Chapter 13 – Current Liabilities and Contingencies BUS1 121B – Intermediate Accounting II Dr. Benjamin Anderson

Liabilities Basic element in the conceptual framework: Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

Liabilities Probable or future sacrifices of economic benefits Arise from present obligations to other entities Result due to past transactions or events

Current Liabilities Payable or result in an outflow of economic resources in one year or one operating cycle, whichever is longer Normal classification of current vs. long-term

Common Types Accounts Payable and Trades Notes Payable Informal borrowing arrangement paid under customary terms Short-term Notes Payable Formal borrowing arrangement for a short term Accrued Liabilities Expenses incurred but not yet paid Liabilities due to Advance Collections Cash receipts that result in a future payout of cash, goods, or services

Accounts Payable Accounted for in a parallel way to accounts receivable Cash discounts: use either the gross or the net method

Example Receive invoice for $50,000 inventory on May 4, 2017, terms 2/15 n/45. Pay on May 10, 2017 Pay on May 24, 2017

Short-Term Notes Payable Often occur under an existing line of credit Agreement to provide short-term financing according to certain terms Calculate interest as: Face amount*Annual Rate*Time To Maturity Recall that when the stated rate differs from the rate, then interest expense will differ from the interest paid or payable

Example 1 Bank loan of $100,000 on March 1, 2017. Interest rate is 5%, which is equal to the effective market rate and is due at maturity on October 1, 2017

Example 2 Noninterest-bearing note from bank taken on May 1, 2017. $500,000 is due on November 1, 2017. Appropriate market rate of interest is 8%.

Commercial Paper Commercial paper is when companies loan directly to each other However, typically they are backed by a line of credit at a bank Accounting is exactly the same as other short-term notes: the only difference is that the lender is not a bank.

Accrued Liabilities These are expenses that have been incurred but have not yet had a cash outflow

Accrued Interest Payable Interest payable represents cash interest that has been accrued but not yet paid Note that this will differ from interest expense when the market rate of interest differs from the stated rate

Vacations and Other Paid Future Absences If employees accrue paid vacation time which can be carried over to a following period, and some of it goes unused, then this represents a liability Calculated as the existing wage rate times amount of time off earned but not used Can be done on an individual basis or

Example Have 500 employees, which earn 2 weeks of vacation over the year. 200 have used all vacation earned in the year. 250 have used one week. 50 have used neither week of vacation. The average worker is paid $800 per week

Liabilities due to Advance Collections Liabilities can result from events where a company collects cash, but there is the requirement that, in the future, it may have to repay that cash or provide some good or service

Deposits If a company collects cash from customers that may have to be returned later, upon the completion of some event, then should be recorded as a liability

Advances/Prepayments Sometimes companies will collect cash in advance of services or goods being provided In this case, we call the liability ‘deferred revenue’ The revenue is subsequently recognized when the performance obligation(s) is(are) satisfied

Collections for Third Parties Collections which are to be remitted to another party are also liabilities Example: Company makes $1,000,000 in sales, on which it collects a sales tax of 7%

Other Matters Current maturities of long-term debt Obligations callable by the creditor Short-term obligations refinanced by long-term debt

Dollar Amount of Potential Loss Not Reasonably Estimable Loss Contingencies Contingencies arise due to an existing, uncertain situation involving potential loss depending on whether some future event occurs Dollar Amount of Potential Loss Known Reasonably Estimable Not Reasonably Estimable Likelihood Probable Liability Accrued and Disclosure Note Disclosure Note Only Remote No Disclosure Required

Product Warranties and Guarantees Accruing for product warranties and other guarantees is an example of accruing for a type of loss contingency If the liability will be resolved within one year and there is a single ‘most probable’ amount, then we

Example Excellent Electronics sells home electronics products, which are covered by a one year warranty against defects. In 2016, it sold $22.5 million in electronics and had $200,000 in warranty costs this year. Internal analysts expect warranty costs to equal 2.5% of sales

Multiple Possible Amounts Sometimes, instead of a single expected outflow, there are multiple with certain probabilities In this case, we use the expected value of the expected outflow

Example Adequate Accentures sells used furniture, which are covered by a one year warranty against defects. In 2017, it sold $30 million of furniture and had warranty expenses of $150,000 40% chance that warranty costs are $400,000, 35% chance that they are $500,000, and 25% chance that they are $550,000

Multiple Years until Payment When more than one year will pass until the liability is resolved, then we must consider the time value of money as well

Litigation Litigation represents a potential future loss for companies However, most companies do not accrue losses related to litigation Often even after losing a lawsuit, so long as it’s in appeal

Subsequent Events Companies must accrue for or disclose contingencies which become evident following the financial statement end date If the financial statements have not yet been issued

Unasserted Claims If it is probably that the claim will be asserted, then the claim must be treated as though it has been asserted, even if one has not yet been For example, fines and penalties due to environmental regulations

Gain Contingencies Never accrued Disclosed when future realization is probable