Accounting Chapter 8
Terms in this set (32)
A present responsibility to sacrifice assets in the future due to a transaction or other event that happened in the past.
-Liabilities represent probable future sacrifices of benefits.
-Most require the future sacrifice of cash.
-Unearned revenue is a liability payed in inventory or a service rather than cash.
Three Essential Characteristics of Liabilities
1. Probable future sacrifices of economic benefits.
2. Arising from present obligations to other entities.
3. Resulting from the past transactions or events.
Debts that, in most cases, are due within one year. However when a company has an operating cycle that is longer than a year, its current liabilities are defined by the length of the operating cycle, rather than by the length of one year.
-After notes and accounts payable, companies list other current liabilities from largest to smallest generally.
Most Frequent Current Liabilities
Notes Payable (Primary)-1st
Accounts Payable (Primary)-2nd
Payroll Liabilities (Primary)
Sales Tax Payable
Current Portion of Long-Term Debt
Debts due more than one year from now.
-Given the choice, most companies would rather report a liability as long-term rather than current, because doing so may cause the firm to appear less risky.
-Less risky firms may enjoy lower lower interest rates on borrowing and command higher stock prices for new stock listings.
The time it takes to produce revenue- "from cash to cash"
Written promises to repay amounts borrowed plus interest.
-A liability that creates an interest expense.
-Short-term funds usually offer lower interest rates than long-term debt.
Notes Payable Interest Calculation
Interest= Face Value x Annual Interest Rate x Fraction of the Year
-Consistent with matching principle.
Reporting Notes Payable Adjustment
If reporting period ends before note is due, company records the 4 months' interest incurred in the previous year in an adjustment prior to preparing the previous year's financial statements.
-Firm will not pay the interest until it is due, so it debits interest expense and credits interest payable.
-When the note comes due, the firm will pay the face value of the loan (debit) and the entire amount of interest incurred (Debit to interest expense and interest payable).
-Consistent with Matching Principle.
-Lender records it as a note receivable and generates interest revenue.
Line of Credit
An informal agreement that permits a company to borrow up to a prearranged limit without having to follow formal loan procedures and prepare paperwork.
-Works like a note payable.
Borrowing from another company rather than a bank.
-Sold with maturities ranging from 30-270 days.
-Interest rate is usually lower than on a bank loan.
Amounts the company owes to suppliers of merchandise or services it has bought on credit.
-When a company purchases items on account, it increases a liability called Accounts Payable.
-Later, when the company pays the amount owed, it decreases both Cash and Accounts Payable.
These liabilities make up a significant portion of current liabilities for labor-intensive companies.
-Employers have costs that are much more than the employees monthly paycheck.
-Pay for fed. and state unemployment taxes, the employer portion of Social Security and Medicare, insurance, and contributions to retirement and savings plans.
Based on Federal Insurance Contribution Act
-Taxes withheld from employees' paychecks and matched by employers for Social Security (6.2% up to max base amount) and Medicare (1.45%).
-Tax is 7.65% up to a max base amount, and 1.45% on all income after base amount
Tax to cover federal and state unemployment costs paid by the employer on behalf of its employees.
-6.2% tax on first $7K earned by each employee. Amount is reduced by a 5.4% max credit for contributions to state unemployment programs, so net federal rate often is 0.8%
Additional employee benefits paid for by the employer.
A liability account used to record cash received in advance of the sale or service.
-When a company receives cash in advance, it debits Cash and credits Unearned Revenue, a current liability account
-When it earns the revenue, the company debits Unearned Revenue and credits Sales Revenue.
Sales Tax Payable
Sales tax collected from customers by the seller representing current liabilities payable to the government.
-When company collects the sales tax, it increases (debits) Cash and increases (credits) Sales Tax Payable
Current Portion of Long-Term Debt
Debt that will be paid within the next year.
-Provides information about a company's liquidity, a useful indicator of risk for investors.
Deferred Tax Liability
Difference between financial accounting and tax accounting can result in a company recording financial income now, but deferring payment of some of its income tax expense to future years.
-Remember that there are differences between net income reported on the income statement and taxable income reported on the tax return, and these differences can result in deferred tax liabilities, both current and long-term.
Uncertain situations which can result in a gain or loss for a company.
A possible liability for which payment is contingent upon another event.
-Recorded only if a loss is probable AND the amount can be reasonably estimated.
-*Record this with a debit to Loss (acts as expense account) and a credit to Contingent Liability.
-May not be a liability at all
-Ex: Pending litigation, product warranties, environmental problems, and premium offers.
Criteria for Reporting a Contingent Liability
1. The likelihood of payment
a) Probable-Likely to occur
***When no amount in the range appears more likely than others, we record the minimum amount and disclose the potential added loss.
b) Reasonably Possible- More than remote but less than probable.
***Record no entry but make full disclosure in a note in financial statement to disclose the contingency.
c) Remote- The chance is slight.
***Disclosure usually not required.
2. The ability to estimate the payment amount is either:
a) Known or reasonably estimable.
b) Not reasonably estimable.
Products often come with warranties covering the hardware from defect for a disclosed amount of time.
-Perhaps most common contingent liability
- Based on the matching principle, the company needs to record the warranty expense in the same accounting period in which it sells you the product.
-When customers make warranty claims and Dell incurs costs to satisfy those claims, the liability is reduced.
An existing uncertain situation that may result in a gain.
-We DO NOT record contingent gains until the gain is certain.
-In lawsuit, plaintiff has a contingent gain.
-Sometimes disclosed in notes to the financial statements.
Refers to having sufficient cash (or other current assets convertible to cash in a relatively short time) to pay currently maturing debts.
-A company's ability to pay for currently maturing debt.
-Lack of liquidity can result in financial difficulties or even bankruptcy
-Profitability is probably best long-run indicator of liquidity.
Three Liquidity Measures
1. Working Capital
2. Current Ratio
3. Acid-Test Ratio
Difference between current assets and current liabilities
Working Capital= Current Assets-Current Liabilities.
-Large positive working capital is an indication of liquidity.
-Not best measure of liquidity when comparing one company to another, since it does not control for the relative size of each company.
Current assets divided by current liabilities; Measures availability of current assets to pay current liabilities.
Current Ratio= Current Assets/Current Liabilities
-Current ratio > 1 implies more current assets than liabilities. Often reflects an acceptable measure of liquidity.
-The higher the current ratio, the higher a company's liquidity.
-Not all current assets are equally liquid.
Acid-Test Ratio (Quick Ratio)
Cash, Current Investments, and Accounts Receivable divided by Current Liabilities; Measures the availability of liquid current assets to pay current liabilities.
-By eliminating current assets, such as inventory and prepaid expenses, that are less readily convertible to cash, this test may provide best picture of liquidity.
Includes only Cash, Current Investments, and Accounts Receivable.
An agreement between a borrower and a lender that requires that certain minimum financial measures be met or the lender can recall the debt.
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