© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 13 Current Liabilities and Contingencies

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 13-2 Liabilities... Resulting from past transactions or events.... Arising from present obligations to other entities... Probable future sacrifices or economic benefits...

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 13-3 What is a Current Liability? LIABILITIES Long-term Liabilities Expected to be satisfied with current assets or by the creation of other current liabilities. Current Liabilities Obligations payable within one year or one operating cycle, whichever is longer.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 13-4 Current Liabilities Short-term notes payable Accrued expenses Cash dividends payable Taxes payable Accounts payable Unearned revenues

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 13-5 Open Accounts and Notes Accounts Payable Obligations to suppliers for goods purchased on open account. Trade Notes Payable Similar to accounts payable, but recognized by a written promissory note. Short-term Notes Payable Cash borrowed from the bank and recognized by a promissory note. Accounts Payable Obligations to suppliers for goods purchased on open account. Trade Notes Payable Similar to accounts payable, but recognized by a written promissory note. Short-term Notes Payable Cash borrowed from the bank and recognized by a promissory note.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 13-6 Credit Lines Prearranged agreements with a bank that allow a company to borrow cash without following normal loan procedures and paperwork.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 13-7 Interest Interest on notes is calculated as follows: Amount borrowed Interest rate is always stated as an annual rate. Interest owed is adjusted for the portion of the year that the face amount is outstanding.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 13-8 Interest-Bearing Notes Example On September 1, Eagle Boats borrows $80,000 from Cooke Bank. The note is due in 180 days and has a stated interest rate of 9%. Record the borrowing on September 1. On September 1, Eagle Boats borrows $80,000 from Cooke Bank. The note is due in 180 days and has a stated interest rate of 9%. Record the borrowing on September 1.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 13-9 Interest-Bearing Notes Example How much interest is due to Cooke Bank at year-end, on December 31? a.$2,400 b.$3,600 c.$7,200 d.$87,200 How much interest is due to Cooke Bank at year-end, on December 31? a.$2,400 b.$3,600 c.$7,200 d.$87,200

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide How much interest is due to Cooke Bank at year-end, on December 31? a.$2,400 b.$3,600 c.$7,200 d.$87,200 How much interest is due to Cooke Bank at year-end, on December 31? a.$2,400 b.$3,600 c.$7,200 d.$87,200 Interest-Bearing Notes Example Interest is calculated as: Face Annual Time to Amount Rate maturity $80,000 9% 4/12 $2,400 interest due to Cooke Bank. Interest is calculated as: Face Annual Time to Amount Rate maturity $80,000 9% 4/12 $2,400 interest due to Cooke Bank. ×× ×× = =

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Interest-Bearing Notes Example Assume Eagle Boats’ year-end is December 31. Record the necessary adjustment at year-end. Assume Eagle Boats’ year-end is December 31. Record the necessary adjustment at year-end.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Interest-Bearing Notes Example Assume Eagle Boats’ year-end is December 31. Record the necessary adjustment at year-end. Assume Eagle Boats’ year-end is December 31. Record the necessary adjustment at year-end.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Interest-Bearing Notes Example Assume Eagle Boats’ year-end is December 31. Record the necessary journal entry when the note matures on February 28. Assume Eagle Boats’ year-end is December 31. Record the necessary journal entry when the note matures on February 28.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Interest-Bearing Notes Example Assume Eagle Boats’ year-end is December 31. Record the necessary journal entry when the note matures on February 28. Assume Eagle Boats’ year-end is December 31. Record the necessary journal entry when the note matures on February 28.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Short-Term Notes Payable Noninterest-Bearing Notes without a stated interest rate carry an implicit, or effective, rate. The face of the note includes the amount borrowed and the interest. Notes without a stated interest rate carry an implicit, or effective, rate. The face of the note includes the amount borrowed and the interest.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Noninterest-Bearing Notes Example On May 1, 2003, Batter-Up, Inc. issued a one- year, noninterest-bearing note with a face amount of $10,600 in exchange for equipment valued at $10,000. How much interest will Batter-up pay on the note? On May 1, 2003, Batter-Up, Inc. issued a one- year, noninterest-bearing note with a face amount of $10,600 in exchange for equipment valued at $10,000. How much interest will Batter-up pay on the note? Interest = Face Amount - Amount Received = $10,600 - $10,000 = $600 Interest = Face Amount - Amount Received = $10,600 - $10,000 = $600

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Noninterest-Bearing Notes Example On May 1, 2003, Batter-Up, Inc. issued a one- year, noninterest-bearing note with a face amount of $10,600 in exchange for equipment valued at $10,000. What is the implicit interest rate on the note? On May 1, 2003, Batter-Up, Inc. issued a one- year, noninterest-bearing note with a face amount of $10,600 in exchange for equipment valued at $10,000. What is the implicit interest rate on the note?

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Liabilities from Advance Collections Refundable Deposits Advances from Customers Collections for Third Parties

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Short-Term Obligations Expected to Be Refinanced A short-term liability may be reclassified as long-term if: The short-term liability is actually refinanced before the statement issue date. The expected refinancing is evidenced by good faith entrance into a long-term, noncancelable refinancing agreement with a viable lender. or

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Refinancing Agreement Criteria 1. The agreement must be noncancelable by all parties and must extend beyond one year. 2. The company must not be in violation of the agreement on the balance sheet or the issue date. 3. The lender must be financially capable of honoring the agreement. 1. The agreement must be noncancelable by all parties and must extend beyond one year. 2. The company must not be in violation of the agreement on the balance sheet or the issue date. 3. The lender must be financially capable of honoring the agreement. SFAS No. 6 requires:

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Let’s look at Contingent Liabilities

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Contingencies A loss contingency is an existing uncertain situation involving potential loss depending on whether some future event occurs.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Contingencies Two factors affect whether a loss contingency must be accrued and reported as a liability: 1.the likelihood that the confirming event will occur. 2.whether the loss amount can be reasonably estimated. Two factors affect whether a loss contingency must be accrued and reported as a liability: 1.the likelihood that the confirming event will occur. 2.whether the loss amount can be reasonably estimated.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Contingencies – Likelihood of Occurrence Probable A confirming event is likely to occur. Reasonably Possible The chance the confirming event will occur is > remote, but < likely. Remote The chance the confirming event will occur is slight. Probable A confirming event is likely to occur. Reasonably Possible The chance the confirming event will occur is > remote, but < likely. Remote The chance the confirming event will occur is slight.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Loss Contingencies Accounting Treatments

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Product Warranties and Guarantees Product warranties inevitably entail costs. The amount of those costs can be reasonably estimated using commonly available estimation techniques. The estimate requires the following entry: Product warranties inevitably entail costs. The amount of those costs can be reasonably estimated using commonly available estimation techniques. The estimate requires the following entry:

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Extended Warranties Extended warranties are sold separately from the product.Extended warranties are sold separately from the product. The related revenue is not earned untilThe related revenue is not earned until Claims are made against the extended warranty, orClaims are made against the extended warranty, or The extended warranty period expires.The extended warranty period expires. Extended warranties are sold separately from the product.Extended warranties are sold separately from the product. The related revenue is not earned untilThe related revenue is not earned until Claims are made against the extended warranty, orClaims are made against the extended warranty, or The extended warranty period expires.The extended warranty period expires.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Premiums Premiums included with the product are expensed in the period of sale. Premiums that are contingent on action by the customer require accounting similar to warranties. Premiums included with the product are expensed in the period of sale. Premiums that are contingent on action by the customer require accounting similar to warranties.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Litigation Claims The majority of medium and large-size corporations annually report loss contingencies due to litigation. The majority of medium and large-size corporations annually report loss contingencies due to litigation. The most common disclosure is a note to the financial statements. The most common disclosure is a note to the financial statements. The majority of medium and large-size corporations annually report loss contingencies due to litigation. The majority of medium and large-size corporations annually report loss contingencies due to litigation. The most common disclosure is a note to the financial statements. The most common disclosure is a note to the financial statements.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Subsequent Events Events occurring between the year-end date and report date can affect the appearance of disclosures on the financial statements. Fiscal Year EndsFinancial Statements ClarificationCause of Loss Contingency

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Generally, for unasserted claims and assessments, apply the same rules as for other contingencies. Unasserted Claims and Assessments Even claims that have not been asserted must be recorded if they are probable and the amount can be reasonably estimated.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Gain Contingencies As a general rule, we never record GAIN contingencies. Note that the prior rules have supported the recording of LOSS contingencies.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide You said that I will owe you $1,000,000 if I miss the next putt. So does that mean I have to disclose a contingent loss on my personal financial statement? End of Chapter 13