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Chapter 13
Current Liabilities and Contingencies
Characteristics of Liabilities
Result from past transactio
ns or events.
Result from past transactio
ns or events.
Arise from
present obligatio
ns to other
entities.
Arise from
present obligatio
ns to other
entities.
Probable future
sacrifices of
economic benefits.
Probable future
sacrifices of
economic benefits.
Characteristics of Liabilities:
Most liabilities obligate the debtor to pay cash at specified times and result from legally enforceable agreements.
Some liabilities may not be payable in cash in future.
A liability is a present obligation to sacrifice assets in the future
because of something that already has occurred.
What is a Current Liability?
LIABILITIESLIABILITIES
Long-term Liabilities
Long-term Liabilities
Expected to be satisfied with current
assets or by the creation of other current liabilities.
Expected to be satisfied with current
assets or by the creation of other current liabilities.
Current LiabilitiesCurrent Liabilities
Obligations payable within one year or one
operating cycle, whichever is longer.
Obligations payable within one year or one
operating cycle, whichever is longer.
Current Liabilities
Current Liabilitie
s
Short-term notes
payable
Accrued expense
s
Cash dividends payable
Taxes payable
Accounts
payable
Unearned
revenues
CURRENT LIABILITIES
GENERAL MILLS, INC. BALANCE SHEET ($ IN MILLIONS)MAY 29, 2011 AND MAY 30, 2010
ASSETS[BY CLASSIFICATION]
LIABILITIESCURRENT LIABILITIES: 2011 2010 Accounts payable $ 995.1 $849.5 Current portion of long-term debt 1,031.3 107.3 Notes payable 311.3 1,050.1Other current liabilities 1,321.5 1,769.1 Total current liabilities $3,659.2 $3,769.1
LONG-TERM LIABILITIES: [LISTED INDIVIDUALLY]
Shareholders’ equity[BY SOURCE]
Salaries, Commissions, and Bonuses
Compensation expenses such as salaries,
commissions, and bonuses are liabilities at the balance
sheet date if earned but unpaid.
These accrued expenses/accrued
liabilities are recorded with an adjusting entry
prior to preparing financial statements.
Vacations, Sick Days, and OtherPaid Future Absences
Sick pay quite often meets the conditions for accrual, but accrual is not mandatory because future absence depends on future illness, which usually is not a certainty.
An employer should accrue an expense and the related liabilityfor employees’ compensation for future absences (such asvacation pay) if the obligation meets all four of these conditions:1.The obligation is for services already performed.2.The paid absence can be taken in a later year—the benefitvests or the benefit can be accumulated over time.3.Payment is probable.4.The amount can be reasonably estimated.
Exercise 13–4Wages expense (increases wages expense to $410,000) 6,000
Liability—compensated future absences 6,000*
* ($404,000 – 4,000] = $400,000 non-vacation wages x 1/40 = 10,000 vacation pay earned
(4,000) vacation pay taken = $ 6,000 vacation pay carried over
Exercise 13–5Requirement 1 Wages expense (700 x $900) 630,000
Liability—compensated future absences 630,000
Requirement 2 Liability—compensated future absences 630,000Wages expense ($31 million + [5% x $630,000]) 31,031,500
Cash (or wages payable) (total) 31,661,500
Liabilities from Advance Collections
Refundable deposits Advances from customers Gift cards Collections for third parties
Refundable deposits Advances from customers Gift cards Collections for third parties
Customer Advance
A customer advance produces an obligation that is satisfied when the product or service is provided. Tomorrow Publications collects magazine subscriptions from customers at the time subscriptions are sold. Subscription revenue is recognized over the term of the subscription. Tomorrow collected $20 million in subscription sales during its first year of operations. At December 31, the average subscription was one-fourth expired.
($ in millions)When Advance is Collected
Cash 20Unearned subscriptions revenue 20
When Product is DeliveredUnearned subscriptions revenue 5
Subscriptions revenue 5 Common example: Gift cards. Earn the revenue when either the gift card is used or the probability of redemption is viewed as remote.
Exercise 13–6: Customer Advances (Gift Cards) & Sales taxesRequirement 1
Cash 5,200Liability—gift certificates 5,200
Cash ($2,100 + 84 – 1,300) 884Liability—gift certificates 1,300
Sales revenue 2,100Sales taxes payable (4% x $2,100) 84
Requirement 2 Gift certificates sold $5,200Gift certificates redeemed (1,300)Liability to be reported at December 31 $3,900
Requirement 3 The sales tax liability is a current liability because it is payable in January.The liability for gift certificates is part current and part noncurrent:
Gift certificates sold $5,200 x 80%
Estimated current liability $4,160Gift certificates redeemed (1,300)Current liability at December 31 $2,860Noncurrent liability at December 31 ($5,200 x 20%) 1,040 Total $3,900
A Closer Look at the Current andNoncurrent Classification
Debt that is callable by the lender in the coming year (or operating cycle, if
longer) should be classified as a current liability, even if the debt is not
expected to be called.
Debt that is callable by the lender in the coming year (or operating cycle, if
longer) should be classified as a current liability, even if the debt is not
expected to be called.
Current maturities of long-term obligations usually are reclassified and reported as current liabilities if they are
payable within the upcoming year (or operating cycle, if longer than a year).
Current maturities of long-term obligations usually are reclassified and reported as current liabilities if they are
payable within the upcoming year (or operating cycle, if longer than a year).
NOTE ISSUED FOR CASH Interest Bearing Notes:
FACE AMOUNT x ANNUAL RATE x TIME TO MATURITY On May 1, Affiliated Technologies, Inc., a consumer electronics firm, borrowed $700,000 cash from First BancCorp under a noncommitted short-term line of credit arrangement and issued a 6-month, 12% promissory note. Interest was payable at maturity.
May 1Cash 700,000
Notes payable 700,000
November 1Interest expense ($700,000 x 12% x 6/12) 42,000Notes payable 700,000
Cash ($700,000 + 42,000) 742,000
Noninterest-Bearing NoteThe proceeds of the note are reduced by the interest in a “noninterest-bearing” note.Situation: $700,000 noninterest-bearing note, with a 12% “discount rate.” The $42,000 interest is “discounted” at the outset, rather than explicitly stated: May 1Cash (difference) 658,000Discount on notes ($700,000 x 12% x 6/12) 42,000
Notes payable (face amount) 700,000
November 1Interest expense 42,000
Discount on notes 42,000
Notes payable (face amount) 700,000Cash 700,000
EFFECTIVE INTEREST RATEThe amount borrowed is only $658,000, but the interest is calculated as the discount rate times the $700,000 face amount. This causes the effective interest rate to be higher than the 12% stated rate:
$ 42,000 interest for 6 months ÷ $658,000 amount borrowed= 6.38% rate for 6 monthsx 12/6 to annualize the rate= 12.76% effective interest rate
ACCRUED LIABILITIES Liabilities accrue for expenses that are incurred, but not yet paid.
Recorded by adjusting entries at the end of the reporting period, prior to preparing financial statements.
Common examples are: salaries and wages payable, income taxes payable, and interest payable.
ACCRUED INTEREST PAYABLE On May 1, Affiliated Technologies, Inc., a consumer electronics firm, borrowed $700,000 cash from First Banc Corp under a non-committed short-term line of credit arrangement and issued a 6-month, 12% promissory note. Interest was payable at maturity. The fiscal period for Affiliated Technologies ends on June 30, two months after the 6-month note is issued.
The issuance of the note, intervening adjusting entry, and note payment would be recorded as shown below:
Issuance of note May 1Cash 700,000
Note payable 700,000
Accrual of interest on June 30Interest expense ($700,000 x 12% x 2/12) 14,000
Interest payable 14,000
Note payment November 1Interest expense ($700,000 x 12% x 4/12) 28,000Interest payable (from adjusting entry) 14,000Note payable 700,000
Cash ($700,000 + 42,000) 742,000
The ability to refinance on a long-term basiscan be demonstrated by an existing refinancing agreement, or actual financing prior to issuance of the financial statements.
The ability to refinance on a long-term basiscan be demonstrated by an existing refinancing agreement, or actual financing prior to issuance of the financial statements.
Short-Term ObligationsExpected to be Refinanced
A company may reclassify a short-term liability as long-term if two conditions are met:
A company may reclassify a short-term liability as long-term if two conditions are met:
It has the intent to refinance on a long-term basis.
It has the intent to refinance on a long-term basis.
It has demonstrated the ability to refinance.
It has demonstrated the ability to refinance.
and
INTERNATIONAL FINANCIAL REPORTING STANDARDS Classification of Liabilities to be Refinanced. Under U.S. GAAP, liabilities payable within the coming year are classified as long-term liabilities if refinancing is completed before date of issuance of the financial statements.
Under IFRS, refinancing must be completed before the balance sheet date.
Exercise 13–11Normally, short-term debt (payable within a year) is classified as current liabilities. However, when such debt is to be refinanced on a long-term basis, it should be included with long-term liabilities.
The narrative indicates that Sprint has both (1) the intent and (2) the ability ("existing long-term credit facilities") to refinance on a long-term basis.
Thus, Sprint reported the debt as long-term liabilities.
Exercise 13–12Requirement 1 Normally, IFRS requires that short-term debt (payable within a year) be classified as current liabilities.
However, when such debt is to be refinanced on a long-term basis, it may be included with long-term liabilities.
The narrative indicates that Sprint has both (1) the intent and (2) the ability ("existing long-term credit facilities") to refinance on a long-term basis.
Thus, Sprint reported the debt as long-term liabilities.
Requirement 2 IFRS requires that the refinancing capability be in place as of the balance sheet date. Therefore, given that the refinancing was not arranged until after year-end, IFRS would require that the debt be classified as a current liability.
Exercise 13
Loss Contingencies
A loss contingency is an existing uncertain situation
involving potential loss depending on whether some future event occurs.
A loss contingency is an existing uncertain situation
involving potential loss depending on whether some future event occurs.
Two factors affect whether a loss contingency must be accrued and
reported as a liability:1. The likelihood (probability) that the
confirmingevent 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 (probability) that the
confirmingevent will occur.
2. Whether the loss amount can be reasonably estimated.
KnownReasonably Estimable
Not Reasonably Estimable
Liability accrued and disclosure note
Liability accrued and disclosure note
Disclosure note only
Disclosure note only
Disclosure note only
Disclosure note only
No disclosure required
No disclosure required
No disclosure required
Estimatible (Dollar Amount of Potential Loss)
Likelihood
Probable
Reasonably possible
Remote
Loss Contingencies
A loss contingency is accrued only if a loss is probable A loss contingency is accrued only if a loss is probable and the amount can reasonably be estimated.and the amount can reasonably be estimated.
A loss contingency is accrued only if a loss is probable A loss contingency is accrued only if a loss is probable and the amount can reasonably be estimated.and the amount can reasonably be estimated.
Exercise 13-17 Brief Exercises 13, 14, 15, 16
IFRS defines “probable” as “more likely than not” (greater than 50%), which is a lower threshold than typically associated with “probable” in U.S. GAAP. If a liability is accrued, IFRS measures the liability as the best estimate of the expenditure required to settle the present obligation.
If there is a range of equally likely outcomes, IFRS would use the midpoint of the range, while U.S. GAAP requires use of the low end of the range.
Brief Exercises 17
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:
Warranty expense ......................................... $,$$$Estimated warranty liability .............. $,$$$
To accrue warranty expense.
Exercise 13-15, Brief Exercise 12
Extended Warranty Contracts
Extended warranties are sold separately from the product.
The related revenue is not earned until: Claims are made against the
extended warranty, or The extended warranty period
expires.
Extended warranties are sold separately from the product.
The related revenue is not earned until: Claims are made against the
extended warranty, or The extended warranty period
expires.
Exercise 13-16
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.
Exercise 13-19
Litigation Claims
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 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.
Subsequent Events
Events occurring between the fiscal year-end date and report date can
affect the appearance of disclosures on the financial statements.
Events occurring between the fiscal year-end date and report date can
affect the appearance of disclosures on the financial statements.
Fiscal Year Ends Financial Statements
ClarificationCause of Loss Contingency
Subsequent Events
Events occurring after the year-end date but before the financial statements can
also affect the appearance of disclosures on the financial statements.
Events occurring after the year-end date but before the financial statements can
also affect the appearance of disclosures on the financial statements.
Fiscal Year Ends Financial Statements
ClarificationCause of Loss Contingency
Unasserted Claims and Assessments
Is a claimIs a claimor assessmentor assessment
probable?probable?
Is a claimIs a claimor assessmentor assessment
probable?probable?No
Yes
NoNodisclosuredisclosure
neededneeded
NoNodisclosuredisclosure
neededneeded
UnassertedUnassertedclaimclaim
UnassertedUnassertedclaimclaim
Evaluate (a) the likelihood of an unfavorable outcome andEvaluate (a) the likelihood of an unfavorable outcome and(b) whether the dollar amount can be estimated.(b) whether the dollar amount can be estimated.
An estimated loss and contingent liability would beaccrued if an unfavorable outcome is probable and the
amount can be reasonably estimated.
Evaluate (a) the likelihood of an unfavorable outcome andEvaluate (a) the likelihood of an unfavorable outcome and(b) whether the dollar amount can be estimated.(b) whether the dollar amount can be estimated.
An estimated loss and contingent liability would beaccrued if an unfavorable outcome is probable and the
amount can be reasonably estimated.
Gain Contingencies
As a general As a general rule, we never rule, we never record record GAINGAIN
contingencies.contingencies.
Note that the prior rules Note that the prior rules have supported the have supported the recording of recording of LOSSLOSS
contingencies.contingencies.
End of Chapter 13