employer Payroll Taxes
P3
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Your employer must match your contributions for FICA and Medicare taxes.
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P3
2006: 6.2% on the first $7,000 of wages paid to each employee (A credit up to 5.4% is given for SUTA paid, therefore the net rate is .8%.)
Federal Unemployment Tax (FUTA)
2006: Basic rate of 5.4% on the first $7,000 of wages paid to each employee (Merit ratings may lower SUTA rates.)
State Unemployment Tax (SUTA)
2
2
In addition to matching your contributions for FICA and Medicare, your employer must pay all federal and state unemployment taxes.
The federal and state unemployment tax rates are subject to change. In 2006, the federal rate was a maximum of six point two percent on the first seven thousand dollars of earnings for each employee. The federal tax can be reduced by as much as five point four percent if your employer has a very good employment record. Therefore the resulting net rate used for most FUTA calculations is point eight percent.
The state portion of the rate is five point four percent on the first seven thousand dollars of earnings by each employee. Most states reduce this rate to employers with excellent employment records.
McGraw-Hill/Irwin
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The entry to record the employer payroll taxes for January might look like this:
SUTA: $4,000 ´ 5.4% = $216
FUTA: $4,000 ´ (6.2% - 5.4%) = $32
FICA amounts are the same as that withheld from the employee’s gross pay.
Recording Employer Payroll Taxes
2
2
Here is a typical entry to record the payroll tax expenses paid by employers. Notice that we debit payroll tax expense for the total amount involved. We record current liabilities for the FICA and Medicare taxes payable, and for the federal and state unemployment taxes payable.
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Date
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Debit
Credit
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Total
216
44
61
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3,000
$ 275,000
Balance, June 30, 2002
$ 174,000
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Often include unearned revenues and notes payable.
Unearned revenues from magazine subscriptions often cover more than one accounting period. A portion of the earned revenue is recognized each period and the unearned revenue account is reduced.
P3
*
2
2
When a liability crosses several accounting periods, a portion will be classified as current and a portion as a long-term liability. We must make adjusting entries at the end of each accounting period for these multi-period liabilities. Two common multi-period liabilities include subscriptions and long-term notes payable that have a portion maturing each year.
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An estimated liability is a known obligation of an uncertain amount, but one that can be reasonably estimated.
Estimated Liabilities
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In addition to our known liabilities, we also have to estimate certain liabilities. To estimate a liability, we must know that we have an obligation, but we are uncertain as to exactly how much will have to be paid or when it will be paid. The amounts involved must be subject to reasonable estimation before we may actually record an estimated liability.
McGraw-Hill/Irwin
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Employer expenses for pensions or medical, dental, life and disability insurance
Health and Pension Benefits
Assume an employer agrees to pay an amount for medical insurance equal to $8,000, and contribute an additional 10% of the employees’ $120,000 gross salary to a retirement program.
P4
Part One
An employer may agree to pay a portion of your medical, dental, life, or disability insurance. In this case, the employer agrees to pay eight thousand dollars toward employee medical insurance coverage and ten percent of gross salaries for a pension program. The employee may have to make contributions to each of these plans, but at this time, we are interested in the employer costs. Let’s look at the journal entry we make in connection with the employer’s payments.
Part Two
We debit, or increase, the employee benefits expenses for twenty thousand dollars, credit medical insurance payable for eight thousand dollars, and the retirement program payable for twelve thousand dollars. Contributions made by the employer are an additional cost of having you as an employee.
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$ 174,000
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Vacation Benefits
Assume an employee earns $62,400 per year and earns two weeks of paid vacation each year.
P4
Part One
Most employers have an expense for amounts paid to employees who are on vacation. Assume you make sixty-two thousand, four hundred dollars per year, and earn two weeks paid vacation each year.
Part Two
If you work the full fifty-two weeks of the year, your weekly gross pay is twelve hundred dollars. However, you only work fifty weeks per year and get the other two weeks off. If we spread your salary over the fifty weeks you work, the effective cost to the company is twelve hundred forty-eight dollars per week. So, your weekly vacation benefits are forty-eight dollars. Let’s look at the entry your employer will make each week.
Part Three
We debit the vacation benefits expense account for forty-eight dollars per week and credit the vacation benefits payable for the same amount. When you take your vacation, your employer will reduce the vacation benefits payable liability and credit cash for the payment made to you.
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Many bonuses paid to employees are based on reported net income.
Bonus Plans
Assume the annual yearly bonus to the store manager is equal to 10% of the company’s annual net income minus the bonus. The store earned $100,000 net income this year.
P4
Part One
Many managers are paid a fixed salary and an additional bonus based on reported net income. Let’s assume you are a manager at a store and receive an annual bonus equal to ten percent of the store’s annual net income minus the bonus paid to you. In the last year, your store earned one hundred thousand dollars. What will be your bonus?
Part Two
We can set up the basic bonus equation which states that your bonus (B) is equal to ten percent times net income minus the bonus.
Part Three
The equation may be simplified to state that the bonus is equal to ten thousand dollars minus point one times the bonus. Now let’s solve for the bonus amount.
Part Four
As you can see, your bonus is equal to nine thousand, ninety-one dollars rounded to the nearest whole dollar.
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Many bonuses paid to employees are based on reported net income.
Bonus Plans
Assume the annual yearly bonus to the store manager is equal to 10% of the company’s annual net income minus the bonus. The store earned $100,000 net income this year.
P4
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Once the bonus has been calculated, the company will debit the employee bonus expense account, and credit the liability account, bonus payable, for nine thousand, ninety-one dollars. When the bonus is paid to you, the company will debit, or eliminate, the bonus payable balance, and credit cash.
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Warranty Liabilities
Seller’s obligation to replace or correct a product (or service) that fails to perform as expected within a specified period. To conform with the matching principle, the seller reports expected warranty expense in the period when revenue from the sale is reported.
A dealer sells a car for $32,000, on December 1, 2007, with a warranty for parts and labor for 12 months, or 12,000 miles. The dealership experiences an average warranty cost of 3% of the selling price of each car.
P4
Part One
Many products sold are covered by a warranty. The seller is liable for replacing or repairing the product while it is under warranty. To make sure we follow the matching principle, we must report the estimated warranty liability in the year in which the sale is made. In this way, we are matching expense with revenues.
Part Two
A dealer sells a car for thirty-two thousand dollars on December first, 2007. The car is covered by a twelve-month or twelve-thousand mile warranty. Based upon past experience, the dealership estimates average warranty costs at three percent of the selling price of each car.
Let’s look at the proper accounting for the estimated warranty expense.
McGraw-Hill/Irwin
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Warranty Liabilities
A dealer sells a car for $32,000, on December 1, 2007, with a warranty for parts and labor for 12 months, or 12,000 miles. The dealership experiences an average warranty cost of 3% of the selling price of each car.
On February 15, 2008, parts of $200 and labor of $250 covered under warranty were incurred.
P4
Part One
On the date of sale, December first, the dealership will debit warranty expense and credit the current liability account, estimated warranty liability, for nine hundred sixty dollars. The amount of the estimated liability is determined by multiplying the thirty-two thousand dollar cost of the car times the three percent historical warranty cost percent.
Part Two
On February fifteenth, 2008, the dealership paid two hundred dollars for parts and two hundred fifty dollars for labor covered by the warranty. Can you prepare the proper journal entry? It is a little tough, so take your time.
Part Three
On February fifteenth, the dealership will debit, or reduce, the estimated warranty liability for total costs incurred of four hundred fifty dollars. We will credit the auto parts inventory for two hundred dollars, and salaries payable for two hundred fifty dollars.
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Contingent Liabilities
Potential obligation that depends on a future event arising out of a past transaction or event.
C3
Amount . . .
Part One
A contingent liability is a potential liability whose outcome depends upon the occurrence of some future event. If the future event occurs, we have a definite liability.
Part Two
We have prepared this table to help you determine the proper accounting for contingent liabilities. First, we must assess the probability of a future sacrifice, and then determine if the amount involved can be estimated. Our assessment of future sacrifice must be placed in one of three categories: (1) it is probable that we will have a future sacrifice; (2) it is reasonably possible that we will have a future sacrifice; and (3) there is only a remote probability of a future sacrifice.
You can see that if we assess the probability as remote, no action is required by the accountant. When we assess the probability as reasonably possible, we must disclose the contingent liability in the notes to the financial statements. Finally, if the probability of a future sacrifice is probable, we will record a contingent liability in the amount of the sacrifice if it can be estimated. If we cannot estimate the amount involved, we must disclose the contingent liability in the notes to the financial statements.
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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. Three possibilities are identified in the chart shown: A company may be required to record the liability, disclose it in the notes, or not to disclose it at all. Take a moment to review the chart. You may want to refer to it later when you are studying for your exam.
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Reasonably Possible Contingent Liabilities
Potential Legal Claims – A potential claim is recorded if the amount can be reasonably estimated and payment for damages is probable.
Debt Guarantees – The guarantor usually discloses the guarantee in its financial statement notes. If it is probable that the debtor will default, the guarantor should record and report the guarantee as a liability.
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If it is probable that a company will have a future sacrifice as the result of current litigation, and if the amount of the sacrifice can be estimated, we will record a liability for potential loss from litigation. If we cannot estimate the amount involved, we will disclose the legal claim in the notes to the financial statements. In these litigious times, many companies are being sued for a wide variety of reasons.
When a company guarantees the debt of an affiliated company, it may eventually have to pay the obligation. If the original debtor fails to pay, the obligation becomes the responsibility of the guarantor.
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If income before interest and taxes varies greatly from year to year, fixed interest charges can increase the risk that an owner will not earn a positive return and be unable to pay interest charges.
Times Interest Earned
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Companies that loan money to a business want to be assured that the principal and interest will be paid when due. One measure that helps creditors assess the risk of a loan is the Times Interest Earned ratio.
We calculate the ratio by dividing income before interest and income taxes by interest expense. Income before interest and income taxes is sometimes referred to as operating income.
A high Times Interest Earned ratio usually means that the risk of nonpayment is low.
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*
Some of you may have borrowed money to attend college, or you may borrow money soon to finance major purchases like a home or car.
Investing in yourself is one of the best investments you can ever make. A solid knowledge about the calculation of interest and the specific terms of debt obligations will help you in the future.
We hope you found this chapter on current liabilities and the basics of payroll accounting interesting and useful.
0%20%40%60%80%100%
Cannondale
DRCR
DRCR
DRCR
Oct 30Notes payable - Carter5,000
interest
DRCR
DRCR
Dec 16Cash8,000
Notes payable8,000
DR CR
DR CR
FICA - Medicare Tax Payable58
Employee Medical Insurance Payable48
Employee Union Dues Payable100
DR CR
FICA - Medicare Tax Payable58
State Unemployment Taxes Payable216
Federal Unemployement Taxes Payable32
DR CR
Jan. 5Vacation Benefits Expense48
employee
DR CR
DR CR
Estimated
financial stmts.financial stmts.

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Chapter 9