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At the end of this section students should be able to meet the following objectives:
Question: Current liabilities often include rent payable, salary payable, insurance payable, and the like. These debts are incurred in connection with day-to-day operations. The amounts are known and payment will be made within a relatively short period of time.
Liabilities that result from physical events such as the purchase of inventory or supplies are often reported under the generic title “accounts payable.” Other current debts (interest payable or rent payable, for example) are sometimes grouped together as accrued liabilitiesLiabilities that grow gradually because of the passage of time; common examples include salaries, rent, and interest. because they grow gradually in size over time rather than through a specific transaction. How does an organization determine the amount of current liabilities to be reported on its balance sheet?
Answer: As discussed in a previous chapter, the timing for the recognition of a purchase is guided by the FOB point specified by the seller or negotiated by the parties. If marked “FOB shipping point,” the liability is reported by the buyer when the goods leave the seller’s place of business. “FOB destination” delays recording until the merchandise is received by the buyer. Unless goods are damaged during transit or a dispute arises over payment for transportation charges, the FOB point is only relevant near the end of the fiscal year as the accountant attempts to separate transactions between one period and the next.
Many other liabilities are not created by a specific event but rather grow gradually day by day. Interest and rent are common examples but salaries, payroll taxes, and utilities also accrue in the same manner. They increase based on the passage of time. Interest on a loan or the amount due to an employee gets larger on a continual basis until paid. Adjusting entries are required at the end of a period to recognize any accrued liabilities that have been omitted from the general ledger.
To illustrate, assume a large group of employees earns total wages of $10,000 per day. They work Monday through Friday with payment made on the final day of each week. If the company’s fiscal year ends on a Wednesday, an adjustment is necessary so that both the expense on the income statement and the liability on the balance sheet are presented fairly for the three days that passed without payment. The adjustment shown in Figure 13.3 "Year-End Adjusting Entry to Recognize Debt to Employees for Three Days’ Work" is made for $30,000 ($10,000 per day for three days) so that the debt incurred for salaries prior to the end of the year is reported. The expense is recognized in this period to match the cost with the revenues that were earned during these three days by the employees.
Figure 13.3 Year-End Adjusting Entry to Recognize Debt to Employees for Three Days’ Work
As a second example, assume a company borrows $100,000 from a bank on December 1 with payment to be made in six months. The bank has to earn a profit and charges a 6 percent annual interest rate. By the end of that year, the company owes interest but only for the one month that has passed. As of December 31, interest expense has grown to $500 ($100,000 principal × 6 percent × 1/12 year). This accrued liability is recognized through the adjusting entry shown in Figure 13.4 "Year-End Adjusting Entry to Recognize Interest for One Month".
Figure 13.4 Year-End Adjusting Entry to Recognize Interest for One Month
An organization rents a warehouse for $8,000 per week. Cash payments are made to the owner of the building at the end of every six weeks. No payments were made for the last four weeks of Year One but the company accountant forgot to accrue this liability. Which of the following statements is not true concerning the Year One financial statements?
The correct answer is choice c: Net income is understated.
Rent expense and rent payable for these four weeks ($32,000) have been omitted. Current liabilities (and, hence, total liabilities) are understated because of the debt was never recorded. If current liabilities are too low, the current ratio (current assets/current liabilities) is too high. Rent for this period has not been recorded so the expense on the income statement is understated, which makes the reported net income too high.
Question: The February 26, 2011, balance sheet for Best Buy Co. Inc. shows several typical current liability accounts such as accounts payable and accrued liabilities. However, a $474 million figure also appears titled “Unredeemed Gift Card LiabilitiesAn obligation arising when a business accepts cash and issues a card that can be redeemed in the future for a specified amount of assets or services..”
Over the last decade or so, the importance of gift cards has escalated dramatically as a source of revenue for many businesses. By purchasing such cards, customers obtain the right to a specified amount of goods or services. From Starbucks to McDonald’s to Amazon.com, these cards are sold to serve as gifts or merely as a convenient method for handling future payments. How does a company such as Best Buy account for the thousands of gift cards that it sells each year?
Answer: As stated previously, a liability represents a probable future sacrifice of an asset or service. By selling a gift card, a company has created an obligation to the customer that must be reported. Businesses such as Best Buy or Barnes & Noble accept cash but then have to be willing to hand over inventory items such as cameras or books whenever the gift card is presented. Or, perhaps, some service is due to the cardholder such as the repair of a computer or a massage. To the seller, a gift card reflects a liability but one that is not normally settled with cash. Undoubtedly, the most common type of gift card in the world is a postal stamp. When bought, the stamp provides a person with the right to receive a particular service, the mailing of a letter or package.
To illustrate, assume that a company sells ten thousand gift cards with a redemption value of $50 each. Revenue cannot be reported at the time of sale; the earning process is not yet substantially complete. No asset or service has been conveyed to the customer. Rather, as shown in Figure 13.5 "Sale of Ten Thousand $50 Gift Cards for Cash", a liability (labeled as “unearned revenue” or “gift card liability”) is recognized to indicate that the company has an obligation to the holder of the card.
Figure 13.5 Sale of Ten Thousand $50 Gift Cards for Cash
Over time, customers will present their gift cards for selected merchandise. To complete this illustration, assume that a person uses one of the $50 cards to acquire goods that had originally cost the company $32. Upon redemption, the liability is satisfied and the revenue is recognized. This exchange is reported in Figure 13.6 "Redemption of Gift Card". A perpetual inventory system is used in this example to demonstrate the impact on inventory and cost of goods sold.
Figure 13.6 Redemption of Gift Card
Question: Some gift cards are never redeemed. They might be lost or just forgotten by their owners. Does the liability for a gift card remain on a company’s balance sheet indefinitely if it is unlikely that redemption will ever occur?
Answer: One reason that gift cards have become so popular with businesses is that some percentage will never be redeemed. They will be misplaced, stolen, or the holder will move away or die. Perhaps the person simply does not want the merchandise that is available. In such cases, the seller received money but has never had to fulfill the obligation. The entire amount of cash from the sale of the gift card is profit.
For the accountant, a question arises as to the appropriate timing of revenue recognition from such anticipated defaults. The earning process is never substantially completed by a redemption. In theory, a company recognizes this revenue when reasonable evidence exists that the card will never be used by the customer. Practically, though, determining this precise point is a matter of speculation.
Companies typically report the revenue from unused gift cards at one of three possible times:
Because of this accounting issue, a note to the financial statements produced by Best Buy explains, “We recognize revenue from gift cards when: (i) the gift card is redeemed by the customer, or (ii) the likelihood of the gift card being redeemed by the customer is remote (‘gift card breakage’), and we determine that we do not have a legal obligation to remit the value of unredeemed gift cards to the relevant jurisdictions. We determine our gift card breakage rate based upon historical redemption patterns.”
The Boston Book Company (BBC) sells $700,000 of gift cards during Year One. Of this amount, 60 percent are redeemed before the end of the year and properly recorded. Another 4 percent expired because of time limitations. The others remain outstanding at the end of the year. The accountant for BBC did not realize that the time limitations had been reached so made no entry for the 4 percent. What is the result of the accountant’s failure to make an entry?
The correct answer is choice c: Liabilities are overstated.
When the gift cards were sold, the total amount was recorded as a liability to indicate that the company owed a service or an asset to the customer. At the time of redemption or expiration, this liability should have been reclassified as revenue. That adjustment was not made for the cards that had expired. The liability was not properly reduced. It remains too high while revenue (and, hence, net income) is understated because of the failure to recognize this amount.
Companies report a wide variety of current liabilities. Accounts payable are normally created by the purchase of inventory or supplies. Accrued liabilities such as rent and interest are those debts that grow gradually over time. All such liabilities must be found and recorded prior to the preparation of financial statements. One common liability is created by the sale of gift cards. In today’s retail world, many companies offer these cards in hopes of increasing profits. Because a product or service must be provided when the card is presented, the company has an obligation so that a liability is reported. This liability is later reclassified as revenue when the card is redeemed because the earning process is substantially complete at that point. Revenue should also be recorded for a gift card when it becomes likely that redemption will never occur. Cards can be lost, stolen, or the customer might die or leave the area. The revenue associated with unredeemed gift cards must be reported at an appropriate point in time such as on the date of expiration or in proportion to the redemption of other cards.