Chapter Twelve Current Liabilities and Contingencies

12 - 2Copyright © Houghton Mifflin Company.All rights reserved. Current Liabilities Economic obligations that are expected to be liquidated using current assets or refinanced by other current liabilities during the normal operating cycle, or within one year of the balance sheet date, whichever is longer Accounts payable Notes payable within one year Dividends payable Advances from customers or collections Accrual for salaries, wages, commissions, rents

12 - 3Copyright © Houghton Mifflin Company.All rights reserved. Accrued Liabilities Record expenses that have been incurred but not yet paid (accruals) Salaries Taxes Interest At year end, record the accrual for any unpaid expenses. Assume you have received a utility bill for $250, but have not yet paid it: Utilities Expense xxx Utilities Payable xxx

12 - 4Copyright © Houghton Mifflin Company.All rights reserved. Deferred Liabilities Adjust for amounts that have been received but have not been earned as of the end of the period (deferrals or unearned income) Advances from customers Refundable deposits When advance payment is received: Cash xxx Deferred Revenue (or Unearned Income) xxx Income (or Revenue) xxx At year end, record amount earned:

12 - 5Copyright © Houghton Mifflin Company.All rights reserved. Employee-Related Liabilities Amounts owed to employees or other entities at the balance sheet date, but not yet paid Reflected as current liabilities Wages and salaries Payroll deductions for taxes, insurance, or union dues Bonuses Compensated absences

12 - 6Copyright © Houghton Mifflin Company.All rights reserved. Compensated Absences Vacation and sick pay that are expected to be paid out in future periods The employer is expected to accrue a liability for compensated absences if all of these conditions are met: Employee has rendered service required to earn the benefits. The obligation relates to rights that accumulate or vest. Payment of compensation is probable. Amount of liability can be reasonably estimated.

12 - 7Copyright © Houghton Mifflin Company.All rights reserved. Calculating Vacation Pay Accruals Illustration: Assume that Nichols Co. has 50 employees during Each employee earns 10 days of vacation pay per year. Assume that each employee’s salary rate during 2005 is $100 per day and vacation days can accumulate and be used in future years. Accrue vacation pay at December 31, 2005 Payroll Expense (50 x 10 x $100) 50,000 Vacation Payable 50,000 Ten employees use all vacation days in When they are paid their vacation pay, record this entry: Vacation Payable (10 x 10 x $100) 10,000 Cash 10,000

12 - 8Copyright © Houghton Mifflin Company.All rights reserved. Calculating Vacation Pay Accruals (continued) Illustration continued: Assume that the other 40 employees use all vacation pay in 2006, when the salary rate is $105 per day. When the vacation is taken, record this entry: Vacation Payable (40 x 10 x $100) 40,000 Payroll Expense (40 x 10 x $5) 2,000 Cash (40 x 10 x $105) 42,000

12 - 9Copyright © Houghton Mifflin Company.All rights reserved. Calculating Sick Pay Accruals If sick pay vests (employee can be paid for unused days when he or she leaves the company), then sick pay must be accrued. If sick pay does not vest, no accrual is required. Sick pay is conceptually different from vacation pay since sick pay is dependent on a future event (illness). Vacation pay is earned as a result of past service.

Copyright © Houghton Mifflin Company.All rights reserved. Short-Term Obligations to Be Refinanced Loans or obligations that are due within one year but that may not be paid off with current assets when due Obligation expected to be refinanced can be excluded from short-term liabilities if intent and ability to refinance are present. Example: ABC Co. has a loan due 1 year from balance sheet date. The loan is part of a revolving credit arrangement. Thus, ABC can refinance the loan when it becomes due.

Copyright © Houghton Mifflin Company.All rights reserved. Demonstrating the Ability to Refinance 1.If a company issues a long-term obligation or equity securities after the balance sheet date but before the statements are issued, it has demonstrated the ability to refinance. 2.If a company signs a financing agreement before the balance sheet date that clearly permits the refinancing of the short-term debt, the company has demonstrated the ability to refinance.

Copyright © Houghton Mifflin Company.All rights reserved. Contingencies 1.As of the balance sheet date, an event must have occurred or a condition must be in existence. 2.The outcome of that event or condition must be dependent upon a future event. An existing situation, condition, or set of circumstances involving uncertainty that will be resolved when one or more future events occur

Copyright © Houghton Mifflin Company.All rights reserved. Examples of Contingencies Lawsuit filed but not settled Collectibility of receivables Obligations for product warranties or guarantees Threat of expropriation of assets Pending or threatened litigation Guarantees of the indebtedness of others Actual or possible assessments or claims

Copyright © Houghton Mifflin Company.All rights reserved. Contingency Issues to Consider If a contingency exists: 1.Should the company recognize an amount as a liability? 2.How likely is the potential of a loss? 3.How much should be recognized as a liability? 4.How should a loss contingency be disclosed? 5.Are gain contingencies recorded?

Copyright © Houghton Mifflin Company.All rights reserved. Loss Contingencies Existing circumstances involving a potential loss that hinges on some future event If a contingent item is both a loss contingency and is material, a liability should be accrued if: 1.The loss is probable. 2.The amount can be reasonably estimated. Requires accountants to exercise professional judgment

Copyright © Houghton Mifflin Company.All rights reserved. Disclosure of Loss Contingencies If contingency is probable… Accrue as a liability, disclose details in notes to financials If contingency is reasonably possible… If contingency is remote… Do not accrue as a liability, but disclose in notes to the financials Do not accrue as a liability or disclose in notes

Copyright © Houghton Mifflin Company.All rights reserved. Warranties An implied or expressed promise by the seller to compensate the buyer for a deficiency in the product Usually involve a promise to replace or repair the product if deficient; or may involve a promise to pay a certain dollar amount

Copyright © Houghton Mifflin Company.All rights reserved. Warranty Liabilities If amount of liability can be reasonably estimated at the time of the sale, report as follows: When the credit entry is made to record the liability, the debit is normally made to an expense account. Current liabilities: Any portion of the liability expected to be paid within one year of the balance sheet date Long-term liabilities: Remainder of liability not expected to be paid in one year

Copyright © Houghton Mifflin Company.All rights reserved. Warranty Liabilities Illustrated Illustration: Assume that BigCar Co. sells 100 cars for $30,000 each during Each car has a warranty that covers repairs for the first three years or 36,000 miles. Based on past history, the company estimates that repairs are 2 percent of sales. Record the following warranty liability for 2005: Assume that during 2005, repair costs on current-year sales were $26,000. The costs should be recorded: Warranty Expense ($3,000,000 x 0.02) 60,000 Warranty Liability 60,000 Warranty Liability 26,000 Cash, Parts Inventory, or A/P 26,000

Copyright © Houghton Mifflin Company.All rights reserved. Cash Warranty Liabilities Illustrated Illustration: Assume that BigCar Co. sells 50 extended warranties in 2005 for $1,000 each. The warranty covers repairs for two years after the basic three-year warranty/36,000-mile warranty has expired. Record the sale as follows: At year end 2008, $20,000 of repair costs were incurred under the extended warranty agreements. BigCar should record: Cash 50,000 Extended Warranty Liability 50,000 Warranty Expense 20,000 Cash, Parts Inventory, or A/P 20,000 Extended Warranty Liability ($50,000 x ½) 25,000 Warranty Revenue 25,000

Copyright © Houghton Mifflin Company.All rights reserved. Premium or Coupon Offers Premium or coupon offers represent the creation of a contingent liability If a company sells products that include a coupon to purchase other products at a discount, the company has an obligation to sell to the customer at a discounted price. At year end, the company must estimate the number of coupons that will be redeemed and the cost of the product to be sold to establish the liability. Expense for Coupons to Be Redeemed xxx Estimated Liability for Coupons xxx

Copyright © Houghton Mifflin Company.All rights reserved. Gain Contingencies Uncertain situations that may result in a claim to an asset or a reduction in a liability Gain contingencies should not be recorded because revenue should not be recognized prior to its realization. Evidence of the conservatism principle in accounting

Copyright © Houghton Mifflin Company.All rights reserved. Liquidity Analysis and Current Liabilities Current Ratio = Current Assets  Current Liabilities Identifies the amount of current assets available to continue business operations Identifies how well a company is able to meet its current obligations Working Capital = Total Assets – Total Liabilities

Copyright © Houghton Mifflin Company.All rights reserved. Window Dressing Refers to inappropriate actions taken by management at the end of an accounting period to make the company’s financial ratios appear more favorable than they actually are.

Copyright © Houghton Mifflin Company.All rights reserved. Cash Flow and Current Liabilities An increase in a current liability account indicates that less cash was paid and should be deducted on the statement of cash flows A decrease in a current liability account indicates that more cash was paid and should be added on the statement of cash flows Most current liabilities are related to operating activities When determining actual cash flows for current liabilities, examine the balances of all current liability accounts

Copyright © Houghton Mifflin Company.All rights reserved. Check Your Understanding QWhat journal entry is generally made when cash is received in advance but has not yet been earned? ADebit Cash; Credit Deferred Revenue (or Unearned Income)

Copyright © Houghton Mifflin Company.All rights reserved. Check Your Understanding QWhen a company carries a short-term loan that it expects to refinance, how does it demonstrate the ability to refinance? A(1) By issuing a long-term obligation or equity securities to replace the current debt after the balance sheet date but before the issuance of the financial statements, or (2) By signing a financing agreement before the balance sheet date that permits the refinancing.

Copyright © Houghton Mifflin Company.All rights reserved. Check Your Understanding QIf a contingent loss is probable and can be reasonably estimated, how should it be recorded and/or disclosed? AThe contingent loss should be reported as a liability, and the details of the liability should be disclosed in the notes to the financial statements.

Copyright © Houghton Mifflin Company.All rights reserved. Check Your Understanding QHow are gain contingencies accounted for? AGain contingencies should not be recorded because revenue should not be recognized prior to its realization.

Copyright © Houghton Mifflin Company.All rights reserved. Check Your Understanding QWhat journal entry is generally made to record product warranties included in product sales? AIf the amount can be reasonably estimated, debit Warranty Expense and credit Warranty Liability

Copyright © Houghton Mifflin Company.All rights reserved. Check Your Understanding QWhat is window dressing in relation to financial statement presentation? AWindow dressing refers to inappropriate financial actions taken by management at the end of a fiscal period to make the financial ratios appear more favorable.

Copyright © Houghton Mifflin Company.All rights reserved. Check Your Understanding QHow would an increase in a current liability account be treated on the statement of cash flows using the indirect method? AAn increase in a current liability account indicates that less cash was paid and should thus be deducted on the statement of cash flows.

Copyright © Houghton Mifflin Company.All rights reserved. Check Your Understanding QAre current liabilities generally related to operating, financing or investing activities? ACurrent liabilities are most often related to operating activities.