Estimated Liabilities Financial Accounting CPA Exam FAR Ch 11 P 3

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“And welcome to this session in which we would look at estimated liabilities in the the prior session. We looked at known liabilities now we re going to be look estimated liabilities. No liabilities are liabilities that we know the amount the amount and the time and to whom we are paying estimated liabilities are little bit different as the word suggests they are estimated they are not they are not 100 known so let s take a look to see what are some examples of estimated liabilities common examples are bonus bonus vacation pay health and pension expense as well as warranty a business may know that a liability exists. So they know in the future.

They re gonna have a liability. But they don t know the exact amount so what do they do they will estimate so they will estimate the liability so here s what s gonna happen we re gonna debit in expense and we re gonna credit a liability and we could say this is an estimated expense and an estimated liability. It doesn t matter if you add the word estimated or not we re gonna debit an expense we re gonna credit a liability and this is the form that those liabilities take okay so it must estimate the amount of the liability. And reported on the balance sheet again we re going to look at four examples the first example.

We re gonna look at is bonus bonus plane. What is a bonus plane basically the company wants to compensate their employees. So what do they do they they reward them they said if we earn a certain profit you ll get a certain percentage of that profit. Why is because they want to they want to encourage your employee to work harder for the company so here s what s gonna happen smart touch learning estimate that it will pay five percent bonus on the annual net income after deducting the bonus.

So it s not it s not three fifteen times five percent. That s not the answer so it s after deducting the bonus. It s it s it s five percent. So let s take a look at the formula first on how to calculate the bonus because you need to know how to do this because some students they just take the three fifteen times five percent and said well we don t get it well here s how you here s the formula for the bonus calculation.

Okay and here s the formula so the formula is this to figure out your bonus to figure out the bonus. You will take the bonus percentage. Which which is for our purposes. It is five percent.

It is five percent then from the bonus percentage. You ll think to find out the bonus. You will take the bonus percentage. Which is five percent then you.

Multiply it by x net. Income then you divided by 1 plus 005. So remember the formula allows you to back out the bonus amount. So this formula because.

Remember your bonus is based on the amount after the bonus. So you have to take into account how much so what s gonna happen is this your bonus is five percent then you will take net income. Okay net income before the bonus then you ll divide this by 1 plus d at the percentage. So this is the formula this formula allows you to back out the bonus amount for example net income minus the bonus so notice what s gonna happen three hundred and fifteen thousand minus.


Fifteen thousand okay the bonus is fifteen thousand so this is going to give us a net income of three hundred thousand okay the bonus is three hundred thousand so the bonus of fifteen thousand is really five percent of three hundred thousand because we have to back out the bonus out of the income so if we take three hundred thousand times five percent that s gonna give us fifteen thousand. But to figure out the three hundred thousand you have to use this formula. So you will take the bonus amount. Which is five percent multiplied by the net income before the bonus.

The net income before the bonus before we deduct the bonus it s given at 315 then you will take one plus. The bonus one the number one plus. The bonus of five percent. So this is how we figure out the bonus.

So we need to figure out the bonus before before net income before the. Bonus nothing. Come before the bonus is 300000. Okay.

So again just use the formula. And it will work fine it should work now the journal entry we debit an expense of. 15000 and we credit a liability of 15000. Now remember this is an estimate.

Why is this an estimate because net income could change this net income could change they re estimating that the company report net income. But that net net income could change. Okay why because you know there is an expense. They did not account for there s a revenue.

They did not account for remember they re making this entry december 31st. But really the company don t know exactly what their net income is net income is until maybe one month or sometime two months after year end so. The company really don t know their net income bad or estimating assuming that income is 350. Now if net income changes you would use you would change it and you will change the estimate.

Okay. But this is an estimated liability. Another estimated liability is vacation. Health and pension benefit vacation is basically vacation.

Time health is health insurance and pension is when they pay you money. After your. Retirement cabe businesses typically offer. Vacation health and.


Pension although in the us. Pension. Is going away less and less well a lot of companies don t offer pension anymore. Even the government they re cutting down on the pension.

So a pension plan provides benefit to retire the employee smart touch learning that the cost of providing vacation benefit is 1000. Per month. So here s what s going to happen as the employees work again this has to do with the matching principle as the employee work for the companies. So as the employee work so you go to work and you work for one month.

Okay here s what s gonna happen as the employee work for one month they qualify for all of them for the company for 1000. Vacation benefit so as they work they qualify for the benefit so as the employee would the company will assume for every month that the our employees work now if they take a vacation. We have to pay them salary and that sally it s gonna cost us 1000. Now we don t wait until they take the vacation.

We don t wait until they take the vacation because they may not take the vacation until maybe six and the neck six months from now well we don t wait what companies do they accrue their expenses so they estimate that they re gonna have 1000. They don t wait until the until the vacation is taking the employee vacation. Expense is accrued so they will debit an expense and the credit a liability so they don t wait they record that ahead of time because they know the employee now qualify for it. But when is the employee going to take this vacation.

We don t know now once the once the employee goes on vacation we debit a vacation benefit payable that that week that they go on vacation and we credit cash for a thousand so when they go on vacation it s the expense was already recorded so we debit vacation benefit payable and we credit cash why because we estimated the expense before it happens and this is specially important december. Usually the companies don t do this until december 31st. At year end they will sit down and they will estimate how much vacation benefit they will they re gonna be responsible for so that s another estimated liability. And another estimated liability could be a pension or health benefit.

Let s assume pension also the company. What would they have to do the pension is not paid until maybe 10 15 years from now because if a company have a pension. The employees are working now so employees working now the employees are working now and pension is paid 20 years from now so here s what s gonna happen every every year the employee work here one every year. The employee would the company will have to estimate because the employee worked for one year we have to estimate now we re gonna have to put away 5000.

For pension and this is not gonna be due until 20 years from now but regardless today we will debit pension expense again this is a simplified version of it credit pension liability for five thousand so they will credit the liability they will estimate the liability for 20 years down the road. Why because they re responsible for it now assume in this this employee left the company then there s adjustments. We have to make but remember those are expenses that they re gonna have to be paid in the future. So the company record the expense and the liability.

Today and those are again examples of estimated liabilities. Another example of estimated liability. Another example of estimated liability. Let s take a look at it is warranty.


Let s take a look at a warranty example in warranty. It s much easier for you to understand okay assume that smart touch learning made made sales on account for 50000 constant 35000 subject to warranties on debts on june. 10th so we made sales of 50000. The cost of the sale was thirty five thousand and the estimated warranty is three percent.

So let s take a look at the journal entries well account. Receivable. First account. Receivable is debited sales.

Is credited. So this should be straightforward. Five thousand cost of goods sold is debited sales is credited that this is the cost of the sale. Now what we are told in this problem.

We are told that there is a three percent warranty three percent warranty expense now this warranty may not happen today it may happen next year that may never happen. But what we have to do on the same date notice. June. 10th june 10th on the same date.

We have to estimate the warranty we have to also the book warranty expense 1500 warranty payable 1500 why because the sale took place i m not sure what year is this let s see if they re giving us the year. It doesn t matter. Let s assume here. Let s assume this is here 2017.

So the sale took place in 2017. So we recorded the sale of 50 thousand. We also recorded cost of goods sold of 35 thousand because that s related to the sale also what s related to the sale is warranty warranty expense of 1500. Now this warranty expense.

So the customer may not come back until 2018 or 2019. So the customer may not come back depending on the warranty. Let s assume. It s a 3 year warranty they may not come back until 2019 for the service.

It doesn t matter we have to record the expense in the same period. We have to record the expense in 2017 once again this has to do with the matching principle record the sale and the expenses in the same period. Therefore you would record the sale and the expense in the same period in this notice. It s a june 10th june 10th june 10th.


Note. The customer is happy with the product. But we have to estimate because based on past experience. We re going to incur a 3 warranty expense ok so this is called an estimated liability.

This is an estimated liability now what happened is this what happened if the customer comes back later for for warranty work assume that the customer makes claim that must be honored through the warranty offered by the company the warranty costs totaled 800. An hour made on june 27th. So while we made the sale on june on june 10th on june 27. Little bit over two weeks.

The customer comes back and we need to honor 800 guess what when we do this we debit estimated warranty payable 800 credit merchandise inventory if we gave the customer cash we credit cash okay assuming we gave the customer cash. But here we are assuming that we gave the customer. What we gave that we replaced a product. So we gave the customer 800 now bear in mind.

What s important here is to keep track of your warranty liability. Why because you estimated 1500. This was june 10th. Then on june 27th you debited this 800.

This was june 27th. So you still have 700 credit balance. That means you are still over your estimate. You did not blew through your estimate.

So if a customer comes back you know for five hundred dollars you d have an estimated warranty payable and you credit merchandise inventory or cash or whatever you incur to service to honor this warranty okay. But if you go over your estimate. Then you will either have to increase this if let s assume you find out that this was not enough. 3 was not enough then what you do you will debit an expense again let s assume 2000 and you credit estimated warranty payable 2000.

If you felt that the 1500 is not good enough you need to increase it you need to increase it okay once and sometime. What happened what would happen if you if you go over it then the company will start to record an expense then they will fix it next year. We don t have to worry about next year. But remember if you have a credit balance that means you have you overestimated your expense.

And this is those are all estimated liabilities warranties vacation. Expense those bonus plans the next topic. We re going to look at is not estimated they re called contingent contingent so if you have any questions any comments by all means email me or ” ..


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