Quiz 7: Accounting for and Presentation of Liabilities

The company is receiving rent from its tenants which is accounted as part of its revenues. If the tenant pays rent every month, it will add to the cash account balance and will also increase the revenue. • However, in the given situation, the tenant has pre-paid three months of rent in advance. Though the entire three months rent is part of the revenue of the company, it cannot be accounted as revenue on the month it was received. This requirement is due to the matching concept. • The company earns its rent only when the tenant uses its property. Since the tenant is paying rent in advance, an income has occurred that pertains to some future period. As per accounting principles, revenue should be accounted only when it is due. Future income cannot be accounted in current period. • However, the company has to account for the cash received which increases the cash account balance. The contra entry cannot be on the revenue account as it will mis-represent actual revenue for the period. • For example, if the account is closed at the end of December, 2016 and profit and loss account statement is created, it will show a higher income to the extent of two months advance rent. • Hence, the advance rent needs to be considered as a liability since the company is yet to perform for the revenue involved. To resolve this issue, a liability account termed "Unearned Revenue" is created to which the advance rent is credited. • As and when the rent becomes due and revenue can be recognized, this account is debited and revenue account is credited. The impact on the financial statements is as shown below: a. The three months of rent collected in advance on December 1, 2016: On December 1, 2016, no rent is due and hence no income can be recognized. So, the entire $25,800 should be credited to the Unearned Revenue account. The entry to record this transaction will be as follows: The above accounting entry implies that cash has been received for $25,800 and a liability in terms of unearned revenue has been created for the same amount. b)The adjustment that will be made at the end of each month to show the amount of rent "earned" during the month. At the end of the December, 2016, the rent for the month of December will be due which can be recognized as revenue. Hence, the revenue account should be credited to the extent of one month's rent. The same amount should be debited to the liability account. The unearned revenue liability does down to the extent of revenue recognize. One month rent due that can be recognized as revenue = = $8,600 Accounting entry recorded at the end of December will be as follows: Similarly, at the end of next two months, the same accounting entry will be passed. Thus, at the end of three months, the entire three month advance rent of unearned revenue account would have been recognized as income in revenue account.

For the period ended on June 25, 2016, the company should recognize an expense due to pay roll in terms of gross pay amount of $28,600. Since the amount is not paid immediately from the cash account, the amount should be recognized as part of the liability accounts. This means the expense account goes up by this amount while the liability account also increases by the same amount. Whenever the actual payment is done to the employees, the cash will decrease by that amount thereby also reducing the liability. • The entire gross amount is not the actual wages payable to the employees. The employees will be paid only the net pay amount. Hence, only the net pay should be recorded as part of the wages payable liability account. • The rest of the amount should be recorded as part of the withholding liability accounts. The amount from the gross pay is withheld and added to respective withholding liability accounts. • For example, the medical insurance contributions should go to the medical insurance payable account. Whenever the company pays medical insurance on behalf of the employees, the cash will decrease while reducing the medical insurance payable account. The other components of the gross pay will also be treated in the same manner. The impact on the financial statements will be as shown below: The accounting entry to record the payroll accrual will be as follows: The above accounting entry recognizes the payroll expense applicable for the period thereby impacting the income statement. The respective liability accounts impact the balance sheet which will show that quantum of liability in terms of pay roll expenses. As and when actual cash payment is made, the respective liability accounts will be reduced to the extent of cash disbursal.

While recognizing the revenue pertaining to sales during a period, the expenses due to possible warranty claims should also be accounted in order to present a realistic profit and loss statement. The expenses due to warranty related claims can only be estimated. These estimated expenses appear as debits in the income statement pertaining to the period during which the sales have occurred in accordance with the matching concept. A provision or liability account is created which will be credited by the provision amount. Whenever claims are settled, the related expenses are debited to the warranty provision account reducing the liability and cash accounts. a. Prepare Warranty expense on income statement: The company expects warranty claims to an extent of 1.5% of sales during the period. The sales during the year were $2,600,000. Hence, there should be a warranty provision to the extent of 1.5% of $2,600,000 equal to $39,000 in the estimated warranty liability account. The amount of provision to be made for the year will be the warranty expense applicable for the year. This provision should be recognized as expense in the income statement as explained above. Hence, an expense of $39,000 will appear in the income statement for the year ended December 31, 2016. b. Actual costs of servicing the products: Whenever a warranty claim is made, the related cash expense is debited to the warranty liability (or provision) account. Hence, the balance in the warranty provision account keeps decreasing during the year till provision for the current year is made at the end of the period when the sales revenue is recognized. The difference between year-end balance and opening balance of the account should be equal to the actual warranty costs during the period after adjusting for the provisions made. The servicing costs can be derived from the following relationship: Year-end balance of warranty liability account = Opening balance - Servicing costs during the year + Provision made for the year Servicing costs = Opening balance - Year-end balance + Provision made for the year Year-end balance = $34,400 Opening balance = $25,000 Provision made pertaining to sales during the year = $39,000 Actual warranty costs or servicing costs = 25,000-34,400+39,000 = $29,600 Hence, the actual costs of servicing products under warranty during the year ending December, 2016 was $29,600

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