 Hello and welcome to this session. This is Professor Farhad and this session we would look at estimated liabilities. This topic is covered in the introductory accounting course as well as the CPA exam. As always I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,600 plus accounting, auditing, finance and tax lectures. This is a list of all my lectures. If you like my lectures, please like them, share them, put them in playlists, subscribe. If they benefit you it means they might benefit other people so share the wealth especially nowadays with the coronavirus out there and please connect with me on Instagram. On my website farhadlectures.com you will find additional resources if you are looking to supplement your accounting education and or study for your CPA exam. Please check out my website for additional resources. So what are estimated liability? Well we talked about liabilities earlier and we know that a liability is something that you have to pay in the future. Usually you know the amount when you have to pay it and how much. There are some liabilities that we don't know all three components. What are the three components? You know how much? How much you have to pay when and for what purpose? So basically you know those three and you know the amount of course how much. So an estimated liability you might have a known liability. You know you have a liability but the amount is uncertain. So the amount you really don't know are you going to pay $10, $10,000 or $10,000,000 but that number can be reasonably estimated. What are some examples? Pensions when you have employees, health care, vacation pay and warranty. So in this session we would look at those what we call estimated liabilities starting with health and pension benefits. So when we talk about health and pension benefit think 30, 40 years down the road. These are retirees. They are working right now. So these four individuals are young individuals who are working right now but maybe 30 to 40 years from now they will be sitting on the beach in Florida and they're getting their pension and they have their health insurance covered. So what's going to happen is this as they work now so as they work now the employer will have to record the expense. Why? Because you have to record the expense when it's accruing. The expense is accruing now as they work now for the company. The company will have an obligation for the future therefore what we have to do we have to record the expense now. So employer expenses for pension or medical, dental, life and disability insurance is an example of that estimated liability. So let's assume to kind of show you how it works. Assume an employer agrees to pay an amount for medical insurance equal to 8000 and contribute an additional 10% to the employer 120,000 gross salaries to a retirement program. So what happened is this we're going to contribute, we're going to have to contribute 10% of their salary which is 12,000 and we're going to have to incur we think we're going to have to incur 8,000 in medical insurance. Now this 8,000 may not be accurate. Why? Because we don't know how much it's going to cost but we think 8,000 should cover the medical insurance down the road. So that's why they are called estimated liability. So what do we have to do when that happened? What do we have to do? We have to debit employee benefit expense some sort of an expense account. So we're going to call it employee benefit expense. So notice we debit an expense for a total of 20,000 we credit employee medical insurance payable. Because remember we're going to have to come up with $8,000 down the road to pay for their medical insurance or we think that's how much we're going to end up paying and we're going to have to contribute 10% of their salary 10% of 120 is 12,000 to a retirement program. So all in all they are working now we take the expense now we take the expense now we may not have to pay this until I don't know 30 years later I don't know how long it's going to take 40 years later 25 years later depending on one day depending on one day when they retire. So when they retire we don't really have an expense all what we do when they are retired we have to fund we have to fund the liability we have to pay the liability so we record the expense now for a liability that's going to be paid who knows when down the road. Another example of estimated liabilities is vacation benefit. So when you work for a company and you take a vacation what happens is as you're taking the vacation you're getting paid but you are not really producing when you're taking the vacation you took the vacation you really earned your vacation when you are producing when you are working so when you are when you are on vacation you are not really working so you're not really incurring an expense so let's assume to see how we do this from an accounting perspective assume an employee earned two weeks of paid vacation each year so you work for the company for two years for a year and for every year you earn two weeks so by December 31st let's assume you worked one year and because you work one year you earned two weeks of vacation now you did not take the two weeks because you earned them you earned them now what happened the company will have to record those two weeks as an expense in this year so this is year one okay so in year one you worked the full year and you earn two weeks of vacation that you might be able to take in either year two usually in year two you're going to be able to take in year two what's going to happen let's assume for two weeks you're going to be paid 3200 so what's going to happen is this the company will have to debit vacation benefit expense some sort of an expense 3200 by December 31st so by the end of the year what we have to do is we have to record the expense we have to record the expense although you did not go on vacation all what you did is you earned your vacation as you earned your vacation the company incurred an expense so the company will debit vacation expense and they will credit vacation payable now when you go to disney when you go to disney what's going to happen when they're paying you when you're in disney what's going to happen it's not an expense anymore let's assume you took 400 of that vacation so far you did not take the full thing therefore they will debit vacation benefit payable 400 and they will credit cash so when you are in disney and you're getting paid well it's not an expense for the company why because the expense they already they already recorded your expense when you have earned it and the reason why they have to record the expense let's assume you leave the company you don't even go on vacation they still have to pay you that money therefore the company will have to record an expense whether you took the vacation or not yet so this is what we mean by estimated liability but we have i'm sorry estimated liability also basically an estimated expense as well another example of of estimated liabilities is bonus plan what is a bonus plan is when the company reward you for your work now here's what happened the company usually uses the profit for example the the company made a profit of let's just assume a hundred thousand dollar and they say because we made a profit of a hundred thousand dollar you're the manager you're gonna get ten percent so it's gonna get ten thousand dollar now what's gonna happen is this the company year end is December 31st but the company don't know exactly the profit maybe until March 1st when they prepare their financial statements so what's gonna happen at December 31st they will estimate and we might be we might make a hundred thousand but they really not sure 100% therefore what they do is they debit an expense bonus expense of ten thousand credit bonus payable now when they pay you the payable in March you know maybe a little bit more than ten thousand a little bit less than ten thousand but they think it's gonna be around ten thousand therefore what we did is we recorded the expense when it took place it took place at the end of the year when you earned it when you earned it when you earned the when you earned it when you earned the bonus although you know it's not paid until March because you earned it for the year it has to be expense during the year not when when paid another common or classic estimated liability is warranties now what are warranties think about when you buy a car when you buy a car you may get a warranty with that car or when you buy some sort of tv or electronic equipment so how does it work how how do warranties work well what's a warranty it's the seller's obligation to either replace or fix a product or service that fail to perform as expected so the product did not perform as you thought it will be or it you know they need to fix it so the seller report expected warranty expense in the period when the revenue from the sale is reported let's assume this is 2020 this is 2020 this family purchased the scar now the this is 2020 so the sale took place in 2020 now with this car comes a warranty so also this car is guaranteed for three years anything that happened they will you know replace or they make you hold what's going to happen is this so it's 21 22 and 23 so it's covered for 21 year 22 and year 20 23 now what's going to happen is this when we sell the car when we sell the car in 2020 we have to report the expense although the expense may not take place till 2021 2022 or 2023 it does not matter we report the expense in the year the sale took place so we can match the revenue with the appropriate expenses we have to match the revenue with the appropriate expenses therefore we would report it as a liability as an estimated liability now the best way to illustrate this is to actually work an example to see how this estimated warranty liability work let's assume on December 31st a dealer sells a car for $16,000 with a maximum one year or 12 000 miles warranty covering parts past experience indicate that warranty expense average four percent of the car selling price so we sold the car and with that car comes a one year warranty anything happened to that car within one year we are responsible for it okay so first let's record the sale we debit cash credit sales debit cost of goods sold credit inventory and how did they come up with this 10 000 just assume the dealer paid 10 000 for the car so the dealer sold you a car for 16 000 which they paid 10 000 now they're not done this is this took place on December 1st also on December 1st what's going to happen is we're going to have to estimate our warranty it's 16 000 times four percent based on our experience we usually incur four percent of the selling price for the vehicle and that's going to be $640 on that same day we will debit on the same day we'll debit warranty expense we will debit an expense of 640 credit estimated warranty liability of 640 so what we did is we recorded the expense in the same period that the sale took place so the sale took place December 1st the expense took place December 1st now on January 9th 2020 a year later in the following year the customer returned the car for repair and the dealer replaced a part for $200 at this point we don't have an expense because we already took the expense at the when when we sold the car therefore what we do is we debit estimated warranty liability 200 and we gave them a part you know we credit our parts inventory 200 that we gave them cash we credit cash if we assign an employee to work we you know we we assign that payroll expense that payroll payroll payable which is our cost for our payroll so whatever we did give them we have to credit so basically this is how warranties work now you might be saying what happened because if you notice we have 640 in warranty so what happened to the warranty account is this we had 640 and we and we only incurred 200 it means it means we still have 540 so a year later if nothing happened we just basically removed this warranty we basically how do we remove it we reverse the entry one way to do it is to reverse the entry to reverse so debit warranty expense debit warranty i'm sorry debit warranty payable and credit warranty expense for the 440 or sometime what we do we might have other cars where they went over the warranty so we cancel those against each other so how the company does this depending on the company's policy but this is how we deal with warranty liability and the next topic we would look at contingent liabilities and times interest ratio as always i would like to remind you to like this recording subscribe and if you're looking for additional resources please visit my website farhatlectures.com especially if you're studying for your cpa exam it's worth it it's you need those seven to ten extra points to pass your exam and stay safe during the coronavirus outbreak good luck and study hard